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Earlier chapters explained how a few simple resources lie at the heart of any organization, determining how it performs through time. These systems contain people, though, and people have feelings and capabilities that determine how they behave: doing more or less of what you would like, or deciding to change from one state to another. This chapter explains the following:
• why intangible factors matter, and what you can do to understand, measure, and manage them
• how intangibles behave through time, responding to influences from elsewhere
• the impact of capabilities in driving business performance
• how intangibles influence the core architecture of simpler tangible factors
08: Intangible Resources and Capabilities
Soft factors play a crucial role in competitive performance—motivated staff are more productive than those with poor morale, a strong reputation in the market helps customer acquisition, a charity that enjoys its donors’ commitment will raise money more easily, and a political party with stronger support among the electorate will get more votes. If we are to improve performance over time, then we have no choice but to understand how to assess and influence these soft factors (Carmelli, 2004; Hall, 1992). The logic is unavoidable:
• Performance at each moment depends on the tangible resources you can access.
• The only way to change performance is to build and sustain these resources.
• So, if soft factors are to make any difference to performance (which they clearly do), they must do so by affecting your firm’s ability to capture and hold on to these same tangible resources.
Unfortunately, intangibles can be tough to manage. You may easily borrow cash, buy production capacity, or hire staff, but it is slow and difficult to build staff morale, a strong reputation, or support from your donors or voters.
Once you have a strong intangible, it will speed the growth of other resources, so imagine the likely performance advantage for an organization with an edge in all such factors. Even better, since it is often hard for competitors to see from outside exactly what these intangibles are and to work out how to collect them, they can give you a sustainable advantage.
8.02: Measuring Intangible Resources
A senior partner at a major global management consultancy once told me, “We don’t include intangible items in our client work, because they are undetectable, unmeasurable, and unmanageable.” Wrong on all three counts!
The atmosphere in a company where people are confident and motivated feels quite different from that in an organization where staff are under pressure. In the same way, salespeople know the difference in a customer’s reaction when they try to sell products with a bad reputation, and CEOs certainly notice the hostility of investors who have lost confidence in their management.
Organizations increasingly measure intangible factors. Product and service quality, staff skills, and motivation now commonly feature in management reports. Even investor sentiment is regularly tracked and scrutinized by many companies.
The achievements of exemplary managers in difficult situations make it clear that the third accusation—that intangibles are unmanageable—is also untrue. Effective factory managers can improve product quality; inspirational sales managers can boost sales force morale and confidence; capable chief executives can reassure anxious investors.
All that is lacking in most cases is a clear link between changes to these critical items and the organization’s performance. Executives know these things matter but need a clearer picture of how they work and how much.
How to Measure Intangible Factors
Some intangibles have simple measures, as shown in Figure 8.2.1. If you have such measures, use them instead of talking in generalities. Performance outcomes cannot be understood through qualitative comments like “We have highly motivated staff” or “Our delivery performance is excellent.” Worse still, we often find management making such comments with no factual evidence to back them up or even when there is evidence to the contrary!
Figure \(1\): Measures for Some Intangible Resources
Many soft factors can be measured on a 0 to 1 scale, where 0 means a complete absence of the resource and 1 is the maximum level you can imagine. Here are some tips:
• Pick the measure that matters. Many soft issues lend themselves to a range of different measures. Product quality, for example, could be how well the product performs its purpose for the customer, how long it lasts before failing, the fraction of units produced that have to be rejected, and so on. So which of these measures (or others) should you be using? The key is to pick the measure (or measures) that most directly affects the next factor you are trying to explain. So, for example, how well the product performs its purpose will affect customer win rates; the failure rate in use will probably affect customer loss rates; and the reject fraction will affect the average production cost of accepted units.
• People do not tell it like it is. You cannot rely on getting accurate answers from people you question. There are many reasons for this. They may give you the answers that they think you want to hear: “How was your meal?” “Fine, thanks.” They may not want to appear ignorant or foolish; they may say they bought their last car because it offered great value when the issue that really swung it was the color or the cup holders. Research professionals understand that surveys are not entirely reliable, and they use a range of methods to get closer to real motivations. There is a limit, though, to how confident you can be in such results, so you may have to cross-check your findings against other information and keep checking!
• Do not use consequences as measures. This is one of the most common mistakes. We do not have good information on how staff feel they are valued, say, so we use the staff turnover rate as a measure of motivation. However, staff turnover could be driven by a host of factors apart from people’s feelings of being valued. You should track the factor itself, not just its consequences.
• Monitor how the reference level for intangible factors changes over time. A great product is quickly matched by competitors, so customers come to expect this standard. Flexible employment terms make working for you seem highly appealing to new employees but are soon taken for granted. So watch out for the reference against which people are comparing: This may be what they have previously experienced, what competitors offer, or what they think should be possible.
Dealing With Intangibles
A clue that you are dealing with an intangible resource comes when the word “perceived” features in your likely explanation for what is going on. Perceived menu quality is key, for example, to a restaurant’s ability to win new customers, because those people do not have any direct experience of what they will be served until they have actually eaten there. The perceived appeal of working in the media industry is key to encouraging young people to seek a job with radio and TV companies. The perceived quality of management is vital for entrepreneurs to win over investors. This is hardly a new idea; the core principle in cognitive psychology is that state of mind drives behavior.
Doing It Right: When Is Quality a Resource?
It is easy to view quality as a driver of customers’ decisions, but certain qualities do not exhibit the characteristics of a resource, meaning they do not fill up gradually over time. For example, if you run a call center that has enough trained staff to handle 1,000 calls per hour, quality will be fine so long as calls arrive at this rate or less. However, if 1,100 calls per hour start arriving, quality will drop instantly. If call rates drop again, quality will quickly recover.
Failure rates or faults in manufactured items, on the other hand, have to be worked at over time, with managers constantly seeking to identify and remove the sources of the problem. This quality, then, does fill up gradually, reaching a limit as it approaches 1. Continual improvement has been the motivation for many quality initiatives such as total quality management and six sigma.
From this it may seem that service qualities respond immediately, and product qualities behave like resources. Unfortunately, things are not quite that simple. If you have plenty of staff, but your service quality reflects levels of skill, then this quality too will gradually improve or deteriorate over time. In this case, the correct approach would be to capture the resource of staff skill, which is filled up by training and drains away when staff leave or forget.
There are two kinds of behavior that particularly interest us in so far as they affect the overall performance of our organizations:
1. People choosing to switch from one state to another: for example, deciding to stop being your customer, to become an investor, or to join your staff
2. People choosing to do more or less of something: for example, using eBay to buy and sell items on line more frequently, sending more text messages by mobile phone, or working harder
Sometimes these choices are helpful—when people choose to join you or do more of what you want—and sometimes they are unhelpful. Negative situations occur where people do more of what you do not want: such as customers denigrating your company to others, or staff criticizing your efforts to make important changes. | textbooks/biz/Business/Introductory_Business/Book%3A_Building_Strategy_and_Performance/08%3A_Intangible_Resources_and_Capabilities/8.01%3A_Why_Intangibles_Matter.txt |
The Case of the IT Service Firm
To understand how feelings drive people to change from one state to another, consider the example of a medium-size information technology (IT) service firm that found itself in trouble. It was losing its best clients, who complained of poor service and was also having trouble winning new business. To make matters worse, vital, skilled staff were leaving. Yet just a couple of years earlier, the firm had exhibited none of these problems and had been enjoying modest growth.
The trouble seemed to lead back to the arrival of a new head of sales and marketing, who had surveyed the firm’s market and found plenty of potential clients who wanted the kind of service support the firm offered. Until then, growth had largely come from occasional referrals by satisfied clients. The new guy convinced his colleagues they were missing a great opportunity and set about launching a sales campaign. Sure enough, he brought in new clients at a good rate (Figure 8.3.1).
This new person had recently left, frustrated by the difficulty he was now having in winning new business and irritated by the growing distrust of the rest of the team. They were worried about what was happening and how to fix it. In particular, client losses had jumped to unacceptable rates and service quality had suffered—calls for help went unanswered and fixes that were done failed to solve customers’ problems. Moreover, the decrease in client acquisition did not seem to have been caused by market conditions; there was still plenty of potential business to be had. Calls to potential clients revealed that the firm had not won this business because of rumors about its poor quality.
Figure \(1\): A Service Firm’s Problem With Winning and Keeping Clients
Examining the quality problem first, the team confirmed what they already suspected, that the service staff had been under mounting pressure from the extra work required to serve all the new clients. They could cope with this pressure at first because they were not especially stretched, but a year or so later it got to be too much for them and they started making mistakes. The team did not know what the exact pressure of work had been, but by checking their records on customer service demand and staff levels, they could make a pretty good estimate.
Turning to the issue of client acquisition, the team surmised that word had gotten around about their quality problems, and so their reputation had been tarnished. From the quality estimates and the contacts that people in their market might have had with each other, they estimated what might have happened to their firm’s reputation. By putting this together with estimates of client losses, they obtained a picture of the dynamics of their client base (Figure 8.3.2).
The company’s management was left with one puzzle. If client losses had risen so that workloads were falling, why had pressure on staff stayed so high? The decrease in workload should have brought things back into balance, and the problem should have fixed itself.
The company had maintained a strong hiring rate, but all the same, its staff numbers had gradually declined. Previously this had not been much of a problem because increasing experience kept productivity moving upward, but the benefit was not powerful enough to keep work pressure under control when all the new client business came in. Staff records showed that turnover had risen particularly sharply in the past year.
Figure \(2\): Pressure of Work Creates Problems With Quality and Reputation
Strangely, the staff turnover problem appeared to be only a recent phenomenon. Conversations with some of the people leaving revealed that they were initially excited at the new opportunities coming in. It had taken time for the constant pressure of impossible demands to hit morale. The effect on motivation had been exacerbated by the now escalating need to refix the same client problems that should have been fixed before.
Doing It Right: Where Quality and Reputation Hit
Although we have to be careful not to force standard answers on a specific situation, the structure in Figure 8.3.2 is remarkably common. Current customers have direct experience of current quality, so they often respond quickly when problems arise. Potential customers, on the other hand, have no direct experience of your performance. They can only go on what they hear about you indirectly, from information that leaks out about you from existing customers. This process may be slow, depending on how often potential customers interact and the effectiveness of trade surveys, for example.
A further important point to note is that this firm felt its reputation was still declining even though quality was getting no worse. This is because continuing bad messages about quality persist in depleting reputation. So current quality often drives customer losses, while reputation (which reflects past quality) drives customer acquisition.
Sketching these phenomena on the board gave the team a clear picture of how the staff had been affected by recent events (Figure 8.3.3). They realized that their original hiring rate had never been high enough to build resilience in their group of professionals. Consequently, when pressure built up, the lid had blown off, which is why staff were now leaving at such a rapid rate.
Fixing the Problem
In this case, we can see two key groups (clients and staff) choosing to move from one state (with the firm) to another (not with it), each driven to make these choices by powerful intangible factors (quality, reputation, and morale). What could be done to fix this problem?
As long as reputation and morale remained weak, three important flows would continue to run against the firm: slow client acquisition and rapid staff and client losses. Since work pressure was driving these problems, this is where any solution would have to be applied. The obvious approach, hiring more staff, turned out to be the worst possible response. New people did not understand the clients’ needs or how the organization’s procedures worked. The already pressured staff had to work even harder to coach them. That left only one solution: cut the workload.
Figure \(3\): Work Pressure Hits Morale, So Staff Losses Escalate
Less work meant fewer clients and perhaps less work from those that remained. The tough decision was made to terminate business from a selection of clients. Since the steady addition of new staff was also distracting the experienced staff, a further decision was made to stop hiring for the moment. However, certain types of work were subcontracted to another company.
The Significance of Counterintuitive Solutions
At first sight, this solution looks absurd: We are losing clients and having trouble winning new ones, so you want us to stop selling and actually terminate existing clients? Also, our staff is under too much pressure, so you want us to stop hiring?
In this case, “Yes” to both questions. The problems were being exacerbated by the very efforts designed to solve them. As ever, the critical question to ask was “What is driving the resource flows?” Only removing the source of the problems would reset the machine to a state where it could cope—although as you might imagine, this can be a tough case to sell.
Our service firm’s perplexing response makes more sense when we look into the detail. First, the high ratio of work to capacity had one useful benefit: profits improved! This happy state was in danger of ending if the downturn continued, of course, but for now there was some financial headroom.
Second, the firm had some business that was more trouble than they were worth. Some clients constantly demanded more support than was in their original agreement. A selection of the worst offenders was called, told of the firm’s difficulties, and asked to refrain from making all but the most urgent support requests while the problems were resolved. Others, including some of the firm’s recent acquisitions, were advised to seek support elsewhere.
Third, client acquisition efforts did not cease altogether, but imminent potential business was just kept warm, rather than being actively sold a project. Indeed, the firm turned its response to its advantage, telling these clients that it was taking steps to fix the very problems about which they had heard rumors.
Beware! Just because dropping clients and freezing the hiring rate was right in this situation, it does not mean it will be right for you. A major implication of the strategy dynamics method is that simple solutions can rarely be transplanted from case to case (as is often implied for other management tools!). What is best for you depends on the specifics—including the numbers—in your own case. | textbooks/biz/Business/Introductory_Business/Book%3A_Building_Strategy_and_Performance/08%3A_Intangible_Resources_and_Capabilities/8.03%3A_Problems_Caused_by_Soft_Factors.txt |
Just like the tangible resources discussed in earlier chapters, intangibles fill and drain away through time; that is what makes them resources. So once again we need to understand both how quickly this is happening and what is driving the flows. Reputation, for example, is raised by the frequency with which satisfied people tell others; staff motivation grows at a rate driven by events that make people feel good about working harder. The more significant and frequent these events and experiences, the more the attitude is developed.
This buildup of positive commitment cannot go on for ever. A look at the service firm’s early situation shows a reputation rating of nearly 1, and a limited buildup of morale among the developers. This is hardly surprising; there is only so much “feeling” you can push into people!
Influencing Intangible Resources
Managers can find ways to influence both the inflow and outflow of intangibles. Positive leadership behaviors, for example, encourage positive feelings among staff; confident statements about an organization’s performance build commitment among investors or donors; and so on.
Skills training is a useful example, since it often comes with clear measurements (Tovey, 1994). Indeed, in many sectors, skills are routinely measured to ensure compliance with required standards. Figure 8.4.1 shows skills being built up by hours of training time but reaching limits in the trainees’ ability to learn more. The framework distinguishes between the management action (amount of training given) and the impact it has on the resource that concerns us (increase in current skill level). We need this distinction in order to identify whether the effort is being effective. Indeed, we need to have measures for both items.
Although this may seem a rather mechanical view of how training works, something like this process goes on in real situations, and it does at least provide a way of making evidence-based judgments about management decisions. In practical cases, skills audits provide useful starting information and a firm’s actual experience in training efforts yields good estimates of training impacts.
There are similarities, too, between the deterioration of tangible resources mentioned in Chapter 3 and the decay of intangible resources. Skill levels drop if not maintained by practice or repeated training; employees can lose their enthusiasm for a job; donors may lose their commitment to supporting a charitable or political cause.
It is hardly surprising to see brands that are universally recognized and understood continuing to spend heavily on advertising. It is not just a matter of persuading newcomers to the market to become committed to the brand, it is also vital to stop those who are already committed from losing their enthusiasm (Figure 8.4.2).
Figure \(1\): Building an Intangible Resource: Staff Skills
Expectations Build and Decay
Consider for a moment how reliable your current car has been since first you owned it (or consider a friend’s car if you do not own one). How many times has it broken down in the past 30,000 miles? Twice maybe, or once, or perhaps not at all? Forty years ago, such reliability would have been rare, and your car would have been remarkable. Today, however, we have come to expect this level of reliability. This change has occurred because the more experience we have of exceptional reliability, the less exceptional it seems.
This phenomenon is important because it affects the way people respond to what you offer. Before these general improvements in vehicle reliability occurred, a company with a better than average performance could use that superiority to capture new customers. Now, that same company with that same reliability level has nothing to boast about.
Figure \(2\): Decay in Commitment to a Brand
The Impact of Negative Perceptions
Unfortunately we often come up against problems caused by a different kind of feeling: a negative perception about something important. Customers and clients become irritated by repeated failures of products or services; staff get annoyed by repeated demands that they cannot fulfill. The consequences can be bizarre. For example, the public may become hostile to the police’s efforts to enforce driving laws even though these laws exist to protect them from injury.
The same principles apply to negative as well as positive perceptions. In our service company example, you may recall that the staff’s positive morale became more and more depleted. It is probable, though, that their annoyance increased to the point that they resigned. Indeed, both processes were probably going on at the same time. One part of their brain was reveling in the energy of constant intensive activity, while another part was getting angry about the pressure.
However, there is a limit or saturation point beyond which things can deteriorate no further. No one’s brain cells, no matter how irate they are, can go on sending angry signals indefinitely. People become tired or bored and stop caring. We therefore need to think about and manage the balance between two countervailing mechanisms. On the one hand, we have customers, staff, or other stakeholders becoming more and more annoyed by a sequence of disappointing events. On the other hand, we have these same people losing the energy to keep being angry about them. If things carry on in this unsatisfactory manner as they are right now, these customers or staff reach an equilibrium level of dissatisfaction. They are not particularly satisfied, but neither are they so annoyed that they will do anything about it.
Intangibles Trigger Catastrophe
Earlier in this chapter I explained that intangibles drive two distinct behaviors among important groups that affect our performance. Intangibles result in us either doing more or less of something (serving customers better, recommending us more often to others, and so on) or else switching from one state to another (becoming a customer, employee, or investor, say). At a strategic level, we are often interested in the second possibility, since the overall behavior of large groups (such as clients, supporters, dealers, staff, or investors) reflects the sum of switching decisions made by each member of that group.
Our imaginary restaurant in earlier chapters relied on a large number of individual consumers deciding to become (or stop being) regular customers. Almost invariably, new consumers on a particular day had not spontaneously decided to become regular customers. It is much more likely that they become increasingly motivated to visit because of what they have heard about the restaurant, either from its marketing activity or from others.
The scale and frequency of received messages are likely to drive this buildup of state of mind until it triggers action. If our consumers had heard only sporadic and lukewarm recommendations, not enough motivation would have built up to spur them to action. Their brains needed a sufficiently strong push from new messages in order to overcome the depletion of their attention—their forgetting.
It is remarkably common for an increasing perception to build up to some trigger level that causes people to act. We work hard to persuade our people to try something new, but they just will not give it a go. We visit the same customer again and again, but we just cannot get them to sign that contract. We present paper after paper to the head office, but they just will not commit to the investment we want. Then all of a sudden, everything moves. Our people change the way they behave; the customer signs the contract; the head office approves our plan. It may even be some apparently trivial event that finally triggers the change.
The same phenomenon occurs with negative events too (Figure 8.4.3). Business may be running smoothly, with sales effort winning customers at a regular slow rate to replace the few who leave each month. Then problems crop up in customer service. They are small and infrequent at first, and because people can be tolerant they forgive and forget these little annoyances.
Figure \(3\): Customers React to a Trigger Level of Annoyance
However, the service problems become more severe and frequent. Unknown to you, customers’ annoyance is building up. Eventually so much annoyance has accumulated that their tolerance threshold is breached, and losses increase. You have experienced what looks like a discontinuity, whereas in fact it is merely the crossover from just tolerable to unacceptable.
Similar mechanisms are widespread and cause a number of difficulties. The trouble that you eventually see (customer losses) is far removed from the original change that brought it about (service problems). As a result, you may have come to regard the situation as acceptable. After all, it has been going on for a long time with no harm, so why worry? The negative intangible stock (annoyance) is difficult—although not impossible—to detect and measure, and you may not even be conscious of the events that are filling it up. Even if you know about customers’ poor experiences, it is hard to estimate how they interact with other things that affect their attitude, such as price or product performance.
There is nothing magical about deciding how to protect your organization from this kind of problem, although it can be difficult to judge whether the problem is important enough to justify the effort required. In particular, you need to
• be conscious of what range of issues are important to customers, especially those that become serious enough to prompt them to leave you;
• estimate how strongly people feel that things are not good enough. You need a sense of the range of events that could upset your customers, plus an idea of how badly different kinds of problems will upset them;
• understand how quickly they will forgive anything that goes wrong.
On the positive side, it is common for high annoyance levels to be rapidly reversed by remedial actions. In some cases, such a fix can even make customers feel better about you than if the problem had never arisen. Even so, I have not as yet found an organization that goes so far as to cause trouble for customers on purpose so it can give them the warm glow of having fixed it!
Finally, note that positive attitudes, too, can build to levels that trigger switching behavior that you do want. For example, good product reviews by lead customers build up a useful resource that other potential customers notice. If good reviews appear frequently enough, they can enable you to win new customers who would previously have been reluctant. | textbooks/biz/Business/Introductory_Business/Book%3A_Building_Strategy_and_Performance/08%3A_Intangible_Resources_and_Capabilities/8.04%3A_The_Growth_and_Decline_of_Intangible_Resources.txt |
Capabilities are especially powerful drivers of performance for businesses and many other kinds of organization (Hamel & Heene,1994; Schoemaker, 1992; Stalk, Evans, & Schulman, 1992). They are the factors that determine how well groups achieve tasks that are critical. For our strategic architecture of resources, the most critical tasks include building and retaining resources. First, let us remind ourselves how capabilities differ from resources:
• Resources are useful items that you own or can access.
• Capabilities are activities that your organization is good at performing.
Capabilities are important because they determine how effectively your organization builds, develops, and retains resources. A more capable organization will be able to build resources faster and hold resource losses to a slower rate than a less capable organization. Capabilities, like intangible resources, are abstract and ambiguous items that are difficult to measure and manage. Nevertheless, they are important drivers of performance through time, so some attempt must be made to understand and manage them.
There are three useful reference points to bear in mind when you assess the strength of your capabilities for building resources:
1. The maximum rate of resource building or retention. For example, given good products and attractive prices, perfect sales capability would show up as a 100% hit rate in new customer acquisition.
2. Best practice within the organization. For example, if all our regional sales teams could build sales per customer as fast as region X does, how quickly would we grow sales?
3. Benchmarks from firms in comparable sectors. For example, if all our regional sales teams could build sales per customer as fast as competitor Y does, how quickly would we grow sales?
A team’s capability is the ratio between the rate at which it is actually achieving tasks and the best rate that we can imagine, given one of the benchmarks above.
Skills Versus Capabilities
Do not confuse team capabilities with individual skills. If you wanted to evaluate the total skills of a group and assess its overall average skill at individual tasks, then you would use the idea of attributes from Chapter 6. Clever organizations manage to take relatively unskilled people and generate outstanding performance. Consulting firms take newly trained professionals and enable them to deliver sophisticated business solutions; fast-food firms take unskilled staff and produce highly consistent products and service; call centers take people with little understanding of an organization’s products and clients and produce excellent customer support; and so on.
Clearly such organizations achieve much of this performance by training people: in other words, by adding to their individual skills. But they do more: They develop, test, and operate proven procedures. Team capability, then, reflects the combination of individual skills and these effective procedures.
Such procedures add up to a library of instructions for completing specific activities quickly and reliably. This library is effectively a resource, something useful that you own, and like any resource it is built up over time. It is also kept up to date by the removal of obsolete or ineffective procedures and the addition of new ones. One of the clearest examples you are likely to find concerns the franchise manuals used by firms like McDonald’s to both train their staff and control their franchisees. Such manuals cover everything from cleaning the fryers, to checking the inventory, to sorting the garbage.
Capabilities Accelerate Resource Development
As I have stressed before, if capabilities are to influence performance then it can only be by improving the organization’s success at developing resources, whether it be winning them in the first place, promoting them from state to state, or retaining them. For example,
• a highly capable human resource (HR) team wins the people that the organization needs quickly, efficiently, and with the greatest likelihood that they will stay;
• a highly capable product development group turns out products quickly and cheaply that satisfy customers’ needs;
• a highly capable customer support team ensures customers are content with the organization’s products and services, thus preventing customer defection.
There is a limit to what capable teams can accomplish though if they do not have the resources to do their job. Even the best customer support group will struggle to keep customers if the products they are supporting are inadequate.
Learning, Capability Building, and Resource Development
The last mystery we need to resolve about capabilities is where they come from. Team capabilities are built up by being used, much as individual skills are. Procedures and methods for getting things done are available to be recorded whenever they take place. So techniques have been developed in many sectors for achieving a sale to a new customer, for example. Indeed, many of these techniques are common to multiple markets and embedded in sales force training systems. The procedures for managing products through a research and development (R&D) process similarly arise from companies’ experience of actually carrying out that activity.
Clearly the more chances the team has to practice its winning, developing, and retention of resources, the more opportunities arise to test, improve, and record the procedures that work best. The bottom line is that the rate of resource flows determines the rate at which capabilities can be improved. If we add the earlier observation that capability levels drive resource flows, we have a simple and direct mutual reinforcement between each capability and the resource to which it relates. There are some cases where capability does not relate directly to a specific resource flow, but they tend to be less influential on long-term strategic performance than are these tightly coupled pairings of resource and capability.
Action Checklist: Managing the Impact of Intangibles on the Resource System
This chapter has explained the importance of intangible factors, given examples of simple measures for them, and shown you how they operate. Here are some techniques to ensure your intangibles are healthy and working well with the rest of your business system:
• Identify the important intangibles. Since your performance comes from concrete resources, start with these and ask whether an intangible factor is likely to influence your ability to win or lose them. However, do not go on an exhaustive search for as many soft factors as possible; each part of your strategic architecture will probably be most strongly influenced by one or two intangibles.
• Be clear which of these soft factors genuinely accumulate through time and which are simply varying features of your organization. “Quality” often reflects immediately the balance between what has to be done and what is available to do it, in which case it does not accumulate. Reputation, motivation, commitment, and perception, on the other hand, are built up and drain away over time in response to an entire history of events.
• Specify intangibles carefully and identify the best measure. What exactly is it that drives the choices of each group? That will be the measure that matters. Our IT service firm’s current clients, for example, were strongly influenced by the error rate they experienced, while potential clients responded to the firm’s reputation.
• Identify the events causing each intangible to fill up and drain away. This is the same bathtub principle we have used before, so remember that different items may be featured on either side of this question.
• Look for places where you can strengthen intangibles. If you were to lose some of your client relationship managers, for example, what could you do quickly to keep your reputation strong with the wider market and sustain the morale of your other staff?
• Watch out for negative resources. What can you do to slow down the unfortunate events that are filling up these negative feelings? Is there anything you can do to actively dissipate them?
• Build intangible measures into your performance tracking system. Reporting systems now commonly incorporate soft measures from various parts of the organization, recognizing that they are crucial to an effective system.
• If you do not know, do not ignore the issue! Soft factors are influencing your organization, continually and strongly. Remember that if you choose to ignore them, you are not actually leaving them out. Rather, you are assuming that they are OK and unchanging. This is unlikely to be the case, so make your best estimate and start tracking and understanding them.
9.01: Going Forward
Going Forward
This book has introduced the essential elements of the strategy dynamics approach to strategic management of businesses and other organizations. In an effort to make the ideas accessible to the widest possible range of people, I have kept the book short and the examples easy to follow. I have also simplified or left out many features and details of the approach while retaining the most powerful elements.
As with any methodical approach to management issues, it is much easier to make progress if everyone involved shares the same understanding, so it is helpful to develop a coalition of colleagues who have picked up the ideas and tried using them. Equally, it can be difficult to win support for new efforts when there is so much else going on around you. It is best to start small, perhaps using just one or two of the most useful frameworks from this book to work on specific challenges. As confidence grows, you can seek support for doing more.
There is much more to learn about how an organization’s performance develops through time and how professional strategic management can drive big improvements to this trajectory.
• Another short book—my Developing Employee Talent to Perform (Business Expert Press, 2009)—provides guidance on how general managers and their teams can understand their organization’s performance and drive it into the future. Those wishing to study the underlying method in more depth should see my book Strategic Management Dynamics (2008).
• The implications for marketing and brand strategy are well understood and have been put to good use in many businesses (see Lars Finskud, Competing for Choice, 2009).
• Learning materials, including a 10-class online course, simulation-based exercises, and worksheets, are available from Strategy Dynamics Ltd. at www.strategydynamics.com. These are designed for individual and team study, as well as for business school degree courses and executive training. | textbooks/biz/Business/Introductory_Business/Book%3A_Building_Strategy_and_Performance/08%3A_Intangible_Resources_and_Capabilities/8.05%3A_Capabilities_-_Activities_You_Are_Good_At.txt |
As the story of Apple suggests, today is an interesting time to study business. Advances in technology are bringing rapid changes in the ways we produce and deliver goods and services. The Internet and other improvements in communication (such as smartphones, video conferencing, and social networking) now affect the way we do business. Companies are expanding international operations, and the workforce is more diverse than ever. Corporations are being held responsible for the behavior of their executives, and more people share the opinion that companies should be good corporate citizens. Plus—and this is a big plus—businesses today are facing the lingering effects of what many economists believe is the worst financial crisis since the Great Depression (Hilsenrath, et. al., 2008). Economic turmoil that began in the housing and mortgage industries as a result of troubled subprime mortgages quickly spread to the rest of the economy. In 2008, credit markets froze up and banks stopped making loans. Lawmakers tried to get money flowing again by passing a \$700 billion Wall Street bailout, yet businesses and individuals were still denied access to needed credit. Without money or credit, consumer confidence in the economy dropped and consumers cut back their spending. Businesses responded by producing fewer products, and their sales and profits dropped. Unemployment rose as troubled companies shed the most jobs in five years, and 760,000 Americans marched to the unemployment lines1. The stock market reacted to the financial crisis and its stock prices dropped by 44 percent while millions of Americans watched in shock as their savings and retirement accounts took a nose dive. In fall 2008, even Apple, a company that had enjoyed strong sales growth over the past five years, began to cut production of its popular iPhone. Without jobs or cash, consumers would no longer flock to Apple’s fancy retail stores or buy a prized iPhone (Gallagher, 2008). Things have turned around for Apple, which reported blockbuster sales for 2011 in part because of strong customer response to the iPhone 4S. But not all companies or individuals are doing so well. The economy is still struggling, unemployment is high (particularly for those ages 16 to 24), and home prices remain low.
As you go through the course with the aid of this text, you’ll explore the exciting world of business. We’ll introduce you to the various activities in which businesspeople engage—accounting, finance, information technology, management, marketing, and operations. We’ll help you understand the roles that these activities play in an organization, and we’ll show you how they work together. We hope that by exposing you to the things that businesspeople do, we’ll help you decide whether business is right for you and, if so, what areas of business you’d like to study further.
1“How the Economy Stole the Election,” CNN.com, http://money.cnn.com/galleries/2008/news/0810/gallery.economy_election/index.html (accessed January 21, 2012).
1.02: Getting Down to Business
Learning Objective
1. Identify the main participants of business, the functions that most businesses perform, and the external forces that influence business activities.
A business is any activity that provides goods or services to consumers for the purpose of making a profit. When Steve Jobs and Steve Wozniak created Apple Computer in Jobs’s family garage, they started a business. The product was the Apple I, and the company’s founders hoped to sell their computers to customers for more than it cost to make and market them. If they were successful (which they were), they’d make a profit.
Before we go on, let’s make a couple of important distinctions concerning the terms in our definitions. First, whereas Apple produces and sells goods (Mac, iPhone, iPod, iPad), many businesses provide services. Your bank is a service company, as is your Internet provider. Hotels, airlines, law firms, movie theaters, and hospitals are also service companies. Many companies provide both goods and services. For example, your local car dealership sells goods (cars) and also provides services (automobile repairs).
Second, some organizations are not set up to make profits. Many are established to provide social or educational services. Such not-for-profit (or nonprofit) organizations include the United Way of America, Habitat for Humanity, the Boys and Girls Clubs, the Sierra Club, the American Red Cross, and many colleges and universities. Most of these organizations, however, function in much the same way as a business. They establish goals and work to meet them in an effective, efficient manner. Thus, most of the business principles introduced in this text also apply to nonprofits.
1.03: What Is Economics
Learning Objectives
1. Define economics and identify factors of production.
2. Explain how economists answer the three key economics questions.
3. Compare and contrast economic systems.
To appreciate how a business functions, we need to know something about the economic environment in which it operates. We begin with a definition of economics and a discussion of the resources used to produce goods and services.
1.04: Perfect Competition and Supply and Demand
Learning Objective
1. Describe perfect competition, and explain how supply and demand interact to set prices in a free market system.
Under a mixed economy, such as we have in the United States, businesses make decisions about which goods to produce or services to offer and how they are priced. Because there are many businesses making goods or providing services, customers can choose among a wide array of products. The competition for sales among businesses is a vital part of our economic system. Economists have identified four types of competition—perfect competition, monopolistic competition, oligopoly, and monopoly. We’ll introduce the first of these—perfect competition—in this section and cover the remaining three in the following section.
1.05: Monopolistic Competition Oligopoly and Monopoly
Learning Objective
1. Describe monopolistic competition, oligopoly, and monopoly.
Economists have identified four types of competition—perfect competition, monopolistic competition, oligopoly, and monopoly. Perfect competition was discussed in the last section; we’ll cover the remaining three types of competition here.
1.06: Measuring the Health of the Economy
Learning Objective
1. Understand the criteria used to assess the status of the economy.
Every day, we are bombarded with economic news. We’re told that the economy is struggling, unemployment is high, home prices are low, and consumer confidence is down. As a student learning about business, and later as a business manager, you need to understand the nature of the U.S. economy and the terminology that we use to describe it. You need to have some idea of where the economy is heading, and you need to know something about the government’s role in influencing its direction.
1.07: Governments Role in Managing the Economy
Learning Objective
1. Discuss the government’s role in managing the economy.
In every country, the government takes steps to help the economy achieve the goals of growth, full employment, and price stability. In the United States, the government influences economic activity through two approaches: monetary policy and fiscal policy. Through monetary policy, the government exerts its power to regulate the money supply and level of interest rates. Through fiscal policy, it uses its power to tax and to spend. | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/01%3A_The_Foundations_of_Business/1.01%3A_Introduction.txt |
Learning on the Web (AACSB)
The “Economy” section of the CNNMoney Web site provides current information on a number of economic indicators. Go to money.cnn.com and click on “Economy” and then on “Jobs,” and find answers to the following questions:
1. You read in the chapter that an important goal of all economies is to make jobs available to everyone who wants one. Review the CNNMoney discussion on job growth and then answer the following questions:
a. Is the current level of unemployment rising or falling?
b. What do economists expect will happen to unemployment rates in the near future?
c. Is the current level of unemployment a burden or an asset to the economy? In what ways?
2. Do you remember the first dollar you earned? Maybe you earned it delivering newspapers, shoveling snow, mowing lawns, or babysitting. How much do you think that dollar is worth today? Go to the WestEgg site at http://www.westegg.com/inflation and find the answer to this question. After determining the current value of your first dollar, explain how the calculator was created. (Hint: Apply what you know about CPI.)
Career Opportunities
Is a Career in Economics for You?
Are you wondering what a career in economics would be like? Go to the U.S. Department of Labor Web site (www.bls.gov/oco/ocos055.htm) and review the occupational outlook for economists. Look for answers to the following questions:
1. What issues interest economists?
2. What kinds of jobs do government economists perform? What about those who work in private industry? In education?
3. What educational background and training is needed for these jobs?
4. What is the current job outlook for economists?
5. What is the entry-level salary for an economist with a bachelor’s degree? With a master’s degree?
Ethics Angle (AACSB)
How Much Is That CD in the Window?
The early 1990s were a good time to buy CDs, mainly because discounters such as Wal-Mart and Best Buy were accumulating customers by dropping prices from \$15 to \$10. They were losing money, but they figured that the policy still made good business sense. Why? They reasoned that while customers were in the store to shop for CDs, they’d find other, more profitable products.
The policy was a windfall for CD buyers, but a real problem for traditional music retailers such as Tower Records. With discounters slashing prices, CD buyers were no longer willing to pay the prices asked by traditional music retailers. Sales plummeted and companies went out of business.
Ultimately, the discounters’ strategy worked: stores such as Wal-Mart and Best Buy gained customers who once bought CDs at stores like Tower Records.
Let’s pause at this point to answer the following questions:
1. Does selling a product at below cost make business sense?
2. Whom does it hurt? Whom does it help?
3. Is it ethical?
Let’s continue and find out how traditional music retailers responded to this situation.
They weren’t happy, and neither were the record companies. Both parties worried that traditional retailers would put pressure on them to reduce the price that they charged for CDs so that retailers could lower their prices and compete with discounters. The record companies didn’t want to lower prices. They just wanted things to return to “normal”—to the world in which CDs sold for \$15 each.
Most of the big record companies and several traditional music retailers got together and made a deal affecting every store that sold CDs. The record companies agreed with retail chains and other CD outlets to charge a minimum advertised price for CDs. Any retailer who broke ranks by advertising below-price CDs would incur substantial financial penalties. Naturally, CD prices went up.
Now, think about the following:
1. Does the deal made between the record companies and traditional retailers make business sense?
2. Whom does it hurt? Whom does it help?
3. Is it ethical?
4. Is it legal?
Team-Building Skills (AACSB)
Get together in groups of four selected by your instructor and pick any three items from the following list:
• Pint of milk
• Gallon of gas
• Roundtrip airline ticket between Boston and San Francisco
• Large pizza
• Monthly cost of an Internet connection
• CD by a particular musician
• Two-day DVD rental
• Particular brand of DVD player
• Quarter-pound burger
Outside of class, each member of the team should check the prices of the three items, using his or her own sources. At the next class meeting, get together and compare the prices found by team members. Based on your findings, answer the following questions as a group:
1. Are the prices of given products similar, or do they vary?
2. Why do the prices of some products vary while those of others are similar?
3. Can any price differences be explained by applying the concepts of supply and demand or types of competition?
The Global View (AACSB)
Life Is Good in France (if You Have Le Job)
A strong economy requires that people have money to spend on goods and services. Because most people earn their money by working, an important goal of all economies is making jobs available to everyone who wants one. A country has “full employment” when 95 percent of those wanting work are employed. Unfortunately, not all countries achieve this goal of full employment. France, for example, often has a 10 percent unemployment rate overall and a 20 percent unemployment rate among young people.
Does this mean that France isn’t trying as hard as the United States to achieve full employment? A lot of people in France would say yes.
Let’s take a quick trip to France to see what’s going on economically. The day is March 19, 2006, and more than a million people are marching through the streets to protest a proposed new employment law that would make it easier for companies to lay off workers under the age of twenty-six during their first two years of employment. Granted, the plan doesn’t sound terribly youth-friendly, but, as usual, economic issues are never as clear-cut as they seem (or as we’d like them to be).
To gain some further insight into what’s going on in France, go to a BusinessWeek Web site (http://www.businessweek.com/globalbiz/content/mar2006/gb20060321_896473.htm) and read the article “Job Security Ignites Debate in France.” Then answer the following questions:
1. Why does the French government support the so-called First Employment Contract? Who’s supposed to be helped by the law?
2. Which two groups are most vocal in protesting the law? Why?
3. If you were a long-time worker at a French company, would you support the new law? Why, or why not?
4. If you were a young French person who had just graduated from college and were looking for your first job, would you support the law? Why, or why not?
5. What do you think of France’s focus on job security? Does the current system help or hurt French workers? Does it help or hurt recent college graduates?
6. Does the French government’s focus on job security help or hinder its economy? Should the government be so heavily involved in employment matters? | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/01%3A_The_Foundations_of_Business/1.08%3A_Cases_and_Problems.txt |
Learning Objectives
1. Define business ethics and explain what it means to act ethically in business.
2. Explain how you can recognize an ethical organization.
The WorldCom situation is not an isolated incident. The boom years of the 1990s were followed by revelations of massive corporate corruption, including criminal schemes at companies such as Enron, Adelphia, and Tyco. In fall 2001, executives at Enron, an energy supplier, admitted to accounting practices concocted to overstate the company’s income over a period of four years. In the wake of the company’s collapse, stock prices plummeted from \$90 to \$1 a share, inflicting massive financial losses on the investment community. Thousands of employees lost not only their jobs but their retirement funds, as well (Kadlec, 2002). Before the Enron story was off the front pages, officials at Adelphia, the nation’s sixth-largest cable company, disclosed that founder and CEO John Rigas had treated the publicly owned firm as a personal piggy bank, siphoning off billions of dollars to support his family’s extravagant lifestyle and bankrupting the company in the process (Lieberman, 2004). Likewise, CEO Dennis Koslowzki of conglomerate Tyco International was apparently confused about what was his and what belonged to the company. Besides treating himself to a \$30 million estate in Florida and a \$7 million Park Avenue apartment, Koslowzki indulged in a taste for expensive office accessories—such as a \$15,000 umbrella stand, a \$17,000 traveling toilette box, and a \$2,200 wastebasket—that eventually drained \$600 million from company coffers1.
As crooked as these CEOs were, Bernie Madoff, founder of Bernard L. Madoff Investment Securities and former chairman of the NASDAQ stock exchange, makes them seem like dime-store shoplifters2. Madoff is alleged to have run a giant Ponzi scheme (Langan, 2008) that cheated investors of up to \$65 billion. His wrongdoings won him a spot at the top of Time Magazine’s Top 10 Crooked CEOs. According to the SEC charges, Madoff convinced investors to give him large sums of money. In return, he gave them an impressive 8 percent to 12 percent return a year. But Madoff never really invested their money. Instead, he kept it for himself. He got funds to pay the first investors their return (or their money back if they asked for it) by bringing in new investors. Everything was going smoothly until the fall of 2008, when the stock market plummeted and many of his investors asked for their money back. As he no longer had their money, the game was over and he had to admit that the whole thing was just one big lie. Thousands of investors, including many of his wealthy friends, not-so-rich retirees who trusted him with their life savings, and charitable foundations, were financially ruined. All those harmed by Madoff either directly or indirectly were pleased when he was sentenced to jail for one-hundred and fifty years.
Are these cases merely aberrations? A Time/CNN poll conducted in the midst of all these revelations found that 72 percent of those surveyed don’t think so. They believe that breach of investor and employee trust represents an ongoing, long-standing pattern of deceptive behavior by officials at a large number of companies (Gibbs, et. al., 2002). If they’re right, then a lot of questions need to be answered. Why do such incidents happen (and with such apparent regularity)? Who are the usual suspects? How long until the next corporate bankruptcy record is set? What action can be taken—by individuals, organizations, and the government—to discourage such behavior? | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/02%3A_Business_Ethics_and_Social_Responsibility/2.01%3A_Misgoverning_Corporations-_An_Overview.txt |
Learning Objective
1. Specify the steps that you would take to solve an ethical dilemma and make an ethical decision.
Betty Vinson didn’t start out at WorldCom with the intention of going to jail. She undoubtedly knew what the right behavior was, but the bottom line is that she didn’t do it. How can you make sure that you do the right thing in the business world? How should you respond to the kinds of challenges that you’ll be facing? Because your actions in the business world will be strongly influenced by your moral character, let’s begin by assessing your current moral condition. Which of the following best applies to you (select one)?
1. I’m always ethical.
2. I’m mostly ethical.
3. I’m somewhat ethical.
4. I’m seldom ethical.
5. I’m never ethical.
Now that you’ve placed yourself in one of these categories, here are some general observations. Few people put themselves below the second category. Most of us are ethical most of the time, and most people assign themselves to category number two—“I’m mostly ethical.” Why don’t more people claim that they’re always ethical? Apparently, most people realize that being ethical all the time takes a great deal of moral energy. If you placed yourself in category number two, ask yourself this question: How can I change my behavior so that I can move up a notch? The answer to this question may be simple. Just ask yourself an easier question: How would I like to be treated in a given situation (Maxwell, 2003)?
Unfortunately, practicing this philosophy might be easier in your personal life than in the business world. Ethical challenges arise in business because business organizations, especially large ones, have multiple stakeholders and because stakeholders make conflicting demands. Making decisions that affect multiple stakeholders isn’t easy even for seasoned managers; and for new entrants to the business world, the task can be extremely daunting. Many managers need years of experience in an organization before they feel comfortable making decisions that affect various stakeholders. You can, however, get a head start in learning how to make ethical decisions by looking at two types of challenges that you’ll encounter in the business world: ethical dilemmas and ethical decisions.
2.03: Identifying Ethical Issues
Learning Objective
1. Identify ethical issues that you might face in business, and analyze rationalizations for unethical behavior.
Make no mistake about it: When you enter the business world, you’ll find yourself in situations in which you’ll have to choose the appropriate behavior. How, for example, would you answer questions like the following?
• Is it OK to accept a pair of sports tickets from a supplier?
• Can I buy office supplies from my brother-in-law?
• Is it appropriate to donate company funds to my local community center?
• If I find out that a friend is about to be fired, can I warn her?
• Will I have to lie about the quality of the goods I’m selling?
• Can I take personal e-mails and phone calls at work?
• What do I do if I discover that a coworker is committing fraud?
Obviously, the types of situations are numerous and varied. Fortunately, we can break them down into a few basic categories: bribes, conflicts of interest, conflicts of loyalty, issues of honesty and integrity, and whistle-blowing. Let’s look a little more closely at each of these categories. | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/02%3A_Business_Ethics_and_Social_Responsibility/2.02%3A_The_Individual_Approach_to_Ethics.txt |
Learning Objective
1. Specify actions that managers can take to create and sustain ethical organizations.
Ethics is more than a matter of individual behavior; it’s also about organizational behavior. Employees’ actions aren’t based solely on personal values alone: They’re influenced by other members of the organization, from top managers and supervisors to coworkers and subordinates. So how can ethical companies be created and sustained? In this section, we’ll examine some of the most reasonable answers to this question.
2.05: Corporate Social Responsibility
Learning Objective
1. Define corporate social responsibility and explain how organizations are responsible to their stakeholders.
Corporate social responsibility refers to the approach that an organization takes in balancing its responsibilities toward different stakeholders when making legal, economic, ethical, and social decisions. What motivates companies to be “socially responsible” to their various stakeholders? We hope it’s because they want to do the right thing, and for many companies, “doing the right thing” is a key motivator. The fact is, it’s often hard to figure out what the “right thing” is: What’s “right” for one group of stakeholders isn’t necessarily just as “right” for another. One thing, however, is certain: Companies today are held to higher standards than ever before. Consumers and other groups consider not only the quality and price of a company’s products but also its character. If too many groups see a company as a poor corporate citizen, it will have a harder time attracting qualified employees, finding investors, and selling its products. Good corporate citizens, by contrast, are more successful in all these areas.
Figure 2.6 “The Corporate Citizen” presents a model of corporate responsibility based on a company’s relationships with its stakeholders. In this model, the focus is on managers—not owners—as the principals involved in all these relationships. Here, owners are the stakeholders who invest risk capital in the firm in expectation of a financial return. Other stakeholders include employees, suppliers, and the communities in which the firm does business. Proponents of this model hold that customers, who provide the firm with revenue, have a special claim on managers’ attention. The arrows indicate the two-way nature of corporation-stakeholder relationships: All stakeholders have some claim on the firm’s resources and returns, and it’s management’s job to make decisions that balance these claims (Baron, D. P., 2003).
Figure 2.6 The Corporate Citizen
Let’s look at some of the ways in which companies can be “socially responsible” in considering the claims of various stakeholders.
2.06: Environmentalism
Learning Objectives
1. Identify threats to the natural environment, and explain how businesses are addressing them.
2. Define sustainability and understand why companies are now focusing on environmental and socially responsibility issues.
Today, virtually everyone agrees that companies must figure out how to produce products without compromising the right of future generations to meet their own needs. Clearly, protecting natural resources is the right thing to do, but it also has become a business necessity. Companies’ customers demand that they respect the environment. Let’s identify some key environmental issues and highlight the ways in which the business community has addressed them.
2.07: Stages of Corporate Responsibility
Learning Objective
1. List the stages of corporate responsibility.
We expect companies to recognize issues of social importance and to address them responsibly. The companies that do this earn reputations as good corporate citizens and enjoy certain benefits, such as the ability to keep satisfied customers, to attract capital, and to recruit and retain talented employees. But companies don’t become good corporate citizens overnight. Learning to identify and develop the capacity to address social concerns takes time and requires commitment. The task is arduous because so many different issues are important to so many different members of the public—issues ranging from the environment, to worker well-being (both at home and abroad), to fairness to customers, to respect for the community in which a company operates. | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/02%3A_Business_Ethics_and_Social_Responsibility/2.04%3A_The_Organizational_Approach_to_Ethics.txt |
Learning on the Web (AACSB)
Lessons in Community Living
Executives consider it an honor to have their company named one of Business Ethics magazine’s “100 Best Corporate Citizens.” Companies are chosen from a group of one thousand, according to how well they serve their stakeholders—owners, employees, customers, and the communities with which they share the social and natural environment. Being in the top one hundred for five years in a row is cause for celebration. Two of the twenty-nine companies that enjoy this distinction are Timberland and the New York Times Company.
The two companies are in very different industries. Timberland designs and manufactures boots and other footwear, apparel, and accessories; the New York Times Company is a media giant, with nineteen newspapers (including the New York Times and the Boston Globe), eight television stations, and more than forty Web sites. Link to the Timberland Web site (http://www.timberland.com/corp/index...ge=csroverview) and the New York Times Company Web site (www.nytco.com/social_responsibility/index.html) to learn how each, in its own way, supports the communities with which it shares the social and natural environment. Look specifically for information that will help you answer the following questions:
1. How does each company assist its community? To what organizations does each donate money? How do employees volunteer their time? What social causes does each support?
2. How does each company work to protect the natural environment?
3. Are the community-support efforts of the two companies similar or dissimilar? In what ways do these activities reflect the purposes of each organization?
4. In your opinion, why do these companies support their communities? What benefits do they derive from being good corporate citizens?
Career Opportunities
Is “WorldCom Ethics Officer” an Oxymoron?
As you found out in this chapter, WorldCom’s massive accounting scandal cost investors billions and threw the company into bankruptcy. More than one hundred employees who either participated in the fraud or passively looked the other way were indicted or fired, including accountant Betty Vinson, CFO Scott Sullivan, and CEO Bernard Ebbers. With the name “WorldCom” indelibly tarnished, the company reclaimed its previous name, “MCI.” It was put on court-imposed probation and ordered to follow the directives of the court. One of those directives called for setting up an ethics office. Nancy Higgins, a corporate attorney and onetime vice president for ethics at Lockheed Martin, was brought in with the title of chief ethics officer.
Higgins’s primary responsibility is to ensure that MCI lives up to new CEO Michael Capellas’s assertion that the company is dedicated to integrity and its employees are committed to high ethical standards. Her tasks are the same as those of most people with the same job title, but she’s under more pressure because MCI can’t afford any more ethical lapses. She oversees the company’s ethics initiatives, including training programs and an ethics hotline. She spends a lot of her time with employees, listening to their concerns and promoting company values.
Higgins is a member of the senior executive team and reports to the CEO and board of directors. She attends all board meetings and provides members with periodic updates on the company’s newly instituted ethics program (including information gleaned from the new ethics hotline).
Answer the following questions:
1. Would you be comfortable in Higgins’s job? Does the job of ethics officer appeal to you? Why, or why not?
2. Would you find it worthwhile to work in an ethics office for a few years at some point in your career? Why, or why not?
3. What qualities would you look for if you were hiring an ethics officer?
4. What factors will help (or hinder) Higgins’s ability to carry out her mandate to bolster integrity and foster ethical standards?
5. Would the accounting scandals have occurred at WorldCom if Higgins had been on the job back when Vinson, Sullivan, and Ebbers were still there? Explain your opinion.
Team-Building Skills (AACSB)
What Are the Stakes When You Play with Wal-Mart?
In resolving an ethical dilemma, you have to choose between two or more opposing alternatives, both of which, while acceptable, are important to different groups. Both alternatives may be ethically legitimate, but you can act in the interest of only one group.
This project is designed to help you learn how to analyze and resolve ethical dilemmas in a business context. You’ll work in teams to address three ethical dilemmas involving Wal-Mart, the world’s largest company. Before meeting as a group, every team member should go to the BusinessWeek Web site (http://www.businessweek.com/magazine...2001_mz001.htm) and read “Is Wal-Mart Too Powerful?” The article discusses Wal-Mart’s industry dominance and advances arguments for why the company is both admired and criticized.
Your team should then get together to analyze the three dilemmas that follow. Start by reading the overview of the dilemma and any assigned material. Then debate the issues, working to reach a resolution through the five-step process summarized in Figure 2.2 “How to Face an Ethical Dilemma”:
1. Define the problem and collect the relevant facts.
2. Identify feasible options.
3. Assess the effect of each option on stakeholders.
4. Establish criteria for determining the most appropriate action.
5. Select the best option based on the established criteria.
Finally, prepare a report on your deliberations over each dilemma, making sure that each report contains all the following items:
• The team’s recommendation for resolving the dilemma
• An explanation of the team’s recommendation
• A summary of the information collected for, and the decisions made at, each step of the dilemma-resolution process
Three Ethical Dilemmas
Ethical Dilemma 1: Should Wal-Mart Close a Store because It Unionizes?
Scenario:
In February 2005, Wal-Mart closed a store in Quebec, Canada, after its workers voted to form a union. The decision has ramifications for various stakeholders, including employees, customers, and stockholders. In analyzing and arriving at a resolution to this dilemma, assume that you’re the CEO of Wal-Mart, but ignore the decision already made by the real CEO. Arrive at your own recommendation, which may or may not be the same as that reached by your real-life counterpart.
Before analyzing this dilemma, go to the Washington Post Web site (www.washingtonpost.com/wp-dyn...2005Feb10.html) and read the article “Wal-Mart Chief Defends Closing Unionized Store.”
Ethical Dilemma 2: Should Levi Strauss Go into Business with Wal-Mart?
Scenario:
For years, the words jeans and Levi’s were synonymous. Levi Strauss, the founder of the company that carries his name, invented blue jeans in 1850 for sale to prospectors in the gold fields of California. Company sales peaked at \$7 billion in 1996 but then plummeted to \$4 billion by 2003. Management has admitted that the company must reverse this downward trend if it hopes to retain the support of its twelve thousand employees, operate its remaining U.S. factories, and continue its tradition of corporate-responsibility initiatives. At this point, Wal-Mart made an attractive offer: Levi Strauss could develop a low-cost brand of jeans for sale at Wal-Mart. The decision, however, isn’t as simple as it may seem: Wal-Mart’s relentless pressure to offer “everyday low prices” can have wide-ranging ramifications for its suppliers’ stakeholders—in this case, Levi Strauss’s shareholders, employees, and customers, as well as the beneficiaries of its various social-responsibility programs. Assume that, as the CEO of Levi Strauss, you have to decide whether to accept Wal-Mart’s offer. Again, ignore any decision already made by your real-life counterpart, and instead work toward an independent recommendation.
Before you analyze this dilemma, go to the Fast Company Web site (http://www.fastcompany.com/magazine/77/walmart.html) and read the article “The Wal-Mart You Don’t Know.”
Ethical Dilemma 3: Should You Welcome Wal-Mart into Your Neighborhood?
Scenario:
In 2002, Wal-Mart announced plans to build forty “supercenters” in California—a section of the country that has traditionally resisted Wal-Mart’s attempts to dot the landscape with big-box stores. Skirmishes soon broke out in California communities between those in favor of welcoming Wal-Mart and those determined to fend off mammoth retail outlets.
You’re a member of the local council of a California city, and you’ll be voting next week on whether to allow Wal-Mart to build in your community. The council’s decision will affect Wal-Mart, as well as many local stakeholders, including residents, small business owners, and employees of community supermarkets and other retail establishments. As usual, ignore any decisions already made by your real-life counterparts.
Before working on this dilemma, go to the USA Today Web site (http://www.usatoday.com/money/indust...wal-mart_x.htm) and read the article “California Tries to Slam Lid on Big-Boxed Wal-Mart.”
The Global View (AACSB)
Was Nike Responsible for Compensating Honduran Factory Workers?
Honduras is an impoverished country in which 70% of its residents live in poverty. Jobs are scarce, particularly those that pay decent wages along with benefits, such as health care. It is not surprising then that workers at two Honduran factories making products for U.S. companies, including Nike, were extremely upset when their factories closed down and they lost their jobs. Even worse, the owners of the factories refused to pay the 1,800 workers \$2 million in severance pay and other benefits due to them by law. Although the factory owners had been paid in full by Nike for the apparel they produced, the workers argued that Nike should be responsible for paying the \$2 million in severance that the factory owners had not received.
Nike’s original response was to sympathize with the workers but refuse to pay the workers the severance pay they had not received from the factory owners. This stance did not settle well with student groups around the country who rallied in support of the unpaid workers. In the end Nike gave into pressure from the students and paid \$1.5 million to a relief fund for the employees. In addition, the company said it would provide vocational training and health coverage for the unemployed workers.
To learn more about this case, read the following:
• Nike Press Release: Nike Statement Regarding Vision Tex and Hugger (April 20, 2010) www.nikebiz.com/media/pr/2010...rHonduras.html
• Working in These Times: Honduran Workers Speak Out Against Nike’s Labor Violations (April 21, 2010) http://inthesetimes.org/working/entr...or_violations/
• New York Times: Pressured, Nike to Help Workers in Honduras (July 26, 2010) http://www.nytimes.com/2010/07/27/bu...al/27nike.html
• Time Magazine: Just Pay It: Nike Creates Fund for Honduran Workers (July 27, 2010) www.time.com/time/printout/0,...006646,00.html
• Nike Press Release: Nike and CGT Statement (July 26, 2010) www.nikebiz.com/media/pr/2010...statement.html
Answer the following questions:
1. Do you think Nike was responsible for compensating the workers in Honduras? Why did it change its stance?
2. Did the students, universities, and workers themselves have all of the information they needed before becoming involved in the protest? Are their facts accurate?
3. Should students be activists? Do companies such as Nike ignore them at their own peril? | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/02%3A_Business_Ethics_and_Social_Responsibility/2.08%3A_Cases_and_Problems.txt |
Learning Objectives
1. Explain why nations and companies participate in international trade.
2. Describe the concepts of absolute and comparative advantage.
3. Explain how trade between nations is measured.
The globalization of business is bound to affect you. Not only will you buy products manufactured overseas, but it’s highly likely that you’ll meet and work with individuals from various countries and cultures as customers, suppliers, colleagues, employees, or employers. The bottom line is that the globalization of world commerce has an impact on all of us. Therefore, it makes sense to learn more about how globalization works.
Figure 3.1
World commerce has become increasingly international, so understanding how global business works is key to a successful career.
Richter Frank-Jurgen – Horasis Global China Business Meeting 2013 – CC BY-SA 2.0.
3.02: Opportunities in International Business
Learning Objectives
1. Define importing and exporting.
2. Explain how companies enter the international market through licensing agreements or franchises.
3. Describe how companies reduce costs through contract manufacturing and outsourcing.
4. Explain the purpose of international strategic alliances and joint ventures.
5. Understand how U.S. companies expand their businesses through foreign direct investments and international subsidiaries.
6. Understand the arguments for and against multinational corporations.
The fact that nations exchange billions of dollars in goods and services each year demonstrates that international trade makes good economic sense. For an American company wishing to expand beyond national borders, there are a variety of ways it can get involved in international business. Let’s take a closer look at the more popular ones.
3.03: The Global Business Environment
Learning Objective
1. Appreciate how cultural, economic, legal, and political differences between countries create challenges to successful business dealings.
In the classic movie The Wizard of Oz, a magically misplaced Midwest farm girl takes a moment to survey the bizarre landscape of Oz and then comments to her little dog, “I don’t think we’re in Kansas anymore, Toto.” That sentiment probably echoes the reaction of many businesspeople who find themselves in the midst of international ventures for the first time. The differences between the foreign landscape and the one with which they’re familiar are often huge and multifaceted. Some are quite obvious, such as differences in language, currency, and everyday habits (say, using chopsticks instead of silverware). But others are subtle, complex, and sometimes even hidden. Success in international business means understanding a wide range of cultural, economic, legal, and political differences between countries. Let’s look at some of the more important of these differences.
3.04: Trade Controls
Learning Objective
1. Describe the ways in which governments and international bodies promote and regulate global trade.
The debate about the extent to which countries should control the flow of foreign goods and investments across their borders is as old as international trade itself. Governments continue to control trade. To better understand how and why, let’s examine a hypothetical case. Suppose you’re in charge of a small country in which people do two things—grow food and make clothes. Because the quality of both products is high and the prices are reasonable, your consumers are happy to buy locally made food and clothes. But one day, a farmer from a nearby country crosses your border with several wagonloads of wheat to sell. On the same day, a foreign clothes maker arrives with a large shipment of clothes. These two entrepreneurs want to sell food and clothes in your country at prices below those that local consumers now pay for domestically made food and clothes. At first, this seems like a good deal for your consumers: they won’t have to pay as much for food and clothes. But then you remember all the people in your country who grow food and make clothes. If no one buys their goods (because the imported goods are cheaper), what will happen to their livelihoods? Will everybody be out of work? And if everyone’s unemployed, what will happen to your national economy?
That’s when you decide to protect your farmers and clothes makers by setting up trade rules. Maybe you’ll increase the prices of imported goods by adding a tax to them; you might even make the tax so high that they’re more expensive than your homemade goods. Or perhaps you’ll help your farmers grow food more cheaply by giving them financial help to defray their costs. The government payments that you give to the farmers to help offset some of their costs of production are called subsidies. These subsidies will allow the farmers to lower the price of their goods to a point below that of imported competitors’ goods. What’s even better is that the lower costs will allow the farmers to export their own goods at attractive, competitive prices.
The United States has a long history of subsidizing farmers. Subsidy programs guarantee farmers (including large corporate farms) a certain price for their crops, regardless of the market price. This guarantee ensures stable income in the farming community but can have a negative impact on the world economy. How? Critics argue that in allowing American farmers to export crops at artificially low prices, U.S. agricultural subsidies permit them to compete unfairly with farmers in developing countries. A reverse situation occurs in the steel industry, in which a number of countries—China, Japan, Russia, Germany, and Brazil—subsidize domestic producers. U.S. trade unions charge that this practice gives an unfair advantage to foreign producers and hurts the American steel industry, which can’t compete on price with subsidized imports.
Whether they push up the price of imports or push down the price of local goods, such initiatives will help locally produced goods compete more favorably with foreign goods. Both strategies are forms of trade controls—policies that restrict free trade. Because they protect domestic industries by reducing foreign competition, the use of such controls is often called protectionism. Though there’s considerable debate over the pros and cons of this practice, all countries engage in it to some extent. Before debating the issue, however, let’s learn about the more common types of trade restrictions: tariffs, quotas, and, embargoes.
3.05: Reducing International Trade Barriers
Learning Objective
1. Discuss the various initiatives designed to reduce international trade barriers and promote free trade.
A number of organizations work to ease barriers to trade, and more countries are joining together to promote trade and mutual economic benefits. Let’s look at some of these important initiatives.
3.06: Preparing for a Career in International Business
Learning Objective
1. Understand how to prepare for a career in international business.
No matter where your career takes you, you won’t be able to avoid the reality and reach of international business. We’re all involved in it. Some readers may want to venture more seriously into this exciting arena. The career opportunities are exciting and challenging, but taking the best advantage of them requires some early planning. Here are some hints. | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/03%3A_Business_in_a_Global_Environment/3.01%3A_The_Globalization_of_Business.txt |
Learning on the Web (AACSB)
Keeping Current About Currency
On a day-to-day basis, you probably don’t think about what the U.S. dollar (US\$) is worth relative to other currencies. But there will likely be times when ups and downs in exchange rates will seem extremely important to you in your business career. The following are some hypothetical scenarios that illustrate what these times may be. (Note: To respond to the questions raised in each scenario, search Google for a currency converter.)
Scenario 1: Your Swiss Vacation
Your family came from Switzerland, and you and your parents visited relatives there back in 2007. Now that you’re in college, you want to make the trip on your own during spring break. While you’re there, you also plan to travel around and see a little more of the country. You remember that in 2007, US\$1 bought 1.22 Swiss francs (Frs). You estimate that, at this rate, you can finance your trip (excluding airfare) with the \$1,200 that you earned this summer. You’ve heard, however, that the exchange rate has changed. Given the current exchange rate, about how much do you think your trip would cost you? As a U.S. traveler going abroad, how are you helped by a shift in exchange rates? How are you hurt?
Scenario 2: Your British Friends
A few years ago, you met some British students who were visiting the United States. This year, you’re encouraging them to visit again so that you can show them around New York City. When you and your friends first talked about the cost of the trip back in 2007, the British pound (£) could be converted into US\$1.90. You estimated that each of your British friends would need to save up about £600 to make the trip (again, excluding plane fare). Given today’s exchange rate, how much will each person need to make the trip? Have your plans been helped or hindered by the change in exchange rates? Was the shift a plus for the U.S. travel industry? What sort of exchange-rate shift hurts the industry?
Scenario 3: Your German Soccer Boots
Your father rarely throws anything away, and while cleaning out the attic a few years ago, he came across a pair of vintage Adidas soccer boots made in 1955. Realizing that they’d be extremely valuable to collectors in Adidas’s home country of Germany, he hoped to sell them for US \$5,000 and, to account for the exchange rate at the time, planned to price them at \$7,200 in euros. Somehow, he never got around to selling the boots and has asked if you could sell them for him on eBay. If he still wants to end up with US \$5,000, what price in euros will you now have to set? Would an American company that exports goods to the European Union view the current rate more favorably or less favorably than it did back in 2007?
Career Opportunities (AACSB)
Broadening Your Business Horizons
At some point in your life, you’ll probably meet and work with people from various countries and cultures. Participating in a college study-abroad program can help you prepare to work in the global business environment, and now is as good a time as any to start exploring this option. Here’s one way to go about it:
• Select a study-abroad program that interests you. To do this, you need to decide what country you want to study in and your academic field of interest. Unless you speak the language of your preferred country, you should pick a program offered in English.
• If your school offers study-abroad programs, choose one that has been approved by your institution.
• If your school doesn’t offer study-abroad programs, locate one through a Web search.
• Describe the program, the school that’s offering it, and the country to which it will take you.
• Indicate why you’ve selected this particular program, and explain how it will help you prepare for your future business career.
Ethics Angle (AACSB)
The Right, Wrong, and Wisdom of Dumping and Subsidizing
When companies sell exported goods below the price they’d charge in their home markets (and often below the cost of producing the goods), they’re engaging in dumping. When governments guarantee farmers certain prices for crops regardless of market prices, the beneficiaries are being subsidized. What do you think about these practices? Is dumping an unfair business practice? Why, or why not? Does subsidizing farmers make economic sense for the United States? What are the effects of farm subsidies on the world economy? Are the ethical issues raised by the two practices comparable? Why, or why not?
Team-Building Skills (AACSB)
Three Little Words: The China Price
According to business journalists Pete Engardio and Dexter Roberts, the scariest three words that a U.S. manufacturer can hear these days are the China price. To understand why, go to the Business Week Web site (http://www.businessweek.com/magazine...9/b3911401.htm) and read its article “The China Price,” which discusses the benefits and costs of China’s business expansion for U.S. companies, workers, and consumers. Once you’ve read the article, each member of the team should be able to explain the paradoxical effect of U.S.–Chinese business relationships—namely, that they can hurt American companies and workers while helping American companies and consumers.
Next, your team should get together and draw up two lists: a list of the top five positive outcomes and a list of the top five negative outcomes of recent Chinese business expansion for U.S. businesses, workers, and consumers. Then, the team should debate the pros and cons of China’s emergence as a global business competitor and, finally, write a group report that answers the following questions:
1. Considered on balance, has China’s business expansion helped or harmed U.S. companies, workers, and consumers? Justify your answers.
2. What will happen to U.S. companies, workers, and consumers in the future if China continues to grow as a global business competitor?
3. How should U.S. companies respond to the threats posed by Chinese competitors in their markets?
4. What can you do as a student to prepare yourself to compete in an ever-changing global business environment?
When you hand in your report, be sure to attach all the following items:
• Members’ individually prepared lists of ways in which business relationships with China both hurt and help U.S. businesses, workers, and consumers
• Your group-prepared list of the top five positive and negative effects of Chinese business expansion on U.S. businesses, workers, and consumers
The Global View (AACSB)
Go East, Young Job Seeker
How brave are you when it comes to employment? Are you bold enough to go halfway around the world to find work? Instead of complaining about U.S. jobs going overseas, you could take the bull by the horns and grab one job back. It’s not that tough to do, and it could be a life-changing experience. U.S. college graduates with business or technical backgrounds are highly sought after by companies that operate in India. If you qualify (and if you’re willing to relocate), you could find yourself working in Bangalore or New Delhi for some multinational company like Intel, Citibank, or GlaxoSmithKline (a pharmaceutical company). In addition, learning how to live and work in a foreign country can build self-confidence and make you more attractive to future employers. To get a glimpse of what it would be like to live and work in India, go to the Web sites of American Way magazine (http://www.americanwaymag.com/jeffre...e-leela-palace) and CNN and Money (http://money.cnn.com/2004/03/09/pf/workers_to_india), and check out the posted articles: “Passage to India,” and “Needs Job, Moves to India.” Then, go to the Monster Work Abroad Web site (http://jobsearch.monsterindia.com/re...gin/index.html) and find a job in India that you’d like to have, either right after graduation or about five years into your career. (When selecting the job, ignore its actual location and proceed as if it’s in Bangalore.) After you’ve pondered the possibility of living and working in India, answer the following questions:
1. What would your job entail?
2. What would living and working in Bangalore be like? What aspects would you enjoy? Which would you dislike?
3. What challenges would you face as an expatriate (a person who lives outside his or her native country)? What opportunities would you have?
4. How would the experience of working in India help your future career?
5. Would you be willing to take a job in India for a year or two? Why, or why not? | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/03%3A_Business_in_a_Global_Environment/3.07%3A_Cases_and_Problems.txt |
Learning Objective
1. Identify the questions to ask in choosing the appropriate form of ownership for a business.
If you’re starting a new business, you have to decide which legal form of ownership is best for you and your business. Do you want to own the business yourself and operate as a sole proprietorship? Or, do you want to share ownership, operating as a partnership or a corporation? Before we discuss the pros and cons of these three types of ownership—sole proprietorship, partnership, and corporation—let’s address some of the questions that you’d probably ask yourself in choosing the appropriate legal form for your business.
1. What are you willing to do to set up and operate your business? Do you want to minimize the costs of getting started? Do you hope to avoid complex government regulations and reporting requirements?
2. How much control would you like? Do you want to own the company yourself, or do you want to share ownership with other people? Are you willing to share responsibility for running the business?
3. Do you want to be the sole benefactor of your efforts or are you willing to share profits with other people? Do you want to be in charge of deciding how much of the company’s profits will be retained in the business?
4. Do you want to avoid special taxes? Do you want to avoid paying “business” income taxes on your business and then paying “personal” income taxes on profits earned by the business?
5. Do you have all the skills needed to run the business? Do you possess the talent and skills to run the business yourself, or would the business benefit from a diverse group of owners? Are you likely to get along with co-owners over an extended period of time?
6. Should it be possible for the business to continue without you? Is it important to you that the business survive you? Do you want to know that other owners can take over if you die or become disabled? Do you want to make it easy for ownership to change hands?
7. What are your financing needs? How do you plan to finance your company? Will you need a lot of money to start, operate, and grow your business? Can you furnish the money yourself, or will you need some investment from other people? Will you need bank loans? If so, will you have difficulty getting them yourself?
8. How much liability exposure are you willing to accept? Are you willing to risk your personal assets—your bank account, your car, maybe even your home—for your business? Are you prepared to pay business debts out of your personal funds? Do you feel uneasy about accepting personal liability for the actions of fellow owners?
No single form of ownership will give you everything you desire. You’ll have to make some trade-offs. Because each option has both advantages and disadvantages, your job is to decide which one offers the features that are most important to you. In the following sections we’ll compare the three ownership options (sole proprietorship, partnership, corporation) on the eight dimensions that we identified previously: setup costs and government regulations control, profit sharing, income taxes, skills, continuity and transferability, ability to obtain financing, and liability exposure.
Key Takeaways
• Some of the questions that you’d probably ask yourself in choosing the appropriate legal form for your business include the following:
1. What are you willing to do to set up and operate your business?
2. How much control do you want?
3. Do you want to share profits with others?
4. Do you want to avoid special taxes on your business?
5. Do you have all the skills needed to run the business?
6. Should it be possible for the business to continue without you?
7. What are your financing needs?
8. How much liability exposure are you willing to accept?
• No single form of ownership—sole proprietorship, partnership, or corporation—will give you everything you want. Each has advantages and disadvantages.
Exercise
(AACSB) Analysis
Review the eight questions identified in this section that you’d probably ask yourself in choosing the appropriate legal form. Rate each of the questions using this scale: [1] not at all important; [2] not very important; [3] somewhat important; [4] very important; [5] extremely important. Select the two questions that are most important to you and the two questions that are least important to you, and explain your responses to these four questions. | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/04%3A_Selecting_a_Form_of_Business_Ownership/4.01%3A_Factors_to_Consider.txt |
Learning Objective
1. Describe the sole proprietorship form of organization, and specify its advantages and disadvantages.
A sole proprietorship is a business owned by only one person. The most common form of ownership, it accounts for about 72 percent of all U.S. businesses (The National Data Book, 2011). It’s the easiest and cheapest type of business to form: if you’re using your own name as the name of your business, you just need a license to get started, and once you’re in business, you’re subject to few government regulations.
4.03: Partnership
Learning Objectives
1. Identify the different types of partnerships, and explain the importance of a partnership agreement.
2. Describe the advantages and disadvantages of the partnership form of organization.
A partnership (or general partnership) is a business owned jointly by two or more people. About 10 percent of U.S. businesses are partnerships (The National Data Book, 2011), and though the vast majority are small, some are quite large. For example, the big four public accounting firms are partnerships. Setting up a partnership is more complex than setting up a sole proprietorship, but it’s still relatively easy and inexpensive. The cost varies according to size and complexity. It’s possible to form a simple partnership without the help of a lawyer or an accountant, though it’s usually a good idea to get professional advice. Professionals can help you identify and resolve issues that may later create disputes among partners.
4.04: Corporation
Learning Objectives
1. Explain how corporations are formed and how they operate.
2. Discuss the advantages and disadvantages of the corporate form of ownership.
A corporation (sometimes called a regular or C-corporation) differs from a sole proprietorship and a partnership because it’s a legal entity that is entirely separate from the parties who own it. It can enter into binding contracts, buy and sell property, sue and be sued, be held responsible for its actions, and be taxed. As Figure 4.5 “Types of U.S. Businesses” shows, corporations account for 18 percent of all U.S. businesses but generate almost 82 percent of the revenues (The National Data Book, 2011). Most large well-known businesses are corporations, but so are many of the smaller firms with which you do business.
Figure 4.5 Types of U.S. Businesses
Source: “Number of Tax Returns, Receipts, and Net Income by Type of Business,” The 2011 Statistical Abstract: The National Data Book, www.census.gov/compendia/stat...porations.html (accessed August 27, 2011); “Number of Tax Returns and Business Receipts by Size of Receipts,” The 2011 Statistical Abstract: The National Data Book, www.census.gov/compendia/stat...porations.html (accessed August 27, 2011).
4.05: Other Types of Business Ownership
Learning Objective
1. Examine special types of business ownership, including S-corporations, limited-liability companies, cooperatives, and not-for-profit corporations.
In addition to the three commonly adopted forms of business organization—sole proprietorship, partnership, and regular corporations—some business owners select other forms of organization to meet their particular needs. We’ll look at several of these options:
• S-corporations
• Limited-liability companies
• Cooperatives
• Not-for-profit corporations
4.06: Mergers and Acquisitions
Learning Objective
1. Define mergers and acquisitions, and explain why companies are motivated to merge or acquire other companies.
The headline read, “Wanted: More than 2,000 in Google Hiring Spree” (Oreskovic, 2011; The Official Google Blog, 2011). The largest Web search engine in the world was disclosing its plans to grow internally and increase its workforce by more than 2,000 people, with half of the hires coming from the United States and the other half coming from other countries. The added employees will help the company expand into new markets and battle for global talent in the competitive Internet information providers industry. When properly executed, internal growth benefits the firm.
An alternative approach to growth is to merge with or acquire another company. The rationale behind growth through merger or acquisition is that 1 + 1 = 3: the combined company is more valuable than the sum of the two separate companies. This rationale is attractive to companies facing competitive pressures. To grab a bigger share of the market and improve profitability, companies will want to become more cost efficient by combining with other companies. | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/04%3A_Selecting_a_Form_of_Business_Ownership/4.02%3A_Sole_Proprietorship.txt |
Learning on the Web (AACSB)
Do you have an idea for a charitable organization you’d like to start? Think of some cause that’s important to you. Then go online and review this article by Joanne Fritz, “How to Incorporate as a Nonprofit: A Check List” located at http://nonprofit.about.com/od/nonprofitbasics/ht/startingsteps.htm. Draft a mission statement for your not-for-profit organization, and indicate the types of people you’d ask to serve on your board of directors. Then list the steps you’d take to set up your not-for-profit organization.
Career Opportunities
Where Do You Find Happiness?
Have you given much thought to whether you’d be happier working for a small company or for a big one? Here’s your chance to compare and contrast the opportunities that small companies and big companies offer. First, read the article “Company Research—Investigate Small Companies” (http://jobsearch.about.com/cs/employerresearch/a/compresearch.htm). Then read the article “Benefits of Working in a Small Company vs. a Corporation” (http://www.streetdirectory.com/travel_guide/190820/careers_and_job_hunting/benefits_of _working_in_a_small_company_vs_a_corporation.html) (Doyle, 2011; Jacowsk, 2011). Identify five advantages of working for a small company and five advantages of working for a big one. Indicate your choice of employer (small or big company), and explain why you selected this option.
Ethics Angle (AACSB)
Bermuda Is Beautiful, but Should You Incorporate There?
A company can incorporate in any state it chooses. Most small businesses incorporate in the state in which they do business, while larger companies typically hunt around for the state or country that gives them the most favorable treatment (lower taxes, fewer restrictions). A growing number of U.S. companies are incorporating in Bermuda to lower their corporate income taxes while still enjoying the benefits of doing business in the United States. Does this seem right to you? Read these two articles and answer the questions that follow:
Questions:
• What advantages do U.S. companies gain by incorporating in Bermuda?
• What disadvantages do U.S. companies incur by incorporating in Bermuda?
• Do you find the practice of incorporating in Bermuda unethical? Why, or why not?
Team-Building Skills (AACSB)
Legally Speaking
Here’s the scenario: You and your team serve as consultants to business owners who need help in deciding which legal form of ownership is best for them. You’re currently working with three clients. For each client, you’ll evaluate possible legal forms of organization, debate the alternatives, and make a recommendation. Then, you’ll write a report to your client, presenting your recommendation and explaining why you arrived at your conclusion.
In addition to learning the basic facts about each company, you’ve gathered additional information by asking each client the following questions:
• How much control do you want?
• Do you want to share profits with others?
• How much liability exposure are you willing to accept?
• What are your financing needs?
• What are you willing to do to set up and operate your business?
• Should it be possible for the business to continue without you?
The following is the information that you’ve collected about each client, along with ownership options you should consider.
Client 1: Rainforest Adventures
Rainforest Adventures offers one-day and multiday tours of several locations in Australia. It works both with tourists and with study groups, and its clientele varies from people who want a relaxing experience away from hectic urban life to those who are keenly interested in the exotic environment. The business is dedicated to the preservation of Australia’s tropical and wetland preserves. Its guides have many years of experience leading tourists through the rainforests, particularly at night when they come alive.
Rainforest Adventures was started three years ago by Courtney Kennedy, who has fifteen years of experience in the ecotourism industry. She runs the business as a sole proprietorship but is considering a partnership. (She doesn’t want the cost or hassle of doing business as a corporation.) In questioning her, you found out the following: Kennedy is dedicated to preserving the Australian wetlands and sees her business as a way of encouraging people to support conservation efforts. However, her guides have displayed an “it’s just-a-job” attitude, have become increasingly undependable, and are unwilling to share her commitment. Still, Kennedy has several trusted friends who not only have years of experience as guides, but who also share her enthusiasm for environmental preservation. She’s optimistic that they’d be willing to join her in the business. She dreams of expanding her business to offer classes on the ecology of the rainforest but doesn’t have enough cash, and she’s afraid that a loan application will be turned down by the bank.
Options
Because Kennedy doesn’t want to incorporate, she’s left with two options: to continue doing business as a sole proprietorship or to find one or more individuals to join her in a partnership. After evaluating these two alternatives, you should recommend the one that you consider most appropriate. You should discuss the pros and cons of both options and explain how each applies to Kennedy’s situation. If you recommend forming a partnership, you need to distinguish between a general partnership and a limited partnership, as well as explain what a partnership agreement is, what it covers, and why it’s important.
Client 2: Scuffy the Tugboat
Scuffy the Tugboat is a family-run business that makes tugboats. It was formed as a partnership in 1996 by the three McLaughlin brothers—Mick (a naval architect), Jack (an accountant), and Bob (a marine engineer). Their first tugboat is still towing ships in Boston harbor, and over the years, success has allowed them to grow the company by plowing money back into it. Last year’s sales were more than \$7 million. Now, however, they want to double production by expanding their factory by five thousand square feet. They estimate a cost of about \$1 million, yet a bigger facility would enable them to avoid late-delivery penalties that can run up to \$2,000 a day. They’re not sure, however, about the best way to raise the needed funds. None of the brothers has \$1 million on hand, and because lenders are often hesitant to loan money to shipbuilders, even those with good performance records, local banks haven’t been encouraging.
Unlike many partners, the three brothers get along quite well. They’re concerned, though, about the risks of taking on personal debts for the business. In particular, they don’t like being liable not only for their own actions, but also for the actions of all the partners.
Options
You should recommend that Scuffy the Tugboat either remain a partnership or become a privately-held corporation. State the pros and cons of both forms of organization, and explain how they apply to the brothers’ situation.
Client 3: Dinner Rendezvous
For three years, owner Peggy Deardon has been operating Dinner Rendezvous, which gives individuals an opportunity to meet others and expand their social networks, in Austin, Texas. Interested clients go to the company’s Web site and fill out applications and privacy statements. There’s an annual membership fee of \$125 and a \$15 charge for each dinner attended (plus the cost of dinner and drinks). Deardon sets up all dinners and is onsite at the restaurant to introduce guests and serve complimentary champagne. While the company has a steady clientele, it’s not a big moneymaker. If Deardon didn’t have a regular full-time job, she couldn’t keep the business running. She stays with it because she enjoys it and believes that she provides a good service for Austin residents. Because it’s run out of her home, and because her biggest cost is the champagne, it’s a low-risk business with no debts. With a full-time job, she also appreciates the fact that it requires only a few hours of her time each week.
Options
Since your client wants advice on whether to incorporate, you should evaluate two options—remaining a sole proprietorship or forming a corporation. In addition to your recommendation, you should state the pros and cons of both forms of organization and explain how they apply to Deardon’s situation.
The Global View (AACSB)
America for Sale
Our U.S. companies continue to expand by merging with or acquiring other companies. This is acceptable business practice. But what happens when our U.S. companies and other assets are bought up by firms and individuals outside the United States? Is this acceptable business practice or something we should be concerned about? Learn how this is happening by reading this article by Geoff Colvin:
Questions:
• Why are foreigners buying U.S. assets?
• Is the current trend in foreign investments in U.S. assets positive or negative for the United States? Whom does it help? Whom does it hurt? Explain.
• What, if anything, can the United States do to stop this trend?
• If you were able, would you limit foreign investment in U.S. assets? Why, or why not? | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/04%3A_Selecting_a_Form_of_Business_Ownership/4.07%3A_Cases_and_Problems.txt |
Learning Objectives
1. Define entrepreneur.
2. Describe the three characteristics of entrepreneurial activity.
3. Identify five potential advantages to starting your own business.
4. Explain the differences among three types of start-up firms.
In developing BTIO and Realityworks Inc., the Jurmains were doing what entrepreneurs do (and doing it very well). In fact, Mary was nominated three times for the Ernst & Young Entrepreneur of the Year Award and named 2001 Wisconsin Entrepreneurial Woman of the Year by the National Association of Women Business Owners. So what, exactly, is an entrepreneur? What does an entrepreneur do? According to one definition, an entrepreneur is an “individual who starts a new business,” and that’s true as far as it goes. Another definition identifies an entrepreneur as someone who uses “resources to implement innovative ideas for new, thoughtfully planned ventures,” (Canadian Foundation for Economic Education, 2008) which is also true as far as it goes. But an important component of a satisfactory definition is still missing. To appreciate fully what it is, let’s go back to the story of the Jurmains, for whom entrepreneurship seems to have worked out quite well. We hasten to point out that, in 1993, the Jurmains were both unemployed—Rick had been laid off by General Dynamics Corp., and Mary by the San Diego Gas and Electric Company. While they were watching the show about teenagers and flour sacks, they were living off a loan from her father and the returns from a timely investment in coffee futures. Rick recalls that the idea for a method of creating BTIO came to him while “I was awake in bed, worrying about being unemployed.” He was struggling to find a way to feed his family. He had to make the first forty simulators himself, and at the end of the first summer, BTIO had received about four hundred orders—a promising start, perhaps, but, at \$250 per baby (less expenses), not exactly a windfall. “We were always about one month away from bankruptcy,” recalls Mary.
At the same time, it’s not as if the Jurmains started up BTIO simply because they had no “conventional” options for improving their financial prospects. Rick, as we’ve seen, was an aerospace engineer, and his résumé includes work on space-shuttle missions at NASA. Mary, who has not only a head for business but also a degree in industrial engineering, has worked at the Johnson Space Center. Therefore, the idea of replacing a sack of flour with a computer-controlled simulator wasn’t necessarily rocket science for the couple. But taking advantage of that idea—choosing to start a new business and to commit themselves to running it—was a risk. Risk taking is the missing component that we’re looking for in a definition of entrepreneurship, and so we’ll define an entrepreneur as someone who identifies a business opportunity and assumes the risk of creating and running a business to take advantage of it.
5.02: The Importance of Small Business to the U.S. Economy
Learning Objectives
1. Define a small business.
2. Explain the importance of small businesses to the U.S. economy.
3. Explain why small businesses tend to foster innovation more effectively than large ones.
4. Describe some of the ways in which small companies work with big ones.
5.03: What Industries Are Small Businesses In
Learning Objectives
1. Describe the goods-producing and service-producing sectors of an economy.
2. Identify the industries in which small businesses are concentrated.
If you want to start a new business, you probably should avoid certain types of businesses. You’d have a hard time, for example, setting up a new company to make automobiles or aluminum, because you’d have to make tremendous investments in property, plant, and equipment, and raise an enormous amount of capital to pay your workforce.
Fortunately, plenty of opportunities are still available if you’re willing to set your sights a little lower. Many types of businesses require reasonable initial investments, and not surprisingly, these are the ones that usually present attractive small business opportunities.
5.04: Advantages and Disadvantages of Business Ownership
Learning Objective
1. Summarize the advantages and disadvantages of business ownership.
Do you want to be a business owner someday? Before deciding, you might want to consider the following advantages and disadvantages of business ownership (Small Business Development Center, 2006).
5.05: Starting a Business
Learning Objectives
1. Explain what it takes to start a business.
2. Evaluate the advantages and disadvantages of several small business ownership options—starting a business from scratch, buying an existing business, and obtaining a franchise.
Starting a business takes talent, determination, hard work, and persistence. It also requires a lot of research and planning. Before starting your business, you should appraise your strengths and weaknesses and assess your personal goals to determine whether business ownership is for you (Allen, 2001).
5.06: The Business Plan
Learning Objective
1. Discuss the importance of planning for your business, and identify the key sections of a business plan.
If you want to start a business, you must prepare a business plan. This essential document should tell the story of your business concept, provide an overview of the industry in which you will operate, describe the goods or services you will provide, identify your customers and proposed marketing activities, explain the qualifications of your management team, and state your projected income and borrowing needs. | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/05%3A_The_Challenges_of_Starting_a_Business/5.01%3A_What_Is_an_Entrepreneur.txt |
Learning Objectives
1. Discuss ways to succeed in managing a business, and explain why some businesses fail.
2. Identify sources of small business assistance from the Small Business Administration.
Why Do Businesses Succeed?
Being successful as a business owner requires more than coming up with a brilliant idea and working hard. You need to learn how to manage and grow your business. In the process, you’ll face numerous challenges, and your ability to meet them will be a major factor in your success (or failure) (D&B, 2008). To give yourself a fighting chance in making a success of your business, you should do the following:
• Know your business. It seems obvious, but it’s worth mentioning: successful businesspeople know what they’re doing. They’re knowledgeable about the industry in which they operate (both as it stands today and where it’s headed), and they know who their competitors are. They know how to attract customers and who the best suppliers and distributors are, and they understand the impact of technology on their business.
• Know the basics of business management. You might be able to start a business on the basis of a great idea, but to manage it you need to understand the functional areas of business—accounting, finance, management, marketing, and production. You need to be a salesperson, as well as a decision maker and a planner.
• Have the proper attitude. When you own a business, you are the business. If you’re going to devote the time and energy needed to transform an idea into a successful venture, you need to have a passion for your work. You should believe in what you’re doing and make a strong personal commitment to your business.
• Get adequate funding. It takes a lot of money to start a business and guide it through the start-up phase (which can last for over a year). You can have the most brilliant idea in the world, the best marketing approach, and a talented management team, yet if you run out of cash, your career as a business owner could be brief. Plan for the long term and work with lenders and investors to ensure that you’ll have sufficient funds to get open, stay open during the start-up phase, and, ultimately, expand.
• Manage your money effectively. You’ll be under constant pressure to come up with the money to meet payroll and pay your other bills. That’s why you need to keep an eye on cash flow—money coming in and money going out. You need to control costs and collect money that’s owed you, and, generally, you need to know how to gather the financial information that you require to run your business.
• Manage your time efficiently. A new business owner can expect to work sixty hours a week. If you want to grow a business and have some type of nonwork life at the same time, you’ll have to give up some control—to let others take over some of the work. Thus, you must develop time-management skills and learn how to delegate responsibility.
• Know how to manage people. Hiring, keeping, and managing good people are crucial to business success. As your business grows, you’ll depend more on your employees. You need to develop a positive working relationship with them, train them properly, and motivate them to provide quality goods or services.
• Satisfy your customers. You might attract customers through impressive advertising campaigns, but you’ll keep them only by providing quality goods or services. Commit yourself to satisfying—or even exceeding—customer needs.
• Know how to compete. Find your niche in the marketplace, keep an eye on your competitors, and be prepared to react to changes in the marketplace. The history of business (and much of life) can be summed up in three words: “Adapt or perish.”
Why Do Businesses Fail?
If you’ve paid attention to the occupancy of shopping malls over a few years, you’ve noticed that retailers come and go with surprising frequency. The same thing happens with restaurants—indeed, with all kinds of businesses. By definition, starting a business—small or large—is risky, and though many businesses succeed, a large proportion of them don’t. One-third of small businesses that have employees go out of business within the first two years. More than half of small businesses have closed by the end of their fourth year, and 70 percent do not make it past their seventh year (Knaup & Piazza, 2011; Knaup & Piazza, 2007).
Table 5:2 Survival Rate of New Companies
Number of Years after Start-up Rate of Survival
1 81.2%
2 65.8%
3 54.3%
4 44.4%
5 38.3%
6 34.4%
7 31.2%
Note: Percentages based on a total of 212,182 businesses
that started up in the second quarter of 1998.
Source: “Characteristics of Survival: Longevity of Business Establishments in the Business Employment Dynamics Data: Extension.” www.bls.gov/osmr/pdf/st060040.pdf.
As bad as these statistics on business survival are, some industries are worse than others. If you want to stay in business for a long time, you might want to avoid some of these risky industries. Even though your friends think you make the best macaroni and cheese pizza in the world, this doesn’t mean you can succeed as a pizza parlor owner. Opening a restaurant or a bar is one of the riskiest ventures (and, therefore, start-up funding is hard to get). You might also want to avoid the transportation industry. Owning a taxi might appear lucrative until you find out what a taxi license costs. It obviously varies by city, but in New York City the price tag is upward of \$400,000. And setting up a shop to sell clothing can be challenging. Your view of “what’s in” may be off, and one bad season can kill your business. The same is true for stores selling communication devices: every mall has one or more cell phone stores so the competition is steep, and business can be very slow (Farrell, 2011).
Businesses fail for any number of reasons, but many experts agree that the vast majority of failures result from some combination of the following problems:
• Bad business idea. Like any idea, a business idea can be flawed, either in the conception or in the execution. If you tried selling snowblowers in Hawaii, you could count on little competition, but you’d still be doomed to failure.
• Cash problems. Too many new businesses are underfunded. The owner borrows enough money to set up the business but doesn’t have enough extra cash to operate during the start-up phase, when very little money is coming in but a lot is going out.
• Managerial inexperience or incompetence. Many new business owners have no experience in running a business; many have limited management skills. Maybe an owner knows how to make or market a product but doesn’t know how to manage people. Maybe an owner can’t attract and keep talented employees. Maybe an owner has poor leadership skills and isn’t willing to plan ahead.
• Lack of customer focus. A major advantage of a small business is the ability to provide special attention to customers. But some small businesses fail to seize this advantage. Perhaps the owner doesn’t anticipate customers’ needs or keep up with changing markets or the customer-focused practices of competitors.
• Inability to handle growth. You’d think that a sales increase would be a good thing. Often it is, of course, but sometimes it can be a major problem. When a company grows, the owner’s role changes. He or she needs to delegate work to others and build a business structure that can handle the increase in volume. Some owners don’t make the transition and find themselves overwhelmed. Things don’t get done, customers become unhappy, and expansion actually damages the company.
Help from the SBA
If you had your choice, which cupcake would you pick—vanilla Oreo, tripple chocolate, or latte? In the last few years, cupcake shops are popping up in almost every city. Perhaps the bad economy has put people in the mood for small, relatively inexpensive treats. Whatever the reason, you’re fascinated with the idea of starting a cupcake shop. You have a perfect location, have decided what equipment you need, and have tested dozens of recipes (and eaten lots of cupcakes). You are set to go with one giant exception: you don’t have enough savings to cover your start-up costs. You have made the round of most local banks, but they are all unwilling to give you a loan. So what do you do? Fortunately, there is help available. It is through your local Small Business Administration (SBA), which offers an array of programs to help current and prospective small business owners. The SBA won’t actually loan you the money, but it will increase the liklihood that you will get funding from a local bank by guaranteeing the loan. Here’s how the SBA’s loan guaranty program works: You apply to a bank for financing. A loan officer decides if the bank will loan you the money without an SBA guarantee. If the answer is no (because of some weakness in your application), the bank then decides if it will loan you the money if the SBA guarantees the loan. If the bank decides to do this, you get the money and make payments on the loan. If you default on the loan, the government reimburses the bank for its loss, up to the amount of the SBA guarantee.
In the process of talking with someone at the SBA, you will discover other programs it offers that will help you start your business and manage your organization. For example, to apply for funding you will need a well-written business plan. Once you get the loan and move to the business start-up phase, you will have lots of questions that need to be answered (including setting up a computer system for your company). And you are sure you will need help in a number of areas as you operate your cupcake shop. Fortunately, the SBA can help with all of these management and technical-service tasks.
This assistance is available through a number of channels, including the SBA’s extensive Web site, online courses, and training programs. A full array of individualized services is also available. The Small Business Development Center (SBDC) assists current and prospective small business owners with business problems and provides free training and technical information on all aspects of small business management. These services are available at approximately one thousand locations around the country, many housed at colleges and universities (U.S. Small Business Administration, 2011).
If you need individualized advice from experienced executives, you can get it through the Service Corps of Retired Executives (SCORE). Under the SCORE program, a businessperson needing advice is matched with someone on a team of retired executives who work as volunteers. Together, the SBDC and SCORE help more than a million small businesspersons every year (U.S. Small Business Administration, 2011; SBDC Economic Impact, 2011).
Key Takeaways
• Business owners face numerous challenges, and the ability to meet them is a major factor in success (or failure). As a business owner, you should do the following:
1. Know your business. Successful businesspeople are knowledgeable about the industry in which they operate, and they know who their competitors are.
2. Know the basics of business management. To manage a business, you need to understand the functional areas of business—accounting, finance, management, marketing, and production.
3. Have the proper attitude. You should believe in what you’re doing and make a strong personal commitment to it.
4. Get adequate funding. Plan for the long term and work with lenders and investors to ensure that you’ll have sufficient funds to get open, stay open during the start-up phase, and, ultimately, expand.
5. Manage your money effectively. You need to pay attention to cash flow—money coming in and money going out—and you need to know how to gather the financial information that you require to run your business.
6. Manage your time efficiently. You must develop time-management skills and learn how to delegate responsibility.
7. Know how to manage people. You need to develop a positive working relationship with your employees, train them properly, and motivate them to provide quality goods or services.
8. Satisfy your customers. Commit yourself to satisfying—or even exceeding—customer needs.
9. Know how to compete. Find your niche in the marketplace, keep an eye on your competitors, and be prepared to react to changes in your business environment.
• Businesses fail for any number of reasons, but many experts agree that the vast majority of failures result from some combination of the following problems:
1. Bad business idea. Like any idea, a business idea can be flawed, either in the conception or in the execution.
2. Cash problems. Too many new businesses are underfunded.
3. Managerial inexperience or incompetence. Many new business owners have no experience in running a business, and many have limited management skills.
4. Lack of customer focus. Some owners fail to make the most of a small business’s advantage in providing special attention to customers.
5. Inability to handle growth. When a company grows, some owners fail to delegate work or to build an organizational structure that can handle increases in volume.
• Services available to current and prospective small business owners from the SBA include assistance in developing a business plan, starting a business, obtaining financing, and managing an organization.
• The SBDC (Small Business Development Centers) matches businesspeople needing advice with teams of retired executives who work as volunteers through the SCORE program.
Exercise
(AACSB) Analysis
1. It’s the same old story: you want to start a small business but don’t have much money. Go to http://entrepreneurs.about.com/cs/businessideas/a/10startupideas.htm and read the article titled “Business Ideas on a Budget.” Identify a few businesses that you can start for \$20 or less (that’s right—\$20 or less). Select one of these business opportunities that interests you. Why did you select this business? Why does the idea interest you? What would you do to ensure that the business was a success? If you needed assistance starting up or operating your business, where could you find help, and what type of assistance would be available?
2. Why do some businesses succeed while others fail? Identify three factors that you believe to be the most critical to business success. Why did you select these factors? Identify three factors that you believe to be primarily responsible for business failures, and indicate why you selected these factors. | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/05%3A_The_Challenges_of_Starting_a_Business/5.07%3A_How_to_Succeed_in_Managing_a_Business.txt |
Learning on the Web (AACSB)
Would You Like to Own a Sub Shop?
How would you like to own your own sandwich shop? You could start one on your own or buy one that’s already in business, but an easier way might be buying a franchise from SUBWAY, the largest fast-food franchise in the world (even bigger than McDonald’s). SUBWAY began in 1965 when seventeen-year-old Fred DeLuca opened a tiny sandwich shop in Bridgeport, Connecticut, hoping to put himself through college. As it turns out, his venture paid off in more ways than one. By 1974, DeLuca was franchising his business concept, and today, there are more than fifteen thousand SUBWAY franchisees in some seventy-five countries.
Go to www.subway.com to link to the SUBWAY Web site and learn more about franchise opportunities with the company. After reviewing the information provided on the company’s Web site, answer the following questions:
1. What do you have to do to get a SUBWAY franchise?
2. How much would it cost to open a SUBWAY shop?
3. What training and support would you receive from SUBWAY?
4. What advantages do you see in buying a SUBWAY franchise rather than starting a business from scratch? What disadvantages do you see?
Career Opportunities
Do You Want to Be an Entrepreneur?
Want to learn what it’s like to be an entrepreneur? To help you decide whether life as an entrepreneur might be for you, go to http://entrepreneurs.about.com/od/interviews/null.htm; then link to the “Interview with Entrepreneurs” section of the About.com Web site and review the entrepreneur interviews. Select two entrepreneurs who interest you, and for each, do the following:
1. Describe the company that he or she founded.
2. Explain the reasons why he or she became an entrepreneur.
3. Explain what qualities, background, or both, prepared the individual to start a business.
After reading the interviews with these two entrepreneurs, answer the following questions:
1. What aspects of being an entrepreneur are particularly rewarding?
2. What’s the downside of being an entrepreneur?
3. What challenges do entrepreneurs face?
4. Is entrepreneurship for you? Why, or why not?
Ethics Angle (AACSB)
Term Papers for Sale
You and some fellow classmates are sitting around over pizza one night when someone comes up with an idea for a business. All of you have old term papers and essays lying around, and a couple of you know how to set up a Web page. What if you combine these two assets and start a business selling term papers over the Internet? Over time, you could collect or buy additional inventory from other students, and since some of you are good at research and others are good writers, you could even offer “student clients” the option of customized papers researched and written just for them. You figure that you can charge \$15 for an “off-the-rack” paper, and for customized jobs, \$10 per double-spaced page seems reasonable.
You all agree that the idea is promising, and you and a partner volunteer to put together a business plan. You have no difficulty with the section describing your proposed business: you know what your business will do, what products it will offer, who your customers will be, how your products will be sold, and where you’ll be located. So far, so good.
Let’s pause at this point to consider the following questions:
1. Does selling term papers over the Internet make business sense? Is it a good business idea?
2. Could the venture be profitable?
Let’s continue and find out how the business plan proceeds.
Now you’re ready to write your section on industry analysis and the first question you need to answer is, who are the players in the industry? To get some answers, you go online, log on to Google, and enter the search term “term papers for sale.” Much to your surprise, up pop dozens of links to companies that have beaten you to market. The first company you investigate claims to have a quarter-million papers in stock, plus a team of graduate students on hand to write papers for anyone needing specialized work.
There’s also a statement that says something like this: “Our term papers and essays are intended to help students write their own papers. They should be used for research purposes only. Students using our term papers and essays should write their own papers and cite our work.”
You realize now that you’re facing not only stiff competition but an issue that, so far, you and your partners have preferred to ignore: Is the business that you have in mind even ethical? It occurs to you that you could probably find the answer to this question in at least one of the 8,484 term papers on ethics available on your competitor’s Web site, but you decide that it would be more efficient to give the question some thought on your own.
At this point, then, let’s pause again to identify a couple of questions that you need to ask yourself as you prepare a report of your findings for your partners:
1. Is the sole purpose of running a business to make a profit, or do you need to be concerned about what your products will be used for? Explain your reasoning.
2. Do you need to consider the ethics of what other people do with your product? Explain your reasoning.
When you report on the problem that you’ve uncovered, your would-be partners are pretty discouraged, some by the prospect of competition and some by the nagging ethical issue. Just as you’re about to dissolve the partnership, one person speaks up: “How about selling software that lets faculty search to see if students have plagiarized material on the Web?”
“Sorry,” says someone else. “It’s already out there. Two students at Berkeley have software that compares papers to a hundred million Web pages.”
Team-Building Skills (AACSB)
Knowing how to be an effective team member is a vital lifetime skill. It will help you in your academic career, in the business world, and in nonwork activities as well. It takes time and effort to learn how to work in a team. Part of the challenge is learning how to adjust your behavior to the needs of the group. Another part is learning how to motivate members of a group. A well-functioning team allows members to combine knowledge and skills, and this reliance on diverse backgrounds and strengths often results in team decisions that are superior to those made by individuals working alone.
Are You a Team Player?
As a first step, you should do a self-assessment to evaluate whether you possess characteristics that will help you be a successful team member. You can do this by taking a “Team Player” quiz available at the Quintessential Careers Web site. Go to www.quintcareers.com/team_player_quiz.html to link to this quiz. You’ll get feedback that helps you identify the characteristics you need to work on if you want to improve your teamwork skills.
Working Together as a Team
The best approach to specifying appropriate behavior for team members is for the team to come up with some ground rules. Get together with three other students selected by your instructor, and establish working guidelines for your team. Prepare a team report in which you identify the following:
1. Five things that team members can do to increase the likelihood of group success
2. Five things that team members can do to jeopardize group success
The Global View (AACSB)
Global Versions of MySpace
When Andrew Mason founded Groupon in November 2008, he had no idea that he was headed for an overnight success, but two years after he set out on his entrepreneurial adventure (which, admittedly, isn’t actually overnight), Groupon had more than fifty million registered users and nine million customers who had purchased at least one “daily deal” (http://www.digital-dd.com/wp-content/uploads/2011/06/groupon-ipo-s-1.pdf).
What’s ahead for Groupon? Can its business model be exported to even more locations outside the United States? If you were in charge of global expansion for Groupon, what country would you enter next? What country would you avoid? To identify promising and not-so-promising foreign markets, go to the Groupon Wikipedia article (http://en.Wikipedia.org/wiki/Groupon) and click on “Geographic Markets” to obtain a list of counties in which Groupon operates. Also go to http://news.bbc.co.uk/1/hi/country_profiles/default.stm to link to the Country Profiles Web site maintained by BBC News. Study the economic and political profiles of possible overseas locations, and answer the following questions:
1. Why do you think Groupon has been so successful in the United States? Cite some of the challenges that it still faces in this country.
2. If you were in charge of global expansion at Groupon, which country would you enter next? Why do you think the Groupon business concept will succeed in this country? What challenges will the company face there?
3. What country would you avoid? Why is it incompatible with the Groupon business concept? | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/05%3A_The_Challenges_of_Starting_a_Business/5.08%3A_Cases_and_Problems.txt |
Learning Objective
1. Identify the four interrelated functions of management: planning, organizing, directing, and controlling.
You’ll accomplish this task through management: the process of planning, organizing, directing, and controlling resources to achieve specific goals. A plan enables you to take your business concept beyond the idea stage. It does not, however, get the work done. You have to organize things if you want your plan to become a reality. You have to put people and other resources in place to make things happen. And because your note-taking venture is supposed to be better off with you in charge, you need to be a leader who can motivate your people to do well. Finally, to know whether things are in fact going well, you’ll have to control your operations—that is, measure the results and compare them with the results that you laid out in your plan. Figure 6.1 “The Role of Planning” gives you a good idea of the interrelationship between planning and the other functions that managers perform.
Figure 6.1 The Role of Planning
Functions of Management
6.02: Planning
Learning Objective
1. Understand the process by which a company develops and implements a strategic plan.
Without a plan, it’s hard to succeed at anything. The reason is simple: if you don’t know where you’re going, you can’t really move forward. Successful managers decide where they want to be and then figure out how to get there. In planning, managers set goals and determine the best way to achieve them. As a result of the planning process, everyone in the organization knows what should be done, who should do it, and how it should be done.
6.03: Organizing
Learning Objective
1. Discuss various options for organizing a business, and create an organization chart.
Now that you’ve developed a strategic plan for Notes-4-You, you need to organize your company so that it can implement your plan. A manager engaged in organizing allocates resources (people, equipment, and money) to achieve a company’s plans. Successful managers make sure that all the activities identified in the planning process are assigned to some person, department, or team and that everyone has the resources needed to perform assigned activities.
6.04: Directing
Learning Objective
1. Explain how managers direct others and motivate them to achieve company goals.
The third management function is directing—providing focus and direction to others and motivating them to achieve organizational goals. As owner and president of Notes-4-You, you might think of yourself as an orchestra leader. You have given your musicians (employees) their sheet music (plans). You’ve placed them in sections (departments) and arranged the sections (organizational structure) so the music will sound as good as possible. Now your job is to tap your baton and lead the orchestra so that its members make beautiful music together (Reh, 2011).
6.05: Controlling
Learning Objective
1. Describe the process by which a manager monitors operations and assesses performance.
Let’s pause for a minute and reflect on the management functions that we’ve discussed so far—planning, organizing, and directing. As founder of Notes-4-You, you began by establishing plans for your new company. You defined its mission and set objectives, or performance targets, which you needed to meet in order to achieve your mission. Then, you organized your company by allocating the people and resources required to carry out your plans. Finally, you provided focus and direction to your employees and motivated them to achieve organizational objectives. Is your job finished? Can you take a well-earned vacation? Unfortunately, the answer is no: your work has just begun. Now that things are rolling along, you need to monitor your operations to see whether everything is going according to plan. If it’s not, you’ll need to take corrective action. This process of comparing actual to planned performance and taking necessary corrective action is called controlling.
6.06: Managerial Skills
Learning Objective
1. Describe the skills needed to be a successful manager.
To be a successful manager, you’ll have to master a number of skills. To get an entry-level position, you’ll have to be technically competent at the tasks you’re asked to perform. To advance, you’ll need to develop strong interpersonal and conceptual skills. The relative importance of different skills varies from job to job and organization to organization, but to some extent, you’ll need them all to forge a managerial career. Throughout your career, you’ll also be expected to communicate ideas clearly, use your time efficiently, and reach sound decisions.
6.07: Cases and Problems
Learning on the Web (AACSB)
Mission “Improvisable”
A mission statement tells customers, employees, and stakeholders why the organization exists—its purpose. It can be concise, like the one from Mary Kay Cosmetics—“To enrich the lives of women around the world”—or it can be more detailed, such as the following from FedEx:
FedEx Corporation will produce superior financial returns for its shareowners by providing high value-added logistics, transportation and related business services through focused operating companies. Customer requirements will be met in the highest quality manner appropriate to each market segment served. FedEx will strive to develop mutually rewarding relationships with its employees, partners and suppliers. Safety will be the first consideration in all operations. Corporate activities will be conducted to the highest ethical and professional standards.
Mission statements are typically constructed to communicate several pieces of information: what the company strives to accomplish, what it’s known for, and how it serves its customers. Here are a few examples:
• The Hershey Company: Bringing sweet moments of Hershey happiness to the world every day.
• Microsoft: Our Mission At Microsoft, we work to help people and businesses throughout the world realize their full potential. This is our mission. Everything we do reflects this mission and the values that make it possible.
• Google: Google’s mission is to organize the world’s information and make it universally accessible and useful.
Assignment
Create hypothetical mission statements for each of these four companies: Outback Steakhouse, Tesoro, Got Junk?, and Staples. To find descriptions of all four, go to the Web site for each of the companies: www.outbacksteakhouse.com, http://www.tesorocorp.com, http://www.1800gotjunk.com/us_en, www.staples.com.
In composing your four mission statements, follow the format suggested previously: each statement should be about two or three sentences long and should provide several pieces of information—what the company strives to accomplish, what it’s known for, and how it serves its customers (and perhaps its employees and shareholders, too).
One last thing: your statements should be originals, not duplicates of the companies’ official statements. | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/06%3A_Managing_for_Business_Success/6.01%3A_What_Do_Managers_Do.txt |
Learning Objective
1. Define human resource management and explain how managers develop and implement a human resource plan.
Employees at Starbucks are vital to the company’s success. They are its public face, and every dollar of sales passes through their hands (Schultz & Yang, 1997). According to Howard Schultz, they can make or break the company. If a customer has a positive interaction with an employee, the customer will come back. If an encounter is negative, the customer is probably gone for good. That’s why it’s crucial for Starbucks to recruit and hire the right people, train them properly, motivate them to do their best, and encourage them to stay with the company. Thus, the company works to provide satisfying jobs, a positive work environment, appropriate work schedules, and fair compensation and benefits. These activities are part of Starbucks’s strategy to deploy human resources in order to gain competitive advantage. The process is called human resource management (HRM), which consists of all actions that an organization takes to attract, develop, and retain quality employees. Each of these activities is complex. Attracting talented employees involves the recruitment of qualified candidates and the selection of those who best fit the organization’s needs. Development encompasses both new-employee orientation and the training and development of current workers. Retaining good employees means motivating them to excel, appraising their performance, compensating them appropriately, and doing what’s possible to retain them.
7.02: Developing Employees
Learning Objective
1. Explain how companies train and develop employees, and discuss the importance of a diverse workforce.
Because companies can’t survive unless employees do their jobs well, it makes economic sense to train them and develop their skills. This type of support begins when an individual enters the organization and continues as long as he or she stays there.
7.03: Motivating Employees
Learning Objective
1. Define motivation and describe several theories of motivation.
Motivation refers to an internally generated drive to achieve a goal or follow a particular course of action. Highly motivated employees focus their efforts on achieving specific goals; those who are unmotivated don’t. It’s the manager’s job, therefore, to motivate employees—to get them to try to do the best job they can. But what motivates employees to do well? How does a manager encourage employees to show up for work each day and do a good job? Paying them helps, but many other factors influence a person’s desire (or lack of it) to excel in the workplace. What are these factors? Are they the same for everybody? Do they change over time? To address these questions, we’ll examine four of the most influential theories of motivation: hierarchy-of-needs theory, two-factor theory, expectancy theory, and equity theory.
7.04: What Makes a Great Place to Work
Learning Objective
1. Identify factors that make an organization a good place to work, including competitive compensation and benefits packages.
Every year, the Great Places to Work Institute analyzes comments from thousands of employees and compiles a list of “The 100 Best Companies to Work for in America,” which is published in Fortune magazine. Having compiled its list for more than twenty years, the institute concludes that the defining characteristic of a great company to work for is trust between managers and employees. Employees overwhelmingly say that they want to work at a place where employees “trust the people they work for, have pride in what they do, and enjoy the people they work with” (Great Place to Work Institute, 2011). They report that they’re motivated to perform well because they’re challenged, respected, treated fairly, and appreciated. They take pride in what they do, are made to feel that they make a difference, and are given opportunities for advancement (Great Place to Work Institute, 2006). The most effective motivators, it would seem, are closely aligned with Maslow’s higher-level needs and Herzberg’s motivating factors.
7.05: Performance Appraisal
Learning Objective
1. Explain how managers evaluate employee performance and retain qualified employees.
Employees generally want their managers to tell them three things: what they should be doing, how well they’re doing it, and how they can improve their performance. Good managers address these issues on an ongoing basis. On a semiannual or annual basis, they also conduct formal performance appraisals to discuss and evaluate employees’ work performance.
7.06: Labor Unions
Learning Objective
1. Explain why workers unionize and how unions are structured, and describe the collective-bargaining process.
As we saw earlier, Maslow believed that individuals are motivated to satisfy five levels of unmet needs (physiological, safety, social, esteem, and self-actualization). From this perspective, employees should expect that full-time work will satisfy at least the two lowest-level needs: they should be paid wages that are sufficient for them to feed, house, and clothe themselves and their families, and they should have safe working conditions and some degree of job security. Organizations also have needs: they need to earn profits that will satisfy their owners. Sometimes, the needs of employees and employers are consistent: the organization can pay decent wages and provide workers with safe working conditions and job security while still making a satisfactory profit. At other times, there is a conflict—real, perceived, or a little bit of both—between the needs of employees and those of employers. In such cases, workers may be motivated to join a labor union—an organized group of workers that bargains with employers to improve its members’ pay, job security, and working conditions.
Figure 7.10 “Labor Union Density, 1930–2010” charts labor-union density—union membership as a percentage of payrolls—in the United States from 1930 to 2010. As you can see, there’s been a steady decline since the mid-1950s, and, today, only about 12 percent of U.S. workers belong to unions (U.S. Department of Labor, 2011). Only membership among public workers (those employed by federal, state, and local governments, such as teachers, police, and firefighters) has grown. In the 1940s, 10 percent of public workers and 34 percent of those in the private sector belonged to unions. Today, this has reversed: 36 percent of public workers and 7 percent of those in the private sector are union members (Wikipedia, 2011).
Figure 7.10 Labor Union Density, 1930–2010
Why the decline in private sector unionization? Many factors come into play. The poor economy has reduced the number of workers who can become union members. In addition, we’ve shifted from a manufacturing-based economy characterized by large, historically unionized companies to a service-based economy made up of many small firms that are hard to unionize. Finally, there are more women in the workforce, and they’re more likely to work part-time or intermittently (Maher, 2010; Greenhouse, 2011). | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/07%3A_Recruiting_Motivating_and_Keeping_Quality_Employees/7.01%3A_Human_Resource_Management.txt |
Learning on the Web (AACSB)
What’s Your (Emotional) IQ?
If you were an HR manager, on what criteria would you base a hiring decision—intelligence (IQ), education, technical skills, experience, references, or performance on the interview? All these can be important determinants of a person’s success, but some experts believe that there’s an even better predictor of success. It’s called emotional intelligence (or EI), and it gained some currency in the mid-1990s thanks to Daniel Goleman’s book Emotional Intelligence: Why It Can Matter More Than IQ. EI is the ability to understand both our own emotions and those of others, as well as the ability to use that understanding in managing our behavior, motivating ourselves, and encouraging others to achieve goals.
An attractive aspect of EI is that, unlike IQ, it’s not fixed at an early age. Rather, its vital components—self-awareness, self-management, social awareness, and relationship management—can be strengthened over time. To assess your level of EI, go to the Web site maintained by the Hay Group, a management-consulting firm, and take the ten-item test that’s posted there (http://psychology.about.com/library/...num=6&cor=2399). After completing the test, you’ll get your EI score, some instructions for interpreting it, and an answer key.
When you’ve finished with the test, rank the following items according to the importance that you’d give them in making a hiring decision: intelligence, education, technical skills, experience, references, interview skills, and emotional intelligence. Explain your ranking.
Career Opportunities
Are You a People Person?
You might not like the idea of sitting across the desk from a corporate college recruiter and asking for a job, but what if you were on the other side of the desk? As a recruiter, you’d get to return to campus each year to encourage students to join your company. Or, maybe you’d like to help your company develop a new compensation and benefits program, implement a performance-evaluation system, or create a new training program. All these activities fall under the umbrella of HR.
To learn more about the field of HR, go to the WetFeet Web site (wetfeet.com/Careers-and-Indus...obdescriptions) and read the page “Human Resources Overview.” Then answer these questions:
1. What is the human resources field like?
2. What do HR professionals like about their jobs? What do they dislike?
3. Are job prospects in the HR field positive or negative? Which HR areas will experience the fastest growth?
4. Based on the job descriptions posted, which specific HR job would you want?
Finally, write a paragraph responding to this question: Do you find the HR field interesting? Why, or why not?
Ethics Angle (AACSB)
Misstating the Facts
Life couldn’t get much better for George O’Leary when he was named the head football coach at Notre Dame. Unfortunately, he barely had time to celebrate his new job before he was ruled ineligible: after just a week on the job, he was forced to resign, embarrassing himself, his family, his friends, and Notre Dame itself. Why? Because of a few lies that he’d put on his résumé twenty years earlier. To get the facts behind this story, go to the Sports Illustrated Web site (sportsillustrated.cnn.com/foo...ary_notredame/) and read the article “Short Tenure: O’Leary Out at Notre Dame After One Week.” Then, answer the following questions:
1. Was O’Leary’s punishment appropriate? If you were the athletic director at Notre Dame, would you have meted out the same punishment? Why, or why not?
2. False information on his résumé came back to haunt O’Leary after twenty years. Once he’d falsified his résumé, was there any corrective action that he could have taken? If so, what?
3. If O’Leary had told Notre Dame about the falsifications before they came to light, would they have hired him?
4. Would his previous employer take him back?
5. O’Leary was later hired as a head coach by the University of Central Florida. Will the episode involving his résumé undermine his ability to encourage players to act with integrity? Will it affect his ability to recruit players?
6. What’s the lesson to be learned from O’Leary’s experience? In what ways might a few (theoretical) misstatements on your résumé come back to haunt you?
Team-Building Skills (AACSB)
Dorm Room Rescue
Any night of the week (at least as of this writing), you can relax in front of the TV and watch a steady stream of shows about how to improve your living space—such as New Spaces. You like the concept of these programs well enough, but you’re tired of watching them in a tiny, cluttered dorm room that’s decorated in early barracks style. Out of these cramped conditions, however, you and a team of friends come up with an idea. On graduation, you’ll start a business called Dorm Room Rescue to provide decorating services to the dorm dwellers who come after you. You’ll help college students pick colors and themes for their rooms and select space-saving furniture, storage materials, area rugs, and wall decorations. Your goal will be to create attractive dorm rooms that provide comfort, functionality, and privacy, as well as pleasant spaces in which students can relax and even entertain.
The team decides to develop a plan for the HR needs of your future company. You’ll need to address the following issues:
1. Number of employees
2. Job descriptions: duties and responsibilities for each type of employee
3. Job specifications: needed skills, knowledge, and abilities
2. Recruitment of qualified employees
• Recruitment plan: how and where to find candidates
• Selection process: steps taken to select employees
3. Developing employees
• New-employee orientation
• Training and development
4. Compensation and benefits
• Wages, salaries, and incentive programs
• Benefits
5. Work/Life quality
• Work schedules and alternative work arrangements
• Family-friendly programs
6. Performance appraisal
• Appraisal process
• Retaining valuable employees
You might want to divide up the initial work, but you’ll need to regroup as a team to make your final decisions on these issues and to create a team-prepared report.
The Global View (AACSB)
Sending Ed to China
You’re the HR manager for a large environmental consulting firm that just started doing business in China. You’ve asked your top engineer, Ed Deardon, to relocate to Shanghai for a year. Though China will be new to Deardon, working overseas won’t be; he’s already completed assignments in the Philippines and Thailand; as before, his wife and three children will be going with him.
You’ve promised Deardon some advice on adapting to living and working conditions in Shanghai, and you intend to focus on the kinds of cultural differences that tend to create problems in international business dealings. Unfortunately, you personally know absolutely nothing about living in China and so must do some online research. Here are some promising sites:
• Executive Planet (www.executiveplanet.com/index.php?title=China)
• China Window (china-window.com)
• Los Angeles Chinese Learning Center (http://chinese-school.netfirms.com)
Instructions
Prepare a written report to Deardon in which you identify and explain five or six cultural differences between business behavior in the United States and China, and offer some advice on how to deal with them. | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/07%3A_Recruiting_Motivating_and_Keeping_Quality_Employees/7.07%3A_Cases_and_Problems.txt |
Learning Objectives
1. Define a team and describe its key characteristics.
2. Explain why organizations use teams, and describe different types of teams.
8.02: Why Teamwork Works
Learning Objectives
1. Explain why teams may be effective or ineffective.
2. Identify factors that contribute to team cohesiveness.
Now that we know a little bit about how teams work, we need to ask ourselves why they work. Not surprisingly, this is a fairly complex issue. In this section, we’ll answer these closely related questions: Why are teams often effective? Why are they sometimes ineffective?
8.03: The Team and Its Members
Learning Objectives
1. Understand the importance of learning to participate in team-based activities.
2. Identify the skills needed by team members and the roles that members of a team might play.
3. Learn how to survive team projects in college (and actually enjoy yourself).
4. Explain the skills and behaviors that foster effective team leadership.
8.04: The Business of Communication
Learning Objectives
1. Discuss the role of communication in the design of the RAZR cell phone.
2. Define communication and discuss the ways in which organizations benefit from effective communication.
8.05: Communication Channels
Learning Objectives
1. Discuss the nature of communications in an organizational setting, including communication flows, channels, and networks.
2. Explain barriers to communication, and discuss the most common types of barriers to group communication.
8.06: Forms of Communication
Learning Objectives
1. Explain the do’s and don’ts of business e-mails.
2. Describe the process followed to create and deliver successful presentations.
3. Learn how to write clear, concise memos.
As mentioned previously, the College Board identified these communication skills as “frequently” or “almost always” necessary in the workplace (College Board, 2004): e-mail, presentation with visuals, technical reports, formal reports, memos, and presentations without visuals. The skill ranked highest in importance was the use of e-mails, including the ability to adapt messages to different receivers or compose persuasive messages when necessary. The ability to make presentations (with visuals) ranked second in importance. Report writing came next. Given the complexity of report writing, we will not cover this topic here. Instead, we will look at the remaining three forms of communication: e-mail, presentations with visuals, and memos.
8.07: Cases and Problems
Learning on the Web (AACSB)
Factors Contributing to Nike’s Success
This writing assignment solicits your opinion on factors contributing to Nike’s success. To complete it, you should go to www.nikebiz.com/company_overview/timeline to learn about Nike’s history by reviewing the company’s time line.
Memo Format
Use the memo format described in the chapter for this assignment. Your memo should not exceed two pages. It should be single spaced (with an extra space between paragraphs and bulleted items).
Scenario
You’re one of the fortunate college students selected to participate in Nike’s summer internship program. The program is quite competitive, and you still can’t believe that you were chosen. You arrived in Beaverton, Oregon, yesterday morning and have been busy ever since. Last night, you attended a dinner for new interns where you were welcomed to Nike by CEO Mark Parker.
You were lucky to be sitting next to a personable, well-informed Nike veteran named Simon Pestridge. Pestridge joined Nike about twelve years ago. He was telling you about a past assignment he had as director of marketing for Australia. (You were impressed with his status at Nike, not just because he doesn’t look much older than you, but also because you’ve always wanted to travel to Australia.) The dinner conversation turned to a discussion of the reasons for Nike’s success. Others at the table were giving their opinions on the subject when Pestridge turned to you and said, “As a new intern, give us an outsider’s point of view. Why do you think Nike’s been so successful?” You were about to venture an opinion when Pestridge was called away for a phone call. As he got up, however, he quickly said, “Send me a memo telling me what factors you think have contributed to Nike’s success. Keep it simple. Three factors are plenty.” Though you were relieved to have a little time to think about your answer, you were also a bit nervous about the prospect of writing your first official memo.
As everyone else headed for the Bo Jackson gym, you went back to your room to think about Pestridge’s question and to figure out how to go about writing your memo. You want to be sure to start by telling him that you enjoyed talking with him. You also need to remind him that you’re responding to his question about three factors in Nike’s success, and must be sure to explain why you believe they’re important. You’ll end by saying that you hope the information is helpful and that he can contact you if he has any further questions.
So far, so good, but you’re still faced with the toughest part of your task—identifying the three factors that you deem important to Nike’s success. Fortunately, even at Nike there’s always tomorrow to get something done, so you decide to sleep on it and write your memo in the morning.
Ethics Angle (AACSB)
The Goof-Off
You and three other students have been working on a group project all semester in your Introduction to Business class. One of the members of the team did very little work; he failed to attend almost all the meetings, took no responsibility for any of the tasks, didn’t attend the practice session before your presentation, and in general was a real goof-off. But he happens to be friends with two of the team members. You and your other team members have been asked to complete the attached team member evaluation. You want to give the student what he deserves—almost no credit. But your other two team members don’t agree. They argue that it is “unsocial and mean” to tell the truth about this student’s lack of contribution. Instead, they want to report that everyone shared the work equally. The evaluation will be used in determining grades for each team member. Those who contributed more will get a higher grade than those who did not. Prepare an argument that you can advance to the other team members on the ethics of covering for this student. Assuming that your two teammates won’t change their minds, what would you do?
Attachment to Ethics Angle Problem
Introduction to Business
Team Member Evaluation
(To be given to your faculty member during the last week of class)
TEAM ___________________
You have a total of \$100,000. You can use this to reward your team members (including yourself) for their contributions to the team project.
Fill in each team member’s name below (including your own), and show beside each name how much of the \$100,000 you would give that member for his or her contributions to the preparation and presentation of the team project. Do not share your recommendations with your team members.
Your recommendations will be confidential.
Team Members (including yourself) Amount to be given for efforts on team project
____________________________________ \$_________________________
____________________________________ \$_________________________
____________________________________ \$_________________________
____________________________________ \$_________________________
____________________________________ \$_________________________
____________________________________ \$_________________________
TOTAL (MUST EQUAL \$100,000) \$_________________________
YOUR NAME ______________________________________________________
Team-Building Skills (AACSB)
Team Skills and Talents
Team projects involve a number of tasks that are handled by individual team members. These tasks should be assigned to team members based on their particular skills and talents. The next time you work on a team project, you should use the following table to help your team organize its tasks and hold its members responsible for their completion.
Here is how you should use this document:
1. Identify all tasks to be completed.
2. Assign each task to a member (or members) of your team based on their skills, talents, and time available.
3. Determine a due date for each task.
4. As a task is completed, indicate its completion date and the team member (or members) who completed the task. If more than one team member works on the assignment, indicate the percentage of time each devoted to the task. You can add tasks that surface as your team works its way through the project.
5. If the assigned person fails to complete the task, or submits poor quality work, add a note to the report explaining what happened and how the situation was corrected (for example, another team member had to redo the task).
6. Submit the completed form (with all columns completed) to your faculty member at the class after your team project is due. Include a cover sheet with your team’s name (or number) and the name of each team member.
Tasks to Be Completed Initials of Team Member(s) Who Will Complete Task Date to Be Completed Date Completed Initials of Team Member(s) Who Completed Task (Add a Note Below the Table Explaining Any Problems with Completion or Quality of Work)
________ ________ ________ ________ ________
________ ________ ________ ________ ________
________ ________ ________ ________ ________
________ ________ ________ ________ ________
________ ________ ________ ________ ________ | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/08%3A_Teamwork_and_Communications/8.01%3A_The_Team_and_the_Organization.txt |
Learning on the Web (AACSB)
The Economics of Online Annoyance
You’ve just accessed a Web page and begun searching for the information you want to retrieve. Suddenly the page is plastered from top to bottom with banner ads. Some pop up, some float across the screen, and in some, animated figures dance and prance to inane music. As a user of the Internet, feel free to be annoyed. As a student of business, however, you should stop and ask yourself a few questions: Where do banner ads come from? Who stands to profit from them?
To get a handle on these questions, go to the How Stuff Works Web site (http://computer.howstuffworks.com/web-advertising.htm) and read the article “How Web Advertising Works,” by Marshall Brain. When you’ve finished, answer the following questions from the viewpoint of a company advertising on the Web:
1. What are the advantages and disadvantages of banner ads? Why are they less popular with advertisers today than they were about ten years ago?
2. What alternative forms of Web advertising are more common today? (For each of these alternative forms, describe the type of ad, explain how it’s more effective than banner advertising, and list any disadvantages.)
3. Why are there so many ads on the Web? Is it easy to make money selling ads on the Web? Why, or why not?
4. Assume that you’re in charge of Web advertising for a company that sells cell-phone ring tones. On which sites would you place your ads and what type of ads would you use? Why?
Career Opportunities
So Many Choices
How would you like to work for an advertising agency? How about promoting a new or top-selling brand? Want to try your hand at sales? Or does marketing research or logistics management sound more appealing? With a marketing degree, you can pursue any of these career options—and more. To learn more about these options, go to the WetFeet Web site (wetfeet.com/Careers—Industries.aspx). Scroll down to the “Careers” section and select two of the following career options that interest you: advertising, brand management, marketing, sales, or supply chain management. For each of the two selected, answer the following questions:
1. What would you do if you worked in this field?
2. Who does well?
3. What requirements are needed to be hired into this field?
4. Are job prospects in the field positive or negative?
5. What career track would you follow?
Finally, write a paragraph responding to these questions: Does a career in marketing appeal to you? Why, or why not? Which career option do you find most interesting? Why?
Ethics Angle (AACSB)
Pushing Cigarettes Overseas
A senior official of the United Nation’s World Health Organization (WHO) claims that the marketing campaigns of international tobacco companies are targeting half a billion young people in the Asia Pacific region by linking cigarette smoking to glamorous and attractive lifestyles. WHO accuses tobacco companies of “falsely associating use of their products with desirable qualities such as glamour, energy and sex appeal, as well as exciting outdoor activities and adventure” (Agence France Presse, 2008). WHO officials have expressed concern that young females are a major focus of these campaigns.
The organization called on policymakers to support a total ban on tobacco advertising saying that “the bombardment of messages through billboards, newspapers, magazines, radio and television ads, as well as sports and fashion sponsorships and other ploys, are meant to deceive young people into trying their first stick” (Associated Press, 2008). WHO stresses the need for a total ban on advertising as partial bans let tobacco companies switch from one marketing scheme to another.
WHO officials believe that extensive tobacco advertising gives young people the false impression that smoking is normal and diminishes their ability to comprehend that it can kill. Representatives of the organization assert that the tobacco industry is taking advantage of young people’s vulnerability to advertising.
Instructions: Read the following articles and provide your opinion on the questions that follow:
• Agence France Presse (AFP), “WHO: Half a Billion Young Asians at Risk from Tobacco Addiction,” May 31, 2008, afp.google.com/article/ALeqM5...asEdZ20BsmiDfQ.
• Associated Press, “WHO Criticizes Tobacco Industry Focus on Asian Young People,” May 30, 2008, www.chinapost.com.tw/news/200...criticizes.htm
• Were Blockbuster’s actions unethical?
Provide your opinion on the following :
• U.S. laws prohibit advertising by the tobacco companies. Should developing countries in which cigarette smoking is promoted by the international tobacco companies follow suit—should they also ban tobacco advertising?
• Are U.S. companies that engage in these advertising practices acting unethically? Why or why not?
• Should international policymakers support a total ban on tobacco advertising? Why or why not?
• If tobacco advertising was banned globally, what would be the response of the international tobacco companies?
Team-Building Skills (AACSB)
Build a Better iPod and They Will Listen
Right now, Apple is leading the pack of consumer-electronics manufacturers with its extremely successful iPod. But that doesn’t mean that Apple’s lead in the market can’t be surmounted. Perhaps some enterprising college students will come up with an idea for a better iPod and put together a plan for bringing it to market. After all, Apple founders (the late Steve Jobs and Stephen Wozniak) were college students (actually, college dropouts) who found entrepreneurship more rewarding than scholarship. Here’s your team assignment for this exercise:
1. Select a target market for your product.
2. Develop your product so that it offers features that meet the needs of your target market.
3. Describe the industry in which you’ll compete.
4. Set a price for your product and explain your pricing strategy.
5. Decide what distribution channels you’ll use to get your product to market.
6. Develop a promotion mix to create demand for your product.
The Global View (AACSB)
Made in China—Why Not Sell in China?
One of Wow Wee’s recent robots, Roboscooper, is manufactured in China. Why shouldn’t it sell the product in China? In fact, the company has introduced its popular robot to the Chinese market through a Toys “R” Us store in Hong Kong. Expanding into other parts of China, however, will require a well-crafted, well-executed marketing plan. You’re director of marketing for Wow Wee, and you’ve been asked to put together a plan to expand sales of Roboscooper in China. You can be introduced to Roboscooper by going to the product section of Wow Wee’s site: http://www.wowwee.com/en/products/to...cs/roboscooper. To get some background on selling toys in China, go to the Epoch Times Web site (en.epochtimes.com/news/4-12-23/25184.html) and read the article “China Could Soon Become Booming Toy Market.” Then, draw up a brief marketing plan for increasing sales in China, being sure to include all the following components:
• Profile of your target market (gender, age, income level, geographic location, interests, and so forth)
• Proposed changes to the company’s current marketing mix: modifications to product design, pricing, distribution, and promotional strategies
• Estimated sales in units for each of the next five years, including a list of the factors that you considered in arriving at your projections
• Discussion of threats and opportunities posed by expansion in the Chinese market | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/09%3A_Marketing-_Providing_Value_to_Customers/9.01%3A_9.1-0_Cases_and_Problems.txt |
Learning Objectives
1. Define the terms marketing, marketing concept, and marketing strategy.
2. Outline the tasks involved in selecting a target market.
When you consider the functional areas of business—accounting, finance, management, marketing, and operations—marketing is the one you probably know the most about. After all, as a consumer and target of all sorts of advertising messages, you’ve been on the receiving end of marketing initiatives for most of your life. What you probably don’t appreciate, however, is the extent to which marketing focuses on providing value to the customer. According to the American Marketing Association, “Marketing is the activity, set of institutions, and processes for creating, communicating, delivering, and exchanging offerings that have value for customers, clients, partners, and society at large” (American Marketing Association, 2011).
In other words, marketing isn’t just advertising and selling. It includes everything that organizations do to satisfy customer needs:
• Coming up with a product and defining its features and benefits
• Setting its price
• Identifying its target market
• Making potential customers aware of it
• Getting people to buy it
• Delivering it to people who buy it
• Managing relationships with customers after it has been delivered
Not surprisingly, marketing is a team effort involving everyone in the organization. Think about a typical business—a local movie theater, for example. It’s easy to see how the person who decides what movies to show is involved in marketing: he or she selects the product to be sold. It’s even easier to see how the person who puts ads in the newspaper works in marketing: he or she is in charge of advertising—making people aware of the product and getting them to buy it. But what about the ticket seller and the person behind the counter who gets the popcorn and soda? What about the projectionist? Are they marketing the business? Absolutely: the purpose of every job in the theater is satisfying customer needs, and as we’ve seen, identifying and satisfying customer needs is what marketing is all about.
If everyone is responsible for marketing, can the average organization do without an official marketing department? Not necessarily: most organizations have marketing departments in which individuals are actively involved in some marketing-related activity—product design and development, pricing, promotion, sales, and distribution. As specialists in identifying and satisfying customer needs, members of the marketing department manage—plan, organize, direct, and control—the organization’s overall marketing efforts.
9.03: The Marketing Mix
Learning Objectives
1. Identify the four Ps of the marketing mix.
2. Explain how to conduct marketing research.
3. Discuss various branding strategies and explain the benefits of packaging and labeling.
After identifying a target market, your next step is developing and implementing a marketing program designed to reach it. As Figure 9.4 “The Marketing Mix” shows, this program involves a combination of tools called the marketing mix, often referred to as the “four Ps” of marketing:
1. Developing a product that meets the needs of the target market
2. Setting a price for the product
3. Distributing the product—getting it to a place where customers can buy it
4. Promoting the product—informing potential buyers about it
Figure 9.4 The Marketing Mix
The goal is to develop and implement a marketing strategy that combines these four elements. To see how this process works, let’s look at Wow Wee Toys’ marketing program for Robosapien (Wow Wee Toys Ltd., 2004).
9.04: Pricing a Product
Learning Objective
1. Identify pricing strategies that are appropriate for new and existing products.
The second of the four Ps in the marketing mix is price. Pricing a product involves a certain amount of trial and error because there are so many factors to consider. If you price too high, a lot of people simply won’t buy your product. Or you might find yourself facing competition from some other supplier that thinks it can beat your price. On the other hand, if you price too low, you might not make enough profit to stay in business. So how do you decide on a price? Let’s look at several pricing options that were available to those marketers at Wow Wee who were responsible for pricing Robosapien. We’ll begin by discussing two strategies that are particularly applicable to products that are being newly introduced.
9.05: Placing a Product
Learning Objectives
1. Explore various product-distribution strategies.
2. Explain how companies create value through effective supply chain management.
The next element in the marketing mix is place, which refers to strategies for distribution. Distribution entails all activities involved in getting the right quantity of your product to your customers at the right time and at a reasonable cost. Thus, distribution involves selecting the most appropriate distribution channels and handling the physical distribution of products.
9.06: Promoting a Product
Learning Objective
1. Describe the elements of the promotion mix.
Your promotion mix—the means by which you communicate with customers—may include advertising, personal selling, sales promotion, and publicity. These are all tools for telling people about your product and persuading potential customers, whether consumers or organizational users, to buy it. Before deciding on an appropriate promotional strategy, you should consider a few questions:
• What’s the main purpose of the promotion? Am I simply trying to make people aware of my product, or am I trying to get people to buy it right now? Am I trying to develop long-term customers? Am I trying to connect with my current customers? Am I trying to promote my company’s image?
• What’s my target market? What’s the best way to reach it?
• Which product features (quality, price, service, availability, innovativeness) should I emphasize? How does my product differ from those of competitors?
• How much can I afford to invest in a promotion campaign?
• How do my competitors promote their products? Should I take a similar approach?
To promote a product, you need to imprint a clear image of it in the minds of your target audience. What do you think of, for instance, when you hear “Ritz-Carlton”? What about “Motel 6”? They’re both hotel chains, but the names certainly conjure up different images. Both have been quite successful in the hospitality industry, but they project very different images to appeal to different clienteles. The differences are evident in their promotions. The Ritz-Carlton Web site describes “luxury hotels” and promises that the chain provides “the finest personal service and facilities throughout the world” (Ritz-Carlton, 2011). Motel 6, by contrast, characterizes its facilities as “discount hotels” and assures you that you’ll pay “discount hotel rates” (Motel 6, 2011).
9.07: Interacting with Your Customers
Learning Objectives
1. Explain how companies manage customer relationships.
2. Describe social media marketing and identify its advantages and disadvantages. | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/09%3A_Marketing-_Providing_Value_to_Customers/9.02%3A_What_Is_Marketing.txt |
Learning Objective
1. Explain how a product moves through its life cycle and how this brings about shifts in marketing-mix strategies.
Figure 9.12
LEGO has decided to go back to basics and focus on the classic bricks rather than complicated kits.
Mark Nicolson – Lego house – CC BY 2.0.
Did you play with LEGO blocks when you were a kid? Almost everyone did. They were a big deal. Store shelves were stacked with boxes of plastic bricks, wheels, and windows, plus packages containing just the pieces you needed to make something special, like a LEGO helicopter. McDonald’s put LEGO sets in Happy Meals. If you walk down a toy-store aisle today, you’ll still find LEGOs. They’re shelved alongside the XBOX Kinect, Buzz Lightyear, and other playthings that appeal to contemporary kids. Like these products, they’re more sophisticated. They’re often tied in with movies, such as Toy Story, Cars, Star Wars, and Harry Potter.
Nowadays, the seventy-nine-year old Denmark company is doing very well: in 2010, its sales rose 37 percent and profits were up 70 percent (Reuters, 2011). The LEGO Group has moved its way up to the fifth largest toy company in the world based on sales (Brown, 2011). Things were very different seven years earlier—LEGO sales had declined drastically in the early 2000s. In its 2003 annual report, its CEO admitted that “2003 was a very disappointing year for LEGO Company.” Net sales fell by 26 percent, resulting in a loss in earnings for the year and significant decline in market share. LEGO planned to drop many of its recent initiatives and focus on its classic LEGO brick products (LEGO Group, 2003).
Let’s look closer and find out what happened to the LEGO brand prior to its turnaround seven years ago. It was moving through stages of development and decline (KeepMedia, 2004; KeepMedia, 2004; Fishman, 2001). Marketers call this process the product life cycle, which is illustrated in Figure 9.13 “The Product Life Cycle”. In theory, it’s a lot like the life cycle that people go through. Once it’s developed, a new product is introduced to the market. With any success at all, it begins to grow, attracting more buyers. At some point, the market stabilizes, and the product becomes mature. Eventually, however, its appeal diminishes, and it’s overtaken by competing brands or substitute products. Sales decline, and it’s ultimately taken off the market.
Figure 9.13 The Product Life Cycle
This is a simplified version of the cycle. There are lots of exceptions to the product life-cycle rules. For one thing, most products never make it past the introduction stage; they die an early death. Second, some products (like some people) avoid premature demise by reinventing themselves. This is what the LEGO Group did. The company had been reinventing itself during the fifteen-year period of 1990 to 2005, launching new products in an effort to recover its customer base and overcome a series of financial crises. Unfortunately, this strategy was unsuccessful. As pointed out by its CEO, the introduction of new products and the resulting costs “have not produced the desired results. In some cases,” admits the company, “new products have even cannibalized on the sales of LEGO Company’s core products and thus eroded earnings” (LEGO Group, 2003).
A take-over threat by Mattel Toy Company forced its CEO into action (Batra, 2010). His first stop in formulating a resurrection plan was to fly to Virginia and attend a convention for adult fans of LEGO’s. The attendees’ stories of how LEGOs helped shape their minds gave him hope that the family-owned company could be saved. He returned to Denmark and put into place a plan that included downsizing the number of employees, selling its LEGOLAND theme parks, simplifying product designs, cutting unprofitable product lines, and focusing on what made the company great: LEGO building blocks.
9.09: The Marketing Environment
Learning Objectives
1. Describe the external marketing environment in which businesses operate.
2. Discuss the factors that influence consumer behavior.
By and large, managers can control the four Ps of the marketing mix: they can decide which products to offer, what prices to charge for them, how to distribute them, and how to reach target audiences. Unfortunately, there are other forces at work in the marketing world—forces over which marketers have much less control. These forces make up a company’s external marketing environment, which, as you can see in Figure 9.14 “The Marketing Environment”, we can divide into five sets of factors:
1. Political and regulatory
2. Economic
3. Competitive
4. Technological
5. Social and cultural
Figure 9.14 The Marketing Environment
These factors—and changes in them—present both threats and opportunities that require shifts in marketing plans. To spot trends and other signals that conditions may be in flux, marketers must continually monitor the environment in which their companies operate. To get a better idea of how they affect a firm’s marketing activities, let’s look at each of the five areas of the external environment.
9.10: Careers in Marketing
Learning Objective
1. Describe opportunities in the field of marketing.
The field of marketing is extensive, and so are the opportunities for someone graduating with a marketing degree. While one person may seek out the excitement of an advertising agency that serves multiple clients, another might prefer to focus on brand management at a single organization. For someone else, working as a buyer for a retail chain is appealing. A few people might want to get into marketing research. Others might have an aptitude for supply chain management or logistics management, the aspect of supply chain management that focuses on the flow of products between suppliers and customers. Many people are attracted to sales positions because of the potential financial rewards. Let’s look more closely at a few of your options. | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/09%3A_Marketing-_Providing_Value_to_Customers/9.08%3A_The_Product_Life_Cycle.txt |
Learning Objectives
1. Define product.
2. Describe the four major categories of product developments: new-to-the-market, new-to-the-company, improvement of existing product, and extension of product line.
Basically, a product is something that can be marketed to customers because it provides them with a benefit and satisfies a need. It can be a physical good, such as the PowerSki Jetboard, or a service, such as a haircut or a taxi ride. The distinction between goods and services isn’t always clear-cut. Say, for example, that a company hires a professional to provide an in-house executive training program on “netiquette” (e-mail etiquette). Off the top of our heads, most of us would say that the company is buying a service. What if the program is offered online? We’d probably still argue that the product is a service. But what if the company buys training materials that the trainer furnishes on DVD? Is the customer still buying a service? Probably not: we’d have to say that when it buys the DVD, the company is buying a tangible good.
In this case, the product that satisfies the customer’s need has both a tangible component (the training materials on DVD) and an intangible component (the educational activities performed by the seller). Not surprisingly, many products have both tangible and intangible components. If, for example, you buy a Hewlett-Packard computer, you get not only the computer (a tangible good) but certain promises to answer any technical questions that you might have and certain guarantees to fix your computer if it breaks within a specified time period (intangible services).
10.02: Where Do Product Ideas Come From
Learning Objective
1. Explain where product ideas come from.
For some people, coming up with a great product idea is a gratifying adventure. For most, however, it’s a daunting task. The key to coming up with a product idea is identifying something that customers want—or, perhaps more important, filling an unmet customer need. In coming up with a product idea, ask not “what do I want to sell?” but rather “what does the customer want to buy?” (Thurm, 2005) With this piece of advice in mind, let’s get back to the task of coming up with a product idea. Nobel Prize–winning chemist Linus Pauling suggested that “the best way to have a good idea is to have lots of ideas,” and though this notion might seem a little whimsical at first, it actually makes a lot of sense, especially if you’re trying to be innovative in the entrepreneurial sense. Every year, for example, companies launch about thirty thousand new food, beverage, and beauty products, and up to 90 percent fail within a year (Catalina, 2011; Kotler & Armstrong, 2008). You might need ten good ideas just to have one that stands a chance.
10.03: Identifying Business Opportunities
Learning Objectives
1. Explain how an idea turns into a business opportunity.
2. Describe the four types of utility provided by a product: time, place, ownership, and form.
An idea turns into a business opportunity when it has commercial potential—when you can make money by selling the product. But needless to say, not all ideas generate business opportunities. Consider these products that made the list of the “Top 25 Biggest Product Flops of All Time” (WalletPop, 2011):
• Bic underwear. When you think of Bic you think of inexpensive pens and disposable razors and lighters. But disposable underwear? Women didn’t find the idea of buying intimate attire from a pen manufacturer appealing, and the disposability factor was just plain weird.
Figure 10.3
There might be many creative ways for Bic to extend its product lines, aside from the disposable underwear idea. Can you think of a product idea that might be more successful for Bic?
Kevin – bic – CC BY-NC-ND 2.0.
10.04: Understand Your Industry
Learning Objective
1. Explain how to research an industry.
Before you invest a lot of time and money to develop a new product, you need to understand the industry in which it’s going to be sold. As inventor of the PowerSki Jetboard, Bob Montgomery had the advantage of being quite familiar with the industry that he proposed to enter. With more than twenty years’ experience in the water-sports and personal-watercraft industry, he felt at home in this business environment. He knew who his potential customers were, and he knew who his competitors were. He had experience in marketing similar products, and he was familiar with industry regulations.
Most people don’t have the same head start as Montgomery. So, how does the average would-be businessperson learn about an industry? What should you want to know about it? Let’s tackle the first question first.
10.05: Forecasting Demand
Learning Objective
1. Forecast demand for a product.
It goes without saying, but we’ll say it anyway: without enough customers, your business will go nowhere. So, before you delve into the complex, expensive world of developing and marketing a new product, ask yourself questions like those in Figure 10.5 “When to Develop and Market a New Product”. When Bob Montgomery asked himself these questions, he concluded that he had two groups of customers for the PowerSki Jetboard: (1) the dealerships that would sell the product and (2) the water-sports enthusiasts who would buy and use it. His job, therefore, was to design a product that dealers would want to sell and enthusiasts would buy. When he was confident that he could satisfy these criteria, he moved forward with his plans to develop the PowerSki Jetboard.
Figure 10.5 When to Develop and Market a New Product
After you’ve identified a group of potential customers, your next step is finding out as much as you can about what they think of your product idea. Remember: because your ultimate goal is to roll out a product that satisfies customer needs, you need to know ahead of time what your potential customers want. Precisely what are their unmet needs? Ask them questions such as these (Ulrich & Eppinger, 2000; Allen, 2001):
• What do you like about this product idea? What don’t you like?
• What improvements would you make?
• What benefits would you get from it?
• Would you buy it? Why, or why not?
• What would it take for you to buy it?
Before making a substantial investment in the development of a product, you need to ask yourself yet another question: are there enough customers willing to buy my product at a price that will allow me to make a profit? Answering this question means performing one of the hardest tasks in business: forecasting demand for your proposed product. There are several possible approaches to this task that can be used alone or in combination. | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/10%3A_Product_Design_and_Development/10.01%3A_What_Is_a_Product.txt |
Learning Objective
1. Learn how to use breakeven analysis to estimate the number of sales units at which net income is zero.
Forecasting sales of shoes has started you thinking. Selling twelve thousand pair of shoes the first year you run the business sounds great, but you still need to find an answer to the all-important question: are there enough customers willing to buy my jogging shoes at a price that will allow me to make a profit? Is there some way to figure out the level of sales I would need to avoid losing money—to “break even”? Fortunately, an accountant friend of yours informs you that there is. Not surprisingly, it’s called breakeven analysis, and here’s how it works: to break even (have no profit or loss), total sales revenue must exactly equal all your expenses (both variable and fixed). To determine the level of sales at which this will occur, you need to do the following:
1. Fixed costs = \$210,000 salaries + \$60,000 rent + \$10,000 advertising + \$8,000 insurance + 12,000 other fixed costs = \$300,000
2. Variable cost per unit = \$40 (cost of each pair of shoes) + \$5 sales commission = \$45
3. Contribution margin per unit = \$80 selling price minus \$45 variable cost per unit = \$35
4. Breakeven in units = \$300,000 fixed costs ÷ \$35 contribution margin per unit = 8,571 units
Your calculation means that if you sell 8,571 pairs of shoes, you will end up with zero profit (or loss) and will exactly break even.
If your sales estimate is realistic (a big “if”), then you should be optimistic about starting the business. All your fixed costs will be covered once you sell 8,571 pairs of shoes. Any sales above that level will be pure profit. So, if you sell your expected level of twelve thousand pairs of shoes, you’ll make a profit of \$120,015 for the first year. Here’s how we calculated that profit:
• 12,000 expected sales level – 8,571 breakeven sales level = 3,429 units × \$35 contribution margin per unit = \$120,015 first-year profit
As you can see, breakeven analysis is pretty handy. It allows you to determine the level of sales that you must reach to avoid losing money and the profit you’ll make if you reach a higher sales goal. Such information will help you plan for your business.
Key Takeaways
• Breakeven analysis is a method of determining the level of sales at which the company will break even (have no profit or loss).
• The following information is used in calculating the breakeven point: fixed costs, variable costs, and contribution margin per unit.
• Fixed costs are costs that don’t change when the amount of goods sold changes. For example, rent is a fixed cost.
• Variable costs are costs that vary, in total, as the quantity of goods sold changes but stay constant on a per-unit basis. For example, sales commissions paid based on unit sales are a variable cost.
• Contribution margin per unit is the excess revenue per unit over the variable cost per unit.
• The breakeven point in units is calculated with this formula: fixed costs divided by contribution margin per unit (selling price per unit less variable cost per unit).
Exercise
(AACSB) Analysis
For the past ten years, you’ve worked at a PETCO Salon as a dog groomer. You’re thinking of starting your own dog grooming business. You found a place you could rent that’s right next to a popular shopping center, and two of your friends (who are also dog groomers) have agreed to work for you. The problem is that you need to borrow money to start the business and your banker has asked for a breakeven analysis. You have prepared the following cost estimates for your first year of operations:
Fixed Costs
Salaries \$105,000
Rent and utilities \$36,000
Advertising \$2,000
Equipment \$3,000
Variable Cost per Dog
Shampoo \$2.00
Coat conditioner \$1.50
Pet cologne \$0.75
Dog treats \$1.25
Hair ribbons \$0.50
You went online and researched grooming prices in your area. Based on your review, you have decided to charge \$32 for each grooming.
• Part 1:
• What’s the breakeven point in units—how many dogs will you need to groom in the first year to break even?
• If you and your two employees groomed dogs five days a week, seven hours a day, fifty weeks a year, how many dogs would each of you need to groom each day? Is this realistic given that it takes one hour to groom a dog?
• Part 2:
• If you raised your grooming fee to \$38, how many dogs would you need to groom to break even?
• At this new price, how many dogs will each of you have to groom each day (assuming, again, that the three of you groom dogs fifty weeks a year, five days a week, seven hours a day)?
• Part 3:
• Would you start this business?
• What price would you charge to groom a dog?
• How could you lower the breakeven point and make the business more profitable? | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/10%3A_Product_Design_and_Development/10.06%3A_Breakeven_Analysis.txt |
Learning Objective
1. Describe the process of developing a product that meets customer needs.
Like PowerSki, every organization—whether it produces goods or provides services—sees Job 1 as furnishing customers with quality products. The success of a business depends on its ability to identify the unmet needs of consumers and to develop products that meet those needs at a low cost (Ulrich & Eppinger, 2000). In other words, effective product development results in goods and services that can be sold at a profit. In addition, it results in high-quality products that not only satisfy consumer needs but also can be developed in a timely, cost-efficient manner. Accomplishing these goals entails a collaborative effort by individuals from all areas of an organization: operations management (including representatives from engineering, design, and manufacturing), marketing, accounting, and finance. In fact, companies increasingly assign representatives from various functional areas who work together as a project team throughout the product development processes. This approach allows individuals with varied backgrounds and experience to provide input as the product is being developed.
10.08: Protecting Your Idea
Learning Objective
1. Learn how to protect your product idea by applying for a patent.
You can protect your rights to your idea with a patent from the U.S. Patent and Trademark Office, which grants you “the right to exclude others from making, using, offering for sale, or selling” the invention in the United States for twenty years (U.S. Patent and Trademark Office, 2011).
What do you need to know about applying for a patent? For one thing, document your idea as soon as you think of it. Simply fill out a form, stating the purpose of your invention and the current date. Then sign it and get someone to witness it. The procedure sounds fairly informal, but you may need this document to strengthen your claim that you came up with the idea before someone else who also claims it. Later, you’ll apply formally for a patent by filling out an application (generally with the help of a lawyer), sending it to the U.S. Patent and Trademark Office, and waiting. Nothing moves quickly through the U.S. Patent and Trademark Office, and it takes a long time for any application to get through the process.
Will your application get through at all? There’s a good chance if your invention meets all the following criteria:
• It’s new. No one else can have known about it, used it, or written about it before you filed your patent application (so keep it to yourself until you’ve filed).
• It’s not obvious. It has to be sufficiently different from everything that’s been used for the purpose in the past (you can’t patent a new color for a cell phone).
• It has utility. It can’t be useless; it must have some value.
Applying for a U.S. patent is only the first step. If you plan to export your product outside the United States, you’ll need patent protection in each country in which you plan to do business, and as you’ve no doubt guessed, getting a foreign patent isn’t any easier than getting a U.S. patent. The process keeps lawyers busy: during a three-year period, PowerSki International had to take out more than eighty patents on the PowerSki Jetboard. It still has a long way to go to match the number of patents issued to some extremely large corporations. Microsoft, for example, recently obtained its ten thousandth patent (Fried, 2011).
Clearly, the patent business is booming. The U.S. Patent and Trademark Office issued more than a half million patents in 2010 (U.S. Patent and Trademark Office, 2011). One reason for the recent proliferation of patents is the high-tech boom: over the last decade, the number of patents granted has increased by more than 50 percent.
Key Takeaways
• You can protect your rights to your idea with a patent from the U.S. Patent and Trademark Office.
• A patent grants you “the right to exclude others from making, using, offering for sale, or selling” the invention in the United States for twenty years.
• To be patentable, an invention must meet all the following criteria: it’s new (no one else can have known about it, used it, or written about it before you filed your patent application); it’s not obvious (it’s sufficiently different from everything that’s been used for the purpose in the past); and it has utility (it must have some value; it can’t be useless).
Exercise
(AACSB) Analysis
A friend of yours described a product idea she had been working on. It is a child’s swing set with a sensor to stop the swing if anyone walks in front of it. She came to you for advice on protecting her product idea. What questions would you need to ask her to determine whether her product idea is patentable? How would she apply for a patent? What protection would the patent give her? How long would the patent apply? | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/10%3A_Product_Design_and_Development/10.07%3A_Product_Development.txt |
Learning on the Web (AACSB)
Breaking Even on Burgers
You and your business partner plan to open a gourmet burger restaurant. Your partner estimated the new business will sell a hundred fifty thousand burgers during its first year and a half of operations. You want to determine the number of burgers you must sell to break even during this period.
Here are the figures you know so far:
• The variable cost for each burger is \$0.97 each.
• The fixed cost of making burgers for eighteen months is \$140,000 (this includes costs such as rent, utilities, insurance).
• You will sell your burgers for \$1.99 each.
• At the \$1.99 per-unit selling price, how many burgers will you have to sell to break even?
Part 1: Using the previous information, manually calculate the breakeven number of burgers. How close is the breakeven number of burgers to your partner’s sales estimate of one hundred fifty thousand burgers? How confident are you that your restaurant will be profitable?
Part 2: Now, recalculate the breakeven number of burgers using a higher selling price. Pretend that your likely customers are burger fanatics and will pay \$2.79 for a burger (rather than \$1.99). Also pretend that the variable cost for each burger and your fixed costs won’t change (variable cost per burger is still \$0.97 and fixed costs are still \$140,000). Manually calculate the number of burgers you must sell to break even at this higher selling price. Are you now more confident that the business will succeed?
Part 3: Without recalculating breakeven, answer these two questions:
1. If the variable cost for each burger went down from \$0.97 to \$0.80 per burger (and your selling price stayed at \$1.99), would you need to sell more or fewer burgers to break even?
2. If fixed costs went down from \$140,000 to \$100,000 (and your selling price stayed at \$1.99 and variable cost per burger returned to \$0.97), would you need to sell more or fewer burgers to break even?
Career Opportunities
Being a “Big Idea” Person
Imagine a career in which you design the products people use every day. If you’re a “big idea” person, have an active imagination, have artistic flair, and possess the ability to understand how products function, then a career in product design and development might be for you. To learn what opportunities are available in this field, go to the Job Bank section of the Product Development and Management Association’s Web site (www.pdma.org/job_bank.cfm) and click on “View Posted Jobs.” Explore the various job openings by clicking on a position (to highlight it); and then clicking on the “View Job Details” button at the bottom of the screen. Find a position that interests you and look for answers to these questions:
1. What’s the job like?
2. What educational background, work experience, and skills are needed for the job?
3. What aspects of the job appeal to you? What aspects are unappealing?
4. Are you cut out for a career in product design and development? Why, or why not?
Ethics Angle (AACSB)
Who’s Getting Fat from Fast Food?
Product liability laws cover the responsibility of manufacturers, sellers, and others for injuries caused by defective products. Under product liability laws, a toy manufacturer can be held liable if a child is harmed by a toy that’s been marketed with a design flaw. The manufacturer can also be held liable for defects in marketing the toy, such as giving improper instructions on its use or failing to warn consumers about potential dangers. But what if the product isn’t a toy, but rather a fast-food kid’s meal? And what if the harm isn’t immediately obvious but emerges over time?
These questions are being debated in the legal and health professions (and the media). Some people believe that fast-food restaurants should be held responsible (at least in part) for childhood obesity. They argue that fast-food products—such as kids’ meals made up of high-calorie burgers, fried chicken fingers, French fries, and sugary soft drinks—are helping to make U.S. children overweight. They point out that while restaurant chains spend billions each year to advertise fast food to children, they don’t do nearly enough to warn parents of the dangers posed by such foods. On the other side of the debate are restaurant owners, who argue that they’re not the culprits. They say that their food can be a part of a child’s diet—if it’s eaten in moderation.
There’s no disputing that 15 percent of American children are obese and that fast-food consumption by children has increased by 500 percent since 1970. Most observers also accept the data furnished by the U.S. Surgeon General: that obesity in the United States claims some three hundred thousand lives a year and costs \$117 billion in health care. The controversy centers on the following questions:
1. Who really is to blame for the increase in obesity among U.S. children?
2. Under current consumer-protection laws, is fast-food marketing aimed at children misleading?
3. Should fast-food restaurants be held legally liable for the health problems associated with their products?
What’s your opinion? If you owned a fast-food restaurant, what action (if any) would you take in response to the charges leveled by critics of your industry?
Team-Building Skills (AACSB)
The Great Idea
Get together with members of your team and brainstorm ideas for a new-to-the-market product. Begin the brainstorming session by asking each person to write an idea on a sticky note. Post the idea and repeat the process four times. After the team has evaluated and discussed the ideas, all members should vote. Each gets ten votes, which can be placed on one idea or spread over many. Once the voting ends, add up the votes received by each idea and declare one idea the winner.
Write a group report that answers the following questions:
1. What is the idea?
2. How would the idea work?
3. Who would our customers be?
4. What unmet need does it fill?
2. Industry
• What is the product’s industry, segment, and niche?
• Is the industry growing or contracting?
• Who are our major competitors?
• How does our product differ from those of our competitors?
• What opportunities exist in the industry? What threats?
3. Product
• What will the product look like?
• What features will it have?
• How will customers benefit from our product?
• Why will customers buy the product from us?
• Why will our product be financially successful?
The Global View (AACSB)
What to Do When the “False” Alarm Goes Off
If someone on the street tried to sell you a “Rolex” watch for \$20, you’d probably suspect that it’s a fake. But what about a pair of New Balance athletic shoes? How do you know they’re authentic? How can you tell? Often you can’t. Counterfeiters are getting so good at copying products that even experts have trouble telling a fake from the real thing. What if the counterfeit product in question was a prescription drug? Even worse, what if it had been counterfeited with unsterile equipment or contained no active ingredients?
How likely is it that you’ll buy a counterfeit product in the next year? Unfortunately, it’s very likely. To learn a little more about the global counterfeiting business, go to the BusinessWeek and Washington Post Web sites. Read the BusinessWeek article “Fakes!” (http://www.businessweek.com/magazine...9001_mz001.htm) and the Washington Post article “Counterfeit Goods That Trigger the ‘False’ Alarm” (http://www.highbeam.com/doc/1P2-4576.html). After you read these articles, answer the following questions:
1. How has the practice of counterfeiting changed over time? What factors have allowed it to escalate?
2. What types of products are commonly counterfeited, and why might they be unsafe? What counterfeit products are particularly dangerous?
3. How do the counterfeiters get goods onto the market? How can you reduce your chances of buying fake goods?
4. Why is counterfeiting so profitable? How can counterfeiters compete on price with those making the authentic goods? How do counterfeiters harm U.S. businesses?
5. What efforts are international companies and governments (including China) making to stop counterfeiters?
6. If you know that a product is fake, is it ethical to buy it? | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/10%3A_Product_Design_and_Development/10.09%3A_Cases_and_Problems.txt |
Learning Objectives
1. Define operations management, and discuss the role of the operations manager in a manufacturing company.
2. Describe the decisions made in planning the production process in a manufacturing company.
Like PowerSki, every organization—whether it produces goods or provides services—sees Job 1 as furnishing customers with quality products. Thus, to compete with other organizations, a company must convert resources (materials, labor, money, information) into goods or services as efficiently as possible. The upper-level manager who directs this transformation process is called an operations manager. The job of operations management (OM), then, consists of all the activities involved in transforming a product idea into a finished product, as well as those involved in planning and controlling the systems that produce goods and services. In other words, operations managers manage the process that transforms inputs into outputs. Figure 11.1 “The Transformation Process” illustrates this traditional function of operations management.
Figure 11.1 The Transformation Process
In the rest of this chapter, we’ll discuss the major activities of operations managers. We’ll start by describing the role that operations managers play in the various processes designed to produce goods and offer services. Next, we’ll look at the production of goods in manufacturing firms; then, we’ll describe operations management activities in companies that provide services. We’ll wrap up the chapter by explaining the role of operations management in such processes as quality control and outsourcing.
11.02: Facility Layouts
Learning Objective
1. Describe four major types of facility layouts: process, product, cellular, and fixed position.
The next step in production planning is deciding on plant layout—how equipment, machinery, and people will be arranged to make the production process as efficient as possible. In this section, we’ll examine four common types of facility layouts: process, product, cellular, and fixed position.
The process layout groups together workers or departments that perform similar tasks. Goods in process (goods not yet finished) move from one workstation to another. At each position, workers use specialized equipment to perform a particular step in the production process. To better understand how this layout works, we’ll look at the production process at the Vermont Teddy Bear Company. Let’s say that you just placed an order for a personalized teddy bear—a “hiker bear” with khaki shorts, a white T-shirt with your name embroidered on it, faux-leather hiking boots, and a nylon backpack with sleeping bag. Your bear begins at the fur-cutting workstation, where its honey-brown “fur” coat is cut. It then moves to the stuffing and sewing workstation to get its insides and have its sides stitched together. Next, it moves to the dressing station, where it’s outfitted with all the cool clothes and gear that you ordered. Finally, it winds up in the shipping station and starts its journey to your house. For a more colorful “Online Mini-Tour” of this process, log on to the Vermont Teddy Bear Web site at www.vermontteddybear.com/Stat...mestation.aspx (or see Figure 11.3 “Process Layout at Vermont Teddy Bear Company”).
Figure 11.3 Process Layout at Vermont Teddy Bear Company
In a product layout, high-volume goods are produced efficiently by people, equipment, or departments arranged in an assembly line—that is, a series of workstations at which already-made parts are assembled. Just Born, a candy maker located in Bethlehem, Pennsylvania, makes a product called Marshmallow Peeps on an assembly line. First, the ingredients are combined and whipped in huge kettles. Then, sugar is added for color. At the next workstation, the mixture—colored warm marshmallow—is poured into baby-chick–shaped molds carried on conveyor belts. The conveyor-belt parade of candy pieces then moves forward to stations where workers add eyes or other details. When the finished candy reaches the packaging area, it’s wrapped for shipment to stores around the world. To take an online tour of the Marshmallow Peeps production process, log on to the Just Born Web site at www.justborn.com/get-to-know-us/our-factory (or see Figure 11.4 “Product Layout at Just Born, Inc.”).
Figure 11.4 Product Layout at Just Born, Inc.
Both product and process layouts arrange work by function. At the Vermont Teddy Bear Company, for example, the cutting function is performed in one place, the stuffing-and-sewing function in another place, and the dressing function in a third place. If you’re a cutter, you cut all day; if you’re a sewer, you sew all day: that’s your function. The same is true for the production of Marshmallow Peeps at Just Born: if your function is to decorate peeps, you stand on an assembly line and decorate all day; if your function is packing, you pack all day.
Arranging work by function, however, isn’t always efficient. Production lines can back up, inventories can build up, workers can get bored with repetitive jobs, and time can be wasted in transporting goods from one workstation to another. To counter some of these problems, many manufacturers have adopted a cellular layout, in which small teams of workers handle all aspects of building a component, a “family” of components, or even a finished product. Each team works in a small area, or cell, equipped with everything that it needs to function as a self-contained unit. Machines are sometimes configured in a U-shape, with people working inside the U. Because team members often share duties, they’re trained to perform several different jobs. Teams monitor both the quantity and the quality of their own output. This arrangement often results in faster completion time, lower inventory levels, improved quality, and better employee morale. Cellular manufacturing is used by large manufacturers, such as Boeing, Raytheon, and Pratt & Whitney (Chaneski, 1998), as well as by small companies, such as Little Enterprise, which makes components for robots (Modern Machine Shop Magazine, 2001; Little Enterprises, Inc., 2011). Figure 11.5 “Cellular Layout” illustrates a typical cellular layout.
Figure 11.5 Cellular Layout
It’s easy to move teddy bears and marshmallow candies around the factory while you’re making them, but what about airplanes or ships? In producing large items, manufacturers use fixed-position layout in which the product stays in one place and the workers (and equipment) go to the product. This is the arrangement used by General Housing Corporation in constructing modular homes. Each house is constructed at the company’s factory in Bay City, Michigan, according to the customer’s design. Because carpenters, electricians, plumbers, and others work on each building inside the climate-controlled factory, the process can’t be hindered by weather. Once it’s done, the house is transported in modules to the owner’s building site and set up in one day. For a closer view of General Housing Corporation’s production process, go to the General Housing Web site at http://www.genhouse.com.
Key Takeaways
• Managers have several production layout choices, including process, product, cellular, and fixed-position.
• The process layout groups together workers or departments that perform similar tasks. At each position, workers use specialized equipment to perform a particular step in the production process.
• In a product layout, high-volume goods are produced in assembly-line fashion—that is, a series of workstations at which already-made parts are assembled.
• In a cellular layout, small teams of workers handle all aspects of building a component, a “family of components,” or even a finished product.
• A fixed-position layout is used to make large items (such as ships or buildings) that stay in one place while workers and equipment go to the product.
Exercise
(AACSB) Analysis
As purchasing manager for a company that flies corporate executives around the world, you’re responsible for buying everything from airplanes to onboard snacks. You plan to visit all the plants that make the things you buy: airplanes, passenger seats, TV/DVDs that go in the back of the passenger seats, and the specially designed uniforms (with embroidered company logos) worn by the flight attendants. What type of layout should you expect to find at each facility—process, product, or fixed-position? What will each layout look like? Why is it appropriate for the company’s production process? Could any of these plants switch to a cellular layout? What would this type of layout look like? What would be its advantages? | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/11%3A_Operations_Management_in_Manufacturing_and_Service_Industries/11.01%3A_Operations_Management_in_Manufacturing.txt |
Learning Objective
1. Identify the activities undertaken by the operations manager in overseeing the production process in a manufacturing company.
Once the production process is in place, the attention of the operations manager shifts to the daily activities of materials management, which encompass the following activities: purchasing, inventory control, and work scheduling.
11.04: Graphical Tools- PERT and Gantt Charts
Learning Objective
1. Explain how to create and use both PERT and Gantt charts.
Because they also need to control the timing of all operations, managers set up schedules: They select jobs to be performed during the production process, assign tasks to work groups, set timetables for the completion of tasks, and make sure that resources will be available when and where they’re needed. There are a number of scheduling techniques. We’ll focus on two of the most common—Gantt and PERT charts.
11.05: The Technology of Goods Production
Learning Objective
1. Explain how manufacturing companies use technology to produce and deliver goods in an efficient, cost-effective manner.
PowerSki founder and CEO Bob Montgomery spent sixteen years designing the Jetboard and bringing it to production. At one point, in his efforts to get the design just right, he’d constructed thirty different prototypes. Needless to say, this process took a very long time, but even so, Montgomery thought that he could handle the designing of the engine without the aid of a computer. Before long, however, he realized that it was impossible to keep track of all the changes.
11.06: Operations Management for Service Providers
Learning Objectives
1. List the characteristics that distinguish service operations from manufacturing operations.
2. Describe the decisions made in planning the product delivery process in a service company.
3. Identify the activities undertaken to manage operations in a service organization.
As the U.S. economy has changed from a goods producer to a service provider, the predominance of the manufacturing sector has declined substantially over the last sixty years. Today, only about 9 percent of U.S. workers are employed in manufacturing, in contrast to 30 percent in 1950 (The Global Language Monitor, 2010; Strauss, 2010). Most of us now hold jobs in the service sector, which accounts for 77 percent of U.S. gross domestic product (International Monetary Fund, 2010; Wikipedia, 2011). Wal-Mart is now America’s largest employer, followed by IBM, United Parcel Service (UPS), McDonald’s, and Target. Not until we drop down to the seventh-largest employer—Hewlett Packard—do we find a company with even a manufacturing component (24/7 Wall Street, 2011).
Figure 11.9
Wal-Mart employs more than a million people in the United States.
Mike Mozart – Walmart – CC BY 2.0.
11.07: Producing for Quality
Learning Objective
1. Explain how manufacturing and service companies alike use total quality management and outsourcing to provide value to customers.
What do you do if you get it home and your brand-new DVD player doesn’t work? What if you were late for class because it took you twenty minutes to get a burger and order of fries at the drive-through window of a fast-food restaurant? Like most people, you’d probably be more or less disgruntled. As a customer, you’re constantly assured that when products make it to market, they’re of the highest possible quality, and you tend to avoid brands that have failed to live up to your expectations or to producers’ claims. You’re told that workers in such businesses as restaurants are there to serve you, and you probably don’t go back to establishments where you’ve received poor-quality service.
But what is quality? According to the American Society for Quality, quality refers to “the characteristics of a product or service that bear on its ability to satisfy stated or implied needs” (American Society of Quality, 2011). When you buy a DVD player, you expect it to play DVDs. When it doesn’t, you question its quality. When you go to a drive-through window, you expect to be served in a reasonable amount of time. If you’re forced to wait, you conclude that you’re the victim of poor-quality service. | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/11%3A_Operations_Management_in_Manufacturing_and_Service_Industries/11.03%3A_Managing_the_Production_Process_in_a_Manufacturing_Company.txt |
Learning on the Web (AACSB)
How to Build a BMW
How’d you like to own a Series 3 BMW? How about a convertible priced at \$48,000 for those warm summer days? Or maybe a less expensive coupe for \$39,000? Or, if you need more space for hauling camping equipment, dogs, or kids, maybe you would prefer a wagon at \$37,000? We can’t help you finance a BMW, but we can show you how they’re made. Go to http://www.bmw-plant-munich.com/ to link to the BMW Web site for a virtual tour of the company’s Munich, Germany, plant.
First, click on “Location” and then on “The Plant in Figures.” Before going any further, answer the following questions:
1. How many associates (employees) work in the plant?
2. How many apprentices (trainees) work there? Why does the plant have trainees?
3. How many cars are made in the plant each day? How many engines?
Next, click on “Production” to open a drop-down list that looks like this:
Fascination Production
Press Shop
Body Shop
Paint Shop
Engine Assembly
Assembly
Click on “Fascination Production,” and watch a video that zips you through the production steps needed to make a BMW. Continue your tour by clicking on each progressive step taken to build a quality car: press shop, body shop, paint shop, engine assembly and final assembly. After reading about and watching the brief video describing the work done in a particular area of the plant, pause and answer the following questions (you will answer this set of questions five times—once for each of these areas of the factory: press shop, body shop, paint shop, engine assembly, and final assembly):
1. What production steps occurred in this area of the plant?
2. What technology does BMW use in the production process?
3. Approximately what percentage of the work was done by people?
4. What procedures were followed to ensure the production of high-quality vehicles?
Career Opportunities
Wanted: Problem Solvers and Creative Thinkers
If you had a time machine plus a craving for a great hamburger, you could return to the early 1950s and swing by Dick and Mac McDonald’s burger stand in San Bernardino, California. Take a break from eating and watch the people in the kitchen. You’ll see an early application of operations management in the burger industry. Dick and Mac, in an effort to sell more burgers in less time, redesigned their kitchen to use assembly-line procedures. As the number of happy customers grew, word spread about their speedy system, and their business thrived. Curiously, it wasn’t Dick and Mac who made McDonald’s what it is today, but rather a traveling milkshake-mixer salesman named Ray Kroc. He visited the hamburger stand to learn how they could sell twenty thousand shakes a year. When he saw their operations and the lines of people walking away with bags filled with burgers, fries, and shakes, he knew he had a winner. In cooperation with the McDonald brothers, he started selling franchises around the country, and the rest is history.
So, what does this story have to do with a career in operations management? If you’re a problem solver like Dick and Mac (who discovered a way to make burgers faster and cheaper) or a creative thinker like Ray Kroc (who recognized the value in an assembly-line burger production system), then a career in operations management might be for you. The field is broad and offers a variety of opportunities. To get a flavor of the choices available, go to www.wetfeet.com/Careers-and-I...perations.aspx to link to the WetFeet Web site and review the dozen or so operations management positions listed. Provide a brief description of each position. Indicate how interesting you find each position by rating it using a five-point scale (with 1 being uninteresting and 5 being very interesting). Based on your assessment, pick the position you find most interesting and the one you find least interesting. Explain why you made your selections.
Ethics Angle (AACSB)
In many ways, Eastman Kodak (a multinational manufacturer and distributor of photographic equipment and supplies) is a model corporate citizen. Fortune magazine has ranked it as one of the country’s most admired companies, applauding it in particular for its treatment of minorities and women. Its community-affairs programs and contributions have also received praise, but Eastman Kodak remains weak in one important aspect of corporate responsibility: it has consistently received low scores on environmental practices. For example, the watchdog group Scorecard rated Eastman Kodak’s Rochester, New York, facility as the third-worst emitter of airborne carcinogens in the United States. Other reports have criticized the company for dumping cancer-causing chemicals into the nation’s waters.
Go to www.kodak.com/US/en/corp/HSE/homepage.jhtml?pd-path=2879/7196 to link to the Eastman Kodak Web site and read its own assessment of its environmental practices. Then answer the following questions:
• Based on the information provided on its Web site, how favorable do you feel about Eastman Kodak’s environmental practices?
• In what ways is the company responding to criticisms of its environmental practices and improving them?
• Do the statements on the Web site mesh with the criticism that the company has received? If not, what accounts for the differences?
Team-Building Skills (AACSB)
Growing Accustomed to Your Fit
Instead of going to the store to try on several pairs of jeans that may or may not fit, wouldn’t it be easier to go online and order a pair of perfect-fitting jeans? Lands’ End has made this kind of shopping possible through mass-customization techniques and some sophisticated technology.
To gain some firsthand experience at shopping for mass-customized goods, have each member of your team go to Nike’s iD site at http://nikeid.nike.com. Each team member should go through the process of customizing a different Nike product but stop right before placing an order. After everyone has gone through the process, get together and write a report in which the team explains exactly what’s entailed by online mass customization and details the process at Nike. Be sure to say which things impressed you and which didn’t. Explain why Nike developed this means of marketing products and, finally, offer some suggestions on how the process could be improved.
The Global View (AACSB)
What’s the State of Homeland Job Security?
Over the past several decades, more and more U.S. manufacturers began outsourcing production to such low-wage countries as Mexico and China. The number of U.S. manufacturing jobs dwindled, and the United States became more of a service economy. People who were directly affected were understandably unhappy about this turn of events, but most people in this country didn’t feel threatened. At least, not until service jobs also started going to countries that, like India, have large populations of well-educated, English-speaking professionals. Today, more technology-oriented jobs, including those in programming and Internet communications, are being outsourced to countries with lower wage rates. And tech workers aren’t alone: the jobs of accountants, analysts, bankers, medical technicians, paralegals, insurance adjusters, and even customer-service representatives have become candidates for overseas outsourcing.
Many U.S. workers are concerned about job security (though the likelihood of a particular individual’s losing a job to an overseas worker is still fairly low). The issues are more complex than merely deciding where U.S. employers should be mailing paychecks, and politicians, economists, business executives, and the general public differ about the causes and consequences of foreign outsourcing. Some people think it’s a threat to American quality of life, while others actually think that it’s a good thing.
Spend some time researching trends in outsourcing. Formulate some opinions, and then answer the following questions:
1. About what percentage of U.S. jobs have left the country in the last five years? What percentage will probably leave in the next five years?
2. What kinds of jobs are being outsourced, and where are they going? What kinds of jobs can’t be outsourced?
3. How does global outsourcing help U.S. businesses? How does it hinder them?
4. How has the trend in outsourcing manufacturing and service operations to foreign countries helped average Americans? How has it harmed them?
5. Does overseas outsourcing help or hurt the U.S. economy? In what ways? | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/11%3A_Operations_Management_in_Manufacturing_and_Service_Industries/11.08%3A_Cases_and_Problems.txt |
Learning Objectives
1. Define accounting and explain the differences between managerial accounting and financial accounting.
2. Identify some of the users of accounting information and explain how they use it.
Accounting is often called “the language of business.” Why? Because it communicates so much of the information that owners, managers, and investors need to evaluate a company’s financial performance. These people are all stakeholders in the business—they’re interested in its activities because they’re affected by them. In fact, the purpose of accounting is to help stakeholders make better business decisions by providing them with financial information. Obviously, you wouldn’t try to run an organization or make investment decisions without accurate and timely financial information, and it’s the accountant who prepares this information. More importantly, accountants make sure that stakeholders understand the meaning of financial information, and they work with both individuals and organizations to help them use financial information to deal with business problems. Actually, collecting all the numbers is the easy part—today, all you have to do is start up your accounting software. The hard part is analyzing, interpreting, and communicating the information. Of course, you also have to present everything clearly while effectively interacting with people from every business discipline. In any case, we’re now ready to define accounting as the process of measuring and summarizing business activities, interpreting financial information, and communicating the results to management and other decision makers.
12.02: Understanding Financial Statements
Learning Objectives
1. Understand the function of the income statement.
2. Understand the function of the balance sheet.
3. Understand the function of the statement of owner’s equity.
We hope that, so far, we’ve made at least one thing clear: If you’re in business, you need to understand financial statements. For one thing, the law no longer allows high-ranking executives to plead ignorance or fall back on delegation of authority when it comes to taking responsibility for a firm’s financial reporting. In a business environment tainted by episodes of fraudulent financial reporting and other corporate misdeeds, top managers are now being held accountable (so to speak) for the financial statements issued by the people who report to them. For another thing, top managers need to know if the company is hitting on all cylinders or sputtering down the road to bankruptcy. To put it another way (and to switch metaphors): if he didn’t understand the financial statements issued by the company’s accountants, an executive would be like an airplane pilot who doesn’t know how to read the instrument in the cockpit—he might be able keep the plane in the air for a while, but he wouldn’t recognize any signs of impending trouble until it was too late.
12.03: Accrual Accounting
Learning Objectives
1. Understand the difference between cash-basis and accrual accounting.
2. Understand the purpose of a statement of cash flows and describe its format.
In this section, we’re going to take a step further into the world of accounting by examining the principles of accrual accounting. In our Stress-Buster illustration, we’ve assumed that all your transactions have been made in cash: You paid cash for your inputs (plastic treasure chests and toys) and for your other expenses, and your customers paid cash when they bought Stress-Buster packs. In the real world, of course, things are rarely that simple. In the following cases, timing plays a role in making and receiving payments:
• Customers don’t always pay in cash; they often buy something and pay later. When this happens, the seller is owed money and has an account receivable (it will receive something later).
• Companies don’t generally pay cash for materials and other expenses—they often pay later. If this is the case, the buyer has an account payable (it will pay something later).
• Many companies manufacture or buy goods and hold them in inventory before selling them. Under these circumstances, they don’t report payment for the goods until they’ve been sold.
• Companies buy long-term assets (also called fixed assets), such as cars, buildings, and equipment, which they plan to use over an extended period (as a rule, for more than one year).
12.04: Financial Statement Analysis
Learning Objective
1. Evaluate a company’s performance using financial statements and ratio analysis.
Now that you know how financial statements are prepared, let’s see how they’re used to help owners, managers, investors, and creditors assess a firm’s performance and financial strength. You can glean a wealth of information from financial statements, but first you need to learn a few basic principles for “unlocking” it.
12.05: The Profession- Ethics and Opportunities
Learning Objectives
1. Understand why it’s not a good idea to falsify financial statements.
2. Appreciate the background behind stricter legal and professional standards in U.S. business and accounting practice.
3. Understand ethics and their importance in the accounting profession.
4. Identify career opportunities in accounting. | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/12%3A_The_Role_of_Accounting_in_Business/12.01%3A_The_Role_of_Accounting.txt |
Learning on the Web (AACSB)
Discounting Retailers
There was a time when Kmart was America’s number-one discount retailer and Sears, Roebuck & Co. was the seventh largest corporation in the world. Things have changed since Wal-Mart came on the scene. In the fifty years since Sam Walton opened the first Wal-Mart store in Rogers, Arkansas, the company has propelled itself to the number-one spot in discount retailing, and (even more impressive) has higher sales than any other company in the world. Over this same fifty-year period, Target emerged as a major player in the retail industry. The fifty-year period wasn’t kind to Kmart and Sears, and both stores watched their dominance in the retail market slip away. In an effort to reverse the downward spiral of both retailers, in November 2004, Sears and Kmart merged into a new company called Sears Holdings. To learn more about how Wal-Mart, Target, and Sears Holdings are doing today, go to the National Retail Federation’s Web site (http://www.stores.org/STORES%20Magaz...-100-retailers) to access a report that ranks the 2010 top 100 retailers. After reading the introduction and reviewing the list of top retailers, prepare a report comparing the three retailers on the following:
• U.S. sales and percentage increase or decrease in sales
• Worldwide sales
• Number of stores and percentage increase or decrease in number of stores
Based on your analysis and reading of the introductory write-up, answer the following questions:
1. Do you believe that Target will be able to compete against Wal-Mart in the future? If so, how?
2. What about Sears Holdings? Will the company survive?
3. Some people criticize Wal-Mart for forcing other retailers out of business and for lowering the average wage for retail workers. Is this a legitimate criticism? In your opinion, has Wal-Mart helped the American people or hurt them?
Career Opportunities
Is a Career in Accounting for You?
Do you want to learn what opportunities are available for people graduating with degrees in accounting? Go to the Web site of the American Institute of Certified Public Accountants (http://www.startheregoplaces.com) and click on “Why Accounting?” (top, left). Then click on “Career Options” (left side bar). Select two areas of interest. Click on each interest area and select a job in that area that interests you. For each of two jobs selected (one from each interest area), answer the following questions:
• What is the job like?
• Why does the job seem interesting to you?
Ethics Angle (AACSB)
Counting Earnings before They Hatch
You recently ran into one of your former high school teachers. You were surprised to learn that he’d left teaching, gone back to school, and, a little more than a year ago, started a business that creates Web sites for small companies. It so happens that he needs a loan to expand his business, and the bank wants financial statements. When he found out that you were studying accounting, he asked whether you’d look over a set of statements that he’d just prepared for his first year in business. Because you’re anxious to show off your accounting aptitude, you agreed.
First, he showed you his income statement. It looked fine: revenues (from designing Web sites) were \$94,000, expenses were \$86,000, and net income was \$8,000. When you observed how unusual it was that he’d earned a profit in his first year, he seemed a little uneasy.
“Well,” he confessed, “I fudged a little when I prepared the statements. Otherwise, I’d never get the loan.”
He admitted that \$10,000 of the fees shown on the income statement was for work he’d recently started doing for a client (who happened to be in big trouble with the IRS). “It isn’t like I won’t be earning the money,” he explained. “I’m just counting it a little early. It was easy to do. I just added \$10,000 to my revenues and recorded an accounts receivable for the same amount.”
You quickly did the math: without the \$10,000 payment for the client in question, his profit of \$8,000 would become a loss of \$2,000 (revenues of \$84,000 less expenses of \$86,000).
As your former teacher turned to get his balance sheet, you realized that, as his accountant, you had to decide what you’d advise him to do. The decision is troublesome because you agree that if he changes the income statement to reflect the real situation, he won’t get the bank loan.
1. What did you decide to do, and why?
2. Assuming that he doesn’t change the income statement, will his balance sheet be incorrect? How about his statement of cash flows? What will happen to next year’s income: will it be higher or lower than it should be?
3. What would happen to your former teacher if he gave the bank the fraudulent financial statements and the bank discovered the truth? How could the bank learn the truth?
Team-Building Skills (AACSB)
Taking Stock of Ratios
Your class has been told that each group of three students will receive a share of stock in one of three companies in the same industry. But there’s a catch: each group has to decide which of the companies it wants to own stock in. To reach this decision, your team will use ratio analysis to compare the three companies. Each team member will analyze one of the companies using the ratios presented in this chapter. Then, you’ll get together, compare your results, and choose a company. Here are the details of the project:
1. The team selects a group of three companies in the same industry. Here are just a few examples:
• Auto manufacturers. Ford, General Motors, Toyota
• Airlines. Southwest, United Airlines, American Airlines
• Drug companies. GlaxoSmithKline, Eli Lilly & Co., Bristol-Myers Squibb
• Specialty retailers. Bed Bath & Beyond, Pottery Barn, Pier 1 Imports
• Computers. Hewlett Packard, Gateway, Apple Computer
2. Every team member gets a copy of one company’s most recent annual report (which includes its financial statements) from the company’s Web site (investor section).
3. Every member calculates the following ratios for the company for the last two years: gross profit margin, net profit margin, inventory turnover (if applicable), return on assets, current ratio, debt-to-equity, and interest coverage.
4. Get together as a group and compare your results. Decide as a group which company you want to own stock in.
5. Write a report indicating the company that your team selected and explain your choice. Attach the following items to your team report:
The Global View (AACSB)
Why Aren’t Shoes Made in the USA?
Having just paid \$70 for a pair of athletic shoes that were made in China, you wonder why they had to be made in that country. Why weren’t they made in the United States, where lots of people need good-paying jobs? You also figure that the shoe company must be making a huge profit on each pair it sells. Fortunately, you were able to get a breakdown of the costs for making a pair of \$70 athletic shoes (Canderbilt, 1998):
Production labor \$2.75
Materials 9.00
Rent, equipment 3.00
Supplier’s operating profit 1.75
Duties 3.00
Shipping 0.50
Cost to the Manufacturer \$20.00
Research and development 0.25
Promotion and advertising 4.00
Sales, distribution, administration 5.00
Shoe company’s operating profit 6.25
Cost to the Retailer \$35.50
Retailer’s Rent 9.00
Personnel 9.50
Other 7.00
Retailer’s operating profit 9.00
Cost to Consumer \$70.00
You’re surprised at a few of these items. First, out of the \$70, the profit made by the manufacturer was only \$6.25. Second, at \$2.75, labor accounted for only about 4 percent of the price you paid. The advertising cost (\$4.00) was higher than the labor cost. If labor isn’t a very big factor in the cost of the shoes, why are they made in China?
Deciding to look further into this puzzle, you discover that the \$2.75 labor cost was for two hours of work. Moreover, that \$2.75 includes not only the wages paid to the workers, but also labor-related costs, such as food, housing, and medical care.
That’s when you begin to wonder. How much would I have to pay for the same shoes if they were made in the United States? Or what if they were made in Mexico? How about Spain? To answer these questions, you need to know the hourly wage rates in these countries. Fortunately, you can get this information by going to the Foreign Labor section of the Bureau of Labor Statistics Web site (http://www.bls.gov/news.release/ichcc.t08.htm). The table you want is “Production Workers: Hourly Compensation Costs in U.S. Dollars.” Use the most recent hourly compensation figures.
To investigate this issue further, you should do the following:
1. Recalculate the cost of producing the shoes in the United States and two other countries of your choice. Because operating profit for the supplier, the shoe company, and the retailer will change as the cost to make the shoe changes, you have decided to determine this profit using the following percentage rates:
• Supplier’s operating profit: 10 percent of its costs
• Shoe company’s operating profit: 20 percent of its costs (including the cost paid to the supplier to make the shoes)
• Retailer’s operating profit: 15 percent of its costs (including the cost paid to the shoe company)
2. Prepare a report that does the following:
• Shows the selling price of the shoe for each manufacturing country (the United States and the other two countries you selected)
• Lists any costs other than labor that might change if shoe production was moved to the United States
• Identifies other factors that should be considered when selecting a manufacturing country
• Indicates possible changes to production methods that would make production in the United States less costly
3. Finally, draw some conclusions: Do you, as a U.S. citizen, benefit from shoe production in foreign countries? Does the United States benefit overall? Does the world benefit? Should shoe production return to the United States? | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/12%3A_The_Role_of_Accounting_in_Business/12.06%3A_Cases_and_Problems.txt |
Learning Objective
1. Identify the functions of money and describe the three government measures of the money supply.
Finance is about money. So our first question is, what is money? If you happen to have one on you, take a look at a \$5 bill. What you’ll see is a piece of paper with a picture of Abraham Lincoln on one side and the Lincoln Memorial on the other. Though this piece of paper—indeed, money itself—has no intrinsic value, it’s certainly in demand. Why? Because money serves three basic functions. Money is the following:
1. A medium of exchange
2. A measure of value
3. A store of value
Figure 13.1. Money itself has no intrinsic value. 401(K) 2012 – Money – CC BY-SA 2.0.
To get a better idea of the role of money in a modern economy, let’s imagine a system in which there is no money. In this system, goods and services are bartered—traded directly for one another. Now, if you’re living and trading under such a system, for each barter exchange that you make, you’ll have to have something that another trader wants. For example, say you’re a farmer who needs help clearing his fields. Because you have plenty of food, you might enter into a barter transaction with a laborer who has time to clear fields but not enough food: he’ll clear your fields in return for three square meals a day.
This system will work as long as two people have exchangeable assets, but needless to say, it can be inefficient. If we identify the functions of money, we’ll see how it improves the exchange for all the parties in our hypothetical set of transactions.
Medium of Exchange
Money serves as a medium of exchange because people will accept it in exchange for goods and services. Because people can use money to buy the goods and services that they want, everyone’s willing to trade something for money. The laborer will take money for clearing your fields because he can use it to buy food. You’ll take money as payment for his food because you can use it not only to pay him but also to buy something else you need (perhaps seeds for planting crops).
For money to be used in this way, it must possess a few crucial properties:
1. It must be divisible—easily divided into usable quantities or fractions. A \$5 bill, for example, is equal to five \$1 bills. If something costs \$3, you don’t have to rip up a \$5 bill; you can pay with three \$1 bills.
2. It must be portable—easy to carry; it can’t be too heavy or bulky.
3. It must be durable. It must be strong enough to resist tearing and the print can’t wash off if it winds up in the washing machine.
4. It must be difficult to counterfeit; it won’t have much value if people can make their own.
Measure of Value
Money simplifies exchanges because it serves as a measure of value. We state the price of a good or service in monetary units so that potential exchange partners know exactly how much value we want in return for it. This practice is a lot better than bartering because it’s much more precise than an ad hoc agreement that a day’s work in the field has the same value as three meals.
Store of Value
Money serves as a store of value. Because people are confident that money keeps its value over time, they’re willing to save it for future exchanges. Under a bartering arrangement, the laborer earned three meals a day in exchange for his work. But what if, on a given day, he skipped a meal? Could he “save” that meal for another day? Maybe, but if he were paid in money, he could decide whether to spend it on food each day or save some of it for the future. If he wanted to collect on his “unpaid” meal two or three days later, the farmer might not be able to “pay” it; unlike money, food could go bad.
The Money Supply
Now that we know what money does, let’s tackle another question: How much money is there? How would you go about “counting” all the money held by individuals, businesses, and government agencies in this country? You could start by counting the money that’s held to pay for things on a daily basis. This category includes cash (paper bills and coins) and funds held in demand deposits—checking accounts, which pay given sums to “payees” when they demand them.
Then, you might count the money that’s being “saved” for future use. This category includes interest-bearing accounts, time deposits (such as certificates of deposit, which pay interest after a designated period of time), and money market mutual funds, which pay interest to investors who pool funds to make short-term loans to businesses and the government.
M-1 and M-2
Counting all this money would be a daunting task (in fact, it would be impossible). Fortunately, there’s an easier way—namely, by examining two measures that the government compiles for the purpose of tracking the money supply: M-1 and M-2.
• The narrowest measure, M-1, includes the most liquid forms of money—the forms, such as cash and checking-accounts funds, that are spent immediately.
• M-2 includes everything in M-1 plus near-cash items invested for the short term—savings accounts, time deposits below \$100,000, and money market mutual funds.
So what’s the bottom line? How much money is out there? To find the answer, you can go to the Federal Reserve Board Web site. The Federal Reserve reports that in September 2011, M-1 was about \$2.1 trillion and M-2 was \$9.6 trillion (Federal Reserve, 2011). Figure 13.2 “The U.S. Money Supply, 1980–2010” shows the increase in the two money-supply measures since 1980.
Figure 13.2. The U.S. Money Supply, 1980–2010
If you’re thinking that these numbers are too big to make much sense, you’re not alone. One way to bring them into perspective is to figure out how much money you’d get if all the money in the United States were redistributed equally. According to the U.S. Census Population Clock (U.S. Census Bureau, 2011), there are more than three hundred million people in the United States. Your share of M-1, therefore, would be about \$6,700 and your share of M-2 would be about \$31,000.
What, Exactly, Is “Plastic Money”?
Are credit cards a form of money? If not, why do we call them plastic money? Actually, when you buy something with a credit card, you’re not spending money. The principle of the credit card is buy-now-pay-later. In other words, when you use plastic, you’re taking out a loan that you intend to pay off when you get your bill. And the loan itself is not money. Why not? Basically because the credit card company can’t use the asset to buy anything. The loan is merely a promise of repayment. The asset doesn’t become money until the bill is paid (with interest). That’s why credit cards aren’t included in the calculation of M-1 and M-2.
Key Takeaways
• Money serves three basic functions:
1. Medium of exchange: because you can use it to buy the goods and services you want, everyone’s willing to trade things for money.
2. Measure of value: it simplifies the exchange process because it’s a means of indicating how much something costs.
3. Store of value: people are willing to hold onto it because they’re confident that it will keep its value over time.
• The government uses two measures to track the money supply: M-1 includes the most liquid forms of money, such as cash and checking-account funds. M-2 includes everything in M-1 plus near-cash items, such as savings accounts and time deposits below \$100,000.
Exercise
(AACSB) Analysis
Instead of coins jingling in your pocket, how would you like to have a pocketful of cowrie shells? These smooth, shiny snail shells, which are abundant in the Indian Ocean, have been used for currency for more than four thousand years. At one point, they were the most widely used currency in the world. Search “cowrie shells” on Google and learn as much as you can about them. Then answer the following questions:
1. How effectively did they serve as a medium of exchange in ancient times?
2. What characteristics made them similar to today’s currencies?
3. How effective would they be as a medium of exchange today? | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/13%3A_Managing_Financial_Resources/13.01%3A_The_Functions_of_Money.txt |
Learning Objectives
1. Distinguish among different types of financial institutions.
2. Discuss the services that financial institutions provide and explain their role in expanding the money supply.
For financial transactions to happen, money must change hands. How do such exchanges occur? At any given point in time, some individuals, businesses, and government agencies have more money than they need for current activities; some have less than they need. Thus, we need a mechanism to match up savers (those with surplus money that they’re willing to lend out) with borrowers (those with deficits who want to borrow money). We could just let borrowers search out savers and negotiate loans, but the system would be both inefficient and risky. Even if you had a few extra dollars, would you lend money to a total stranger? If you needed money, would you want to walk around town looking for someone with a little to spare?
Depository and Nondepository Institutions
Now you know why we have financial institutions: they act as intermediaries between savers and borrowers and they direct the flow of funds between them. With funds deposited by savers in checking, savings, and money market accounts, they make loans to individual and commercial borrowers. In the next section, we’ll discuss the most common types of depository institutions (banks that accept deposits), including commercial banks, savings banks, and credit unions. We’ll also discuss several nondepository institutions (which provide financial services but don’t accept deposits), including finance companies, insurance companies, brokerage firms, and pension funds.
Commercial Banks
Commercial banks are the most common financial institutions in the United States, with total financial assets of about \$13.5 trillion (85 percent of the total assets of the banking institutions) (Insurance Information Institute, 2011). They generate profit not only by charging borrowers higher interest rates than they pay to savers but also by providing such services as check processing, trust- and retirement-account management, and electronic banking. The country’s 7,000 commercial banks range in size from very large (Bank of America, J.P. Morgan Chase) to very small (local community banks). Because of mergers and financial problems, the number of banks has declined significantly in recent years, but, by the same token, surviving banks have grown quite large. If you’ve been with one bank over the past ten years or so, you’ve probably seen the name change at least once or twice.
Savings Banks
Savings banks (also called thrift institutions and savings and loan associations, or S&Ls) were originally set up to encourage personal saving and provide mortgages to local home buyers. Today, however, they provide a range of services similar to those offered by commercial banks. Though not as dominant as commercial banks, they’re an important component of the industry, holding total financial assets of almost \$1.5 trillion (10 percent of the total assets of the banking institutions) (Insurance Information Institute, 2010). The largest S&L, Sovereign Bancorp, has close to 750 branches in nine Northeastern states. Savings banks can be owned by their depositors (mutual ownership) or by shareholders (stock ownership).
Credit Unions
To bank at a credit union, you must be linked to a particular group, such as employees of United Airlines, employees of the state of North Carolina, teachers in Pasadena, California, or current and former members of the U.S. Navy. Credit unions are owned by their members, who receive shares of their profits. They offer almost anything that a commercial bank or savings and loan does, including savings accounts, checking accounts, home and car loans, credit cards, and even some commercial loans (Pennsylvania Association of Community Bankers, 2011). Collectively, they hold about \$812 billion in financial assets (around 5 percent of the total assets of the financial institutions).
Figure 13.3 “Where Our Money Is Deposited” summarizes the distribution of assets among the nation’s depository institutions.
Figure 13.3 Where Our Money Is Deposited
Finance Companies
Finance companies are nondeposit institutions because they don’t accept deposits from individuals or provide traditional banking services, such as checking accounts. They do, however, make loans to individuals and businesses, using funds acquired by selling securities or borrowed from commercial banks. They hold about \$1.9 trillion in assets (Insurance Information Institute, 2010). Those that lend money to businesses, such as General Electric Capital Corporation, are commercial finance companies, and those that make loans to individuals or issue credit cards, such a Citgroup, are consumer finance companies. Some, such as General Motors Acceptance Corporation, provide loans to both consumers (car buyers) and businesses (GM dealers).
Insurance Companies
Insurance companies sell protection against losses incurred by illness, disability, death, and property damage. To finance claims payments, they collect premiums from policyholders, which they invest in stocks, bonds, and other assets. They also use a portion of their funds to make loans to individuals, businesses, and government agencies.
Brokerage Firms
Companies like A.G. Edwards & Sons and T. Rowe Price, which buy and sell stocks, bonds, and other investments for clients, are brokerage firms (also called securities investment dealers). A mutual fund invests money from a pool of investors in stocks, bonds, and other securities. Investors become part owners of the fund. Mutual funds reduce risk by diversifying investment: because assets are invested in dozens of companies in a variety of industries, poor performance by some firms is usually offset by good performance by others. Mutual funds may be stock funds, bond funds, and money market funds, which invest in safe, highly liquid securities. (Recall our definition of liquidity in Chapter 12 “The Role of Accounting in Business” as the speed with which an asset can be converted into cash.)
Finally, pension funds, which manage contributions made by participating employees and employers and provide members with retirement income, are also nondeposit institutions.
Financial Services
You can appreciate the diversity of the services offered by commercial banks, savings banks, and credit unions by visiting their Web sites. For example, Wells Fargo promotes services to four categories of customers: individuals, small businesses, corporate and institutional clients, and affluent clients seeking “wealth management.” In addition to traditional checking and savings accounts, the bank offers automated teller machine (ATM) services, credit cards, and debit cards. It lends money for homes, cars, college, and other personal and business needs. It provides financial advice and sells securities and other financial products, including individual retirement account (IRA), by which investors can save money that’s tax free until they retire. Wells Fargo even offers life, auto, disability, and homeowners insurance. It also provides electronic banking for customers who want to check balances, transfer funds, and pay bills online (Wells Fargo, 2011).
Bank Regulation
How would you react if you put your life savings in a bank and then, when you went to withdraw it, learned that the bank had failed—that your money no longer existed? This is exactly what happened to many people during the Great Depression. In response to the crisis, the federal government established the Federal Depository Insurance Corporation (FDIC) in 1933 to restore confidence in the banking system. The FDIC insures deposits in commercial banks and savings banks up to \$250,000. So today if your bank failed, the government would give you back your money (up to \$250,000). The money comes from fees charged member banks.
To decrease the likelihood of failure, various government agencies conduct periodic examinations to ensure that institutions are in compliance with regulations. Commercial banks are regulated by the FDIC, savings banks by the Office of Thrift Supervision, and credit unions by the National Credit Union Administration. As we’ll see later in the chapter, the Federal Reserve System also has a strong influence on the banking industry.
Crisis in the Financial Industry (and the Economy)
What follows is an interesting, but scary, story about the current financial crisis in the banking industry and its effect on the economy. In the years between 2001 and 2005, lenders made billions of dollars in subprime adjustable-rate mortgages (ARMs) to American home buyers. Subprime loans are made to home buyers who don’t qualify for market-set interest rates because of one or more risk factors—income level, employment status, credit history, ability to make only a very low down payment. In 2006 and 2007, however, housing prices started to go down. Many homeowners with subprime loans, including those with ARMs whose rates had gone up, were able neither to refinance (to lower their interest rates) nor to borrow against their homes. Many of these homeowners got behind in mortgage payments, and foreclosures became commonplace—1.3 million in 2007 alone (Lahart, 2011). By April 2008, 1 in every 519 American households had received a foreclosure notice (RealtyTrac Inc., 2011). By August, 9.2 percent of the \$12 trillion in U.S. mortgage loans was delinquent or in foreclosure (Mortgage Bankers Association, 2008; Duhigg, 2011).
The repercussions? Banks and other institutions that made mortgage loans were the first sector of the financial industry to be hit. Largely because of mortgage-loan defaults, profits at more than 8,500 U.S. banks dropped from \$35 billion in the fourth quarter of 2006 to \$650 million in the corresponding quarter of 2007 (a decrease of 89 percent). Bank earnings for the year 2007 declined 31 percent and dropped another 46 percent in the first quarter of 2008 (Federal Deposit Insurance Corporation, 2008; FDIC, 2008).
Losses in this sector were soon felt by two publicly traded government-sponsored organizations, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Both of these institutions are authorized to make loans and provide loan guarantees to banks, mortgage companies, and other mortgage lenders; their function is to make sure that these lenders have enough money to lend to prospective home buyers. Between them, Fannie Mae and Freddie Mac backed approximately half of that \$12 trillion in outstanding mortgage loans, and when the mortgage crisis hit, the stock prices of the two corporations began to drop steadily. In September 2008, amid fears that both organizations would run out of capital, the U.S. government took over their management.
Freddie Mac also had another function: to increase the supply of money available in the country for mortgage loans and new home purchases, Freddie Mac bought mortgages from banks, bundled these mortgages, and sold the bundles to investors (as mortgage-backed securities). The investors earned a return because they received cash from the monthly mortgage payments. The banks that originally sold the mortgages to Freddie Mac used the cash they got from the sale to make other loans. So investors earned a return, banks got a new influx of cash to make more loans, and individuals were able to get mortgages to buy the homes they wanted. This seemed like a good deal for everyone, so many major investment firms started doing the same thing: they bought individual subprime mortgages from original lenders (such as small banks), then pooled the mortgages and sold them to investors.
But then the bubble burst. When many home buyers couldn’t make their mortgage payments (and investors began to get less money and consequently their return on their investment went down), these mortgage-backed securities plummeted in value. Institutions that had invested in them—including investment banks—suffered significant losses (Tully, 2007). In September 2008, one of these investment banks, Lehman Brothers, filed for bankruptcy protection; another, Merrill Lynch, agreed to sell itself for \$50 billion. Next came American International Group (AIG), a giant insurance company that insured financial institutions against the risks they took in lending and investing money. As its policyholders buckled under the weight of defaulted loans and failed investments, AIG, too, was on the brink of bankruptcy, and when private efforts to bail it out failed, the U.S. government stepped in with a loan of \$85 billion (Robb, et. al., 2008). The U.S. government also agreed to buy up risky mortgage-backed securities from teetering financial institutions at an estimated cost of “hundreds of billions” (Mortgage Bankers Association, 2008). And the banks started to fail—beginning with the country’s largest savings and loan, Washington Mutual, which had 2,600 locations throughout the country. The list of failed banks kept getting longer: by November of 2008, it had grown to nineteen.
The economic troubles that began in the banking industry as a result of the subprime crisis spread to the rest of the economy. Credit markets froze up and it became difficult for individuals and businesses to borrow money. Consumer confidence dropped, people stopped spending, businesses cut production, sales dropped, company profits fell, and many lost their jobs. It would be nice if this story had an ending (and even nicer if it was positive), but it might take us years before we know the ending. At this point in time, all we do know is that the economy is going through some very difficult times and no one is certain about the outcome. As we head into 2012, one in three Americans believe the United States is headed in the wrong direction. Our debt has been downgraded by Moody’s, a major credit rating agency. Unemployment seems stuck at around 9 percent, with the long-term unemployed making up the biggest portion of the jobless since records began in 1948. “As the superpower’s clout seems to ebb towards Asia, the world’s most consistently inventive and optimistic country has lost its mojo” (The Economist, 2011).
How Banks Expand the Money Supply
When you deposit money, your bank doesn’t set aside a special pile of cash with your name on it. It merely records the fact that you made a deposit and increases the balance in your account. Depending on the type of account, you can withdraw your share whenever you want, but until then, it’s added to all the other money held by the bank. Because the bank can be pretty sure that all its depositors won’t withdraw their money at the same time, it holds on to only a fraction of the money that it takes in—its reserves. It lends out the rest to individuals, businesses, and the government, earning interest income and expanding the money supply.
The Money Multiplier
Precisely how do banks expand the money supply? To find out, let’s pretend you win \$10,000 at the blackjack tables of your local casino. You put your winnings into your savings account immediately. The bank will keep a fraction of your \$10,000 in reserve; to keep matters simple, we’ll use 10 percent. The bank’s reserves, therefore, will increase by \$1,000 (\$10,000 × 0.10). It will then lend out the remaining \$9,000. The borrowers (or the parties to whom they pay it out) will then deposit the \$9,000 in their own banks. Like your bank, these banks will hold onto 10 percent of the money (\$900) and lend out the remainder (\$8,100). Now let’s go through the process one more time. The borrowers of the \$8,100 (or, again, the parties to whom they pay it out) will put this amount into their banks, which will hold onto \$810 and lend the remaining \$7,290. As you can see in Figure 13.4 “The Effect of the Money Multiplier”, total bank deposits would now be \$27,100. Eventually, bank deposits would increase to \$100,000, bank reserves to \$10,000, and loans to \$90,000. A shortcut for arriving at these numbers depends on the concept of the money multiplier, which is determined using the following formula:
Money multiplier = 1/Reserve requirement
In our example, the money multiplier is 1/0.10 = 10. So your initial deposit of \$10,000 expands into total deposits of \$100,000 (\$10,000 × 10), additional loans of \$90,000 (\$9,000 × 10), and increased bank reserves of \$10,000 (\$1,000 × 10). In reality, the multiplier will actually be less than 10. Why? Because some of the money loaned out will be held as currency and won’t make it back into the banks.
Figure 13.4 The Effect of the Money Multiplier
Key Takeaways
• Financial institutions serve as financial intermediaries between savers and borrowers and direct the flow of funds between the two groups.
• Those that accept deposits from customers—depository institutions—include commercial bankssavings banks, and credit unions; those that don’t—nondepository institutions—include finance companiesinsurance companies, and brokerage firms.
• Financial institutions offer a wide range of services, including checking and savings accounts, ATM services, and credit and debit cards. They also sell securities and provide financial advice.
• A bank holds onto only a fraction of the money that it takes in—an amount called its reserves—and lends the rest out to individuals, businesses, and governments. In turn, borrowers put some of these funds back into the banking system, where they become available to other borrowers. The money multiplier effect ensures that the cycle expands the money supply.
Exercises
1. (AACSB) Analysis
Does the phrase “The First National Bank of Wal-Mart” strike a positive or negative chord? Wal-Mart isn’t a bank, but it does provide some financial services: it offers a no-fee Wal-Mart Discovery credit card with a 1 percent cash-back feature, cashes checks and sells money orders through an alliance with MoneyGram International, and houses bank branches in more than a thousand of its superstores. Through a partnering arrangement with SunTrust Banks, the retailer has also set up in-store bank operations at a number of outlets under the cobranded name of “Wal-Mart Money Center by SunTrust.” A few years ago, Wal-Mart made a bold attempt to buy several banks but dropped the idea when it encountered stiff opposition. Even so, some experts say that it’s not a matter of whether Wal-Mart will become a bank, but a matter of when. What’s your opinion? Should Wal-Mart be allowed to enter the financial-services industry and offer checking and savings accounts, mortgages, and personal and business loans? Who would benefit if Wal-Mart became a key player in the financial-services arena? Who would be harmed?
2. (AACSB) Analysis
Congratulations! You just won \$10 million in the lottery. But instead of squandering your newfound wealth on luxury goods and a life of ease, you’ve decided to stay in town and be a financial friend to your neighbors, who are hardworking but never seem to have enough money to fix up their homes or buy decent cars. The best way, you decide, is to start a bank that will make home and car loans at attractive rates. On the day that you open your doors, the reserve requirement set by the Federal Reserve System is 10 percent. What’s the maximum amount of money you can lend to residents of the town? What if the Fed raises the reserve requirement to 12 percent? Then how much could you lend? In changing the reserve requirement from 10 percent to 12 percent, what’s the Fed trying to do—curb inflation or lessen the likelihood of a recession? Explain how the Fed’s action will contribute to this goal. | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/13%3A_Managing_Financial_Resources/13.02%3A_Financial_Institutions.txt |
Learning Objective
1. Identify the goals of the Federal Reserve System and explain how it uses monetary policy to control the money supply and influence interest rates.
Figure 13.5. The Federal Reserve Building in Washington, DC. Tim Evanson – Federl Reserve Building – eagle – CC BY-SA 2.0.
Who decides how much banks should keep in reserve? The decision is made by the Federal Reserve System (popularly known as “the Fed”), a central banking system established in 1913. Most large banks belong to the Federal Reserve System, which divides the country into twelve districts, each with a member-owned Federal Reserve Bank. The twelve banks are coordinated by a board of governors.
The Tools of the Fed
The Fed has three major goals:
1. Price stability
2. Sustainable economic growth
3. Full employment (Federal Reserve System, 2011)
Recall our definition of monetary policy in Chapter 1 “The Foundations of Business” as the efforts of the Federal Reserve System to regulate the nation’s money supply. We also defined price stability as conditions under which the prices for products remain fairly constant. Now, we can put the two concepts together: the Fed seeks to stabilize prices by regulating the money supply and interest rates. In turn, stable prices promote economic growth and full employment—at least in theory. To conduct monetary policy, the Fed relies on three tools: reserve requirements, the discount rate, and open market operations.
Reserve Requirements
Under what circumstances would the Fed want to change the reserve requirement for banks? The purpose of controlling the money supply is primarily to lessen the threat of inflation (a rise in the overall price level) or recession (an economic slowdown gauged by a decline in gross domestic product). Here’s how it works (again, in theory). If the Fed raises the reserve requirement (for example, from 10 percent to 11 percent), banks must set aside more money. Consequently, they have less to lend and so raise their interest rates. Under these conditions, it’s harder and more expensive for people to borrow money, and if they can’t borrow as much, they can’t spend as much, and if people don’t spend as much, prices don’t go up. Thus, the Fed has lessened the likelihood of inflation.
Conversely, when the Fed lowers the reserve requirement (for example, from 10 percent to 9 percent), banks need to set aside less money. Because they have more money to lend, they keep interest rates down. Borrowers find it easier and cheaper to get money for buying things, and the more consumers buy, the higher prices go. In this case, the Fed has reduced the likelihood of a recession.
A 1 percent change in the reserve requirement, whether up to 11 percent or down to 9 percent, may not seem like much, but remember our earlier discussion of the money multiplier: because of the money-multiplier effect, a small change in the reserve requirement has a dramatic effect on the money supply. (For the same reason, the Fed changes reserve requirements only rarely.)
The Discount Rate
To understand how the Fed uses the discount rate to control the money supply, let’s return to our earlier discussion of reserves. Recall that banks must keep a certain fraction of their deposits as reserves. The bank can hold these reserve funds or deposit them into a Federal Reserve Bank account. Recall, too, that the bank can lend out any funds that it doesn’t have to put on reserve. What happens if a bank’s reserves fall below the required level? The Fed steps in, permitting the bank to “borrow” reserve funds from the Federal Reserve Bank and add them to its reserve account at the Bank. There’s a catch: the bank must pay interest on the borrowed money. The rate of interest that the Fed charges member banks is called the discount rate. By manipulating this rate, the Fed can make it appealing or unappealing to borrow funds. If the rate is high enough, banks will be reluctant to borrow. Because they don’t want to drain their reserves, they cut back on lending. The money supply, therefore, decreases. By contrast, when the discount rate is low, banks are more willing to borrow because they’re less concerned about draining their reserves. Holding fewer excess reserves, they lend out a higher percentage of their funds, thereby increasing the money supply.
Even more important is the carryover effect of a change in the discount rate to the overall level of interest rates (Heilbroner & Thurow, 1998). When the Fed adjusts the discount rate, it’s telling the financial community where it thinks the economy is headed—up or down. Wall Street, for example, generally reacts unfavorably to an increase in the discount rate. Why? Because the increase means that interest rates will probably rise, making future borrowing more expensive.
Open Market Operations
The Fed’s main tool for controlling the money supply and influencing interest rates is called open market operations: the sale and purchase of U.S. government bonds by the Fed in the open market. To understand how this process works, we first need to know a few facts:
• The Fed’s assets include a substantial dollar amount of government bonds.
• The Fed can buy or sell these bonds on the open market (consisting primarily of commercial banks).
• Because member banks use cash to buy these bonds, they decrease their reserve balances when they buy them.
• Because member banks receive cash from the sale of the bonds, they increase their reserve balances when they sell them.
• Banks must maintain a specified balance in reserves; if they dip below this balance, they have to make up the difference by borrowing money.
If the Fed wants to decrease the money supply, it can sell bonds, thereby reducing the reserves of the member banks that buy them. Because these banks would then have less money to lend, the money supply would decrease. If the Fed wants to increase the money supply, it will buy bonds, increasing the reserves of the banks that sell them. The money supply would increase because these banks would then have more money to lend.
The Federal Funds Rate
In conducting open market operations, the Fed is trying to do the same thing that it does in using its other tools—namely, to influence the money supply and, thereby, interest rates. But it also has something else in mind. To understand what that is, you need to know a few more things about banking. When a bank’s reserve falls below its required level, it may, as we’ve seen, borrow from the Fed (at the discount rate). But it can also borrow from other member banks that have excess reserves. The rate that banks pay when they borrow through this channel is called the federal funds rate (Federal Reserve System, 2011).
How does the federal funds rate affect the money supply? As we’ve seen, when the Fed sells bonds in the open market, the reserve balances of many member banks go down. To get their reserves back to the required level, they must borrow, whether from the Fed or from other member banks. When Bank 1 borrows from Bank 2, Bank 2’s supply of funds goes down; thus, it increases the interest rate that it charges. In short, the increased demand for funds drives up the federal funds rate.
All this interbank borrowing affects you, the average citizen and consumer. When the federal funds rate goes up, banks must pay more for their money, and they’ll pass the cost along to their customers: banks all over the country will raise the interest rates charged on mortgages, car loans, and personal loans. Figure 13.6 “Key Interest Rates, 2002–2011” charts ten-year fluctuations in the discount rate, federal funds rate, and prime rate—the rate that banks charge their best customers. Because all three rates tend to move in the same direction, borrowers—individuals, as well as organizations—generally pay more to borrow money when banks have to pay more and less when banks have to pay less. Notice that the prime rate (which banks charge their customers) is higher than both the federal funds and discount rates (which banks must pay when they need to borrow). That’s why banks make profits when they make loans. Note, too, that the Fed lowered the discount rate and federal funds rate drastically in 2008 in an attempt to stimulate a weakening economy. Despite continued low rates through 2011, the economy is still very weak.
Figure 13.6 Key Interest Rates, 2002–2011
The Banker’s Bank and the Government’s Banker
The Fed performs another important function: it serves its member banks in much the same way as your bank serves you. When you get a check, you deposit it in your checking account, thereby increasing your balance. When you pay someone by check, the dollar amount of the check is charged to your account, and your balance goes down. The Fed works in much the same way, except that its customers are member banks. Just as your bank clears your check, the Fed clears the checks that pass through its member banks. The monumental task of clearing more than fifteen billion checks a year is complicated by the fact that there are twelve district banks. If someone in one district (for example, Boston) writes a check to a payee in another district (say, San Francisco), the check must be processed through both districts (Federal Reserve System, 2011).
Prior to 2004, clearing checks took days because the checks themselves needed to be physically moved through the system. But thanks to the passage of Check 21 (a U.S. federal law), things now move much more quickly. Instead of physically transporting checks, banks are allowed to make an image of the front and back of a check and send the digital version of the original check, called a “substitute” check, through the system electronically (Privacy Rights Clearinghouse, 2011). The good news is that Check 21 shortened the time it takes to clear a check, often down to one day. The bad news is that Check 21 shortened the time it takes to clear a check, which increases the risk that a check you write will bounce. So be careful: don’t write a check unless you have money in the bank to cover it.
In performing the following functions, the Fed is also the U.S. government’s banker:
• Holding the U.S. Treasury’s checking account
• Processing the paperwork involved in buying and selling government securities
• Collecting federal tax payments
• Lending money to the government by purchasing government bonds from the Treasury
The Fed also prints, stores, and distributes currency and destroys it when it’s damaged or worn out. Finally, the Fed, in conjunction with other governmental agencies, supervises and regulates financial institutions to ensure that they operate soundly and treat customers fairly and equitably (Federal Reserve System, 2011).
Key Takeaways
• Most large banks are members of the central banking system called the Federal Reserve System (commonly known as “the Fed”).
• The Fed’s goals include price stability, sustainable economic growth, and full employment. It uses monetary policy to regulate the money supply and the level of interest rates.
• To achieve these goals, the Fed has three tools:
1. it can raise or lower reserve requirements—the percentage of its funds that banks must set aside and can’t lend out;
2. it can raise or lower the discount rate—the rate of interest that the Fed charges member banks to borrow “reserve” funds;
3. it can conduct open market operations—buying or selling government securities on the open market.
Exercise
(AACSB) Analysis
Answer this three-part question on the Federal Reserve:
1. What is the Federal Reserve?
2. What is the purpose of the Federal Reserve? What are its goals?
3. How does the Federal Reserve affect the U.S. economy? | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/13%3A_Managing_Financial_Resources/13.03%3A_The_Federal_Reserve_System.txt |
Learning Objectives
1. Explain the ways in which a new business gets start-up cash.
2. Identify approaches used by existing companies to finance operations and growth.
So far, we’ve focused our attention on the financial environment in which U.S. businesses operate. Now let’s focus on the role that finance plays within an organization. In Chapter 1 “The Foundations of Business”, we defined finance as all the activities involved in planning for, obtaining, and managing a company’s funds. We also explained that a financial manager determines how much money the company needs, how and where it will get the necessary funds, and how and when it will repay the money that it has borrowed. The financial manager also decides what the company should do with its funds—what investments should be made in plant and equipment, how much should be spent on research and development, and how excess funds should be invested.
13.05: Understanding Securities Markets
Learning Objectives
1. Show how the securities market operates and how it’s regulated.
2. Understand how market performance is measured.
So, before long, you’re a publicly traded company. Fortunately, because your degree in finance comes with a better-than-average knowledge of financial markets, you’re familiar with the ways in which investors will evaluate your company. Investors will look at the overall quality of the company and ask some basic questions:
• How well is it managed?
• Is it in a growing industry? Is its market share increasing or decreasing?
• Does it have a good line of products? Is it coming out with innovative products?
• How is the company doing relative to its competitors?
• What is its future? What is the future of its industry?
Investors also analyze the company’s performance over time and ask more-specific questions:
• Are its sales growing?
• Is its income going up?
• Is its stock price rising or falling?
• Are earnings per share rising?
They’ll assess the company’s financial strength, asking another series of specific questions:
• Can it pay its bills on time?
• Does it have too much debt?
• Is it managing its productive assets (such as inventory) efficiently?
13.06: Financing the Going Concern
Learning Objective
1. Define equity and debt financing, and discuss the advantages and disadvantages of each financing approach.
Let’s assume that taking your company public was a smart move: in posing questions like those that we’ve just listed, investors have decided that your business is a good buy. With the influx of investment capital, the little laundry business that you started in your dorm ten years ago has grown into a very large operation with laundries at more than seven hundred colleges all across the country, and you’re opening two or three laundries a week. But there’s still a huge untapped market out there, and you’ve just left a meeting with your board of directors at which it was decided that you’ll seek additional funding for further growth. Everyone agrees that you need about \$8 million for the proposed expansion, yet there’s a difference of opinion among your board members on how to go about getting it. You have two options:
1. Equity financing: raising the needed capital through the sale of stock
2. Debt financing: raising the needed capital by selling bonds
Let’s review some of the basics underlying your options.
13.07: Careers in Finance
Learning Objective
1. Discuss career opportunities in finance.
A financial career path offers a number of interesting, entry-level jobs that can develop into significant senior-level positions. In addition to a strong finance education, you’ll need to be familiar with both accounting and economics. Along with possessing strong analytical skills and the ability to assess financial data, you’ll need to work effectively with colleagues throughout an organization. So you’ll need good interpersonal and communication skills: you’ll have to write and speak clearly and, in particular, you’ll have to be able to present complex financial data in terms that everyone can understand.
Generally, most positions in finance fall into one of three broad areas: commercial banking, corporate finance, and the investment industry. | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/13%3A_Managing_Financial_Resources/13.04%3A_The_Role_of_the_Financial_Manager.txt |
Learning on the Web (AACSB)
How Much Should You Reveal in Playboy?
What can you do if you’re sitting around your dorm room with nothing else to do (or at least nothing else you want to do)? How about starting a business? It worked for Michael Dell, who found assembling and selling computers more rewarding than attending classes at the University of Texas. It also worked for two Stanford graduate students, Sergey Brin and Larry Page. They came up with a novel (though fairly simple) idea for a search engine that ranked Web sites according to number of hits and online linkages. Because their goal was to organize massive amounts of electronic data, they wanted a name that connoted seemingly infinite volumes of information. They liked the word “googol” (a child’s coinage for a very big number—1 followed by a hundred zeros), but, unfortunately, someone already owned the domain name “Googol.” So Brin and Page did a little letter juggling and settled (as we all know by now) for “Google.”
By 2004, the company that they’d started in 1998 was the number-one search engine in the world. Their next step, like that of so many successful entrepreneurs before them, was to go public, and that’s where our exercise starts. To learn more about this episode in the epic story of Google—and to find out what role Playboy magazine plays in it—read the article, “Google Sets \$2.7 Billion IPO” (http://money.cnn.com/2004/04/29/technology/google), read Google’s Playboy interview (http://www.google-watch.org/playboy.html), and read the BusinessWeek article, “Google Dodges a Bullet” (http://www.businessweek.com/technolo...0781_tc119.htm).
When you’ve finished reading the articles, answer the following questions:
1. What’s an IPO? Why did Brin and Page take their company public? What disadvantages did they incur by going public? Are they likely to lose control of their company?
2. How does a Playboy interview enter into the Google story? What did Brin and Page do wrong? (By the way, the interview appeared in the August 2004 issue of Playboy; because Google incorporated the text into its revised IPO filing, it’s now in the public domain and available online.)
3. Did the Google founders get off the hook? Was the punishment (or lack of it) appropriate? Quitting school to run Google paid off big for Brin and Page. Their combined net worth as a result of the IPO suddenly skyrocketed to \$8 billion. But how about you? Could you have gotten rich if you’d jumped on the Google bandwagon just as it started to roll? Could you at least have earned enough to pay another year’s tuition? To respond to these questions, you need to know two things: (1) the IPO price of Google stock—\$85—and (2) Google’s current stock price. To find the current price, go to finance.yahoo.com to link to the finance section of the Yahoo.com Web site. Enter Google’s stock symbol—GOOG—and click “Go.” When you find the current stock price, answer the following questions:
a. If you’d bought Google stock on the IPO date and sold it today, how many shares of Google would you have had to buy in order to make enough to cover this year’s tuition?
b. If you owned Google stock today, would you sell it or hold it? Explain your answer.
Career Opportunities
Financial Futures
One advantage of a finance major is that it prepares you for a wide range of careers. Some graduates head for Wall Street to make big bucks in investment banking. Others prefer the security of working in the corporate finance department of a large firm, while still others combine finance and selling in fields such as insurance or real estate. If you like working with other people’s finances, you might end up in commercial banking or financial planning. To better acquaint yourself with the range of available finance careers, go to http://www.careers-in-finance.com/ to link to the Careers in Finance Web site. After reviewing the descriptions of each career option, select two areas that you find particularly interesting and two that you find unattractive. For each of your four selections, answer the following questions:
1. Why do you find a given area interesting (or unattractive)?
2. What experience and expertise are entailed by a career in a given area?
Ethics Angle (AACSB)
The Inside Story
You’re the founder and CEO of a publicly traded biotech firm that recently came up with a promising cancer drug. Right now, life on Wall Street is good: investors are high on your company, and your stock price is rising. On top of everything else, your personal wealth is burgeoning because you own a lot of stock in the company. You’re simply waiting to hear from the FDA, which is expected to approve the product. But when the call comes, the news is bad: the FDA has decided to delay approval because of insufficient data on the drug’s effectiveness. You know that when investors hear the news, the company’s stock price will plummet. The family and friends that you encouraged to buy into your company will lose money, and you’ll take a major hit.
Quickly, you place an order to sell about \$5 million worth of your own stock. Then you start making phone calls. You tell your daughter to dump her stock, and you advise your friends to do the same thing. When you tell your stockbroker the news, he gets on the phone and gives a heads-up to his other clients. Unfortunately, he can’t reach one client (who happens to be a good friend of yours), so he instructs his assistant to contact her and tell her what’s happened. As a result, the client places an order to sell four thousand shares of stock at a market value of \$225,000.
Let’s pause at this point to answer a few questions:
1. Are you being a nice guy or doing something illegal?
2. Is your stockbroker doing something illegal?
3. Is the assistant doing something illegal or merely following orders?
4. Is the stockbroker’s client acting illegally?
Fast-forward a few months. Federal investigators are interested in the sale of your stock and the sale of your daughter’s stock. Because all signs point to the truth as being an invitation to trouble, you lie. When they talked with your friend about her sale, say investigators, she explained a standing agreement that instructed her broker to sell the stock when the market price went below a specified level. It sounds like a good explanation, so you go along with it.
Now, answer this question.
1. What have you done wrong? What has your client friend done wrong?
The Reality Version of the Story
At this point, let’s stop protecting the not-so-innocent and name some names. The biotech company is ImClone, and its founder and CEO is Dr. Samuel Waksal. The Merrill Lynch broker is named Peter Bacanovic and his assistant Douglas Faneuil. The client friend who dumped her stock is Martha Stewart.
Let’s focus on Stewart, who is the founder of Martha Stewart Living Omnimedia, a prosperous lifestyle empire. Her actions and their consequences are detailed in an article titled “Martha’s Fall,” which you can access by going to www.newsweek.com/id/53363 and linking to the MSNBC Web site. Read the article and then answer the following questions:
1. Do you believe Stewart’s story that she sold the stock because of a preexisting sell order and not because she learned that the cancer drug wouldn’t be approved? What did she do that was illegal? What was she actually convicted of doing?
2. Waksal got seven years in prison for insider trading (and a few other illegal schemes). Bacanovic (Stewart’s broker) got five months in jail and five months of home confinement for lying and obstructing the investigation into the sale of ImClone stock. In return for helping the prosecutors convict Stewart, Faneuil (the broker’s assistant) got a federal “get-out-of-jail” card but was fined \$2,000 for accepting a payoff (namely, an extra week of vacation and a bump in his commission) to stonewall investigators. Stewart went to prison for five months and spent another five under house arrest. Was her punishment too lenient? Too harsh? If you’d been the judge, what sentence would you have given her?
3. How could Stewart have avoided prison? Did her celebrity status or reputation help or hurt her? Did she, as some people claim, become a poster CEO for corporate wrongdoing?
4. Why are government agencies, such as the SEC, concerned about insider trading? Who’s hurt by it? Who’s helped by government enforcement of insider-trading laws?
Team-Building Skills (AACSB)
Looking for a High-Flying Stock
Congratulations! Your team has just been awarded \$100,000 in hypothetical capital. There is, however, a catch: you have to spend the money on airline stocks. Rather than fly by the seat of your pants, you’ll want to research a number of stocks. To familiarize yourself with the airline industry, go to www.airlines.org/Economics/Re...yEconomic.aspx to link to and read the article: “2010 Airline Industry Economic Perspective.”
Each team member is responsible for researching and writing a brief report on a different company. Don’t duplicate your research. Be sure to include low-cost airlines as well as larger carriers. To cover the industry, pick airlines from the following list. The URLs bring you to each airline’s information page on Yahoo! Finance. If any of the links listed below do not work, you can get to that airline’s page by doing the following: Go to beta.finance.yahoo.com/; under “Investing” on the top bar, select “Industries” from the drop-down list. Then click on “Complete Industry List” on left sidebar. Under “Services” click on “Major Airlines” and then “Company Index” to find the first four airlines listed below (AMR/American, Delta, U.S. Airways, and Spirit); click on “Regional Airlines” to find the remaining two airlines (Jet Blue and Southwest).
• AMR Corporation (American Airlines) (biz.yahoo.com/ic/10/10021.html)
• Delta Air Lines (biz.yahoo.com/ic/10/10448.html)
• U.S. Airways (biz.yahoo.com/ic/11/11527.html)
• Spirit Airlines (biz.yahoo.com/ic/11/11527.html)
• Jet Blue Airways (biz.yahoo.com/ic/99/99674.html)
• Southwest Airlines (biz.yahoo.com/ic/11/11377.html)
Each member should prepare a report detailing the following information about his or her chosen company:
• A description of the airline
• The percentage change in revenue over the last fiscal year
• The percentage change in net income over the last fiscal year
• A chart comparing the movement in the company’s stock price over the past year with the movement of the DJIA
• Current earnings per share (EPS): net income divided by number of common shareholders
• Current PE ratio
• Current stock price
Here are some hints for finding this information on the Yahoo! page devoted to a given company:
• The company will be described in a “Company Profile” appearing toward the top of the page.
• You can get the remaining information by going to the bottom of the page and clicking on the following:
• “Financials” for changes in revenues and net income
• “Chart” for trends in stock prices
• “Quote” for EPS, PE ratio, and current stock price
• When reviewing financial statements to calculate percentage changes in revenues and net income, be sure you click on “Annual Data” to get information for the entire year rather than for just the quarter.
Team Report
Once each member has researched one airline, the team should get together and decide how to invest its \$100,000. Announce your decision in a final report that includes the following items:
1. An overall description and assessment of the airline industry, including a report on opportunities, threats, and future outlook
2. A decision on how you’ll invest your \$100,000, including the names of the stock or stocks that you plan to purchase, current market prices, and numbers of shares
3. An explanation of the team’s investment decision
4. Individual member reports on each researched company
Follow-Up
A few weeks later, you might want to check on the stock prices of your picks to see how you’d have done if you’d actually invested \$100,000.
The Global View (AACSB)
Where’s the Energy in the Chinese Stock Market?
Warren Buffett is the third-richest man in the world (behind Bill Gates). As CEO of Berkshire Hathaway, a holding company with large stakes in a broad portfolio of investments, Buffett spends a lot of his time looking for companies with promising futures. His time has been quite well spent: the market price of a share in Berkshire Hathaway now tops \$115,000—up from \$16 a share in 1964.
In 2002 and 2003, Berkshire Hathaway paid \$488 million for two million shares in PetroChina, an energy firm 90 percent owned by the Chinese government. In 2007, he sold the stock for \$4 billion, realizing an incredible more than 700 percent gain. To evaluate Buffett’s thinking in buying and then selling stock in PetroChina, you’ll need to do some research.
First, find out something about the company by going to www.petrochina.com.cn/ptr and linking to the English version of the PetroChina Web site. Explore the sections “About PetroChina” and “Investor Relations.” Look for answers to the following questions:
1. What does the company do? What products and services does it provide? How does it distribute its products?
2. On which stock exchanges are its shares sold?
Next, to learn about the company’s financial performance, go to finance.yahoo.com to link to the Finance section of the Yahoo.com Web site. Enter the company’s stock symbol—PTR—and review the information provided on the site. To see what analysts think of the stock, for example, click on “Analyst Opinion.” To gain insight into why Buffett sold his stock and whether it was a good or a bad move, read these articles: “Should We Buy the PetroChina Stock Warren Buffett Sold?” (www.peridotcapitalist.com/200...ck-warren.html) and “Buffett’s PetroChina Sale: Fiscal or Social Move,” (investorsagainstgenocide.net/page1001126)
Now, answer the following questions:
1. What do analysts think of the stock?
2. Should Buffett have bought the stock in PetroChina? Was it a good decision at the time? Why or why not?
3. Should Buffett have sold his stock in the company? Why do you think he sold the stock? Was it a good decision at the time? Why or why not?
4. If you personally had \$50,000 to invest, how likely is it that you’d buy stock in PetroChina? What factors would you consider in making your decision?
To learn more about the pros and cons of buying stock in Chinese companies, go to www.newsweek.com/id/54174 to link to the MSNBC Web site and read the article “Nice Place to Visit.” Then answer these final questions:
1. What are the advantages of investing in the stock of Chinese companies? What are the disadvantages?
2. In your opinion, should the average investor put money in Chinese stock? Why, or why not? | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/13%3A_Managing_Financial_Resources/13.08%3A_Cases_and_Problems.txt |
Learning Objectives
1. Define personal finances and financial planning.
2. Explain the financial planning life cycle.
3. Discuss the advantages of a college education in meeting short- and long-term financial goals.
4. Describe the steps you’d take to get a job offer and evaluate alternative job offers, taking benefits into account.
5. Understand the ways to finance a college education.
Before we go any further, we need to nail down a couple of key concepts. First, just what, exactly, do we mean by personal finances? Finance itself concerns the flow of money from one place to another, and your personal finances concern your money and what you plan to do with it as it flows in and out of your possession. Essentially, then, personal finance is the application of financial principles to the monetary decisions that you make either for your individual benefit or for that of your family.
Second, as we suggested in Section 14—and as we’ll insist in the rest of it—monetary decisions work out much more beneficially when they’re planned rather than improvised. Thus our emphasis on financial planning—the ongoing process of managing your personal finances in order to meet goals that you’ve set for yourself or your family.
Financial planning requires you to address several questions, some of them relatively simple:
• What’s my annual income?
• How much debt do I have, and what are my monthly payments on that debt?
Others will require some investigation and calculation:
• What’s the value of my assets?
• How can I best budget my annual income?
Still others will require some forethought and forecasting:
• How much wealth can I expect to accumulate during my working lifetime?
• How much money will I need when I retire?
The Financial Planning Life Cycle
Another question that you might ask yourself—and certainly would do if you were a professional in financial planning—is something like, “How will my financial plans change over the course of my life?” Figure 14.3 “Financial Life Cycle” illustrates the financial life cycle of a typical individual—one whose financial outlook and likely outcomes are probably a lot like yours (Keown, 2007). As you can see, our diagram divides this individual’s life into three stages, each of which is characterized by different life events (such as beginning a family, buying a home, planning an estate, retiring). At each stage, too, there are recommended changes in the focus of the individual’s financial planning:
Figure 14.3 Financial Life Cycle
At each stage, of course, complications can set in—say, changes in such conditions as marital or employment status or in the overall economic outlook. Finally, as you can also see, your financial needs will probably peak somewhere in stage 2, at approximately age fifty-five, or ten years before typical retirement age.
• In stage 1, the focus is on building wealth.
• In stage 2, the focus shifts to the process of preserving and increasing the wealth that one has accumulated and continues to accumulate.
• In stage 3, the focus turns to the process of living on (and, if possible, continuing to grow) one’s saved wealth.
Choosing a Career
Until you’re eighteen or so, you probably won’t generate much income; for the most part, you’ll be living off your parents’ wealth. In our hypothetical life cycle, however, financial planning begins in the individual’s early twenties. If that seems like rushing things, consider a basic fact of life: this is the age at which you’ll be choosing your career—not only the sort of work you want to do during your prime income-generating years, but also the kind of lifestyle you want to live in the process (Keown, 2007).
What about college? Most readers of this book, of course, have decided to go to college. If you haven’t yet decided, you need to know that college is an extremely good investment of both money and time.
Table 14.1 “Education and Average Income”, for example, summarizes the findings of a study conducted by the U.S. Census Bureau (U.S. Census Bureau, 2008). A quick review shows that people who graduate from high school can expect to increase their average annual earnings by about 49 percent over those of people who don’t, and those who go on to finish college can expect to generate 82 percent more annual income than that. Over the course of the financial life cycle, families headed by those college graduates will earn about \$1.6 million more than families headed by high school graduates who didn’t attend college. (With better access to health care—and, studies show, with better dietary and health practices—college graduates will also live longer. And so will their children.) (U.S. Census Bureau, 2008)
Table 1:.1 Education and Average Income
Education Average income Percentage increase over next-highest level
High school dropout \$20,873
High school diploma \$31,071 48.9%
College degree \$56,788 82.8%
Advanced higher-education degree \$82,320 45.0%
And what about the debt that so many people accumulate to finish college? For every \$1 that you spend on your college education, you can expect to earn about \$35 during the course of your financial life cycle (Hansen, 2008). At that rate of return, you should be able to pay off your student loans (unless, of course, you fail to practice reasonable financial planning).
Naturally, there are exceptions to these average outcomes. You’ll find English-lit majors stocking shelves at 7-Eleven, and you’ll find college dropouts running multibillion-dollar enterprises. Microsoft cofounder Bill Gates dropped out of college after two years, as did his founding partner, Paul Allen. Current Microsoft CEO Steve Ballmer finished his undergraduate degree but quit his MBA program to join Microsoft (where he apparently fit in among the other dropouts in top management). It’s always good to remember, however, that though exceptions to rules (and average outcomes) occasionally modify the rules, they invariably fall far short of disproving them: in entrepreneurship as in most other walks of adult life, the better your education, the more promising your financial future. One expert in the field puts the case for the average person bluntly: educational credentials “are about being employable, becoming a legitimate candidate for a job with a future. They are about climbing out of the dead-end job market” (Ramsay, 2008).
Finally, does it make any difference what you study in college? To a perhaps surprising extent, not necessarily. Some career areas, such as engineering, architecture, teaching, and law, require targeted degrees, but the area of study designated on your degree often doesn’t matter much when you’re applying for a job. If, for instance, a job ad says, “Business, communications, or other degree required,” most applicants and hires will have those “other” degrees. When poring over résumés for a lot of jobs, potential employers look for the degree and simply note that a candidate has one; they often don’t need to focus on the particulars (Roth, 2008).
This is not to say, however, that all degrees promise equal job prospects. Figure 14.4 “Top 25 Fastest-Growing Jobs, 2006–2016”, for example, summarizes a U.S. Bureau of Labor Statistics projection of the thirty fast-growing occupations for the years 2006–2016. Veterinary technicians and makeup artists will be in demand as never before, but as you can see, occupational prospects are fairly diverse1.
Figure 14.4 Top 25 Fastest-Growing Jobs, 2006–2016
Nor, of course, do all degrees pay off equally. In Table 14.2 “College Majors and Average Annual Earnings”, we’ve extracted the findings of a study conducted by the National Science Foundation on the earnings of individuals with degrees in various undergraduate fields (Penrice, 1999; Harrington & Sum, 2011). Clearly, some degrees—notably in the engineering fields—promise much higher average earnings than others. Chemical engineers, for instance, can earn nearly twice as much as elementary school teachers, but there’s a catch: if you graduate with a degree in chemical engineering, your average annual salary will be about \$67,000 if you can find a job related to that degree; if you can’t, you may have to settle for as much as 40 percent less (Penrice, 1999). (Supermodel Cindy Crawford cut short her studies in chemical engineering because there was more money to be made on the runway.)
Table 1:.2 College Majors and Average Annual Earnings
Major Average Earnings with Bachelor’s Degree Major Average Earnings with Bachelor’s Degree
Chemical engineering \$67,425 History \$45,926
Aerospace engineering \$65,649 Biology \$45,532
Computer engineering \$62,527 Nursing \$45,538
Physics \$62,104 Psychology \$43,963
Electrical engineering \$61,534 English \$43,614
Mechanical engineering \$61,382 Health technology \$42,524
Industrial engineering \$61,030 Criminal justice \$41,129
Civil engineering \$58,993 Physical education \$40,207
Accounting \$56,637 Secondary education \$39,976
Finance \$55,104 Fine arts \$38,857
Computer science \$52,615 Philosophy \$38,239
Business management \$52,321 Dramatic arts \$37,091
Marketing \$51,107 Music \$36,811
Journalism \$46,835 Elementary education \$34,564
Information systems \$46,519 Special education \$34,196
In short, when you’re planning what to do with the rest of your life, it’s a good idea to check into the fine points and realities, as well as the statistical data. If you talk to career counselors and people in the workforce, you might be surprised by what you learn about the relationship between certain college majors and various occupations. Onetime Hewlett-Packard CEO Carly Fiorina majored in medieval history and philosophy. | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/14%3A_Personal_Finances/14.01%3A_Financial_Planning.txt |
Learning Objectives
1. Explain compound interest and the time value of money.
2. Discuss the value of getting an early start on your plans for saving.
The fact that you have to choose a career at an early stage in your financial life cycle isn’t the only reason that you need to start early on your financial planning. Let’s assume, for instance, that it’s your eighteenth birthday and that on this day you take possession of \$10,000 that your grandparents put in trust for you. You could, of course, spend it; in particular, it would probably cover the cost of flight training for a private pilot’s license—something you’ve always wanted but were convinced that you couldn’t afford for another ten or fifteen years. Your grandfather, of course, suggests that you put it into some kind of savings account. If you just wait until you finish college, he says, and if you can find a savings plan that pays 5 percent interest, you’ll have the \$10,000 plus another \$2,209 to buy a pretty good used car.
The total amount you’ll have— \$12,209—piques your interest. If that \$10,000 could turn itself into \$12,209 after sitting around for four years, what would it be worth if you actually held on to it until you did retire—say, at age sixty-five? A quick trip to the Internet to find a compound-interest calculator informs you that, forty-seven years later, your \$10,000 will have grown to \$104,345 (assuming a 5 percent interest rate). That’s not really enough to retire on, but after all, you’d at least have some cash, even if you hadn’t saved another dime for nearly half a century. On the other hand, what if that four years in college had paid off the way you planned, so that (once you get a good job) you’re able to add, say, another \$10,000 to your retirement savings account every year until age sixty-five? At that rate, you’ll have amassed a nice little nest egg of slightly more than \$1.6 million.
14.03: The Financial Planning Process
Learning Objectives
1. Identify the three stages of the personal-finances planning process.
2. Explain how to draw up a personal net-worth statement, a personal cash-flow statement, and a personal budget.
We’ve divided the financial planning process into three steps:
1. Evaluate your current financial status by creating a net worth statement and a cash flow analysis.
2. Set short-term, intermediate-term, and long-term financial goals.
3. Use a budget to plan your future cash inflows and outflows and to assess your financial performance by comparing budgeted figures with actual amounts.
14.04: A House Is Not a Piggy Bank- A Few Lessons from the Subprime Crisis
Learning Objectives
1. Discuss the trend in the U.S. savings rate.
2. Define a subprime loan and explain the difference between a fixed-rate mortgage and an adjustable-rate mortgage.
3. Discuss what can go wrong with a subprime loan at an adjustable rate. Discuss what can go wrong with hundreds of thousands of subprime loans at adjustable rates.
4. Define risk and explain some of the risks entailed by personal financial transactions.
Joe isn’t old enough to qualify, but if his grandfather had deposited \$1,000 in an account paying 7 percent interest in 1945, it would now be worth \$64,000. That’s because money invested at 7 percent compounded will double every ten years. Now, \$64,000 may or may not seem like a significant return over fifty years, but after all, the money did all the heavy lifting, and given the miracle of compound interest, it’s surprising that Americans don’t take greater advantage of the opportunity to multiply their wealth by saving more of it, even in modest, interest-bearing accounts. Ironically, with \$790 billion in credit card debt, it’s obvious that a lot of American families are experiencing the effects of compound interest—but in reverse (Frank, 2005).
As a matter of fact, though Joe College appears to be on the right track when it comes to saving, many people aren’t. A lot of Americans, it seems, do indeed set savings goals, but in one recent survey, nearly 70 percent of the respondents reported that they fell short of their monthly goals because their money was needed elsewhere. About one-third of Americans say that they’re putting away something but not enough, and another third aren’t saving anything at all. Almost one-fifth of all Americans have net worth of zero—or less (Taylor, 2007; Frank, 2005).
As we indicated in the opening section of this chapter, this shortage of savings goes hand in hand with a surplus in spending. “My parents,” says one otherwise gainfully employed American knowledge worker, “are appalled at the way I justify my spending. I think, ‘Why work and make money unless you’re going to enjoy it?’ That’s a fine theory,” she adds, “until you’re sixty, homeless, and with no money in the bank” (Gardner, 2008). And indeed, if she doesn’t intend to alter her personal-finances philosophy, she has good reason to worry about her “older adult” years. Sixty percent of Americans over the age of sixty-five have less than \$100,000 in savings, and only 30 percent of this group have more than \$25,000; 45 percent have less than \$15,000. As for income, 75 percent of people over age sixty-five generate less than \$35,000 annually, and 30 percent are in the “poverty to near-poverty” range of \$10,000 to \$20,000 (as compared to 12 percent of the under-sixty-five population) (Rubin, et. al., 2000).
14.05: Cases and Problems
Learning on the Web (AACSB)
Go to https://www.quizzle.com[1] and request a free copy of your credit report. Review the report. If you identify any errors, get them fixed. Write a brief report explaining the value of good credit.
Ethics Angle (AACSB)
Go online and read this article at Forbes.com: “Most Common Resume Lies,” by Kate DuBose Tomassi at www.forbes.com/workspecial/2006/05/20/resume-lies-work_cx_kdt_06work_0523lies.html. View the slide show of common résumé lies. Answer these questions: What are the most common lies made in résumés? Why is it a bad idea to lie on such a document? What are the potential consequences of misstating facts on your résumé?
Team-Building Skills (AACSB)
It’s becoming more difficult for individuals to buy homes. This has meant that many people who would have bought a home have remained in apartments. In big cities, such as New York, sharing an apartment with roommates is a good way to save money. Yet it has some disadvantages. Get together as a team and identify the pros and cons of sharing housing. Pretend that each member of the group has agreed to share one apartment. Create a document that details each member’s rights and responsibilities. Decide as a group whether the lease should be in one person’s name or in all your names. Explain the pros and cons of both approaches.
The Global View (AACSB)
You’re looking forward to taking a month-long vacation to Australia when you graduate from college in two years. Create a budget for this trip after researching likely costs. Determine how much you’ll need for the trip and calculate how much you’d have to save each month to afford the trip. | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/14%3A_Personal_Finances/14.02%3A_Time_Is_Money.txt |
Learning Objectives
1. Distinguish between data and information.
2. Define information system (IS) and identify the tasks of the information systems manager.
By the time the company took the plunge and committed \$100 million to marketing-related information technology (IT), Caesars had been collecting and storing data about customers for almost a decade. “While the company thought it important to collect customer information,” recalls a senior marketing executive, “the problem was we had millions of customers to collect information on, but we had no systematic way of turning it into a marketing decision. We didn’t know what to do with it.” In other words, Caesars was collecting a lot of data but not necessarily any information. So what’s the difference?
As an example, suppose that you want to know how you’re doing in a particular course. So far, you’ve taken two 20-question multiple-choice tests. On the first, you got questions 8, 11, and 14 wrong; on the second, you did worse, missing items 7, 15, 16, and 19. The items that you got wrong are merely data—unprocessed facts. What’s important is your total score. You scored 85 on the first exam and 80 on the second. These two numbers constitute information—data that have been processed, or turned into some useful form. Knowing the questions that you missed simply supplied you with some data for calculating your scores.
Now let’s fast-forward to the end of the semester. At this point, in addition to taking the two tests, you’ve written two papers and taken a final. You got a 90 and 95 on the papers and a 90 on the final. You now have more processed data, but you still want to organize them into more useful information. What you want to know is your average grade for the semester. To get the information you want, you need yet more data—namely, the weight assigned to each graded item. Fortunately, you’ve known from day one that each test counts 20 percent, each paper 10 percent, and the final exam 40 percent. A little math reveals an average grade of 87.
Though this is the information you’re interested in, it may be mere data to your instructor, who may want different information: an instructor who intends to scale grades, for example, will want to know the average grade for the entire class. You’re hoping that the class average is low enough to push your average of 87 up from a B+ to an A– (or maybe even an A—it doesn’t hurt to hope for the best). The moral of the story is that what constitutes information at one stage can easily become data at another: or, one person’s information can be another person’s data.
As a rule, you want information; data are good only for generating the information. So, how do you convert data into information that’s useful in helping you make decisions and solve problems? That’s the question we’ll explore in the next section.
15.02: Managing Data
Learning Objective
1. Explain how IS managers capture, store, and analyze data.
Did you ever think about how much data you yourself generate? Just remember what you went through to start college. First, you had to fill out application forms asking you about test scores, high school grades, extracurricular activities, and finances, plus demographic data about you and your family. Once you’d picked a college, you had to supply data on your housing preferences, the curriculum you wanted to follow, and the party who’d be responsible for paying your tuition. When you registered for classes, you gave more data to the registrar’s office. When you arrived on campus, you gave out still more data to have your ID picture taken, to get your computer and phone hooked up, to open a bookstore account, and to buy an on-campus food-charge card. Once you started classes, data generation continued on a daily basis: your food card and bookstore account, for example, tracked your various purchases, and your ID tracked your coming and going all over campus. And you generated grades.
And all these data apply to just one aspect of your life. You also generated data every time you used your credit card and your cell phone. Who uses all these data? How are they collected, stored, analyzed, and distributed in organizations that have various reasons for keeping track of you?
15.03: Types of Information Systems
Learning Objective
1. Discuss ways in which an IS can be designed to meet the needs of individuals at various organizational levels.
As we saw earlier, different managers, operational units, and functional areas have different information needs. That’s why organizations often tailor information systems to meet particular needs. Caesars’s IT group, for example, developed the Player Contact System (Dunn, 2003; Dunn, 2003). to help its casino salespeople connect to top customers on a more personal basis. Working from a prioritized list of customer names displayed on a computer screen, the salesperson clicks on a name to view relevant information about the customer, such as background and preferred casino activities. There’s even a printed script that can be used to guide the conversation. Such a system isn’t very helpful, however, to middle or top-level managers, who need systems to help them carry out their oversight and planning responsibilities. To design marketing programs, for instance, marketing managers rely on summary information gleaned from a dedicated customer-relationship management system. Let’s look at some of the widely available information systems designed to support people at the operational and upper-management levels. | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/15%3A_Managing_Information_and_Technology/15.01%3A_Data_versus_Information.txt |
Learning Objectives
1. Describe the main systems for sharing information through networked computers.
2. Define cloud computing and identify its advantages and disadvantages.
Once it’s grown beyond just a handful of employees, an organization needs a way of sharing information. Imagine a flower shop with twenty employees. The person who takes phone orders needs access to the store’s customer list, as do the delivery person and the bookkeeper. Now, the store may have one computer and everyone could share it. It’s more likely, however, that there are a number of computers (several for salespeople, one for delivery, and one for bookkeeping). In this case, everyone needs to be sure that customer records have been updated on all computers every time that a change is required.
15.05: Data Communications Networks
Learning Objective
1. Explain how four networking technologies—the Internet, the World Wide Web, intranets, and extranets—make data communication possible.
In addition to using networks for information sharing within the organization, companies use networks to communicate and share information with those outside the organization. All this is made possible by data communication networks, which transmit digital data (numeric data, text, graphics, photos, video, and voice) from one computer to another using a variety of wired and wireless communication channels. Let’s take a closer look at the networking technologies that make possible all this electronic communication—in particular, the Internet (including the World Wide Web), intranets, and extranets.
15.06: Security Issues in Electronic Communication
Learning Objective
1. Identify and discuss challenges faced by companies engaged in e-commerce.
E-commerce has presented businesses with opportunities undreamt of only a couple of decades ago. But it also has introduced some unprecedented challenges. For one thing, companies must now earmark more than 5 percent of their annual IT budgets for protecting themselves against disrupted operations and theft due to computer crime and sabotage (Alexander, 2011). The costs resulting from cyber crimes—criminal activity done using computers or the Internet—are substantial and increasing at an alarming rate. A 2010 study of forty-five large U.S. companies revealed that the median cost of cybercrime for the companies in the study was \$3.8 million a year (Ponemon, 2010). And some cybercrimes involve viruses that can spread rapidly from computer to computer creating enormous damage. It’s estimated, for example, that damage to 50,000 personal computers and corporate networks from the so-called Blaster worm in August 2003 totaled \$2 billion, including \$1.2 billion paid by Microsoft to correct the problem (Shukovsky, 2011). The battle against technology crime is near the top of the FBI’s list of priorities, behind only the war against terrorism and espionage (Alexander, 2011). In addition to protecting their own operations from computer crime, companies engaged in e-commerce must clear another hurdle: they must convince consumers that it’s safe to buy things over the Internet—that credit-card numbers, passwords, and other personal information are protected from theft or misuse. In this section, we’ll explore some of these challenges and describe a number of the efforts being made to meet them.
15.07: Careers in Information Management
Learning Objective
1. Identify career opportunities in information management.
The number and variety of opportunities in the IS field have grown substantially as organizations have expanded their use of IT. In most large organizations, the senior management team includes a chief information officer (CIO) who oversees information and telecommunications systems. A large organization might also have a chief technology officer who reports to the CIO and oversees IT planning and implementation.
Most entry-level IS jobs require a business degree with a major in information systems. Many people supplement their IS majors with minors in computer science or some other business area, such as accounting, finance, marketing, or operations management.
If you’re starting out with an IS degree, you may choose to follow either a management path or a technical path. At Kraft Foods, for example, IS professionals can focus on one of two areas: applications development (a management focus) and information technology (a technology focus). “Applications development,” according to the company itself, “calls for an ability to analyze [Kraft’s] clients’ needs and translate them into systems applications. Information technology calls for the ability to convert business systems specifications into technical specifications and to provide guidance and technical counsel to other Kraft professionals” (Kraft Foods, 2006). Despite the differences in focus, Kraft encourages IS specialists to develop expertise in both areas. After all, it’s the ability to apply technical knowledge to business situations that makes IS professionals particularly valuable to organizations. (By the way, if you want a career in casinos, you can major in casino management at a number of business schools.)
Key Takeaways
• The number and variety of opportunities in the information systems (IS) field have grown substantially as companies have expanded their use of information technology.
• The senior management team in large organizations includes a chief information officer who oversees information and a chief technology officer who oversees IT planning and implementation.
• Most entry-level IS jobs require a business degree with a major in information systems.
• Many supplement their IS majors with computer science or some other business area, such as accounting, finance, marketing, or operations management.
• Those entering organizations with IS degrees may choose to follow either a management or a technology path.
Exercise
(AACSB) Reflective Skills
Why is studying IT important to you as a student? How will competency in this area help you get and keep a job in the future? | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/15%3A_Managing_Information_and_Technology/15.04%3A_Computer_Networks_and_Cloud_Computing.txt |
Learning on the Web
Taking Care of Your Cyber Health
It seems that some people have nothing better to do than wreak havoc by spreading computer viruses, and as a computer user, you should know how to protect yourself from malicious tampering. One place to start is by reading the article “How Computer Viruses Work,” by Marshall Brain, which you can access by going to the How Stuff Works Web site (http://computer.howstuffworks.com/virus.htm). After reading the article, answer the following questions:
1. Why do people create viruses?
2. What can you do to protect yourself against viruses?
Career Opportunities
Could You Manage a Job in IT or IS?
Do you have an aptitude for dealing with IT? Would you enjoy analyzing the information needs of an organization? Are you interested in directing a company’s Internet operations or overseeing network security? If you answered yes to any of these questions, then a career in IT and IS might be for you. Go to the U.S. Department of Labor Web site (www.bls.gov/oco/ocos258.htm) and learn more about the nature of the work, qualifications, and job outlook in IT and IS management. Bearing in mind that many people who enter the IT field attain middle-management positions, look for answers to the following questions:
1. What kinds of jobs do IT managers perform?
2. What educational background, work experience, and skills are needed for positions in IT management?
3. What’s the current job outlook for IS and IT managers? What factors drive employment opportunities?
4. What’s the median annual income of a mid-level IT manager?
Ethics Angle (AACSB)
Campus Commando or Common Criminal?
Do you want to be popular (or at least more prominent) on campus? You could set up a Web site that lets fellow students share music files over the campus network. All you have to do is seed the site with some of your own downloaded music and let the swapping begin. That’s exactly what Daniel Peng did when he was a sophomore at Princeton. It was a good idea, except for one small hitch: it was illegal, and he got caught. Unimpressed with Peng’s technological ingenuity, the Recording Industry Association of America (RIAA) sued him, and he was forced to settle for \$15,000. Instead of delivering music, Peng’s Web site now asks visitors to send money to help defray the \$15,000 and another \$8,000 in legal costs.
To learn more about the case, read these articles from the Daily Princetonian: “Peng, RIAA Settle Infringement Case” (www.dailyprincetonian.com/2003/05/02/8154/), and “Peng ’05 Sued by Recording Industry for ‘Wake’ Site” (www.dailyprincetonian.com/2003/04/04/7791).
After researching the topic, answer the following questions:
1. The practice of sharing commercial music files is illegal. Do you think that it’s also unethical? Why, or why not?
2. What steps to curb the practice are being taken by the music industry? By college administrators? By the government? Do you approve of these steps? Have they been effective?
3. What, ultimately, do you see as the solution to the problem?
Source: Josh Brodie, “Peng, RIAA Settle Infringement Case,” The Daily Princetonian, www.dailyprincetonian.com/2003/05/02/8154/ (accessed November 14, 2011); Zachary Goldfarb and Josh Brodie, “Peng ’05 Sued by Recording Industry for ‘Wake’ Site,” The Daily Princetonianwww.dailyprincetonian.com/2003/04/04/7791/ (accessed November 14, 2011).
Team-Building Skills (AACSB)
CampusCupid.com
It’s no secret that college can be fun. For one thing, you get to hang around with a bunch of people your own age. Occasionally, you want to spend time with just one special someone, but finding that special person on a busy campus can take some of the fun out of matriculating. Fortunately, you’re in the same love boat with a lot of other people, so one possible solution—one that meshes nicely with your desire to go into business—is to start an online dating service that caters to your school. Inasmuch as online dating is nothing new, you can do some preliminary research. For example, go to the Internetnews Web site (http://www.internetnews.com/ec-news/article.php/2228891/Online+Personals+Big+Profits+Intense+Competition.htm) and read the article “Online Personals: Big Profits, Intense Competition.”
Next, you and several of your classmates should work as a team to create a business model for an online dating service at your school. After working out the details, submit a group report that covers the following issues:
1. Services. How will you earn revenues? What services will you offer? How will you price these services? What forms of payment will you accept? Will you sell ads? If so, what kinds?
2. Appearance. What will your site look like? Will it have graphics? Sound? Video? What will your domain name be? What information will you collect from customers? What information will you provide to visitors?
3. Operations. What criteria will you use to match customers? How will your customers interface with the Web site? How will they connect with each other? Will you design your own software or buy or lease it from vendors? Before you answer, go to these vendors’ Web sites and check out their dating software:
• WebDate (www.webscribble.com/products/...te/index.shtml)
• PG Dating (www.datingpro.com/dating)
4. Attracting Customers. How will you attract customers to the site? How will you monitor and analyze site activity?
5. Security. How will you guarantee confidentiality? How will you ensure that your site is secure? How will you limit access to students at your school?
6. Opportunities and Challenges. What opportunities do e-businesses offer? What challenges do they create? How would your business model change if you decided to run it as a traditional business rather than as an e-business?
The Global View (AACSB)
“Hong Kong—Traditional Chinese”
Hewlett-Packard (HP) provides technology solutions to individuals, businesses, and institutions around the world. It generates annual revenues of \$80 billion from the sale of IT products, including computers, printers, copiers, digital photography, and software. Anyone in the United States who wants to buy an HP product, get technical support, download software, learn about the company, or apply for a job can simply go to the HP Web site. But what if you live in Hong Kong? How would you get answers to your questions? You’d do the same thing as people in this country do—go to HP’s Web site.
Try to imagine, however, the complex process of developing and maintaining a Web site that serves the needs of customers in more than seventy countries. To get a better idea, go to the HP Web site (www.hp.com). Start by looking at HP’s line of notebooks and checking its prices. Then, review the company information (click on “About HP” in the bottom right) that’s posted on the site, and, finally, look for a job—it’s good practice (click on “Jobs” in the bottom right).
Now pretend that you live in Hong Kong and repeat the process. Start by going to the same HP Web site (www.hp.com). Click on the United States (next to U.S. flag in the bottom left) and then Asia and Oceania. If you can read Chinese, click on “Hong Kong—Traditional Chinese.” Otherwise, click on “Hong Kong—English.” Then, answer the following questions:
1. How easy was it to navigate the site and to switch back and forth between the U.S. and Hong Kong sections of the site?
2. Identify at least five differences between the two sections.
3. Does HP’s Web site meet the needs of customers in both the United States and Hong Kong? Why, or why not? How could it be improved? | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/15%3A_Managing_Information_and_Technology/15.08%3A_Cases_and_Problems.txt |
Learning Objectives
1. Define law and explain how it differs from a legal system.
2. Explain the concept of the rule of law and discuss the role of flexibility and fairness in a legal system governed by the rule of law.
3. Discuss the primary functions of law in the United States.
In the eighteenth century, when the legal and regulatory environment of everything was a lot simpler than it is today, the great Irish satirist Jonathan Swift likened laws to cobwebs because they seem to stretch in every direction to catch innocent flies while failing utterly to stop wasps and other creatures responsible for much greater crimes against human comfort. Like George McGovern, many people no doubt find this comparison at least as true today as it was in Swift’s time. After all, in order to be law-abiding innkeepers (or just plain citizens), we must negotiate a vast web of constitutional law, federal law, regulatory law, and state and local law; criminal law, civil law, and common law; substantive law and procedural law; public law and private law; and business law, which includes contract law, product-liability law, patent law, consumer-protection law, environmental law, employment and labor law, insurance law, cyberlaw, agency law, and a host of other forms of law. In fact, being a truly law-abiding citizen is virtually out of the question. According to one estimate, the average American driver deserves ten speeding tickets a day. Other underpenalized violations range from stealing cable TV and scalping tickets to exhibitionism and illegal fishing and hunting (Sexton, 2008).
16.02: Criminal versus Civil Law
Learning Objectives
1. Distinguish between criminal law and civil law, and understand the roles of plaintiffs and defendants in both criminal and civil cases.
2. Define a tort, explain tort law, and discuss an intentional tort.
In the case of George McGovern and his Stratford Inn, we saw what sort of legal entanglements could discourage even a veteran lawmaker from pursuing a modest dream of business ownership. What about you? How easily discouraged would you be? Put yourself in the following scenario, which could happen to anybody:
When you were in high school, you worked part time and over the summers for your father, a house painter. Now that you’re in college, you’ve decided to take advantage of that experience to earn some money during your summer vacation. You set yourself up as a house-painting business and hire your college roommate to help you out. One fine summer day, the two of you are putting a coat of Misty Meadow acrylic latex on the exterior of a two-story Colonial. You’re working on the ground floor around the door of the house while your roommate is working from scaffolding over the garage. Looking up, you notice that, despite several warnings, your roommate has placed his can of paint at his feet rather than fixed it to the ladder bracing the platform. You’re about to say something yet one more time, but it’s too late: He accidentally kicks the bucket (so to speak), which bounces off the homeowner’s red sports car, denting the hood and splattering it with Misty Meadow. As luck would have it, the whole episode is witnessed by the homeowner’s neighbor, who approaches the scene of the disaster just as your roommate has climbed down from the scaffold. “Man, you must be dumber than a bag of hammers,” says the neighbor to your roommate, who’s in no mood for unsolicited opinions, and before you know what’s happening, he breaks the neighbor’s nose with a single well-placed punch.
The homeowner sues you and your roommate for negligence, and the neighbor sues you and your roommate for assault and battery(Moran, 2008).
Clearly, being an employer—even of just one person—isn’t nearly as simple as you thought it would be. What should you have known about the basics of employment law in the state where you intended to paint houses? What should you have known about tort law? What about tax law? If you have to pay damages as a result of the homeowner’s negligence claim, can you at least deduct them as business expenses?
Welcome to the legal environment of business—the place where business interacts with the legal system. Besides the fact that these interactions are usually quite complicated, what valuable lessons should you learn from your experience once your case has been adjudicated (resolved in court)? You probably won’t be surprised to learn that your roommate is liable for negligence in kicking over the paint bucket, but you may be dismayed to learn that you are, too. When it comes to the claim of assault and battery, your roommate is also liable for that, but you may be protected from liability. As for the damages that you’ll probably have to pay in order to settle the homeowner’s negligence suit, you’ll be pleased to learn that you can indeed write them off as “ordinary” business expenses (unless they’re paid by your insurance company).
As we work our way through this chapter, we’ll look a little more closely at the types of law involved in your case, but we’ll start by observing that, in at least one respect, your roommate’s predicament can be more instructive than yours. That’s because assault and battery violates statutes established by two different types of law—criminal and civil. | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/16%3A_The_Legal_and_Regulatory_Environment_of_Business/16.01%3A_Law_and_the_Legal_System.txt |
Learning Objectives
1. Define a negligence tort and discuss the elements of a negligence claim.
2. Explain a contract and discuss the requirements of an enforceable contract.
3. Explain the concepts of respondeat superior and scope of employment and discuss their roles in an employment contract.
We can now get back to your role in this case, though doing so means first taking a closer look at further aspects of your roommate’s role. You and your roommate are being sued by the homeowner for a different type of tort—a negligence tort, which results not from intentional wrongdoing, but from carelessness. When he placed that can of paint at his feet, where he might easily dislodge it as he moved around the platform, your roommate allowed his conduct to fall below a certain standard of care—namely, the degree of care necessary to protect others from an unreasonable likelihood of harm.
16.04: Product Liability
Learning Objectives
1. Define product liability and discuss the three grounds, or “theories of recovery,” for a claim of product liability.
2. Discuss the three forms of manufacturer’s negligence that may be claimed in a product-liability case.
3. Define strict liability and explain the doctrine of strict liability in tort.
4. Define a warranty and distinguish between express warranties and implied warranties.
5. Identify the primary goal of tort law and distinguish between compensatory damages and punitive damages.
In addition to intentional and negligence torts, U.S. law recognizes a third category of torts: strict liability torts involve actions that are inherently dangerous and for which a party may be liable no matter how carefully he or she (or it) performs them. To better appreciate the issues involved in cases of strict liability, let’s take up the story of your legal adventures in the world of business where we left off:
Having escaped the house-painting business relatively unscathed, you head back home to rethink your options for gainful employment over your summer vacation. You’ve stored your only remaining capital assets—the two ladders and the platform that you’d used for scaffolding—in your father’s garage, where one afternoon, your uncle notices them. Examining one of the ladders, he asks you how much weight it’s designed to hold, and you tell him what the department manager at Ladders ’N’ Things told you—three hundred pounds per rung. He nods as if this is a good number, and, sensing that he might want to buy them, you hasten to add that though you got them at a cut-rate price because of a little rust, they’re virtually brand-new. As it turns out, he doesn’t want to buy them, but he does offer to pay you \$35 an hour to take them to his house and help him put up new roofing. He’s easygoing, he’s family, and he probably won’t sue you for anything, so you jump at the opportunity.
Everything goes smoothly until day two, when you’re working on the scaffolding two stories off the ground. As you’re in the process of unwrapping a bundle of shingles, one of the ladders buckles, bringing down the platform and depositing you on your uncle’s stone patio with a cervical fracture.
Fortunately, there’s no damage to your spinal cord, but you’re in pain and you need surgery. Now it’s your turn to sue somebody. But whom? And for what? | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/16%3A_The_Legal_and_Regulatory_Environment_of_Business/16.03%3A_Negligence_Torts.txt |
Learning Objectives
1. Explain the difference between private law and public law.
2. Define statutory law and give examples of statutory laws at various governmental levels.
3. Explain externalities and show why taxation is used as a means of addressing them.
4. Discuss the idea of market failure and the principle of efficiency as a foundation of law.
5. Define administrative law and discuss the role of federal administrative agencies in making and enforcing administrative laws.
6. Define case law and explain the concepts of precedent and judicial review.
Both tort law and contract law fall into the larger domain of private law, which deals with private relationships among individuals and organizations. In addition, of course, there are numerous types of law that deal with the relationship of government to private individuals and other private entities, including businesses. This is the area of public law, which falls into three general categories (Kubasek, 2009):
• Criminal law, which we’ve already introduced, prohibits and punishes wrongful conduct.
• Constitutional law concerns the laws and basic legal principles set forth by the U.S. Constitution.
• Administrative law refers to statutes and regulations related to the activities of certain legal bodies known as administrative agencies. We’ll have more to say about administrative agencies and administrative law later in the chapter.
Public law obviously has a major impact on the activities of both individuals and businesses in the United States, and in the following section, we’ll discuss the nature of this impact and the reasons why so many private activities are subject to the rules and principles of public law. Like most areas of the law, public law is an extremely complex field of study, and to keep things manageable we’re going to explore this field by focusing on three less-than-glamorous legal issues: why cigarette littering is against the law, why cigarettes cost so much, and why businesses ban smoking in the workplace.
16.06: Cases and Problems
Career Opportunities
Would You Like to Be a Lawyer?
Are you interested in a career in law? To learn what lawyers do, read the article on About.com, “Lawyer” by Sally Kane, http://legalcareers.about.com/od/car...s/p/Lawyer.htm
As a follow-up (and because getting a job is a good thing), read a second article on About.com, “Who Hires Lawyers?” by Tara Kuther, http://gradschool.about.com/od/lawsc.../f/lawjobs.htm. Then, answer the following questions, being sure to provide an explanation for each of your answers:
• What about being a lawyer interests you?
• What might discourage you from pursuing a career in law?
• Overall, does a career in law appeal to you? Why, or why not?
Ethics Angle (AACSB)
The Product Liability Debate
The article “Who Should Pay? The Product Liability Debate,” by Claire Andre and Manuel Velasquez, provides the pros and cons of the current product liability legal environment. Read the article, which can be found at www.scu.edu/ethics/publicatio.../v4n1/pay.html, and answer these questions:
1. Should consumers bear more responsibility for product injuries?
2. Should drug manufacturers bear more responsibility?
3. Is the current product-liability legal system broken? Why, or why not? If you believe it is broken, how would you fix it?
Team-Building Skills (AACSB)
Get together as a team and debate these two related issues: “How much should a pack of cigarettes cost?” and “Should businesses ban smoking the workplace?” Write a “position” paper explaining your group’s opinion. If the group doesn’t reach an agreement on the issues, include a “minority report”—the opinion of a minority of the group.
The Global View (AACSB)
What issues would you encounter as a businessperson negotiating a sales contract with a company in China? How would you overcome these issues? | textbooks/biz/Business/Introductory_Business/Book%3A_Exploring_Business/16%3A_The_Legal_and_Regulatory_Environment_of_Business/16.05%3A_Some_Principles_of_Public_Law.txt |
Learning Objectives
1. Define a team and describe its key characteristics.
2. Explain why organizations use teams and describe different types of teams.
3. Explain why teams may be effective or ineffective.
4. Identify factors that contribute to team cohesiveness.
5. Understand the importance of learning to participate in team-based activities.
6. Identify the skills needed by team members and the roles that members of a team might play.
7. Learn how to survive team projects in college (and actually enjoy yourself).
8. Explain the skills and behaviors that foster effective team leadership.
01: Teamwork in Business
The Team with the RAZR’s Edge
The publicly traded company Motorola Mobility was created when Motorola spun off its Mobile Devices division, creating a new entity. The newly-formed company’s executive team was under intense pressure to come out with a smartphone that could grab substantial market share from Apple’s iPhone 4S and Samsung’s Galaxy Nexus. To do this, the team oversaw the design of an Android version of the Motorola RAZR, which was once the best-selling phone in the world. The hope of the executive team was that past customers who loved the RAZR would love the new ultra-thin smartphone—the Droid RAZR. The Droid RAZR was designed by a team, as are other Motorola products. To understand the team approach at Motorola, let’s review the process used to design the RAZR.
By winter 2003, the company that for years had run ringtones around the competition had been bumped from the top spot in worldwide sales.1 Motorola found itself stuck in the number-three slot. Their sales had declined because consumers were less than enthusiastic about the uninspired style of Motorola phones, and for many people, style is just as important in picking a cell phone as features. As a reviewer for one industry publication put it, “We just want to see the look on people’s faces when we slide [our phones] out of our pockets to take a call.”
Yet there was a glimmer of hope at Motorola. Despite its recent lapse in cell phone fashion sense, Motorola still maintained a concept-phone unit—a group responsible for designing futuristic new product features such as speech-recognition capability, flexible touchscreens, and touch-sensitive body covers. In every concept-phone unit, developers engage in an ongoing struggle to balance the two often-opposing demands of cell phone design: building the smallest possible phone with the largest possible screen. The previous year, Motorola had unveiled the rough model of an ultra-trim phone—at 10 millimeters, about half the width of the average flip-top or “clamshell” design. It was on this concept that Motorola decided to stake the revival of its reputation as a cell phone maker who knew how to package functionality with a wow factor.
The next step in developing a concept phone is actually building it. Teamwork becomes critical at this point. The process requires some diversity in expertise. An electronics engineer, for example, knows how to apply energy to transmit information through a system but not how to apply physics to the design and manufacture of the system; that’s the specialty of a mechanical engineer. Engineers aren’t designers—the specialists who know how to enhance the marketability of a product through its aesthetic value. Designers bring their own unique value to the team.
In addition, when you set out to build any kind of innovative high-tech product, you need to become a master of trade-offs—in Motorola’s case, compromises resulted from the demands of state-of-the-art functionality on one hand and fashionable design on the other. Negotiating trade-offs is a team process: it takes at least two people to resolve design disputes.
The responsibility for assembling and managing the Motorola “thin-clam” team fell to veteran electronic engineer Roger Jellicoe. His mission: create the world’s thinnest phone, do it in one year, and try to keep it a secret. Before the project was completed, the team had grown to more than twenty members, and with increased creative input and enthusiasm came increased confidence and clout. Jellicoe had been warned by company specialists in such matters that no phone wider than 49 millimeters could be held comfortably in the human hand. When the team had finally arrived at a satisfactory design that couldn’t work at less than 53 millimeters, they ignored the “49 millimeters warning,” built a model, passed it around, and came to a consensus: as one team member put it, “People could hold it in their hands and say, ‘Yeah, it doesn’t feel like a brick.’” Four millimeters, they decided, was an acceptable trade-off, and the new phone went to market at 53 millimeters. While small by today’s standards, at the time, 53 millimeters was a gamble.
Team members liked to call the design process the “dance.” Sometimes it flowed smoothly and sometimes people stepped on one another’s toes, but for the most part, the team moved in lockstep toward its goal. After a series of trade-offs about what to call the final product (suggestions ranged from Razor Clam to V3), Motorola’s new RAZR was introduced in July 2004. Recall that the product was originally conceived as a high-tech toy—something to restore the luster to Motorola’s tarnished image. It wasn’t supposed to set sales records, and sales in the fourth quarter of 2004, though promising, were in fact fairly modest. Back in September, however, a new executive named Ron Garriques had taken over Motorola’s cell phone division; one of his first decisions was to raise the bar for RAZR. Disregarding a 2005 budget that called for sales of two million units, Garriques pushed expected sales for the RAZR up to twenty million. The RAZR topped that target, shipped ten million in the first quarter of 2006, and hit the fifty-million mark at midyear. Talking on a RAZR, declared hip-hop star Sean “P. Diddy” Combs, “is like driving a Mercedes versus a regular ol’ ride.”2
Jellicoe and his team were invited to attend an event hosted by top executives, receiving a standing ovation, along with a load of stock options. One of the reasons for the RAZR’s success, said Jellicoe, was that “It took the world by surprise. Very few Motorola products do that.” For a while, the new RAZR was the best-selling phone in the world. | textbooks/biz/Business/Introductory_Business/Book%3A_Fundamentals_of_Business_(Skripak)/01%3A_Teamwork_in_Business/1.00%3A_Prelude_-_The_Team_with_the_RAZRs_Edge.txt |
What Is a Team? How Does Teamwork Work?
A team (or a work team) is a group of people with complementary skills who work together to achieve a specific goal.3 In the case of Motorola’s RAZR team, the specific goal was to develop (and ultimately bring to market) an ultrathin cell phone that would help restore the company’s reputation. The team achieved its goal by integrating specialized but complementary skills in engineering and design and by making the most of its authority to make its own decisions and manage its own operations.
Teams versus Groups
As Bonnie Edelstein, a consultant in organizational development suggests, “A group is a bunch of people in an elevator. A team is also a bunch of people in an elevator, but the elevator is broken.”4 This distinction may be a little oversimplified, but as our tale of teamwork at Motorola reminds us, a team is clearly something more than a mere group of individuals. In particular, members of a group—or, more accurately, a working group—go about their jobs independently and meet primarily to work towards a shared objective. A group of department-store managers, for example, might meet monthly to discuss their progress in cutting plant costs. However, each manager is focused on the goals of his or her department because each is held accountable for meeting those goals.
Some Key Characteristics of Teams
To put teams in perspective, let’s identify five key characteristics. Teams:5
• Share accountability for achieving specific common goals
• Function interdependently
• Require stability
• Hold authority and decision-making power
• Operate in a social context
Why Organizations Build Teams
Why do major organizations now rely so much on teams to improve operations? Executives at Xerox have reported that team-based operations are 30 percent more productive than conventional operations. General Mills says that factories organized around team activities are 40 percent more productive than traditionally organized factories. FedEx says that teams reduced service errors (lost packages, incorrect bills) by 13 percent in the first year.6
Today it seems obvious that teams can address a variety of challenges in the world of corporate activity. Before we go any further, however, we should remind ourselves that the data we’ve just cited aren’t necessarily definitive. For one thing, they may not be objective—companies are more likely to report successes than failures. As a matter of fact, teams don’t always work. According to one study, team-based projects fail 50 to 70 percent of the time.7
The Effect of Teams on Performance
Research shows that companies build and support teams because of their effect on overall workplace performance, both organizational and individual. If we examine the impact of team-based operations according to a wide range of relevant criteria, we find that overall organizational performance generally improves. Figure 1.3 lists several areas in which we can analyze workplace performance and indicates the percentage of companies that have reported improvements in each area.
Figure 1.3: Performance improvements due to team-based operations
Area of Performance Firms Reporting Improvement
Product and service quality 70%
Customer service 67%
Worker satisfaction 66%
Quality of work life 63%
Productivity 61%
Competitiveness 50%
Profitability 45%
Absenteeism/turnover 23%
Source: Adapted from Edward E. Lawler, S. A. Mohman, and G. E. Ledford (1992). Creating High Performance Organizations: Practices and Results of Employee Involvement and Total Quality in Fortune 1000 Companies. San Francisco: Wiley. Reprinted with permission of John Wiley & Sons Inc.
Types of Teams
Teams, then, can improve company and individual performance in a number of areas. Not all teams, however, are formed to achieve the same goals or charged with the same responsibilities. Nor are they organized in the same way. Some, for instance, are more autonomous than others—less accountable to those higher up in the organization. Some depend on a team leader who’s responsible for defining the team’s goals and making sure that its activities are performed effectively. Others are more or less self- governing: though a leader lays out overall goals and strategies, the team itself chooses and manages the methods by which it pursues its goals and implements its strategies.8 Teams also vary according to their membership. Let’s look at several categories of teams.
Manager-Led Teams
As its name implies, in the manager-led team the manager is the team leader and is in charge of setting team goals, assigning tasks, and monitoring the team’s performance. The individual team members have relatively little autonomy. For example, the key employees of a professional football team (a manager-led team) are highly trained (and highly paid) athletes, but their activities on the field are tightly controlled by a head coach. As team manager, the coach is responsible both for developing the strategies by which the team pursues its goal of winning games and for the outcome of each game and season. He’s also solely responsible for interacting with managers above him in the organization. The players are responsible mainly for executing plays.9
Self-Managing Teams
Self-managing teams (also known as self-directed teams) have considerable autonomy. They are usually small and often absorb activities that were once performed by traditional supervisors. A manager or team leader may determine overall goals, but the members of the self-managing team control the activities needed to achieve those goals.
Self-managing teams are the organizational hallmark of Whole Foods Market, the largest natural-foods grocer in the United States. Each store is run by ten departmental teams, and virtually every store employee is a member of a team. Each team has a designated leader and its own performance targets. (Team leaders also belong to a store team, and store-team leaders belong to a regional team.) To do its job, every team has access to the kind of information—including sales and even salary figures—that most companies reserve for traditional managers.10
Not every self-managed team enjoys the same degree of autonomy. Companies vary widely in choosing which tasks teams are allowed to manage and which ones are best left to upper-level management only. As you can see in Figure 1.5 for example, self-managing teams are often allowed to schedule assignments, but they are rarely allowed to fire coworkers.
Cross-Functional Teams
Many companies use cross-functional teams—teams that, as the name suggests, cut across an organization’s functional areas (operations, marketing, finance, and so on). A cross-functional team is designed to take advantage of the special expertise of members drawn from different functional areas of the company. When the Internal Revenue Service, for example, wanted to study the effects on employees of a major change in information systems, it created a cross-functional team composed of people from a wide range of departments. The final study reflected expertise in such areas as job analysis, training, change management, industrial psychology, and ergonomics.11
Cross-functional teams figure prominently in the product-development process at Nike, where they take advantage of expertise from both inside and outside the company.
Typically, team members include not only product designers, marketing specialists, and accountants but also sports-research experts, coaches, athletes, and even consumers. Likewise, Motorola’s RAZR team was a cross-functional team; responsibility for developing the new product wasn’t passed along from the design team to the engineering team but rather was entrusted to a special team composed of both designers and engineers.
Committees and task forces, both of which are dedicated to specific issues or tasks, are often cross-functional teams. Problem-solving teams, which are created to study such issues as improving quality or reducing waste, may be either intradepartmental or cross- functional.12
Virtual Teams
Technology now makes it possible for teams to function not only across organizational boundaries like functional areas but also across time and space. Technologies such as videoconferencing allow people to interact simultaneously and in real time, offering a number of advantages in conducting the business of a virtual team.13 Members can participate from any location or at any time of day, and teams can “meet” for as long as it takes to achieve a goal or solve a problem—a few days, weeks, or months.
Team size does not seem to be an obstacle when it comes to virtual-team meetings; in building the F-35 Strike Fighter, U.S. defense contractor Lockheed Martin staked the \$225 billion project on a virtual product-team of unprecedented global dimension, drawing on designers and engineers from the ranks of eight international partners from Canada, the United Kingdom, Norway, and Turkey.14
The original version of this chapter contained H5P content. You may want to remove or replace this element. | textbooks/biz/Business/Introductory_Business/Book%3A_Fundamentals_of_Business_(Skripak)/01%3A_Teamwork_in_Business/1.01%3A_The_Team_and_the_Organization.txt |
Now that we know a little bit about how teams work, we need to ask ourselves why they work. Not surprisingly, this is a fairly complex issue. In this section, we’ll explore why teams are often effective and when they ineffective.
Factors in Effective Teamwork
First, let’s begin by identifying several factors that contribute to effective teamwork. Teams are most effective when the following factors are met:
• Members depend on each other. When team members rely on each other to get the job done, team productivity and efficiency tend to be high.
• Members trust one another.
• Members work better together than individually. When team members perform better as a group than alone, collective performance exceeds individual performance.
• Members become boosters. When each member is encouraged by other team members to do his or her best, collective results improve.
• Team members enjoy being on the team.
• Leadership rotates.
Some of these factors may seem intuitive. Because such issues are rarely clear-cut, we need to examine the issue of group effectiveness from another perspective—one that considers the effects of factors that aren’t quite so straightforward.
Group Cohesiveness
The idea of group cohesiveness refers to the attractiveness of a team to its members. If a group is high in cohesiveness, membership is quite satisfying to its members. If it’s low in cohesiveness, members are unhappy with it and may try to leave it.15
What Makes a Team Cohesive?
Numerous factors may contribute to team cohesiveness, but in this section, we’ll focus on five of the most important:
• Size. The bigger the team, the less satisfied members tend to be. When teams get too large, members find it harder to interact closely with other members; a few members tend to dominate team activities, and conflict becomes more likely.
• Similarity. People usually get along better with people like themselves, and teams are generally more cohesive when members perceive fellow members as people who share their own attitudes and experience.
• Success. When teams are successful, members are satisfied, and other people are more likely to be attracted to their teams.
• Exclusiveness. The harder it is to get into a group, the happier the people who are already in it. Team status also increases members’ satisfaction.
• Competition. Membership is valued more highly when there is motivation to achieve common goals and outperform other teams.
Maintaining team focus on broad organizational goals is crucial. If members get too wrapped up in immediate team goals, the whole team may lose sight of the larger organizational goals toward which it’s supposed to be working. Let’s look at some factors that can erode team performance.
Groupthink
It’s easy for leaders to direct members toward team goals when members are all on the same page—when there’s a basic willingness to conform to the team’s rules. When there’s too much conformity, however, the group can become ineffective: it may resist fresh ideas and, what’s worse, may end up adopting its own dysfunctional tendencies as its way of doing things. Such tendencies may also encourage a phenomenon known as groupthink—the tendency to conform to group pressure in making decisions, while failing to think critically or to consider outside influences.
Groupthink is often cited as a factor in the explosion of the space shuttle Challenger in January 1986: engineers from a supplier of components for the rocket booster warned that the launch might be risky because of the weather but were persuaded to set aside their warning by NASA officials who wanted the launch to proceed as scheduled.16
Motivation and Frustration
Remember that teams are composed of people, and whatever the roles they happen to be playing at a given time, people are subject to psychological ups and downs. As members of workplace teams, they need motivation, and when motivation is low, so are effectiveness and productivity. The difficulty of maintaining a high level of motivation is the chief cause of frustration among members of teams. As such, it’s also a chief cause of ineffective teamwork, and that’s one reason why more employers now look for the ability to develop and sustain motivation when they’re hiring new managers.17
Other Factors that Erode Performance
Let’s take a quick look at three other obstacles to success in introducing teams into an organization:18
• Unwillingness to cooperate. Failure to cooperate can occur when members don’t or won’t commit to a common goal or set of activities. What if, for example, half the members of a product-development team want to create a brand-new product and half want to improve an existing product? The entire team may get stuck on this point of contention for weeks or even months. Lack of cooperation between teams can also be problematic to an organization.
• Lack of managerial support. Every team requires organizational resources to achieve its goals, and if management isn’t willing to commit the needed resources— say, funding or key personnel—a team will probably fall short of those goals.
• Failure of managers to delegate authority. Team leaders are often chosen from the ranks of successful supervisors—first-line managers give instructions on a day-to-day basis and expect to have them carried out. This approach to workplace activities may not work very well in leading a team—a position in which success depends on building a consensus and letting people make their own decisions.
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“Life Is All about Group Work”
“I’ll work extra hard and do it myself, but please don’t make me have to work in a group.”
Like it or not, you’ve probably already notice that you’ll have team-based assignments in college. More than two-thirds of all students report having participated in the work of an organized team, and if you’re in business school, you will almost certainly find yourself engaged in team-based activities.19
Why do we put so much emphasis on something that, reportedly, makes many students feel anxious and academically drained? Here’s one college student’s practical-minded answer to this question:
“In the real world, you have to work with people. You don’t always know the people you work with, and you don’t always get along with them. Your boss won’t particularly care, and if you can’t get the job done, your job may end up on the line. Life is all about group work, whether we like it or not. And school, in many ways, prepares us for life, including working with others.”20
She’s right. In placing so much emphasis on teamwork skills and experience, business colleges are doing the responsible thing—preparing students for the business world. A survey of Fortune 1000 companies reveals that 79 percent use self-managing teams and 91 percent use other forms of employee work groups. Another survey found that the skill that most employers value in new employees is the ability to work in teams.21 Consider the advice of former Chrysler Chairman Lee Iacocca: “A major reason that capable people fail to advance is that they don’t work well with their colleagues.”22 The importance of the ability to work in teams was confirmed in a survey of leadership practices of more than sixty of the world’s top organizations.23
When top executives in these organizations were asked what causes the careers of high-potential leadership candidates to derail, 60 percent of the organizations cited “inability to work in teams.” Interestingly, only 9 percent attributed the failure of these executives to advance to “lack of technical ability.”
To put it in plain terms, the question is not whether you’ll find yourself working as part of a team. You will. The question is whether you’ll know how to participate successfully in team-based activities.
Will You Make a Good Team Member?
What if your instructor decides to divide the class into teams and assigns each team to develop a new product plus a business plan to get it on the market? What teamwork skills could you bring to the table, and what teamwork skills do you need to improve? Do you possess qualities that might make you a good team leader?
What Skills Does the Team Need?
Sometimes we hear about a sports team made up of mostly average players who win a championship because of coaching genius, flawless teamwork, and superhuman determination.24 But not terribly often. In fact, we usually hear about such teams simply because they’re newsworthy—exceptions to the rule. Typically a team performs well because its members possess some level of talent. Members’ talents must also be managed in a collective effort to achieve a common goal.
In the final analysis, a team can succeed only if its members provide the skills that need managing. In particular, every team requires some mixture of three sets of skills:
• Technical skills. Because teams must perform certain tasks, they need people with the skills to perform them. For example, if your project calls for a lot of math work, it’s good to have someone with the necessary quantitative skills.
• Decision-making and problem-solving skills. Because every task is subject to problems, and because handling every problem means deciding on the best solution, it’s good to have members who are skilled in identifying problems, evaluating alternative solutions, and deciding on the best options.
• Interpersonal skills. Because teams need direction and motivation and depend on communication, every group benefits from members who know how to listen, provide feedback, and resolve conflict. Some members must also be good at communicating the team’s goals and needs to outsiders.
The key is ultimately to have the right mix of these skills. Remember, too, that no team needs to possess all these skills—never mind the right balance of them—from day one. In many cases, a team gains certain skills only when members volunteer for certain tasks and perfect their skills in the process of performing them. For the same reason, effective teamwork develops over time as team members learn how to handle various team-based tasks. In a sense, teamwork is always work in progress.
What Roles Do Team Members Play?
As a student and later in the workplace, you’ll be a member of a team more often than a leader. Team members can have as much impact on a team’s success as its leaders. A key is the quality of the contributions they make in performing non-leadership roles.25
What, exactly, are those roles? At this point, you’ve probably concluded that every team faces two basic challenges:
• Accomplishing its assigned task
• Maintaining or improving group cohesiveness
Whether you affect the team’s work positively or negatively depends on the extent to which you help it or hinder it in meeting these two challenges.26 We can thus divide teamwork roles into two categories, depending on which of these two challenges each role addresses. These two categories (task-facilitating roles and relationship-building roles) are summarized here:
Figure 1.7: Team member roles
Task-facilitating Roles Example Relationship-Building Roles Example
Direction giving “Jot down a few ideas and we’ll see what everyone has come up with.” Supporting “Now, that’s what I mean by a practical application.”
Information seeking “Does anyone know if this is the latest data we have?” Harmonizing “Actually, I think you’re both saying pretty much the same thing.”
Information giving “Here are the latest numbers from….” Tension relieving “Before we go on, would anyone like a drink?”
Elaborating “I think a good example of what you’re talking about is….” Confronting “How does that suggestion relate to the topic that we’re discussing?”
Urging “Let’s try to finish this proposal before we adjourn.” Energizing “It’s been a long time since I’ve had this many laughs at a meeting in this department.”
Monitoring “If you’ll take care of the first section, I’ll make sure that we have the second by next week.” Developing “If you need some help pulling the data together, let me know.”
Process Analyzing “What happened to the energy level in this room?” Consensus Building “Do we agree on the first four points even if number five needs a little more work?”
Reality Testing “Can we make this work and stay within budget?” Empathizing “It’s not you. The numbers are confusing.”
Enforcing “We’re getting off track. Let’s try to stay on topic.” Summarizing “Before we jump ahead, here’s what we’ve decided so far.”
Adapted from David A. Whetten and Kim S. Cameron (2007). Developing Management Skills, 7th ed. Upper Saddle River, NJ: Pearson Education. Pp. 517, 519.
Task-Facilitating Roles
Task-facilitating roles address challenge number one—accomplishing the team goals. As you can see from Table P.6, such roles include not only providing information when someone else needs it but also asking for it when you need it. In addition, it includes monitoring (checking on progress) and enforcing (making sure that team decisions are carried out). Task facilitators are especially valuable when assignments aren’t clear or when progress is too slow.
Relationship-Building Roles
When you challenge unmotivated behavior or help other team members understand their roles, you’re performing a relationship-building role and addressing challenge number two—maintaining or improving group cohesiveness. This type of role includes activities that improve team “chemistry,” from empathizing to confronting.
Bear in mind three points about this model: (1) Teams are most effective when there’s a good balance between task facilitation and relationship-building; (2) it’s hard for any given member to perform both types of roles, as some people are better at focusing on tasks and others on relationships; and (3) overplaying any facet of any role can easily become counterproductive. For example, elaborating on something may not be the best strategy when the team needs to make a quick decision; and consensus building may cause the team to overlook an important difference of opinion.
Blocking Roles
Finally, review Figure 1.8, which summarizes a few characteristics of another kind of team-membership role. So-called blocking roles consist of behavior that inhibits either team performance or that of individual members. Every member of the team should know how to recognize blocking behavior. If teams don’t confront dysfunctional members, they can destroy morale, hamper consensus building, create conflict, and hinder progress.
Figure 1.8: Types and examples of blocking behaviors
Blocking Behavior Tactics
Dominate Talk as much as possible; interrupt and interject
Overanalyze Split hairs and belabor every detail
Stall Frustrate efforts to come to conclusions: decline to agree, sidetrack the discussion, rehash old ideas
Remain passive Stay on the fringe; keep interaction to a minimum; wait for others to take on work
Overgeneralize Blow things out of proportion; float unfounded conclusions
Find fault Criticize and withhold credit whenever possible
Make premature decisions Rush to conclusions before goals are set, information is shared, or problems are clarified
Present opinions as facts Refuse to seek factual support for ideas that you personally favor
Reject Object to ideas by people who tend to disagree with you
Pull Rank Use status or title to push through ideas, rather than seek consensus on their value
Resist Throw up roadblocks to progress; look on the negative side
Deflect Refuse to stay on topic; focus on minor points rather than main points
Adapted from David A. Whetten and Kim S. Cameron (2007). Developing Management Skills, 7th ed. Upper Saddle River, NJ: Pearson Education. Pp. 519-20.
Class Team Projects
In your academic career you’ll participate in a number of team projects. To get insider advice on how to succeed on team projects in college, let’s look at some suggestions offered by students who have gone through this experience.27
• Draw up a team charter. At the beginning of the project, draw up a team charter that includes: the goals of the group; ways to ensure that each team member’s ideas are considered; timing and frequency of meeting. A more informal way to arrive at a team charter is to simply set some ground rules to which everyone agrees.
• Contribute your ideas. Share your ideas with your group. The worst that could happen is that they won’t be used (which is what would happen if you kept quiet).
• Never miss a meeting or deadline. Pick a weekly meeting time and write it into your schedule as if it were a class. Never skip it.
• Be considerate of each other. Be patient, listen to everyone, involve everyone in decision making, avoid infighting, build trust.
• Create a process for resolving conflict. Do so before conflict arises. Set up rules to help the group decide how conflict will be handled.
• Use the strengths of each team member. All students bring different strengths. Utilize the unique value of each person.
• Don’t do all the work yourself. Work with your team to get the work done. The project output is often less important than the experience.
What Does It Take to Lead a Team?
To borrow from Shakespeare, “Some people are born leaders, some achieve leadership, and some have leadership thrust upon them.” At some point in a successful career, you will likely be asked to lead a team. What will you have to do to succeed as a leader?
Like so many of the questions that we ask in this book, this question doesn’t have any simple answers. We can provide one broad answer: a leader must help members develop the attitudes and behavior that contribute to team success: interdependence, collective responsibility, shared commitment, and so forth.
Team leaders must be able to influence their team members. Notice that we say influence: except in unusual circumstances, giving commands and controlling everything directly doesn’t work very well.28 As one team of researchers puts it, team leaders are more effective when they work with members rather than on them.29 Hand-in-hand with the ability to influence is the ability to gain and keep the trust of team members. People aren’t likely to be influenced by a leader whom they perceive as dishonest or selfishly motivated.
Assuming you were asked to lead a team, there are certain leadership skills and behaviors that would help you influence your team members and build trust. Let’s look briefly at some of them:
• Demonstrate integrity. Do what you say you’ll do and act in accordance with your stated values. Be honest in communicating and follow through on promises.
• Be clear and consistent. Let members know that you’re certain about what you want and remember that being clear and consistent reinforces your credibility.
• Generate positive energy. Be optimistic and compliment team members. Recognize their progress and success.
• Acknowledge common points of view. Even if you’re about to propose some kind of change, recognize the value of the views that members already hold in common.
• Manage agreement and disagreement. When members agree with you, confirm your shared point of view. When they disagree, acknowledge both sides of the issue and support your own with strong, clearly-presented evidence.
• Encourage and coach. Buoy up members when they run into new and uncertain situations and when success depends on their performing at a high level.
• Share information. Give members the information they need and let them know that you’re knowledgeable about team tasks and individual talents. Check with team members regularly to find out what they’re doing and how the job is progressing.
The original version of this chapter contained H5P content. You may want to remove or replace this element.
Key Take-Aways
1. A team (or a work team) is a group of people with complementary skills and diverse areas of expertise who work together to achieve a specific goal.
2. Work teams have five key characteristics. They are accountable for achieving specific common goals. They function interdependently. They are stable. They have authority. And they operate in a social context.
3. Work teams may be of several types:
4. In the traditional manager-led team, the leader defines the team’s goals and activities and is responsible for its achieving its assigned goals.
5. The leader of a self-managing team may determine overall goals, but employees control the activities needed to meet them.
6. A cross-functional team is designed to take advantage of the special expertise of members drawn from different functional areas of the company.
7. On virtual teams, geographically dispersed members interact electronically in the process of pursuing a common goal.
8. Group cohesiveness refers to the attractiveness of a team to its members. If a group is high in cohesiveness, membership is quite satisfying to its members; if it’s low in cohesiveness, members are unhappy with it and may even try to leave it.
9. As the business world depends more and more on teamwork, it’s increasingly important for incoming members of the workforce to develop skills and experience in team-based activities.
10. Every team requires some mixture of three skill sets:
11. Technical skills: skills needed to perform specific tasks
12. Decision-making and problem-solving skills: skills needed to identify problems, evaluate alternative solutions, and decide on the best options
13. Interpersonal skills: skills in listening, providing feedback, and resolving conflict
1.04: References
Figure 1.1: OptoScalpel (2005): Motorola RAZR V3i mobile phone. Public Domain. Retrieved from: https://commons.wikimedia.org/wiki/File:Motorola_RAZR_V3i_03.JPG
Figure 1.2: Conrad Longmore (2011). “Motorola RAZR XT910 showing Wikipedia home page.” CC BY-SA 3.0. Retrieved from: en.Wikipedia.org/wiki/Droid_Razr#/media/File:Motorola_RAZR_XT910.jpg
Figure 1.3: Adapted from Edward E. Lawler, S. A. Mohman, and G. E. Ledford (1992). Creating High Performance Organizations: Practices and Results of Employee Involvement and Total Quality in Fortune 1000 Companies. San Francisco: Wiley. Reprinted with permission of John Wiley & Sons Inc.
Figure 1.4: Daniel Lin (2010). “ACC Football Championship vs. Florida State, 2010.” CC BY-SA 2.0. Retrieved from: https://commons.wikimedia.org/wiki/File:Jimbo_Fisher_and_Frank_Beamer_2010.jpg
Figure 1.6: Federal Government (1983). “Space Shuttle Challenger, 04-04-1983.” Public domain, Retrieved from: en.Wikipedia.org/wiki/Space_Shuttle_Challenger#/media/File:Space_Shuttle_Challenger_(04-04-1983).JPEG
Figure 1.7: Adapted from David A. Whetten and Kim S. Cameron (2007). Developing Management Skills, 7th ed. Upper Saddle River, NJ: Pearson Education. Pp. 517, 519.
Figure 1.8: Adapted from David A. Whetten and Kim S. Cameron (2007). Developing Management Skills, 7th ed. Upper Saddle River, NJ: Pearson Education. Pp. 519-20. | textbooks/biz/Business/Introductory_Business/Book%3A_Fundamentals_of_Business_(Skripak)/01%3A_Teamwork_in_Business/1.03%3A_The_Team_and_Its_Members.txt |
Learning Objectives
1. Describe the concept of stakeholders and identify the stakeholder groups relevant to an organization
2. Discuss and be able to apply the PESTEL macro-business-environment model to an industry or emerging technology
3. Explain other key terms related to this chapter including: entrepreneur; profit; revenue.
• 2.0: Prelude - Why Is Apple Successful?
In 1976 Steve Jobs and Steve Wozniak created their first computer, the Apple I. They invested a mere \$1,300 and set up business in Jobs’ garage. Three decades later, their business—Apple Inc.—has become one of the world’s most influential and successful companies. Jobs and Wozniak were successful entrepreneurs: those who take the risks and reap the rewards associated with starting a new business enterprise.
• 2.1: Introduction
As the story of Apple suggests, today is an interesting time to study business. Advances in technology are bringing rapid changes in the ways we produce and deliver goods and services. The Internet and other improvements in communication (such as smartphones, video conferencing, and social networking) now affect the way we do business. Companies are expanding international operations, and the workforce is more diverse than ever.
• 2.2: Getting Down to Business
Let’s begin our discussion of business by identifying the main participants of business and the functions that most businesses perform. Then we’ll finish this section by discussing the external factors that influence a business’ activities.
• 2.3: Getting Down to Business
The activities needed to operate a business can be divided into a number of functional areas. Examples include: management, operations, marketing, accounting, and finance. Let’s briefly explore each of these areas.
• 2.4: Functional Areas of Business
• 2.5: External Forces that Influence Business Activities
• 2.6: End of Chapter Material
02: The Foundations of Business
In 1976 Steve Jobs and Steve Wozniak created their first computer, the Apple I.1 They invested a mere \$1,300 and set up business in Jobs’ garage. Three decades later, their business—Apple Inc.—has become one of the world’s most influential and successful companies. Jobs and Wozniak were successful entrepreneurs: those who take the risks and reap the rewards associated with starting a new business enterprise. Did you ever wonder why Apple flourished while so many other young companies failed? How did it grow from a garage start-up to a company generating over \$233 billion in sales in 2015? How was it able to transform itself from a nearly bankrupt firm to a multinational corporation with locations all around the world? You might conclude that it was the company’s products, such as the Apple I and II, the Macintosh, or more recently its wildly popular iPod, iPhone, and iPad. Or, you could decide that it was its dedicated employees, management’s wiliness to take calculated risks, or just plain luck – that Apple simply was in the right place at the right time.
Before we draw any conclusions about what made Apple what it is today and what will propel it into a successful future, you might like to learn more about Steve Jobs, the company’s cofounder and former CEO. Jobs was instrumental in the original design of the Apple I and, after being ousted from his position with the company, returned to save the firm from destruction and lead it onto its current path. Growing up, Jobs had an interest in computers. He attended lectures at Hewlett-Packard after school and worked for the company during the summer months. He took a job at Atari after graduating from high school and saved his money to make a pilgrimage to India in search of spiritual enlightenment. Following his India trip, he attended Steve Wozniak’s “Homebrew Computer Club” meetings, where the idea for building a personal computer surfaced.2 “Many colleagues describe Jobs as a brilliant man who could be a great motivator and positively charming. At the same time his drive for perfection was so strong that employees who did not meet his demands [were] faced with blistering verbal attacks.”3 Not everyone at Apple appreciated Jobs’ brilliance and ability to motivate. Nor did they all go along with his willingness to do whatever it took to produce an innovative, attractive, high-quality product. So at age thirty, Jobs found himself ousted from Apple by John Sculley, whom Jobs himself had hired as president of the company several years earlier. It seems that Sculley wanted to cut costs and thought it would be easier to do so without Jobs around. Jobs sold \$20 million of his stock and went on a two-month vacation to figure out what he would do for the rest of his life. His solution: start a new personal computer company called NextStep. In 1993, he was invited back to Apple (a good thing, because neither his new company nor Apple was doing well).
Steve Jobs was definitely not known for humility, but he was a visionary and had a right to be proud of his accomplishments. Some have commented that “Apple’s most successful days occurred with Steve Jobs at the helm.”4
Jobs did what many successful CEOs and managers do: he learned, adjusted, and improvised.5 Perhaps the most important statement that can be made about him is this: he never gave up on the company that once turned its back on him. So now you have the facts. Here’s a multiple-choice question that you’ll likely get right: Apple’s success is due to (a) its products, (b) its customers, (c) luck, (d) its willingness to take risks, (e) Steve Jobs, or (f) some combination of these options. | textbooks/biz/Business/Introductory_Business/Book%3A_Fundamentals_of_Business_(Skripak)/02%3A_The_Foundations_of_Business/2.00%3A_Prelude_-_Why_Is_Apple_Successful.txt |
As the story of Apple suggests, today is an interesting time to study business. Advances in technology are bringing rapid changes in the ways we produce and deliver goods and services. The Internet and other improvements in communication (such as smartphones, video conferencing, and social networking) now affect the way we do business. Companies are expanding international operations, and the workforce is more diverse than ever. Corporations are being held responsible for the behavior of their executives, and more people share the opinion that companies should be good corporate citizens. Because of the role they played in the worst financial crisis since the Great Depression, businesses today face increasing scrutiny and negative public sentiment.6
Economic turmoil that began in the housing and mortgage industries as a result of troubled subprime mortgages quickly spread to the rest of the economy. In 2008, credit markets froze up and banks stopped making loans. Lawmakers tried to get money flowing again by passing a \$700 billion Wall Street bailout, now-cautious banks became reluctant to extend credit. Without money or credit, consumer confidence in the economy dropped and consumers cut back on spending. Unemployment rose as troubled companies shed the most jobs in five years, and 760,000 Americans marched to the unemployment lines.7 The stock market reacted to the financial crisis and its stock prices dropped by 44 percent while millions of Americans watched in shock as their savings and retirement accounts took a nose dive. In fall 2008, even Apple, a company that had enjoyed strong sales growth over the past five years, began to cut production of its popular iPhone. Without jobs or cash, consumers would no longer flock to Apple’s fancy retail stores or buy a prized iPhone.8 Since then, things have turned around for Apple, which continues to report blockbuster sales and profits. But not all companies or individuals are doing so well. The economy is still struggling, unemployment is high (particularly for those ages 16 to 24), and home prices have not fully rebounded from the crisis.
As you go through the course with the aid of this text, you’ll explore the exciting world of business. We’ll introduce you to the various activities in which business people engage—accounting, finance, information technology, management, marketing, and operations. We’ll help you understand the roles that these activities play in an organization, and we’ll show you how they work together. We hope that by exposing you to the things that businesspeople do, we’ll help you decide whether business is right for you and, if so, what areas of business you’d like to study further.
2.02: New Page
A business is any activity that provides goods or services to consumers for the purpose of making a profit. Be careful not to confuse the terms revenue and profit. Revenue represents the funds an enterprise receives in exchange for its goods or services. Profit is what’s left (hopefully) after all the bills are paid. When Steve Jobs and Steve Wozniak launched the Apple I, they created Apple Computer in Jobs’ family garage in the hope of making a profit. Before we go on, let’s make a couple of important distinctions concerning the terms in our definitions. First, whereas Apple produces and sells goods (Mac, iPhone, iPod, iPad, Apple Watch), many businesses provide services. Your bank is a service company, as is your Internet provider. Hotels, airlines, law firms, movie theaters, and hospitals are also service companies. Many companies provide both goods and services. For example, your local car dealership sells goods (cars) and also provides services (automobile repairs). Second, some organizations are not set up to make profits. Many are established to provide social or educational services. Such not-for profit (or nonprofit), organizations include the United Way of America, Habitat for Humanity, the Boys and Girls Clubs, the Sierra Club, the American Red Cross, and many colleges and universities. Most of these organizations, however, function in much the same way as a business. They establish goals and work to meet them in an effective, efficient manner. Thus, most of the business principles introduced in this text also apply to nonprofits.
Query \(1\)
Business Participants and Activities
Let’s begin our discussion of business by identifying the main participants of business and the functions that most businesses perform. Then we’ll finish this section by discussing the external factors that influence a business’ activities.
Participants
Every business must have one or more owners whose primary role is to invest money in the business. When a business is being started, it’s generally the owners who polish the business idea and bring together the resources (money and people) needed to turn the idea into a business. The owners also hire employees to work for the company and help it reach its goals. Owners and employees depend on a third group of participants— customers. Ultimately, the goal of any business is to satisfy the needs of its customers in order to generate a profit for the owners.
Stakeholders
Consider your favorite restaurant. It may be an outlet or franchise of a national chain (more on franchises in a later chapter) or a local “mom and pop” without affiliation to a larger entity. Whether national or local, every business has stakeholders – those with a legitimate interest in the success or failure of the business and the policies it adopts. Stakeholders include customers, vendors, employees, landlords, bankers, and others (Figure \(1\)). All have a keen interest in how the business operates, in most cases for obvious reasons. If the business fails, employees will need new jobs, vendors will need new customers, and banks may have to write off loans they made to the business. Stakeholders do not always see things the same way – their interests sometimes conflict with each other. For example, lenders are more likely to appreciate high profit margins that ensure the loans they made will be repaid, while customers would probably appreciate the lowest possible prices. Pleasing stakeholders can be a real balancing act for any company.
Query \(1\) | textbooks/biz/Business/Introductory_Business/Book%3A_Fundamentals_of_Business_(Skripak)/02%3A_The_Foundations_of_Business/2.01%3A_Introduction.txt |
The activities needed to operate a business can be divided into a number of functional areas. Examples include: management, operations, marketing, accounting, and finance. Let’s briefly explore each of these areas.
Management
Managers are responsible for the work performance of other people. Management involves planning for, organizing, leading, and controlling a company’s resources so that it can achieve its goals. Managers plan by setting goals and developing strategies for achieving them. They organize activities and resources to ensure that company goals are met and staff the organization with qualified employees and managers lead them to accomplish organizational goals. Finally, managers design controls for assessing the success of plans and decisions and take corrective action when needed.
Operations
All companies must convert resources (labor, materials, money, information, and so forth) into goods or services. Some companies, such as Apple, convert resources into tangible products—Macs, iPhones, etc. Others, such as hospitals, convert resources into intangible products — e.g., health care. The person who designs and oversees the transformation of resources into goods or services is called an operations manager. This individual is also responsible for ensuring that products are of high quality.
Marketing
Marketing consists of everything that a company does to identify customers’ needs (i.e. market research) and design products to meet those needs. Marketers develop the benefits and features of products, including price and quality. They also decide on the best method of delivering products and the best means of promoting them to attract and keep customers. They manage relationships with customers and make them aware of the organization’s desire and ability to satisfy their needs.
Accounting
Managers need accurate, relevant and timely financial information, which is provided by accountants. Accountants measure, summarize, and communicate financial and managerial information and advise other managers on financial matters. There are two fields of accounting. Financial accountants prepare financial statements to help users, both inside and outside the organization, assess the financial strength of the company. Managerial accountants prepare information, such as reports on the cost of materials used in the production process, for internal use only.
Finance
Finance involves planning for, obtaining, and managing a company’s funds. Financial managers address such questions as the following: How much money does the company need? How and where will it get the necessary money? How and when will it pay the money back? What investments should be made in plant and equipment? How much should be spent on research and development? Good financial management is particularly important when a company is first formed, because new business owners usually need to borrow money to get started.
2.04: New Page
The activities needed to operate a business can be divided into a number of functional areas. Examples include: management, operations, marketing, accounting, and finance. Let’s briefly explore each of these areas.
Management
Managers are responsible for the work performance of other people. Management involves planning for, organizing, leading, and controlling a company’s resources so that it can achieve its goals. Managers plan by setting goals and developing strategies for achieving them. They organize activities and resources to ensure that company goals are met and staff the organization with qualified employees and managers lead them to accomplish organizational goals. Finally, managers design controls for assessing the success of plans and decisions and take corrective action when needed.
Operations
All companies must convert resources (labor, materials, money, information, and so forth) into goods or services. Some companies, such as Apple, convert resources into tangible products—Macs, iPhones, etc. Others, such as hospitals, convert resources into intangible products — e.g., health care. The person who designs and oversees the transformation of resources into goods or services is called an operations manager. This individual is also responsible for ensuring that products are of high quality.
Marketing
Marketing consists of everything that a company does to identify customers’ needs (i.e. market research) and design products to meet those needs. Marketers develop the benefits and features of products, including price and quality. They also decide on the best method of delivering products and the best means of promoting them to attract and keep customers. They manage relationships with customers and make them aware of the organization’s desire and ability to satisfy their needs.
Accounting
Managers need accurate, relevant and timely financial information, which is provided by accountants. Accountants measure, summarize, and communicate financial and managerial information and advise other managers on financial matters. There are two fields of accounting. Financial accountants prepare financial statements to help users, both inside and outside the organization, assess the financial strength of the company. Managerial accountants prepare information, such as reports on the cost of materials used in the production process, for internal use only.
Finance
Finance involves planning for, obtaining, and managing a company’s funds. Financial managers address such questions as the following: How much money does the company need? How and where will it get the necessary money? How and when will it pay the money back? What investments should be made in plant and equipment? How much should be spent on research and development? Good financial management is particularly important when a company is first formed, because new business owners usually need to borrow money to get started. | textbooks/biz/Business/Introductory_Business/Book%3A_Fundamentals_of_Business_(Skripak)/02%3A_The_Foundations_of_Business/2.03%3A_New_Page.txt |
Apple and other businesses don’t operate in a vacuum; they’re influenced by a number of external factors. These include the economy, government, consumer trends, technological developments, public pressure to act as good corporate citizens, and other factors. Collectively, these forces constitute what is known as the “macro environment” – essentially the big picture world external to a company over which the business exerts very little if any control. Figure 2.3 “Business and Its Environment” sums up the relationship between a business and the outside forces that influence its activities. One industry that’s clearly affected by all these factors is the fast-food industry. Companies such as Taco Bell, McDonald’s, Cook-Out and others all compete in this industry. A strong economy means people have more money to eat out. Food standards are monitored by a government agency, the Food and Drug Administration. Preferences for certain types of foods are influenced by consumer trends (fast food companies are being pressured to make their menus healthier). Finally, a number of decisions made by the industry result from its desire to be a good corporate citizen. For example, several fast-food chains have responded to environmental concerns by eliminating Styrofoam containers.9
Of course, all industries are impacted by external factors, not just the food industry. As people have become more conscious of the environment, they have begun to choose new technologies, like all-electric cars to replace those that burn fossil fuels. Both established companies, like Nissan with its Nissan Leaf, and brand new companies like Tesla have entered the market for all-electric vehicles. While the market is still small, it is expected to grow at a compound annual growth rate of 19.2% between 2013 and 2019.10
PESTEL Analysis
One useful tool for analyzing the external environment in which an industry or company operates is the PESTEL model. PESTEL is an acronym, with each of the letters representing an aspect of the macro-environment that a business needs to consider in its planning. Let’s briefly run through the meaning of each letter.
P stands for the political environment. Governments influence the environment in which businesses operate in many ways, including taxation, tariffs, trade agreements, labor regulations, and environmental regulations.
E represents the economic environment. As we will see in detail in a later chapter, whether the economy is growing or not is a major concern to business. Numerous economic indicators have been created for the specific purpose of measuring the health of the economy.
S indicates the sociocultural environment, which is a category that captures societal attitudes, trends in national demographics, and even fashion trends. The term demographics applies to any attribute that can be used to describe people, such as age, income level, gender, race, and so on. As a society’s attitudes or its demographics change, the market for goods and services can shift right along with it.
T is for technological factors. In the last several decades, perhaps no force has impacted business more than the emergence of the internet. Nearly instantaneous access to information, e-commerce, social media, and even the ability to control physical devices from remote locations have all come about due to technological forces.
The second E stands for environmental forces, which in this case means natural resources, pollution levels, recycling, etc. While the attitudes of a society towards the natural environment would be considered a sociocultural force, the level of pollution, the supply of oil, etc. would be grouped under this second E for environment.
Finally the L represents legal factors. These forces often coincide with the political factors already discussed, because it is politicians (i.e., government) that enacts laws. However, there are other legal factors that can impact businesses as well, such as decisions made by courts that may have broad implications beyond the case being decided.
When conducting PESTEL analysis, it is important to remember that there can be considerable overlap from category to category. It’s more important that businesses use the model to thoroughly assess its external environment, and much less important that they get all the forces covered under the “right” category. It is also important to remember that an individual force, in itself, is not inherently positive or negative but rather presents either an opportunity or a threat to different businesses. For example, societal attitudes moving in favor of green energy are an opportunity for those with capabilities in wind, solar, and other renewables, while presenting a threat, or at least a need to change, to companies whose business models depend exclusively on fossil fuels.
Query \(1\)
2.06: New Page
Key Takeaways
1. The main participants in a business are its owners, employees, and customers.
2. Every business must consider its stakeholders, and their sometimes conflicting interests, when making decisions.
3. The activities needed to run a business can be divided into functional The business functions correspond fairly closely to many majors found within a typical college of business.
4. Businesses are influenced by such externalfactors as the economy, government, and other forces external to the business. The PESTEL model is a useful tool for analyzing these forces. | textbooks/biz/Business/Introductory_Business/Book%3A_Fundamentals_of_Business_(Skripak)/02%3A_The_Foundations_of_Business/2.05%3A_New_Page.txt |
Learning Objectives
1. Describe the foundational philosophies of capitalism and socialism.
2. Discuss private property rights and why they are key to economic development.
3. Discuss the concept of GDP (gross domestic product).
4. Explain the difference between fiscal and monetary policy.
5. Discuss the concept of the unemployment rate measurement.
6. Discuss the concepts of inflation and deflation.
7. Explain other key terms related to this chapter including: supply; demand; equilibrium price; monopoly; recession; depression.
What is Economics?
To appreciate how a business functions, we need to know something about the economic environment in which it operates. We begin with a definition of economics and a discussion of the resources used to produce goods and services.
Resources: Inputs and Outputs
Economics is the study of the production, distribution, and consumption of goods and services. Resources are the inputs used to produce outputs. Resources may include any or all of the following:
• Land and other natural resources
• Labor (physical and mental)
• Capital, including buildings and equipment
• Entrepreneurship
• Knowledge
Resources are combined to produce goods and services. Land and natural resources provide the needed raw materials. Labor transforms raw materials into goods and services. Capital (equipment, buildings, vehicles, cash, and so forth) are needed for the production process. Entrepreneurship provides the skill, drive and creativity needed to bring the other resources together to produce a good or service to be sold to the marketplace.
Because a business uses resources to produce things, we also call these resources factors of production. The factors of production used to produce a shirt would include the following:
• The land that the shirt factory sits on, the electricity used to run the plant, and the raw cotton from which the shirts are made
• The laborers who make the shirts
• The factory and equipment used in the manufacturing process, as well as the money needed to operate the factory
• The entrepreneurship skills and production knowledge used to coordinate the other resources to make the shirts and distribute them to the marketplace
Input and Output Markets
Many of the factors of production are provided to businesses by households. For example, households provide businesses with labor (as workers), land and buildings (as landlords), and capital (as investors). In turn, businesses pay households for these resources by providing them with income, such as wages, rent, and interest. The resources obtained from households are then used by businesses to produce goods and services, which are sold to provide businesses with revenue. The revenue obtained by businesses is then used to buy additional resources, and the cycle continues. This is described in Figure 3.1 “The Circular Flow of Inputs and Outputs”, which illustrates the dual roles of households and businesses:
• Households not only provide factors of production (or resources) but also consume goods and services.
• Businesses not only buy resources but also produce and sell both goods and services
Economic Systems
Economists study the interactions between households and businesses and look at the ways in which the factors of production are combined to produce the goods and services that people need. Basically, economists try to answer three sets of questions:
• What goods and services should be produced to meet consumers’ needs? In what quantity? When?
• How should goods and services be produced? Who should produce them, and what resources, including technology, should be combined to produce them?
• Who should receive the goods and services produced? How should they be allocated among consumers?
The answers to these questions depend on a country’s economic system—the means by which a society (households, businesses, and government) makes decisions about allocating resources to produce products and about distributing those products. The degree to which individuals and business owners, as opposed to the government, enjoy freedom in making these decisions varies according to the type of economic system.
Generally speaking, economic systems can be divided into two systems: planned systems and free market systems.
Planned Systems
In a planned system, the government exerts control over the allocation and distribution of all or some goods and services. The system with the highest level of government control is communism. In theory, a communist economy is one in which the government owns all or most enterprises. Central planning by the government dictates which goods or services are produced, how they are produced, and who will receive them. In practice, pure communism is practically nonexistent today, and only a few countries (notably North Korea and Cuba) operate under rigid, centrally planned economic systems.
Under socialism, industries that provide essential services, such as utilities, banking, and health care, may be government owned. Some businesses may also be owned privately. Central planning allocates the goods and services produced by government-run industries and tries to ensure that the resulting wealth is distributed equally. In contrast, privately owned companies are operated for the purpose of making a profit for their owners. In general, workers in socialist economies work fewer hours, have longer vacations, and receive more health care, education, and child-care benefits than do workers in capitalist economies. To offset the high cost of public services, taxes are generally steep. Examples of countries that lean towards a socialistic approach include Venezuela, Sweden, and France.
Free Market System
The economic system in which most businesses are owned and operated by individuals is the free market system, also known as capitalism. In a free market economy, competition dictates how goods and services will be allocated. Business is conducted with more limited government involvement concentrated on regulations that dictate how businesses are permitted to operate. A key aspect of a free market system is the concept of private property rights, which means that business owners can expect to own their land, buildings, machines, etc., and keep the majority of their profits, except for taxes. The profit incentive is a key driver of any free market system. The economies of the United States and other countries, such as Japan, are based on capitalism. However, a purely capitalistic economy is as rare as one that is purely communist. Imagine if a service such as police protection, one provided by government in the United States, were instead allocated based on market forces. The ability to pay would then become a key determinant in who received these services, an outcome that few in American society would consider to be acceptable.
How Economic Systems Compare
In comparing economic systems, it can be helpful to think of a continuum with communism at one end and pure capitalism at the other, as in Figure 3.2 on the next page. As you move from left to right, the amount of government control over business diminishes. So, too, does the level of social services, such as health care, child-care services, social security, and unemployment benefits. Moving from left to right, taxes are correspondingly lower as well.
Mixed Market Economies
Though it’s possible to have a pure communist system, or a pure capitalist (free market) system, in reality many economic systems are mixed. A mixed market economy relies on both markets and the government to allocate resources. In practice, most economies are mixed, with a leaning towards either free market or socialistic principles, rather than being purely one or the other. Some previously communist economies, such as those of Eastern Europe and China, are becoming more mixed as they adopt more capitalistic characteristics and convert businesses previously owned by the government to private ownership through a process called privatization. By contrast, Venezuela is a country that has moved increasingly towards socialism, taking control of industries such as oil and media through a process called nationalization.
The U.S. Economic System
Like most countries, the United States features a mixed market system: though the U.S. economic system is primarily a free market system, the federal government controls some basic services, such as the postal service and air traffic control. The U.S. economy also has some characteristics of a socialist system, such as providing social security retirement benefits to retired workers.
The free market system was espoused by Adam Smith in his book The Wealth of Nations, published in 1776. According to Smith, competition alone would ensure that consumers received the best products at the best prices. In the kind of competition he assumed, a seller who tries to charge more for his product than other sellers would not be able to find any buyers. A job-seeker who asks more than the going wage won’t be hired. Because the “invisible hand” of competition will make the market work effectively, there won’t be a need to regulate prices or wages. Almost immediately, however, a tension developed among free market theorists between the principle of laissez-faire—leaving things alone—and government intervention. Today, it’s common for the U.S. government to intervene in the operation of the economic system. For example, government exerts influence on the food and pharmaceutical industries through the Food and Drug Administration, which protects consumers by preventing unsafe or mislabeled products from reaching the market.
To appreciate how businesses operate, we must first get an idea of how prices are set in competitive markets. The next section, “Perfect Competition and Supply and Demand,” begins by describing how markets establish prices in an environment of perfect competition.
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Perfect Competition and Supply and Demand
Under a mixed economy, such as we have in the United States, businesses make decisions about which goods to produce or services to offer and how they are priced. Because there are many businesses making goods or providing services, customers can choose among a wide array of products. The competition for sales among businesses is a vital part of our economic system. Economists have identified four types of competition—perfect competition, monopolistic competition, oligopoly, and monopoly. We’ll introduce the first of these—perfect competition—in this section and cover the remaining three in the following section.
Perfect Competition
Perfect competition exists when there are many consumers buying a standardized product from numerous small businesses. Because no seller is big enough or influential enough to affect price, sellers and buyers accept the going price. For example, when a commercial fisher brings his fish to the local market, he has little control over the price he gets and must accept the going market price.
The Basics of Supply and Demand
To appreciate how perfect competition works, we need to understand how buyers and sellers interact in a market to set prices. In a market characterized by perfect competition, price is determined through the mechanisms of supply and demand. Prices are influenced both by the supply of products from sellers and by the demand for products by buyers.
To illustrate this concept, let’s create a supply and demand schedule for one particular good sold at one point in time. Then we’ll define demand and create a demand curve and define supply and create a supply curve. Finally, we’ll see how supply and demand interact to create an equilibrium price—the price at which buyers are willing to purchase the amount that sellers are willing to sell.
Demand and the Demand Curve
Demand is the quantity of a product that buyers are willing to purchase at various prices. The quantity of a product that people are willing to buy depends on its price. You’re typically willing to buy less of a product when prices rise and more of a product when prices fall. Generally speaking, we find products more attractive at lower prices, and we buy more at lower prices because our income goes further.
Using this logic, we can construct a demand curve that shows the quantity of a product that will be demanded at different prices. Let’s assume that the diagram in Figure 3.3 “The Demand Curve” represents the daily price and quantity of apples sold by farmers at a local market. Note that as the price of apples goes down, buyers’ demand goes up. Thus, if a pound of apples sells for \$0.80, buyers will be willing to purchase only fifteen hundred pounds per day. But if apples cost only \$0.60 a pound, buyers will be willing to purchase two thousand pounds. At \$0.40 a pound, buyers will be willing to purchase twenty-five hundred pounds.
Supply and the Supply Curve
Supply is the quantity of a product that sellers are willing to sell at various prices. The quantity of a product that a business is willing to sell depends on its price. Businesses are more willing to sell a product when the price rises and less willing to sell it when prices fall. Again, this fact makes sense: businesses are set up to make profits, and there are larger profits to be made when prices are high.
Now we can construct a supply curve that shows the quantity of apples that farmers would be willing to sell at different prices, regardless of demand. As you can see in Figure 3.4 “The Supply Curve”, the supply curve goes in the opposite direction from the demand curve: as prices rise, the quantity of apples that farmers are willing to sell also goes up. The supply curve shows that farmers are willing to sell only a thousand pounds of apples when the price is \$0.40 a pound, two thousand pounds when the price is \$0.60, and three thousand pounds when the price is \$0.80.
Equilibrium Price
We can now see how the market mechanism works under perfect competition. We do this by plotting both the supply curve and the demand curve on one graph, as we’ve done in Figure 3.5 “The Equilibrium Price”. The point at which the two curves intersect is the equilibrium price.
You can see in Figure 3.5 “The Equilibrium Price” that the supply and demand curves intersect at the price of \$0.60 and quantity of two thousand pounds. Thus, \$0.60 is the equilibrium price: at this price, the quantity of apples demanded by buyers equals the quantity of apples that farmers are willing to supply. If a single farmer tries to charge more than \$0.60 for a pound of apples, he won’t sell very many because other suppliers are making them available for less. As a result, his profits will go down. If, on the other hand, a farmer tries to charge less than the equilibrium price of \$0.60 a pound, he will sell more apples but his profit per pound will be less than at the equilibrium price. With profit being the motive, there is no incentive to drop the price.
What have we learned in this discussion? Without outside influences, markets in an environment of perfect competition will arrive at an equilibrium point at which both buyers and sellers are satisfied. But we must be aware that this is a very simplistic example. Things are more complex in the real world. For one thing, markets don’t always operate without outside influences. For example, if a government set an artificially low price ceiling on a product to keep consumers happy, we would not expect producers to produce enough to satisfy demand, resulting in a shortage. If government set prices high to assist an industry, sellers would likely supply more of a product than buyers need; in that case, there would be a surplus.
Circumstances also have a habit of changing. What would happen, for example, if incomes rose and buyers were willing to pay more for apples? The demand curve would change, resulting in an increase in equilibrium price. This outcome makes intuitive sense: as demand increases, prices will go up. What would happen if apple crops were larger than expected because of favorable weather conditions? Farmers might be willing to sell apples at lower prices rather than letting part of the crop spoil. If so, the supply curve would shift, resulting in another change in equilibrium price: the increase in supply would bring down prices.
Monopolistic Competition, Oligopoly, and Monopoly
As mentioned previously, economists have identified four types of competition—perfect competition, monopolistic competition, oligopoly, and monopoly. Perfect competition was discussed in the last section; we’ll cover the remaining three types of competition here.
Monopolistic Competition
In monopolistic competition, we still have many sellers (as we had under perfect competition). Now, however, they don’t sell identical products. Instead, they sell differentiated products—products that differ somewhat, or are perceived to differ, even though they serve a similar purpose. Products can be differentiated in a number of ways, including quality, style, convenience, location, and brand name. An example in this case might be toothpaste. Although many people are fiercely loyal to their favorites, most products in this category are quite similar and address the same consumer need. But what if there was a substantial price difference among products? In that case, many buyers would likely be persuaded to switch brands, at least on a trial basis.
How is product differentiation accomplished? Sometimes, it’s simply geographical; you probably buy gasoline at the station closest to your home regardless of the brand. At other times, perceived differences between products are promoted by advertising designed to convince consumers that one product is different from an- other—and better than it. Regardless of customer loyalty to a product, however, if its price goes too high, the seller will lose business to a competitor. Under monopolistic competition, therefore, companies have only limited control over price.
Oligopoly
Oligopoly means few sellers. In an oligopolistic market, each seller supplies a large portion of all the products sold in the marketplace. In addition, because the cost of starting a business in an oligopolistic industry is usually high, the number of firms entering it is low. Companies in oligopolistic industries include such large-scale enterprises as automobile companies and airlines. As large firms supplying a sizable portion of a market, these companies have some control over the prices they charge. But there’s a catch: because products are fairly similar, when one company lowers prices, others are often forced to follow suit to remain competitive. You see this practice all the time in the airline industry: When American Airlines announces a fare decrease, Continental, United Airlines, and others do likewise. When one automaker offers a special deal, its competitors usually come up with similar promotions.
Monopoly
In terms of the number of sellers and degree of competition, a monopoly lies at the opposite end of the spectrum from perfect competition. In perfect competition, there are many small companies, none of which can control prices; they simply accept the market price determined by supply and demand. In a monopoly, however, there’s only one seller in the market. The market could be a geographical area, such as a city or a regional area, and doesn’t necessarily have to be an entire country.
There are few monopolies in the United States because the government limits them. Most fall into one of two categories: natural and legal. Natural monopolies include public utilities, such as electricity and gas suppliers. Such enterprises require huge investments, and it would be inefficient to duplicate the products that they provide. They inhibit competition, but they’re legal because they’re important to society. In exchange for the right to conduct business without competition, they’re regulated. For instance, they can’t charge whatever prices they want, but they must adhere to government-controlled prices. As a rule, they’re required to serve all customers, even if doing so isn’t cost efficient.
A legal monopoly arises when a company receives a patent giving it exclusive use of an invented product or process. Patents are issued for a limited time, generally twenty years.1 During this period, other companies can’t use the invented product or process without permission from the patent holder. Patents allow companies a certain period to recover the heavy costs of researching and developing products and technologies. A classic example of a company that enjoyed a patent-based legal monopoly is Polaroid, which for years held exclusive ownership of instant-film technology.2 Polaroid priced the product high enough to recoup, over time, the high cost of bringing it to market. Without competition, in other words, it enjoyed a monopolistic position in regard to pricing.
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Measuring the Health of the Economy
Every day, we are bombarded with economic news (at least if you watch the business news stations). We’re told about things like unemployment, home prices, and consumer confidence trends. As a student learning about business, and later as a business manager, you need to understand the nature of the U.S. economy and the terminology that we use to describe it. You need to have some idea of where the economy is heading, and you need to know something about the government’s role in influencing its direction.
Economic Goals
The world’s economies share three main goals:
• Growth
• High employment
• Price stability
Let’s take a closer look at each of these goals, both to find out what they mean and to show how we determine whether they’re being met.
Economic Growth
One purpose of an economy is to provide people with goods and services—cars, computers, video games, houses, rock concerts, fast food, amusement parks. One way in which economists measure the performance of an economy is by looking at a widely used measure of total output called the gross domestic product (GDP). The GDP is defined as the market value of all goods and services produced by the economy in a given year. The GDP includes only those goods and services produced domestically; goods produced outside the country are excluded. The GDP also includes only those goods and services that are produced for the final user; intermediate products are excluded. For example, the silicon chip that goes into a computer (an intermediate product) would not count directly because it is included when the finished computer is counted. By itself, the GDP doesn’t necessarily tell us much about the direction of the economy. But change in the GDP does. If the GDP (after adjusting for inflation, which will be discussed later) goes up, the economy is growing. If it goes down, the economy is contracting.
The Business Cycle
The economic ups and downs resulting from expansion and contraction constitute the business cycle. A typical cycle runs from three to five years but could last much longer. Though typically irregular, a cycle can be divided into four general phases of prosperity, recession, depression (which the cycle generally skips), and recovery:
• During prosperity, the economy expands, unemployment is low, in- comes rise, and consumers buy more products. Businesses respond by increasing production and offering new and better products.
• Eventually, however, things slow down. GDP decreases, unemployment rises, and because people have less money to spend, business revenues decline. This slowdown in economic activity is called a recession.
• Economists often say that we’re entering a recession when GDP goes down for two consecutive quarters.
• Generally, a recession is followed by a recovery in which the economy starts growing again.
• If, however, a recession lasts a long time (perhaps a decade or so), while unemployment remains very high and production is severely curtailed, the economy could sink into a depression. Unlike for the term recession, economists have not agreed on a uniform standard for what constitutes a depression, though they are generally characterized by their duration. Though not impossible, it’s unlikely that the United States will experience another severe depression like that of the 1930s. The federal government has a number of economic tools (some of which we’ll discuss shortly) with which to fight any threat of a depression.
Full Employment
To keep the economy going strong, people must spend money on goods and services. A reduction in personal expenditures for things like food, clothing, appliances, automobiles, housing, and medical care could severely reduce GDP and weaken the economy. Because most people earn their spending money by working, an important goal of all economies is making jobs available to everyone who wants one. In principle, full employment occurs when everyone who wants to work has a job. In practice, we say that we have full employment when about 95 percent of those wanting to work are employed.
The Unemployment Rate
The U.S. Department of Labor tracks unemployment and reports the unemployment rate: the percentage of the labor force that’s unemployed and actively seeking work. The unemployment rate is an important measure of economic health. It goes up during recessionary periods because companies are reluctant to hire workers when demand for goods and services is low. Conversely, it goes down when the economy is expanding and there is high demand for products and workers to supply them.
Figure 3.6 “The U.S. Unemployment Rate, 1970–2010” traces the U.S. unemployment rate between 1970 and 2010. Please be aware that there are multiple measures of unemployment and that this graph is based on what is known as U3, the most commonly used measurement. Another measurement, U6, is considered to provide a broader picture of unemployment in the United States. It includes two groups of people that U3 doesn’t: those who are not actively looking for work but would like a job and have looked for one in the last 12 months; and those who would like to work full-time jobs but have settled for part-time positions because full-time work was not available to them. Since by definition, U6 is always higher than U3, it is likely that U3 is discussed more often because it paints a more favorable, if not completely accurate, picture.
Price Stability
A third major goal of all economies is maintaining price stability. Price stability occurs when the average of the prices for goods and services either doesn’t change or changes very little. Rapidly rising prices are troublesome for both individuals and businesses. For individuals, rising prices mean people have to pay more for the things they need. For businesses, rising prices mean higher costs, and, at least in the short run, businesses might have trouble passing on higher costs to consumers. When the overall price level goes up, we have inflation. Figure 3.7 “The U.S. Inflation Rate, 1960–2010” shows inflationary trends in the U.S. economy since 1960. When the price level goes down (which rarely happens), we have deflation. A deflationary situation can also be damaging to an economy. When purchasers believe they can expect lower prices in the future, they may defer making purchases, which has the effect of slowing economic growth (GDP) accompanied by a rise in unemployment. Japan experienced a long period of deflation which contributed to economic stagnation in that country from which it is only now beginning to recover.
The Consumer Price Index
The most widely publicized measure of inflation is the consumer price index (CPI), which is reported monthly by the Bureau of Labor Statistics. The CPI measures the rate of inflation by determining price changes of a hypothetical basket of goods, such as food, housing, clothing, medical care, appliances, automobiles, and so forth, bought by a typical household.
The CPI base period is 1982 to 1984, which has been given an average value of 100. Figure 3.8 “Selected CPI Values, 1950–2010” gives CPI values computed for selected years. The CPI value for 1950, for instance, is 24. This means that \$1 of typical purchases in 1982 through 1984 would have cost \$0.24 in 1950. Conversely, you would have needed \$2.18 to purchase the same \$1 worth of typical goods in 2010. The difference registers the effect of inflation. In fact, that’s what an inflation rate is—the percentage change in a price index.
Economic Forecasting
In the previous section, we introduced several measures that economists use to assess the performance of the economy at a given time. By looking at changes in the GDP, for instance, we can see whether the economy is growing. The CPI allows us to gauge inflation. These measures help us understand where the economy stands today. But what if we want to get a sense of where it’s headed in the future? To a certain extent, we can forecast future economic trends by analyzing several leading economic indicators.
Economic Indicators
An economic indicator is a statistic that provides valuable information about the economy. There’s no shortage of economic indicators, and trying to follow them all would be an overwhelming task. So in this chapter, we’ll only discuss the general concept and a few of the key indicators.
Lagging and Leading Indicators
Economists use a variety of statistics to discuss the health of an economy. Statistics that report the status of the economy looking at past data are called lagging economic indicators. This type of indicator looks at trends to determine how strong an economy is and its direction. One such indicator is average length of unemployment. If unemployed workers have remained out of work for a long time, we may infer that the economy has been slow. Another lagging indicator is GDP growth. Even if the last several quarters have followed the same trend, though, there is no way to say with confidence that such a trend will necessarily continue.
Indicators that predict the status of the economy three to twelve months into the future are called leading economic indicators. If such an indicator rises, the economy is more likely to expand in the coming year. If it falls, the economy is more likely to contract. An example of a leading indicator is the number of permits obtained to build homes in a particular time period. If people intend to build more homes, they will be buying materials like lumber and appliances, and also employ construction workers. This type of indicator has a direct predictive value since it tells us something about what level of activity is likely in a future period.
In addition to housing, it is also helpful to look at indicators from sectors like labor and manufacturing. One useful indicator of the outlook for future jobs is the number of new claims for unemployment insurance. This measure tells us how many people recently lost their jobs. If it’s rising, it signals trouble ahead because unemployed consumers can’t buy as many goods and services as they could if they had paychecks. To gauge the level of goods to be produced in the future (which will translate into future sales), economists look at a statistic called average weekly manufacturing hours. This measure tells us the average number of hours worked per week by production workers in manufacturing industries. If it’s on the rise, the economy will probably improve.
Since employment is such a key goal in any economy, the Bureau of Labor Statistics tracks total non-farm payroll employment from which the number of net new jobs created can be determined.
The Conference Board also publishes a consumer confidence index based on results of a monthly survey of five thousand U.S. households. The survey gathers consumers’ opinions on the health of the economy and their plans for future purchases. It’s often a good indicator of consumers’ future buying intent.
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Government’s Role in Managing the Economy
Monetary Policy
Monetary policy is exercised by the Federal Reserve System (“the Fed”), which is empowered to take various actions that decrease or increase the money supply and raise or lower short-term interest rates, making it harder or easier to borrow money. When the Fed believes that inflation is a problem, it will use contractionary policy to decrease the money supply and raise interest rates. When rates are higher, borrowers have to pay more for the money they borrow, and banks are more selective in making loans. Because money is “tighter”—more expensive to borrow—demand for goods and services will go down, and so will prices. In any case, that’s the theory.
The Fed will typically tighten or decrease the money supply during inflationary periods, making it harder to borrow money.
To counter a recession, the Fed uses expansionary policy to increase the money supply and reduce interest rates. With lower interest rates, it’s cheaper to borrow money, and banks are more willing to lend it. We then say that money is “easy.” Attractive interest rates encourage businesses to borrow money to expand production and encourage consumers to buy more goods and services. In theory, both sets of actions will help the economy escape or come out of a recession.
Fiscal Policy
Fiscal policy relies on the government’s powers of spending and taxation. Both taxation and government spending can be used to reduce or increase the total supply of money in the economy—the total amount, in other words, that businesses and consumers have to spend. When the country is in a recession, government policy is typically to increase spending, reduce taxes, or both. Such expansionary actions will put more money in the hands of businesses and consumers, encouraging businesses to expand and consumers to buy more goods and services. When the economy is experiencing inflation, the opposite policy is adopted: the government will decrease spending or increase taxes, or both. Because such contractionary measures reduce spending by businesses and consumers, prices come down and inflation eases.
The National Debt
If, in any given year, the government takes in more money (through taxes) than it spends on goods and services (for things such as defense, transportation, and social services), the result is a budget surplus. If, on the other hand, the government spends more than it takes in, we have a budget deficit (which the government pays off by borrowing through the issuance of Treasury bonds). Historically, deficits have occurred much more often than surpluses; typically, the government spends more than it takes in. Consequently, the U.S. government now has a total national debt of more than \$19 trillion (Note: This number is moving too quickly for the authors to keep the graph current – you can see the current debt at www.usdebtclock.org/).
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Chapter Video
This video presents a balanced view of capitalism and socialism and reinforces key points within the chapter. Since it is rather dry, it would be fine to watch only the first seven minutes or so.
A YouTube element has been excluded from this version of the text. You can view it online here: pb.libretexts.org/biz3/?p=52
(Copyrighted material)
Key Takeaways
1. Economics is the study of the production, distribution, and consumption of goods and services.
2. Economists address these three questions: (1) What goods and services should be produced to meet consumer needs? (2) How should they be produced, and who should produce them? (3) Who should receive goods and services?
3. The answers to these questions depend on a country’s economic system. The primary economic systems that exist today are planned and free-market systems.
4. In a planned system, such as communism and socialism, the government exerts control over the production and distribution of all or some goods and services.
5. In a free-market system, also known as capitalism, business is conducted with limited government involvement. Competition determines what goods and services are produced, how they are produced, and for whom.
6. When the market is characterized by perfect competition, many small companies sell identical products. The price is determined by supply and demand. Commodities like corn are an excellent example.
7. Supply is the quantity of a product that sellers are willing to sell at various prices. Producers will supply more of a product when prices are high and less when they’re low.
8. Demand is the quantity of a product that buyers are willing to purchase at various prices; they’ll buy more when the price is low and less when it’s high.
9. In a competitive market, the decisions of buyers and sellers interact until the market reaches an equilibrium price—the price at which buyers are willing to buy the same amount that sellers are willing to sell.
10. There are three other types of competition in a free market system: monopolistic competition, oligopoly, and monopoly.
11. In monopolistic competition, there are still many sellers, but products are differentiated, e., differ slightly but serve similar purposes. By making consumers aware these differences, sellers exert some control over price.
12. In an oligopoly, a few sellers supply a sizable portion of products in the market. They exert some control over price, but because their products are similar, when one company lowers prices, the others follow.
13. In a monopoly, there is only one seller in the market. The “market” could be a specific geographical area, such as a city. The single seller is able to control prices.
14. All economies share three goals: growth, high employment, and price stability.
15. To get a sense of where the economy is headed in the future, we use statistics called economic indicators. Indicators that report the status of the economy a few months in the past are lagging Those that predict the status of the economy three to twelve months in the future are called leading indicators.
Chapter 3 Text References and Image Credits
Image Credits: Chapter 3
Figure 3.6: “The U.S. Unemployment Rate, 1970-2014.” Data source: Bureau of Labor Statistics. Retrieved from: http://data.bls.gov/timeseries/LNS14000000.
Figure 3.7: “The U.S. Inflation Rate, 1960-2014.” Data source: The World Bank. Retrieved from: http://data.worldbank.org/indicator/FP.CPI.TOTL.ZG.
Figure 3.8: “Selected CPI Values, 1950-2014.” Data source: U.S. Infaltion Calculator. Retrieved from: http://www.usinflationcalculator.com/inflation/consumer-price-index-and-annual-percent-changes-from-1913-to-2008/.
Figure 3.9: “The National Debt, 1940-2014.” Data Source: Treasury Direct. Retrieved from: https://www.treasurydirect.gov/govt/reports/pd/histdebt/histdebt.htm.
Video Credits: Chapter 3
Seralius, Guyus. “Capitalism vs Socialism-A Balanced Approach.” February 20, 2013. Retrieved from: https://www.youtube.com/watch?v=PBIXmXJwIuk | textbooks/biz/Business/Introductory_Business/Book%3A_Fundamentals_of_Business_(Skripak)/03%3A_Economics_and_Business.txt |
Learning Objectives
1. Define business ethics and explain what it means to act ethically in business.
2. Explain why we study business ethics.
3. Identify ethical issues that you might face in business, such as insider trading, conflicts of interest, and bribery, and explain rationalizations for unethical behavior.
4. Identify steps you can take to maintain your honesty and integrity in a business environment.
5. Define corporate social responsibility and explain how organizations are responsible to their stakeholders, including owners, employees, customers, and the community.
6. Discuss how you can identify an ethical organization, and how organizations can prevent behavior like sexual harassment.
7. Learn how to avoid an ethical lapse, and why you should not rationalize when making decisions.
Introduction
“Mommy, Why Do You Have to Go to Jail?”
The one question Betty Vinson would have preferred to avoid is “Mommy, why do you have to go to jail?”1 Vinson graduated with an accounting degree from Mississippi State and married her college sweetheart. After a series of jobs at small banks, she landed a mid-level accounting job at WorldCom, at the time still a small long-distance provider. Sparked by the telecom boom, however, WorldCom soon became a darling of Wall Street, and its stock price soared. Now working for a wildly successful company, Vinson rounded out her life by reading legal thrillers and watching her daughter play soccer.
Her moment of truth came in mid-2000, when company executives learned that profits had plummeted. They asked Vinson to make some accounting adjustments to boost income by \$828 million. Vinson knew that the scheme was unethical (at the very least) but she gave in and made the adjustments. Almost immediately, she felt guilty and told her boss that she was quitting. When news of her decision came to the attention of CEO Bernard Ebbers and CFO Scott Sullivan, they hastened to assure Vinson that she’d never be asked to cook any more books. Sullivan explained it this way: “We have planes in the air. Let’s get the planes landed. Once they’ve landed, if you still want to leave, then leave. But not while the planes are in the air.”2 Besides, she’d done nothing illegal, and if anyone asked, he’d take full responsibility. So Vinson decided to stay. After all, Sullivan was one of the top CFOs in the country; at age thirty-seven, he was already making \$19 million a year.3 Who was she to question his judgment?4
Six months later, Ebbers and Sullivan needed another adjustment—this time for \$771 million. This scheme was even more unethical than the first: it entailed forging dates to hide the adjustment. Pretty soon, Vinson was making adjustments on a quarterly basis—first for \$560 million, then for \$743 million, and yet again for \$941 million. Eventually, Vinson had juggled almost \$4 billion, and before long, the stress started to get to her: she had trouble sleeping, lost weight, and withdrew from people at work. She decided to hang on when she got a promotion and a \$30,000 raise.
By spring 2002, however, it was obvious that adjusting the books was business as usual at WorldCom. Vinson finally decided that it was time to move on, but, unfortunately, an internal auditor had already put two and two together and blown the whistle. The Securities and Exchange Commission charged WorldCom with fraud amounting to \$11 billion—the largest in U.S. history. Seeing herself as a valuable witness, Vinson was eager to tell what she knew. The government, however, regarded her as more than a mere witness. When she was named a co-conspirator, she agreed to cooperate fully and pleaded guilty to criminal conspiracy and securities fraud. But she won’t be the only one doing time: Scott Sullivan will be in jail for five years, and Bernie Ebbers will be locked up for twenty-five years. Both maintain that they are innocent.5
So where did Betty Vinson, mild-mannered midlevel executive and mother, go wrong? How did she manage to get involved in a scheme that not only bilked investors out of billions but also cost seventeen thousand people their jobs?6 Ultimately, of course, we can only guess. Maybe she couldn’t say no to her bosses; perhaps she believed that they’d take full responsibility for her accounting “adjustments.” Possibly she was afraid of losing her job or didn’t fully understand the ramifications of what she was doing. What we do know is that she disgraced herself and went to jail.7
The WorldCom situation is not an isolated incident. Perhaps you have heard of Bernie Madoff, founder of Bernard L. Madoff Investment Securities and former chairman of the NASDAQ stock exchange.8 Madoff is alleged to have run a giant Ponzi scheme9 that cheated investors of up to \$65 billion. His wrongdoings won him a spot at the top of Time Magazine’s Top 10 Crooked CEOs. According to the SEC charges, Madoff convinced investors to give him large sums of money. In return, he gave them an impressive 8 percent to 12 percent return a year. But Madoff never really invested their money. Instead, he kept it for himself. He got funds to pay the first investors their return (or their money back if they asked for it) by bringing in new investors. Everything was going smoothly until the fall of 2008, when the stock market plummeted and many of his investors asked for their money. As he no longer had it, the game was over and he had to admit that the whole thing was just one big lie. Thousands of investors, including many of his wealthy friends, not-so-rich retirees who trusted him with their life savings, and charitable foundations, were financially ruined. Those harmed by Madoff either directly or indirectly were likely pleased when he was sentenced to jail for one-hundred and fifty years.
What is Business Ethics?
The Idea of Business Ethics
It’s in the best interest of a company to operate ethically. Trustworthy companies are better at attracting and keeping customers, talented employees, and capital. Those tainted by questionable ethics suffer from dwindling customer bases, employee turnover, and investor mistrust.
Let’s begin this section by addressing this question: What can individuals, organizations, and government agencies do to foster an environment of ethical behavior in business? First, of course, we need to define the term.
What Is Ethics?
You probably already know what it means to be ethical: to know right from wrong and to know when you’re practicing one instead of the other. We can say that business ethics is the application of ethical behavior in a business context. Acting ethically in business means more than simply obeying applicable laws and regulations: It also means being honest, doing no harm to others, competing fairly, and declining to put your own interests above those of your company, its owners, and its workers. If you’re in business you obviously need a strong sense of what’s right and wrong. You need the personal conviction to do what’s right, even if it means doing something that’s difficult or personally disadvantageous.
Why Study Ethics?
Ideally, prison terms, heavy fines, and civil suits would discourage corporate misconduct, but, unfortunately, many experts suspect that this assumption is a bit optimistic. Whatever the condition of the ethical environment in the near future, one thing seems clear: the next generation entering business—which includes most of you—will find a world much different than the one that waited for the previous generation. Recent history tells us in no uncertain terms that today’s business students, many of whom are tomorrow’s business leaders, need a much sharper understanding of the difference between what is and isn’t ethically acceptable. As a business student, one of your key tasks is learning how to recognize and deal with the ethical challenges that will confront you. Asked what he looked for in a new hire, Warren Buffet, the world’s most successful investor, replied: “I look for three things. The first is personal integrity, the second is intelligence, and the third is a high energy level.” He paused and then added: “But if you don’t have the first, the second two don’t matter.”10
Identifying Ethical Issues and Dilemmas
Ethical issues are the difficult social questions that involve some level of controversy over what is the right thing to do. Environmental protection is an example of a commonly discussed ethical issue, because there can be tradeoffs between environmental and economic factors.
Ethical dilemmas are situations in which it is difficult for an individual to make decisions either because the right course of action is unclear or carries some potential negative consequences for the person or people involved.
Make no mistake about it: when you enter the business world, you’ll find yourself in situations in which you’ll have to choose the appropriate behavior. How, for example, would you answer questions like the following?
1. Is it OK to accept a pair of sports tickets from a supplier?
2. Can I buy office supplies from my brother-in-law?
3. Is it appropriate to donate company funds to a local charity?
4. If I find out that a friend is about to be fired, can I warn her?
Obviously, the types of situations are numerous and varied. Fortunately, we can break them down into a few basic categories: issues of honesty and integrity, conflicts of interest and loyalty, bribes versus gifts, and whistle-blowing. Let’s look a little more closely at each of these categories.
Issues of Honesty and Integrity
Master investor Warren Buffet once told a group of business students the following: “I cannot tell you that honesty is the best policy. I can’t tell you that if you behave with perfect honesty and integrity somebody somewhere won’t behave the other way and make more money. But honesty is a good policy. You’ll do fine, you’ll sleep well at night and you’ll feel good about the example you are setting for your coworkers and the other people who care about you.”11
If you work for a company that settles for its employees’ merely obeying the law and following a few internal regulations, you might think about moving on. If you’re being asked to deceive customers about the quality or value of your product, you’re in an ethically unhealthy environment.
Think about this story:
“A chef put two frogs in a pot of warm soup water. The first frog smelled the onions, recognized the danger, and immediately jumped out. The second frog hesitated: The water felt good, and he decided to stay and relax for a minute. After all, he could always jump out when things got too hot (so to speak). As the water got hotter, however, the frog adapted to it, hardly noticing the change. Before long, of course, he was the main ingredient in frog-leg soup.”12
So, what’s the moral of the story? Don’t sit around in an ethically toxic environment and lose your integrity a little at a time; get out before the water gets too hot and your options have evaporated. Fortunately, a few rules of thumb can guide you.
We’ve summed them up in Figure 4.2.
Conflicts of Interest
Conflicts of interest occur when individuals must choose between taking actions that promote their personal interests over the interests of others or taking actions that don’t. A conflict can exist, for example, when an employee’s own interests interfere with, or have the potential to interfere with, the best interests of the company’s stakeholders (management, customers, and owners). Let’s say that you work for a company with a contract to cater events at your college and that your uncle owns a local bakery. Obviously, this situation could create a conflict of interest (or at least give the appearance of one—which is a problem in itself). When you’re called on to furnish desserts for a luncheon, you might be tempted to send some business your uncle’s way even if it’s not in the best interest of your employer. What should you do? You should disclose the connection to your boss, who can then arrange things so that your personal interests don’t conflict with the company’s.
The same principle holds that an employee shouldn’t use private information about an employer for personal financial benefit. Say that you learn from a coworker at your pharmaceutical company that one of its most profitable drugs will be pulled off the market because of dangerous side effects. The recall will severely hurt the company’s financial performance and cause its stock price to plummet. Before the news becomes public, you sell all the stock you own in the company. What you’ve done is called insider trading – acting on information that is not available to the general public, either by trading on it or providing it to others who trade on it. Insider trading is illegal, and you could go to jail for it.
Conflicts of Loyalty
You may one day find yourself in a bind between being loyal either to your employer or to a friend or family member. Perhaps you just learned that a coworker, a friend of yours, is about to be downsized out of his job. You also happen to know that he and his wife are getting ready to make a deposit on a house near the company headquarters. From a work standpoint, you know that you shouldn’t divulge the information. From a friendship standpoint, though, you feel it’s your duty to tell your friend. Wouldn’t he tell you if the situation were reversed? So what do you do? As tempting as it is to be loyal to your friend, you shouldn’t tell. As an employee, your primary responsibility is to your employer. You might be able to soften your dilemma by convincing a manager with the appropriate authority to tell your friend the bad news before he puts down his deposit.
Bribes versus Gifts
It’s not uncommon in business to give and receive small gifts of appreciation, but when is a gift unacceptable? When is it really a bribe?
There’s often a fine line between a gift and a bribe. The following information may help in drawing it, because it raises key issues in determining how a gesture should be interpreted: the cost of the item, the timing of the gift, the type of gift, and the connection between the giver and the receiver. If you’re on the receiving end, it’s a good idea to refuse any item that’s overly generous or given for the purpose of influencing a decision. Because accepting even small gifts may violate company rules, always check on company policy.
JCPenney’s “Statement of Business Ethics,” for instance, states that employees can’t accept any cash gifts or any noncash gifts except those that have a value below \$50 and that are generally used by the giver for promotional purposes. Employees can attend paid-for business functions, but other forms of entertainment, such as sports events and golf outings, can be accepted only if it’s practical for the Penney’s employee to reciprocate. Trips of several days can’t be accepted under any circumstances.13
Whistle-Blowing
As we’ve seen, the misdeeds of Betty Vinson and her accomplices at WorldCom didn’t go undetected. They caught the eye of Cynthia Cooper, the company’s director of internal auditing. Cooper, of course, could have looked the other way, but instead she summoned up the courage to be a whistle-blower—an individual who exposes illegal or unethical behavior in an organization. Like Vinson, Cooper had majored in accounting at Mississippi State and was a hard-working, dedicated employee. Unlike Vinson, however, she refused to be bullied by her boss, CFO Scott Sullivan. In fact, she had tried to tell not only Sullivan but also auditors from the Arthur Andersen accounting firm that there was a problem with WorldCom’s books. The auditors dismissed her warnings, and when Sullivan angrily told her to drop the matter, she started cleaning out her office. But she didn’t relent. She and her team worked late each night, conducting an extensive, secret investigation. Two months later, Cooper had evidence to take to Sullivan, who told her once again to back off. Again, however, she stood up to him, and though she regretted the consequences for her WorldCom coworkers, she reported the scheme to the company’s board of directors. Within days, Sullivan was fired and the largest accounting fraud in history became public.14
As a result of Cooper’s actions, executives came clean about the company’s financial situation. The conspiracy of fraud was brought to an end, and though public disclosure of WorldCom’s problems resulted in massive stock-price declines and employee layoffs, investor and employee losses would have been greater without Cooper’s intervention. Even though Cooper did the right thing, and landed on the cover of Time magazine for it, the experience wasn’t exactly gratifying.
A lot of people applauded her action, but many coworkers shunned her; some even blamed her for the company’s troubles.15
Whistle-blowing is sometimes career suicide. A survey of two hundred whistle-blowers conducted by the National Whistleblower Center found that half were fired for blowing the whistle.16 Even those who keep their jobs can experience repercussions. As long as they stay, some will treat them (as one whistle-blower put it) “like skunks at a picnic”; if they leave, they may be blackballed in the industry.17 On a positive note, new Federal laws have been passed which are intended to protect whistle-blowers.
For her own part, Cynthia Cooper doesn’t regret what she did. As she told a group of students at Mississippi State: “Strive to be persons of honor and integrity. Do not allow yourself to be pressured. Do what you know is right even if there may be a price to be paid.”18 If your company tells employees to do whatever it takes, push the envelope, look the other way, and “be sure that we make our numbers,” you have three choices: go along with the policy, try to change things, or leave. If your personal integrity is part of the equation, you’re probably down to the last two choices.19
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Corporate Social Responsibility
Corporate social responsibility refers to the approach that an organization takes in balancing its responsibilities toward different stakeholders when making legal, economic, ethical, and social decisions. Remember that we previously defined stakeholders as those with a legitimate interest in the success or failure of the business and the policies it adopts. The term social responsibility refers to the approach that an organization takes in balancing its responsibilities toward their various stakeholders.
What motivates companies to be “socially responsible”? We hope it’s because they want to do the right thing, and for many companies, “doing the right thing” is a key motivator. The fact is, it’s often hard to figure out what the “right thing” is: what’s “right” for one group of stakeholders isn’t necessarily just as “right” for another. One thing, however, is certain: companies today are held to higher standards than ever before. Consumers and other groups consider not only the quality and price of a company’s products but also its character. If too many groups see a company as a poor corporate citizen, it will have a harder time attracting qualified employees, finding investors, and selling its products. Good corporate citizens, by contrast, are more successful in all these areas.
Figure 4.3 presents a model of corporate responsibility based on a company’s relationships with its stakeholders. In this model, the focus is on managers—not owners—as the principals involved in these relationships. Owners are the stakeholders who invest risk capital in the firm in expectation of a financial return. Other stakeholders include employees, suppliers, and the communities in which the firm does business. Proponents of this model hold that customers, who provide the firm with revenue, have a special claim on managers’ attention. The arrows indicate the two-way nature of corporation-stakeholder relationships: All stakeholders have some claim on the firm’s resources and returns, and management’s job is to make decisions that balance these claims.20
Let’s look at some of the ways in which companies can be “socially responsible” in considering the claims of various stakeholders.
Owners
Owners invest money in companies. In return, the people who run a company have a responsibility to increase the value of owners’ investments through profitable operations. Managers also have a responsibility to provide owners (as well as other stakeholders having financial interests, such as creditors and suppliers) with accurate, reliable information about the performance of the business. Clearly, this is one of the areas in which WorldCom managers fell down on the job. Upper-level management purposely deceived shareholders by presenting them with fraudulent financial statements
Managers
Managers have what is known as a fiduciary responsibility to owners: they’re responsible for safeguarding the company’s assets and handling its funds in a trustworthy manner. Yet managers experience what is called the agency problem; a situation in which their best interests do not align with those of the owners who employ them. To enforce managers’ fiduciary responsibilities for a firm’s financial statements and accounting records, the Sarbanes-Oxley Act of 2002 requires CEOs and CFOs to attest to their accuracy. The law also imposes penalties on corporate officers, auditors, board members, and any others who commit fraud. You’ll learn more about this law in your accounting and business law courses.
Employees
Companies are responsible for providing employees with safe, healthy places to work—as well as environments that are free from sexual harassment and all types of discrimination. They should also offer appropriate wages and benefits. In the following sections, we’ll take a closer look at these areas of corporate responsibility.
Wages and Benefits
At the very least, employers must obey laws governing minimum wage and overtime pay. A minimum wage is set by the federal government, though states can set their own rates as long as they are higher. The current federal rate, for example, is \$7.25, while the rate in many states is far higher.21 By law, employers must also provide certain benefits—social security (retirement funds), unemployment insurance (protects against loss of income in case of job loss), and workers’ compensation (covers lost wages and medical costs in case of on-the-job injury). Most large companies pay most of their workers more than minimum wage and offer broader benefits, including medical, dental, and vision care, as well as savings programs, in order to compete for talent.
Safety and Health
Though it seems obvious that companies should guard workers’ safety and health, some simply don’t. For over four decades, for example, executives at Johns Manville suppressed evidence that one of its products, asbestos, was responsible for the deadly lung disease developed by many of its workers.22 The company concealed chest X- rays from stricken workers, and executives decided that it was simply cheaper to pay workers’ compensation claims than to create a safer work environment. A New Jersey court was quite blunt in its judgment: Johns Manville, it held, had made a deliberate, cold-blooded decision to do nothing to protect at-risk workers, in blatant disregard of their rights.23
About four in one hundred thousand U.S. workers die in workplace “incidents” each year. The Department of Labor categorizes deaths caused by conditions like those at Johns Manville as “exposure to harmful substances or environments.” How prevalent is this condition as a cause of workplace deaths? See Figure 4.4, “Workplace Deaths by Event or Exposure, 2014”, which breaks down workplace fatalities by cause. Some jobs are more dangerous than others. For a comparative overview based on workplace deaths by occupation, see Figure 4.5.
Figure 4.5: Workplace deaths by Occupation, 2014
Industry % of Total Workplace Deaths
Construction 19%
Transportation and Warehousing 16%
Agriculture, Forestry, and Fishing 12%
Government 9%
Professional and Business Services 9%
Manufacturing 7%
Retail Trade 6%
Leisure and Hospitality 4%
Mining, Quarrying, and Natural Gas Extraction 4%
Fortunately for most people, things are far better than they were at Johns Manville. Procter & Gamble (P&G), for example, considers the safety and health of its employees paramount and promotes the attitude that “Nothing we do is worth getting hurt for.” With nearly one hundred thousand employees worldwide, P&G uses a measure of worker safety called “total incident rate per employee,” which records injuries resulting in loss of consciousness, time lost from work, medical transfer to another job, motion restriction, or medical treatment beyond first aid. The company attributes the low rate of such incidents—less than one incident per hundred employees—to a variety of programs to promote workplace safety.24
Customers
The purpose of any business is to satisfy customers, who reward businesses by buying their products. Sellers are also responsible—both ethically and legally—for treating customers fairly. The rights of consumers were first articulated by President John F. Kennedy in 1962 when he submitted to Congress a presidential message devoted to consumer issues.25 Kennedy identified four consumer rights:
1. The right to safe products. A company should sell no product that it suspects of being unsafe for buyers. Thus, producers have an obligation to safety-test products before releasing them for public consumption. The automobile industry, for example, conducts extensive safety testing before introducing new models (though recalls remain common).
2. The right to be informed about a product. Sellers should furnish consumers with the product information that they need to make an in- formed purchase decision. That’s why pillows have labels identifying the materials used to make them, for instance.
3. The right to choose what to buy. Consumers have a right to decide which products to purchase, and sellers should let them know what their options are. Pharmacists, for example, should tell patients when a prescription can be filled with a cheaper brand-name or generic drug. Telephone companies should explain alternative calling plans.
4. The right to be heard. Companies must tell customers how to contact them with complaints or concerns. They should also listen and respond.
Companies share the responsibility for the legal and ethical treatment of consumers with several government agencies: the Federal Trade Commission (FTC), which enforces consumer-protection laws; the Food and Drug Administration (FDA), which oversees the labeling of food products; and the Consumer Product Safety Commission, which enforces laws protecting consumers from the risk of product-related injury.
Communities
For obvious reasons, most communities see getting a new business as an asset and view losing one—especially a large employer—as a detriment. After all, the economic impact of business activities on local communities is substantial: They provide jobs, pay taxes, and support local education, health, and recreation programs. Both big and small businesses donate funds to community projects, encourage employees to volunteer their time, and donate equipment and products for a variety of activities. Larger companies can make greater financial contributions. Let’s start by taking a quick look at the philanthropic activities of a few U.S. corporations.
Philanthropy
Many large corporations support various charities, an activity called philanthropy. Some donate a percentage of sales or profits to worthwhile causes. Retailer Target, for example, donates 5 percent of its profits—about \$2 million per week—to schools, neighborhoods, and local projects across the country; its store-based grants underwrite programs in early childhood education, the arts, and family-violence prevention.26 The late actor Paul Newman donated 100 percent of the profits from “Newman’s Own” foods (salad dressing, pasta sauce, popcorn, and other products sold in eight countries). His company continues his legacy of donating all profits and distributing them to thousands of organizations, including the Hole in the Wall Gang camps for seriously ill children.27
Ethical Organizations
How Can You Recognize an Ethical Organization?
One goal of anyone engaged in business should be to foster ethical behavior in the organizational environment. How do we know when an organization is behaving ethically? Most lists of ethical organizational activities include the following criteria:
• Treating employees, customers, investors, and the public fairly
• Holding every member personally accountable for his or her action
• Communicating core values and principles to all members
• Demanding and rewarding integrity from all members in all situations28
Employees at companies that consistently make Business Ethics magazine’s list of the “100 Best Corporate Citizens” regard the items on the previous list as business as usual in the workplace. Companies at the top of the 2016 list include Microsoft, Hasbro, Ecolab, Bristol-Myers-Squibb, and Lockheed Martin.29
By contrast, employees with the following attitudes tend to suspect that their employers aren’t as ethical as they should be:
• They consistently feel uneasy about the work they do.
• They object to the way they’re treated.
• They’re uncomfortable about the way coworkers are treated.
• They question the appropriateness of management directives and policies.30
Sexual Harassment
Sexual harassment occurs when an employee makes “unwelcome sexual advances, requests for sexual favors, and other verbal or physical conduct of a sexual nature” to another employee. It’s also considered sexual harassment when “submission to or rejection of this conduct explicitly or implicitly affects an individual’s employment, unreasonably interferes with an individual’s work performance or creates an intimidating, hostile or offensive work environment.”31
To prevent sexual harassment—or at least minimize its likelihood—a company should adopt a formal anti-harassment policy describing prohibited conduct, asserting its objections to the behavior, and detailing penalties for violating the policy.32 Employers also have an obligation to investigate harassment complaints. Failure to enforce anti-harassment policies can be very costly. In 1998, for example, Mitsubishi paid \$34 million to more than three hundred fifty female employees of its Normal, Illinois, plant to settle a sexual harassment case supported by the Equal Employment Opportunity Commission. The EEOC reprimanded the company for permitting an atmosphere of verbal and physical abuse against women, charging that female workers had been subjected to various forms of harassment, ranging from exposure to obscene graffiti and vulgar jokes to fondling and groping.33
Workforce Diversity
In addition to complying with equal employment opportunity laws, many companies make special efforts to recruit employees who are underrepresented in the workforce according to sex, race, or some other characteristic. In helping to build more diverse workforces, such initiatives contribute to competitive advantage for two reasons:
1. People from diverse backgrounds bring new talents and fresh perspectives to an organization, typically enhancing creativity in the development of new products.
2. By more accurately reflecting the demographics of the marketplace, a diverse workforce improves a company’s ability to serve an ethnically diverse population.
The Individual Approach to Ethics
Betty Vinson didn’t start out at WorldCom with the intention of going to jail. She undoubtedly knew what the right behavior was, but the bottom line is that she didn’t do it. How can you make sure that you do the right thing in the business world? How should you respond to the kinds of challenges that you’ll be facing? Because your actions in the business world will be strongly influenced by your moral character, let’s begin by assessing your current moral condition. Which of the following best applies to you (select one)?
1. I’m always ethical.
2. I’m mostly ethical.
3. I’m somewhat ethical.
4. I’m seldom ethical.
5. I’m never ethical.
Now that you’ve placed yourself in one of these categories, here are some general observations. Few people put themselves below the second category. Most of us are ethical most of the time, and most people assign themselves to category number two— “I’m mostly ethical.” Why don’t more people claim that they’re always ethical?
Apparently, most people realize that being ethical all the time takes a great deal of moral energy. If you placed yourself in category number two, ask yourself this question: How can I change my behavior so that I can move up a notch? The answer to this question may be simple. Just ask yourself an easier question: How would I like to be treated in a given situation?34
Unfortunately, practicing this philosophy might be easier in your personal life than in the business world. Ethical challenges arise in business because companies, especially large ones, have multiple stakeholders who sometimes make competing demands. Making decisions that affect multiple stakeholders isn’t easy even for seasoned managers; and for new entrants to the business world, the task can be extremely daunting. You can, however, get a head start in learning how to make ethical decisions by looking at two types of challenges that you’ll encounter in the business world: ethical dilemmas and ethical decisions.
Addressing Ethical Dilemmas
An ethical dilemma is a morally problematic situation: you must choose between two or more acceptable but often opposing alternatives that are important to different groups. Experts often frame this type of situation as a “right-versus-right” decision. It’s the sort of decision that Johnson & Johnson (known as J&J) CEO James Burke had to make in 1982.35 On September 30, twelve-year-old Mary Kellerman of Chicago died after her parents gave her Extra-Strength Tylenol. That same morning, twenty-seven-year-old Adam Janus, also of Chicago, died after taking Tylenol for minor chest pain. That night, when family members came to console his parents, Adam’s brother and his wife took Tylenol from the same bottle and died within forty-eight hours. Over the next two weeks, four more people in Chicago died after taking Tylenol. The actual connection between Tylenol and the series of deaths wasn’t made until an off-duty fireman realized from news reports that every victim had taken Tylenol. As consumers panicked, J&J pulled Tylenol off Chicago-area retail shelves. Researchers discovered Tylenol capsules containing large amounts of deadly cyanide. Because the poisoned bottles came from batches originating at different J&J plants, investigators determined that the tampering had occurred after the product had been shipped.36
So J&J wasn’t at fault. But CEO Burke was still faced with an extremely serious dilemma: Was it possible to respond to the tampering cases without destroying the reputation of a highly profitable brand?
Burke had two options:
1. He could recall only the lots of Extra-Strength Tylenol that were found to be tainted with cyanide. In 1991, Perrier executives recalled only tainted product when they discovered that cases of their bottled water had been poisoned with benzine. This option favored J&J financially but possibly put more people at risk.
2. Burke could order a nationwide recall—of all bottles of Extra-Strength Tylenol. This option would reverse the priority of the stakeholders, putting the safety of the public above stakeholders’ financial interests.
Burke opted to recall all 31 million bottles of Extra-Strength Tylenol on the market. The cost to J&J was \$100 million, but public reaction was quite positive. Less than six weeks after the crisis began, Tylenol capsules were reintroduced in new tamper-resistant bottles, and by responding quickly and appropriately, J&J was eventually able to restore the Tylenol brand to its previous market position. When Burke was applauded for moral courage, he replied that he’d simply adhered to the long-standing J&J credo that put the interests of customers above those of other stakeholders. His only regret was that the perpetrator was never caught.37
If you’re wondering what your thought process should be if you’re confronted with an ethical dilemma, you might wish to remember the mental steps listed here—which happen to be the steps that James Burke took in addressing the Tylenol crisis:
1. Define the problem: How to respond to the tampering case without destroying the reputation of the Tylenol brand.
2. Identify feasible options: (1) Recall only the lots of Tylenol that were found to be tainted or (2) order a nationwide recall of all bottles of Extra-Strength Tylenol.
3. Assess the effect of each option on stakeholders: Option 1 (recalling only the tainted lots of Tylenol) is cheaper but puts more people at risk. Option 2 (recalling all bottles of Extra-Strength Tylenol) puts the safety of the public above stakeholders’ financial interests.
4. Establish criteria for determining the most appropriate action: Adhere to the J&J credo, which puts the interests of customers above those of other stakeholders.
5. Select the best option based on the established criteria: In 1982, Option 2 was selected, and a nationwide recall of all bottles of Extra-Strength Tylenol was conducted.
Making Ethical Decisions
In contrast to the “right-versus-right” problem posed by an ethical dilemma, an ethical decision entails a “right-versus-wrong” decision—one in which there is clearly a right (ethical) choice and a wrong (unethical or illegal) choice. When you make a decision that’s unmistakably unethical or illegal, you’ve committed an ethical lapse. If you’re presented with this type of choice, asking yourself the questions in Figure 4.6 “How to Avoid an Ethical Lapse” will increase your odds of making an ethical decision.
To test the validity of this approach, let’s take a point-by-point look at Betty Vinson’s decisions:
1. Her actions were clearly illegal.
2. They were unfair to the workers who lost their jobs and to the investors who suffered financial losses (and also to her family, who shared her public embarrassment).
3. She definitely felt badly about what she’d done.
4. She was embarrassed to tell other people what she had done.
5. Reports of her actions appeared in her local newspaper (and just about every other newspaper in the country).
So Vinson could have answered “yes” to all five of our test questions. To simplify matters, remember the following rule of thumb: If you answer yes to any one of these five questions, odds are that you’re about to do something you shouldn’t.
Revisiting Johnson & Johnson
As discussed earlier, Johnson & Johnson received tremendous praise for the actions taken by its CEO, James Burke, in response to the 1982 Tylenol catastrophe. However, things change. To learn how a company can destroy its good reputation, let’s fast forward to 2008 and revisit J&J and its credo, which states, “We believe our first responsibility is to the doctors, nurses and patients, to mothers and fathers and all others who use our products and services. In meeting their needs everything we do must be of high quality.”38 How could a company whose employees believed so strongly in its credo find itself under criminal and congressional investigation for a series of recalls due to defective products?39 In a three-year period, the company recalled twenty-four products, including Children’s, Infants’ and Adults’ Tylenol, Motrin, and Benadryl;40 1-Day Acuvue TruEye contact lenses sold outside the U.S.;41 and hip replacements.42
Unlike the Tylenol recall, no one had died from the defective products, but customers were certainly upset to find they had purchased over-the-counter medicines for themselves and their children that were potentially contaminated with dark particles or tiny specks of metal;43 contact lenses that contained a type of acid that caused stinging or pain when inserted in the eye;44 and defective hip implants that required patients to undergo a second hip replacement.45
Who bears the responsibility for these image-damaging blunders? Two individuals who were at least partially responsible were William Weldon, CEO, and Colleen Goggins, Worldwide Chairman of J&J’s Consumer Group. Weldon has been criticized for being largely invisible and publicly absent during the recalls.46 Additionally, he admitted that he did not understand the consumer division where many of the quality control problems originated.47 Goggins was in charge of the factories that produced many of the recalled products. She was heavily criticized by fellow employees for her excessive cost-cutting measures and her propensity to replace experienced scientists with new hires.48 In addition, she was implicated in scheme to avoid publicly disclosing another J&J recall of a defective product.
After learning that J&J had released packets of Motrin that did not dissolve correctly, the company hired contractors to go into convenience stores and secretly buy up every pack of Motrin on the shelves. The instructions given to the contractors were the following: “You should simply ‘act’ like a regular customer while making these purchases. THERE MUST BE NO MENTION OF THIS BEING A RECALL OF THE PRODUCT!”49 In May 2010, when Goggins appeared before a congressional committee investigating the “phantom recall,” she testified that she was not aware of the behavior of the contractors50 and that she had “no knowledge of instructions to contractors involved in the phantom recall to not tell store employees what they were doing.” In her September 2010 testimony to the House Committee on Oversight and Government Reform, she acknowledged that the company in fact wrote those very instructions.
Refusing to Rationalize
Despite all the good arguments in favor of doing the right thing, why do many reasonable people act unethically (at least at times)? Why do good people make bad choices? According to one study, there are four common rationalizations (excuses) for justifying misconduct:51
1. My behavior isn’t really illegal or immoral. Rationalizers try to convince themselves that an action is OK if it isn’t downright illegal or blatantly immoral. They tend to operate in a gray area where there’s no clear evidence that the action is wrong.
2. My action is in everyone’s best interests. Some rationalizers tell themselves: “I know I lied to make the deal, but it’ll bring in a lot of business and pay a lot of bills.” They convince themselves that they’re expected to act in a certain way.52
3. No one will find out what I’ve done. Here, the self-questioning comes down to “If I didn’t get caught, did I really do it?” The answer is yes. There’s a simple way to avoid succumbing to this rationalization: Always act as if you’re being watched.
4. The company will condone my action and protect me. This justification rests on a fallacy. Betty Vinson may honestly have believed that her actions were for the good of the company and that her boss would, therefore, accept full responsibility (as he promised). When she goes to jail, however, she’ll go on her own.
Here’s another rule of thumb: If you find yourself having to rationalize a decision, it’s probably a bad one.
What to Do When the Light Turns Yellow
Like our five questions, some ethical problems are fairly straightforward. Others, unfortunately, are more complicated, but it will help to think of our five-question test as a set of signals that will warn you that you’re facing a particularly tough decision— that you should think carefully about it and perhaps consult someone else. The situation is like approaching a traffic light. Red and green lights are easy; you know what they mean and exactly what to do. Yellow lights are trickier. Before you decide which pedal to hit, try posing our five questions. If you get a single yes, you’ll almost surely be better off hitting the brake.53
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Chapter Video
Foxconn is a major supplier to Apple. All of its factories are in China and Taiwan, although it recently announced building a new one in the United States. Working conditions are much different than in a typical US factory. As you watch the video, think about what responsibilities Apple has in this situation. They don’t own Foxconn or its factories, yet their reputation can be nevertheless impacted.
To view this video, visit: https://www.youtube.com/watch?v=Jk-xqPKOxl4&=&t=39s
(Copyrighted material)
Key Takeaways
1. Business ethics is the application of ethical behavior in a business context. Ethical (trustworthy) companies are better able to attract and keep customers, talented employees, and capital.
2. Acting ethically in business means more than just obeying laws and regulations. It also means being honest, doing no harm to others, competing fairly, and declining to put your own interests above those of your employer and coworkers.
3. In the business world, you’ll encounter conflicts of interest: situations in which you’ll have to choose between taking action that promotes your personal interest and action that favors the interest of others.
4. Corporate social responsibility refers to the approach that an organization takes in balancing its responsibilities toward different stakeholders (owners, employees, customers, and the communities in which they conduct business) when making legal, economic, ethical, and social decisions.
5. Managers have several responsibilities: to increase the value of owners’ investments through profitable operations, to provide owners and other stakeholders with accurate, reliable financial information, and to safeguard the company’s assets and handle its funds in a trustworthy manner.
6. Companies have a responsibility to pay appropriate wages and benefits, treat all workers fairly, and provide equal opportunities for all employees. In addition, the must guard workers’ safety and health and to provide them with a work environment that’s free from sexual harassment.
7. Consumers have certain legal rights: to use safe products, to be informed about products, to choose what to buy, and to be heard. Sellers must comply with these requirements.
8. Businesspeople face two types of ethical challenges: ethical dilemmas and ethical decisions.
9. An ethical dilemma is a morally problematic situation in which you must choose competing and often conflicting options which do not satisfy all stakeholders.
10. An ethical decision is one in which there’s a right (ethical) choice and a wrong (unethical or downright illegal) choice.
Chapter 4 Text References and Image Credits
Image Credits: Chapter 4
Figure 4.1: “Bernie Madoff’s Mug Shot.” U.S. Department of Justice, public domain. Retrieved from: en.Wikipedia.org/wiki/Bernard_Madoff#/media/File:BernardMadoff.jpg
Figure 4.4: “Workplace deaths by event or exposure, 2014.” Data retrieved from: Bureau of Labor Statistics: http://www.bls.gov/iif/oshwc/cfoi/cfch0013.pdf (p. 3).
Figure 4.5: “Workplace deaths by occupation, 2014.” Data retrieved from: Bureau of Labor Statistics: http://www.bls.gov/iif/oshwc/cfoi/cfch0013.pdf (p. 13).
Figure 4.7: Yellow traffic light. Sir James (2009). “Traffic light modern version Ireland Dublin.” Creative Commons Attribution-Share Alike 3.0 Unported. Retrieved from: https://commons.wikimedia.org/wiki/File:Traffic_light_modern_version_Ireland_Dublin_2_yellow_2009-09-27.jpg
Video Credits: Chapter 4
“Foxconn: An Exclusive Inside Look.” (ABC News). February 21, 2012. Retrieved from: https://www.youtube.com/watch?v=Jk-xqPKOxl4&=&t=39s | textbooks/biz/Business/Introductory_Business/Book%3A_Fundamentals_of_Business_(Skripak)/04%3A_Ethics_and_Social_Responsibility.txt |
Learning Objectives
1. Explain why nations and companies participate in international trade.
2. Describe the concepts of absolute and comparative advantage.
3. Explain how trade between nations is measured.
4. Define importing and exporting.
5. Explain how companies enter the international market through licensing agreements or franchises.
6. Describe how companies reduce costs through contract manufacturing and outsourcing.
7. Explain the purpose of international strategic alliances and joint ventures.
8. Understand how U.S. companies expand their businesses through foreign direct investments and international subsidiaries.
9. Appreciate how cultural, economic, legal, and political differences between countries create challenges to successful business dealings.
10. Describe the ways in which governments and international bodies promote and regulate global trade.
11. Discuss the various initiatives designed to reduce international trade barriers and promote free trade.
Do you wear Nike shoes or Timberland boots? Buy groceries at Giant Stores or Stop & Shop? Listen to Beyoncé, Kenrick Lamar, Twenty One Pilots, or The Neighbourhood on Spotify? If you answered yes to any of these questions, you’re a global business customer. Both Nike and Timberland manufacture most of their products overseas. The Dutch firm Royal Ahold owns all three supermarket chains. And Spotify is a Swedish enterprise.
Take an imaginary walk down Orchard Road, the most fashionable shopping area in Singapore. You’ll pass department stores such as Tokyo-based Takashimaya and London’s very British Marks & Spencer, both filled with such well-known international labels as Ralph Lauren Polo, Burberry, and Chanel. If you need a break, you can also stop for a latte at Seattle-based Starbucks.
When you’re in the Chinese capital of Beijing, don’t miss Tiananmen Square. Parked in front of the Great Hall of the People, the seat of Chinese government, are fleets of black Buicks, cars made by General Motors in Flint, Michigan. If you’re adventurous enough to find yourself in Faisalabad, a medium-size city in Pakistan, you’ll see Hamdard University, located in a refurbished hotel. Step inside its computer labs, and the sensation of being in a faraway place will likely disappear: on the computer screens, you’ll recognize the familiar Microsoft flag—the same one emblazoned on screens in Microsoft’s hometown of Seattle and just about everywhere else on the planet.
The Globalization of Business
The globalization of business is bound to affect you. Not only will you buy products manufactured overseas, but it’s highly likely that you’ll meet and work with individuals from various countries and cultures as customers, suppliers, colleagues, employees, or employers. The bottom line is that the globalization of world commerce has an impact on all of us. Therefore, it makes sense to learn more about how globalization works.
Never before has business spanned the globe the way it does today. But why is international business important? Why do companies and nations engage in international trade? What strategies do they employ in the global marketplace? How do governments and international agencies promote and regulate international trade? These questions and others will be addressed in this chapter. Let’s start by looking at the more specific reasons why companies and nations engage in international trade.
Why Do Nations Trade?
Why does the United States import automobiles, steel, digital phones, and apparel from other countries? Why don’t we just make them ourselves? Why do other countries buy wheat, chemicals, machinery, and consulting services from us? Because no national economy produces all the goods and services that its people need. Countries are importers when they buy goods and services from other countries; when they sell products to other nations, they’re exporters. (We’ll discuss importing and exporting in greater detail later in the chapter.) The monetary value of international trade is enormous. In 2010, the total value of worldwide trade in merchandise and commercial services was \$18.5 trillion.1
Absolute and Comparative Advantage
To understand why certain countries import or export certain products, you need to realize that every country (or region) can’t produce the same products. The cost of labor, the availability of natural resources, and the level of know-how vary greatly around the world. Most economists use the concepts of absolute advantage and comparative advantage to explain why countries import some products and export others.
Absolute Advantage
A nation has an absolute advantage if (1) it’s the only source of a particular product or (2) it can make more of a product using fewer resources than other countries. Because of climate and soil conditions, for example, France had an absolute advantage in wine making until its dominance of worldwide wine production was challenged by the growing wine industries in Italy, Spain, and the United States. Unless an absolute advantage is based on some limited natural resource, it seldom lasts. That’s why there are few, if any, examples of absolute advantage in the world today.
Comparative Advantage
How can we predict, for any given country, which products will be made and sold at home, which will be imported, and which will be exported? This question can be answered by looking at the concept of comparative advantage, which exists when a country can produce a product at a lower opportunity cost compared to another nation. But what’s an opportunity cost? Opportunity costs are the products that a country must forego making in order to produce something else. When a country decides to specialize in a particular product, it must sacrifice the production of another product. Countries benefit from specialization – focusing on what they do best, and trading the output to other countries for what those countries do best. The United States, for instance, is increasingly an exporter of knowledge-based products, such as software, movies, music, and professional services (management consulting, financial services, and so forth). America’s colleges and universities, therefore, are a source of comparative advantage, and students from all over the world come to the United States for the world’s best higher-education system.
France and Italy are centers for fashion and luxury goods and are leading exporters of wine, perfume, and designer clothing. Japan’s engineering expertise has given it an edge in such fields as automobiles and consumer electronics. And with large numbers of highly skilled graduates in technology, India has become the world’s leader in low- cost, computer-software engineering.
How Do We Measure Trade between Nations?
To evaluate the nature and consequences of its international trade, a nation looks at two key indicators. We determine a country’s balance of trade by subtracting the value of its imports from the value of its exports. If a country sells more products than it buys, it has a favorable balance, called a trade surplus. If it buys more than it sells, it has an unfavorable balance, or a trade deficit.
For many years, the United States has had a trade deficit: we buy far more goods from the rest of the world than we sell overseas. This fact shouldn’t be surprising. With high income levels, we not only consume a sizable portion of our own domestically produced goods but enthusiastically buy imported goods. Other countries, such as China and Taiwan, which manufacture high volumes for export, have large trade surpluses because they sell far more goods overseas than they buy.
Managing the National Credit Card
Are trade deficits a bad thing? Not necessarily. They can be positive if a country’s economy is strong enough both to keep growing and to generate the jobs and incomes that permit its citizens to buy the best the world has to offer. That was certainly the case in the United States in the 1990s. Some experts, however, are alarmed at our trade deficit. Investment guru Warren Buffet, for example, cautions that no country can continuously sustain large and burgeoning trade deficits. Why not? Because creditor nations will eventually stop taking IOUs from debtor nations, and when that happens, the national spending spree will have to cease. “Our national credit card,” he warns, “allows us to charge truly breathtaking amounts. But that card’s credit line is not limitless.”2
By the same token, trade surpluses aren’t necessarily good for a nation’s consumers. Japan’s export-fueled economy produced high economic growth in the 1970s and 1980s. But most domestically made consumer goods were priced at artificially high levels inside Japan itself—so high, in fact, that many Japanese traveled overseas to buy the electronics and other high-quality goods on which Japanese trade was dependent.
CD players and televisions were significantly cheaper in Honolulu or Los Angeles than in Tokyo. How did this situation come about? Though Japan manufactures a variety of goods, many of them are made for export. To secure shares in international markets, Japan prices its exported goods competitively. Inside Japan, because competition is limited, producers can put artificially high prices on Japanese-made goods. Due to a number of factors (high demand for a limited supply of imported goods, high shipping and distribution costs, and other costs incurred by importers in a nation that tends to protect its own industries), imported goods are also expensive.3
Balance of Payments
The second key measure of the effectiveness of international trade is balance of payments: the difference, over a period of time, between the total flow of money coming into a country and the total flow of money going out. As in its balance of trade, the biggest factor in a country’s balance of payments is the money that flows as a result of imports and exports. But balance of payments includes other cash inflows and outflows, such as cash received from or paid for foreign investment, loans, tourism, military expenditures, and foreign aid. For example, if a U.S. company buys some real estate in a foreign country, that investment counts in the U.S. balance of payments, but not in its balance of trade, which measures only import and export transactions. In the long run, having an unfavorable balance of payments can negatively affect the stability of a country’s currency. The United States has experienced unfavorable balances of payments since the 1970s which has forced the government to cover its debt by borrowing from other countries.4 Figure 5.2 provides a brief historical overview to illustrate the relationship between the United States’ balance of trade and its balance of payments.
Opportunities in International Business
The fact that nations exchange billions of dollars in goods and services each year demonstrates that international trade makes good economic sense. For a company wishing to expand beyond national borders, there are a variety of ways it can get involved in international business. Let’s take a closer look at the more popular ones.
Importing and Exporting
Importing (buying products overseas and reselling them in one’s own country) and exporting (selling domestic products to foreign customers) are the oldest and most prevalent forms of international trade. For many companies, importing is the primary link to the global market. American food and beverage wholesalers, for instance, import for resale in U.S. supermarkets the bottled waters Evian and Fiji from their sources in the French Alps and the Fiji Islands respectively.5 Other companies get into the global arena by identifying an international market for their products and becoming exporters. The Chinese, for instance, are fond of fast foods cooked in soybean oil. Because they also have an increasing appetite for meat, they need high-protein soybeans to raise livestock.6 American farmers now export over \$9 billion worth of soybeans to China every year.7
Licensing and Franchising
A company that wants to get into an international market quickly while taking only limited financial and legal risks might consider licensing agreements with foreign companies. An international licensing agreement allows a foreign company (the licensee) to sell the products of a producer (the licensor) or to use its intellectual property (such as patents, trademarks, copyrights) in exchange for what is known as royalty fees. Here’s how it works: You own a company in the United States that sells coffee-flavored popcorn. You’re sure that your product would be a big hit in Japan, but you don’t have the resources to set up a factory or sales office in that country. You can’t make the popcorn here and ship it to Japan because it would get stale. So you enter into a licensing agreement with a Japanese company that allows your licensee to manufacture coffee-flavored popcorn using your special process and to sell it in Japan under your brand name. In exchange, the Japanese licensee would pay you a royalty fee – perhaps a percentage of each sale or a fixed amount per unit.
Another popular way to expand overseas is to sell franchises. Under an international franchise agreement, a company (the franchiser) grants a foreign company (the franchisee) the right to use its brand name and to sell its products or services. The franchisee is responsible for all operations but agrees to operate according to a business model established by the franchiser. In turn, the franchiser usually provides advertising, training, and new-product assistance. Franchising is a natural form of global expansion for companies that operate domestically according to a franchise model, including restaurant chains, such as McDonald’s and Kentucky Fried Chicken, and hotel chains, such as Holiday Inn and Best Western.
Contract Manufacturing and Outsourcing
Because of high domestic labor costs, many U.S. companies manufacture their products in countries where labor costs are lower. This arrangement is called international contract manufacturing, a form of outsourcing. A U.S. company might contract with a local company in a foreign country to manufacture one of its products. It will, however, retain control of product design and development and put its own label on the finished product. Contract manufacturing is quite common in the U.S. apparel business, with most American brands being made in a number of Asian countries, including China, Vietnam, Indonesia, and India.8
Thanks to twenty-first-century information technology, nonmanufacturing functions can also be outsourced to nations with lower labor costs. U.S. companies increasingly draw on a vast supply of relatively inexpensive skilled labor to perform various business services, such as software development, accounting, and claims processing. For years, American insurance companies have processed much of their claims-related paperwork in Ireland. With a large, well-educated population with English language skills, India has become a center for software development and customer-call centers for American companies. In the case of India, as you can see in Figure 5.4, the attraction is not only a large pool of knowledge workers but also significantly lower wages.
Figure 5.4: Selected Hourly Wages, United States and India
Occupation U.S. Wage per Hour (per year) Indian Wage per Hour (per year)
Accountant \$22.12 per hour (~\$44,240 per year) \$3.15 per hour (~\$6,300 per year)
Information Technology Consultant \$40.70 per hour (~\$81,400 per year) \$22.40 per hour (~\$44,800 per year)
Cleaner \$8.70 per hour (~\$17,400 per year) \$2.10 per hour (~\$4,200 per year)
Strategic Alliances and Joint Ventures
What if a company wants to do business in a foreign country but lacks the expertise or resources? Or what if the target nation’s government doesn’t allow foreign companies to operate within its borders unless it has a local partner? In these cases, a firm might enter into a strategic alliance with a local company or even with the government itself.
A strategic alliance is an agreement between two companies (or a company and a nation) to pool resources in order to achieve business goals that benefit both partners. For example, Viacom (a leading global media company) has a strategic alliance with Beijing Television to produce Chinese-language music and entertainment programming.9
An alliance can serve a number of purposes:
• Enhancing marketing efforts
• Building sales and market share
• Improving products
• Reducing production and distribution costs
• Sharing technology
Alliances range in scope from informal cooperative agreements to joint ventures— alliances in which the partners fund a separate entity (perhaps a partnership or a corporation) to manage their joint operation. Magazine publisher Hearst, for example, has joint ventures with companies in several countries. So, young women in Israel can read Cosmo Israel in Hebrew, and Russian women can pick up a Russian-language version of Cosmo that meets their needs. The U.S. edition serves as a starting point to which nationally appropriate material is added in each different nation. This approach allows Hearst to sell the magazine in more than fifty countries.10
Foreign Direct Investment and Subsidiaries
Many of the approaches to global expansion that we’ve discussed so far allow companies to participate in international markets without investing in foreign plants and facilities. As markets expand, however, a firm might decide to enhance its competitive advantage by making a direct investment in operations conducted in another country. Foreign direct investment (FDI) refers to the formal establishment of business operations on foreign soil—the building of factories, sales offices, and distribution networks to serve local markets in a nation other than the company’s home country. On the other hand, offshoring occurs when the facilities set up in the foreign country replace U.S. manufacturing facilities and are used to produce goods that will be sent back to the United States for sale. Shifting production to low-wage countries is often criticized as it results in the loss of jobs for U.S. workers.11
FDI is generally the most expensive commitment that a firm can make to an overseas market, and it’s typically driven by the size and attractiveness of the target market. For example, German and Japanese automakers, such as BMW, Mercedes, Toyota, and Honda, have made serious commitments to the U.S. market: most of the cars and trucks that they build in plants in the South and Midwest are destined for sale in the United States.
A common form of FDI is the foreign subsidiary: an independent company owned by a foreign firm (called the parent). This approach to going international not only gives the parent company full access to local markets but also exempts it from any laws or regulations that may hamper the activities of foreign firms. The parent company has tight control over the operations of a subsidiary, but while senior managers from the parent company often oversee operations, many managers and employees are citizens of the host country. Not surprisingly, most very large firms have foreign subsidiaries. IBM and Coca-Cola, for example, have both had success in the Japanese market through their foreign subsidiaries (IBM-Japan and Coca-Cola–Japan). FDI goes in the other direction, too, and many companies operating in the United States are in fact subsidiaries of foreign firms. Gerber Products, for example, is a subsidiary of the Swiss company Novartis, while Stop & Shop and Giant Food Stores belong to the Dutch company Royal Ahold. Where does most FDI capital end up? Figure 5.5 provides an overview of amounts, destinations (high to low income countries), and trends.
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All these strategies have been employed successfully in global business. But success in international business involves more than finding the best way to reach international markets. Global business is a complex, risky endeavor. Over time, many large companies reach the point of becoming truly multi-national.
Figure 5.6: Fortune Top 15 Multinational Firms by Revenue
Company Industry Headquarters Revenue in 2014 (in billions of dollars) Profits in 2014 (in billions of dollars)
1. Wal Mart General Merchandise USA \$485.7 \$16.4
2. Sinopec Group Petroleum China \$446.8 \$5.2
3. Royal Dutch Shell Petroleum Netherlands/Great Britain \$431.3 \$14.9
4. China National Petroleum Petroleum China \$428.6 \$16.4
5. ExxonMobil Petroleum USA \$382.6 \$32.5
6. BP Petroleum Great Britain \$358.7 \$3.8
7. State Grid Utilities China \$339.4 \$9.8
8. Volkswagen Automobile Germany \$268.6 \$14.6
9. Toyota Automobile Japan \$247.7 \$19.8
10. Glencore Mining Switzerland/Great Britain \$221.0 \$2.3
11. Total Petroleum France \$212.0 \$4.2
12. Chevron Petroleum USA \$203.8 \$19.2
13. Samsung Electronics South Korea \$195.8 \$21.9
14. Berkshire Hathaway Insurance USA \$194.7 \$19.9
15. Apple Computers USA \$182.8 \$39.5
Multinational Corporations
A company that operates in many countries is called a multinational corporation (MNC). Fortune magazine’s roster of the top 500 MNCs speaks for the growth of non-U.S. businesses. Only two of the top ten MNCs are headquartered in the U.S.(see Figure 5.6 above): Wal-Mart (number 1) and Exxon (number 5). Three others are in the top 15: Chevron, Berkshire Hathaway, and Apple. The others are non-U.S. firms. Interestingly, of the fifteen top companies, ten are energy suppliers, two are motor vehicle companies, and two are consumer electronics or computer companies. Also interesting is the difference between company revenues and profits: the list would look quite different arranged by profits instead of revenues!
MNCs often adopt the approach encapsulated in the motto “Think globally, act locally.” They often adjust their operations, products, marketing, and distribution to mesh with the environments of the countries in which they operate. Because they understand that a “one-size-fits-all” mentality doesn’t make good business sense when they’re trying to sell products in different markets, they’re willing to accommodate cultural and economic differences. Increasingly, MNCs supplement their mainstream product line with products designed for local markets. Coca-Cola, for example, produces coffee and citrus-juice drinks developed specifically for the Japanese market.12 When Nokia and Motorola design cell phones, they’re often geared to local tastes in color, size, and other features. For example, Nokia introduced a cell phone for the rural Indian consumer that has a dust-resistant keypad, anti-slip grip, and a built-in flashlight.13 McDonald’s provides a vegetarian menu in India, where religious convictions affect the demand for beef and pork.14 In Germany, McDonald’s caters to local tastes by offering beer in some restaurants and a Shrimp Burger in Hong Kong and Japan.15
Likewise, many MNCs have made themselves more sensitive to local market conditions by decentralizing their decision making. While corporate headquarters still maintain a fair amount of control, home-country managers keep a suitable distance by relying on modern telecommunications. Today, fewer managers are dispatched from headquarters; MNCs depend instead on local talent. Not only does decentralized organization speed up and improve decision making, but it also allows an MNC to project the image of a local company. IBM, for instance, has been quite successful in the Japanese market because local customers and suppliers perceive it as a Japanese company. Crucial to this perception is the fact that the vast majority of IBM’s Tokyo employees, including top leadership, are Japanese nationals.16
Criticism of MNC’s
The global reach of MNCs is a source of criticism as well as praise. Critics argue that they often destroy the livelihoods of home-country workers by moving jobs to developing countries where workers are willing to labor under poor conditions and for less pay. They also contend that traditional lifestyles and values are being weakened, and even destroyed, as global brands foster a global culture of American movies; fast food; and cheap, mass-produced consumer products. Still others claim that the demand of MNCs for constant economic growth and cheaper access to natural resources do irreversible damage to the physical environment. All these negative consequences, critics maintain, stem from the abuses of international trade—from the policy of placing profits above people, on a global scale. These views surfaced in violent street demonstrations in Seattle in 1999 and Genoa, Italy, in 2000, and since then, meetings of the International Monetary Fund (IMF) and World Bank have regularly been assailed by protestors.
In Defense of MNC’s
Supporters of MNCs respond that huge corporations deliver better, cheaper products for customers everywhere; create jobs; and raise the standard of living in developing countries. They also argue that globalization increases cross-cultural understanding. Anne O. Kruger, first deputy managing director of the IMF, says the following:
“The impact of the faster growth on living standards has been phenomenal. We have observed the increased well-being of a larger percentage of the world’s population by a greater increment than ever before in history. Growing incomes give people the ability to spend on things other than basic food and shelter, in particular on things such as education and health. This ability, combined with the sharing among nations of medical and scientific advances, has transformed life in many parts of the developing world.
Infant mortality has declined from 180 per 1,000 births in 1950 to 60 per 1,000 births. Literacy rates have risen from an average of 40 percent in the 1950s to over 70 percent today. World poverty has declined, despite still-high population growth in the developing world.”17
The Global Business Environment
In the classic movie The Wizard of Oz, a magically misplaced Midwest farm girl takes a moment to survey the bizarre landscape of Oz and then comments to her little dog, “I don’t think we’re in Kansas anymore, Toto.” That sentiment probably echoes the reaction of many businesspeople who find themselves in the midst of international ventures for the first time. The differences between the foreign landscape and the one with which they’re familiar are often huge and multifaceted. Some are quite obvious, such as differences in language, currency, and everyday habits (say, using chopsticks instead of silverware). But others are subtle, complex, and sometimes even hidden.
Success in international business means understanding a wide range of cultural, economic, legal, and political differences between countries. Let’s look at some of the more important of these differences.
The Cultural Environment
Even when two people from the same country communicate, there’s always a possibility of misunderstanding. When people from different countries get together, that possibility increases substantially. Differences in communication styles reflect differences in culture: the system of shared beliefs, values, customs, and behaviors that govern the interactions of members of a society. Cultural differences create challenges to successful international business dealings. Let’s look at a few of these challenges.
Language
English is the international language of business. The natives of such European countries as France and Spain certainly take pride in their own languages and cultures, but nevertheless English is the business language of the European community.
Whereas only a few educated Europeans have studied Italian or Norwegian, most have studied English. Similarly, on the South Asian subcontinent, where hundreds of local languages and dialects are spoken, English is the official language. In most corners of the world, English-only speakers—such as most Americans—have no problem finding competent translators and interpreters. So why is language an issue for English speakers doing business in the global marketplace? In many countries, only members of the educated classes speak English. The larger population—which is usually the market you want to tap—speaks the local tongue. Advertising messages and sales appeals must take this fact into account. More than one English translation of an advertising slogan has resulted in a humorous (and perhaps serious) blunder. Some classics are listed on the next page in Figure 5.7.
Furthermore, relying on translators and interpreters puts you as an international businessperson at a disadvantage. You’re privy only to interpretations of the messages that you’re getting, and this handicap can result in a real competitive problem. Maybe you’ll misread the subtler intentions of the person with whom you’re trying to conduct business. The best way to combat this problem is to study foreign languages. Most people appreciate some effort to communicate in their local language, even on the most basic level. They even appreciate mistakes you make resulting from a desire to demonstrate your genuine interest in the language of your counterparts in foreign countries. The same principle goes doubly when you’re introducing yourself to non- English speakers in the United States. Few things work faster to encourage a friendly atmosphere than a native speaker’s willingness to greet a foreign guest in the guest’s native language.
Time and Sociability
Americans take for granted many of the cultural aspects of our business practices. Most of our meetings, for instance, focus on business issues, and we tend to start and end our meetings on schedule. These habits stem from a broader cultural preference: we don’t like to waste time. (It was an American, Benjamin Franklin, who coined the phrase “Time is money.”) This preference, however, is by no means universal. The expectation that meetings will start on time and adhere to precise agendas is common in parts of Europe (especially the Germanic countries), as well as in the United States, but elsewhere—say, in Latin America and the Middle East—people are often late to meetings.
High- and Low-Context Cultures
Likewise, don’t expect businesspeople from these regions—or businesspeople from most of Mediterranean Europe, for that matter—to “get down to business” as soon as a meeting has started. They’ll probably ask about your health and that of your family, inquire whether you’re enjoying your visit to their country, suggest local foods, and generally appear to be avoiding serious discussion at all costs. For Americans, such topics are conducive to nothing but idle chitchat, but in certain cultures, getting started this way is a matter of simple politeness and hospitality.
Intercultural Communication
Different cultures have different communication styles—a fact that can take some getting used to. For example, degrees of animation in expression can vary from culture to culture. Southern Europeans and Middle Easterners are quite animated, favoring expressive body language along with hand gestures and raised voices. Northern Europeans are far more reserved. The English, for example, are famous for their understated style and the Germans for their formality in most business settings. In addition, the distance at which one feels comfortable when talking with someone varies by culture. People from the Middle East like to converse from a distance of a foot or less, while Americans prefer more personal space.
Finally, while people in some cultures prefer to deliver direct, clear messages, others use language that’s subtler or more indirect. North Americans and most Northern Europeans fall into the former category and many Asians into the latter. But even within these categories, there are differences. Though typically polite, Chinese and Koreans are extremely direct in expression, while Japanese are indirect: They use vague language and avoid saying “no” even if they do not intend to do what you ask. They worry that turning someone down will result in their “losing face”, i.e., an embarrassment or loss of credibility, and so they avoid doing this in public.
In summary, learn about a country’s culture and use your knowledge to help improve the quality of your business dealings. Learn to value the subtle differences among cultures, but don’t allow cultural stereotypes to dictate how you interact with people from any culture. Treat each person as an individual and spend time getting to know what he or she is about.
The Economic Environment
If you plan to do business in a foreign country, you need to know its level of economic development. You also should be aware of factors influencing the value of its currency and the impact that changes in that value will have on your profits.
Economic Development
If you don’t understand a nation’s level of economic development, you’ll have trouble answering some basic questions, such as: Will consumers in this country be able to afford the product I want to sell? Will it be possible to make a reasonable profit? A country’s level of economic development can be evaluated by estimating the annual income earned per citizen. The World Bank, which lends money for improvements in underdeveloped nations, divides countries into four income categories:
World Bank Country and Lending Groups (by Gross National Income per Capita 2015)18
• High income—\$12,736 or higher (United States, Germany, Japan)
• Upper-middle income—\$4,126 to \$12,735 (China, South Africa, Mexico)
• Lower-middle income—\$1,046 to \$4,125 (Kenya, Philippines, India)
• Low income—\$1,045 or less (Afghanistan, South Sudan, Haiti)
Note that that even though a country has a low annual income per citizen, it can still be an attractive place for doing business. India, for example, is a lower-middle-income country, yet it has a population of a billion, and a segment of that population is well educated—an appealing feature for many business initiatives.
The long-term goal of many countries is to move up the economic development ladder. Some factors conducive to economic growth include a reliable banking system, a strong stock market, and government policies to encourage investment and competition while discouraging corruption. It’s also important that a country have a strong infrastructure—its systems of communications (telephone, Internet, television, newspapers), transportation (roads, railways, airports), energy (gas and electricity, power plants), and social facilities (schools, hospitals). These basic systems will help countries attract foreign investors, which can be crucial to economic development.
Currency Valuations and Exchange Rates
If every nation used the same currency, international trade and travel would be a lot easier. Of course, this is not the case. There are around 175 currencies in the world: Some you’ve heard of, such as the British pound; others are likely unknown to you, such as the manat, the official currency of Azerbaijan. If you were in Azerbaijan you would exchange your U.S. dollars for Azerbaijan manats. The day’s foreign exchange rate will tell you how much one currency is worth relative to another currency and so determine how many manats you will receive. If you have traveled abroad, you already have personal experience with the impact of exchange rate movements.
The Legal and Regulatory Environment
One of the more difficult aspects of doing business globally is dealing with vast differences in legal and regulatory environments. The United States, for example, has an established set of laws and regulations that provide direction to businesses operating within its borders. But because there is no global legal system, key
areas of business law—for example, contract provisions and copyright protection—can be treated in different ways in different countries. Companies doing international business often face many inconsistent laws and regulations. To navigate this sea of confusion, American businesspeople must know and follow both U.S. laws and regulations and those of nations in which they operate.
Business history is filled with stories about American companies that have stumbled in trying to comply with foreign laws and regulations. Coca-Cola, for example, ran afoul of Italian law when it printed its ingredients list on the bottle cap rather than on the bottle itself. Italian courts ruled that the labeling was inadequate because most people throw the cap away.19
One approach to dealing with local laws and regulations is hiring lawyers from the host country who can provide advice on legal issues. Another is working with local businesspeople who have experience in complying with regulations and overcoming bureaucratic obstacles.
Foreign Corrupt Practices Act
One U.S. law that creates unique challenges for American firms operating overseas is the Foreign Corrupt Practices Act, which prohibits the distribution of bribes and other favors in the conduct of business. Unfortunately, though they’re illegal in this country, such tactics as kickbacks and bribes are business-as-usual in many nations. According to some experts, American businesspeople are at a competitive disadvantage if they’re prohibited from giving bribes or undercover payments to foreign officials or business people who expect them. In theory, because the Foreign Corrupt Practices Act warns foreigners that Americans can’t give bribes, they’ll eventually stop expecting them.
Where are American businesspeople most likely and least likely to encounter bribe requests and related forms of corruption? Transparency International, an independent German-based organization, annually rates nations according to “perceived corruption,” (see Figure 5.8) which it defines as “the abuse of entrusted power for private gain.”20
Figure 5.8: Corruption Perceptions around the World, 2015: A score of 100 is perfect, and anything below 30 means that corruption is considered rampant.
Rank Country CPI Score
1 Denmark 91
2 Finland 90
3 Sweden 89
4 New Zealand 88
10 United Kingdom 81
16 United States 76
95 Mexico 35
167 Sudan 12
177 North Korea 8
177 Somalia 8
Case Study: Economic and International Impact of the U.S. Hospitality & Tourism
According to the U.S. International Trade Administration, the travel and tourism industry in the United States generated \$1.6 trillion in economic output and 7.8 million U.S. jobs in 2013, with nearly one in 18 Americans employed directly or indirectly in a travel or tourism-related industry.21 The Bureau of Labor of Labor Statistics indicates that an even higher percentage (11%) of U.S. jobs are in the Leisure and Hospitality sector.22
While the majority of travel, tourism and hospitality in the U.S. tourism industry is domestic, the U.S. leads the world in international travel and tourism exports (i.e., travelers from other countries visiting the U.S.) with 15% of global traveler spending. Travel and tourism ranks as the top services export, accounting for 31 percent of all U.S. services exports in 2014.
Expenditures by international visitors in the United States translate to economic impacts and jobs: including: \$220.8 billion in sales, a \$75.1 billion trade surplus, and 1.1 million total jobs in 2014.23 The sector is poised to grow: the latest U.S. Commerce Department international travel forecast estimates a 20% increase in international visitors in 2020 in comparison to 2014.24
Trade Controls
The debate about the extent to which countries should control the flow of foreign goods and investments across their borders is as old as international trade itself. Governments continue to control trade. To better understand how and why, let’s examine a hypothetical case. Suppose you’re in charge of a small country in which people do two things—grow food and make clothes. Because the quality of both products is high and the prices are reasonable, your consumers are happy to buy locally made food and clothes. But one day, a farmer from a nearby country crosses your border with several wagonloads of wheat to sell. On the same day, a foreign clothes maker arrives with a large shipment of clothes. These two entrepreneurs want to sell food and clothes in your country at prices below those that local consumers now pay for domestically made food and clothes. At first, this seems like a good deal for your consumers: they won’t have to pay as much for food and clothes. But then you remember all the people in your country who grow food and make clothes. If no one buys their goods (because the imported goods are cheaper), what will happen to their livelihoods? And if many people become unemployed, what will happen to your national economy? That’s when you decide to protect your farmers and clothes makers by setting up trade rules. Maybe you’ll increase the prices of imported goods by adding a tax to them; you might even make the tax so high that they’re more expensive than your homemade goods. Or perhaps you’ll help your farmers grow food more cheaply by giving them financial help to defray their costs. The government payments that you give to the farmers to help offset some of their costs of production are called subsidies. These subsidies will allow the farmers to lower the price of their goods to a point below that of imported competitors’ goods. What’s even better is that the lower costs will allow the farmers to export their own goods at attractive, competitive prices.
The United States has a long history of subsidizing farmers. Subsidy programs guarantee farmers (including large corporate farms) a certain price for their crops, regardless of the market price. This guarantee ensures stable income in the farming community but can have a negative impact on the world economy. How? Critics argue that in allowing American farmers to export crops at artificially low prices, U.S. agricultural subsidies permit them to compete unfairly with farmers in developing countries. A reverse situation occurs in the steel industry, in which a number of countries—China, Japan, Russia, Germany, and Brazil—subsidize domestic producers.
U.S. trade unions charge that this practice gives an unfair advantage to foreign producers and hurts the American steel industry, which can’t compete on price with subsidized imports.
Whether they push up the price of imports or push down the price of local goods, such initiatives will help locally produced goods compete more favorably with foreign goods. Both strategies are forms of trade controls—policies that restrict free trade. Because they protect domestic industries by reducing foreign competition, the use of such controls is often called protectionism. Though there’s considerable debate over the pros and cons of this practice, all countries engage in it to some extent. Before debating the issue, however, let’s learn about the more common types of trade restrictions: tariffs, quotas, and, embargoes.
Tariffs
Tariffs are taxes on imports. Because they raise the price of the foreign-made goods, they make them less competitive. The United States, for example, protects domestic makers of synthetic knitted shirts by imposing a stiff tariff of 32.5 percent on imports.25 Tariffs are also used to raise revenue for a government. Shoe imports alone are worth \$2.7 billion annually to the federal government.26
Quotas
A quota imposes limits on the quantity of a good that can be imported over a period of time. Quotas are used to protect specific industries, usually new industries or those facing strong competitive pressure from foreign firms. U.S. import quotas take two forms. An absolute quota fixes an upper limit on the amount of a good that can be imported during the given period. A tariff-rate quota permits the import of a specified quantity and then adds a high import tax once the limit is reached.
Sometimes quotas protect one group at the expense of another. To protect sugar beet and sugar cane growers, for instance, the United States imposes a tariff-rate quota on the importation of sugar—a policy that has driven up the cost of sugar to two to three times world prices.27 These artificially high prices push up costs for American candy makers, some of whom have moved their operations elsewhere, taking high-paying manufacturing jobs with them. Life Savers, for example, were made in the United States for ninety years but are now produced in Canada, where the company saves \$9 million annually on the cost of sugar.28
An extreme form of quota is the embargo, which, for economic or political reasons, bans the import or export of certain goods to or from a specific country. The U. S., for example, bans nearly every commodity originating in Cuba, although this may soon change.
Dumping
A common political rationale for establishing tariffs and quotas is the need to combat dumping: the practice of selling exported goods below the price that producers would normally charge in their home markets (and often below the cost of producing the goods). Usually, nations resort to this practice to gain entry and market share in foreign markets, but it can also be used to sell off surplus or obsolete goods. Dumping creates unfair competition for domestic industries, and governments are justifiably concerned when they suspect foreign countries of dumping products on their markets. They often retaliate by imposing punitive tariffs that drive up the price of the imported goods.
The Pros and Cons of Trade Controls
Opinions vary on government involvement in international trade. Proponents of controls contend that there are a number of legitimate reasons why countries engage in protectionism. Sometimes they restrict trade to protect specific industries and their workers from foreign competition—agriculture, for example, or steel making. At other times, they restrict imports to give new or struggling industries a chance to get established. Finally, some countries use protectionism to shield industries that are vital to their national defense, such as shipbuilding and military hardware.
Despite valid arguments made by supporters of trade controls, most experts believe that such restrictions as tariffs and quotas—as well as practices that don’t promote level playing fields, such as subsidies and dumping—are detrimental to the world economy. Without impediments to trade, countries can compete freely. Each nation can focus on what it does best and bring its goods to a fair and open world market. When this happens, the world will prosper, or so the argument goes. International trade is certainly heading in the direction of unrestricted markets.
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Reducing International Trade Barriers
A number of organizations work to ease barriers to trade, and more countries are joining together to promote trade and mutual economic benefits. Let’s look at some of these important initiatives.
Trade Agreements and Organizations
Free trade is encouraged by a number of agreements and organizations set up to monitor trade policies. The two most important are the General Agreement on Tariffs and Trade and the World Trade Organization.
General Agreement on Tariffs and Trade
After the Great Depression and World War II, most countries focused on protecting home industries, so international trade was hindered by rigid trade restrictions. To rectify this situation, twenty-three nations joined together in 1947 and signed the General Agreement on Tariffs and Trade (GATT), which encouraged free trade by regulating and reducing tariffs and by providing a forum for resolving trade disputes.
The highly successful initiative achieved substantial reductions in tariffs and quotas, and in 1995 its members founded the World Trade Organization to continue the work of GATT in overseeing global trade.
World Trade Organization
Based in Geneva, Switzerland, with nearly 150 members, the World Trade Organization (WTO) encourages global commerce and lower trade barriers, enforces international rules of trade, and provides a forum for resolving disputes. It is empowered, for instance, to determine whether a member nation’s trade policies have violated the organization’s rules, and it can direct “guilty” countries to remove disputed barriers (though it has no legal power to force any country to do anything it doesn’t want to do). If the guilty party refuses to comply, the WTO may authorize the plaintiff nation to erect trade barriers of its own, generally in the form of tariffs.
Affected members aren’t always happy with WTO actions. In 2002, for example, the Bush administration imposed a three-year tariff on imported steel. In ruling against this tariff, the WTO allowed the aggrieved nations to impose counter-tariffs on some politically sensitive American products, such as Florida oranges, Texas grapefruits and computers, and Wisconsin cheese. Reluctantly, the administration lifted its tariff on steel.29
Financial Support for Emerging Economies: The IMF and the World Bank
A key to helping developing countries become active participants in the global marketplace is providing financial assistance. Offering monetary assistance to some of the poorest nations in the world is the shared goal of two organizations: the International Monetary Fund and the World Bank. These organizations, to which most countries belong, were established in 1944 to accomplish different but complementary purposes.
The International Monetary Fund
The International Monetary Fund (IMF) loans money to countries with troubled economies, such as Mexico in the 1980s and mid-1990s and Russia and Argentina in the late 1990s. There are, however, strings attached to IMF loans: in exchange for relief in times of financial crisis, borrower countries must institute sometimes painful financial and economic reforms. In the 1980s, for example, Mexico received financial relief from the IMF on the condition that it privatize and deregulate certain industries and liberalize trade policies. The government was also required to cut back expenditures for such services as education, health care, and workers’ benefits.30
The World Bank
The World Bank is an important source of economic assistance for poor and developing countries. With backing from wealthy donor countries (such as the United States, Japan, Germany, and United Kingdom), the World Bank has committed \$42.5 billion in loans, grants, and guarantees to some of the world’s poorest nations.31 Loans are made to help countries improve the lives of the poor through community-support programs designed to provide health, nutrition, education, infrastructure, and other social services.
Trading Blocs: NAFTA and the European Union
So far, our discussion has suggested that global trade would be strengthened if there were no restrictions on it—if countries didn’t put up barriers to trade or perform special favors for domestic industries. The complete absence of barriers is an ideal state of affairs that we haven’t yet attained. In the meantime, economists and policymakers tend to focus on a more practical question: Can we achieve the goal of free trade on the regional level? To an extent, the answer is yes. In certain parts of the world, groups of countries have joined together to allow goods and services to flow without restrictions across their mutual borders. Such groups are called trading blocs. Let’s examine two of the most powerful trading blocs—NAFTA and the European Union.
North American Free Trade Association
The North American Free Trade Association (NAFTA) is an agreement among the governments of the United States, Canada, and Mexico to open their borders to unrestricted trade. The effect of this agreement is that three very different economies are combined into one economic zone with almost no trade barriers. From the northern tip of Canada to the southern tip of Mexico, each country benefits from the comparative advantages of its partners: each nation is free to produce what it does best and to trade its goods and services without restrictions.
When the agreement was ratified in 1994, it had no shortage of skeptics. Many people feared, for example, that without tariffs on Mexican goods, more U.S. manufacturing jobs would be lost to Mexico, where labor is cheaper. Almost two decades later, most such fears have not been realized, and, by and large, NAFTA has been a success.
Since it went into effect, the value of trade between the United States and Mexico has grown substantially, and Canada and Mexico are now the United States’ top trading partners.
The European Union
The forty-plus countries of Europe have long shown an interest in integrating their economies. The first organized effort to integrate a segment of Europe’s economic entities began in the late 1950s, when six countries joined together to form the European Economic Community (EEC). Over the next four decades, membership grew, and in the late 1990s, the EEC became the European Union. Today, the European Union (EU) is a group of twenty-seven countries that have eliminated trade barriers among themselves (see the map in Figure 5.10).
At first glance, the EU looks similar to NAFTA. Both, for instance, allow unrestricted trade among member nations. But the provisions of the EU go beyond those of NAFTA in several important ways. Most importantly, the EU is more than a trading organization: it also enhances political and social cooperation and binds its members into a single entity with authority to require them to follow common rules and regulations. It is much like a federation of states with a weak central government, with the effect not only of eliminating internal barriers but also of enforcing common tariffs on trade from outside the EU. In addition, while NAFTA allows goods and services as well as capital to pass between borders, the EU also allows people to come and go freely: if you possess an EU passport, you can work in any EU nation.
The Euro
A key step toward unification occurred in 1999, when most (but not all) EU members agreed to abandon their own currencies and adopt a joint currency. The actual conversion occurred in 2002, when a common currency called the euro replaced the separate currencies of participating EU countries. The common currency facilitates trade and finance because exchange-rate differences no longer complicate transactions.32
Its proponents argued that the EU would not only unite economically and politically distinct countries but also create an economic power that could compete against the dominant players in the global marketplace. Individually, each European country has limited economic power, but as a group, they could be an economic superpower.33 Over time, the value of the euro has been questioned. Many of the “euro” countries (Spain, Italy, Greece, Portugal, and Ireland in particular) have been financially irresponsible, piling up huge debts and experiencing high unemployment and problems in the housing market. But because these troubled countries share a common currency with the other “euro countries”, they are less able to correct their economic woes.34 Many economists fear that the financial crisis precipitated by these financially irresponsible countries threaten the very survival of the euro.35 Keep a close eye on Greece because if an exit from the Euro occurs, it will likely start there.
Only time will tell whether the trend toward regional trade agreements is good for the world economy. Clearly, they’re beneficial to their respective participants; for one thing, they get preferential treatment from other members. But certain questions still need to be answered more fully. Are regional agreements, for example, moving the world closer to free trade on a global scale—toward a marketplace in which goods and services can be traded anywhere without barriers?
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Key Takeaways
1. Nations trade because they don’t produce all the products that their inhabitants need.
2. The cost of labor, the availability of natural resources, and the level of know-how vary greatly around the world, so not every country has the same resources or is good at producing the same products.
3. To explain how countries decide what products to import and export, economists use the concepts of absolute and comparative advantage: A nation has an absolute advantage if it’s the only source of a particular product or can make more of a product with the same amount of or fewer resources than other countries. A comparative advantage exists when a country can produce a product at a lower opportunity cost than other nations.
4. We determine a country’s balance of trade by subtracting the value of its imports from the value of its exports. If a country sells more products than it buys, it has a favorable balance, called a trade surplus. If it buys more than it sells, it has an unfavorable balance, or a trade deficit.
5. The balance of payments is the difference, over a period of time, between the total flow coming into a country and the total flow going out. The biggest factor in a country’s balance of payments is the money that comes in and goes out as a result of exports and imports.
6. A company that operates in many countries is called a multinational corporation (MNC).
7. For a company in the United States wishing to expand beyond national borders, there are a variety of ways to get involved in international business:
1. Importing involves purchasing products from other countries and reselling them in one’s own.
2. Exporting entails selling products to foreign customers
3. Under a franchise agreement, a company grants a foreign company the right to use its brand name and sell its products.
4. A licensing agreement allows a foreign company to sell a company’s products or use its intellectual property in exchange for royalty fees.
5. Through international contract manufacturing, or outsourcing, a company has its products manufactured or services provided in other countries.
6. A joint venture is a type of strategic alliance in which a separate entity funded by the participating companies is formed.
7. Foreign direct investment (FDI) refers to the formal establishment of business operations on foreign soil.
8. A common form of FDI is the foreign subsidiary, an independent company owned by a foreign firm.
8. Success in international business requires an understanding an assortment of cultural, economic, and legal/regulatory differences between countries. Cultural challenges stem from differences in language, concepts of time and sociability, and communication styles.
9. Because they protect domestic industries by reducing foreign competition, the use of controls to restrict free trade is often called protectionism.
1. Tariffs are taxes on imports. Because they raise the price of the foreign-made goods, they make them less competitive.
2. Quotas are restrictions on imports that impose a limit on the quantity of a good that can be imported over a period of time. They’re used to protect specific industries, usually new industries or those facing strong competitive pressure from foreign firms.
3. An embargo is a quota that, for economic or political reasons, bans the import or export of certain goods to or from a specific country.
10. A common rationale for tariffs and quotas is the need to combat dumping—the practice of selling exported goods below the price that producers would normally charge in their home markets (and often below the costs of producing the goods).
11. Free trade is encouraged by a number of agreements and organizations set up to monitor trade policies.
1. The General Agreement on Tariffs and Trade (GATT) regulates free trade, reduces tariffs and provides a forum for resolving trade disputes.
2. The World Trade Organization (WTO) encourages global commerce and lower trade barriers, enforces international rules of trade, and provides a forum for resolving disputes.
12. The International MonetaryFund (IMF) and the World Bank both provide monetary assistance to the world’s poorest countries.
13. In certain parts of the world, groups of countries have formed trading blocs to allow goods and services to flow without restrictions across their mutual borders.
1. Examples include the North American Free Trade Association (NAFTA) (United States, Canada, and Mexico) and the European Union (EU), a group of twenty-seven countries that have eliminated trade barriers among themselves.
Chapter 5 Text References and Image Credits
Image Credits: Chapter 5
Figure 5.1: “Orchard Road, Singapore.” (2009) Michael Spencer. CC by 2.0. Image retrieved from: https://www.flickr.com/photos/michaelspencer/4393369407
Figure 5.2: “U.S. Imports, Exports, and Balance of Payments, 1994-2014.” Data source: The U.S. Census Bureau. Retrieved from: https://www.census.gov/foreign-trade/statistics/historical/gands.pdf
Figure 5.3: “First Burger King in Moscow.” Alexander Motin (2010). Public Domain. Retrieved from: https://commons.wikimedia.org/wiki/File:Burger_King_restaurant_Moscow_Metropolis.jpg
Figure 5.4: “Selected Hourly Wages, United States and India.” Data from Rick Noack (2015). “Chart: See how much (or how little) you’d earn if you did the same job in another country.” The Washington Post. Retrieved from: https://www.washingtonpost.com/news/worldviews/wp/2015/03/03/chart-see-how-much-or-how-little-youd-earn-if-you-did-the-same-job-in-another-country/
Figure 5.5: “Where FDI Goes.” Data source: The United Nations Conference on Trade and Development. Retrieved from: http://unctadstat.unctad.org/wds/TableViewer/tableView.aspx?ReportId=96740
Figure 5.6: “Fortune Top 15 Multinational Firms by Revenue.” Data from “Fortune Global 500 2015.” Retrieved from: http://fortune.com/global500/
Figure 5.8: “Corruption Perceptions Around the World.” Data from Transparency International (2016). “Corruption Perceptions Index 2015.” Retrieved from: http://www.transparency.org/cpi2015
Figure 5.9: “U.S. Employment by Industry Sector, 2014.” U.S. Department of Labor, Bureau of Labor Statistics (2015). “Employment Projections: Employment by Major Industry Sector.” Retrieved from: www.bls.gov/emp/ep_table_201.htm
Figure 5.10 “The European Union” Designed for Virginia Tech Libraries by Brian Craig and Robert Browder. Adapted from European Union map.svg [public domain] https://commons.wikimedia.org/wiki/File:European_Union_map.svg. Licensed CC BY 4.0. | textbooks/biz/Business/Introductory_Business/Book%3A_Fundamentals_of_Business_(Skripak)/05%3A_Business_in_a_Global_Environment.txt |
Learning Objectives
1. Identify the questions to ask in choosing the appropriate form of ownership for a business.
2. Describe the sole proprietorship and partnership forms of organization, and specify the advantages and disadvantages.
3. Identify the different types of partnerships, and explain the importance of a partnership agreement.
4. Explain how corporations are formed and how they operate.
5. Discuss the advantages and disadvantages of the corporate form of ownership.
6. Examine special types of business ownership, including limited-liability companies, and not-for-profit corporations.
7. Define mergers and acquisitions, and explain why companies are motivated to merge or acquire other companies.
The Ice Cream Men
Who would have thought it? Two ex-hippies with strong interests in social activism would end up starting one of the best-known ice cream companies in the country—Ben & Jerry’s. Perhaps it was meant to be. Ben Cohen (the “Ben” of Ben & Jerry’s) always had a fascination with ice cream. As a child, he made his own mixtures by smashing his favorite cookies and candies into his ice cream. But it wasn’t until his senior year in high school that he became an official “ice cream man,” happily driving his truck through neighborhoods filled with kids eager to buy his ice cream pops. After high school, Ben tried college but it wasn’t for him. He attended Colgate University for a year and a half before he dropped out to return to his real love: being an ice cream man. He tried college again—this time at Skidmore, where he studied pottery and jewelry making—but, in spite of his selection of courses, still didn’t like it.
In the meantime, Jerry Greenfield (the “Jerry” of Ben & Jerry’s) was following a similar path. He majored in pre-med at Oberlin College in the hopes of one day becoming a doctor. But he had to give up on this goal when he was not accepted into medical school. On a positive note, though, his college education steered him into a more lucrative field: the world of ice cream making. He got his first peek at the ice cream industry when he worked as a scooper in the student cafeteria at Oberlin. So, fourteen years after they first met on the junior high school track team, Ben and Jerry reunited and decided to go into ice cream making big time. They moved to Burlington, Vermont—a college town in need of an ice cream parlor—and completed a \$5 correspondence course from Penn State on making ice cream. After getting an A in the course—not surprising, given that the tests were open book—they took the plunge: with their life savings of \$8,000 and \$4,000 of borrowed funds they set up an ice cream shop in a made-over gas station on a busy street corner in Burlington.1 The next big decision was which form of business ownership was best for them. This chapter introduces you to their options.
Factors to Consider
If you’re starting a new business, you have to decide which legal form of ownership is best for you and your business. Do you want to own the business yourself and operate as a sole proprietorship? Or, do you want to share ownership, operating as a partnership or a corporation? Before we discuss the pros and cons of these three types of ownership, let’s address some of the questions that you’d probably ask yourself in choosing the appropriate legal form for your business.
1. In setting up your business, do you want to minimize the costs of getting started? Do you hope to avoid complex government regulations and reporting requirements?
2. How much control would you like? How much responsibility for running the business are you willing to share? What about sharing the profits?
3. Do you want to avoid special taxes?
4. Do you have all the skills needed to run the business?
5. Are you likely to get along with your co-owners over an extended period of time?
6. Is it important to you that the business survive you?
7. What are your financing needs and how do you plan to finance your company?
8. How much personal exposure to liability are you willing to accept? Do you feel uneasy about accepting personal liability for the actions of fellow owners?
No single form of ownership will give you everything you desire. You’ll have to make some trade-offs. Because each option has both advantages and disadvantages, your job is to decide which one offers the features that are most important to you. In the following sections we’ll compare three ownership options (sole proprietorship, partnership, corporation) on these eight dimensions.
Sole Proprietorship and its Advantages
In a sole proprietorship, as the owner, you have complete control over your business. You make all important decisions and are generally responsible for all day-to-day activities. In exchange for assuming all this responsibility, you get all the income earned by the business. Profits earned are taxed as personal income, so you don’t have to pay any special federal and state income taxes.
Disadvantages of Sole Proprietorships
For many people, however, the sole proprietorship is not suitable. The flip side of enjoying complete control is having to supply all the different talents that may be necessary to make the business a success. And when you’re gone, the business dissolves. You also have to rely on your own resources for financing: in effect, you are the business and any money borrowed by the business is loaned to you personally. Even more important, the sole proprietor bears unlimited liability for any losses incurred by the business. The principle of unlimited personal liability means that if the business incurs a debt or suffers a catastrophe (say, getting sued for causing an injury to someone), the owner is personally liable. As a sole proprietor, you put your personal assets (your bank account, your car, maybe even your home) at risk for the sake of your business. You can lessen your risk with insurance, yet your liability exposure can still be substantial. Given that Ben and Jerry decided to start their ice cream business together (and therefore the business was not owned by only one person), they could not set their company up as a sole proprietorship.
Partnership
A partnership (or general partnership) is a business owned jointly by two or more people. About 10 percent of U.S. businesses are partnerships2 and though the vast majority are small, some are quite large. For example, the big four public accounting firms are partnerships. Setting up a partnership is more complex than setting up a sole proprietorship, but it’s still relatively easy and inexpensive. The cost varies according to size and complexity. It’s possible to form a simple partnership without the help of a lawyer or an accountant, though it’s usually a good idea to get professional advice.
Professionals can help you identify and resolve issues that may later create disputes among partners.
The Partnership Agreement
The impact of disputes can be lessened if the partners have executed a well-planned partnership agreement that specifies everyone’s rights and responsibilities. The agreement might provide such details as the following:
• Amount of cash and other contributions to be made by each partner
• Division of partnership income (or loss)
• Partner responsibilities—who does what
• Conditions under which a partner can sell an interest in the company
• Conditions for dissolving the partnership
• Conditions for settling disputes
Unlimited Liability and the Partnership
A major problem with partnerships, as with sole proprietorships, is unlimited liability: in this case, each partner is personally liable not only for his or her own actions but also for the actions of all the partners. If your partner in an architectural firm makes a mistake that causes a structure to collapse, the loss your business incurs impacts you just as much as it would him or her. And here’s the really bad news: if the business doesn’t have the cash or other assets to cover losses, you can be personally sued for the amount owed. In other words, the party who suffered a loss because of the error can sue you for your personal assets. Many people are understandably reluctant to enter into partnerships because of unlimited liability. Certain forms of businesses allow owners to limit their liability. These include limited partnerships and corporations.
Limited Partnerships
The law permits business owners to form a limited partnership which has two types of partners: a single general partner who runs the business and is responsible for its liabilities, and any number of limited partners who have limited involvement in the business and whose losses are limited to the amount of their investment.
Advantages and Disadvantages of Partnerships
The partnership has several advantages over the sole proprietorship. First, it brings together a diverse group of talented individuals who share responsibility for running the business. Second, it makes financing easier: the business can draw on the financial resources of a number of individuals. The partners not only contribute funds to the business but can also use personal resources to secure bank loans. Finally, continuity needn’t be an issue because partners can agree legally to allow the partnership to survive if one or more partners die.
Still, there are some negatives. First, as discussed earlier, partners are subject to unlimited liability. Second, being a partner means that you have to share decision making, and many people aren’t comfortable with that situation. Not surprisingly, partners often have differences of opinion on how to run a business, and disagreements can escalate to the point of jeopardizing the continuance of the business. Third, in addition to sharing ideas, partners also share profits. This arrangement can work as long as all partners feel that they’re being rewarded according to their efforts and accomplishments, but that isn’t always the case. While the partnership form of ownership is viewed negatively by some, it was particularly appealing to Ben Cohen and Jerry Greenfield. Starting their ice cream business as a partnership was inexpensive and let them combine their limited financial resources and use their diverse skills and talents. As friends they trusted each other and welcomed shared decision making and profit sharing. They were also not reluctant to be held personally liable for each other’s actions.
Corporation
A corporation (sometimes called a regular or C-corporation) differs from a sole proprietorship and a partnership because it’s a legal entity that is entirely separate from the parties who own it. It can enter into binding contracts, buy and sell property, sue and be sued, be held responsible for its actions, and be taxed. Once businesses reach any substantial size, it is advantageous to organize as a corporation so that its owners can limit their liability. Corporations, then, tend to be far larger, on average, than businesses using other forms of ownership. As Figure 6.2 shows, corporations account for 18 percent of all U.S. businesses but generate almost 82 percent of the revenues.3 Most large well-known businesses are corporations, but so are many of the smaller firms with which likely you do business.
Ownership and Stock
Corporations are owned by shareholders who invest money in the business by buying shares of stock. The portion of the corporation they own depends on the percentage of stock they hold. For example, if a corporation has issued 100 shares of stock, and you own 30 shares, you own 30 percent of the company. The shareholders elect a board of directors, a group of people (primarily from outside the corporation) who are legally responsible for governing the corporation. The board oversees the major policies and decisions made by the corporation, sets goals and holds management accountable for achieving them, and hires and evaluates the top executive, generally called the CEO (chief executive officer). The board also approves the distribution of income to shareholders in the form of cash payments called dividends.
Benefits of Incorporation
The corporate form of organization offers several advantages, including limited liability for shareholders, greater access to financial resources, specialized management, and continuity.
Limited Liability
The most important benefit of incorporation is the limited liability to which shareholders are exposed: they are not responsible for the obligations of the corporation, and they can lose no more than the amount that they have personally invested in the company. Limited liability would have been a big plus for the unfortunate individual whose business partner burned down their dry cleaning establishment. Had they been incorporated, the corporation would have been liable for the debts incurred by the fire. If the corporation didn’t have enough money to pay the debt, the individual shareholders would not have been obligated to pay anything. They would have lost all the money that they’d invested in the business, but no more.
Financial Resources
Incorporation also makes it possible for businesses to raise funds by selling stock. This is a big advantage as a company grows and needs more funds to operate and compete. Depending on its size and financial strength, the corporation also has an advantage over other forms of business in getting bank loans. An established corporation can borrow its own funds, but when a small business needs a loan, the bank usually requires that it be guaranteed by its owners.
Specialized Management
Because of their size and ability to pay high sales commissions and benefits, corporations are generally able to attract more skilled and talented employees than are proprietorships and partnerships.
Continuity and Transferability
Another advantage of incorporation is continuity. Because the corporation has a legal life separate from the lives of its owners, it can (at least in theory) exist forever.
Transferring ownership of a corporation is easy: shareholders simply sell their stock to others. Some founders, however, want to restrict the transferability of their stock and so choose to operate as a privately-held corporation. The stock in these corporations is held by only a few individuals, who are not allowed to sell it to the general public.
Companies with no such restrictions on stock sales are called public corporations; stock is available for sale to the general public.
Drawbacks to Incorporation
Like sole proprietorships and partnerships, corporations have both positive and negative aspects. In sole proprietorships and partnerships, for instance, the individuals who own and manage a business are the same people. Corporate managers, however, don’t necessarily own stock, and shareholders don’t necessarily work for the company. This situation can be troublesome if the goals of the two groups differ significantly.
Managers, for example, are often more interested in career advancement than the overall profitability of the company. Stockholders might care more about profits without regard for the well-being of employees. This situation is known as the agency problem, a conflict of interest inherent in a relationship in which one party is supposed to act in the best interest of the other. It is often quite difficult to prevent self-interest from entering into these situations.
Another drawback to incorporation—one that often discourages small businesses from incorporating—is the fact that corporations are more costly to set up. When you combine filing and licensing fees with accounting and attorney fees, incorporating a business could set you back by \$1,000 to \$6,000 or more depending on the size and scope of your business.4 Additionally, corporations are subject to levels of regulation and governmental oversight that can place a burden on small businesses. Finally, corporations are subject to what’s generally called “double taxation.” Corporations are taxed by the federal and state governments on their earnings. When these earnings are distributed as dividends, the shareholders pay taxes on these dividends. Corporate profits are thus taxed twice—the corporation pays the taxes the first time and the shareholders pay the taxes the second time.
Five years after starting their ice cream business, Ben Cohen and Jerry Greenfield evaluated the pros and cons of the corporate form of ownership, and the “pros” won. The primary motivator was the need to raise funds to build a \$2 million manufacturing facility. Not only did Ben and Jerry decide to switch from a partnership to a corporation, but they also decided to sell shares of stock to the public (and thus become a public corporation). Their sale of stock to the public was a bit unusual: Ben and Jerry wanted the community to own the company, so instead of offering the stock to anyone interested in buying a share, they offered stock to residents of Vermont only. Ben believed that “business has a responsibility to give back to the community from which it draws its support.”5 He wanted the company to be owned by those who lined up in the gas station to buy cones. The stock was so popular that one in every hundred Vermont families bought stock in the company.6 Eventually, as the company continued to expand, the stock was sold on a national level.
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Other Types of Business Ownership
In addition to the three commonly adopted forms of business organization—sole proprietorship, partnership, and regular corporations—some business owners select other forms of organization to meet their particular needs. We’ll look at two of these options:
• Limited-liability companies
• Not-for-profit corporations
Limited-Liability Companies
How would you like a legal form of organization that provides the attractive features of the three common forms of organization (corporation, sole proprietorship and partnership) and avoids the unattractive features of these three organization forms? The limited-liability company(LLC) accomplishes exactly that. This form provides business owners with limited liability (a key advantage of corporations) and no “double taxation” (a key advantage of sole proprietorships and partnerships). Let’s look at the LLC in more detail.
In 1977, Wyoming became the first state to allow businesses to operate as limited-liability companies. Twenty years later, in 1997, Hawaii became the last state to give its approval to the new organization form. Since then, the limited-liability company has increased in popularity. Its rapid growth was fueled in part by changes in state statutes that permit a limited-liability company to have just one member. The trend to LLCs can be witnessed by reading company names on the side of trucks or on storefronts in your city. It is common to see names such as Jim Evans Tree Care, LLC, and For-Cats-Only Veterinary Clinic, LLC. But LLCs are not limited to small businesses. Companies such as Crayola, Domino’s Pizza, Ritz-Carlton Hotel Company, and iSold It (which helps people sell their unwanted belongings on eBay) are operating under the limited-liability form of organization.
In a limited-liability company, owners (called members rather than shareholders) are not personally liable for debts of the company, and its earnings are taxed only once, at the personal level (thereby eliminating double taxation).
We have touted the benefits of limited liability protection for an LLC. We now need to point out some circumstances under which an LLC member (or a shareholder in a corporation) might be held personally liable for the debts of his or her company. A business owner can be held personally liable if he or she:
• Personally guarantees a business debt or bank loan which the company fails to pay.
• Fails to pay employment taxes to the government.
• Engages in fraudulent or illegal behavior that harms the company or someone else.
• Does not treat the company as a separate legal entity, for example, uses company assets for personal uses.
Not-for-Profit Corporations
A not-for-profit corporation (sometimes called a nonprofit) is an organization formed to serve some public purpose rather than for financial gain. As long as the organization’s activity is for charitable, religious, educational, scientific, or literary purposes, it can be exempt from paying income taxes. Additionally, individuals and other organizations that contribute to the not-for-profit corporation can take a tax deduction for those contributions. The types of groups that normally apply for nonprofit status vary widely and include churches, synagogues, mosques, and other places of worship; museums; universities; and conservation groups.
There are more than 1.5 million not-for-profit organizations in the United States.7 Some are extremely well funded, such as the Bill and Melinda Gates Foundation, which has an endowment of approximately \$40 billion and has given away \$36.7 billion since its inception.8 Others are nationally recognized, such as United Way, Goodwill Industries, Habitat for Humanity, and the Red Cross. Yet the vast majority is neither rich nor famous, but nevertheless makes significant contributions to society.
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Mergers and Acquisitions
The headline read, “Wanted: More than 2,000 in Google Hiring Spree.”9 The largest Web search engine in the world was disclosing its plans to grow internally and increase its workforce by more than 2,000 people, with half of the hires coming from the United States and the other half coming from other countries. The added employees will help the company expand into new markets and battle for global talent in the competitive Internet information providers industry. When properly executed, internal growth benefits the firm.
An alternative approach to growth is to merge with or acquire another company. The rationale behind growth through merger or acquisition is that 1 + 1 = 3: the combined company is more valuable than the sum of the two separate companies. This rationale is attractive to companies facing competitive pressures. To grab a bigger share of the market and improve profitability, companies will want to become more cost efficient by combining with other companies.
Mergers and Acquisitions
Though they are often used as if they’re synonymous, the terms merger and acquisition mean slightly different things. A merger occurs when two companies combine to form a new company. An acquisition is the purchase of one company by another. An example of a merger is the merging in 2013 of US Airways and American Airlines. The combined company, the largest carrier in the world, flies under the name American Airlines.
Another example of an acquisition is the purchase of Reebok by Adidas for \$3.8 billion.10 The deal was expected to give Adidas a stronger presence in North America and help the company compete with rival Nike. Once this acquisition was completed, Reebok as a company ceased to exist, though Adidas still sells shoes under the Reebok brand.
Motives behind Mergers and Acquisitions
Companies are motivated to merge or acquire other companies for a number of reasons, including the following.
Gain Complementary Products
Acquiring complementary products was the motivation behind Adidas’s acquisition of Reebok. As Adidas CEO Herbert Hainer stated in a conference call, “This is a once-in- a-lifetime opportunity. This is a perfect fit for both companies, because the companies are so complementary…. Adidas is grounded in sports performance with such products as a motorized running shoe and endorsement deals with such superstars as British soccer player David Beckham. Meanwhile, Reebok plays heavily to the melding of sports and entertainment with endorsement deals and products by Nelly, Jay-Z, and 50 Cent. The combination could be deadly to Nike.” Of course, Nike has continued to thrive, but one can’t blame Hainer for his optimism.11
Attain New Markets or Distribution Channels
Gaining new markets was a significant factor in the 2005 merger of US Airways and America West. US Airways was a major player on the East Coast, the Caribbean, and Europe, while America West was strong in the West. The expectations were that combining the two carriers would create an airline that could reach more markets than either carrier could do on its own.12
Realize Synergies
The purchase of Pharmacia Corporation (a Swedish pharmaceutical company) by Pfizer (a research-based pharmaceutical company based in the United States) in 2003 created one of the world’s largest drug makers and pharmaceutical companies, by revenue, in every major market around the globe.13 The acquisition created an industry giant with more than \$48 billion in revenue and a research-and-development budget of more than \$7 billion. Each day, almost forty million people around the globe are treated with Pfizer medicines.14 Its subsequent \$68 billion purchase of rival drug maker Wyeth further increased its presence in the pharmaceutical market.15
In pursuing these acquisitions, Pfizer likely identified many synergies: quite simply, a whole that is greater than the sum of its parts. There are many examples of synergies. A merger typically results in a number of redundant positions; the combined company does not likely need two vice-presidents of marketing, two chief financial officers, and so on. Eliminating the redundant positions leads to significant cost savings that would not be realized if the two companies did not merge. Let’s say each of the companies was operating factories at 50% of capacity, and by merging, one factory could be closed and sold. That would also be an example of a synergy. Companies bring different strengths and weaknesses into the merged entity. If the newly-combined company can take advantage of the marketing capabilities of the stronger entity and the distribution capabilities of the other (assuming they are stronger), the new company can realize synergies in both of these functions.
Hostile Takeover
What happens, though, if one company wants to acquire another company, but that company doesn’t want to be acquired? The outcome could be a hostile takeover—an act of assuming control that’s resisted by the targeted company’s management and its board of directors. Ben Cohen and Jerry Greenfield found themselves in one of these situations: Unilever—a very large Dutch/British company that owns three ice cream brands—wanted to buy Ben & Jerry’s, against the founders’ wishes. Most of the Ben & Jerry’s stockholders sided with Unilever. They had little confidence in the ability of Ben Cohen and Jerry Greenfield to continue managing the company and were frustrated with the firm’s social-mission focus. The stockholders liked Unilever’s offer to buy their Ben & Jerry’s stock at almost twice its current market price and wanted to take their profits. In the end, Unilever won; Ben & Jerry’s was acquired by Unilever in a hostile takeover.16 Despite fears that the company’s social mission would end, it didn’t happen. Though neither Ben Cohen nor Jerry Greenfield are involved in the current management of the company, they have returned to their social activism roots and are heavily involved in numerous social initiatives sponsored by the company.
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Chapter Video: Business Structures
Here is a short video providing a simple and straightforward recap of the key points of each form of business ownership.
A YouTube element has been excluded from this version of the text. You can view it online here: pb.libretexts.org/biz3/?p=73
(Copyrighted material)
Key Takeaways
1. A soleproprietorship, a business owned by only one person, accounts for 72% of all U.S. businesses.
2. Advantages include: complete control for the owner, easy and inexpensive to form, and owner gets to keep all of the profits.
3. Disadvantages include: unlimited liability for the owner, complete responsibility for talent and financing, and business dissolves if the owner dies.
4. A general partnership is a business owned jointly by two or more people, and accounts for about 10% of all U.S. businesses.
5. Advantages include: more resources and talents come with an increase in partners, and the business can continue even after the death of a partner.
6. Disadvantages include: partnership disputes, unlimited liability, and shared profits.
7. A limited partnership has a single general partner who runs the business and is responsible for its liabilities, plus any number of limited partners who have limited involvement in the business and whose losses are limited to the amount of their investment.
8. A corporation is a legal entity that’s separate from the parties who own it, the shareholders who invest by buying shares of stock. Corporations are governed by a Board of Directors, elected by the shareholders.
9. Advantages include: limited liability, easier access to financing, and unlimited life for the corporation.
10. Disadvantages include: the agency problem, double taxation, and incorporation expenses and regulations.
11. A limited-liabilitycompany (LLC) is a business structure that combines the tax treatment of a partnership with the liability protection of a corporation.
12. A not-for-profitcorporation is an organization formed to serve some public purpose rather than for financial gain. It enjoys favorable tax treatment.
13. A merger occurs when two companies combine to form a new company.
14. An acquisition is the purchase of one company by another with no new company being formed. A hostile takeover occurs when a company is purchased even though the company’s management and Board of Directors do not want to be acquired.
Chapter 6 Text References and Image Credits
Image Credits: Chapter 6
Figure 6.1: Dismas (2010).Ben Cohen and Jerry Greenfield in 2010.” CC by SA 3.0Retrieved from: https://en.Wikipedia.org/wiki/Ben_%26_Jerry%27s – /media/File:Ben_and_Jerry.jpg.
Figure 6.2: “Types of U.S. Businesses.” Data source: “Number of Tax Returns, Receipts, and Net Income by Type of Business.” Census.gov. Retrieved from: www.census.gov/prod/2011pubs/12statab/business.pdf
Video Credits: Chapter 6
“Business Structures.” (Bean Counter). March 9, 2014. Retrieved from: https://www.youtube.com/watch?v=z-GLrHhuDEM
2 IRS (2015). “SOI Bulletin Historical Table 12: Number of Business Income Tax Returns, by Size of Business for Income Years 1990-2013.” IRS.gov. Retrieved from: https://www.irs.gov/uac/soi-tax-stats-historical-table-12 3 United States Census Bureau (2011). “Number of Tax Returns, Receipts, and Net Income by Type of Business.” Census.gov. Retrieved from: https://www.census.gov/prod/2011pubs/12statab/business.pdf 4 AllBusiness Editors (2016). “How Much Does it Cost to Incorporate?” AllBusiness.com. Retrieved from: allbusiness.sfgate.com/legal/contracts-agreements-incorporation/2531-1.htm 5 Fred Chico Lager (1994). Ben & Jerry’s: The Inside Scoop. New York: Crown Publishers. P. 91. 6 Fred Chico Lager (1994). Ben & Jerry’s: The Inside Scoop. New York: Crown Publishers. P. 103. 7 Urban Institute National Center for Charitable Statistics (2010). “Number of Nonprofit Organizations in the United States, 1999 – 2009.” Urban Institute National Center for Charitable Statistics Retrieved from: nccsdataweb.urban.org/PubApps/profile1.php?state=US 8 The Bill and Melinda Gates Foundation (2016). “Who We Are: Foundation Fact Sheet.” Gatesfoundation.org. Retrieved from: http://www.gatesfoundation.org/Who-We-Are/General-Information/Foundation-Factsheet 9 Alexei Oreskovic (2010). “Wanted: More than 2,000 in Google Hiring Spree.” Reuters. Retrieved from: http://www.reuters.com/article/us-google-idUSTRE6AI05820101119 10 Theresa Howard (2005). “Adidas, Reebok Lace up for a Run Against Nike.” USAToday. Retrieved from: http://usatoday30.usatoday.com/money/industries/manufacturing/2005-08-02-adidas-usat_x.htm 11 Theresa Howard (2005). “Adidas, Reebok Lace up for a Run Against Nike.” USAToday. Retrieved from: http://usatoday30.usatoday.com/money/industries/manufacturing/2005-08-02-adidas-usat_x.htm 12 CNN (2005). “America West, US Air in Merger Deal.” CNN Money. Retrieved from: http://money.cnn.com/2005/05/19/news/midcaps/airlines/index.htm 13 Robert Frank and Scott Hensley (2002). “Pfizer to Buy Pharmacia for \$60 Billion in Stock.” The Wall Street Journal. Retrieved from: http://www.wsj.com/articles/SB1026684057282753560 14 Pfizer (2003). “2003: Pfizer and Pharmacia Merger.” Pfizer.com. Retrieved from: http://www.pfizer.com/about/history/pfizer_pharmacia 15 Andrew Ross Sorkin and Duff Wilson (2009). “Pfizer Agrees to Pay \$68 Billion for Rival Drug Maker Wyeth.” The New York Times. Retrieved from: http://www.nytimes.com/2009/01/26/business/26drug.html?pagewanted=2&_r=0 16 CNN (2000). “Ben and Jerry’s Scooped Up.” CNN Money. Retrieved from: http://money.cnn.com/2000/04/12/deals/benandjerrys/ | textbooks/biz/Business/Introductory_Business/Book%3A_Fundamentals_of_Business_(Skripak)/06%3A_Forms_of_Business_Ownership.txt |
Learning Objectives
1. Define entrepreneur and describe the three characteristics of entrepreneurial activity.
2. Identify five potential advantages to starting your own business
3. Define a small business and explain the importance of small businesses to the U.S. economy.
4. Explain why small businesses tend to foster innovation more effectively than large ones.
5. Describe the goods-producing and service-producing sectors of an economy.
6. Explain what it takes to start a business and evaluate the advantages and disadvantages starting a business from scratch, buying an existing business, or obtaining a franchise.
7. Explain why some businesses fail.
8. Identify sources of small business assistance from the Small Business Administration.
Cover Story: Build a Better “Baby” and They Will Come
One balmy San Diego evening in 1993, Mary and Rick Jurmain were watching a TV program about teenage pregnancy.1 To simulate the challenge of caring for an infant, teens on the program were assigned to tend baby-size sacks of flour. Rick, a father of two young children, remarked that trundling around a sack of flour wasn’t exactly a true- to-life experience. In particular, he argued, sacks of flour simulated only abnormally happy babies—babies who didn’t cry, especially in the middle of the night. Half-seriously, Mary suggested that her husband—a between-jobs aerospace engineer— build a better baby, and within a couple of weeks, a prototype was born. Rick’s brainchild was a bouncing 6.5-pound bundle of vinyl-covered joy with an internal computer to simulate infant crying at realistic, random intervals. He also designed a drug-affected model to simulate tremors from withdrawal, and each model monitored itself for neglect or ill treatment.
The Jurmains patented Baby Think It Over and started production in 1994 as Baby Think It Over Inc. Their first “factory” was their garage, and the “office” was the kitchen table—“a little business in a house,” as Mary put it. With a boost from articles in USA Today, Newsweek, Forbes, and People—plus a “Product of the Year” nod from Fortune—news of the Jurmains’ “infant simulator” eventually spread to the new company’s targeted education market, and by 1998, some forty thousand simulators had been babysat by more than a million teenagers in nine countries. By that time, the company had moved to Wisconsin, where it had been rechristened BTIO Educational Products Inc. to reflect an expanded product line that now includes not only dolls and equipment, like the Shaken Baby Syndrome Simulator, but also simulator-based programs like START Addiction Education and Realityworks Pregnancy Profile. BTIO was retired and replaced by the new and improved RealCare Baby and, ultimately, by RealCare Baby II–Plus, which requires the participant to determine what the “baby” needs when it cries and downloads data to record misconduct. In 2003, the name of the Jurmains’ company was changed once again, this time to Realityworks Inc.
In developing BTIO and Realityworks Inc., the Jurmains were doing what entrepreneurs do (and doing it very well). In fact, Mary was nominated three times for the Ernst & Young Entrepreneur of the Year Award and named 2001 Wisconsin Entrepreneurial Woman of the Year by the National Association of Women Business Owners. So what, exactly, is an entrepreneur and what does one do? According to one definition, an entrepreneur is an “individual who starts a new business” – and that’s true. Another definition identifies an entrepreneur as someone who “uses resources to implement innovative ideas for new, thoughtfully planned ventures.”2 But an important component of a satisfactory definition is still missing. To appreciate fully what it is, let’s go back to the story of the Jurmains. In 1993, the Jurmains were both unemployed—Rick had been laid off by General Dynamics Corp., and Mary by the San Diego Gas and Electric Company. While they were watching the show about teenagers and flour sacks, they were living off a loan from her father and the returns from a timely investment in coffee futures. Rick recalls that the idea for a method of creating BTIO came to him while “I was awake in bed, worrying about being unemployed.” He was struggling to find a way to feed his family. He had to make the first forty simulators himself, and at the end of the first summer, BTIO had received about four hundred orders—a promising start, perhaps, but, at \$250 per baby (less expenses), not exactly a windfall. “We were always about one month away from bankruptcy,” recalls Mary.
At the same time, it’s not as if the Jurmains started up BTIO simply because they had no “conventional” options for improving their financial prospects. Rick, as we’ve seen, was an aerospace engineer, and his résumé includes work on space-shuttle missions at NASA. Mary, who has not only a head for business but also a degree in industrial engineering, has worked at the Johnson Space Center. Therefore, the idea of replacing a sack of flour with a computer-controlled simulator wasn’t necessarily rocket science for the couple. But taking advantage of that idea—choosing to start a new business and to commit themselves to running it—was a risk. Risk taking is the missing component that we’re looking for in a definition of entrepreneurship, and so we’ll define an entrepreneur as someone who identifies a business opportunity and assumes the risk of creating and running a business to take advantage of it. To be successful, entrepreneurs must be comfortable accepting risk, and positive and confident that they can manage through it successfully.
The Nature of Entrepreneurship
If we look a little more closely at the definition of entrepreneurship, we can identify three characteristics of entrepreneurial activity:3
1. Innovation. Entrepreneurship generally means offering a new product, applying a new technique or technology, opening a new market, or developing a new form of organization for the purpose of producing or enhancing a product.
2. Running a business. A business, as we saw in Chapter 1 “The Foundations of Business,” combines resources to produce goods or services. Entrepreneurship means setting up a business to make a profit.
3. Risktaking. The term risk means that the outcome of the entrepreneurial venture can’t be known. Entrepreneurs, therefore, are always working under a certain degree of uncertainty, and they can’t know the outcomes of many of the decisions that they have to make. Consequently, many of the steps they take are motivated mainly by their confidence in the innovation and in their understanding of the business environment in which they’re operating.
It is easy to recognize these characteristics in the entrepreneurial experience of the Jurmains. They certainly had an innovative idea. But was it a good business idea? In a practical sense, a “good” business idea has to become something more than just an idea. If, like the Jurmains, you’re interested in generating income from your idea, you’ll probably need to turn it into a product—something that you can market because it satisfies a need. If you want to develop a product, you’ll need some kind of organization to coordinate the resources necessary to make it a reality (in other words, a business). Risk enters the equation when you make the decision to start up a business and when you commit yourself to managing it.
A Few Things to Know about Going into Business for Yourself
Mark Zuckerberg founded Facebook while a student at Harvard. By age 27 he built up a personal wealth of \$13.5 billion. By age 31, his net worth was \$37.5 billion.
So what about you? Do you ever wonder what it would be like to start your own business? You might even turn into a “serial entrepreneur” like Marcia Kilgore.4 After high school, she moved from Canada to New York City to attend Columbia University. But when her financial aid was delayed, Marcia abandoned her plans to attend college and took a job as a personal trainer (a natural occupation for a former bodybuilder and middleweight title holder). But things got boring in the summer when her wealthy clients left the city for the Hamptons. To keep busy, she took a skin care course at a Manhattan cosmetology institute. As a teenager, she was self-conscious about her complexion and wanted to know how to treat it herself. She learned how to give facials and work with natural remedies. She started giving facials to her fitness clients who were thrilled with the results. As demand for her services exploded, she started her first business—Bliss Spa—and picked up celebrity clients, including Madonna, Oprah Winfrey, and Jennifer Lopez. The business went international, and she sold it for more than \$30 million.5
But the story doesn’t end here; she launched two more companies: Soap and Glory, a supplier of affordable beauty products sold at Target, and FitFlops, which sells sandals that tone and tighten your leg muscles as you walk. Oprah loves Kilgore’s sandals and plugged them on her show.6 You can’t get a better endorsement than that. Kilgore never did finish college, but when asked if she would follow the same path again, she said, “If I had to decide what to do all over again, I would make the same choices…I found by accident what I’m good at, and I’m glad I did.”
So, a few questions to consider if you want to go into business for yourself:
• How do I come up with a business idea?
• Should I build a business from scratch, buy an existing business, or invest in a franchise?
• What steps are involved in developing a business plan?
• Where could I find help in getting my business started?
• How can I increase the likelihood that I’ll succeed?
In this chapter, we’ll provide some answers to questions like these.
Why Start Your Own Business?
What sort of characteristics distinguishes those who start businesses from those who don’t? Or, more to the point, why do some people actually follow through on the desire to start up their own businesses? The most common reasons for starting a business are the following:
• To be your own boss
• To accommodate a desired lifestyle
• To achieve financial independence
• To enjoy creative freedom
• To use your skills and knowledge
The Small Business Administration (SBA) points out, though, that these are likely to be advantages only “for the right person.” How do you know if you’re one of the “right people”? The SBA suggests that you assess your strengths and weaknesses by asking yourself a few relevant questions:7
• Am I a self-starter? You’ll need to develop and follow through on your ideas.
• How well do I get along with different personalities? Strong working relationships with a variety of people are crucial.
• How good am I at making decisions? Especially under pressure…..
• Do I have the physical and emotional stamina? Expect six or seven work days of about twelve hours every week.
• How well do I plan and organize? Poor planning is the culprit in most business failures.
• How will my business affect my family? Family members need to know what to expect: long hours and, at least initially, a more modest standard of living.
Before we discuss why businesses fail we should consider why a huge number of business ideas never even make it to the grand opening. One business analyst cites four reservations (or fears) that prevent people from starting businesses:8
• Money. Without cash, you can’t get very far. What to do: line up initial financing early or at least have done enough research to have a plan to raise money.
• Security. A lot of people don’t want to sacrifice the steady income that comes with the nine-to-five job. What to do: don’t give up your day job. Run the business part-time or connect with someone to help run your business – a “co-founder”.
• Competition. A lot of people don’t know how to distinguish their business ideas from similar ideas. What to do: figure out how to do something cheaper, faster, or better.
• Lack of ideas. Some people simply don’t know what sort of business they want to get into. What to do: find out what trends are successful. Turn a hobby into a business. Think about a franchise. Find a solution to something that annoys you – entrepreneurs call this a “pain point” – and try to turn it into a business.
If you’re still interested in going into business for yourself, try to regard such drawbacks as mere obstacles to be overcome by a combination of planning and creative thinking.
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Sources of Early-Stage Financing
As noted above, many businesses fail, or never get started, due to a lack of funds. But where can an entrepreneur raise money to start a business? Many first-time entrepreneurs are financed by friends and family, at least in the very early stages. Others may borrow through their personal credit cards, though quite often, high interest rates make this approach unattractive or too expensive for the new business to afford.
An entrepreneur with a great idea may win funding through a pitch competition; localities and state agencies understand that economic growth depends on successful new businesses, and so they will often conduct such competitions in the hopes of attracting them.
Crowd funding has become more common as a means of raising capital. An entrepreneur using this approach would typically utilize a crowd-funding platform like Kickstarter to attract investors. The entrepreneur might offer tokens of appreciation in exchange for funds, or perhaps might offer an ownership stake for a substantial enough investment.
Some entrepreneurs receive funding from angel investors, affluent investors who provide capital to start-ups in exchange for an ownership position in the company. Many angels are successful entrepreneurs themselves and invest not only to make money, but also to help other aspiring business owners to succeed.
Venture capital firms also invest in start-up companies, although usually at a somewhat later stage and in larger dollar amounts than would be typical of angel investors. Like angels, venture firms also take an ownership position in the company. They tend to have a higher expectation of making a return on their money than do angel investors.
Distinguishing Entrepreneurs from Small Business Owners
Though most entrepreneurial ventures begin as small businesses, not all small business owners are entrepreneurs. Entrepreneurs are innovators who start companies to create new or improved products. They strive to meet a need that’s not being met, and their goal is to grow the business and eventually expand into other markets.
In contrast, many people either start or buy small businesses for the sole purpose of providing an income for themselves and their families. They do not intend to be particularly innovative, nor do they plan to expand significantly. This desire to operate is what’s sometimes called a “lifestyle business.”9 The neighborhood pizza parlor or beauty shop, the self-employed consultant who works out of the home, and even a local printing company—many of these are typically lifestyle businesses.
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The Importance of Small Business to the U.S. Economy
What Is a “Small Business”?
To assess the value of small businesses to the U.S. economy, we first need to know what constitutes a small business. Let’s start by looking at the criteria used by the Small Business Administration. According to the SBA, a small business is one that is independently owned and operated, exerts little influence in its industry, and (with a few exceptions) has fewer than five hundred employees.10
Why Are Small Businesses Important?
Small business constitutes a major force in the U.S. economy. There are more than 28 million small businesses in this country, and they generate about 54 percent of sales and 55 percent of jobs in the U.S.11 The millions of individuals who have started businesses in the United States have shaped the business world as we know it today. Some small business founders like Henry Ford and Thomas Edison have even gained places in history. Others, including Bill Gates (Microsoft), Sam Walton (Wal-Mart), Steve Jobs (Apple Computer), and Larry Page and Sergey Brin (Google), have changed the way business is done today.
Aside from contributions to our general economic well-being, founders of small businesses also contribute to growth and vitality in specific areas of economic and socioeconomic development. In particular, small businesses do the following:
• Create jobs
• Spark innovation
• Provide opportunities for many people, including women and minorities, to achieve financial success and independence
In addition, they complement the economic activity of large organizations by providing them with components, services, and distribution of their products. Let’s take a closer look at each of these contributions.
Job Creation
The majority of U.S. workers first entered the business world working for small businesses. Although the split between those working in small companies and those working in big companies is about even, small firms hire more frequently and fire more frequently than do big companies.12 Why is this true? At any given point in time, lots of small companies are started and some expand. These small companies need workers and so hiring takes place. But the survival and expansion rates for small firms is poor, and so, again at any given point in time, many small businesses close or contract and workers lose their jobs. Fortunately, over time more jobs are added by small firms than are taken away, which results in a net increase in the number of workers, as seen in Figure 7.2.
Figure 7.2: Small Business Job Gains and Losses, 2000-2015 (in millions of jobs)
New business opening (closings) Business expansions (contractions) Total
34.3 237.5
(33.1) (233.9)
+1.2 +3.6 +4.8
The size of the net increase in the number of workers for any given year depends on a number of factors, with the economy being at the top of the list. A strong economy encourages individuals to start small businesses and expand existing small companies, which adds to the workforce. A weak economy does just the opposite: discourages start-ups and expansions, which decreases the workforce through layoffs. Figure 7.4 reports the job gains from start-ups and expansions and job losses from business closings and contractions.
Innovation
Given the financial resources available to large businesses, you’d expect them to introduce virtually all the new products that hit the market. Yet according to the SBA, small companies develop more patents per employee than do larger companies. During a recent four-year period, large firms generated 1.7 patents per hundred employees, while small firms generated an impressive 26.5 patents per employee.13 Over the years, the list of important innovations by small firms has included the airplane, air-conditioning, DNA “fingerprinting”, and overnight national delivery.14
Small business owners are also particularly adept at finding new ways of doing old things. In 1994, for example, a young computer-science graduate working on Wall Street came up with the novel idea of selling books over the Internet. During the first year of operations, sales at Jeff Bezos’ new company—Amazon.com—reached half a million dollars. In less than twenty years, annual sales had topped \$107 billion.15 Not only did his innovative approach to online retailing make Bezos enormously rich, but it also established a viable model for the e-commerce industry.
Why are small businesses so innovative? For one thing, they tend to offer environments that appeal to individuals with the talent to invent new products or improve the way things are done. Fast decision making is encouraged, their research programs tend to be focused, and their compensation structures typically reward top performers.
According to one SBA study, the supportive environments of small firms are roughly thirteen times more innovative per employee than the less innovation-friendly environments in which large firms traditionally operate.16
The success of small businesses in fostering creativity has not gone unnoticed by big businesses. In fact, many large companies have responded by downsizing to act more like small companies. Some large organizations now have separate work units whose purpose is to spark innovation. Individuals working in these units can focus their attention on creating new products that can then be developed by the company.
Opportunities for Women and Minorities
Small business is the portal through which many people enter the economic mainstream. Business ownership allows individuals, including women and minorities, to achieve financial success, as well as pride in their accomplishments. While the majority of small businesses are still owned by white males, the past two decades have seen a substantial increase in the number of businesses owned by women and minorities. Figure 7.4 gives you an idea of how many American businesses are owned by women and minorities, and indicates how much the numbers grew between 2007 and 2012.
Figure 7.4: Businesses Owned by Women and Minorities
Business Owners 2007 % of all Businesses 2012 % of all Businesses Increase
Women 28.8 35.8 7.0
Hispanic Americans 8.3 12.0 3.7
African Americans 7.1 9.4 2.3
Asian Americans 5.7 6.9 1.2
What Industries Are Small Businesses In?
If you want to start a new business, you probably should avoid certain types of businesses. You’d have a hard time, for example, setting up a new company to make automobiles or aluminum, because you’d have to make tremendous investments in property, plant, and equipment, and raise an enormous amount of capital to pay your workforce. These large, up-front investments present barriers to entry.
Fortunately, plenty of opportunities are still available. Many types of businesses require reasonable initial investments, and not surprisingly, these are the ones that usually present attractive small business opportunities.
Industries by Sector
Let’s define an industry as a group of companies that compete with one another to sell similar products. We’ll focus on the relationship between a small business and the industry in which it operates, dividing businesses into two broad types of industries, or sectors: the goods-producing sector and the service-producing sector.
• The goods-producing sector includes all businesses that produce tangible goods. Generally speaking, companies in this sector are involved in manufacturing, construction, and agriculture.
• The service-producing sector includes all businesses that provide services but don’t make tangible goods. They may be involved in retail and wholesale trade, transportation, finance, entertainment, recreation, accommodations, food service, and any number of other ventures.
About 20% of small businesses in the United States are concentrated in the goods-producing sector. The remaining 80% are in the service sector.17 The high concentration of small businesses in the service-producing sector reflects the makeup of the overall U.S. economy. Over the past fifty years, the service-producing sector has been growing at an impressive rate. In 1960, for example, the goods-producing sector accounted for 38 percent of GDP, the service-producing sector for 62 percent. By 2015, the balance had shifted dramatically, with the goods-producing sector accounting for only about 21 percent of GDP.18
Goods-Producing Sector
The largest areas of the goods-producing sector are construction and manufacturing. Construction businesses are often started by skilled workers, such as electricians, painters, plumbers, and home builders, and they generally work on local projects. Though manufacturing is primarily the domain of large businesses, there are exceptions. BTIO/Realityworks, for example, is a manufacturing enterprise (components come from Ohio and China, and assembly is done in Wisconsin).
How about making something out of trash? Daniel Blake never followed his mother’s advice at dinner when she told him to eat everything on his plate. When he served as a missionary in Puerto Rico, Aruba, Bonaire, and Curacao after his first year in college, he noticed that the families he stayed with didn’t either. But they didn’t throw their uneaten food into the trash. Instead they put it on a compost pile and used the mulch to nourish their vegetable gardens and fruit trees. While eating at an all-you-can-eat breakfast buffet back home at Brigham Young University, Blake was amazed to see volumes of uneaten food in the trash. This triggered an idea: why not turn the trash into money? Two years later, he was running his company—EcoScraps—collecting 40 tons of food scraps a day from 75 grocers and turning it into high-quality potting soil that he sells online and to nurseries. His profit has reach almost half a million dollars on sales of \$1.5 million.19
Service-Producing Sector
Many small businesses in this sector are retailers—they buy goods from other firms and sell them to consumers, in stores, by phone, through direct mailings, or over the Internet. In fact, entrepreneurs are turning increasingly to the Internet as a venue for start-up ventures. Take Tony Roeder, for example, who had a fascination with the red Radio Flyer wagons that many of today’s adults had owned as children. In 1998, he started an online store through Yahoo! to sell red wagons from his home. In three years, he turned his online store into a million-dollar business.20
Other small business owners in this sector are wholesalers—they sell products to businesses that buy them for resale or for company use. A local bakery, for example, is acting as a wholesaler when it sells desserts to a restaurant, which then resells them to its customers. A small business that buys flowers from a local grower (the manufacturer) and resells them to a retail store is another example of a wholesaler.
A high proportion of small businesses in this sector provide professional, business, or personal services. Doctors and dentists are part of the service industry, as are insurance agents, accountants, and lawyers. So are businesses that provide personal services, such as dry cleaning and hairdressing.
David Marcks, for example, entered the service industry about fourteen years ago when he learned that his border collie enjoyed chasing geese at the golf course where he worked. While geese are lovely to look at, they can make a mess of tees, fairways, and greens. That’s where Marcks’ company, Geese Police, comes in: Marcks employs specially trained dogs to chase the geese away. He now has twenty-seven trucks, thirty-two border collies, and five offices. Golf courses account for only about 5 percent of his business, as his dogs now patrol corporate parks and playgrounds as well.21 Figure 7.5 provides a more detailed breakdown of small businesses by industry.
Advantages and Disadvantages of Business Ownership
Do you want to be a business owner someday? Before deciding, you might want to consider the following advantages and disadvantages of business ownership.22
Advantages of Small Business Ownership
Being a business owner can be extremely rewarding. Having the courage to take a risk and start a venture is part of the American dream. Success brings with it many advantages:
• Independence. As a business owner, you’re your own boss. You can’t get fired. More importantly, you have the freedom to make the decisions that are crucial to your own business success.
• Lifestyle. Owning a small business gives you certain lifestyle advantages. Because you’re in charge, you decide when and where you want to work. If you want to spend more time on non-work activities or with your family, you don’t have to ask for the time off. Given today’s technology, if it’s important that you be with your family all day, you can run your business from your home.
• Financial rewards. In spite of high financial risk, running your own business gives you a chance to make more money than if you were employed by someone else. You benefit from your own hard work.
• Learning opportunities. As a business owner, you’ll be involved in all aspects of your business. This situation creates numerous opportunities to gain a thorough understanding of the various business functions.
• Creative freedom and personal satisfaction. As a business owner, you’ll be able to work in a field that you really enjoy. You’ll be able to put your skills and knowledge to use, and you’ll gain personal satisfaction from implementing your ideas, working directly with customers, and watching your business succeed.
Disadvantages of Small Business Ownership
As the little boy said when he got off his first roller-coaster ride, “I like the ups but not the downs!” Here are some of the risks you run if you want to start a small business:
• Financial risk. The financial resources needed to start and grow a business can be extensive. You may need to commit most of your savings or even go into debt to get started. If things don’t go well, you may face substantial financial loss. In addition, there’s no guaranteed income. There might be times, especially in the first few years, when the business isn’t generating enough cash for you to live on.
• Stress. As a business owner, you are the business. There’s a bewildering array of things to worry about—competition, employees, bills, equipment breakdowns, etc.. As the owner, you’re also responsible for the well-being of your employees.
• Time commitment. People often start businesses so that they’ll have more time to spend with their families. Unfortunately, running a business is extremely time- consuming. In theory, you have the freedom to take time off, but in reality, you may not be able to get away. In fact, you’ll probably have less free time than you’d have working for someone else. For many entrepreneurs and small business owners, a forty-hour workweek is a myth. Vacations will be difficult to take and will often be interrupted. In recent years, the difficulty of getting away from the job has been compounded by cell phones, iPhones, Internet-connected laptops and iPads, and many small business owners have come to regret that they’re always reachable.
• Undesirable duties. When you start up, you’ll undoubtedly be responsible for either doing or overseeing just about everything that needs to be done. You can get bogged down in detail work that you don’t enjoy. As a business owner, you’ll probably have to perform some unpleasant tasks, like firing people.
In spite of these and other disadvantages, most small business owners are pleased with their decision to start a business. A survey conducted by the Wall Street Journal and Cicco and Associates indicates that small business owners and top-level corporate executives agree overwhelmingly that small business owners have a more satisfying business experience. Interestingly, the researchers had fully expected to find that small business owners were happy with their choices; they were, however, surprised at the number of corporate executives who believed that the grass was greener in the world of small business ownership.23
Starting a Business
Starting a business takes talent, determination, hard work, and persistence. It also requires a lot of research and planning. Before starting your business, you should appraise your strengths and weaknesses and assess your personal goals to determine whether business ownership is for you.24
Questions to Ask Before You Start a Business
If you’re interested in starting a business, you need to make decisions even before you bring your talent, determination, hard work, and persistence to bear on your project.
Here are the basic questions you’ll need to address:
• What, exactly, is my business idea? Is it feasible?
• What industry do I want to enter?
• What will be my competitive advantage?
• Do I want to start a new business, buy an existing one, or buy a franchise?
• What form of business organization do I want?
After making these decisions, you’ll be ready to take the most important step in the entire process of starting a business: you must describe your future business in the form of a business plan—a document that identifies the goals of your proposed business and explains how these goals will be achieved. Think of a business plan as a blueprint for a proposed company: it shows how you intend to build the company and how you intend to make sure that it’s sturdy. You must also take a second crucial step before you actually start up your business: You need to get financing—the money that you’ll need to get your business off the ground.
The Business Idea
For some people, coming up with a great business idea is a gratifying adventure. For most, however, it’s a daunting task. The key to coming up with a business idea is identifying something that customers want—or, perhaps more importantly, filling an unmet need. Your business will probably survive only if its purpose is to satisfy its customers—the ultimate users of its goods or services. In coming up with a business idea, don’t ask, “What do we want to sell?” but rather, “What does the customer want to buy?”25
To come up with an innovative business idea, you need to be creative. If your idea is innovative enough, it may be considered intellectualproperty, a right that can be protected under the law. Prior experience accounts for the bulk of new business idea and also increases your chances of success. Take Sam Walton, the late founder of Wal-Mart. He began his retailing career at JCPenney and then became a successful franchiser of a Ben Franklin five-and-dime store. In 1962, he came up with the idea of opening large stores in rural areas, with low costs and heavy discounts. He founded his first Wal-Mart store in 1962, and when he died thirty years later, his family’s net worth was \$25 billion.26
Industry experience also gave Howard Schultz, a New York executive for a housewares company, his breakthrough idea. In 1981, Schultz noticed that a small customer in Seattle—Starbucks Coffee, Tea and Spice—ordered more coffeemaker cone filters than Macy’s and many other large customers. So he flew across the country to find out why. His meeting with the owner-operators of the original Starbucks Coffee Co. resulted in his becoming part-owner of the company. Schultz’s vision for the company far surpassed that of its other owners. While they wanted Starbucks to remain small and local, Schultz saw potential for a national business that not only sold world-class-quality coffee beans but also offered customers a European coffee-bar experience. After attempting unsuccessfully to convince his partners to try his experiment, Schultz left Starbucks and started his own chain of coffee bars, which he called Il Giornale (after an Italian newspaper). Two years later, he bought out the original owners and reclaimed the name Starbucks.27
Ownership Options
As we’ve already seen, you can become a small business owner in one of three ways— by starting a new business, buying an existing one, or obtaining a franchise. Let’s look more closely at the advantages and disadvantages of each option.
Starting from Scratch
The most common—and the riskiest—option is starting from scratch. This approach lets you start with a clean slate and allows you to build the business the way you want. You select the goods or services that you’re going to offer, secure your location, and hire your employees, and then it’s up to you to develop your customer base and build your reputation. This was the path taken by Andres Mason who figured out how to inject hysteria into the process of bargain hunting on the Web. The result is an overnight success story called Groupon.28 Here is how Groupon (a blend of the words “group” and “coupon”) works: A daily email is sent to 6.5 million people in 70 cities across the United States offering a deeply discounted deal to buy something or to do something in their city. If the person receiving the email likes the deal, he or she commits to buying it. But, here’s the catch, if not enough people sign up for the deal, it is cancelled. Groupon makes money by keeping half of the revenue from the deal. The company offering the product or service gets exposure. But stay tuned: the “daily deals website isn’t just unprofitable—it’s bleeding hundreds of millions of dollars.”29 As with all start-ups cash is always a challenge.
Buying an Existing Business
If you decide to buy an existing business, some things will be easier. You’ll already have a proven product, current customers, active suppliers, a known location, and trained employees. You’ll also find it much easier to predict the business’s future success.
There are, of course, a few bumps in this road to business ownership. First, it’s hard to determine how much you should pay for a business. You can easily determine how much things like buildings and equipment are worth, but how much should you pay for the fact that the business already has steady customers?
In addition, a business, like a used car, might have performance problems that you can’t detect without a test drive (an option, unfortunately, that you don’t get when you’re buying a business). Perhaps the current owners have disappointed customers; maybe the location isn’t as good as it used to be. You might inherit employees that you wouldn’t have hired yourself. Careful study called due diligence is necessary before going down this road.
Getting a Franchise
Lastly, you can buy a franchise. A franchiser (the company that sells the franchise) grants the franchisee (the buyer—you) the right to use a brand name and to sell its goods or services. Franchises market products in a variety of industries, including food, retail, hotels, travel, real estate, business services, cleaning services, and even weight-loss centers and wedding services. Figure 7.7 lists the top ten franchises according to Entrepreneur magazine for 2015 and 2016.
Figure 7.7: Entrepreneur’s Franchise 500 Top Franchises, 2015 and 2016
Ranking 2015 2016
1 Hampton by Hilton Jimmy John’s
2 Anytime Fitness Hampton by Hilton
3 Subway Supercuts
4 Jack in the Box Servpro
5 Supercuts Subway
6 Jimmy John’s McDonald’s
7 Servpro 7-Eleven
8 Denny’s Dunkin Donuts
9 Pizza Hut Denny’s
10 7-Eleven Anytime Fitness
As you can see from Figure 7.8 on the next page, the popularity of franchising has been growing quickly since 2011. Although the economic downturn decreased the number of franchises between 2008-11, note that the overall value of franchise outputs steadily increased. A new franchise outlet opens once every eight minutes in the United States, where one in ten businesses is now a franchise. Franchises employ eight million people (13 percent of the workforce) and account for 17 percent of all sales in the U.S. (\$1.3 trillion).30
In addition to the right to use a company’s brand name and sell its products, the franchisee gets help in picking a location, starting and operating the business, and benefits from advertising done by the franchiser. Essentially, the franchisee buys into a ready-to-go business model that has proven successful elsewhere, also getting other ongoing support from the franchiser, which has a vested interest in her success.
Coming with so many advantages, franchises can be very expensive. KFC franchises, for example, require a total investment of \$1.3 million to \$2.5 million each. This fee includes the cost of the property, equipment, training, start-up costs, and the franchise fee—a one-time charge for the right to operate as a KFC outlet. McDonald’s is in the same price range (\$1 million to \$2.3 million). SUBWAY sandwich shops offer a more affordable alternative, with expected total investment ranging from \$116,000 to \$263,000.31
In addition to your initial investment, you’ll have to pay two other fees on a monthly basis—a royalty fee (typically from 3 to 12 percent of sales) for continued support from the franchiser and the right to keep using the company’s trade name, plus an advertising fee to cover your share of national and regional advertising. You’ll also be expected to buy your products from the franchiser.32
But there are disadvantages. The cost of obtaining and running a franchise can be high, and you have to play by the franchiser’s rules, even when you disagree with them. The franchiser maintains a great deal of control over its franchisees. For example, if you own a fast-food franchise, the franchise agreement will likely dictate the food and beverages you can sell; the methods used to store, prepare, and serve the food; and the prices you’ll charge. In addition, the agreement will dictate what the premises will look like and how they’ll be maintained. As with any business venture, you need to do your homework before investing in a franchise.
Launching a Business from the Inside
When someone mentions “entrepreneurship”, many people equate the term to “start up”, but entrepreneurial activity can also come from within established firms. However, it’s often the case that the entrepreneurial spirit is not fully unleashed until an independent entity is formed around a venture.
That’s exactly what happened in the case of Qualtrax, a company located in Blacksburg, Virginia.33 The company was spawned from a need for customers of CCS, Inc. to become compliant with the requirements of the International Standards Organization. CCS (now known as Foxguard Solutions) employees developed a software tool to simplify ISO compliance audits, and the auditors were so impressed that they suggested marketing the tool more broadly. Over a period of nearly twenty years, the business grew to ten dedicated employees, but Foxguard did not invest heavily in the software because the product was essentially a sideline business. Qualtrax shared sales and marketing resources with other business lines, so its growth was not necessarily a focal point for the company.
In 2011, CCS management appointed Amy Ankrum, an executive in their marketing department, to lead the Qualtrax business line with a simple mission in mind – determining whether Qualtrax could be scaled up or should be scaled down. Having the feeling that there was more to the business than had been achieved to date, Amy added Ryan Hagan as engineering manager for the software. Hagan quickly moved Qualtrax to an agile style of development, allowing for 5-6 new releases a year when annual releases had previously been the norm. This approach was much more responsive to customer needs, and in a business that depends on recurring revenue, it led to increased customer retention, which improved to over 95% each year. Revenue growth rates went up double digits.
In 2015, Qualtrax took its biggest leap of faith, moving out of Foxguard headquarters and becoming a separate legal entity. Ankrum located the offices near the campus of Virginia Tech, allowing the company to attract top-notch developers. The new location also allowed the company to take on its own culture – it’s more like a start-up company now than it was 23 years ago when it started! Employees enjoy flexible hours, short walks to downtown lunches, and a brightly-lit, open, and collaborative space with the company values painted right on the walls.
The move to a separate entity also allowed the company to attract new investor funding which will be used to push the company into new markets, such as the utility industry. Much of the new investor group is local and made up of former executives with significant experience in Software-as-a-Service (SaaS) and Business-to-Business (B2B) relationships. These execs will offer expertise beyond what Qualtrax had in-house, and all involved share the objective of increasing job growth in the region.
Asked what was different before and after Qualtrax began its rapid growth, Ankrum said, “It takes focus for any business to reach its full potential.” Since becoming its own company, Qualtrax has certainly enhanced that focus, and the new funding will allow them to offer ownership options to its now 26 employees. Qualtrax now dominates in quality and compliance software for a number of industries, including forensic crime labs. Thanks to the foresight of management, the company’s best days most certainly lie ahead.
Why Some Businesses Fail and Where to Get Help
Why Do Some Businesses Fail?
If you’ve paid attention to the occupancy of shopping malls over a few years, you’ve noticed that retailers come and go with surprising frequency. The same thing happens with restaurants—indeed, with all kinds of businesses. By definition, starting a business—small or large—is risky, and though many businesses succeed, a large proportion of them don’t. One-third of small businesses that have employees go out of business within the first two years. As shown in Figure 7.10, nearly half of small businesses have closed by the end of their fourth year, and 60-70 percent do not make it past their seventh year.34
As bad as these statistics on business survival are, some industries are worse than others. If you want to stay in business for a long time, you might want to avoid some of these risky industries. Even though your friends think you make the best pizza in the world, this doesn’t mean you can succeed as a pizza parlor owner. Opening a restaurant or a bar is one of the riskiest ventures (and, therefore, start-up funding is hard to get).
You might also want to avoid the transportation industry. Owning a taxi might appear lucrative until you find out what a taxi license costs. It obviously varies by city, but in New York City the price tag is upward of \$400,000. No wonder taxi companies are resisting Uber and Lyft with all the energy they can muster. And setting up a shop to sell clothing can be challenging. Your view of “what’s in” may be off, and one bad season can kill your business. The same is true for stores selling communication devices: every mall has one or more cell phone stores so the competition is steep, and business can be very slow.35
Businesses fail for any number of reasons, but many experts agree that the vast majority of failures result from some combination of the following problems:
• Bad business idea. Like any idea, a business idea can be flawed, either in the conception or in the execution.
• Cash problems. Too many new businesses are underfunded. The owner borrows enough money to set up the business but doesn’t have enough extra cash to operate during the start-up phase, when very little money is coming in but a lot is going out.
• Managerial inexperience or incompetence. Many new business owners have no experience in running a business; many have limited management skills. Knowing how to make or market a product doesn’t necessarily mean knowing how to manage people or retain talented employees.
• Lack of customer focus. A major advantage of a small business is the ability to provide special attention to customers. But some small businesses fail to seize this advantage. Perhaps the owner doesn’t anticipate customers’ needs or keep up with changing markets or the customer-focused practices of competitors.
• Inability to handle growth. Growing sales is usually a good thing, but sometimes it can be a major problem. When a company grows, the owner’s role changes. He or she needs to delegate work to others and build a business structure that can handle the increase in volume. Some owners don’t make the transition and find themselves overwhelmed. In such cases, expansion actually damages the company.
• Failure to adapt. The external environment for a company can change dramatically. Companies that fail to keep up will not be around for long.
Help from the Small Business Administration
If you had your choice, which cupcake would you pick—vanilla Oreo, triple chocolate, or latte? In the last few years, cupcake shops are popping up in almost every city. Perhaps the bad economy has put people in the mood for small, relatively inexpensive treats.
Whatever the reason, you’re fascinated with the idea of starting a cupcake shop. You have a perfect location, have decided what equipment you need, and have tested dozens of recipes (and eaten lots of cupcakes). You are set to go with one giant exception: you don’t have enough savings to cover your start-up costs. You have made the round of most local banks, but they are all unwilling to give you a loan. So what do you do? Fortunately, there is help available. It is through your local Small Business Administration (SBA), which offers an array of programs to help current and prospective small business owners. The SBA won’t actually loan you the money, but it will increase the likelihood that you will get funding from a local bank by guaranteeing the loan.
Here’s how the SBA’s loan guarantee program works: You apply to a bank for financing. A loan officer decides if the bank will loan you the money without an SBA guarantee. If the answer is no (because of some weakness in your application), the bank then decides if it will loan you the money if the SBA guarantees the loan. If the bank decides to do this, you get the money and make payments on the loan. If you default on the loan, the government reimburses the bank for its loss, up to the amount of the SBA guarantee.
In the process of talking with someone at the SBA, you will discover other programs it offers that will help you start your business and manage your organization. For example, to apply for funding you will need a well-written business plan. Once you get the loan and move to the business start-up phase, you will have lots of questions that need to be answered. And you are sure you will need help in a number of areas as you operate your cupcake shop. Fortunately, the SBA can help with all of these management and technical-service tasks.
This assistance is available through a number of channels, including the SBA’s extensive website, online courses, and training programs. A full array of individualized services is also available. The Small Business Development Center (SBDC) assists current and prospective small business owners with business problems and provides free training and technical information on all aspects of small business management.
These services are available at approximately one thousand locations around the country, many housed at colleges and universities.36
If you need individualized advice from experienced executives, you can get it through the Service Corps of Retired Executives (SCORE). Under the SCORE program, a businessperson needing advice is matched with someone on a team of retired executives who work as volunteers. Together, the SBDC and SCORE help more than a million small businesspersons every year.37
The original version of this chapter contained H5P content. You may want to remove or replace this element.
Chapter Video
The video for this lesson features two VT students who were attempting to get funding for their business on the hit TV show Shark Tank. The VT students first appear at 13:25 and their segment runs about 10 minutes. You are free to fast forward to the 13:25 mark if you like.
A Dailymotion element has been excluded from this version of the text. You can view it online here: pb.libretexts.org/biz3/?p=83
(Copyrighted Material)
Key Takeaways
1. An entrepreneur is someone who identifies a business opportunity and assumes the risk of creating and running a business to take advantage of it.
2. The three characteristics of entrepreneurial activity are innovating, running a business, and risk taking.
3. A small business is independently owned and operated, exerts little influence in its industry, and has fewer than five hundred employees.
4. Small businesses in the United States generate about 50 percent of our GDP, create jobs, spark innovation, and provide opportunities for women and minorities.
5. An industry is a group of companies that compete with one another to sell similar products. There are two broad types of industries, or sectors: the goods-producing sector and the service-producing sector.
6. Once you decide to start a business, you’ll need to create a business plan—a document that identifies the goals of your proposed business and explains how it will achieve them.
7. The SBA (Small Business Administration) is a government agency that provides many kinds of support for small businesses, including information and funding assistance.
Chapter 7 Text References and Image Credits
Image Credits: Chapter 7
Figure 7.1: Tom Morris (2010). “Mark Zuckerberg.” CC by 2.0. Image retrieved from: https://commons.wikimedia.org/wiki/File:Facebook_Press_Conference_4.jpg
Figure 7.2: “Small Business Job Gains and Losses, 2000-2015.” Data source: Bureau of Labor Statistics. Retrieved from: http://www.bls.gov/bdm/home.htm
Figure 7 . 3 : Data source: Amazon.com annual reports. Retrieved from: http://phx.corporate-ir.net/phoenix.zhtml?c=97664&p=irol-reportsAnnual Amazon.com logo © Amazon.com, retrieved from: https://commons.wikimedia.org/wiki/File:Amazon.com-Logo.svg
Figure 7.4: “Businesses Owned by Women and Minorities.” Data source: Census Bureau. Retrieved from: https://www.census.gov/content/dam/Census/newsroom/releases/2015/cb15-209_graphic.jpg
Figure 7.5: “Small Business by Industry 2012.” Data source: U.S. Census Bureau Survey of Business Owners, 2012. Retrieved from: http://www.census.gov/library/publications/2012/econ/2012-sbo.html
Figure 7.6: John Anderson (2006). “Original Starbucks Store in Pike’s Place Market.” CC BY-SA 2.0. Retrieved from: en.Wikipedia.org/wiki/Original_Starbucks#/media/File:Starbucks_street_musician.jpg
Figure 7.7: Data source: Entrepreneur (2016). “The 2016 Franchise 500.” Entrepreneur. Retrieved from: https://www.entrepreneur.com/franchise500
Figure 7.8: “The Growth of Franchising in the U.S.” Data source: The International Franchise Association. Retrieved from: http://www.franchise.org/sites/default/files/EconomicOutlookInfographic_January2016.pdf
Figure 7.9: Stephen Skipak (2017). “Amy Ankrum at the Qualtrax headquarters in Blacksburg, Virginia.”
Figure 7.10: “Survival rate of new businesses in the U.S., 2007-2015.” Data source: Bureau of Labor Statistics. Retrieved from: http://www.bls.gov/bdm/entrepreneurship/bdm_chart3.htm
Figure 7.11: Evan Amos (2011). “Crumbs Cupcakes in a display case.” Public Domain. Retrieved from: https://commons.wikimedia.org/wiki/File:Crumbs-Bake-Shop-Cupcake-Display.jpg
Video Credits: Chapter 7
“Shark Tank Season 6 Episode 20 LATEST FULL Micro-loans funded by money raised from backpacks made of fabrics from developing countries ABC.” (ABC). February 27, 2015. Retrieved from: https://www.dailymotion.com/video/x2iaij4
References: Chapter 7
1 Vignette based on information from: Realityworks (2016). “The Realityworks Story.” Realityworks.com. Retrieved from: http://www.realityworks.com/about/realityworks-story and Alan Decker (1994). “This Doll Tells the Young to Hold Off.” The New York Times. Retrieved from: http://www.nytimes.com/1994/08/03/us/this-doll-tells-the-young-to-hold-off.html 2 Canadian Foundation for Economic Education (2008). “Glossary of Terms,” Mentors, Ventures & Plans. Retrieved from: http://www.mvp.cfee.org/en/glossary.html#e 3 Adapted from Marc J. Dollinger (2003). Entrepreneurship: Strategies and Resources, 3rd ed. Upper Saddle River, NJ: Prentice Hall. Pp. 5–7. 4 Encyclopedia of World Biography (2006). “Marcia Kilgore: Entrepreneur and spa founder,” Retrieved from: http://www.notablebiographies.com/newsmakers2/2006-Ei-La/Kilgore-Marcia.html 5 Jessica Bruder (2010). “The Rise Of The Serial Entrepreneur.” Forbes. Retrieved from: http://www.forbes.com/2010/08/12/serial-entrepreneur-start-up-business-forbes-woman-entrepreneurs-management.html 6 Ibid. 7 U.S. Small Business Administration (2016). “Is Entrepreneurship For You?” SBA.gov. Retrieved from: https://www.sba.gov/starting-business/how-start-business/entrepreneurship-you 8 Shari Waters (2016). “Top Four Reasons People Don’t Start a Business.” About Money, About.com. Retrieved from: http://retail.about.com/od/startingaretailbusiness/tp/overcome_fears.htm 9 Kathleen Allen (2001). Entrepreneurship for Dummies. New York: Wiley. P. 14. 10 U.S. Small Business Administration (2016). “Qualifying as a Small Business.” Retrieved from: https://www.sba.gov/contracting/getting-started-contractor/qualifying-small-business 11 U.S. Small Business Administration (2016). “Small Business Trends: Small Business, Big impact!” SBA.gov. Retrieved from: https://www.sba.gov/managing-business/running-business/energy-efficiency/sustainable-business-practices/small-business-trends 12 Brian Headd (2010). “An Analysis of Small Business and Jobs,” U.S. Small Business Administration, Office of Advocacy. Retrieved from: https://www.sba.gov/sites/default/files/files/an%20analysis%20of%20small%20business%20and%20jobs(1).pdf 13 Anthony Breitzman and Diana Hicks (2008). “An Analysis of Small Business Patents by Industry and Firm Size.” Office of Advocacy, Small Business Administration. 14 William J. Baumol (2005). “Small Firms: Why Market-Driven Innovation Can’t Get Along without Them.” U.S. Small Business Administration, Office of Advocacy. 15 Yahoo.com (2016). “Amazon.com Income Statement.” Finance.yahoo.com. Retrieved from: finance.yahoo.com/q/is?s=AMZN+Income+Statement&annual 16 William J. Baumol (2005). “Small Firms: Why Market-Driven Innovation Can’t Get Along without Them” U.S. Small Business Administration, Office of Advocacy. 17 U.S. Census Bureau (2012). “Estimates of Business Ownership by Gender, Ethnicity, Race, and Veteran Status: 2012.” U.S. Census Bureau. Retrieved from: http://www.census.gov/library/publications/2012/econ/2012-sbo.html#par_reference_25 18 Central Intelligence Agency (2016). “World Factbook.” CIA.gov. Retrieved from: www.cia.gov/library/publications/the-world-factbook/fields/2012.html 19 Ecoscraps.com (2016). “Our Story.” Ecoscraps.com. Retrieved from: http://ecoscraps.com/pages/our-story 20 Isabel Isidro (2003). “How to Succeed Online with a Niche Business: Case of RedWagons.com.” PowerHomeBiz.com. Retrieved from: http://www.powerhomebiz.com/online-business/success-online-business/succeed-online-niche-business-case-redwagons-com.htm 21 Isabel Isidro (2001). “Geese Police: A Real-Life Home Business Success Story.” PowerHomeBiz.com. Retrieved from: http://www.powerhomebiz.com/working-from-home/success/geese-police-real-life-home-business-success-story.htm 22 Illinois Small Business Development Center at SIU (2016). “Frequently Asked Questions: What are the Pros and Cons of Owning a Business?” Retrieved from: http://sbdc.siu.edu/frequently-asked-questions/index.html 23 Janean Chun (1997). “Type E Personality: What makes entrepreneurs tick?” Entrepreneur. Retrieved from: https://www.entrepreneur.com/article/13764 24 Kathleen Allen (2001). “Getting Started in Entrepreneurship.” Entrepreneurship for Dummies. New York: Wiley. P. 46. 25 Scott Thurm and Joann S. Lublin (2005). “Peter Drucker’s Legacy Includes Simple Advice: It’s All about the People.” The Wall Street Journal. Retrieved from: http://www.wsj.com/articles/SB113192826302796041 26 Peter Krass, ed. (1997). “Sam Walton: Running a Successful Business: Ten Rules that Worked for Me.” The Book of Business Wisdom: Classic Writings by the Legends of Commerce and Industry. New York: Wiley. Pp. 225-230. 27 Howard Schultz and Dori Jones Yang (1997). Pour Your Heart into It. New York: Hyperion. Pp. 24–109. 28 Christopher Steiner (2010). “Meet the Fastest Growing Company Ever.” Forbes. Retrieved from: http://www.forbes.com/forbes/2010/0830/entrepreneurs-groupon-facebook-twitter-next-web-phenom.html 29 The Week (2011). “Groupon’s ‘Startling’ Reversal of Fortune,” News.Yahoo.com. Retrieved from: www.yahoo.com/news/groupons-startling-reversal-fortune-172800802.html 30 U.S. Census Bureau (2008). “2007 Economic Census: Franchise Statistics.” U.S. Census Bureau. Retrieved from: www.census.gov/econ/census/pdf/franchise_flyer.pdf 31 Hayley Peterson (2014). “Here’s How Much It Costs To Open Different Fast Food Franchises In The US.” BusinessInsider.com. Retrieved from: http://www.businessinsider.com/cost-...nchise-2014-11 32 Michael Seid and Kay Marie Ainsley (2002). “Franchise Fee—Made Simple,” Entrepreneur.com, Retrieved from: https://www.entrepreneur.com/article/51174 33 Stephen Skripak (2017). Interview with Amy Ankrum. February 22, 2017. 34 Bureau of Labor Statistics (2016). “Survival rate of new businesses in the U.S., 2007-2015.” Bureau of Labor Statistics. Retrieved from: http://www.bls.gov/bdm/entrepreneurs...bdm_chart3.htm 35 Maureen Farrell (2007). “Risky Business: 44% of Small Firms Reach Year 4.” Forbes. Retrieved from: http://www.msnbc.msn.com/id/16872553/ns/business-forbes_com/t/risky-business-small-firms-reach-year/#.Tl_xVY7CclA 36 U.S. Small Business Administration (2016). “Office of Small Business Development Centers: Entrepreneurial Development Services.” U.S. Small Business Administration. Retrieved from: https://www.sba.gov/tools/local-assi...istrictoffices 37 U.S. Small Business Administration (2016). “SCORE.—Counselors to America’s Small Businesses.” U.S. Small Business Administration. Retrieved from: https://www.score.org/ | textbooks/biz/Business/Introductory_Business/Book%3A_Fundamentals_of_Business_(Skripak)/07%3A_Entrepreneurship_-_Starting_a_Business.txt |
Learning Objectives
1. Identify the four interrelated functions of management: planning, organizing, leading, and controlling.
2. Understand the process by which a company develops and implements a strategic plan.
3. Explain how managers direct others and motivate them to achieve company goals.
4. Describe the process by which a manager monitors operations and assesses performance.
5. Explain what benchmarking is and its importance for managing organizations.
6. Describe the skills needed to be a successful manager.
Noteworthy Management
Consider this scenario: you’re halfway through the semester and ready for midterms. You open your class notes and declare them “pathetic.” You regret scribbling everything so carelessly and skipping class so many times. That’s when it hits you: what if there was a note-taking service on campus? When you were ready to study for a big test, you could buy complete and legible class notes. You’ve heard that there are class-notes services at some larger schools, but there’s no such thing on your campus. So you ask yourself, why don’t I start a note-taking business? Your upcoming set of exams may not be salvageable, but after that, you’d always have great notes. And in the process, you could learn how to manage a business (isn’t that what majoring in business is all about?).
You might begin by hiring a bunch of students to take class notes. Then the note takers will e-mail them to your assistant, who’ll get them copied (on a special type of paper that can’t be duplicated). The last step will be assembling packages of notes and, of course, selling them. You decide to name your company “Notes-4-You.”
It sounds like a great idea, but you’re troubled by one question: why does this business need you? Do the note takers need a boss? Couldn’t they just sell the notes themselves? This process could work, but it would work better if there was someone to oversee the operations: a manager—to make sure that the operations involved in preparing and selling notes were performed in both an effective and an efficient manner. You’d make the process effective by ensuring that the right things got done and that they all contributed to the success of the enterprise. You’d make the process efficient by ensuring that activities were performed in the right way and used the fewest possible resources.
What Do Managers Do?
The Management Process
The effective performance of your business will require solid management: the process of planning, organizing, leading, and controlling resources to achieve specific goals. A plan enables you to take your business concept beyond the idea stage. It does not, however, get the work done. For that to happen, you have to organize things effectively. You’ll have to put people and other resources in place to make things happen. And because your note-taking venture is supposed to be better off with you in charge, you need to be a leader who can motivate your people to do well. Finally, to know whether things are in fact going well, you’ll have to control your operations—that is, measure the results and compare them with the results that you laid out in your plan. Figure 8.2 summarizes the interrelationship between planning and the other functions that managers perform. This chapter will explore planning, leading, and controlling in some detail. Organizing is an especially complex topic, and will be discussed in Chapter 9.
Planning
Without a plan, it’s hard to succeed at anything. The reason is simple: if you don’t know where you’re going, you can’t move forward. Successful managers decide where they want to be and then figure out how to get there; they set goals and determine the best way to achieve them. As a result of the planning process, everyone in the organization knows what should be done, who should do it, and how to do it.
Developing a Strategic Plan
Coming up with an idea—say, starting a note-taking business—is a good start, but it’s only a start. Planning for it is a step forward. Planning begins at the highest level and works its way down through the organization. Step one is usually called strategic planning: the process of establishing an overall course of action. To begin this process, you should ask yourself a couple of very basic questions: why, for example, does the organization exist? What value does it create? Sam Walton posed these questions in the process of founding Wal-Mart: his new chain of stores would exist to offer customers the lowest prices with the best possible service.1
Once you’ve identified the purpose of your company, you’re ready to take the remaining steps in the strategic-planning process:
• Write a mission statement that tells customers, employees, and others why your organization exists.
• Identify core values or beliefs that will guide the behavior of members of the organization.
• Assess the company’s strengths, weaknesses, opportunities, and threats.
• Establish goals and objectives, or performance targets, to direct all the activities that you’ll perform to achieve your mission.
• Develop and implement tactical and operational plans to achieve goals and objectives.
In the next few sections, we’ll examine these components of the strategic-planning process.
Mission Statement
As we saw in an earlier chapter, the mission statement describes the purpose of your organization—the reason for its existence. It tells the reader what the organization is committed to doing. It can be very concise, like the one from Mary Kay Inc. (the cosmetics company): “To enrich the lives of women around the world.”2 Or it can be as detailed as the one from Harley-Davidson: “We fulfill dreams inspired by the many roads of the world by providing extraordinary motorcycles and customer experiences. We fuel the passion for freedom in our customers to express their own individuality.”3
A mission statement for Notes-4-You could be the following: “To provide high-quality class notes to college students.” On the other hand, you could prepare a more detailed statement that explains what the company is committed to doing, who its customers are, what its focus is, what goods or services it provides, and how it serves its customers.
It is worth noting that some companies no longer use mission statements, preferring to communicate their reason for being in other manners.
Core Values
Whether or not your company has defined a mission, it is important to identify what your organization stands for in terms of its values and the principles that will guide its actions. In Chapter 3 on Business Ethics and Social Responsibility, we explained that the small set of guiding principles that you identify as crucial to your company are known as core values—fundamental beliefs about what’s important and what is and isn’t appropriate in conducting company activities. Core values affect the overall planning processes and operations. At Volvo, three values— safety, quality, and environmental care—define the firm’s “approach to product development, design and production.”4 Core values should also guide the behavior of every individual in the organization. At Coca-Cola, for instance, the values of leadership, collaboration, integrity, accountability, passion, diversity and quality tell employees exactly what behaviors are acceptable.5 Companies communicate core values to employees and hold them accountable for putting them into practice by linking their values to performance evaluations and compensation.
In choosing core values for Notes-4-You, you’re determined to be unique. After some thought, you settle on teamwork, trust, and dependability. Why these three? As you plan your business, you realize that it will need a workforce that functions as a team, trusts each other, and can be depended on to satisfy customers. In building your workforce, you’ll seek employees who’ll embrace these values.
Conduct a SWOT Analysis
The next step in the strategic-planning process is to assess your company’s fit with its environment. A common approach to environmental analysis is matching the strengths of your business with the opportunities available to it. It’s called SWOT analysis because it calls for analyzing an organization’s Strengths, Weaknesses, Opportunities, and Threats. It begins with an examination of external factors that could influence the company in either a positive or a negative way. These could include economic conditions, competition, emerging technologies, laws and regulations, and customers’ expectations.
One purpose of assessing the external environment is to identify both opportunities that could benefit the company and threats to its success. For example, a company that manufactures children’s bicycle helmets would view a change in federal law requiring all children to wear helmets as an opportunity. The news that two large sports-equipment companies were coming out with bicycle helmets would be a threat.
The next step is to evaluate the company’s strengths and weaknesses, internal factors that could influence company performance in either a positive or negative way. Strengths might include a motivated workforce, state-of-the-art technology, impressive managerial talent, or a desirable location. The opposite of any of these strengths could signal a potential weakness (poor workforce, obsolete technology, incompetent management, or poor location). Armed with a good idea of internal strengths and weaknesses, as well as external opportunities and threats, managers will be better positioned to capitalize on opportunities and strengths. Likewise, they want to improve on any weak areas and protect the organization from external threats.
For example, Notes-4-You might say that by providing excellent service at a reasonable price while we’re still small, it can solidify its position on campus. When the market grows due to increases in student enrollment, the company will have built a strong reputation and be in a position to grow. So even if a competitor comes to campus (a threat), the company expects to be the preferred supplier of class notes. This strategy will work only if the note-takers are dependable and if the process does not alienate the faculty or administration.
Set Goals and Objectives
Your mission statement affirms what your organization is generally committed to doing, but it doesn’t tell you how to do it. So the next step in the strategic-planning process is establishing goals and objectives. Goals are major accomplishments that the company wants to achieve over a long period. Objectives are shorter-term performance targets that direct the activities of the organization toward the attainment of a goal. They should be clearly stated, achievable, and measurable: they should give target dates for the completion of tasks and stipulate who’s responsible for taking necessary actions.6
An organization will have a number of goals and related objectives. Some will focus on financial measures, such as profit maximization and sales growth. Others will target operational efficiency or quality control. Still others will govern the company’s relationships with its employees, its community, its environment, or all three.
Finally, goals and objectives change over time. As a firm reassesses its place in its business environment, it rethinks not only its mission but also its approach to fulfilling it. The reality of change was a major theme when the late McDonald’s CEO Jim Cantalupo explained his goal to revitalize the company:
“The world has changed. Our customers have changed. We have to change too. Growth comes from being better, not just expanding to have more restaurants. The new McDonald’s is focused on building sales at existing restaurants rather than on adding new restaurants. We are introducing a new level of discipline and efficiency to all aspects of the business and are setting a new bar for performance.” 7
This change in focus was accompanied by specific performance objectives—annual sales growth of 3 to 5 percent and income growth of 6 to 7 percent at existing restaurants, plus a five-point improvement (based on customer surveys) in speed of service, friendliness, and food quality.
In setting strategic goals and performance objectives for Notes-4-You, you should keep things simple. Because you need to make money to stay in business, you could include a financial goal (and related objectives). Your mission statement promises “high-quality, dependable, competitively priced class notes,” so you could focus on the quality of the class notes that you’ll be taking and distributing. Finally, because your mission is to serve students, one goal could be customer oriented. Your list of goals and objectives might look like this:
• Goal 1: Achieve a 10 percent return on sales in your first five years.
• Objective: Sales of \$20,000 and profit of \$2,000 for the first 12 months of operation.
• Goal 2: Produce a high-quality product.
• Objective: First-year satisfaction scores of 90 percent or higher on quality of notes (based on survey responses on understandability, readability, and completeness).
• Goal 3: Attain 98 percent customer satisfaction by the end of your fifth year.
• Objective: Making notes available within two days after class, 95 percent of the time.
Tactical Plans
The overall plan is broken down into more manageable, shorter-term components called tactical plans. These plans specify the activities and allocation of resources (people, equipment, money) needed to implement the strategic plan over a given period. Often, a long-range strategic plan is divided into several tactical plans; a five-year strategic plan, for instance, might be implemented as five one-year tactical plans.
Operational Plans
The tactical plan is then broken down into various operational components that provide detailed action steps to be taken by individuals or groups to implement the tactical and strategic plans. Operational plans cover only a brief period—say, a month or two. At Notes-4-You, note-takers might be instructed to submit typed class notes five hours earlier than normal on the last day of the semester (an operational guideline). The goal is to improve the customer-satisfaction score on dependability (a tactical goal) and, as a result, to earn the loyalty of students through attention to customer service (a strategic goal).
Plan for Contingencies and Crises
Even with great planning, things don’t always turn out the way they’re supposed to. Perhaps your plans were flawed, or maybe something in the environment shifted unexpectedly. Successful managers anticipate and plan for the unexpected. Dealing with uncertainty requires contingency planning and crisis management.
Contingency Planning
With contingency planning, managers identify those aspects of the business that are most likely to be adversely affected by change. Then, they develop alternative courses of action in case an anticipated change does occur. You engage in contingency planning any time you develop a backup or fallback plan.
Crisis Management
Organizations also face the risk of encountering crises that require immediate attention. Rather than waiting until such a crisis occurs and then scrambling to figure out what to do, many firms practice crisis management. Some, for instance, set up teams trained to deal with emergencies. Members gather information quickly and respond to the crisis while everyone else carries out his or her normal duties. The team also keeps the public, the employees, the press, and government officials informed about the situation and the company’s response to it.8
An example of how to handle crisis management involves Wendy’s. After learning that a woman claimed she found a fingertip in a bowl of chili she bought at a Wendy’s restaurant in San Jose, California, the company’s public relations team responded quickly. Within a few days, the company announced that the finger didn’t come from an employee or a supplier. Soon after, the police arrested the woman and charged her with attempted grand larceny for lying about how the finger got in her bowl of chili and trying to extort \$2.5 million from the company. But the crisis wasn’t over for Wendy’s. The incident was plastered all over the news as a grossed-out public sought an answer to the question, “Whose finger is (or was) it?” A \$100,000 reward was offered by Wendy’s to anyone with information that would help the police answer this question. The challenge Wendy’s faced was how to entice customers to return to its fifty San Francisco–area restaurants (where sales had plummeted) while keeping a low profile nationally. Wendy’s accomplished this objective by giving out free milkshakes and discount coupons to customers in the affected regions and, to avoid calling attention to the missing finger, by making no changes in its national advertising. The crisis-management strategy worked and the story died down (though it flared up temporarily when the police arrested the woman’s husband, who allegedly bought the finger from a coworker who had severed it in an accident months earlier).9
Even with crisis-management plans in place, however, it’s unlikely that most companies will emerge from a potentially damaging episode as unscathed as Wendy’s did. For one thing, the culprits in the Wendy’s case were caught, and the public was willing to forgive an organization it viewed as a victim. Given the current public distrust of corporate behavior, however, companies whose reputations have suffered due to questionable corporate judgment usually don’t fare as well. These companies include the international oil company, BP, whose CEO, Tony Hayward, did a disastrous job handling the Gulf of Mexico crisis. A BP-controlled oil rig exploded in the Gulf of Mexico, killing eleven workers and creating the largest oil spill in U.S. history. Hayward’s lack of sensitivity will be remembered forever; particularly his response to a reporter’s question on what he would tell those whose livelihoods were ruined: “We’re sorry for the massive disruption it’s caused their lives. There’s no one who wants this over more than I do. I would like my life back.” His comment was obviously upsetting to the families of the eleven men who lost their lives on the rig.10 Then, there are the companies at which executives have crossed the line between the unethical to the downright illegal—Arthur Andersen, Enron, and Bernard L. Madoff Investment Securities, to name just a few. Given the high risk associated with a crisis, it should come as no surprise that contemporary managers spend more time anticipating crises and practicing their crisis-management responses.
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Leading
The third management function is leading—providing focus and direction to others and motivating them to achieve organizational goals. As owner and president of Notes-4-You, you might think of yourself as an orchestra leader. You have given your musicians (employees) their sheet music (plans). You’ve placed them in sections (departments) and arranged the sections (organizational structure) so the music will sound as good as possible. Now your job is to tap your baton and lead the orchestra so that its members make beautiful music together.11
Leadership Styles
It’s fairly easy to pick up a baton, cue each section, and strike up the band; but it doesn’t mean the music will sound good. What if your cues are ignored or misinterpreted or ambiguous? Maybe your musicians don’t like your approach to making music and will just walk away. On top of everything else, you don’t simply want to make music: you want to inspire your musicians to make great music. How do you accomplish this goal? How do you become an effective leader, and what style should you use to motivate others to achieve organizational goals?
Unfortunately, there are no definitive answers to questions like these. Over time, every manager refines his or her own leadership style, or way of interacting with and influencing others. Despite a vast range of personal differences, leadership styles tend to reflect one of the following approaches to leading and motivating people: the autocratic, the democratic (also known as participative), or the free rein.
• Autocratic style. Managers who have developed an autocratic leadership style tend to make decisions without soliciting input from subordinates. They exercise authority and expect subordinates to take responsibility for performing the required tasks without undue explanation.
• Democratic style. Managers who favor a democratic leadership style generally seek input from subordinates while retaining the authority to make the final decisions. They’re also more likely to keep subordinates informed about things that affect their work.
• Free-rein style. In practicing a free rein leadership style, managers adopt a “hands-off” approach and provide relatively little direction to subordinates. They may advise employees but usually give them considerable freedom to solve problems and make decisions on their own.
At first glance, you’d probably not want to work for an autocratic leader. After all, most people don’t like to be told what to do without having any input. Many like the idea of working for a democratic leader; it’s flattering to be asked for your input. And though working in a free rein environment might seem a little unsettling at first, the opportunity to make your own decisions is appealing to many people. Each leadership style can be appropriate in certain situations.
To illustrate, let’s say that you’re leading a group of fellow students in a team project for your class. Are there times when it would be best for you to use an autocratic leadership style? What if your team was newly formed, unfamiliar with what needs to be done, under a tight deadline, and looking to you for direction? In this situation, you might find it appropriate to follow an autocratic leadership style (on a temporary basis) and assign tasks to each member of the group. In an emergency situation, such as a fire, or in the final seconds of a close ball game, there is generally not time for debate – the leader or coach must make a split second decision that demands an autocratic style.
But since most situations are non-emergency and most people prefer the chance to give input, the democratic leadership style is often favored. People are simply more motivated and feel more ownership of decisions (i.e., buy-in) when they have had a chance to offer input. Note that when using this style, the leader will still make the decision in most cases. As long as their input is heard, most people accept that it is the leader’s role to decide in cases where not everyone agrees.
How about free rein leadership? Many people function most effectively when they can set their own schedules and do their work in the manner they prefer. It takes a great deal of trust for a manager to employ this style. Some managers start with an assumption of trust that is up to the employee to maintain through strong performance. In other cases, this trust must be earned over a period of time. Would this approach always work with your study group? Obviously not. It will work if your team members are willing and able to work independently and welcome the chance to make decisions. On the other hand, if people are not ready to work responsibly to their best of their abilities, using the free rein style could cause the team to miss deadlines or do poorly on the project.
The point being made here is that no one leadership style is effective all the time for all people or in all corporate cultures. While the democratic style is often viewed as the most appropriate (with the free rein style a close second), there are times when following an autocratic style is essential. Good leaders learn how to adjust their styles to fit both the situation and the individuals being directed.
Transformational Leadership
Theories on what constitutes effective leadership evolve over time. One theory that has received a lot of attention in the last decade contrasts two leadership styles: transactional and transformational. So-called transactional leaders exercise authority based on their rank in the organization. They let subordinates know what’s expected of them and what they will receive if they meet stated objectives. They focus their attention on identifying mistakes and disciplining employees for poor performance. By contrast, transformational leaders mentor and develop subordinates, providing them with challenging opportunities, working one-on-one to help them meet their professional and personal needs, and encouraging people to approach problems from new perspectives. They stimulate employees to look beyond personal interests to those of the group.
So, which leadership style is more effective? You probably won’t be surprised by the opinion of most experts. In today’s organizations, in which team building and information sharing are important and projects are often collaborative in nature, transformational leadership has proven to be more effective. Modern organizations look for managers who can develop positive relationships with subordinates and motivate employees to focus on the interests of the organization. Leaders who can be both transactional and transformational are rare, and those few who have both capacities are very much in demand.12
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Controlling
Let’s pause for a minute and reflect on the management functions that we’ve discussed so far—planning, organizing, and leading. As founder of Notes-4-You, you began by establishing plans for your new company. You defined its mission and set objectives, or performance targets, which you needed to meet in order to achieve your mission. Then, you organized your company by allocating the people and resources required to carry out your plans. Finally, you provided focus and direction to your employees and motivated them to achieve organizational objectives. Is your job finished? Can you take a well-earned vacation? Unfortunately, the answer is no: your work has just begun. Now that things are rolling along, you need to monitor your operations to see whether everything is going according to plan. If it’s not, you’ll need to take corrective action. This process of comparing actual to planned performance and taking necessary corrective action is called controlling.
A Five-Step Control Process
You can think of the control function as the five-step process outlined in Figure 8.7. Let’s see how this process might work at Notes-4-You. Let’s assume that, after evaluating class enrollments, you estimate that you can sell one hundred notes packages per month to students taking a popular sophomore-level geology course. So you set your standard at a hundred units. At the end of the month, however, you look over your records and find that you sold only eighty. In talking with your salespeople, you learn why you came up twenty packages short: it turns out that the copy machine broke down so often that packages frequently weren’t ready on time. You immediately take corrective action by increasing maintenance on the copy machine.
Now, let’s try a slightly different scenario. Let’s say that you still have the same standard (one hundred packages) and that actual sales are still eighty packages. In investigating the reason for the shortfall, you find that you overestimated the number of students taking the geology course. Calculating a more accurate number of students, you see that your original standard—estimated sales—was too high by twenty packages. In this case, you should adjust your standards to reflect expected sales of eighty packages.
In both situations, your control process has been helpful. In the first instance, you were alerted to a problem that cut into your sales. Correcting this problem would undoubtedly increase sales and, therefore, profits. In the second case, you encountered a defect in your planning and learned a good managerial lesson: plan more carefully.
Benchmarking
Benchmarking could be considered as a specialized kind of control activity. Rather than controlling a particular aspect of performance (say, defects for a specific product), benchmarking aims to improve a firm’s overall performance. The process of benchmarking involves comparisons to other organizations’ practices and processes with the objective of learning and improvement in both efficiency and effectiveness. Benchmarking exercises can be conducted in a number of ways:
• Organizations often monitor publicly available information to keep tabs on the competition. Annual reports, news articles, and other sources are monitored closely in order to stay aware of the latest developments. In academia, universities often use published rankings tables to see how their programs compare on the basis of standardized test scores, salaries of graduates, and other important dimensions.
• Organizations may also work directly with companies in unrelated industries in order to compare those functions of the business which are similar. A manufacture of aircraft would not likely have a great deal in common with a company making engineered plastics, yet both have common functions such as accounting, finance, information technology, and human resources. Companies can exchange ideas that help each other improve efficiency, and often at a very low cost to either.
• In order to compare more directly to competition without relying solely on publicly available data, companies may enter into benchmarking consortiums in which an outside consultant would collect key data from all participants, anonymize it, and then share the results with all participants. Companies can then gauge how they compare to others in the industry without revealing their own performance to others.
Managerial Skills
To be a successful manager, you’ll have to master a number of skills. To get an entry- level position, you’ll have to be technically competent at the tasks you’re asked to perform. To advance, you’ll need to develop strong interpersonal and conceptual skills. The relative importance of different skills varies from job to job and organization to organization, but to some extent, you’ll need them all to forge a managerial career.
Throughout your career, you’ll also be expected to communicate ideas clearly, use your time efficiently, and reach sound decisions.
Technical Skills
You’ll probably be hired for your first job based on your technical skills—the ones you need to perform specific tasks—and you’ll use them extensively during your early career. If your college major is accounting, you’ll use what you’ve learned to prepare financial statements. If you have a marketing degree and you join an ad agency, you’ll use what you know about promotion to prepare ad campaigns. Technical skills will come in handy when you move up to a first-line managerial job and oversee the task performance of subordinates. Technical skills, though developed through job training and work experience, are generally acquired during the course of your formal education.
Interpersonal Skills
As you move up the corporate ladder, you’ll find that you can’t do everything yourself: you’ll have to rely on other people to help you achieve the goals for which you’re responsible. That’s why interpersonal skills, also known as relational skills—the ability to get along with and motivate other people—are critical for managers in mid-level positions. These managers play a pivotal role because they report to top-level managers while overseeing the activities of first-line managers. Thus, they need strong working relationships with individuals at all levels and in all areas. More than most other managers, they must use “people skills” to foster teamwork, build trust, manage conflict, and encourage improvement.13
Conceptual Skills
Managers at the top, who are responsible for deciding what’s good for the organization from the broadest perspective, rely on conceptual skills—the ability to reason abstractly and analyze complex situations. Senior executives are often called on to “think outside the box”—to arrive at creative solutions to complex, sometimes ambiguous problems. They need both strong analytical abilities and strong creative talents.
Communication Skills
Effective communication skills are crucial to just about everyone. At all levels of an organization, you’ll often be judged on your ability to communicate, both orally and in writing. Whether you’re talking informally or making a formal presentation, you must express yourself clearly and concisely. Talking too loudly, rambling, and using poor grammar reduce your ability to influence others, as does poor written communication. Confusing and error-riddled documents (including e-mails) don’t do your message any good, and they will reflect poorly on you.14
Time-Management Skills
Managers face multiple demands on their time, and their days are usually filled with interruptions. Ironically, some technologies that were supposed to save time, such as voicemail and e-mail, have actually increased workloads. Unless you develop certain time-management skills, you risk reaching the end of the day feeling that you’ve worked a lot but accomplished little. What can managers do to ease the burden? Here are a few common-sense suggestions:
• Prioritize tasks, focusing on the most important things first.
• Set aside a certain time each day to return phone calls and answer e-mail.
• Delegate routine tasks.
• Don’t procrastinate.
• Insist that meetings start and end on time, and stick to an agenda.
• Eliminate unnecessary paperwork.15
Decision-Making Skills
Every manager is expected to make decisions, whether alone or as part of a team. Drawing on your decision-making skills is often a process in which you must define a problem, analyze possible solutions, and select the best outcome. As luck would have it, because the same process is good for making personal decisions, we’ll use a personal example to demonstrate the process approach to decision making. Consider the following scenario: you’re upset because your midterm grades are much lower than you’d hoped. To make matters worse, not only are you in trouble academically, but also the other members of your business-project team are annoyed because you’re not pulling your weight. Your lacrosse coach is very upset because you’ve missed too many practices, and members of the mountain-biking club of which you’re supposed to be president are talking about impeaching you if you don’t show up at the next meeting. And your significant other is feeling ignored.
A Six-Step Approach to Decision Making
Assuming that your top priority is salvaging your GPA, let’s tackle your problem by using a six-step approach to solving problems that don’t have simple solutions. We’ve summarized this model in Figure 8.816
Identify the problem you want to work on
Step one is getting to know your problem, which you can formulate by asking yourself a basic question: how can I improve my grades?
Gather relevant data
Step two is gathering information that will shed light on the problem. Let’s rehash some of the relevant information that you’ve already identified: (a)you did poorly on your finals because you didn’t spend enough time studying; (b) you didn’t study because you went to see your girlfriend (who lives about three hours from campus) over the weekend before your exams (and on most other weekends, as a matter of fact); (c) what little studying you got in came at the expense of your team project and lacrosse practice; and (d) while you were away for the weekend, you forgot to tell members of the mountain-biking club that you had to cancel the planned meeting.
Clarify the problem
Once you review all the given facts, you should see that your problem is bigger than simply getting your grades up; your life is pretty much out of control. You can’t handle everything to which you’ve committed yourself. Something has to give. You clarify the problem by summing it up with another basic question: what can I do to get my life back in order?
Generate possible solutions
Let’s say that you’ve come up with the following possible solutions to your problem: (a) quit the lacrosse team, (b) step down as president of the mountain-biking club, (c) let team members do your share of work on the business project, and (d) stop visiting your significant other so frequently. The solution to your main problem—how to get your life back in order—will probably require multiple actions.
Select the best option
This is clearly the toughest part of the process. Working your way through your various options, you arrive at the following conclusions: (a) you can’t quit the lacrosse team because you’d lose your scholarship; (b) you can resign your post in the mountain-biking club, but that won’t free up much time; (c) you can’t let your business-project team down (and besides, you’d just get a low grade); and (d) she wouldn’t like the idea, but you could visit your girlfriend, say, once a month rather than once a week. So what’s the most feasible (if not necessarily perfect) solution? Probably visiting your significant other once a month and giving up the presidency of the mountain-biking club.
Implement your decision and monitor your choice
When you call your girlfriend, you’re pleasantly surprised to find that she understands. The vice president is happy to take over the mountain-biking club. After the first week, you’re able to attend lacrosse practice, get caught up on your team business project, and catch up in all your other classes. The real test of your solution will be the results of the semester’s finals.
Revisiting Qualtrax
In a previous chapter, we described the decisions made by Foxguard Solutions about its Qualtrax business, a new business venture developed inside the company. The decisions Foxguard made track quite well with the process described above. Consider the following:
Problem Identification— Foxguard had a business line that wasn’t an exact fit with its other business and was not performing up to the potential management believed it held.
Gather Relevant Data— When Amy Ankrum was promoted, one of her first priorities was to determine what information would help her to understand the potential for the business and the resources needed to improve it.
Clarify the Problem— Qualtrax had a definite market and potential to grow, but the parent company hadn’t invested time/energy into doing that. Would more focus grow the business?
Generate Possible Solutions— Management could have continued to try to grow the business in-house, sell it to another company, or spin it off
Select Best Option— After a careful evaluation, management decided the spin-off was the best option to unleash the full potential of Qualtrax
Implement and Monitor— The decision to spin-off Qualtrax could be measured on metrics such as growth in revenue, profits, and employee satisfaction. Based on the results to-date, it certainly seems like they made the right decision.
Applying Your Skills at Notes-4-You
So, what types of skills will managers at Notes-4-You need? To oversee note-taking and copying operations, first-line managers will require technical skills, probably in operations and perhaps in accounting. Middle managers will need strong interpersonal skills to maintain positive working relationships with subordinates and to motivate them. As president (the top manager), you’ll need conceptual skills to solve problems and come up with creative ways to keep the business growing. And everyone will have to communicate effectively: after all, because you’re in the business of selling written notes, it would look pretty bad if your employees wrote poorly. Finally, everyone will have to use time efficiently and call on problem-solving skills to handle the day-to-day crises that seem to plague every new company.
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Chapter Video
Roselinde Torres is an extremely accomplished leadership expert, and her TED Talk shares her insights on what it takes to be a great leader. If you have not seen TED Talks before, you will likely see a great many more before you graduate.
A TED element has been excluded from this version of the text. You can view it online here: pb.libretexts.org/biz3/?p=93
(Video license: CC BY NC ND 4.0)
Key Takeaways
1. Management must include both efficiency (accomplishing goals using the fewest resources possible) and effectiveness (accomplishing goals as accurately as possible).
2. The management process has four functions: planning, organizing, leading, and controlling.
3. Planning for a business starts with strategic planning—the process of establishing an overall course of action.
4. Management first identifies its purposes, creates a mission statement, and defines its core values.
5. A SWOT analysis assesses the company’s strengths and weaknesses and its fit with the external environment.
6. Goals and objectives, or performance targets, are established to direct company actions, and tactical plans and operational plans implement objectives.
7. A manager’s leadership style varies depending on the manager, the situation, and the people being directed. There are several management styles.
1. An autocratic manager tends to make decisions without input and expects subordinates to follow instructions.
2. Managers who prefer a democratic style seek input into decisions.
3. A free rein manager provides no more guidance than necessary and lets subordinates make decisions and solve problems.
4. Transactional style managers exercise authority according to their rank in the organization, let subordinates know what’s expected of them, and step in when mistakes are made.
5. Transformational style managers mentor and develop subordinates and motivate them to achieve organizational goals.
8. The control process can be viewed as a five-step process: (1) establish standards, (2) measure performance, (3) compare actual performance with standards and identify any deviations, (4) determine the reason for deviations, and (5) take corrective action if needed.
9. Benchmarking is a process for improving overall company efficiency and effectiveness by comparing performance to competitors.
10. Top managers need strong conceptualskills, while those at midlevel need good interpersonal skills and those at lower levels need technical skills.
11. All managers need strong communication, decision-making, and time- management skills.
Chapter 8 Text References and Image Credits
Image Credits: Chapter 8
Figure 8.3: “Apple laptop and notes.” Public domain. Retrieved from: www.pexels.com/photo/notes-macbook-study-conference-7102/
Figure 8.4: Dave Mcmt (2009). “A Wendy’s in Miles City Montana.” CC-BY-2.0. Retrieved from: https://commons.wikimedia.org/wiki/File:Miles_City_MT_-_Wendy%27s.jpg
Figure 8.5: The U.S. Coast Guard (2010). “The Deepwater Horizon Offshore Drilling Unit on Fire.” Public domain. Retrieved from: https://commons.wikimedia.org/wiki/F...it_on_fire.jpg
Figure 8.6: Luis Dantas (2007). “A Samsung desktop SOHO MFP.” Public domain. Retrieved from: en.Wikipedia.org/wiki/Multi-function_printer#/media/File:Multifunctional_Samsung.jpg
Video Credits: Chapter 8
Torres, Roselinde. “What it Takes to be a Great Leader.” (TED). October 2013. Retrieved from: https://www.ted.com/talks/roselinde_torres_what_it_takes_to_be_a_great_leader?language=en | textbooks/biz/Business/Introductory_Business/Book%3A_Fundamentals_of_Business_(Skripak)/08%3A_Management_and_Leadership.txt |
Learning Objectives
1. Identify the three levels of management and the responsibilities at each level.
2. Discuss various options for organizing a business, and create an organization chart.
3. Understand how specialization helps make organizations more efficient.
4. Discuss the different ways that an organization can departmentalize.
5. Explain other key terms related to this chapter such as chain of command, delegation of authority, and span of control.
09: Structuring Organizations
If you read our chapter on Management and Leadership, you will recall developing a strategic plan for your new company, Notes-4-You. Once a business has completed the planning process, it will need to organize the company so that it can implement that plan. A manager engaged in organizing allocates resources (people, equipment, and money) to achieve a company’s objectives. Successful managers make sure that all the activities identified in the planning process are assigned to some person, department, or team and that everyone has the resources needed to perform assigned activities.
Levels of Management: How Managers Are Organized
A typical organization has several layers of management. Think of these layers as forming a pyramid like the one in Figure 9.1, with top managers occupying the narrow space at the peak, first-line managers the broad base, and middle-managers the levels in between. As you move up the pyramid, management positions get more demanding, but they carry more authority and responsibility (along with more power, prestige, and pay). Top managers spend most of their time in planning and decision making, while first-line managers focus on day-to-day operations. For obvious reasons, there are far more people with positions at the base of the pyramid than there are at the other two levels. Let’s look at each management level in more detail.
Top Managers
Top managers are responsible for the health and performance of the organization. They set the objectives, or performance targets, designed to direct all the activities that must be performed if the company is going to fulfill its mission. Top-level executives routinely scan the external environment for opportunities and threats, and they redirect company efforts when needed. They spend a considerable portion of their time planning and making major decisions. They represent the company in important dealings with other businesses and government agencies, and they promote it to the public. Job titles at this level typically include chief executive officer (CEO), chief financial officer (CFO), chief operating officer (COO), president, and vice president.
Middle Managers
Middle managers are in the center of the management hierarchy: they report to top management and oversee the activities of first-line managers. They’re responsible for developing and implementing activities and allocating the resources needed to achieve the objectives set by top management. Common job titles include operations manager, division manager, plant manager, and branch manager.
First-Line Managers
First-line managers supervise employees and coordinate their activities to make sure that the work performed throughout the company is consistent with the plans of both top and middle management. It’s at this level that most people acquire their first managerial experience. The job titles vary considerably but include such designations as manager, group leader, office manager, foreman, and supervisor.
Let’s take a quick survey of the management hierarchy at Notes-4-You. As president, you are a member of top management, and you’re responsible for the overall performance of your company. You spend much of your time setting performance targets, to ensure that the company meets the goals you’ve set for it— increased sales, higher-quality notes, and timely distribution.
Several middle managers report to you, including your operations manager. As a middle manager, this individual focuses on implementing two of your objectives: producing high-quality notes and distributing them to customers in a timely manner. To accomplish this task, the operations manager oversees the work of two first-line managers—the note-taking supervisor and the copying supervisor. Each first-line manager supervises several non-managerial employees to make sure that their work is consistent with the plans devised by top and middle management. | textbooks/biz/Business/Introductory_Business/Book%3A_Fundamentals_of_Business_(Skripak)/09%3A_Structuring_Organizations/9.00%3A_New_Page.txt |
Building an organizational structure engages managers in two activities: job specialization (dividing tasks into jobs) and departmentalization (grouping jobs into units). An organizational structure outlines the various roles within an organizational, which positions report to which, and how an organization will departmentalize its work. Take note than an organizational structure is an arrangement of positions that’s most appropriate for your company at a specific point in time. Given the rapidly changing environment in which businesses operate, a structure that works today might be outdated tomorrow. That’s why you hear so often about companies restructuring—altering existing organizational structures to become more competitive once conditions have changed. Let’s now look at how the processes of specialization and departmentalization are accomplished.
Specialization
Organizing activities into clusters of related tasks that can be handled by certain individuals or groups is called specialization. This aspect of designing an organizational structure is twofold:
1. Identify the activities that need to be performed in order to achieve organizational goals.
2. Break down these activities into tasks that can be performed by individuals or groups of employees.
Specialization has several advantages. First and foremost, it leads to efficiency. Imagine a situation in which each department was responsible for paying its own invoices; a person handling this function a few times a week would likely be far less efficient than someone whose job was to pay the bills. In addition to increasing efficiency, specialization results in jobs that are easier to learn and roles that are clearer to employees. But the approach has disadvantages, too. Doing the same thing over and over sometimes leads to boredom and may eventually leave employees dissatisfied with their jobs. Before long, companies may notice decreased performance and increased absenteeism and turnover (the percentage of workers who leave an organization and must be replaced).
Departmentalization
The next step in designing an organizational structure is departmentalization—grouping specialized jobs into meaningful units. Depending on the organization and the size of the work units, they may be called divisions, departments, or just plain groups.
Traditional groupings of jobs result in different organizational structures, and for the sake of simplicity, we’ll focus on two types—functional and divisional organizations.
Functional Organizations
A functional organization groups together people who have comparable skills and perform similar tasks. This form of organization is fairly typical for small to medium-size companies, which group their people by business functions: accountants are grouped together, as are people in finance, marketing and sales, human resources, production, and research and development. Each unit is headed by an individual with expertise in the unit’s particular function. Examples of typical functions in a business enterprise include human resources, operations, marketing, and finance. Also, business colleges will often organize according to functions found in a business.
There are a number of advantages to the functional approach. The structure is simple to understand and enables the staff to specialize in particular areas; everyone in the marketing group would probably have similar interests and expertise. But homogeneity also has drawbacks: it can hinder communication and decision making between units and even promote interdepartmental conflict. The marketing department, for example, might butt heads with the accounting department because marketers want to spend as much as possible on advertising, while accountants want to control costs.
Divisional Organizations
Large companies often find it unruly to operate as one large unit under a functional organizational structure. Sheer size makes it difficult for managers to oversee operations and serve customers. To rectify this problem, most large companies are structured as divisional organizations. They are similar in many respects to stand-alone companies, except that certain common tasks, like legal work, tends to be centralized at the headquarters level. Each division functions relatively autonomously because it contains most of the functional expertise (production, marketing, accounting, finance, human resources) needed to meet its objectives. The challenge is to find the most appropriate way of structuring operations to achieve overall company goals. Toward this end, divisions can be formed according to products, customers, processes, or geography.
Product Divisions
Product division means that a company is structured according to its product lines. General Motors, for example, has four product-based divisions: Buick, Cadillac, Chevrolet, and GMC.1 Each division has its own research and development group, its own manufacturing operations, and its own marketing team. This allows individuals in the division to focus all their efforts on the products produced by their division. A downside is that it results in higher costs as corporate support services (such as accounting and human resources) are duplicated in each of the four divisions.
Customer Divisions
Some companies prefer a customer division structure because it enables them to better serve their various categories of customers. Thus, Johnson & Johnson’s two hundred or so operating companies are grouped into three customer-based business segments: consumer business (personal-care and hygiene products sold to the general public), pharmaceuticals (prescription drugs sold to pharmacies), and professional business (medical devices and diagnostics products used by physicians, optometrists, hospitals, laboratories, and clinics).2
Process Divisions
If goods move through several steps during production, a company might opt for a process division structure. This form works well at Bowater Thunder Bay, a Canadian company that harvests trees and processes wood into newsprint and pulp. The first step in the production process is harvesting and stripping trees. Then, large logs are sold to lumber mills and smaller logs are chopped up and sent to Bowater’s mills. At the mill, wood chips are chemically converted into pulp. About 90 percent is sold to other manufacturers (as raw material for home and office products), and the remaining 10 percent is further processed into newspaper print. Bowater, then, has three divisions: tree cutting, chemical processing, and finishing (which makes newsprint).3
Geographical Divisions
Geographical division enables companies that operate in several locations to be responsive to customers at a local level. Adidas, for example, is organized according to the regions of the world in which it operates. They have eight different regions, and each one reports its performance separately in their annual reports.4
Summing Up Divisional Organizations
There are pluses and minuses associated with divisional organization. On the one hand, divisional structure usually enhances the ability to respond to changes in a firm’s environment. If, on the other hand, services must be duplicated across units, costs will be higher. In addition, some companies have found that units tend to focus on their own needs and goals at the expense of the organization as a whole.
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The Organization Chart
Once an organization has set its structure, it can represent that structure in an organization chart: a diagram delineating the interrelationships of positions within the organization. An example organization chart is shown in Figure 9.3, using our “Notes-4-You” example from Chapter 8.
Imagine putting yourself at the top of the chart, as the company’s president. You would then fill in the level directly below your name with the names and positions of the people who work directly for you—your accounting, marketing, operations, and human resources managers. The next level identifies the people who work for these managers. Because you’ve started out small, neither your accounting manager nor your human resources manager will be currently managing anyone directly. Your marketing manager, however, will oversee one person in advertising and a sales supervisor (who, in turn, oversees the sales staff). Your operations manager will oversee two individuals—one to supervise note-takers and one to supervise the people responsible for making copies. The lines between the positions on the chart indicate the reporting relationships; for example, the Note-Takers Supervisor reports directly to the Operations Manager.
Although the structure suggests that you will communicate only with your four direct reports, this isn’t the way things normally work in practice. Behind every formal communication network there lies a network of informal communications—unofficial relationships among members of an organization. You might find that over time, you receive communications directly from members of the sales staff; in fact, you might encourage this line of communication.
Now let’s look at the chart of an organization that relies on a divisional structure based on goods or services produced—say, a theme park. The top layers of this company’s organization chart might look like the one in Figure 9.4a (left side of the diagram). We see that the president has two direct reports—a vice president in charge of rides and a vice president in charge of concessions. What about a bank that’s structured according to its customer base? The bank’s organization chart would begin like the one in Figure 9.4b. Once again, the company’s top manager has two direct reports, in this case a VP of retail-customer accounts and a VP of commercial-customer accounts.
Over time, companies revise their organizational structures to accommodate growth and changes in the external environment. It’s not uncommon, for example, for a firm to adopt a functional structure in its early years. Then, as it becomes bigger and more complex, it might move to a divisional structure—perhaps to accommodate new products or to become more responsive to certain customers or geographical areas. Some companies might ultimately rely on a combination of functional and divisional structures. This could be a good approach for a credit card company that issues cards in both the United States and Europe. An outline of this firm’s organization chart might look like the one in Figure 9.5.
Chain of Command
The vertical connecting lines in the organization chart show the firm’s chain of command: the authority relationships among people working at different levels of the organization. That is to say, they show who reports to whom. When you’re examining an organization chart, you’ll probably want to know whether each person reports to one or more supervisors: to what extent, in other words, is there unity of command? To understand why unity of command is an important organizational feature, think about it from a personal standpoint. Would you want to report to more than one boss? What happens if you get conflicting directions? Whose directions would you follow?
There are, however, conditions under which an organization and its employees can benefit by violating the unity-of-command principle. Under a matrix structure, for example, employees from various functional areas (product design, manufacturing, finance, marketing, human resources, etc.) form teams to combine their skills in working on a specific project or product. This matrix organization chart might look like the one in the following figure.
Nike sometimes uses this type of arrangement. To design new products, the company may create product teams made up of designers, marketers, and other specialists with expertise in particular sports categories—say, running shoes or basketball shoes. Each team member would be evaluated by both the team manager and the head of his or her functional department.
Span of Control
Another thing to notice about a firm’s chain of command is the number of layers between the top managerial position and the lowest managerial level. As a rule, new organizations have only a few layers of management—an organizational structure that’s often called flat. Let’s say, for instance, that a member of the Notes-4-You sales staff wanted to express concern about slow sales among a certain group of students. That person’s message would have to filter upward through only two management layers—the sales supervisor and the marketing manager—before reaching the president.
As a company grows, however, it tends to add more layers between the top and the bottom; that is, it gets taller. Added layers of management can slow down communication and decision making, causing the organization to become less efficient and productive. That’s one reason why many of today’s organizations are restructuring to become flatter.
There are trade-offs between the advantages and disadvantages of flat and tall organizations. Companies determine which trade-offs to make according to a principle called span of control, which measures the number of people reporting to a particular manager. If, for example, you remove layers of management to make your organization flatter, you end up increasing the number of people reporting to a particular supervisor. If you refer back to the organization chart for Notes-4-You, you’ll recall that, under your present structure, four managers report to you as the president: the heads of accounting, marketing, operations, and human resources. In turn, two of these managers have positions reporting to them: the advertising manager and sales supervisor report to the marketing manager, while the notetakers supervisor and the copiers supervisor report to the operations manager. Let’s say that you remove a layer of management by getting rid of the marketing and operations managers. Your organization would be flatter, but what would happen to your workload? As president, you’d now have six direct reports rather than four: accounting manager, advertising manager, sales manager, notetaker supervisor, copier supervisor, and human resources manager.
So what’s better—a narrow span of control (with few direct reports) or a wide span of control (with many direct reports)? The answer to this question depends on a number of factors, including frequency and type of interaction, proximity of subordinates, competence of both supervisor and subordinates, and the nature of the work being supervised. For example, you’d expect a much wider span of control at a nonprofit call center than in a hospital emergency room.
Delegating Authority
Given the tendency toward flatter organizations and wider spans of control, how do managers handle increased workloads? They must learn how to handle delegation—the process of entrusting work to subordinates. Unfortunately, many managers are reluctant to delegate. As a result, they not only overburden themselves with tasks that could be handled by others, but they also deny subordinates the opportunity to learn and develop new skills.
Responsibility and Authority
As owner of Notes-4-You, you’ll probably want to control every aspect of your business, especially during the start-up stage. But as the organization grows, you’ll have to assign responsibility for performing certain tasks to other people. You’ll also have to accept the fact that responsibility alone—the duty to perform a task—won’t be enough to get the job done. You’ll need to grant subordinates the authority they require to complete a task—that is, the power to make the necessary decisions. (And they’ll also need sufficient resources.) Ultimately, you’ll also hold your subordinates accountable for their performance.
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Centralization and Decentralization
If and when your company expands (say, by offering note-taking services at other schools), you’ll have to decide whether most decisions should still be made by individuals at the top or delegated to lower-level employees. The first option, in which most decision making is concentrated at the top, is called centralization. The second option, which spreads decision making throughout the organization, is called decentralization.
Centralization has the advantage of consistency in decision-making. Since in a centralized model, key decisions are made by the same top managers, those decisions tend to be more uniform than if decisions were made by a variety of different people at lower levels in the organization. In most cases, decisions can also be made more quickly provided that top management does not try to control too many decisions. However, centralization has some important disadvantages. If top management makes virtually all key decisions, then lower-level managers will feel under-utilized and will not develop decision-making skills that would help them become promotable. An overly centralized model might also fail to consider information that only front-line employees have or might actually delay the decision-making process. Consider a case where the sales manager for an account is meeting with a customer representative who makes a request for a special sale price; the customer offers to buy 50% more product if the sales manager will reduce the price by 5% for one month. If the sales manager had to obtain approval from the head office, the opportunity might disappear before she could get approval – a competitor’s sales manager might be the customer’s next meeting.
An overly decentralized decision model has its risks as well. Imagine a case in which a company had adopted a geographically-based divisional structure and had greatly decentralized decision making. In order to expand its business, suppose one division decided to expand its territory into the geography of another division. If headquarters approval for such a move was not required, the divisions of the company might end up competing against each other, to the detriment of the organization as a whole. Companies that wish to maximize their potential must find the right balance between centralized and decentralized decision making.
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Key Takeaways
1. Managers coordinate the activities identified in the planning process among individuals, departments, or other units and allocate the resources needed to perform them.
2. Typically, there are three levels of management: top managers, who are responsible for overall performance; middle managers, who report to top managers and oversee lower-level managers; and first-line managers, who supervise employees to make sure that work is performed correctly and on time.
3. Management must develop an organizational structure, or arrangement of people within the organization, that will best achieve company goals.
4. The process begins with specialization—dividing necessary tasks into jobs; the principle of grouping jobs into units is called departmentalization.
5. Units are then grouped into an appropriate organizational structure. Functional organization groups people with comparable skills and tasks; divisional organization creates a structure composed of self-contained units based on product, customer, process, or geographical division. Forms of organizational division are often combined.
6. An organization’s structure is represented in an organization chart—a diagram showing the interrelationships of its positions.
7. This chart highlights the chain of command, or authority relationships among people working at different levels.
8. It also shows the number of layers between the top and lowest managerial levels. An organization with few layers has a wide span of control, with each manager overseeing a large number of subordinates; with a narrow span of control, only a limited number of subordinates reports to each manager.
9.02: New Page
Figure 9.2: “Adidas Group geographic divisions.” Data source: Adidas Group Annual Report 2015. Retrieved from: www.adidas-group.com/en/investors/financial-reports/#/2015/ World map source: Mmikle. CC-BY-2.0. Retrieved from: https://commons.wikimedia.org/wiki/File:A_large_blank_world_map_with_oceans_marked_in_blue-edited.png Adidas logo © Adidas group. Retrieved from: https://commons.wikimedia.org/wiki/File:Adidas_Logo.svg
Figures 9.3 “An organizational chart for “Notes-4-Young.” Designed for Virginia Tech Libraries by Brian Craig. commons.wikimedia.org/wiki/Category:Figures_from_Fundamentals_of_Business_by_Skripak. Licensed CC BY 4.0.
Figure 9.4a-b “Organizational charts for divisional structures” Designed for Virginia Tech Libraries by Brian Craig. commons.wikimedia.org/wiki/Category:Figures_from_Fundamentals_of_Business_by_Skripak. Licensed CC BY 4.0.
Figure 9.5 “An organization with a combination of functional and divisional structures” Designed for Virginia Tech Libraries by Brian Craig. https://commons.wikimedia.org/wiki/Category:Figures_from_Fundamentals_of_Business_by_Skripak. Licensed CC BY 4.0.
Figure 9.6 “A chart of a matrix structure” Designed for Virginia Tech Libraries by Brian Craig. https://commons.wikimedia.org/wiki/Category:Figures_from_Fundamentals_of_Business_by_Skripak. Licensed CC BY 4.0. | textbooks/biz/Business/Introductory_Business/Book%3A_Fundamentals_of_Business_(Skripak)/09%3A_Structuring_Organizations/9.01%3A_New_Page.txt |
Learning Objectives
1. Define operations management and discuss the role of the operations manager in a manufacturing company.
2. Describe the decisions and activities of the operations manager in overseeing the production process in a manufacturing company.
3. Explain how to create and use both PERT and Gantt charts.
4. Explain how manufacturing companies use technology to produce and deliver goods in an efficient, cost-effective manner.
5. Describe the decisions made in planning the product delivery process in a service company.
6. List the characteristics that distinguish service operations from manufacturing operations and identify the activities undertaken to manage operations in a service organization.
7. Explain how manufacturing and service companies alike use total quality management and outsourcing to provide value to customers.
The Challenge: Producing Quality Jetboards
The product development process can be complex and lengthy. It took sixteen years for Bob Montgomery and others at his company to develop the PowerSki Jetboard, and this involved thousands of design changes. It was worth it, though: the Jetboard was an exciting, engine-propelled personal watercraft – a cross between a high-performance surfboard and a competition water-ski/wakeboard that received extensive media attention and rave reviews. It was showered with honors, including Time magazine’s “Best Invention of the Year” award.1 Stories about the Jetboard appeared in more than fifty magazines around the world, and it was featured in several movies, over twenty-five TV shows, and on YouTube.2
Montgomery and his team at PowerSki enjoyed taking their well-deserved bows for the job they did designing the product, but having a product was only the beginning for the company. The next step was developing a system that would produce high-quality Jetboards at reasonable prices. Before putting this system in place, PowerSki managers had to address several questions.
• What kind of production process should they use to make the Jetboards?
• How large should their production facilities be, and where should they be located?
• Where should they buy needed materials?
• What systems will be needed to control the production process and ensure a quality product?
Answering these and other questions helped PowerSki set up a manufacturing system through which it could accomplish the most important task that it had set for itself: efficiently producing quality Jetboards.
Operations Management in Manufacturing
Like PowerSki, every organization—whether it produces goods or provides services— sees Job 1 as furnishing customers with quality products. Thus, to compete with other organizations, a company must convert resources (materials, labor, money, information) into goods or services as efficiently as possible. The upper-level manager who directs this transformation process is called an operations manager. The job of operations management (OM) consists of all the activities involved in transforming a product idea into a finished product. In addition, operations managers are involved in planning and controlling the systems that produce goods and services. In other words, operations managers manage the process that transforms inputs into outputs. Figure 10.2 illustrates these traditional functions of operations management.
Like PowerSki, all manufacturers set out to perform the same basic function: to transform resources into finished goods. To perform this function in today’s business environment, manufacturers must continually strive to improve operational efficiency. They must fine-tune their production processes to focus on quality, to hold down the costs of materials and labor, and to eliminate all costs that add no value to the finished product. Making the decisions involved in the effort to attain these goals is another job of operations managers. Their responsibilities can be grouped as follows:
• Production planning. During production planning, managers determine how goods will be produced, where production will take place, and how manufacturing facilities will be laid out.
• Production control. Once the production process is under way, managers must continually schedule and monitor the activities that make up that process. They must solicit and respond to feedback and make adjustments where needed. At this stage, they also oversee the purchasing of raw materials and the handling of inventories.
• Quality control. The operations manager is directly involved in efforts to ensure that goods are produced according to specifications and that quality standards are maintained.
Let’s take a closer look at each of these responsibilities.
Planning the Production Process
The decisions made in the planning stage have long-range implications and are crucial to a firm’s success. Before making decisions about the operations process, managers must consider the goals set by marketing managers. Does the company intend to be a low-cost producer and to compete on the basis of price? Or does it plan to focus on quality and go after the high end of the market? Many decisions involve trade-offs. For example, low cost doesn’t normally go hand in hand with high quality. All functions of the company must be aligned with the overall strategy to ensure success.
With these thoughts in mind, let’s look at the specific types of decisions that have to be made in the production planning process. We’ve divided these decisions into those dealing with production methods, site selection, facility layout, and components and materials management.
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Production-Method Decisions
The first step in production planning is deciding which type of productionprocess is best for making the goods that your company intends to manufacture. In reaching this decision, you should answer such questions as:
• Am I making a one-of-a-kind good based solely on customer specifications, or am I producing high-volume standardized goods to be sold later?
• Do I offer customers the option of “customizing” an otherwise standardized good to meet their specific needs?
One way to appreciate the nature of this decision is by comparing three basic types of processes or methods: make-to-order, mass production, and mass customization. The task of the operations manager is to work with other managers, particularly marketers, to select the process that best serves the needs of the company’s customers.
Make-to-Order
At one time, most consumer goods, such as furniture and clothing, were made by individuals practicing various crafts. By their very nature, products were customized to meet the needs of the buyers who ordered them. This process, which is called a make-to-order strategy, is still commonly used by such businesses as print or sign shops that produce low-volume, high-variety goods according to customer specifications. This level of customization often results in a longer production and delivery cycle than other approaches.
Mass Production
By the early twentieth century, a new concept of producing goods had been introduced: mass production (or make-to-stock strategy), the practice of producing high volumes of identical goods at a cost low enough to price them for large numbers of customers. Goods are made in anticipation of future demand (based on forecasts) and kept in inventory for later sale. This approach is particularly appropriate for standardized goods ranging from processed foods to electronic appliances and generally result in shorter cycle times than a make-to-order process.
Mass Customization
There is at least one big disadvantage to mass production: customers, as one old advertising slogan put it, can’t “have it their way.” They have to accept standardized products as they come off assembly lines. Increasingly, however, customers are looking for products that are designed to accommodate individual tastes or needs but can still be bought at reasonable prices. To meet the demands of these consumers, many companies have turned to an approach called mass customization, which combines the advantages of customized products with those of mass production.
This approach requires that a company interact with the customer to find out exactly what the customer wants and then manufacture the good, using efficient production methods to hold down costs. One efficient method is to mass-produce a product up to a certain cut-off point and then to customize it to satisfy different customers.
One of the best-known mass customizers is Nike, which has achieved success by allowing customers to configure their own athletic shoes, apparel, and equipment through Nike’s iD program. The Web has a lot to do with the growth of mass customization. Levi’s, for instance, lets customers find a pair of perfect fitting jeans by going through an online fitting process. Oakley offers customized sunglasses, goggles, watches, and backpacks, while Mars, Inc. can make M&M’s in any color the customer wants (say, school colors) as well as add text and even pictures to the candy.
Naturally, mass customization doesn’t work for all types of goods. Most people don’t care about customized detergents or paper products. And while many of us like the idea of customized clothes, footwear, or sunglasses, we often aren’t willing to pay the higher prices they command.
Facilities Decisions
After selecting the best production process, operations managers must then decide where the goods will be manufactured, how large the manufacturing facilities will be, and how those facilities will be laid out.
Site Selection
In site selection (choosing a location for the business), managers must consider several factors:
• To minimize shipping costs, managers often want to locate plants close to suppliers, customers, or both.
• They generally want to locate in areas with ample numbers of skilled workers.
• They naturally prefer locations where they and their families will enjoy living.
• They want locations where costs for resources and other expenses—land, labor, construction, utilities, and taxes—are low.
• They look for locations with a favorable business climate—one in which, for example, local governments might offer financial incentives (such as tax breaks) to entice them to do business in their locales. For example, an enterprise zone is an area in which incentives are used to attract investments from private companies.
Managers rarely find locations that meet all these criteria. As a rule, they identify the most important criteria and aim at satisfying them. In deciding to locate in San Clemente, California, for instance, PowerSki was able to satisfy three important criteria: (1) proximity to the firm’s suppliers, (2) availability of skilled engineers and technicians, and (3) favorable living conditions. These factors were more important than operating in a low-cost region or getting financial incentives from local government. Because PowerSki distributes its products throughout the world, proximity to customers was also unimportant.
Capacity Planning
Now that you know where you’re going to locate, you have to decide on the quantity of products that you’ll produce. You begin by forecasting demand for your product, which isn’t easy. To estimate the number of units that you’re likely to sell over a given period, you have to understand the industry that you’re in and estimate your likely share of the market by reviewing industry data and conducting other forms of research.
Once you’ve forecasted the demand for your product, you can calculate the capacity requirements of your production facility—the maximum number of goods that it can produce over a given time under normal working conditions. In turn, having calculated your capacity requirements, you’re ready to determine how much investment in plant and equipment you’ll have to make, as well as the number of labor hours required for the plant to produce at capacity.
Like forecasting, capacity planning is difficult. Unfortunately, failing to balance capacity and projected demand can be seriously detrimental to your bottom line. If you set capacity too low (and so produce less than you should), you won’t be able to meet demand, and you’ll lose sales and customers. If you set capacity too high (and turn out more units than you should), you’ll waste resources and inflate operating costs.
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Managing the Production Process in a Manufacturing Company
Operations managers engage in the daily activities of materials management, which encompasses the activities of purchasing, inventory control, and work scheduling.
Purchasing and Supplier Selection
The process of acquiring the materials and services to be used in production is called purchasing (or procurement). For many products, the costs of materials make up about 50 percent of total manufacturing costs. Not surprisingly, materials acquisition gets a good deal of the operations manager’s time and attention. As a rule, there’s no shortage of vendors willing to supply materials, but the trick is finding the best suppliers. Operations managers must consider questions such as:
• Can the vendor supply the needed quantity of materials at a reasonable price?
• Is the quality good?
• Is the vendor reliable (will materials be delivered on time)?
• Does the vendor have a favorable reputation?
• Is the company easy to work with?
Getting the answers to these questions and making the right choices—a process known as supplier selection—is a key responsibility of operations management.
e-Procurement
Technology has changed the way businesses buy things. Through e-procurement, companies use the Internet to interact with suppliers. The process is similar to the one you’d use to find a consumer good—say, a high-definition TV—over the Internet. To choose a TV, you might browse the websites of manufacturers like Sony then shop prices and buy at Amazon, the world’s largest online retailer.
If you were a purchasing manager using the Internet to buy parts and supplies, you’d follow basically the same process. You’d identify potential suppliers by going directly to private websites maintained by individual suppliers or to public sites that collect information on numerous suppliers. You could do your shopping through online catalogs, or you might participate in an online marketplace by indicating the type and quantity of materials you need and letting suppliers bid. Finally, just as you paid for your TV electronically, you could use a system called electronic data interchange (EDI) to process your transactions and transmit all your purchasing documents.
The Internet provides an additional benefit to purchasing managers by helping them communicate with suppliers and potential suppliers. They can use the Internet to give suppliers specifications for parts and supplies, encourage them to bid on future materials needs, alert them to changes in requirements, and give them instructions on doing business with their employers. Using the Internet for business purchasing cuts the costs of purchased products and saves administrative costs related to transactions. It’s also faster for procurement and fosters better communications.
Inventory Control
If a manufacturer runs out of the materials it needs for production, then production stops. In the past, many companies guarded against this possibility by keeping large inventories of materials on hand. It seemed like the thing to do at the time, but it often introduced a new problem—wasting money. Companies were paying for parts and other materials that they wouldn’t use for weeks or even months, and in the meantime, they were running up substantial storage and insurance costs. If the company redesigned its products, some parts might become obsolete before ever being used.
Most manufacturers have since learned that to remain competitive, they need to manage inventories more efficiently. This task requires that they strike a balance between two threats to productivity: losing production time because they’ve run out of materials and wasting money because they’re carrying too much inventory. The process of striking this balance is called inventory control, and companies now regularly rely on a variety of inventory-control methods.
Just-in-Time Production
One method is called just-in-time (JIT) production: the manufacturer arranges for materials to arrive at production facilities just in time to enter the manufacturing process. Parts and materials don’t sit unused for long periods, and the costs of “holding” inventory are significantly cut. JIT, however, requires considerable communication and cooperation between the manufacturer and the supplier. The manufacturer has to know what it needs and when. The supplier has to commit to supplying the right materials, of the right quality, at exactly the right time.
Material Requirements Planning
A software tool called material requirements planning (MRP), relies on sales forecasts and ordering lead times for materials to calculate the quantity of each component part needed for production and then determine when they should be ordered or made. The detailed sales forecast is turned into a master production schedule (MPS), which MRP then explodes into a forecast for the needed parts based on the bill of materials for each item in the forecast. A bill of materials is simply a list of the various parts that make up the end product. The role of MRP is to determine the anticipated need for each part based on the sales forecast and to place orders so that everything arrives just in time for production.
Graphical Tools: Gantt and PERT Charts
To control the timing of all operations, managers set up schedules: they select jobs to be performed during the production process, assign tasks to work groups, set timetables for the completion of tasks, and make sure that resources will be available when and where they’re needed. There are a number of scheduling techniques. We’ll focus on two of the most common—Gantt and PERT charts.
Gantt Charts
A Gantt chart, named after the designer, Henry Gantt, is an easy-to-use graphical tool that helps operations managers determine the status of projects. Let’s say that you’re in charge of making the “hiking bear” offered by the Vermont Teddy Bear Company. Figure 10.3 is a Gantt chart for the production of one hundred of these bears. As you can see, it shows that several activities must be completed before the bears are dressed: the fur has to be cut, stuffed, and sewn; and the clothes and accessories must be made. Our Gantt chart tells us that by day six, all accessories and clothing have been made. The sewing and stuffing, however (which must be finished before the bears are dressed), isn’t scheduled for completion until the end of day eight. As operations manager, you’ll have to pay close attention to the progress of the sewing and stuffing operations to ensure that finished products are ready for shipment by their scheduled date.
PERT Charts
Gantt charts are useful when the production process is fairly simple and the activities aren’t interrelated. For more complex schedules, operations managers may use PERT charts. PERT (which stands for Program Evaluation and Review Technique) is designed to diagram the activities required to produce a good, specify the time required to perform each activity in the process, and organize activities in the most efficient sequence. It also identifies a critical path: the sequence of activities that will entail the greatest amount of time. Figure 10.4 is a PERT diagram showing the process for producing one “hiker” bear at Vermont Teddy Bear.
Our PERT chart shows how the activities involved in making a single bear are related. It indicates that the production process begins at the cutting station. Next, the fur that’s been cut for this particular bear moves first to the sewing and stuffing stations and then to the dressing station. At the same time that its fur is moving through this sequence of steps, the bear’s clothes are being cut and sewn and its T-shirt is being embroidered. Its backpack and tent accessories are also being made at the same time. Note that fur, clothes, and accessories all meet at the dressing station, where the bear is dressed and outfitted with its backpack. Finally, the finished bear is packaged and shipped to the customer’s house.
What was the critical path in this process? The path that took the longest amount of time was the sequence that included cutting, stuffing, dressing, packaging, and shipping—a sequence of steps taking sixty-five minutes. If you wanted to produce a bear more quickly, you’d have to save time on this path. Even if you saved the time on any of the other paths, you still wouldn’t finish the entire job any sooner: the finished clothes would just have to wait for the fur to be sewn and stuffed and moved to the dressing station. We can gain efficiency only by improving our performance on one or more of the activities along the critical path.
The Technology of Goods Production
PowerSki founder and CEO Bob Montgomery spent sixteen years designing the Jetboard and bringing it to production. At one point, in his efforts to get the design just right, he’d constructed thirty different prototypes. Montgomery thought that he could handle the designing of the engine without the aid of a computer. Before long, however, he realized that it was impossible to keep track of all the changes.
Computer-Aided Design
That’s when Montgomery turned to computer technology for help and began using a computer-aided design (CAD) software package to design not only the engine but also the board itself and many of its components. The CAD program enabled Montgomery and his team of engineers to test the product digitally and work out design problems before moving to the prototype stage.
The sophisticated CAD software allowed Montgomery and his team to put their design paper in a drawer and to start building both the board and the engine on a computer screen. By rotating the image on the screen, they could even view the design from every angle. Having used their CAD program to make more than four hundred design changes, they were ready to test the Jetboard in the water. During the tests, onboard sensors transmitted data to computers, allowing the team to make adjustments from the shore while the prototype was still in the water. Nowadays, PowerSki uses collaboration software to transmit design changes to the suppliers of the 340 components that make up the Jetboard. In fact, a majority of design work these days is done with the aid of computers, which add speed and precision to the process.
Computer-Aided Manufacturing
For many companies, the next step is to link CAD to the manufacturing process. A computer-aided manufacturing (CAM) software system determines the steps needed to produce the component and instructs the machines that do the work. Because CAD and CAM programs can “talk” with each other, companies can build components that satisfy exactly the requirements set by the computer-generated model. CAD/CAM systems permit companies to design and manufacture goods faster, more efficiently, and at a lower cost, and they’re also effective in helping firms monitor and improve quality. CAD/CAM technology is used in many industries, including the auto industry, electronics, and clothing. If you have ever seen how a 3-D printer works, you have a pretty good idea of how CAM works too.
Computer-Integrated Manufacturing
By automating and integrating all aspects of a company’s operations, computer- integrated manufacturing (CIM) systems have taken the integration of computer-aided design and manufacturing to a higher level—and are in fact revolutionizing the production process. CIM systems expand the capabilities of CAD/CAM. In addition to design and production applications, they handle such functions as order entry, inventory control, warehousing, and shipping. In the manufacturing plant, the CIM system controls the functions of industrial robots—computer-controlled machines used to perform repetitive tasks that are also hard or dangerous for human workers to perform.
Operations Management for Service Providers
As the U.S. economy has changed from a goods producer to a service provider over the last sixty years, the dominance of the manufacturing sector has declined substantially. Today, only about 8 percent of U.S. workers are employed in manufacturing,3 in contrast to 30 percent in 1950.4 Most of us now hold jobs in the service sector, which accounts for 80 percent of U.S. jobs.5 In 2013, Wal-Mart was America’s largest employer, followed by McDonald’s, United Parcel Service (UPS), Target and Kroger. Not until we drop down to the ninth-largest employer—Hewlett Packard—do we find a company with a manufacturing component.6
Though the primary function of both manufacturers and service providers is to satisfy customer needs, there are several important differences between the two types of operations. Let’s focus on three of them:
• Intangibility. Manufacturers produce tangible products—things that can be touched or handled, such as automobiles and appliances. Service companies provide intangible products, such as banking, entertainment, or education.
• Customization. Most manufactured goods are standardized. Services, by contrast, are often customized to satisfy the specific needs of a customer. For example, when you go to the hairdresser, you ask for a haircut that looks good on you because of the shape of your face and the texture of your hair.
• Customer contact. You could spend your entire working life assembling cars in Detroit and never meet a customer who bought a car that you helped to make. But if you were a restaurant server, you’d interact with customers every day. In fact, their satisfaction with your product would be determined in part by the service that you provided. Unlike manufactured goods, many services are bought and consumed at the same time.
Here is just one of the over twelve thousand Burger King restaurants across the globe. Not surprisingly, operational efficiency is just as important in service industries as it is in manufacturing. To get a better idea of the role of operations management in the service sector, we’ll look closely at Burger King (BK), the world’s fourth-largest restaurant chain.7 BK has grown substantially since selling the first Whopper (for \$0.37) almost half a century ago. The instant success of the fire-grilled burger encouraged the Miami founders of the company to expand by selling franchises.
Today, there are BK company- and independently-owned franchised restaurants in 100 countries, and they employ over 34,000 people.8 More than eleven million customers visit BK each day.9
Operations Planning
When starting or expanding operations, businesses in the service sector must make a number of decisions quite similar to those made by manufacturers:
• What services (and perhaps what goods) should they offer?
• Where will they locate their business, and what will their facilities look like?
• How will they forecast demand for their services?
Let’s see how service firms like BK answer questions such as these.10
Operations Processes
Service organizations succeed by providing services that satisfy customers’ needs. Companies that provide transportation, such as airlines, have to get customers to their destinations as quickly and safely as possible. Companies that deliver packages, such as FedEx, must pick up, sort, and deliver packages in a timely manner. Companies that provide both services and goods, such as Domino’s Pizza, have a dual challenge: they must produce a quality good and deliver it satisfactorily.
Service providers that produce goods can adopt either a make-to-order or a make-to-stock approach to producing them. BK, which encourages patrons to customize burgers and other menu items, uses a make-to-order approach, building sandwiches one at a time. Meat patties, for example, go from the grill to a steamer for holding until an order comes in. Although many fast food restaurants have adopted the make-to-order model, a few continue to make-to-stock. For example, Dunkin’ Donuts does not customize doughnuts, and so they do not have to wait for customer orders before making them.
Like manufacturers, service providers must continuously look for ways to improve operational efficiency. Throughout its sixty-year history, BK has introduced a number of innovations that have helped make the company (as well as the fast-food industry itself) more efficient. BK, for example, was the first to offer drive-through service (which now accounts for over 50 percent of its sales11).
It was also a BK vice president, David Sell, who came up with the idea of moving the drink station from behind the counter so that customers could take over the time-consuming task of filling cups with ice and beverages. BK was able to cut back one employee per day at every one of its more than eleven thousand restaurants. Material costs also went down because customers usually fill cups with more ice, which is cheaper than a beverage. Moreover, there were savings on supply costs because most customers don’t bother with lids, and many don’t use straws. On top of everything else, most customers liked the system (for one thing, it allowed them to customize their own drinks by mixing beverages), and as a result, customer satisfaction went up. Overall, the new process was a major success and quickly became the industry standard.
Facilities
When starting or expanding a service business, owners and managers must invest a lot of time in selecting a location, determining its size and layout, and forecasting demand. A poor location or a badly designed facility can cost customers, and inaccurate estimates of demand for products can result in poor service, excessive costs, or both.
Site Selection
Site selection is also critical in the service industry, but not for the same reasons as in the manufacturing industry. Service businesses need to be accessible to customers. Some service businesses, such as cable-TV providers, package-delivery services, and e-retailers, go to their customers. Many others, however—hotels, restaurants, stores, hospitals, and airports—have to attract customers to their facilities. These businesses must locate where there’s a high volume of available customers. In picking a location, BK planners perform a detailed analysis of demographics and traffic patterns; the most important factor is usually traffic count—the number of cars or people that pass by a specific location in the course of a day. In the United States, where we travel almost everywhere by car, so BK looks for busy intersections, interstate interchanges with easy off and on ramps, or such “primary destinations” as shopping malls, tourist attractions, downtown business areas, or movie theaters. In Europe, where public transportation is much more common, planners focus on subway, train, bus, and trolley stops.
Once planners find a site with an acceptable traffic count, they apply other criteria. It must, for example, be easy for vehicles to enter and exit the site, which must also provide enough parking to handle projected dine-in business. Local zoning must permit standard signage, especially along interstate highways. Finally, expected business must be high enough to justify the cost of the land and building.
Size and Layout
In the service sector, most businesses must design their facilities with the customer in mind: they must accommodate the needs of their customers while keeping costs as low as possible. Let’s see how BK has met this challenge.
For its first three decades, almost all BK restaurants were pretty much the same. They all sat on one acre of land (located “through the light and to the right”), had about four thousand square feet of space, and held seating for seventy customers. All kitchens were roughly the same size. As long as land was cheap and sites were readily available, this system worked well. By the early 1990s, however, most of the prime sites had been taken, if not by BK itself, then by one of its fast-food competitors or other businesses needing a choice spot, including gas stations and convenience stores. With everyone bidding on the same sites, the cost of a prime acre of land had increased from \$100,000 to over \$1 million in a few short years.
To continue growing, BK needed to change the way it found and developed its locations. Planners decided that they had to find ways to reduce the size of a typical BK restaurant. For one thing, they could reduce the number of seats, because the business at a typical outlet had shifted over time from 90 percent inside dining to a 50-50 split between drive through and eat-in service.
David Sell (the same executive who had recommended letting customers fill their own drink cups) proposed to save space by wrapping Whoppers in paper instead of serving them in the cardboard boxes that took up more space. So BK switched to a single paper wrapper with the label “Whopper” on one side and “Cheese Whopper” on the other. To show which product was inside, employees just folded the wrapper in the right direction. Ultimately, BK replaced pallets piled high with boxes with just a few boxes of wrappers.
Ideas like these helped BK trim the size of a restaurant from four thousand square feet to as little as one thousand. In turn, smaller facilities enabled the company to enter markets that were once cost prohibitive. Now BK could locate profitably in airports, food courts, strip malls, center-city areas, and even schools.
Capacity Planning
Estimating capacity needs for a service business isn’t the same thing as estimating those of a manufacturer. Service providers can’t store their products for later use: hairdressers can’t “inventory” haircuts, and amusement parks can’t “inventory” roller-coaster rides. Service firms have to build sufficient capacity to satisfy customers’ needs on an “as-demanded” basis. Like manufacturers, service providers must consider many variables when estimating demand and capacity:
• How many customers will I have?
• When will they want my services (which days of the week, which times of the day)?
• How long will it take to serve each customer?
• How will external factors, such as weather or holidays, affect the demand for my services?
Forecasting demand is easier for companies like BK, which has a long history of planning facilities, than for brand-new service businesses. BK can predict sales for a new restaurant by combining its knowledge of customer-service patterns at existing restaurants with information collected about each new location, including the number of cars or people passing the proposed site and the effect of nearby competition.
Managing Operations
Overseeing a service organization puts special demands on managers, especially those running firms, such as hotels, retail stores, and restaurants, who have a high degree of contact with customers. Service firms provide customers with personal attention and must satisfy their needs in a timely manner. This task is complicated by the fact that demand can vary greatly over the course of any given day. Managers, therefore, must pay particular attention to employee work schedules and, in many cases, inventory management.
Managing service operations is about more than efficiency of service. It is about finding a balance between profitability, customer satisfaction and associate satisfaction, sometimes referred to as the balanced scorecard.
In his book titled Moments of Truth, Jan Carlzon, former Chief Executive Office of SAS Group, refers to those moments when an employee interacts with a customer.12 Moments can range from calling a help line, checking in at an airline counter, the greeting from a hostess in a restaurant to having a maintenance problem resolved in a hotel guest room. The quality of staff a company hires, how they train their employees, and the focus management places on creating a culture of service will determine how successful the company is in service delivery and maximizing the impact of these moments of truth.
The Ritz-Carlton hotel company maximizes their moments of truth by living their motto, “We are Ladies and Gentleman serving Ladies and Gentleman”. Ritz-Carlton Three Steps of Service are:
1. A warm and sincere greeting. Use the guest’s name.
2. Anticipation and fulfillment of each the needs of each guest.
3. Fond farewell. Give a warm good-bye and use the guest’s name.13
Ritz-Carlton reinforces this service culture daily in short meetings with all staff at the beginning of each shift.
Chick-fil-A is recognized as an industry leader in service for the fast food industry. Chick-fil-A uses the term “my pleasure” which founder S. Truett Cathy credits to Ritz-Carlton.14 The company follows customer-centered leadership. Staff focus on being swift and attentive to customer needs. Chick-fil-A uses this You Tube video as part of their employee orientation and training: “Every life has a story”.
Well-known blogger and marketing consultant Marcus Sheridan explains his view of the success of Chick-Fil-A in this blog post:15
Dang I love it when I see great people and great businesses kicking butt at what they do. Such was the case recently when the fam and I stopped into a local Chick-fil-A restaurant here in Virginia and I was treated to a free course entitled, “This is How To Run a Business that Kicks Butt and Takes Names….”, or at least that something like that …..
As the kids were all eating their food and I was busy being blown away by this perfect company and business model, I decided to ask my 9 year old daughter a simple question:
Me : Danielle, what do you notice about this restaura nt that’s different than others?
Danielle (by now used to weird business questions from her father): Well, first of all everyone that works here is happy.
Me : Yes, they are, aren’t they? How’s that make you feel to see them smiling?
Danielle : It makes me feel good inside.
Me : I agree…What else do you notice?
Danielle : There are pictures everywhere. And writings on the walls. And it’s really clean.
Me : Good observations dear. Danielle, you’re looking at the most well run business in America.
For any of you that have been to Chick-fil-A before, you may already understand and appreciate what I’m talking about. If you haven’t gone to one and would like 4 years’ worth of business school wrapped up in 45 minutes, then take a stroll on over to one of their restaurants for lunch and just sit, watch, and observe.
But to make what could be a long blog much shorter, allow me to quickly list the 8 reasons why Chick-fil-A has the best business model in America.
Happy Employees/Service: It’s unbelievable what type of employees this company has. Heck, while we were eating our meal the other day, an employee with a big smile came over and asked us if we’d like refills on our drinks. For a fast food company, this is utterly unheard of in our society these days. It’s obvious that Chick-fil-A doesn’t go cheap on their people nor their way of doing things. I’m sure they pay decent wages but they also create an atmosphere that attracts great people. What a wonderful model this is for any business.
They’re Clean!: Somewhere along the lines sanitation and cleanliness became a lost art in the fast food industry. Notwithstanding this trend, Chick-fil-A has bucked the system and their restaurants, as well as their bathrooms, are almost always immaculate. I don’t know about you, but I’ll pay more for clean any day of the week.
They Know What They’re GREAT At: Most businesses try to be a jack of all trades, which ends up causing them to be master of none. That’s why Chick-fil-A will never have a burger on their menu. Why? Because they don’t care. They know they’ll never be the best at beef but they sure as heck have created a culture around the chicken sandwich. Wow, what a lesson this is for those businesses out there with no identity, niche, or individual greatness.
They Ain’t Cheap: Yep, having high prices is actually a GOOD business model. I don’t know about you, but the idea of having to sell a lot to make a little stinks. Chick-fil-A has prices a good bit higher than most of their fast food competitors, notwithstanding they are always full of smiling customers, just waiting to spend the extra green stamps. These higher prices lead to better employees, service, food quality, customers, etc. I’m sure never once has their management even asked, “How can we be the cheapest?” But I’d bet my home they’ve asked, “How can we be the best, regardless of what it costs?”
Ambiance: The next time you go to Chick-fil-A check out all the little things they do to make their restaurants warm and attractive. They have photos of employees, quotes on the walls, paintings from local children, etc. Everywhere you look in one of their stores you’ll find something that makes you smile.
Community Involvement: Wow do they do this better than any fast food company. In fact, this one isn’t even close. They are constantly doing promos within the community for youth teams, causes, etc. In fact, it’s like they’ve take social media to another level because for them it’s not just about using Facebook and the like, it’s about actually being involved and in the trenches. Huge props to Chick-fil-A for this.
Awesome Website: All of you that read this blog know how I feel about the importance of having a great website and web presence in order to be a successful business. If you want to see what a great business website looks like, head on over. Whether it’s bios of the employees, social media links, customers stories, etc—this site is spot-on.
The Food is Actually Good: Ahh yes, lest we forget this other forgotten trait of fast food restaurants—great food. Everybody likes Chick-fil-A. Nothing on their menu is poor quality. They’re proud of their food and they have every right to be.
So there you have it folks—the 8 qualities of the best business model in America. What’s great is that every business can copy the way Chick-fil-A has built their company. The qualities listed above are simply principles that can be applied to any business or any website for that matter. So if you’re lacking inspiration for your business, it might be time for a Chicken Sandwich and waffle fries.
**Author’s Note: It goes without saying that I have no affiliation with Chick-fil-A, I just happen to write about greatness when I see it.
Scheduling
In manufacturing, managers focus on scheduling the activities needed to transform raw materials into finished goods. In service organizations, they focus on scheduling workers so that they’re available to handle fluctuating customer demand. Each week, therefore, every BK store manager schedules employees to cover not only the peak periods of breakfast, lunch, and dinner, but also the slower periods in between. If he or she staffs too many people, labor cost per sales dollar will be too high. If there aren’t enough employees, customers have to wait in lines. Some get discouraged, and even leave, and many may never come back.
Scheduling is made easier by information provided by a point-of-sale device built into every BK cash register. The register sends data on every sandwich, beverage, and side order sold by the hour, every hour of the day, every day of the week to a computer system that helps managers set schedules. To determine how many people will be needed for next Thursday’s lunch hour, the manager reviews last Thursday’s data, using sales revenue and a specific BK formula to determine the appropriate staffing level. Each manager can adjust this forecast to account for other factors, such as current marketing promotions or a local sporting event that will increase customer traffic.
Inventory Control
Businesses that provide both goods and services, such as retail stores and auto-repair shops, have the same inventory control problems as manufacturers: keeping levels too high costs money, while running out of inventory costs sales. Technology, such as the point-of-sale registers used at BK, makes the job easier. BK’s system tracks everything sold during a given time and lets each store manager know how much of everything should be kept in inventory. It also makes it possible to count the number of burgers and buns, bags and racks of fries, and boxes of beverage mixes at the beginning or end of each shift. Because there are fixed numbers of supplies—say, beef patties or bags of fries—in each box, employees simply count boxes and multiply. In just a few minutes, the manager knows whether the inventory is correct (and should be able to see if any theft has occurred on the shift).
Producing for Quality
What do you do if your brand-new DVD player doesn’t work when you get it home? What if you were late for a test because it took you twenty minutes to get a burger and fries at a drive-through window? Like most people, you’d probably be more or less disgruntled. As a customer, you’re constantly assured that when products make it to market, they’re of the highest possible quality, and you tend to avoid brands that have failed to live up to your expectations or to producers’ claims.
But what is quality? According to the American Society for Quality, the term quality refers to “the characteristics of a product or service that bear on its ability to satisfy stated or implied needs.”16 When you buy a DVD player, you expect it to play DVDs. When you go to a drive-through window, you expect to be served in a reasonable amount of time. If your expectations are not met, you’ll conclude that you’re the victim of poor-quality.
Quality Management
Total quality management (TQM), or quality assurance, includes all the steps that a company takes to ensure that its goods or services are of sufficiently high quality to meet customers’ needs. Generally speaking, a company adheres to TQM principles by focusing on three tasks:
1. Customer satisfaction
2. Employee involvement
3. Continuous improvement
Let’s take a closer look at these three principles.
Customer Satisfaction
Companies that are committed to TQM understand that the purpose of a business is to generate a profit though customer satisfaction. Thus, they let their customers define quality by identifying desirable product features and then offering them. They encourage customers to tell them how to offer services that work the right way.
Armed with this knowledge, they take steps to make sure that providing quality is a factor in every facet of their operations—from design, to product planning and control, to sales and service. To get feedback on how well they’re doing, many companies routinely use surveys and other methods to monitor customer satisfaction. By tracking the results of feedback over time, they can see where they need to improve.
Employee Involvement
Successful TQM requires that everyone in the organization, not simply upper-level management, commits to satisfying the customer. When customers wait too long at a drive-through window, it’s the responsibility of a number of employees, not the manager alone. A defective DVD isn’t solely the responsibility of the manufacturer’s quality control department; it’s the responsibility of every employee involved in its design, production, and even shipping. To get everyone involved in the drive for quality assurance, managers must communicate the importance of quality to subordinates and motivate them to focus on customer satisfaction. Employees have to be properly trained not only to do their jobs but also to detect and correct quality problems.
In many companies, employees who perform similar jobs work as teams, sometimes called quality circles, to identify quality, efficiency, and other work-related problems, to propose solutions, and to work with management in implementing their recommendations.
Continuous Improvement
An integral part of TQM is continuous improvement: the commitment to making constant improvements in the design, production, and delivery of goods and services.
Improvements can almost always be made to increase efficiency, reduce costs, and improve customer service and satisfaction. Everyone in the organization is constantly on the lookout for ways to do things better.
Statistical Process Control
Companies can use a variety of tools to identify areas for improvement. A common approach in manufacturing is called statistical process control. This technique monitors production quality by testing a sample of output to see whether goods in process are being made according to predetermined specifications. An example of a statistical process control method is Six Sigma. A Six-Sigma process is one in which 99.99966% of all opportunities to perform an operation are free of defects. This percentage equates to only 3.4 defects per million opportunities.
Assume for a moment that you work for Kellogg’s, the maker of Raisin Bran cereal. You know that it’s the company’s goal to pack two scoops of raisins in every box of cereal.
How can you test to determine whether this goal is being met? You could use a statistical process control method called a sampling distribution. On a periodic basis, you would take a box of cereal off the production line and measure the amount of raisins in the box. Then you’d record that amount on a control chart designed to compare actual quantities of raisins with the desired quantity (two scoops). If your chart shows that several samples in a row are low on raisins, you’d take corrective action.
Outsourcing
PowerSki’s Web site states that “PowerSki International has been founded to bring a new watercraft, the PowerSki Jetboard, and the engine technology behind it, to market.”17 That goal was reached in May 2003, when the firm emerged from a lengthy design period. Having already garnered praise for its innovative product, PowerSki was ready to begin mass-producing Jetboards. At this juncture, the management team made a strategic decision; rather than producing Jetboards in-house, they opted for outsourcing: having outside vendors manufacture the engines, fiberglass hulls, and associated parts. Assembly of the final product took place in a manufacturing facility owned by All American Power Sports in Moses Lake, Washington. This decision doesn’t mean that the company relinquished control over quality; in fact, every component that goes into the PowerSki Jetboard is manufactured to exact specifications set by PowerSki. One advantage of outsourcing its production function is that the management team can thereby devote its attention to refining its product design and designing future products.
Outsourcing in the Manufacturing Sector
Outsourcing has become an increasingly popular option among manufacturers. For one thing, few companies have either the expertise or the inclination to produce everything needed to make a product. Today, more firms, like PowerSki, want to specialize in the processes that they perform best—and outsource the rest. Like PowerSki, they also want to take advantage of outsourcing by linking up with suppliers located in regions with lower labor costs. Outsourcing can be local, regional, or even international, and companies can outsource everything from parts for their products, like automobile manufacturers do, to complete manufacturing of their products, like Nike and Apple do.
Outsourcing in the Service Sector
Outsourcing is by no means limited to the manufacturing sector. Service providers also outsource many of their non-core functions. Some universities, for instance, outsource functions such as food services, maintenance, bookstore sales, printing, grounds keeping, security, and even residence operations. For example, there are several firms, like RGIS, who offer inventory services. They will send a team to your company to count your inventory for you. As RGIS puts it, “Our teams deliver the hands-on help needed to complete a wide variety of retail projects of all sizes, allowing your team to keep customer service as the number one priority.”18 Some software developers outsource portions of coding as a cost-saving measure. If you’ve ever had to get phone or chat assistance on your laptop, there’s a good chance you spoke with someone in an outsourced call center. The center itself may have even been located offshore. This kind of arrangement can present unique challenges in quality control as differences in accents and the use of slang words can sometimes inhibit understanding. Nevertheless, in this era of globalization, expect the trend towards outsourcing offshore to continue.
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Chapter Video
This video presents operations from multiple perspectives including manufacturing, restaurant food preparation, and brewing. Pay attention to the level of automation, which is a key aspect of operational decisions as labor gets more expensive.
A YouTube element has been excluded from this version of the text. You can view it online here: pb.libretexts.org/biz3/?p=111
(Copyrighted material)
Key Takeaways
1. Operations management oversees the process of transforming resources into goods and services.
2. During production planning, managers determine how goods will be produced, where production will take place, and how manufacturing facilities will be laid out.
3. In selecting the appropriate production process, managers consider three basic methods:
1. make-to-order
2. mass production
3. mass customization
4. In site selection for a company’s manufacturing operations, managers look for locations that minimize shipping costs, have an ample supply of skilled workers, provide a favorable community for workers and their families, offer resources at low cost, and have a favorable business climate.
5. Commonly used inventory control methods include just-in-time (JIT) production, by which materials arrive just in time to enter the manufacturing process, and material requirements planning (MRP), a software tool to determine material needs.
6. Gantt and PERT charts are two common tools used by operations managers.
1. A Gantt chart helps operations managers determine the status of projects.
2. PERT charts diagram the activities and time required and identify the critical path—the sequence of activities that will require the greatest amount of time.
7. Service firms provide intangible products that are often customized to satisfy specific needs. Unlike manufactured goods, many services are bought and consumed at the same time.
8. Estimating capacity needs for a service business is more difficult than for a manufacturer because service providers can’t store their services for later use.
9. Many companies deliver quality goods and services by adhering to principles of total quality management (TQM).
10. Outsourcing can save companies money by using lower cost, specialized labor, located domestically or abroad.
Chapter 10 Text References and Image Credits
Image Credits: Chapter 10
Figure 10.1: © HydroForce Group LLC. Permission granted for use in this and all future editions of this book.
Figure 10.2 “The Transformation Process” Designed for Virginia Tech Libraries by Brian Craig. https://commons.wikimedia.org/wiki/Category:Figures_from_Fundamentals_of_Business_by_Skripak. Licensed CC BY 4.0.
Figure 10.3 “A Gantt chart for Vermont Teddy Bears.” Designed for Virginia Tech Libraries by Brian Craig. Adapted from http://www.saylor.org/site/textbooks/Exploring%20Business.docx CC BY NC SA 3.0
Figure 10.4 “A PERT chart for Vermont Teddy Bears” Designed for Virginia Tech Libraries by Brian Craig. Adapted from http://www.saylor.org/site/textbooks/Exploring%20Business.docx CC BY NC SA 3.0
Figure 10.5: “Felix 3D Printer – Printing Set-up With Examples.” Jonathan Juursema (2014). CC BY-SA 3.0. Retrieved from: https://commons.wikimedia.org/wiki/File:Felix_3D_Printer_-_Printing_Set-up_With_Examples.JPG
Figure 10.6: “BMW Werk Leipzig.” CC BY SA 2.0 de. Retrieved from: en.Wikipedia.org/wiki/High_tech#/media/File:BMW_Leipzig_MEDIA_050719_Download_Karosseriebau_max.jpg
Figure 10.7: “Burger King, Saugus NJ.” Anthony92931 (2008). CC BY-SA 3.0. Retrieved from: https://commons.wikimedia.org/wiki/File:Burger_King,_Saugus.jpg
Figure 10.8: “Dunkin’ Donuts Selection.” JohnnyMrNinja (2007). CC BY 2.0. Retrieved from: commons.wikimedia.org/wiki/File:Dunkin_donuts_selection.jpg
Video Credits: Chapter 10
“UniversityNow: Production and Operations Management Course Cover.” (University Now). October 7, 2013. Retrieved from: https://www.youtube.com/watch?v=sL7hi5i9xMo&=&feature=youtu.be | textbooks/biz/Business/Introductory_Business/Book%3A_Fundamentals_of_Business_(Skripak)/10%3A_Operations_Management.txt |
Learning Objectives
1. Define motivation, and understand why it is important in the workplace.
2. Understand the difference between intrinsic and extrinsic motivation.
3. Explain the major theories of motivation:
1. The Hierarchy of Needs theory
2. The Two-Factor theory
3. Expectancy theory
4. Equity theory
Motivation refers to an internally generated drive to achieve a goal or follow a particular course of action. Highly motivated employees focus their efforts on achieving specific goals. It’s the manager’s job, therefore, to motivate employees—to get them to try to do the best job they can. Motivated employees call in sick less frequently, are more productive, and are less likely to convey bad attitudes to customers and co-workers. They also tend to stay in their jobs longer, reducing turnover and the cost of hiring and training employees. But what motivates employees to do well? How does a manager encourage employees to show up for work each day and do a good job? Paying them helps, but many other factors influence a person’s desire (or lack of it) to excel in the workplace. What are these factors, are they the same for everybody, and do they change over time? To address these questions, we’ll examine four of the most influential theories of motivation: hierarchy-of-needs theory, two-factor theory, expectancy theory, and equity theory.
Intrinsic and Extrinsic Motivation
Before we begin our discussion of the various theories of motivation, it is important to establish the distinction between intrinsic and extrinsic motivation. Simply put, intrinsicmotivation comes from within: the enjoyment of a task, the satisfaction of a job well done, and the desire to achieve are all sources of intrinsic motivation. On the other hand, extrinsicmotivation comes about because of external factors such as a bonus or another form of reward. Avoiding punishment or a bad outcome can also be a source of extrinsic motivation; fear, it is said, can be a great motivator.
Hierarchy of Needs Theory
Psychologist Abraham Maslow’s hierarchyofneeds theory proposed that we are motivated by six initially unmet needs, arranged in the hierarchical order shown in Figure 11, which also lists specific examples of each type of need in both the personal and work spheres of life. Look, for instance, at the list of personal needs in the middle column. At the bottom are physiological needs (such life-sustaining needs as food and shelter). Working up the hierarchy we experience safety needs (financial stability, freedom from physical harm), social needs (the need to belong and have friends), esteem needs (the need for self-respect and status), and self-actualization needs (the need to reach one’s full potential or achieve some creative success). Late in his life, Maslow added self-transcendence to his model – the need to further a cause beyond the self.1 There are two key things to remember about Maslow’s model:
1. We must satisfy lower-level needs before we seek to satisfy higher-level needs.
2. Once we’ve satisfied a need, it no longer motivates us; the next higher need takes its place.
Figure 11.1: Maslow’s Hierarchy of needs with examples
Maslow’s Hierarchy of Needs Personal Fulfillment Professional Fulfillment
Highest: Self- Transcendence Devotion to a cause Service to others
Self-Actualization Creative success and achievement Challenging work, leadership, professional achievement
Esteem Status and respect Authority, titles, recognition
Social Family and friendships Team membership and social activities
Safety Financial stability Seniority/Job security
Lowest: Physiological Food and shelter Salary
Let’s say, for example, that for a variety of reasons that aren’t your fault, you’re broke, hungry, and homeless. Because you’ll probably take almost any job that will pay for food and housing (physiological needs), you go to work repossessing cars. Fortunately, your student loan finally comes through, and with enough money to feed yourself, you can go back to school and look for a job that’s not so risky (a safety need). You find a job as a night janitor in the library, and though you feel secure, you start to feel cut off from your friends, who are active during daylight hours. You want to work among people, not books (a social need). So now you join several of your friends selling pizza in the student center. This job improves your social life, but even though you’re very good at making pizzas, it’s not terribly satisfying. You’d like something that your friends will respect enough to stop teasing you about the pizza job (an esteem need). So you study hard and land a job as an intern in the governor’s office. On graduation, you move up through a series of government appointments and eventually run for state senator. As you’re sworn into office, you realize that you’ve reached your full potential (a self-actualization need) and you comment to yourself, “It doesn’t get any better than this.”
Needs Theory and the Workplace
What implications does Maslow’s theory have for business managers? There are two key points: (1) Not all employees are driven by the same needs, and (2) the needs that motivate individuals can change over time. Managers should consider which needs different employees are trying to satisfy and should structure rewards and other forms of recognition accordingly. For example, when you got your first job repossessing cars, you were motivated by the need for money to buy food. If you’d been given a choice between a raise or a plaque recognizing your accomplishments, you’d undoubtedly have opted for the money. As a state senator, by contrast, you may prefer public recognition of work well done (say, election to higher office) to a pay raise.
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Two-Factor Theory
Another psychologist, Frederick Herzberg, set out to determine which work factors (such as wages, job security, or advancement) made people feel good about their jobs and which factors made them feel bad about their jobs. He surveyed workers, analyzed the results, and concluded that to understand employee satisfaction (or dissatisfaction), he had to divide work factors into two categories:
Motivationfactors. Those factors that are strong contributors to job satisfaction
Hygienefactors. Those factors that are not strong contributors to satisfaction but that must be present to meet a worker’s expectations and prevent job dissatisfaction
Figure 11.2 illustrates Herzberg’s two-factor theory. Note that motivation factors (such as promotion opportunities) relate to thenatureofthework itselfandthewaytheemployeeperformsit. Hygiene factors (such as physical working conditions) relate to theenvironmentin which it’sperformed.
Two-Factor Theory and the Workplace
We’ll ask the same question about Herzberg’s model as we did about Maslow’s: What does it mean for managers? Suppose you’re a senior manager in an accounting firm, where you supervise a team of accountants, each of whom has been with the firm for five years. How would you use Herzberg’s model to motivate the employees who report to you? Let’s start with hygiene factors. Are salaries reasonable? What about working conditions? Does each accountant have his or her own workspace, or are they crammed into tiny workrooms? Are they being properly supervised or are they left on their own to sink or swim? If hygiene factors like these don’t meet employees’ expectations, they may be dissatisfied with their jobs.
Fixing problems related to hygiene factors may alleviate job dissatisfaction, but it won’t necessarily improve anyone’s job satisfaction. To increase satisfaction (and motivate someone to perform better), you must address motivation factors. Is the work itself challenging and stimulating? Do employees receive recognition for jobs well done? Will the work that an accountant has been assigned help him or her to advance in the firm? According to Herzberg, motivation requires a twofold approach: eliminating “dissatisfiers” and enhancing satisfiers.
Expectancy Theory
If you were a manager, wouldn’t you like to know how your employees decide whether to work hard or goof off? Wouldn’t it be nice to know whether a planned rewards program will have the desired effect—namely, motivating them to perform better in their jobs? These are the issues considered by psychologist Victor Vroom in his expectancy theory, which proposes that employees will work hard to earn rewards that they value and that they consider “attainable”.
As you can see from Figure 11.3, Vroom argues that an employee will be motivated to exert a high level of effort to obtain a reward under three conditions – the employee:
1. believes that his or her efforts will result in acceptable performance.
2. believes that acceptable performance will lead to the desired reward.
3. values the reward.
Expectancy Theory and the Workplace
To apply expectancy theory to a real-world situation, let’s analyze an automobile- insurance company with one hundred agents who work from a call center. Assume that the firm pays a base salary of \$2,000 a month, plus a \$200 commission on each policy sold above ten policies a month. In terms of expectancy theory, under what conditions would an agent be motivated to sell more than ten policies a month?
1. The agent would have to believe that his or her efforts would result in policy sales (that, in other words, there’s a positive link between effort and performance).
2. The agent would have to be confident that if he or she sold more than ten policies in a given month, there would indeed be a bonus (a positive link between performance and reward).
3. The bonus per policy—\$200—would have to be of value to the agent.
Now let’s alter the scenario slightly. Say that the company raises prices, thus making it harder to sell the policies. How will agents’ motivation be affected? According to expectancy theory, motivation will suffer. Why? Because agents may be less confident that their efforts will lead to satisfactory performance. What if the company introduces a policy whereby agents get bonuses only if buyers don’t cancel policies within ninety days? Now agents may be less confident that they’ll get bonuses even if they do sell more than ten policies. Motivation will decrease because the link between performance and reward has been weakened. Finally, what will happen if bonuses are cut from \$200 to \$25? Obviously, the reward would be of less value to agents, and, again, motivation will suffer. The message of expectancy theory, then, is fairly clear: managers should offer rewards that employees value, set performance levels that they can reach, and ensure a strong link between performance and reward.
Equity Theory
What if you spent thirty hours working on a class report, did everything you were supposed to do, and handed in an excellent assignment (in your opinion). Your roommate, on the other hand, spent about five hours and put everything together at the last minute. You know, moreover, that he ignored half the requirements and never even ran his assignment through a spell-checker. A week later, your teacher returns the reports. You get a C and your roommate gets a B+. In all likelihood, you’ll feel that you’ve been treated unfairly relative to your roommate.
Your reaction makes sense according to the equitytheoryof motivation, which focuses on our perceptions of how fairly we’re treated relative to others. Applied to the work environment, this theory proposes that employees analyze their contributions or jobinputs (hours worked, education, experience, work performance) and their rewards or joboutcomes (salary, bonus, promotion, recognition). Then they create a contributions/rewards ratio and compare it to those of other people. The basis of comparison can be any one of the following:
• Someone in a similar position
• Someone holding a different position in the same organization
• Someone with a similar occupation
• Someone who shares certain characteristics (such as age, education, or level of experience)
• Oneself at another point in time
When individuals perceive that the ratio of their contributions to rewards is comparable to that of others, they perceive that they’re being treated fairly or equitably; when they perceive that the ratio is out of balance, they perceive inequity. Occasionally, people will perceive that they’re being treated better than others. More often, however, they conclude that others are being treated better (and that they themselves are being treated worse). This is what you concluded when you saw your grade in the previous example. You’ve calculated your ratio of contributions (hours worked, research and writing skills) to rewards (project grade), compared it to your roommate’s ratio, and concluded that the two ratios are out of balance.
What will an employee do if he or she perceives an inequity? The individual might try to bring the ratio into balance, either by decreasing inputs (working fewer hours, not taking on additional tasks) or by increasing outputs (asking for a raise). If this strategy fails, an employee might complain to a supervisor, transfer to another job, leave the organization, or rationalize the situation (e.g., deciding that the situation isn’t so bad after all). Equity theory advises managers to focus on treating workers fairly, especially in determining compensation, which is, naturally, a common basis of comparison.
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Key Takeaways
1. Motivation describes an internally generated drive that propels people to achieve goals or pursue particular courses of action.
2. There are four influential theories of motivation: hierarchy-of-needs theory, two-factor theory, expectancy theory, and equity theory:
1. Hierarchy-of-needs theory proposes that we’re motivated by five unmet needs— physiological, safety, social, esteem, and self-actualization— and must satisfy lower- level needs before we seek to satisfy higher-level needs.
2. Two-factor theory divides work factors into motivation factors (those that are strong contributors to job satisfaction) and hygiene factors (those that, though not big contributors to satisfaction, must be present to prevent job dissatisfaction).
3. Expectancy theory proposes that employees work harder to obtain a reward when they value the reward, believe that their efforts will result in acceptable performance, and believe that acceptable performance will lead to a desired outcome or reward.
4. Equity theory focuses on our perceptions of how fairly we’re treated relative to others. This theory proposes that employees create rewards ratios that they compare to those of others and will be less motivated when they perceive an imbalance in treatment.
Chapter 11 Text References and Image Credits
Image Credits: Chapter 11
Figure 11.4: Scale drawing, public domain. Source: http://www.publicdomainpictures.net/view-image.php?image=72186&picture=scales-of-justice | textbooks/biz/Business/Introductory_Business/Book%3A_Fundamentals_of_Business_(Skripak)/11%3A_Motivating_Employees.txt |
Learning Objectives
1. Define human resource management and explain how managers develop and implement a human resource plan.
2. Explain how companies train and develop employees, and discuss the importance of a diverse workforce.
3. Identify factors that make an organization a good place to work, including competitive compensation and benefits packages.
4. Explain how managers evaluate employee performance and retain qualified employees.
The Grounds of a Great Work Environment
Howard Schultz has vivid memories of his father slumped on the couch with his leg in a cast.1 The ankle would heal, but his father had lost another job—this time as a driver for a diaper service. It was a crummy job; still, it put food on the table, and if his father couldn’t work, there wouldn’t be any money. Howard was seven, but he understood the gravity of the situation, particularly because his mother was seven months pregnant, and the family had no insurance.
This was just one of the many setbacks that plagued Schultz’s father throughout his life—an honest, hard-working man frustrated by a system that wasn’t designed to cater to the needs of common workers. He’d held a series of blue-collar jobs (cab driver, truck driver, factory worker), sometimes holding two or three at a time. Despite his willingness to work, he never earned enough money to move his family out of Brooklyn’s federally-subsidized housing projects. Schultz’s father died never having found fulfillment in his work life—or even a meaningful job. It was the saddest day of Howard’s life.
As a kid, did Schultz ever imagine that one day he’d be the founder and chairman of Starbucks Coffee Company? Of course not. But he did decide that if he was ever in a position to make a difference in the lives of people like his father, he’d do what he could. Remembering his father’s struggles and disappointments, Schultz has tried to make Starbucks the kind of company where he wished his father had worked. “Without even a high school diploma,” Schultz admits, “my father probably could never have been an executive. But if he had landed a job in one of our stores or roasting plants, he wouldn’t have quit in frustration because the company didn’t value him. He would have had good health benefits, stock options, and an atmosphere in which his suggestions or complaints would receive a prompt, respectful response.”2
Schultz is motivated by both personal and business considerations: “When employees have self-esteem and self-respect,” he argues, “they can contribute so much more: to their company, to their family, to the world.”3 His commitment to his employees is embedded in Starbuck’s mission statement, whose first objective is to “provide a great work environment and treat each other with respect and dignity.”4 Those working at Starbucks are called partners because Schultz believes working for his company is not just a job, it’s a passion.5
Human Resource Management
Employees at Starbucks are vital to the company’s success. They are its public face, and every dollar of sales passes through their hands.6 According to Howard Schultz, they can make or break the company. If a customer has a positive interaction with an employee, the customer will come back. If an encounter is negative, the customer is probably gone for good. That’s why it’s crucial for Starbucks to recruit and hire the right people, train them properly, motivate them to do their best, and encourage them to stay with the company. Thus, the company works to provide satisfying jobs, a positive work environment, appropriate work schedules, and fair compensation and benefits. These activities are part of Starbucks’s strategy to deploy human resources in order to gain competitive advantage. The process is called human resource management (HRM), which consists of all actions that an organization takes to attract, develop, and retain quality employees. Each of these activities is complex. Attracting talented employees involves the recruitment of qualified candidates and the selection of those who best fit the organization’s needs. Development encompasses both new-employee orientation and the training and development of current workers. Retaining good employees means motivating them to excel, appraising their performance, compensating them appropriately, and doing what’s possible to keep them.
Human Resource Planning
How does Starbucks make sure that its worldwide retail locations are staffed with just the right number of committed employees? How does Norwegian Cruise Lines make certain that when the Norwegian Dawn pulls out of New York harbor, it has a complete, fully trained crew on board to feed, entertain, and care for its passengers? Managing these tasks is a matter of strategic human resource planning—the process of developing a plan for satisfying an organization’s human resources (HR) needs.
A strategic HR plan lays out the steps that an organization will take to ensure that it has the right number of employees with the right skills in the right places at the right times. HR managers begin by analyzing the company’s mission, objectives, and strategies. Starbucks’s objectives, for example, include the desire to “develop enthusiastically satisfied customers” as well as to foster an environment in which employees treat both customers and each other with respect.7 Thus, the firm’s HR managers look for people who are “adaptable, self-motivated, passionate, creative team members.”8 The main goal of Norwegian Cruise Lines—to lavish passengers with personal attention—determines not only the type of employee desired (one with exceptionally good customer-relation skills and a strong work ethic) but also the number needed (one for every two passengers on the Norwegian Dawn).9
Job Analysis
To develop an HR plan, HR managers must be knowledgeable about the jobs that the organization needs performed. They organize information about a given job by performing a job analysis to identify the tasks, responsibilities, and skills that it entails, as well as the knowledge and abilities needed to perform it. Managers also use the information collected for the job analysis to prepare two documents:
• A job description, which lists the duties and responsibilities of a position
• A job specification, which lists the qualifications—skills, knowledge, and abilities— needed to perform the job
HR Supply and Demand Forecasting
Once they’ve analyzed the jobs within the organization, HR managers must forecast future hiring (or firing) needs. This is the three-step process summarized below.
Starbucks, for instance, might find that it needs three hundred new employees to work at stores scheduled to open in the next few months. Disney might determine that it needs two thousand new cast members to handle an anticipated surge in visitors. The Norwegian Dawn might be short two dozen restaurant workers because of an unexpected increase in reservations.
After calculating the disparity between supply and future demand, HR managers must draw up plans for bringing the two numbers into balance. If the demand for labor is going to outstrip the supply, they may hire more workers, encourage current workers to put in extra hours, subcontract work to other suppliers, or introduce labor-saving initiatives. If the supply is greater than the demand, they may deal with overstaffing by not replacing workers who leave, encouraging early retirements, laying off workers, or (as a last resort) firing workers.
Recruiting Qualified Employees
Armed with information on the number of new employees to be hired and the types of positions to be filled, the HR manager then develops a strategy for recruiting potential employees. Recruiting is the process of identifying suitable candidates and encouraging them to apply for openings in the organization.
Before going any further, we should point out that in recruiting and hiring, managers must comply with antidiscrimination laws; violations can have legal consequences. Discrimination occurs when a person is treated unfairly on the basis of a characteristic unrelated to ability. Under federal law, it’s illegal to discriminate in recruiting and hiring on the basis of race, color, religion, sex, national origin, age, or disability. (The same rules apply to other employment activities, such as promoting, compensating, and firing.)10 The Equal Employment Opportunity Commission (EEOC) enforces a number of federal employment laws, including the following:
• Title VII of the Civil Rights Act of 1964, which prohibits employment discrimination based on race, color, religion, sex, or national origin. Sexual harassment is also a violation of Title VII.
• The Equal Pay Act of 1963, which protects both women and men who do substantially equal work from sex-based pay discrimination.
• The Age Discrimination in Employment Act of 1964, which protects individuals who are forty or older.
• Title I and Title V of the Americans with Disabilities Act of 1990, which prohibits employment discrimination against individuals with disabilities.11
Where to Find Candidates
The first step in recruiting is to find qualified candidates. Where do you look for them, and how do you decide whether they’re qualified? Companies must assess not only the ability of a candidate to perform the duties of a job, but also whether he or she is a good “fit” for the company– i.e., how well the candidate’s values and interpersonal style match the company’s values and culture.
Internal versus External Recruiting
Where do you find people who satisfy so many criteria? Basically, you can look in two places: inside and outside your own organization. Both options have pluses and minuses. Hiring internally sends a positive signal to employees that they can move up in the company—a strong motivation tool and a reward for good performance. In addition, because an internal candidate is a known quantity, it’s easier to predict his or her success in a new position. Finally, it’s cheaper to recruit internally. On the other hand, you’ll probably have to fill the promoted employee’s position. Going outside gives you an opportunity to bring fresh ideas and skills into the company. In any case, it’s often the only alternative, especially if no one inside the company has just the right combination of skills and experiences. Entry-level jobs are usually filled from the outside.
How to Find Candidates
Whether you search inside or outside the organization, you need to publicize the opening. If you’re looking internally in a small organization, you can alert employees informally. In larger organizations, HR managers generally post openings on bulletin boards (often online) or announce them in newsletters. They can also seek direct recommendations from various supervisors.
Recruiting people from outside is more complicated. It’s a lot like marketing a product to buyers: in effect, you’re marketing the virtues of working for your company. Starbucks uses the following outlets to advertise openings:
• A dedicated section of the corporate web site (“Job Center,” which lists openings, provides information about the Starbucks experience, and facilitates the submission of online applications)
• College campus recruiting (holding on-campus interviews and information sessions and participating in career fairs)
• Internships designed to identify future talent among college students
• Announcements on employment web sites like Monster.com, Vault.com, Glassdoor.com, and SimplyHired.com
• Newspaper classified ads
• Facebook and Twitter
• Local job fairs
• In-store recruiting posters
• Informative “business cards” for distribution to customers12
When asked what it takes to attract the best people, Starbucks’s senior executive Dave Olsen replied, “Everything matters.” Everything Starbucks does as a company bears on its ability to attract talent. Accordingly, everyone is responsible for recruiting, not just HR specialists. In fact, the best source of quality applicants is often the company’s own labor force.13
The Selection Process
Recruiting gets people to apply for positions, but once you’ve received applications, you still have to select the best candidate—another complicated process.
The selection process entails gathering information on candidates, evaluating their qualifications, and choosing the right one. At the very least, the process can be time- consuming—particularly when you’re filling a high-level position—and often involves several members of an organization.
Let’s examine the selection process more closely by describing the steps that you’d take to become a special agent for the Federal Bureau of Investigation (FBI).14 Most business students don’t generally aspire to become FBI agents, but the FBI is quite interested in business graduates—especially if you have a major in accounting or finance. With one of these backgrounds, you’ll be given priority in hiring. Why?
Unfortunately, there’s a lot of white-collar crime that needs to be investigated, and people who know how to follow the money are well suited for the task.
Application
The first step in a new graduate being hired as an FBI accountant is applying for the job. Make sure you meet the minimum qualifications they advertise. To provide factual information on your education and work background, you’ll submit an application, which the FBI will use as an initial screening tool.
Employment Tests
Next comes a battery of tests (a lot more than you’d take in applying for an everyday business position). Like most organizations, the FBI tests candidates on the skills and knowledge entailed by the job. Unlike most businesses, however, the FBI will also measure your aptitude, evaluate your personality, and assess your writing ability. You’ll have to take a polygraph (lie-detector) test to determine the truthfulness of the information you’ve provided, uncover the extent of any drug use, and disclose potential security problems.
Interview
If you pass all these tests (with sufficiently high marks), you’ll be granted an interview. It serves the same purpose as it does for business recruiters: it allows the FBI to learn more about you and gives you a chance to learn more about your prospective employer and your possible future in the organization. The FBI conducts structured interviews—a series of standard questions. You’re judged on both your answers and your ability to communicate orally.
Physical Exam and Reference Checks
Let’s be positive and say you passed the interview. What’s next? You still have to pass a rigorous physical examination (including a drug test), as well as background and reference checks. Given its mission, the FBI sets all these hurdles a little higher than the average employer. Most businesses will ask you to take a physical exam, but you probably won’t have to meet the fitness standards set by the FBI. Likewise, many businesses check references to verify that applicants haven’t lied about (or exaggerated) their education and work experience. The FBI goes to great lengths to ensure that candidates are suitable for law-enforcement work.
Final Decision
The last stage in the process is out of your control. Will you be hired or not? This decision is made by one or more people who work for the prospective employer. For a business, the decision maker is generally the line manager who oversees the position being filled. At the FBI, the decision is made by a team at FBI headquarters.
Contingent Workers
Though most people hold permanent, full-time positions, there’s a growing number of individuals who work at temporary or part-time jobs. Many of these are contingent workers hired to supplement a company’s permanent workforce. Most of them are independent contractors, consultants, or freelancers who are paid by the firms that hire them. Others are on-call workers who work only when needed, such as substitute teachers. Still others are temporary workers (or “temps”) who are employed and paid by outside agencies or contract firms that charge fees to client companies.
The Positives and Negatives of Temp Work
The use of contingent workers provides companies with a number of benefits. Because they can be hired and fired easily, employers can better control labor costs. When things are busy, they can add temps, and when business is slow, they can release unneeded workers. Temps are often cheaper than permanent workers, particularly because they rarely receive costly benefits. Employers can also bring in people with specialized skills and talents to work on special projects without entering into long-term employment relationships. Finally, companies can “try out” temps: if someone does well, the company can offer permanent employment; if the fit is less than perfect, the employer can easily terminate the relationship. There are downsides to the use of contingent workers, including increased training costs and decreased loyalty to the company. Also, many employers believe that because temps are usually less committed to company goals than permanent workers, productivity suffers.
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Developing Employees
Because companies can’t survive unless employees do their jobs well, it makes economic sense to train them and develop their skills. This type of support begins when an individual enters the organization and continues as long as he or she stays there.
New-Employee Orientation
Have you ever started your first day at a new job feeling upbeat and optimistic only to walk out at the end of the day thinking that maybe you’ve taken the wrong job? If this happens too often, your employer may need to revise its approach to orientation—the way it introduces new employees to the organization and their jobs. Starting a new job is a little like beginning college; at the outset, you may be experiencing any of the following feelings:
• Somewhat nervous but enthusiastic
• Eager to impress but not wanting to attract too much attention
• Interested in learning but fearful of being overwhelmed with information
• Hoping to fit in and worried about looking new or inexperienced15
The employer who understands how common such feelings are is more likely not only to help newcomers get over them but also to avoid the pitfalls often associated with new-employee orientation:
• Failing to have a workspace set up for you
• Ignoring you or failing to supervise you
• Neglecting to introduce you to coworkers
• Swamping you with facts about the company16
A good employer will take things slowly, providing you with information about the company and your job on a need-to-know basis while making you feel as comfortable as possible. You’ll get to know the company’s history, traditions, policies, and culture over time. You’ll learn more about salary and benefits and how your performance will be evaluated. Most importantly, you’ll find out how your job fits into overall operations and what’s expected of you.
Training and Development
It would be nice if employees came with all the skills they need to do their jobs. It would also be nice if job requirements stayed the same: once you’ve learned how to do a job, you’d know how to do it forever. In reality, new employees must be trained; moreover, as they grow in their jobs or as their jobs change, they’ll need additional training. Unfortunately, training is costly and time-consuming.
How costly? Training magazine reported that businesses spent over \$55 billion on training in 2013.17 At Darden Restaurants, the parent company to restaurants such as Olive Garden and Red Lobster, training focuses on diversity skills.18 What’s the payoff? Why are such companies willing to spend so much money on their employees? Darden has been recognized by Fortune magazine as a “Diversity Champion,” ranking it as one of the Top 20 employers on their list of diverse workforces.19 At Booz Allen Hamilton, consultants specialize in finding innovative solutions to client problems, and their employer makes sure that they’re up-to-date on all the new technologies by maintaining a “technology petting zoo” at its training headquarters. It’s called a “petting zoo” because employees get to see, touch, and interact with new and emerging technologies. For example, a Washington Post reporter visiting the “petting zoo” in 2007 saw fabric that could instantly harden if struck by a knife or bullet, and “smart” clothing that could monitor a wearer’s health or environment.20
At Booz Allen Hamilton’s technology “petting zoo,” employees are receiving off-the-job training. This approach allows them to focus on learning without the distractions that would occur in the office. More common, however, is informal on-the-job training, which may be supplemented with formal training programs. This is the method, for example, by which you’d move up from mere coffee maker to a full-fledged “barista” if you worked at Starbucks.21 You’d begin by reading a large spiral book (titled Starbucks University) on the responsibilities of the barista, pass a series of tests on the reading, then get hands-on experience in making drinks, mastering one at a time.22 Doing more complex jobs in business will likely require even more training than is required to be a barista.
Diversity in the Workplace
The makeup of the U.S. workforce has changed dramatically over the past 50 years. In the 1950s, more than 60 percent was composed of white males.23 Today’s workforce reflects the broad range of differences in the population—differences in gender, race, ethnicity, age, physical ability, religion, education, and lifestyle. As you can see in Figure 12.5, more women and minorities have entered the workforce, and white males now make up only 36 percent of the workforce.24
Figure 12.5: Employment by Gender and Ethnic Group, 2015
Group Total Males Females
All employees 100% 53% 47%
White 79% 54% 46%
African American 12% 47% 53%
Asian/Pacific Islander/Other 9% 53% 47%
Hispanic/Latino Ethnicity 16% 58% 42%
Most companies today strive for diverse workforces. HR managers work hard to recruit, hire, develop, and retain a diverse workforce. In part, these efforts are motivated by legal concerns: discrimination in recruiting, hiring, advancement, and firing is illegal under federal law and is prosecuted by the EEOC.25 Companies that violate antidiscrimination laws are subject to severe financial penalties and also risk reputational damage. In November 2004, for example, the EEOC charged that recruiting policies at Abercrombie & Fitch, a national chain of retail clothing stores, had discriminated against minority and female job applicants between 1999 and 2004. The EEOC alleged that A&F had hired a disproportionate number of white salespeople, placed minorities and women in less visible positions, and promoted a virtually all-white image in its marketing efforts. Six days after the EEOC filed a lawsuit, the company settled the case at a cost of \$50 million, but the negative publicity may hamper both recruitment and sales for some time.26
Reasons for building a diverse workforce go well beyond mere compliance with legal standards. It even goes beyond commitment to ethical standards. It’s good business. People with diverse backgrounds bring fresh points of view that can be invaluable in generating ideas and solving problems. In addition, they can be the key to connecting with an ethnically diverse customer base. If a large percentage of your customers are Hispanic, it might make sense to have a Hispanic marketing manager. In short, capitalizing on the benefits of a diverse workforce means that employers should view differences as assets rather than liabilities.
What Makes a Great Place to Work?
Every year, the Great Places to Work Institute analyzes comments from thousands of employees and compiles a list of “The 100 Best Companies to Work for in America®,” which is published in Fortune magazine. Having compiled its list for more than twenty years, the institute concludes that the defining characteristic of a great company to work for is trust between managers and employees. Employees overwhelmingly say that they want to work at a place where employees “trust the people they work for, have pride in what they do, and enjoy the people they work with.”27 They report that they’re motivated to perform well because they’re challenged, respected, treated fairly, and appreciated. They take pride in what they do, are made to feel that they make a difference, and are given opportunities for advancement.28 The most effective motivators, it would seem, are closely aligned with Maslow’s higher-level needs and Herzberg’s motivating factors. The top ten companies are listed in Figure 12.7.
Figure 12.7: The top ten from the 2016 Fortune Best Companies to Work For®. Each name is a link to that company’s career page.
Rank Company
1 Google
2 Acuity Insurance
3 Boston Consulting Group
4 Wegman’s Food Markets
5 Quicken Loans
6 Robert W. Baird & Co.
7 Kimley-Horn
8 SAS Institute
9 Camden Property Trust
10 Edward Jones
Job Redesign
The average employee spends more than two thousand hours a year at work. If the job is tedious, unpleasant, or otherwise unfulfilling, the employee probably won’t be motivated to perform at a very high level. Many companies practice a policy of job redesign to make jobs more interesting and challenging. Common strategies include job rotation, job enlargement, and job enrichment.
Job Rotation
Specialization promotes efficiency because workers get very good at doing particular tasks. The drawback is the tedium of repeating the same task day in and day out. The practice of job rotation allows employees to rotate from one job to another on a systematic basis, often but not necessarily cycling back to their original tasks. A computer maker, for example, might rotate a technician into the sales department to increase the employee’s awareness of customer needs and to give the employee a broader understanding of the company’s goals and operations. A hotel might rotate an accounting clerk to the check- in desk for a few hours each day to add variety to the daily workload. Through job rotation, employees develop new skills and gain experience that increases their value to the company. So great is the benefit of this practice that many companies have established rotational training programs that include scheduled rotations during the first 2-3 years of employment. Companies benefit because cross-trained employees can fill in for absentees, thus providing greater flexibility in scheduling, offer fresh ideas on work practices, and become promotion-ready more quickly.
Job Enlargement
Instead of a job in which you performed just one or two tasks, wouldn’t you prefer a job that gave you many different tasks? In theory, you’d be less bored and more highly motivated if you had a chance at job enlargement—the policy of enhancing a job by adding tasks at similar skill levels. The job of sales clerk, for example, might be expanded to include gift-wrapping and packaging items for shipment. The additional duties would add variety without entailing higher skill levels.
Job Enrichment
Merely expanding a job by adding similar tasks won’t necessarily “enrich” it by making it more challenging and rewarding. Job enrichment is the practice of adding tasks that increase both responsibility and opportunity for growth. It provides the kinds of benefits that, according to Maslow and Herzberg, contribute to job satisfaction: stimulating work, sense of personal achievement, self-esteem, recognition, and a chance to reach your potential.
Consider, for example, the evolving role of support staff in the contemporary office. Today, employees who used to be called “secretaries” assume many duties previously in the domain of management, such as project coordination and public relations. Information technology has enriched their jobs because they can now apply such skills as word processing, desktop publishing, creating spreadsheets, and managing databases. That’s why we now use a term such as administrative assistant instead of secretary.29
Work/Life Quality
Building a career requires a substantial commitment in time and energy, and most people find that they aren’t left with much time for non-work activities. Fortunately, many organizations recognize the need to help employees strike a balance between their work and home lives.30 By helping employees combine satisfying careers and fulfilling personal lives, companies tend to end up with a happier, less-stressed, and more productive workforce. The financial benefits include lower absenteeism, turnover, and health care costs.
Alternative Work Arrangements
The accounting firm KPMG, which has made the list of the “100 Best Companies for Working Mothers” for nineteen years,31 is committed to promoting a balance between its employees’ work and personal lives. KPMG offers a variety of work arrangements designed to accommodate different employee needs and provide scheduling flexibility.32
Flextime
Employers who provide for flextime set guidelines that allow employees to designate starting and quitting times. Guidelines, for example, might specify that all employees must work eight hours a day (with an hour for lunch) and that four of those hours must be between 10 a.m. and 3 p.m. Thus, you could come in at 7 a.m. and leave at 4 p.m., while coworkers arrive at 10 a.m. and leave at 7 p.m. With permission you could even choose to work from 8 a.m to 2 p.m., take two hours for lunch, and then work from 4 p.m. to 6 p.m.
Compressed Workweeks
Rather than work eight hours a day for five days a week, you might elect to earn a three-day weekend by working ten hours a day for four days a week.
Job Sharing
Under job sharing, two people share one full-time position, splitting the salary and benefits of the position as each handles half the job. Often they arrange their schedules to include at least an hour of shared time during which they can communicate about the job.
Telecommuting
Telecommuting means that you regularly work from home (or from some other non-work location). You’re connected to the office by computer, fax, and phone. You save on commuting time, enjoy more flexible work hours, and have more opportunity to spend time with your family. A study of 5,500 IBM employees (one-fifth of whom telecommute) found that those who worked at home not only had a better balance between work and home life but also were more highly motivated and less likely to leave the organization.33
Though it’s hard to count telecommuters accurately, Global Workplace Analytics estimates that, in 2016, “at least 3.7 million people (2.8 percent of the workforce) work from home at least half the time.”34 Telecommuting isn’t for everyone. Working at home means that you have to discipline yourself to avoid distractions, such as TV, personal phone calls, and home chores and also not be impacted by feeling isolated from the social interaction in the workplace.
Family-Friendly Programs
In addition to alternative work arrangements, many employers, including KPMG, offer programs and benefits designed to help employees meet family and home obligations while maintaining busy careers. KPMG offers each of the following benefits.35
Dependent Care
Caring for dependents—young children and elderly parents—is of utmost importance to some employees, but combining dependent-care responsibilities with a busy job can be particularly difficult. KPMG provides on-site child care during tax season (when employees are especially busy) and offers emergency backup dependent care all year round, either at a provider’s facility or in the employee’s home. To get referrals or information, employees can call KPMG’s LifeWorks Resource and Referral Service.
KPMG is by no means unique in this respect: more than 7 percent of U.S. companies maintained on-site day care in 2012,36 and 17 percent of all U.S. companies offered child-care resources or referral services.37
Paid Parental Leave
The United States is one of only two countries in the world that does not guarantee paid leave to new mothers (or fathers), although California, Rhode Island and New Jersey are implementing state programs, and many employers offer paid parental leave as an employee benefit.38 Any KPMG employee (whether male or female) who becomes a parent can take two weeks of paid leave. New mothers may also get time off through short-term disability benefits.
Caring for Yourself
Like many companies, KPMG allows employees to aggregate all paid days off and use them in any way they want. In other words, instead of getting, say, ten sick days, five personal days, and fifteen vacation days, you get a total of thirty days to use for anything. If you’re having personal problems, you can contact the Employee Assistance Program. If staying fit makes you happier and more productive, you can take out a discount membership at one of more than nine thousand health clubs. In fact, many employers, like North Carolina software company SAS, now have on-site fitness centers for employee use.39
Unmarried without Children
You’ve undoubtedly noticed by now that many programs for balancing work and personal lives target married people, particularly those with children. Single individuals also have trouble striking a satisfactory balance between work and non-work activities, but many single workers feel that they aren’t getting equal consideration from employers.40 They report that they’re often expected to work longer hours, travel more, and take on difficult assignments to compensate for married employees with family commitments.
Needless to say, requiring singles to take on additional responsibilities can make it harder for them to balance their work and personal lives. It’s harder to plan and keep personal commitments while meeting heavy work responsibilities. Frustration can lead to increased stress and job dissatisfaction. In several studies of stress in the accounting profession, unmarried workers reported higher levels of stress than any other group, including married people with children.41
With singles, as with married people, companies can reap substantial benefits from programs that help employees balance their work and non-work lives. PepsiCo, for example, offers a “concierge service,” which maintains a dry cleaner, travel agency, convenience store, and fitness center on the premises of its national office in Somers, New York.42 Single employees seem to find these services helpful, but what they value most of all is control over their time. In particular, they want predictable schedules that allow them to plan social and personal activities. They don’t want employers assuming that being single means that they can change plans at the last minute. It’s often more difficult for singles to deal with last-minute changes because, unlike married coworkers, they don’t have the at-home support structure to handle such tasks as tending to elderly parents or caring for pets.
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Compensation and Benefits
Though paychecks and benefits packages aren’t the only reasons why people work, they do matter. Competitive pay and benefits also help organizations attract and retain qualified employees. Companies that pay their employees more than their competitors generally have lower turnover. Consider, for example, The Container Store, which regularly appears on Fortune magazine’s list of “The 100 Best Companies to Work For.”43 The retail chain staffs its stores with fewer employees than its competitors but pays them more—in some cases, three times the industry average for retail workers. This strategy allows the company to attract extremely talented workers who, moreover, aren’t likely to leave the company. Low turnover is particularly valuable in the retail industry because it depends on service-oriented personnel to generate repeat business. In addition to salary and wages, compensation packages often include other financial incentives, such as bonuses and profit-sharing plans, as well as benefits, such as medical insurance, vacation time, sick leave, and retirement accounts.
Wages and Salaries
The largest, and most important, component of a compensation package is the payment of wages or salary. If you’re paid according to the number of hours you work, you’re earning wages. Counter personnel at McDonald’s, for instance, get wages, which are determined by multiplying an employee’s hourly wage rate by the number of hours worked during the pay period. On the other hand, if you’re paid for fulfilling the responsibilities of a position—regardless of the number of hours required to do it— you’re earning a salary. The McDonald’s manager gets a salary for overseeing the operations of the restaurant. He or she is expected to work as long as it takes to get the job done, without any adjustment in compensation.
Piecework and Commissions
Sometimes it makes more sense to pay workers according to the quantity of product that they produce or sell. Byrd’s Seafood, a crab-processing plant in Crisfield, Maryland, pays workers on piecework: workers’ pay is based on the amount of crabmeat that’s picked from recently cooked crabs. (A good picker can produce fifteen pounds of crabmeat an hour and earn about \$100 a day.)44 On the other hand, if you’re working on commission, you’re probably getting paid a percentage of the total dollar amount you sell. If you were a sales representative for an insurance company, like The Hartford, you’d get a certain amount of money for each automobile or homeowner policy you sold.45
Incentive Programs
In addition to regular paychecks, many people receive financial rewards based on performance, whether their own, their employer’s, or both. Other incentive programs designed to reward employees for good performance include bonus plans and stock options.
Bonus Plans
Texas Instruments’ (TI) year-end bonuses—annual income given in addition to salary—are based on individual and company-wide performance. If the company has a profitable year, and if you contributed to that success, you’ll get a bonus.46 If the company doesn’t do well, you may be out of luck – regardless of your personal performance, you might not receive a bonus.
Bonus plans have become quite common, and the range of employees eligible for bonuses has widened in recent years. In the past, bonus plans were usually reserved for managers above a certain level. Today, companies have realized the value of extending plans to include employees at virtually every level. The magnitude of bonuses still favors those at the top. High-ranking officers often get bonuses ranging from 30 percent to 50 percent of their salaries. Upper-level managers may get from 15 percent to 25 percent and middle managers from 10 percent to 15 percent. At lower levels, employees may expect bonuses from 3 percent to 5 percent of their annual compensation.47
Profit-Sharing Plans
Delta Airlines48 and General Motors49 both have profit-sharing arrangements with employees. Today, about 40% of all U.S. companies offer some type of profit-sharing program.50
TI’s plan is also pretty generous—as long as the company has a good year. Here’s how it works. An employee’s profit share depends on the company’s operating profit for the year. If profits from operations reach 10 percent of sales, the employee gets a bonus worth 2 percent of his or her salary. In 2011, TI’s operating profit was 22 percent, and employee bonuses were 7.9 percent of salary. But if operating profits are below 10 percent, nobody gets anything.51
Stock-Option Plans
The TI compensation plan also gives employees the right to buy shares of company stock at a 15% discount four times a year.52 So, if the price of the stock goes up, the employee benefits. Say, for example, that the stock was selling for \$30 a share when the option was granted in 2007. The employee would be entitled to buy shares at a price of \$25.50, earning them an immediate 15% gain in value. Any increase in share price would add to that gain.53
At TI, stock options are used as an incentive to attract and retain top people.54 Starbucks, by contrast, isn’t nearly as selective in awarding stock options. At Starbucks, all employees can earn “Bean Stock”—the Starbucks employee stock-option plan. Both full- and part-time employees get Starbucks shares based on their earnings and their time with the company. If the company does well and its stock goes up, employees make a profit. CEO Howard Schultz believes that Bean Stock pays off because employees are rewarded when the company does well, they have a stronger incentive to add value to the company (and so drive up its stock price). Starbucks has a video explaining their employee stock option program on this webpage.55
Benefits
Another major component of an employee’s compensation package is benefits— compensation other than salaries, hourly wages, or financial incentives. Types of benefits include the following:
• Legally required benefits (Social Security and Medicare, unemployment insurance, workers’ compensation)
• Paid time off (vacations, holidays, sick leave)
• Insurance (health benefits, life insurance, disability insurance)
• Retirement benefits
The cost of providing benefits is staggering. According to the U.S. Bureau of Labor Statistics, it costs an average employer about 30 percent of a worker’s salary to provide the same worker with benefits. If you include pay for time not worked (while on vacation or sick and so on), the percentage increases to 37 percent. The most money goes for paid time off (6.9% of salary costs), health care (8.1%), and retirement benefits (3.8%).56
Some workers receive only the benefits required by law while part-timers often receive no benefits at all.57 Again, Starbucks is generous in offering benefits. The company provides benefits even to the part-timers who make up two-thirds of the company’s workforce; anyone working at least twenty hours a week is eligible to participate in group medical coverage.58
Performance Appraisal
Employees generally want their managers to tell them three things: what they should be doing, how well they’re doing it, and how they can improve their performance. Good managers address these issues on an ongoing basis. On a semiannual or annual basis, they also conduct formal performance appraisals to discuss and evaluate employees’ work performance.
The Basic Three-Step Process
Appraisal systems vary both by organization and by the level of the employee being evaluated, but as you can see in Figure 12.8, it’s generally a three-step process:
1. Before managers can measure performance, they must set goals and performance expectations and specify the criteria (such as quality of work, quantity of work, dependability, initiative) that they’ll use to measure performance.
2. At the end of a specified time period, managers complete written evaluations that rate employee performance according to the predetermined criteria.
3. Managers then meet with each employee to discuss the evaluation. Jointly, they suggest ways in which the employee can improve performance, which might include further training and development.
It sounds fairly simple, but why do so many managers report that, except for firing people, giving performance appraisals is their least favorite task?59 To get some perspective on this question, we’ll look at performance appraisals from both sides, explaining the benefits and identifying potential problems with some of the most common practices.
Among other benefits, formal appraisals provide the following:
• An opportunity for managers and employees to discuss an employee’s performance and to set future goals and performance expectations
• A chance to identify and discuss appropriate training and career-development opportunities for an employee
• Formal documentation of the evaluation that can be used for salary, promotion, demotion, or dismissal purposes60
As for disadvantages, most stem from the fact that appraisals are often used to determine salaries for the upcoming year. Consequently, meetings to discuss performance tend to take on an entirely different dimension: the manager may appear judgmental (rather than supportive), and the employee may get defensive. This adversarial atmosphere can make many managers not only uncomfortable with the task but also less likely to give honest feedback. (They may give higher marks in order to avoid delving into critical evaluations.) HR professionals disagree about whether performance appraisals should be linked to pay increases. Some experts argue that the connection eliminates the manager’s opportunity to use the appraisal to improve an employee’s performance. Others maintain that it increases employee satisfaction with the process and distributes raises on the basis of effort and results.61
360-Degree and Upward Feedback
Instead of being evaluated by one person, how would you like to be evaluated by several people—not only those above you in the organization but those below and beside you? The approach is called 360-degree feedback, and the purpose is to ensure that employees (mostly managers) get feedback from all directions—from supervisors, reporting subordinates, coworkers, and even customers. If it’s conducted correctly, this technique furnishes managers with a range of insights into their performance in a number of roles.
Some experts, however, regard the 360-degree approach as too cumbersome. An alternative technique, called upward feedback, requires only the manager’s subordinates to provide feedback. Computer maker Dell uses this approach as part of its manager-development plan. Every year, forty thousand Dell employees complete a survey in which they rate their supervisors on a number of dimensions, such as practicing ethical business principles and providing support in balancing work and personal life. Dell uses survey results for development purposes only, not as direct input into decisions on pay increases or promotions.62
Retaining Valuable Employees
When a valued employee quits, the loss to the employer can be serious. Not only will the firm incur substantial costs to recruit and train a replacement, but it also may suffer temporary declines in productivity and lower morale among remaining employees who have to take on heavier workloads. Given the negative impact of turnover—the permanent separation of an employee from a company—most organizations do whatever they can to retain qualified employees. Compensation plays a key role in this effort: companies that don’t offer competitive compensation packages tend to lose employees. Other factors also come into play, such as training and development, as well as helping employees achieve a satisfying work/non-work balance. In the following sections, we’ll look at a few other strategies for reducing turnover and increasing productivity.63
Creating a Positive Work Environment
Employees who are happy at work are more productive, provide better customer service, and are more likely to stay with the company. A study conducted by Sears, for instance, found a positive relationship between customer satisfaction and employee attitudes on ten different issues: a 5 percent improvement in employee attitudes results in a 1.3 percent increase in customer satisfaction and a 0.5 percent increase in revenue.64
The Employee-Friendly Workplace
What sort of things improve employee attitudes? The 12,000 employees of software maker SAS Institute fall into the category of “happy workers.” They choose the furniture and equipment in their offices, eat subsidized meals at one of three on-site restaurants, and enjoy other amenities like a 77,000 square-foot fitness center. They also have job security: no one’s ever been laid off because of an economic downturn. The employee-friendly work environment helps SAS employees focus on their jobs and contribute to the attainment of company goals.65 Not surprisingly, it also results in very low 3 percent turnover.
Recognizing Employee Contributions
Thanking people for work done well is a powerful motivator. People who feel appreciated are more likely to stay with a company than those who don’t.66 While a personal thank-you is always helpful, many companies also have formal programs for identifying and rewarding good performers. The Container Store rewards employee accomplishments in a variety of ways. For example, employees with 20 years of service are given a “dream trip”—one employee went on a seven day Hawaiian cruise.67 The company is known for its supportive environment and in 2016 celebrated its seventeenth year on Fortune’s 100 Best Companies to Work For®.68
Involving Employees in Decision Making
Companies have found that involving employees in decisions saves money, makes workers feel better about their jobs, and reduces turnover. Some have found that it pays to take their advice. When General Motors asked workers for ideas on improving manufacturing operations, management was deluged with more than forty-four thousand suggestions during one quarter. Implementing a few of them cut production time on certain vehicles by 15 percent and resulted in sizable savings.69
Similarly, in 2001, Edward Jones, a personal investment company, faced a difficult situation during the stock-market downturn. Costs had to be cut, and laying off employees was one option. Instead, however, the company turned to its workforce for solutions. As a group, employees identified cost savings of more than \$38 million. At the same time, the company convinced experienced employees to stay with it by assuring them that they’d have a role in managing it.70
Why People Quit
As important as such initiatives can be, one bad boss can spoil everything. The way a person is treated by his or her boss may be the primary factor in determining whether an employee stays or goes. People who have quit their jobs cite the following behavior by superiors:
• Making unreasonable work demands
• Refusing to value their opinions
• Failing to be clear about what’s expected of subordinates
• Showing favoritism in compensation, rewards, or promotions71
Holding managers accountable for excessive turnover can help alleviate the “bad-boss” problem, at least in the long run. In any case, whenever an employee quits, it’s a good idea for someone—other than the individual’s immediate supervisor—to conduct an exit interview to find out why. Knowing why people are quitting gives an organization the opportunity to correct problems that are causing high turnover rates.
Involuntary Termination
Some companies employ a process called Forced Ranking to manage out their under-performers. In this approach, only a certain percentage of employees can receive a particular performance evaluation score, which forces some employees to the bottom of the distribution—sort of the opposite of a curved exam score. The employee pool in question is typically made up of those who do similar kinds of work. Ideally after being given some amount of time to improve, those who remain at the bottom of the performance distribution are then separated from the company. As you can imagine, this practice has caused a fair amount of controversy!
Before we leave this section, we should say a word or two about termination—getting fired. Though turnover—voluntary separations—can create problems for employers, they’re not nearly as devastating as the effects of involuntary termination on employees. Losing your job is what psychologists call a “significant life change,” and it’s high on the list of “stressful life events” regardless of the circumstances. Sometimes, employers lay off workers because revenues are down and they must resort to downsizing—to cutting costs by eliminating jobs. Sometimes a particular job is being phased out, and sometimes an employee has simply failed to meet performance requirements.
Employment at Will
Is it possible for you to get fired even if you’re doing a good job and there’s no economic justification for your being laid off? In some cases, yes—especially if you’re not working under a contract. Without a formal contract, you’re considered to be employed at will, which means that both you and your employer have the right to terminate the employment relationship at any time. You can quit whenever you want, but your employer can also fire you whenever they want.
Fortunately for employees, over the past several decades, the courts have made several decisions that created exceptions to the employment-at-will doctrine.72 Since managers generally prefer to avoid the expense of fighting wrongful discharge claims in court, many no longer fire employees at will. A good practice in managing terminations is to maintain written documentation so that employers can demonstrate just cause when terminating an employee. If it’s a case of poor performance, the employee would be warned in advance that his or her current level of performance could result in termination and then be permitted an opportunity to improve performance. When termination is necessary, communication should be handled in a private conversation, with the manager explaining precisely why the action is being taken.
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Key Takeaways
1. The process of humanresource management consists of actions that an organization takes to attract, develop, and retain quality employees.
2. Human resource managers engage in strategic human resource planning—the process of developing a plan for satisfying the organization’s human resource needs
3. The HR manager forecasts future hiring needs and begins the recruiting process to fill those needs.
4. In recruiting and hiring, managers must comply with antidiscrimination laws enforced by the Equal Employment Opportunity Commission (EEOC). They cannot treat people unfairly on the basis of a characteristic unrelated to ability, such as race, color, religion, sex, national origin, age, or disability.
5. HR managers also oversee employee training, from the first orientation to continuing on– or off-the-job training.
6. Attracting a diverse workforce goes beyond legal compliance and ethical commitments, because a diverse group of employees can offer perspectives that may be valuable in generating ideas, solving problems, and connecting with an ethnically diverse customer base.
7. Employees are motivated to perform well when they’re challenged, respected, treated fairly, and appreciated.
8. Some other factors that contribute to employee satisfaction include job redesign to make jobs more interesting and challenging, job rotation, which allows employees to rotate from one job to another, job enlargement, which enhances a job by adding tasks at similar skill levels, and job enrichment, which adds tasks that increase both responsibility and opportunity for growth.
9. Many organizations recognize the need to help employees strike a balance between their work and home lives and offer a variety of work arrangements to accommodate different employee needs, such as flextime (flexible scheduling), job sharing (when two people share a job), and telecommuting (working from outside the office).
10. Compensation includes pay and benefits. Workers who are paid by the hour earn wages, while those who are paid to fulfill the responsibilities of the job earn salaries. Some people receive commissions based on sales or are paid for output, based on a piecework approach.
11. In addition employees can may receive year-end bonuses, participate in profit-sharing plans, or receive stock options.
12. Managers conduct performanceappraisals to evaluate work performance.
13. Turnover is the permanent separation of an employee from a company and may happen if an employee is unsatisfied with their job, or because the organization is not satisfied with the employee. Sometimes, firms lay off workers, or downsize, to cut costs.
Chapter 12 References and Image Credits
Image Credits: Chapter 12
Figure 12.1: Photobra Adam Bielawski (2011). “Howard Schultz.” CC BY-SA 3.0
Figure 12.2: Hao Xing (2015). “Starbucks Coffee Company-True North Blend™ Blonde Roast.” CC BY 2.0 Retrieved from: https://www.flickr.com/photos/130000572@N03/16285653016
Figure 12.4: Nazareth College (2015). “Career Job Fair 2015.” CC BY 2.0 Retrieved from: https://www.flickr.com/photos/nazareth_college/16925555392
Figure 12.5: Data for the table from: Bureau of Labor Statistics (2016). “Labor Force Statistics from the Current Population Survey: Table 10 Employed persons by occupation, race, Hispanic or Latino ethnicity, and sex.” Retrieved from: http://www.bls.gov/cps/cpsaat10.pdf
Figure 12.6: William Murphy (2012). “Abercrombie & Fitch First store In Ireland Opened Today.” CC BY 2.0 Retrieved from: https://www.flickr.com/photos/infomatique/8145283663
Figure 12.7: List from: Great Place to Work and Fortune (2016). “The 2016 Fortune Best Companies to Work For®” Fortune.com. Retrieved from: clients.greatplacetowork.com/list-calendar/fortune-100-best-companies-to-work-for?utm_source=website&utm_medium=main-menu&utm_content=lists-fortune-100&utm_campaign=dotcom-links | textbooks/biz/Business/Introductory_Business/Book%3A_Fundamentals_of_Business_(Skripak)/12%3A_Managing_Human_Resources.txt |
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13: Union
Learning Objectives
1. Explain why workers unionize and how unions are structured, and describe the collective-bargaining process
2. Discuss key terms associated with union/management issues, such as mediation and arbitration.
3. Identify the tactics used by each side to support their negotiating positions: strikes, picketing, boycotting, and lockouts.
Labor Unions
As we saw in Chapter 11, Maslow believed that individuals are motivated to satisfy five levels of unmet needs (physiological, safety, social, esteem, and self-actualization). From this perspective, employees hope that full-time work will satisfy at least the two lowest-level needs: they want to be paid wages that are sufficient for them to feed, house, and clothe themselves and their families, and they expect safe working conditions and hope for some degree of job security.
Organizations also have needs: they need to earn profits that will satisfy their owners. They need to keep other stakeholders satisfied as well, which can cost money. Consider a metal-plating business that uses dangerous chemicals in its manufacturing processes; waste-water treatment is essential – and expensive. Sometimes, the needs of employees and employers are consistent: the organization can pay decent wages and provide workers with safe working conditions and job security while still making a satisfactory profit. At other times, there is a conflict—real, perceived, or a little bit of both—between the needs of employees and those of employers. In such cases, workers may be motivated to join a labor union—an organized group of workers that bargains with employers to improve its members’ pay, job security, and working conditions.
Figure 13.1 on the next page graphs labor-union density—union membership as a percentage of payrolls—in the United States from 1930 to 2015. As you can see, there’s been a steady decline since the middle part of the 1950s. Recently, only about 11 percent of U.S. workers have taken steps to belong to unions.1 Only union membership among public workers (those employed by federal, state, and local governments, such as teachers, police, and firefighters) has grown. In the 1940s, 10 percent of public workers and 34 percent of those in the private sector belonged to unions. Today, this has reversed: 36 percent of public workers and 7 percent of those in the private sector are union members.2
Why the decline in private sector unionization? Many factors come into play. The relatively weak economy has reduced the number of workers who have the confidence to go through a union organizing campaign; many workers are content just to have jobs and do not want to be seen as “rocking the boat.” In addition, the United States has shifted from a manufacturing-based economy characterized by large, historically unionized companies to a service-based economy made up of many small firms that are harder to unionize.3
Union Structure
Unions have a pyramidal structure much like that of large corporations. At the bottom are locals that serve workers in a particular geographical area. Certain members are designated as shop stewards to serve as go-betweens in disputes between workers and supervisors. Locals are usually organized into national unions that assist with local contract negotiations, organize new locals, negotiate contracts for entire industries, and lobby government bodies on issues of importance to organized labor. In turn, national unions may be linked by a labor federation, such as the American Federation of Labor and Congress of Industrial Organizations (AFL-CIO), which provides assistance to member unions and serves as a principal political organ for organized labor.
Collective Bargaining
In a non-union environment, the employer makes largely unilateral, i.e., one-sided decisions on issues affecting its labor force, such as salary and benefits. Typically, employees are in no position to bargain for better deals. At the same time, however, employers have a vested interest in treating workers fairly. As we saw in Chapter 10, a reputation for treating employees well, for example, is a key factor in attracting talented people. Most employers want to avoid the costs involved in managing a unionized workforce; as a result, many offer generous pay and benefit packages in the hopes of keeping their workers happy – and un-unionized.
The process of setting pay and benefit levels is a lot different in a unionized environment. Union workers operate on a contract which usually covers some agreed-upon, multi-year period. When a given contract period begins to approach expiration, union representatives determine with members what they want in terms of salary increases, benefits, working conditions, and job security in their next contract. Union officials then tell the employer what its workers want and ask what they’re willing to offer. When there’s a discrepancy between what workers want and what management is willing to give—as there usually is—union officials serve as negotiators on behalf of their workforce, with the objective of extracting the best package of salary, benefits, and other conditions possible. The process of settling differences and establishing mutually agreeable conditions under which employees will work is called collective bargaining.
The Negotiation Process
Negotiations start when each side states its position and presents its demands. As in most negotiations, these opening demands simply stake out starting positions. Both parties usually expect some give-and-take and realize that the final agreement will fall somewhere between the two positions. If everything goes smoothly, a tentative agreement can be reached and then voted on by union members. If they accept the agreement, the process is complete and a contract is put into place to govern labor-management relations for a stated period. If workers reject the agreement, negotiators from both sides must go back to the bargaining table.
Mediation and Arbitration
If negotiations stall, the sides may call in outsiders. One option for engaging outside parties is called mediation, under which an impartial third party assesses the situation and makes recommendations for reaching an agreement. A mediator’s advice can be accepted or rejected by either side. If mediation does not result in an agreement, because one or both sides are unwilling to accept the decision of the third party, they may opt instead for arbitration, under which the third party studies the situation and arrives at a binding agreement. The key difference between mediation and arbitration is the word “binding” – whatever the third party says goes, because both the union and management have agreed to accept the decision of the third party as a condition of entering into the arbitration process.
Grievance Procedures
Another difference between union and non-union environments is the handling of grievances—worker complaints on contract-related matters. When non-union workers feel that they’ve been treated unfairly, they can take up the matter with supervisors, who may or may not satisfy their complaints. When unionized workers have complaints (such as being asked to work more hours than stipulated under their contract), they can call on union representatives to resolve the problem, in conjunction with supervisory personnel, who are part of company management. If the outcome isn’t satisfactory to the worker, the union can choose to take the problem to higher-level management on his or her behalf. If there is still no resolution, the union may submit the grievance to an arbitrator.
At times, labor and management can’t resolve their differences through collective bargaining or formal grievance procedures. When this happens, each side may resort to a variety of tactics to win support for its positions and force the opposition to agree to its demands.
Union Tactics
Unions have several options at their disposal to pressure company management into accepting the terms and conditions union members are demanding. The tactics available to the union include striking, picketing, and boycotting. When they go on strike, workers walk away from their jobs and refuse to return until the issue at hand has been resolved. As undergraduates at Yale discovered when they arrived on campus in fall 2003, the effects of a strike can engulf parties other than employers and strikers: with four thousand dining room workers on strike, students had to scramble to find food at local minimarkets. The strike—the eighth at the school since 1968—lasted twenty-three days, and in the end, the workers got what they wanted: better pension plans.4
Though a strike sends a strong message to management, it also has consequences for workers, who don’t get paid when they’re on strike. Unions often ease the financial pressure on strikers by providing cash payments, which are funded from the dues members pay to the unions. It is important to note that some unionized workers may not have the right to strike. For example, strikes by federal employees, such as air-traffic controllers, can be declared illegal if they jeopardize the public interest.
When you see workers parading with signs outside a factory or an office building (or even a school), they’re probably using the tactic known as picketing (see Figure 13.2). The purpose of picketing is informative—to tell people that a workforce is on strike or to publicize some management practice that is unacceptable to the union. In addition, because other union workers typically won’t cross picket lines, marchers can sometimes interrupt the daily activities of the targeted organization. In April 2001, faculty at the University of Hawaii, unhappy about salaries, went on strike for thirteen days. Initially, many students cheerfully headed for the beach, but before long, many more—particularly graduating seniors—began to worry about finishing the semester with the credits they needed to keep their lives on schedule.5
The final tactic available to unions is boycotting, in which union workers refuse to buy a company’s products and try to get other people to follow suit. The tactic is often used by the AFL-CIO, which maintains a national “Don’t Buy or Patronize” boycott list. In 2003, for example, at the request of two affiliates, the Actor’s Equity Association and the American Federation of Musicians, the AFL-CIO added the road show of the Broadway musical Miss Saigon to the list. Why? The unions objected to the use of non-union performers who worked for particularly low wages and to the use of a “virtual orchestra,” an electronic apparatus that can replace a live orchestra with software-generated orchestral accompaniment.6
Management Tactics
Management doesn’t typically sit by passively, especially if the company has a position to defend or a message to get out. One available tactic is the lockout—closing the workplace to workers—though it’s rarely used because it’s legal only when unionized workers pose a credible threat to the employer’s financial viability. If you are a fan of professional basketball, you may remember the NBA lockout in 2011 (older fans may remember a similar scenario that took place in 1999) which took place because of a dispute regarding the division of revenues and the structure of the salary cap.
Lockout tactics were also used in the 2011 labor dispute between the National Football League (NFL) and the National Football League Players Association when club owners and players failed to reach an agreement on a new contract. Prior to the 2011 season, the owners imposed a lockout, which prevented the players from practicing in team training facilities. Both sides had their demands: the players wanted a greater percentage of the revenues, which the owners were against. The owners wanted the players to play two additional regular season games, which the players were against. With the season drawing closer, an agreement was finally reached in July 2011 bringing the 130-day lockout to an end and ensuring that the 2011 football season would begin on time.7
Another management tactic is replacing striking workers with strikebreakers—non-union workers who are willing to cross picket lines to replace strikers. Though the law prohibits companies from permanently replacing striking workers, it’s often possible for a company to get a court injunction that allows it to bring in replacement workers. For example, the NFL employed replacement referees in 2012, a move which led to a number of very questionable calls on the field.8
Why Managers Often Resist Unionization Efforts
No union organizing campaign ever started with the premise that by unionizing, employees would receive lower wages or weaker benefit programs. To the contrary, unions approach prospective members with promises like higher pay, better health insurance, and more vacation time. Not surprisingly, then, business managers resist unions because they generally add to the cost of doing business. Higher costs can be addressed in several ways. Managers could accept lower profits, though such an outcome is unlikely given that owners/shareholders benefit from higher profits. They could raise prices and pass the higher costs along to customers, but doing so could hurt their competitiveness in the marketplace. Alternatively. they could find other ways to offset the increase in costs, but since managers are already supposed to be paying attention to costs, finding offsets can be quite difficult.
Another reason managers sometimes resist unionization is that unions often attempt to negotiate work rules that are to the benefit of their members. Business people who have worked in union environments have often complained of the lack of flexibility and the difficulty unions sometimes create in dealing with poor performing union employees. The grievance process can sometimes be long, cumbersome, and costly to administer.
Some companies find working with unions to be so unpleasant that they decide to voluntarily increase pay and benefits to preempt unions in advertising these benefits.
The Future of Unions
As we noted earlier, union membership in the United States has been declining for some time. So will membership continue to decline causing unions to lose even more power? The AFL-CIO is optimistic about union membership, pointing out recent gains in membership among women and immigrants, as well as health care workers, graduate students, and professionals.9
Convincing workers to unionize is still more difficult than it used to be and could become even harder in the future. Given their resistance to being unionized, employers have developed strategies for dissuading workers from unionizing—in particular, tactics for withholding job security. If unionization threatens higher costs for wages and benefits, management can resort to part-time or contract workers. They can also outsource work, eliminating jobs entirely. Many employers are now investing in technology designed to reduce the amount of human labor needed to produce goods or offer services. While it is impossible to predict the future, it is likely that unions and managers will remain adversaries for the foreseeable future.
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Chapter Videos
There are two videos for this chapter, in order to present two opposing points of view as well as some useful history. Pay attention for the historical benefits we take for granted today but that came about as a result of efforts by unions.
A YouTube element has been excluded from this version of the text. You can view it online here: pb.libretexts.org/biz3/?p=129
(Copyrighted material)
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(Copyrighted material)
Key Takeaways
1. Labor unions are organized groups of workers that bargain with employers to improve members’ pay, job security, and working conditions.
2. When there’s a discrepancy between what workers want in terms of salary increases, benefits, working conditions, and job security and what management is willing to give, the two sides engage in a process called collective bargaining.
3. If negotiations break down, the sides may resort to mediation (in which an impartial third party makes recommendations for reaching an agreement) or arbitration (in which the third party imposes a binding agreement).
4. When unionized workers feel that they’ve been treated unfairly, they can file grievances—complaints over contract-related matters that are resolved by union representatives and employee supervisors.
5. If labor differences can’t be resolved through collective bargaining or formal grievance procedures, each side may resort to a variety of tactics. The union can do the following:
1. Call a strike (in which workers leave their jobs until the issue is settled)
2. Organize picketing (in which workers congregate outside the workplace to publicize their position)
3. Arrange for boycotting (in which workers and other consumers are urged to refrain from buying an employer’s products)
6. Management may resort to a lockout—closing the workplace to workers—or call in strikebreakers (nonunion workers who are willing to cross picket lines to replace strikers)
Chapter 13 Text References and Image Credits
Image Credits: Chapter 13
Figure 13.1: Data sources: Gerald Mayer (2004). “Union Membership Trends in the United States.”Cornell University International Labor Relations School (Digital Commons). Retrieved from: http://digitalcommons.ilr.cornell.edu/cgi/viewcontent.cgi?article=1176&context=key_workplace and Bureau of Labor Statistics (2016). “Economic News Release: Table 1. Union affiliation of employed wage and salary workers by selected characteristics.” BLS.gov. Retrieved from: http://www.bls.gov/news.release/union2.t01.htm
Figure 13.2: Brad Perkins (2012). “Fair Contract Now.” CC BY-SA 2.0. Retrieved from: https://www.flickr.com/photos/br5ad/7972608004
Figure 13.3: Keith Allison (2014). “NFL Referees.” CC BY-SA 2.0. Retrieved from: www.flickr.com/photos/keithallison/15391686440
Video Credits: Chapter 13
“Managing in a Union Environment.” (Thomson Reuters Compliance Learning). November 6, 2009. Retrieved from: https://www.youtube.com/watch?v=tPqS-HdqnUg
“The Labor Movement in the United States.” (History). September 26, 2017. Retrieved from: https://www.youtube.com/watch?v=ewu-v36szlE&=&feature=youtu.be | textbooks/biz/Business/Introductory_Business/Book%3A_Fundamentals_of_Business_(Skripak)/13%3A_Union/13.00%3A_Chapter_13_Union_Management_Issues.txt |
Learning Objectives
1. Define the terms marketing, marketing concept, and marketing strategy.
2. Outline the tasks involved in selecting a target market.
3. Identify the four Ps of the marketing mix.
4. Explain how to conduct marketing research.
5. Discuss various branding strategies and explain the benefits of packaging and labeling.
6. Describe the elements of the promotion mix
7. Explain how companies manage customer relationships.
8. Identify the advantages and disadvantages of social media marketing.
A Robot with Attitude
Mark Tilden used to build robots for NASA that ended up being destroyed on Mars, but after seven years of watching the results of his work meet violent ends thirty-six million miles from home, he decided to specialize in robots for earthlings. He left the space world for the toy world and teamed up with Wow Wee Toys Ltd. to create “Robosapien,” an intelligent robot with an attitude.1 The fourteen-inch-tall robot, which is operated by remote control, has great moves. In addition to walking forward, backward, and turning, he dances, raps, and gives karate chops. He can pick up small objects and even fling them across the room, and he does everything while grunting, belching, and emitting other “bodily” sounds.
Robosapien gave Wow Wee Toys a good head start in the toy robot market: in the first five months, more than 1.5 million Robosapiens were sold.2 The company expanded the line to more than a dozen robotics and other interactive toys, including FlyTech Bladestar, a revolutionary indoor flying machine that won a Popular Mechanics magazine Editor’s Choice Award in 2008).3
What does Robosapien have to do with marketing? The answer is fairly simple: though Mark Tilden is an accomplished inventor who has created a clever product, Robosapien wouldn’t be going anywhere without the marketing expertise of Wow Wee. In this chapter, we’ll look at the ways in which marketing converts product ideas like Robosapien into commercial successes.
What Is Marketing?
When you consider the functional areas of business—accounting, finance, management, marketing, and operations—marketing is the one you probably know the most about. After all, as a consumer and target of all sorts of advertising messages, you’ve been on the receiving end of marketing initiatives for most of your life. What you probably don’t appreciate, however, is the extent to which marketing focuses on providing value to the customer. According to the American Marketing Association, “Marketing is the activity, set of institutions, and processes for creating, communicating, delivering, and exchanging offerings that have value for customers, clients, partners, and society at large.”4
In other words, marketing isn’t just advertising and selling. It includes everything that organizations do to satisfy customer needs:
• Coming up with a product and defining its features and benefits
• Setting its price
• Identifying its target market
• Making potential customers aware of it
• Getting people to buy it
• Delivering it to people who buy it
• Managing relationships with customers after it has been delivered
Think about a typical business—a local movie theater, for example. It’s easy to see how the person who decides what movies to show is involved in marketing: he or she selects the product to be sold. It’s even easier to see how the person who puts ads in the newspaper works in marketing: he or she is in charge of advertising—making people aware of the product and getting them to buy it. What about the ticket seller and the person behind the counter who gets the popcorn and soda or the projectionist? Are they marketing the business? Absolutely. The purpose of every job in the theater is satisfying customer needs, and as we’ve seen, identifying and satisfying customer needs is what marketing is all about. Marketing is a team effort involving everyone in the organization.
If everyone is responsible for marketing, can the average organization do without an official marketing department? Not necessarily: most organizations have marketing departments in which individuals are actively involved in some marketing-related activity—product design and development, pricing, promotion, sales, and distribution. As specialists in identifying and satisfying customer needs, members of the marketing department manage—plan, organize, lead, and control—the organization’s overall marketing efforts.
The Marketing Concept
Figure 14.2 is designed to remind you that to achieve company profitability goals, you need to start with three things:
1. Find out what customers or potential customers need.
2. Develop products to meet those needs.
3. Engage the entire organization in efforts to satisfy customers.
At the same time, you need to achieve organizational goals, such as profitability and growth. This basic philosophy—satisfying customer needs while meeting organizational goals—is called the marketing concept, and when it’s effectively applied, it guides all of an organization’s marketing activities.
The marketing concept puts the customer first: as your most important goal, satisfying the customer must be the goal of everyone in the organization. But this doesn’t mean that you ignore the bottom line; if you want to survive and grow, you need to make some profit. What you’re looking for is the proper balance between the commitments to customer satisfaction and company survival. Consider the case of Medtronic, a manufacturer of medical devices, such as pacemakers and defibrillators. The company boasts more than 50 percent of the market in cardiac devices and is considered the industry standard setter.5 Everyone in the organization understands that defects are intolerable in products that are designed to keep people alive. Thus, committing employees to the goal of zero defects is vital to both Medtronic’s customer base and its bottom line. “A single quality issue,” explains CEO Arthur D. Collins Jr., “can deep-six a business.”6
Selecting a Target Market
Businesses earn profits by selling goods or providing services. It would be nice if everybody in the marketplace was interested in your product, but if you tried to sell it to everybody, you’d probably spread your resources too thin. You need to identify a specific group of consumers who should be particularly interested in your product, who would have access to it, and who have the means to buy it. This group represents your target market, and you need to aim your marketing efforts at its members.
Identifying Your Market
How do marketers identify target markets? First, they usually identify the overall market for their product—the individuals or organizations that need a product and are able to buy it. This market can include either or both of two groups:
1. A consumer market—buyers who want the product for personal use
2. An industrial market—buyers who want the product for use in making other products
You might focus on only one market or both. A farmer, for example, might sell blueberries to individuals on the consumer market and, on the industrial market, to bakeries that will use them to make muffins and pies.
Segmenting the Market
The next step in identifying a target market is to divide the entire market into smaller portions, or market segments—groups of potential customers with common characteristics that influence their buying decisions. An especially narrow market segment is known as a niche market, for example, extreme luxury goods that less than 1% of people can afford. Let’s look at some of the most useful categories in detail.
Demographic Segmentation
Demographic segmentation divides the market into groups based on such variables as age, marital status, gender, ethnic background, income, occupation, and education.
Age, for example, will be of interest to marketers who develop products for children, retailers who cater to teenagers, colleges that recruit students, and assisted-living facilities that promote services among the elderly. Lifetime Television for Women targets female viewers, while Telemundo networks targets Hispanics. When Hyundai offers recent college graduates a \$400 bonus towards leasing or buying a new Hyundai, the company’s marketers are segmenting the market according to education level.7
Geographic Segmentation
Geographic segmentation—dividing a market according to such variables as climate, region, and population density (urban, suburban, small-town, or rural)—is also quite common. Climate is crucial for many products: snow shovels would not sell in Hawaii. Consumer tastes also vary by region. That’s why McDonald’s caters to regional preferences, offering a breakfast of Spam and rice in Hawaii, 8 tacos in Arizona, and lobster rolls in Massachusetts.9 Outside the United States, menus diverge even more widely (you can get seaweed burgers or, if you prefer, seasoned seaweed fries in Japan).10
Likewise, differences between urban and suburban life can influence product selection. For example, it’s a hassle to parallel park on crowded city streets. Thus, Toyota engineers have developed a product especially for city dwellers. The Japanese version of the Prius, Toyota’s hybrid gas-electric car, can automatically parallel park itself. Using computer software and a rear-mounted camera, the parking system measures the spot, turns the steering wheel, and swings the car into the space (making the driver—who just sits there—look like a master of parking skills).11 After its success in the Japanese market, the self-parking feature was brought to the United States.
Behavioral Segmentation
Dividing consumers by such variables as attitude toward the product, user status, or usage rate is called behavioral segmentation. Companies selling technology-based products might segment the market according to different levels of receptiveness to technology. They could rely on a segmentation scale developed by Forrester Research that divides consumers into two camps: technology optimists, who embrace new technology, and technology pessimists, who are indifferent, anxious, or downright hostile when it comes to technology.12
Some companies segment consumers according to user status, distinguishing among nonusers, potential users, first-time users, and regular users of a product. Depending on the product, they can then target specific groups, such as first-time users. Credit-card companies use this approach when they offer membership points to potential customers in order to induce them to get their card.
Psychographic Segmentation
Psychographic segmentation classifies consumers on the basis of individual lifestyles as they’re reflected in people’s interests, activities, attitudes, and values. Do you live an active life and love the outdoors? If so, you may be a potential buyer of hiking or camping equipment or apparel. If you’re a risk taker, you might catch the attention of a gambling casino. The possibilities are limited only by the imagination.
Clustering Segments
Typically, marketers determine target markets by combining, or “clustering,” segmenting criteria. What characteristics does Starbucks look for in marketing its products? Three demographic variables come to mind: age, geography, and income. Buyers are likely to be males and females ranging in age from about twenty-five to forty (although college students, aged eighteen to twenty-four, are moving up in importance). Geography is a factor as customers tend to live or work in cities or upscale suburban areas. Those with relatively high incomes are willing to pay a premium for Starbucks specialty coffee and so income—a socioeconomic factor—is also important.
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The Marketing Mix
After identifying a target market, your next step is developing and implementing a marketing program designed to reach it. As Figure 14.4 shows, this program involves a combination of tools called the marketing mix, often referred to as the “four Ps” of marketing:
1. Developing a product that meets the needs of the target market
2. Setting a price for the product
3. Distributing the product—getting it to a place where customers can buy it
4. Promoting the product—informing potential buyers about it
Pricing will be covered in more detail in its own dedicated chapter.
Developing a Product
The development of Robosapien was a bit unusual for a company that was already active in its market.13 Generally, product ideas come from people within the company who understand its customers’ needs. Internal engineers are then challenged to design the product. In the case of Robosapien, the creator, Mark Tilden, had conceived and designed the product before joining Wow Wee Toys. The company gave him the opportunity to develop the product for commercial purposes, and Tilden was brought on board to oversee the development of Robosapien into a product that satisfied Wow Wee’s commercial needs.
Robosapien is not a “kid’s toy,” though kids certainly love its playful personality. It’s a home-entertainment product that appeals to a broad audience—children, young adults, older adults, and even the elderly. It’s a big gift item, and it has developed a following of techies and hackers who take it apart, tinker with it, and even retrofit it with such features as cameras and ice skates.
Conducting Marketing Research
Before settling on a strategy for Robosapien, the marketers at Wow Wee did some homework. First, to zero in on their target market, they had to find out what various people thought of the product. More precisely, they needed answers to questions like the following:
• Who are our potential customers?
• What do they like about Robosapien? What would they change?
• How much are they willing to pay for it?
• Where will they expect to buy it?
• How can we distinguish it from competing products?
• Will enough people buy Robosapien to return a reasonable profit for the company?
The last question would be left up to Wow Wee management, but, given the size of the investment needed to bring Robosapien to market, Wow Wee couldn’t afford to make the wrong decision. Ultimately, the company was able to make an informed decision because its marketing team provided answers to key questions through marketing research—the process of collecting and analyzing the data that are relevant to a specific marketing situation. This data had to be collected in a systematic way. Market research seeks two types of data:
1. Marketers generally begin by looking at secondary data—information already collected, whether by the company or by others, that pertains to the target market.
2. With secondary data in hand, they’re prepared to collect primary data—newly collected information that addresses specific questions.
Secondary data can come from inside or outside the organization. Internally available data includes sales reports and other information on customers. External data can come from a number of sources. The U.S. Census Bureau, for example, posts demographic information on American households (such as age, income, education, and number of members), both for the country as a whole and for specific geographic areas.
Population data helped Wow Wee estimate the size of its potential U.S. target market. Other secondary data helped the firm assess the size of foreign markets in regions around the world, such as Europe, the Middle East, Latin America, Asia, and the Pacific Rim. This data helped position the company to sell Robosapien in eighty-five countries, including Canada, England, France, Germany, South Africa, Australia, New Zealand, Hong Kong, and Japan.
Using secondary data that is already available (and free) is a lot easier than collecting your own information. Unfortunately, however, secondary data didn’t answer all the questions that Wow Wee was asking in this particular situation. To get these answers, the marketing team had to conduct primary research, working directly with members of their target market. First they had to decide exactly what they needed to know, then determine who to ask and what methods would be most effective in gathering the information.
We know what they wanted to know—we’ve already listed example questions. As for whom to talk to, they randomly selected representatives from their target market. There is a variety of tools for collecting information from these people, each of which has its advantages and disadvantages. To understand the marketing-research process fully, we need to describe the most common of these tools:
• Surveys. Sometimes marketers mail questionnaires to members of the target market. The process is time consuming and the response rate generally low. Online surveys are easier to answer and so get better response rates than other approaches.
• Personal interviews. Though time consuming, personal interviews not only let you talk with real people but also let you demonstrate the product. You can also clarify answers and ask open-ended questions.
• Focus groups. With a focus group, you can bring together a group of individuals (perhaps six to ten) and ask them questions. A trained moderator can explain the purpose of the group and lead the discussion. If sessions are run effectively, you can come away with valuable information about customer responses to both your product and your marketing strategy.
Wow Wee used focus groups and personal interviews because both approaches had the advantage of allowing people to interact with Robosapien. In particular, focus-group sessions provided valuable opinions about the product, proposed pricing, distribution methods, and promotion strategies.
Researching your target market is necessary before you launch a new product, but the benefits of marketing research don’t extend merely to brand-new products. Companies also use it when they’re deciding whether or not to refine an existing product or develop a new marketing strategy for an existing product. Kellogg’s, for example, conducted online surveys to get responses to a variation on its Pop-Tarts brand—namely, Pop-Tarts filled with a mixture of traditional fruit filling and yogurt. Marketers had picked out four possible names for the product and wanted to know which one kids and mothers liked best. They also wanted to know what they thought of the product and its packaging. Both mothers and kids liked the new Pop-Tarts (though for different reasons) and its packaging, and the winning name for the product launched in the spring of 2011 was “Pop-Tarts Yogurt Blasts.” The online survey of 175 mothers and their children was conducted in one weekend by an outside marketing research group.14
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Branding
Armed with positive feedback from their research efforts, the Wow Wee team was ready for the next step: informing buyers—both consumers and retailers—about their product. They needed a brand—some word, letter, sound, or symbol that would differentiate their product from similar products on the market. They chose the brand name Robosapien, hoping that people would get the connection between homo sapiens (the human species) and Robosapien (the company’s coinage for its new robot “species”). To prevent other companies from coming out with their own “Robosapiens,” they took out a trademark: a symbol, word, or words legally registered or established by use as representing a company or product. Trademarking requires registering the name with the U.S. Patent and Trademark Office. Though this approach—giving a unique brand name to a particular product—is a bit unusual, it isn’t unprecedented. Mattel, for example, established a separate brand for Barbie, and Anheuser-Busch sells beer under the brand name Budweiser. Note, however, that the more common approach, which is taken by such companies as Microsoft, Dell, and Apple, calls for marketing all the products made by a company under the company’s brand name.
Branding Strategies
Companies can adopt one of three major strategies for branding a product:
1. With private branding (or private labeling), a company makes a product and sells it to a retailer who in turn resells it under its own name. A soft-drink maker, for example, might make cola for Wal-Mart to sell as its Sam’s Choice Cola.
2. With generic branding, the maker attaches no branding information to a product except a description of its contents. Customers are often given a choice between a brand-name prescription drug or a cheaper generic drug with the same formula.
3. With manufacturer branding, a company sells one or more products under its own brand names. Adopting a multiproduct-branding approach, it sells many products under one brand name. Food-maker ConAgra sells soups, frozen treats, and complete meals under its Healthy Choice label. Using a multibranding approach, the company assigns different brand names to products covering different segments of the market. Automakers often use multibranding. The Volkwagen group of brands also includes Audi and Lamborghini.
Branding is used in hotels to allow chains (Marriott, Hyatt, Hilton) to offer hotel brands that meet various customers’ travel needs while still maintaining their loyalty to the chain. The same customer who would choose an Extended Stay hotel with a full kitchen when on a long term assignment might stay at a convention hotel when attending a trade show and then stay in a resort property when traveling with their family. By segmenting different types of hotel locations, amenities, room sizes and décor, hotel chains can meet the needs of a wide variety of travelers. In the past decade “soft” branding has become common to allow unique hotels to take advantage of being part of a chain reservation system and loyalty program. For example, Marriott has over 100 affiliated independent hotels in its Autograph Collection.15
Figure 14.5: Major hotel chains and their brands
Type of Hotel Mariott Hilton Hyatt
Luxury Ritz Carlton
JW Marriott
Waldorf Astoria
Conrad
Park Hyatt
Andaz
Independent Autograph Collection Curio Collection Unbound Collection
Full Service Marriott
Renaissance
Gaylord
Hilton
Canopy
Doubletree
Hyatt
Select Service Courtyard by Marriott
AC Hotels
Hilton Garden Inn
Hampton Inn
Hyatt Place
Extended Stay Residence Inn Homewood Suites Hyatt House
Loyalty programs are heavily used in the hospitality industry, especially airlines and hotels, as part of their Customer Relationship Management programs. Loyalty programs are often targeted to high value business travelers with less price sensitivity. They achieve loyalty status and perks while traveling as well as earning points to use for personal travel rewards. Once a loyalty program member obtains elite status with significant associated perks such as guaranteed room availability, airport club lounge access, etc., the customer is much less likely to use other brands.
Building Brand Equity
Wow Wee went with the multibranding approach, deciding to market Robosapien under the robot’s own brand name. Was this a good choice? The answer would depend, at least in part, on how well the product sells. Another consideration is the impact on Wow Wee’s other brands. If Robosapien fared poorly, its failure would not reflect badly on Wow Wee’s other products. On the other hand, if customers liked Robosapien, they would have no reason to associate it with other Wow Wee products. In this case, Wow Wee wouldn’t gain much from its brand equity—any added value generated by favorable consumer experiences with Robosapien. To get a better idea of how valuable brand equity is, think for a moment about the effect of the name Dell on a product. When you have a positive experience with a Dell product—say, a laptop or a printer—you come away with a positive opinion of the entire Dell product line and will probably buy more Dell products. Over time, you may even develop brand loyalty: you may prefer—or even insist on—Dell products. Not surprisingly, brand loyalty can be extremely valuable to a company. Because of customer loyalty, Apple’s brand tops Interbrand’s Best Global Brands ranking with a value of over \$170 billion. Google’s brand is valued at \$120 billion, the Coca-Cola brand is estimated at more than \$78 billion, and Microsoft and IBM round out the top five, with brands valued at over \$65 billion each.16
Packaging and Labeling
Packaging can influence a consumer’s decision to buy a product or pass it up. Packaging gives customers a glimpse of the product, and it should be designed to attract their attention, with consideration given to color choice, style of lettering, and many other details. Labeling not only identifies the product but also provides information on the package contents: who made it and where or what risks are associated with it (such as being unsuitable for small children).
How has Wow Wee handled the packaging and labeling of Robosapien? The robot is fourteen inches tall, and is also fairly heavy (about seven pounds), and because it’s made out of plastic and has movable parts, it’s breakable. The easiest, and least expensive, way of packaging it would be to put it in a square box of heavy cardboard and pad it with Styrofoam. This arrangement would not only protect the product from damage during shipping but also make the package easy to store. However, it would also eliminate any customer contact with the product inside the box (such as seeing what it looks like). Wow Wee, therefore, packages Robosapien in a container that is curved to his shape and has a clear plastic front that allows people to see the whole robot. Why did Wow Wee go to this much trouble and expense? Like so many makers of so many products, it has to market the product while it’s still in the box.
Meanwhile, the labeling on the package details some of the robot’s attributes. The name is highlighted in big letters above the descriptive tagline “A fusion of technology and personality.” On the sides and back of the package are pictures of the robot in action with such captions as “Dynamic Robotics with Attitude” and “Awesome Sounds, Robo-Speech & Lights.” These colorful descriptions are conceived to entice the consumer to make a purchase because its product features will satisfy some need or want.
Packaging can serve many purposes. The Robosapien package attracts attention to the product’s features. For other products, packaging serves a more functional purpose. Nabisco packages some of its snacks— Oreos, Chips Ahoy, and Lorna Doone’s—in “100 Calorie Packs.” The packaging makes life simpler for people who are keeping track of calories.
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Place
A great deal is involved in getting a product to the place in which it is ultimately sold. If you’re a fast food retailer, for example, you’ll want your restaurants to be in high-traffic areas to maximize your potential business. If your business is selling beer, you’ll want it to be offered in bars, restaurants, grocery stores, convenience stores, and even stadiums. Placing a product in each of these locations requires substantial negotiations with the owners of the space, and often the payment of slotting fees, an allowance paid by the manufacturer to secure space on store shelves.
Retailers are marketing intermediaries that sell products to the eventual consumer. Without retailers, companies would have a much more difficult time selling directly to individual consumers, no doubt at a substantially higher cost. The most common types of retailers are summarized in Figure 14.7 below. You will likely recognize many of the examples provided. It is important to note that many retailers do not fit neatly into only one category. For example, WalMart, which began as a discount store, has added groceries to many of its outlets, also placing it in competition with supermarkets.
Figure 14.7: The Most Common Types of Retailers, with examples
Type of Retailer Description Examples
Category Killer Sells a wide variety of products of a particular type, selling at a low price due to their large scale Dick’s Sporting Goods
Convenience Store Offers food, beverages, and other products, typically in individual servings, at a higher price, and geared to fast service 7-Eleven
Department Store Offers a wide assortment of products grouped into different departments (e.g., jewelry, apparel, perfume) Nordstrom, Macy’s
Discount Store Organized into departments, but offer a range of merchandise generally seen as lower quality and at a much lower price Target, Wal Mart
Specialty Store Offers goods typically confined to a narrow category; high level of personal service and higher prices than other retailers Local running shops or jewelry stores
Supermarket Offers mostly consumer staples such as food and other household items Kroger, Food Lion
Warehouse Club Stores Offers a wide variety of products in a warehouse-style setting; sells many products in bulk; usually requires membership fee Costco, Sam’s Club
Of course, in an age where e-commerce is taking an increasing share of the retail spending dollar, “place” is not always a physical location that the customer visits. Products ordered online ship from manufacturers to distribution centers and then directly on to the end customer without passing through a traditional retail outlet. An emerging trend in retailing is showrooming in which a customer visits a traditional retailer, gets familiar with particular items available, and then orders the item online, often from an unrelated online retailer. The term comes from the fact that the traditional retail outlet has served only as a showroom – a place to view the product, as opposed to a place where the sale is made. As shopping habits change, retailers have been challenged to keep their space relevant and attractive to the ultimate consumer.
Promoting a Product
Your promotion mix—the means by which you communicate with customers—may include advertising, personal selling, sales promotion, and publicity. These are all tools for telling people about your product and persuading potential customers to buy it. Before deciding on an appropriate promotional strategy, you should consider a few questions:
• What’s the main purpose of the promotion?
• What is my target market?
• Which product features should I emphasize?
• How much can I afford to invest in a promotion campaign?
• How do my competitors promote their products?
To promote a product, you need to imprint a clear image of it in the minds of your target audience. What do you think of, for instance, when you hear “Ritz-Carlton”? What about “Motel 6”? They’re both hotel chains, that have been quite successful in the hospitality industry, but they project very different images to appeal to different clienteles. The differences are evident in their promotions. The Ritz-Carlton web site describes “luxury hotels” and promises that the chain provides “the finest personal service and facilities throughout the world.”17 Motel 6, by contrast, characterizes its facilities as “discount hotels” and assures you that you’ll pay “the lowest price of any national chain.”18
Promotional Tools
We’ll now examine each of the elements that can go into the promotion mix— advertising, personal selling, sales promotion, and publicity. Then we’ll see how Wow Wee incorporated them into a promotion mix to create a demand for Robosapien.
Advertising
Advertising is paid, non-personal communication designed to create an awareness of a product or company. Ads are everywhere—in print media (such as newspapers, magazines, the Yellow Pages), on billboards, in broadcast media (radio and TV), and on the Internet. It’s hard to escape the constant barrage of advertising messages; it’s estimated that the average consumer is confronted by about 5,000 ad messages each day (compared with about 500 ads a day in the 1970s).19 For this very reason, ironically, ads aren’t as effective as they used to be. Because we’ve learned to tune them out, companies now have to come up with innovative ways to get through to potential customers. A New York Times article20 claims that “anywhere the eye can see, it’s likely to see an ad.” Subway turnstiles are plastered with ads for GEICO auto insurance, Chinese food containers are decorated with ads for Continental Airways, and parking meters display ads for Campbell’s Soup21 Advertising is still the most prevalent form of promotion.
The choice of advertising media depends on your product, target audience, and budget. A travel agency selling spring-break getaways to college students might post flyers on campus bulletin boards or run ads in campus newspapers. The cofounders of Nantucket Nectars found radio ads particularly effective. Rather than pay professionals, they produced their own ads themselves.22 As unprofessional as this might sound, the ads worked, and the business grew.
Personal Selling
Personal selling refers to one-on-one communication with customers or potential customers. This type of interaction is necessary in selling large-ticket items, such as homes, and it’s also effective in situations in which personal attention helps to close a sale, such as sales of cars and insurance policies.
Many retail stores depend on the expertise and enthusiasm of their salespeople to persuade customers to buy. Home Depot has grown into a home-goods giant in large part because it fosters one-on-one interactions between salespeople and customers. The real difference between Home Depot and everyone else isn’t the merchandise; it’s the friendly, easy-to-understand advice that sales people give to novice homeowners, according to one of its cofounders.23 Best Buy’s knowledgeable sales associates make them “uniquely positioned to help consumers navigate the increasing complexity of today’s technological landscape” according to CEO Hubert Joly.24
Sales Promotion
It’s likely that at some point, you have purchased an item with a coupon or because it was advertised as a buy-one-get-one special. If so, you have responded to a sales promotion – one of the many ways that sellers provide incentives for customers to buy. Sales promotion activities include not only those mentioned above but also other forms of discounting, sampling, trade shows, in-store displays, and even sweepstakes. Some promotional activities are targeted directly to consumers and are designed to motivate them to purchase now. You’ve probably heard advertisers make statements like “limited time only” or “while supplies last”. If so, you’ve encountered a sales promotion directed at consumers. Other forms of sales promotion are directed at dealers and intermediaries. Trade shows are one example of a dealer-focused promotion. Mammoth centers such as McCormick Place in Chicago host enormous events in which manufacturers can display their new products to retailers and other interested parties. At food shows, for example, potential buyers can sample products that manufacturers hope to launch to the market. Feedback from prospective buyers can even result in changes to new product formulations or decisions not to launch.
Publicity and Public Relations
Free publicity—say, getting your company or your product mentioned or pictured in a newspaper or on TV—can often generate more customer interest than a costly ad. When Dr. Dre and Jimmy Iovine were finalizing the development of their Beats headphones, they sent a pair to LeBron James. He liked them so much he asked for 15 more pairs, and they “turned up on the ears of every member of the 2008 U.S. Olympic basketball team when they arrived in Shanghai. ‘Now that’s marketing,’ says Iovine.”25 It wasn’t long before the pricey headphones became a must-have fashion accessory for everyone from celebrities to high school students.
Consumer perception of a company is often important to a company’s success. Many companies, therefore, manage their public relations in an effort to garner favorable publicity for themselves and their products. When the company does something noteworthy, such as sponsoring a fund-raising event, the public relations department may issue a press release to promote the event. When the company does something negative, such as selling a prescription drug that has unexpected side effects, the public relations department will work to control the damage to the company. Each year the Hay Group and Korn Ferry survey more than a thousand company top executives, directors, and industry leaders in twenty countries to identify companies that have exhibited exceptional integrity or commitment to corporate social responsibility. The rankings are publishes annually as Fortune magazine’s “World’s Most Admired Companies.®”26 Topping the list in 2016 are Apple, Alphabet (Google), Amazon, Berkshire Hathaway, and Walt Disney.27
Marketing Robosapien
Now let’s look more closely at the strategy that Wow Wee pursued in marketing Robosapien in the United States. The company’s goal was ambitious: to promote the robot as a must-have item for kids of all ages. As we know, Wow Wee intended to position Robosapien as a home-entertainment product, not as a toy. The company rolled out the product at Best Buy, which sells consumer electronics, computers, entertainment software, and appliances. As marketers had hoped, the robot caught the attention of consumers shopping for TV sets, DVD players, home and car audio equipment, music, movies, and games. Its \$99 price tag was a little lower than the prices of other merchandise, and that fact was an important asset: shoppers were willing to treat Robosapien as an impulse item—something extra to pick up as a gift or as a special present for children, as long as the price wasn’t too high.
Meanwhile, Robosapien was also getting lots of free publicity. Stories appeared in newspapers and magazines around the world, including the New York Times, the Times of London, Time magazine, and National Parenting magazine. Commentators on The Today Show, The Early Show, CNN, ABC News, and FOX News all covered it. The product received numerous awards, and experts predicted that it would be a hot item for the holidays.
At Wow Wee, Marketing Director Amy Weltman (who had already had a big hit with the Rubik’s Cube) developed a gala New York event to showcase the product. From mid- to late August, actors dressed in six-foot robot costumes roamed the streets of Manhattan, while the fourteen-inch version of Robosapien performed in venues ranging from Grand Central Station to city bars. Everything was recorded, and film clips were sent to TV stations.
The stage was set for expansion into other stores. Macy’s ran special promotions, floating a twenty-four-foot cold-air robot balloon from its rooftop and lining its windows with armies of Robosapien’s. Wow Wee trained salespeople to operate the product so that they could help customers during in-store demonstrations. Other retailers, including The Sharper Image, Spencer’s, and Toys “R” Us, carried Robosapien, as did e-retailers such as Amazon.com. The product was also rolled out (with the same marketing flair) in Europe and Asia.
When national advertising hit in September, all the pieces of the marketing campaign came together—publicity, sales promotion, personal selling, and advertising. Wow Wee ramped up production to meet anticipated fourth-quarter demand and waited to see whether Robosapien would live up to commercial expectations.
Interacting with Customers
Customer-Relationship Management
Customers are the most important asset that any business has. Without enough good customers, no company can survive. Firms must not only attract new customers but also retain current customers. In fact, repeat customers are more profitable. It’s estimated that it costs as much as five times more to attract and sell to a new customer than to an existing one.28 Repeat customers also tend to spend more, and they’re much more likely to recommend you to other people.
Retaining customers is the purpose of customer-relationship management—a marketing strategy that focuses on using information about current customers to nurture and maintain strong relationships with them. The underlying theory is fairly basic: to keep customers happy, you treat them well, give them what they want, listen to them, reward them with discounts and other loyalty incentives, and deal effectively with their complaints.
Take Caesars Entertainment Corporation, which operates more than fifty casinos under several brands, including Caesars, Harrah’s, Bally’s, and Horseshoe. Each year, it sponsors the World Series of Poker with a top prize in the millions. Caesars gains some brand recognition when the twenty-two-hour event is televised on ESPN, but the real benefit derives from the information cards filled out by the seven thousand entrants who put up \$10,000 each. Data from these cards is fed into Caesars database, and almost immediately every entrant starts getting special attention, including party invitations, free entertainment tickets, and room discounts. The program is all part of Harrah’s strategy for targeting serious gamers and recognizing them as its best customers.29
Sheraton Hotels uses a softer approach to entice return customers. Sensing that its resorts needed both a new look and a new strategy for attracting repeat customers, Sheraton launched its “Year of the Bed” campaign; in addition to replacing all its old beds with luxurious new mattresses and coverings, it issued a “service promise guarantee”—a policy that any guest who’s dissatisfied with his or her Sheraton stay will be compensated. The program also calls for a customer-satisfaction survey and discount offers, both designed to keep the hotel chain in touch with its customers.30
Another advantage of keeping in touch with customers is the opportunity to offer them additional products. Amazon.com is a master at this strategy. When you make your first purchase at Amazon.com, you’re also making a lifelong “friend”—one who will suggest (based on what you’ve bought before) other things that you might like to buy. Because Amazon.com continually updates its data on your preferences, the company gets better at making suggestions.
Social Media Marketing
In the last several years, the popularity of social media marketing has exploded. You already know what social media is — Facebook, Twitter, LinkedIn, YouTube, and any number of other online sites that allow you to network, share your opinions, ideas, photos, etc. Social media marketing is the practice of including social media as part of a company’s marketing program.
Why do businesses use social media marketing? Before responding, ask yourself these questions: how much time do I spend watching TV? When I watch TV, do I sit through the ads? Do I read newspapers or magazines and flip right past the ads? Now, put yourself in the place of Annie Young-Scrivner, global chief marketing officer of Starbucks. Does it make sense for her to spend millions of dollars to place an ad for Starbucks on TV or in a newspaper or magazine? Or should she instead spend the money on social media marketing initiatives that have a high probability of connecting to Starbucks’s market?
For companies like Starbucks, the answer is clear. The days of trying to reach customers through ads on TV, in newspapers, or in magazines are over. Most television watchers skip over commercials, and few Starbucks’s customers read newspapers or magazines, and even if they do, they don’t focus on the ads. Social media marketing provides a number of advantages to companies, including enabling them to:31
• create brand awareness;
• connect with customers and potential customers by engaging them in two-way communication;
• build brand loyalty by providing opportunities for a targeted audience to participate in company-sponsored activities, such as contests;
• offer and publicize incentives, such as special discounts or coupons;
• gather feedback and ideas on how to improve products and marketing initiatives;
• allow customers to interact with each other and spread the word about a company’s products or marketing initiatives; and
• take advantage of low-cost marketing opportunities by being active on free social sites, such as Facebook.
To get an idea of the power of social media marketing, think of the ALS Ice Bucket Challenge. According to the ALS Association: “the ALS Ice Bucket Challenge started in the summer of 2014 and became the world’s largest global social media phenomenon. More than 17 million people uploaded their challenge videos to Facebook; these videos were watched by 440 million people a total of 10 billion times.”32 The ALS Association raised \$115 million in six weeks (their usual annual budget was only \$20 million).33 To see how companies try to harness this power, let’s look at social media campaigns of two leaders in this field: PepsiCo (Mountain Dew) and Starbucks.
Mountain Dew (PepsiCo)
When PepsiCo announced it wouldn’t show a television commercial during the 2010 Super Bowl game, it came as a surprise (probably a pleasant one to its competitor, Coca-Cola, who had already signed on to show several Super Bowl commercials). What PepsiCo planned to do instead was invest \$20 million into social media marketing campaigns. One of PepsiCo’s most successful social media initiatives has been the DEWmocracy campaign, which two years earlier, resulted in the launch of product—Voltage—created by Mountain Dew fans.34 Now called DEWcision, the 2016 campaign asks fans to vote between two rival flavors of Mountain Dew. The campaign engages a number of social media outlets with challenges for fans to earn votes for their favorite flavor, including Twitter, Instagram, and Facebook.35 The example in Figure 14.14 is for a challenge to dye your hair the color of your favorite flavor, then Tweet the picture with the hashtag #DewDye. According to Mountain Dew’s director of marketing, “PepsiCo looks at social media as the best way to get direct dialog with their fans and for the company to hear from those fans without filters. ‘It’s been great for us to have this really unique dialogue that we normally wouldn’t have,’ he said. ‘It really has opened our eyes up.’”36
Starbucks
One of most enthusiastic users of social media marketing is Starbucks. Let’s look at a few of their promotions: a discount for “Foursquare” mayors and free coffee on Tax Day via Twitter’s promoted tweets and a free pastry day promoted through Twitter and Facebook.37
Discount for “Foursquare” Mayors of Starbucks
This promotion was a joint effort of Foursquare and Starbucks. Foursquare is a mobile social network, and in addition to the handy “friend finder” feature, you can use it to find new and interesting places around your neighborhood to do whatever you and your friends like to do. It even rewards you for doing business with sponsor companies, such as Starbucks. The individual with the most “check in’s” at a particular Starbucks holds the title of mayor. For a period of time, the mayor of each store got \$1 off a Frappuccino. Those who used Foursquare were particularly excited about Starbucks’s nationwide mayor rewards program because it brought attention to the marketing possibilities of the location-sharing app.38
Free Coffee on Tax Day (via Twitter’s Promoted Tweets)
Starbucks was not the only company to give away freebies on Tax Day, April 15, 2010. Lots of others did.39 But it was the only company to spread the message of their giveaway on the then-new Twitter’s Promoted Tweets platform (which went into operation on April 13, 2010). Promoted Tweets are Twitter’s means of making money by selling sponsored links to companies.40 Keeping with Twitter’s 140 characters per tweet rule, Starbucks’s Promoted Tweet read, “On 4/15 bring a reusable tumbler and we’ll fill it with brewed coffee for free. Let’s all switch from paper cups.” The tweet also linked to a page that detailed Starbucks’s environmental initiatives.41
Free Pastry Day (Promoted through Twitter and Facebook)
Starbucks’s “free pastry day” was promoted on Facebook and Twitter.42 As the word spread from person to person in digital form, the wave of social media activity drove more than a million people to Starbucks’s stores around the country in search of free food.43
As word of the freebie offering spread, Starbucks became the star of Twitter, with about 1 percent of total tweets commenting on the brand. That’s almost ten times the number of mentions on an average day. It performed equally well on Facebook’s event page where almost 600,000 people joined their friends and signed up as “attendees.”44 This is not surprising given that Starbucks is the most popular brand on Facebook and has over 36 million “likes” in 2016.45
How did Starbucks achieve this notoriety on Facebook? According to social media marketing experts, Starbucks earned this notoriety by making social media a central part of its marketing mix, distributing special offers, discounts, and coupons to Facebook users and placing ads on Facebook to drive traffic to its page. As explained by the CEO of Buddy Media, which oversees the brand’s social media efforts, “Starbucks has provided Facebook users a reason to become a fan.”46
Social Media Marketing Challenges
The main challenge of social media marketing is that it can be very time consuming. It takes determination and resources to succeed. Small companies often lack the staff to initiate and manage social media marketing campaigns.47 Even large companies can find the management of media marketing initiates overwhelming. A recent study of 1,700 chief marketing officers indicates that many are overwhelmed by the sheer volume of customer data available on social sites, such as Facebook and Twitter.48 This is not surprising given that in 2016, Facebook had more than 1.6 billion active users,49 and five hundred million tweets are sent each day.50 The marketing officers recognize the potential value of this data but are not always capable of using it. A chief marketing officer in the survey described the situation as follows: “The perfect solution is to serve each consumer individually. The problem? There are 7 billion of them.”51 In spite of these limitations, 82 percent of those surveyed plan to increase their use of social media marketing over the next 3 to 5 years. To understand what real-time information is telling them, companies will use analytics software, which is capable of analyzing unstructured data. This software is being developed by technology companies, such as IBM, and advertising agencies.
The bottom line: what is clear is that marketing, and particularly advertising, has changed forever. As Simon Pestridge, Nike’s global director of marketing for Greater China, said about Nike’s marketing strategy, “We don’t do advertising any more. Advertising is all about achieving awareness, and we no longer need awareness. We need to become part of people’s lives, and digital allows us to do that.”52
A New Marketing Model
The 4 P’s have served marketers well for generations, but new innovations can disrupt even the most established concepts. A new framework is taking hold in marketing – the 4 C’s. In this model, each of the C words replaces one of the P’s, flipping the model from the perspective of the marketer to that of the customer. In the new model:
1. Consumer replaces Product: Products solve a need for a customer; by focusing on the consumer in the 4 C’s model, the point of view changes to a customer-based perspective and also allows for the inclusion of services, which are purchased about as often as physical products.
2. Convenience rather than Place: Both words speak to the same point – where can my customers obtain my product or service? But in an age where so many products and services are sourced online, the word “convenience” incorporates more than just a physical location, as was implied by the word “place”.
3. Cost takes the place of Price: From the standpoint of the buyer, the price charged by the seller becomes their cost. Moving to the word “cost” results in seeing things from the perspective of the customer, consistent with other aspects of the model.
4. Communication replaces Promotion: In its most basic form, promotion is about informing potential customers so that they will recognize the value in a product or service and part with the funds necessary to obtain it. However, the word “promotion” also has taken on the context of a deal or discount. By moving to the word “communication”, the new model incorporates all forms of reaching customers, whether through advertising, coupons, social media campaigns, and many others.
The 4 C’s framework appears to be gaining traction, and it may eventually replace the 4 P’s altogether. If so, we will no doubt find ourselves rewriting this entire chapter!
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Chapter Video
Marketing is unfortunately not always truthful or entirely accurate. This video features some examples of misleading advertising which persists in business because it often works.
A YouTube element has been excluded from this version of the text. You can view it online here: pb.libretexts.org/biz3/?p=144
(Copyrighted material)
Key Takeaways
1. Marketing is a set of processes for creating, communicating, and delivering value to customers and for improving customer relationships.
2. A target market is a specific group of consumers who are particularly interested in a product, would have access to it, and are able to buy it.
3. Target markets are identified through market segmentation—finding specific subsets of the overall market that have common characteristics that influence buying decisions.
4. Markets can be segmented on a number of variables including Demographics, Geographics, Behavior, and Psychographics (or lifestyle variables).
5. Developing and implementing a marketing program involves a combination of tools called the marketingmix: product, price, place, and promotion.
6. Before settling on a marketing strategy, marketers often do marketingresearch to collect and analyze relevant data.
7. Methods for collecting primary data include surveys, personalinterviews, and focusgroups.
8. To protect a brand name, companies register trademarks with the U.S. Patent and Trademark Office.
9. There are three major brandingstrategies:
1. With private branding, the maker sells a product to a retailer who resells it under its own name.
2. Under generic branding, a no-brand product contains no identification except for a description of the contents.
3. Using manufacturerbranding, a company sells products under its own brand names.
10. When consumers have a favorable experience with a product, it builds brand equity.
1. If consumers are loyal to it over time, it enjoys brand loyalty.
11. Retailers are intermediaries that sell to the end consumer. Types of retailers include category killers, convenience stores, department stores, discount stores, specialty stores, supermarkets, and warehouse club stores.
12. The promotion mix includes all the tools for telling people about a product and persuading potential customers to buy it. It can include advertising, personal selling, sales promotion, and publicity.
Chapter 14 Text References and Image Credits
Image Credits: Chapter 14
Figure 14.1: Eirik Newth (2006). “Mark Tilden in Oslo, Sept. 1, 2006.” CC BY-2.0. Retrieved from: https://www.flickr.com/photos/eiriknewth/234768064
Figure 14.3: ProjectManhattan (2013). “McDonald’s ebi burger, sold in Singapore in November 2013.” Public Domain. Retrieved from: en.Wikipedia.org/wiki/McDonald%27s#/media/File:Ebi_burger.jpg
Figure 14 .6 : The Gadgeteer (2004). “ Robosapien Robot Review.” The-gadgeteer.com . Retrieved from: http://the-gadgeteer.com/2004/09/03/robosapien_robot_review/
Figure 14.8: MTA Photos (2014). “Subway Station Digital Advertising Screens.” CC BY-2.0. Retrieved from: https://www.flickr.com/photos/61135621@N03/13251000543
Figure 14.9: Intel Free Press (2012). “Ultrabook Zone Best Buy.” CC BY-2.0. Retrieved from: https://www.flickr.com/photos/54450095@N05/8164405406
Figure 14.10: Wal-Mart (2011). “Walmart’s “Action Alley” Display Signs Feature Value and Convenience on Popular Shopping Items.” CC BY-2.0. Retrieved from: https://www.flickr.com/photos/walmartcorporate/5684811762
Figure 14.11:Titanas(2010). “Beats Audio Headphones.” CC BY-2.0. Retrieved from: https://www.flickr.com/photos/titanas/5246996650
Figure 14.12: Jonobacon (2007). “Robosapien.” CC BY-2.0. Retrieved from: https://www.flickr.com/photos/jonobacon/416581867
Figure 14.13: slgckgc (2014). “A person performing the ALS Ice Bucket Challenge.” CC BY-2.0. Retrieved from: en.Wikipedia.org/wiki/Ice_Bucket_Challenge#/media/File:Doing_the_ALS_Ice_Bucket_Challenge_(14927191426).jpg
Figure 14 . 14 : @ AlahnaRad (2016). “# DewDye #Undecided # FlavorsUnite .” Used with permission. Retrieved from: https://twitter.com/AlahnaRad/status/731708982151110656
Figure 14.15:@glethamGIS (2010). “Rewards for Starbucks mayors.” CC BY-2.0. Retrieved from: https://www.flickr.com/photos/gisuser/4616080416
Video Credits: Chapter 14
Top 10 Misleading Marketing Tactics.” (WatchMojo.com). September 24, 2014. Retrieved from: https://www.youtube.com/watch?v=M-HrTC8QCbM | textbooks/biz/Business/Introductory_Business/Book%3A_Fundamentals_of_Business_(Skripak)/14%3A_Marketing_-_Providing_Value_to_Customers.txt |
Learning Objectives
1. Identify pricing strategies that are appropriate for new and existing products
2. Understand the stages of the product life cycle.
Pricing a Product
As introduced in a previous chapter, one of the four Ps in the marketing mix is price. Pricing is such an important aspect of marketing that it merits its own chapter. Pricing a product involves a certain amount of trial and error because there are so many factors to consider. If a product or service is priced too high, many people simply won’t buy it. Or your company might even find itself facing competition from some other supplier that thinks it can beat your price. On the other hand, if you price too low, you might not make enough profit to stay in business. Let’s look at several pricing options that were available to those marketers at Wow Wee who were responsible for pricing Robosapien, an example we introduced earlier. We’ll begin by discussing two strategies that are particularly applicable to products that are being newly introduced.
New Product Pricing Strategies
When Robosapien was introduced to the market, it had little direct competition in its product category. True, there were some “toy” robots available, but they were not nearly as sophisticated. Sony offered a pet dog robot called Aibo, but its price tag of \$1,800 was really high. Even higher up the price-point scale was the \$3,600 iRobi robot made by the Korean company Yujin Robotics to entertain kids and even teach them foreign languages. Parents could also monitor kids’ interactions with the robot through its video-camera eyes; in fact, they could even use the robot to relay video messages telling kids to shut it off and go to sleep.1
Skimming and Penetration Pricing
Because Wow Wee was introducing an innovative product in an emerging market with few direct competitors, it considered one of two pricing strategies:
1. With a skimming strategy, Wow Wee would start off with the highest price that keenly interested customers would pay. This approach would generate early profits, but when competition enters—and it will, because at high prices, healthy profits can be made in the market—Wow Wee would have to lower its price. Even without competition, they would likely lower prices gradually to bring in another group of consumers not willing to pay the initial high price.
2. Using penetration pricing, Wow Wee would initially charge a low price, both to discourage competition and to grab a sizable share of the market. This strategy might give the company some competitive breathing room (potential competitors won’t be attracted to low prices and modest profits). Over time, as its dominating market share discourages competition, Wow Wee could push up its prices.
Other Pricing Strategies
In their search for the best price level, Wow Wee’s marketing managers could consider a variety of other approaches, such as cost-based pricing, demand-based pricing, prestige pricing, and odd-even pricing. Any of these methods could be used not only to set an initial price but also to establish long-term pricing levels.
Before we examine these strategies, let’s pause for a moment to think about the pricing decisions that you have to make if you’re selling goods for resale by retailers. Most of us think of price as the amount that we—consumers—pay for a product. But when a manufacturer (such as Wow Wee) sells goods to retailers, the price it gets is not what we the consumers will pay for the product. In fact, it’s a lot less.
Here’s an example. Say you buy a shirt at the mall for \$40 and that the shirt was sold to the retailer by the manufacturer for \$20. In this case, the retailer would have applied a mark-up of 100 percent to this shirt, or in other words \$20 mark-up is added to the \$20 cost to arrive at its price (hence a 100% markup) resulting in a \$40 sales price to the consumer. Mark-up allows the retailer to cover its costs and make a profit.
Cost-Based Pricing
Using cost-based pricing, Wow Wee’s accountants would figure out how much it costs to make Robosapien and then set a price by adding a profit to the cost. If, for example, it cost \$40 to make the robot, Wow Wee could add on \$10 for profit and charge retailers \$50. Cost-based pricing has a fundamental flaw – it ignores the value that consumers would place on the product. As a result, it is typically only employed in cases where something new or customized is being developed where the cost and value cannot easily be determined before the product is developed. A defense contractor might use cost-based pricing for a new missile system, for example. The military might agree to pay costs plus some agreed amount of profit to create the needed incentives for the contractor to develop the system. Building contractors might also use cost-based pricing to protect themselves from unforeseen changes in a project: the client wanting a home addition would get an estimate of the cost and have an agreement for administrative fees or profit, but if the client changes what they want, or the contractor has unexpected complications in the project, the client will pay for the additional costs.
Demand-Based Pricing
Let’s say that Wow Wee learns through market research how much people are willing to pay for Robosapien. Following a demand-based pricing approach, it would use this information to set the price that it charges retailers. If consumers are willing to pay \$120 retail, Wow Wee would charge retailers a price that would allow retailers to sell the product for \$120. What would that price be? If the 100% mark-up example applied in this case, here’s how we would arrive at it: \$120 consumer selling price minus a \$60 markup by retailers means that Wow Wee could charge retailers \$60. Retailer markup varies by product category and by retailer, so this example is just to illustrate the concept.
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Dynamic Pricing
In the hospitality industry, the supply of available rooms or seats is fixed; it cannot be changed easily. Moreover, once the night is over or the flight has departed, you can no longer sell that room or seat. This fact combined with the variation in demand for rooms or flights on certain days or times (think holidays or special events), has led to dynamic pricing. Revenue management, and the growth of online travel agencies (OTA’s) like Hotwire, Expedia, and Priceline are methods of maximizing revenue for a given night or flight. Hotels and airlines use sophisticated revenue management tools to forecast demand and adjust the availability of various price points. Online travel agents like Hotwire publicize last-minute availability with special rates so that unsold rooms or flights can attract customers and still earn revenue. This approach allows hotels and airlines to maximize revenue opportunities for high demand times such as university graduations and holidays, and also for special events like the Super Bowl or the Olympics. Losses are minimized during low-demand times because unused capacity is offered at a discount, attracting customers who might not have considered travelling at off peak times.
Prestige Pricing
Some people associate a high price with high quality—and, in fact, there generally is a correlation. Thus, some companies adopt a prestige-pricing approach—setting prices artificially high to foster the impression that they’re offering a high-quality product.
Competitors are reluctant to lower their prices because it would suggest that they’re lower-quality products. Let’s say that Wow Wee finds some amazing production method that allows it to produce Robosapien at a fraction of its current cost. It could pass the savings on by cutting the price, but it might be reluctant to do so: what if consumers equate low cost with poor quality?
Odd-Even Pricing
Do you think \$9.99 sounds cheaper than \$10? If you do, you’re part of the reason that companies sometimes use odd-even pricing—pricing products a few cents (or dollars) under an even number. Retailers, for example, might price Robosapien at \$99 (or even \$99.99) if they thought consumers would perceive it as less than \$100.
Loss Leaders
Have you ever seen items in stores that were priced so low that you wondered how the store could make any money? There’s a good chance they weren’t – the store may have been using a loss leader strategy – pricing an item at a loss to draw customers into the store. Once there, store managers hope that the customer will either buy accessories to go along with the new purchase or actually select a different item not priced at a loss. You might have visited the store to buy a specially-priced laptop and ended up leaving with a more expensive one that had a faster processor. Or perhaps you bought the HDTV that was advertised, but then also bought a new surge protector and a streaming player. In either case, you did exactly what the store hoped when they priced the advertised item at a loss.
Bundling
Perhaps you are one of the many customers of a cable television provider that also buys their high-speed internet and/or their phone service. Or when you stop by your favorite fast-food outlet for lunch, maybe you sometimes buy the combo of burger, fries, and a drink. If you do, you’ve experienced the common practice of a bundling strategy – pricing items as a group, or bundle, at a discount to the cost of buying the items separately. Bundling has significant advantages to both buyers and sellers. Obviously, buyers receive the discount. Sellers, on the other hand, can sell more goods and services with this approach. Perhaps you would have settled for a water instead of a soft drink, but the combo price made the soft drink just a few cents more. Without bundling, that soft drink might not have been sold.
If the sale involves some kind of recurring service – like the previously-mentioned example of cable – bundling can also result in higher levels of customer retention. If you decided one day that you wanted to replace your cable with satellite TV, for example, you might well find that the discount from moving to satellite was far less than you expected, because unbundled from cable TV, the price for your internet service could take a substantial jump. If so, like many others who have likely considered making this move, you might find it in your best interests to stick with the original bundled package, no matter how trapped or frustrated you might feel as a result.
The Concept of Mark-Up
Inherent in any pricing strategy is the need to make money – no business would last long selling items or services below cost. A mark-up is simply the amount added to the cost of a product in order to cover indirect costs and provide a profit. For example, if a producer of packaged cookies sold them to convenience stores for 40 cents a unit, and the convenience store resold them for 60 cents, the store would have taken a 20 cent mark-up on the cookies. Mark-up can also be calculated in percentage terms, in which case the percentage is determined from the original cost. In our cookie example, the mark-up is 50% – 20 cents of mark-up divided by the 40 cents that the convenience store paid for them. While the concept of mark-up is most commonly used in a retail setting, it can be applied in any case in which an item is resold by an intermediary that links the producer to the ultimate consumer.
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The Product Life Cycle
Sport utility vehicles (SUVs) are among the most popular categories of passenger car on U.S. roads. Offering an elevated view of the road, the safety that comes with size, spacious interior and cargo areas, and often superior handling performance in bad weather – especially 4-wheel-drive SUVs – it is no wonder that American consumers have bought tens of millions of these vehicles. For a long time, SUV sales followed close to the classical pattern of what is known as the product life cycle:
Yet in 2009, when the economy faltered due to the financial crisis and oil prices surged from about \$40 a barrel to nearly \$80,2 many pundits declared the SUV to be in permanent decline. In fact, the data appeared to support this contention:
As you can see from the figure, SUV sales did in fact decline, rather dramatically. But SUV sales are too critical to the profitability of the major automakers for them to just watch their cash flows disappear.3 Instead, the automakers redesigned their products, including an increased emphasis on smaller SUVs. In fact, the Honda CR-V and the Toyota RAV4, two of the smaller SUV’s on the market, now battle each other for the crown of top-selling SUV in the U.S.4 Many consumers adapted their budgets to compensate for higher oil prices. Sales, particularly of mid-sized SUVs, roared back in 2010, with sales of large SUV’s showing a similar, but smaller, upward trend too.
While their new designs certainly helped to reinvigorate sales, more recently automakers have gotten a somewhat unexpected additional boost from declining oil prices. For all their benefits, SUVs are not the most fuel efficient cars on the market. But as consumers began to pay less at the pump, the cost of operating SUVs declined, and SUV sales have continued to be strong. Automakers continue to invest in new models – for example, German automaker Volkswagen introduced a new 5-seat mid-sized SUV at the Detroit auto show in January, 2015. The company is assembling a group of about 200 experts, including representatives of its dealer network, to help it better cater its offerings to the American market.5
Many products tend to follow the classical product life cycle pattern of Figure 15.4. Let’s take a closer look at the product life cycle and see what we can learn from it. The graph is a simplified depiction of the product life cycle concept. Many products never make it past the introduction stage. Some products avoid or reverse decline by reinventing themselves. In part, reinvention is what the SUV market has experienced, in addition to the boost it has received from lower gas prices.
The Life Cycle and the Changing Marketing Mix
As a product or brand moves through its life cycle, the company that markets it will shift its marketing-mix strategies. Figure 15.6 summarizes the market and industry features of each stage. Let’s see how the mix might be changed to address the differences from one stage to the next.
Figure 15.6: The Product Life Cycle: characteristics of each stage
Stage Introduction Growth Maturity Decline
Price Levels Depends on choice of introductory strategy Converges as competitors enter market Initially high but tend to decline as growth disappears Initially declines but may rise as competitors exit
Number of Competitors Few Rapidly Rising Begins to decline through consolidation Few or one
Industry Profits Negative Rising Highest Declining
Customers Few – Innovators Only Rising – Early Adopters High/Stable, begins to drop late in cycle Declining
Objectives Awareness and Adoption Gain Market Share Defend Share and Maximize Profits Milk Remaining Value, Minimize Investment
Introduction Stage
At the start of the introductionstage, people – other than those who work in the industry – are likely to be completely unaware that a product even exists. Building awareness is a key to adoption of the product. Companies invest in advertising to make consumers aware of their offerings and the benefits of becoming a customer. For many products, the early adopters are people who value newness and innovation. If a company faces only limited competition, it might use a skimming approach to pricing because people who want to be among the first to have the product will generally be willing to pay a higher price (recall that “skimming” means that the company will set initial prices high, and only those consumers who feel especially excited about the product will buy it). The company will then lower prices to appeal to the next layer of consumers – those who wanted the product but were unwilling to pay the high introductory price. The company will continue to gradually lower prices, in effect taking off layer after layer of potential customers until the product is priced low enough to be afforded by the mass market.
If the company has or expects a lot of competition, though, it may decide to use penetration pricing and capture a lot of market share, which may discourage some potential competitors from entering the market at all. The higher the price levels in a market, the more likely it is that new competitors will want to enter.
During the introductory stage, the industry as whole will sell only a relatively small quantity of the product, so competitors will distribute the product through just a few channels. Most retailers charge what is called a “slotting fee” – a payment the manufacturer makes to persuade the retailer to stock the item. If the product fails, they do not offer refunds on these charges, so producers will want to be confident that a product will draw enough customers before they pay these fees and so may limit its initial distribution. Because sales at this stage are low while advertising and other costs are high, all competitors tend to lose money during this stage.
Growth Stage
As the competitors in an industry focus on building sales, successful products will enter a stage of rapid customer adoption, which is not surprisingly called the growth stage in the product life cycle. Depending on how innovative and attractive a product is, the industry might reach the growth stage relatively quickly – or it could take many months or even longer for that point to arrive, if it happens at all. In order for industry sales to increase rapidly, advertising costs will generally be very high during the growth stage. If competition appears, companies may respond by lowering prices to retain their market shares. Competitors will also be looking for channels in which to distribute their products. Where possible, they will try to establish exclusive arrangements with distributors, at least for a period of time, so that their product may be the only one available in a product category at a particular retail outlet. During the growth stage, it is also important for companies to invest in making improvements to their products so as to maintain any advantage they may have established over their competitors. Since sales are rising rapidly during the growth stage, many products begin to turn a profit here, even though they are still investing heavily in advertising, establishing distribution, and refining the product itself.
Maturity Stage
If a product survives the growth stage, it will probably remain in the maturity stage for a long time. Sales still grow in the initial part of this stage, though at a decreasing rate. Later in the maturity stage, sales will plateau and eventually begin to move in a slightly downward direction. By this stage, if not sooner, competitors will have settled on a strategy intended to deliver them a sustainable competitive advantage – either by being the low cost producer of a product, or by successfully differentiating their product from the competition. Since at least one competitor will generally move towards a low-cost strategy, after initially peaking, price levels begin to decline during the maturity stage. Price wars may even occur, but profits still tend to be strong because sales volume remains high.
As the product becomes outdated, the company may make changes in keeping with changing consumer preferences, but usually not as rapidly as in the earlier stages of the life of a product. Branding becomes a key aspect of success in the maturity stage, particularly for those companies seeking to differentiate their products as their source of competitive advantage. Also during the maturity stage, industry consolidation is high; in other words, larger competitors will buy up smaller competitors in order to find synergies and build share and scale economies. Some models of the product life cycle reflect a stage called “shakeout”, which occurs towards the end of the growth and the beginning of the maturity stages. The term shakeout reflects this trend towards industry consolidation. Some competitors survive and others get “shaken out,” either by going out of business or by being acquired by a stronger competitor.
Decline Stage
At some point, virtually every product will reach the decline stage, the point at which sales drop significantly. New innovations, changes in consumer tastes, regulations, and other forces from the macro-level business environment can change the outlook for a product almost overnight. Products with a very short life cycle are known as “fads”. They may move through the entire product life cycle in a matter of months. Many products, particularly those which have experienced a long period in maturity, may stay in the decline phase for years. Ironically, price levels during the decline stage may actually increase, which occurs because the number of competitors is few – in fact, there may be only one remaining, giving that company great pricing power over the few consumers who still want or need the product. New product development is usually very limited, unless a company believes that innovation can restart growth in the category, as we saw with new SUV models. Also, advertising is typically limited or non-existent – those who need the product are likely to know about it already. So while it may seem counter-intuitive, many companies make a lot of money while they are riding the downward shape of the product life cycle curve during the decline stage.
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Key Takeaways
1. There are several pricing strategies appropriate for different product and market situations:
1. A new product can be introduced with a skimming strategy—starting off with a high price that keenly interested customers are willing to pay. The alternative is a penetration strategy, charging a low price, both to keep out competition and to grab as much market share as possible
2. With cost-based pricing, a company determines the cost of making a product and then sets a price by adding a profit to the cost.
3. With demand-based pricing, marketers set the price that they think consumers will pay.
4. Companies use prestige pricing to capitalize on the common association of high price and quality, setting an artificially high price to substantiate the impression of high quality.
5. Finally, with odd-even pricing, companies set prices at such figures as \$9.99 (an odd amount), counting on the common impression that it sounds cheaper than \$10 (an even amount).
2. The stages of development and decline that products go through over their lives is called the product life cycle.
3. The stages a product goes through are introduction, growth, maturity, and decline. A process called shakeout occurs during the transition between growth and maturity, resulting in fewer competitors remaining in the market.
4. As a product moves through its life cycle, the company that markets it will shift its marketing-mix strategies.
Chapter 15 Text References and Image Credits
Image Credits: Chapter 15
Figure 15.1: Kate Nevens (2005). “Aibo.” CC BY-SA 2.0. Retrieved from: https://www.flickr.com/photos/katenev/72775121
Figure 15.2: © BrokenSphere / Wikimedia Commons (2010). “FF XIII Xbox 360 version price tag with gift card offer at Target.” CC BY-SA 3.0Retrieved from: https://commons.wikimedia.org/wiki/File:FF_XIII_Xbox_360_version_price_tag_with_gift_card_offer_at_Target,_Tanforan.JPG
Figure 15.3: Mr. Choppers (2013). “A 2013 Toyota RAV4 XLE AWD.” CC BY-SA 3.0. Retrieved from: en.Wikipedia.org/wiki/Toyota_RAV4#/media/File:2013_Toyota_RAV4_XLE_AWD_front_left.jpg.
Figure 15.5: SUV sales and gas prices: Data sources: Office of Energy Efficiency & Renewable Energy (2016). “Fact #915: March 7, 2016 Average Historical Annual Gasoline Pump Price, 1929-2015.” Energy.gov. Retrieved from: http://energy.gov/eere/vehicles/fact-915-march-7-2016-average-historical-annual-gasoline-pump-price-1929-2015 and United States Department of Transportation Bureau of Transportation Statistics (2013). “Table 1-21: Period Sales, Market Shares, and Sales-Weighted Fuel Economies of New Domestic and Imported Light Trucks (Thousands of vehicles).” U.S. Department of Transportation. Retrieved from: www.rita.dot.gov/bts/sites/r...ble_01_21.html
Figure 15.7: Dr. Ned Sahin (2014). “Dr. Ned Sahin wearing Google Glass.” CC BY_SA 4.0. Retrieved from: commons.wikimedia.org/wiki/File:Dr._Ned_Sahin_wearing_Google_Glass.png
Figure 15.8: JustynaZajdel (2016). “Smartwatch Samsung Gear S2.” CC BY_SA 4.0. Retrieved from: https://commons.wikimedia.org/wiki/File:Smartwatch_Samsung_Gear_S2.jpeg
Figure 15.9: Maurizio Pesce (2014). “OnePlus One vs LG G3 vs Apple iPhone 6 Plus vs Samsung Galaxy Note 4.” CC BY-SA 2.0. Retrieved from: https://www.flickr.com/photos/pestoverde/16324871102
Figure 15.10: Anton Diaz (2008). “Siemens Gigaset A165.” CC BY-SA 3.0. Retrieved from: en.Wikipedia.org/wiki/Push-button_telephone#/media/File:%D0%A0%D0%B0%D0%B4%D0%B8%D0%BE%D1%82%D0%B5%D0%BB%D0%B5%D1%84%D0%BE%D0%BD.jpg | textbooks/biz/Business/Introductory_Business/Book%3A_Fundamentals_of_Business_(Skripak)/15%3A_Pricing_Strategy.txt |
Learning Objectives
1. Understand what tourism is: definition, components, and importance.
2. Understand the economic, social and environmental benefits and costs of tourism.
3. Define hospitality and the pineapple tradition.
4. Identify the types of hotel categories and how they are determined.
5. Examine the different categories of food service operations.
6. Understand the different types of events, meetings and conventions.
Tourism
The tourism industry is often cited as the largest industry in the world, contributing 10% of the world’s GDP. In 2016 there were over 1.2 billion international tourists: that’s a substantial economic impact and movement of goods and services!1 Tourism is also considered an export and is unique in that the consumers come to the product where it is consumed on-site. Before we dig any deeper, let’s explore what the term “tourism” means.
Definition of Tourism
There are a number of ways tourism can be defined. The United Nations World Tourism Organization (UNWTO) embarked on a project from 2005 to 2007 to create a common glossary of terms for tourism. It defines tourism as follows:
A social, cultural and economic phenomenon which entails the movement of people to countries or places outside their usual environment for personal or business/professional purposes. These people are called visitors (which may be either tourists or excursionists; residents or non-residents) and tourism has to do with their activities, some of which imply tourism expenditure.2
In other words, tourism is the movement of people for a number of purposes (whether business or pleasure). It is important to understand the various groups and constituencies involved in this movement. Of course it includes the tourist, but also the vast array of businesses providing goods and services for the tourist, the government and political structure of a destination, and the local residents of the destination community itself. Each of these components are necessary parts of a successful tourism destination and operate within private and public sectors, the built environment, and the natural environment. All these come together to create the processes, activities, and outcomes of tourism.
If it all seems a little overwhelming, it might be helpful to break tourism down into broad industry groups, each of which will be covered in this chapter:
• Accommodation and Lodging
• Food and Beverage Services (F & B)
• Recreation and Entertainment
• Convention & Event Management
• Travel Services
• Private Clubs
Benefits and Costs of Tourism
Tourism impacts can be grouped into three main categories: economic, social, and environmental. These impacts are analyzed using data gathered by businesses, governments, and industry organizations. Some impacts gain more attention than others. It is also important to recognize that different groups and constituencies are impacted differently.
Economic Impacts of Tourism
The tourism industry has a huge economic impact that continues to expand to new markets and destinations. According to the UNWTO, in 2016 “The total export value from international tourism amounted to US\$ 1.5 trillion.”3 Regions with the highest growth in terms of tourism dollars earned (2016 vs 2015) are Africa, Asia and the Pacific, the Americas Europe. Only the Middle East posted negative growth at the time of the report. As well, the UNWTO’s Tourism 2030 Vision report predicts that international arrivals will reach nearly 1.8 billion by 2030.4 Figure 16.2 provides additional information about the impact of tourism worldwide.
Positive impacts from this economic boom include robust foreign exchange, increases in income, and GDP growth. Tourism can also offer diverse employment opportunities, can be developed with local products, and is often compatible with other economic activities within a destination. Tourism often injects money into the community that leads to secondary economic development as well. For example, successful resorts may create the need for a commercial laundry facility or a pet boarding business.
However, there are also negative impacts. Property values may increase to the point of unaffordability for local residents, and the seasonality of the tourism industry may create a feast-or-famine economy. As with any economy, if too many resources are focused on just one industry, communities may be vulnerable to any unexpected economic, social, or environmental changes. One example is the New Jersey shore after the devastation of Hurricane Sandy in 2012. The tourism industry was severely impacted, leaving no economic fallback for local residents.
Social Impacts of Tourism
In addition to the economic benefits of tourism development, positive social impacts include an increase in amenities (e.g., parks, recreation facilities), investment in arts, culture, heritage and tradition, celebration of indigenous communities, and community pride. Tourism also has the potential to break down language, socio-cultural, religious, and political barriers. When developed conscientiously, tourism can, and does, contribute to a positive quality of life for residents and promotes a positive image of the destination.
However, as identified by the United Nations Environment Programme, negative social impacts of tourism can include: change or loss of indigenous identity and values; culture clashes; changes in family structure; conflict within the community for the tourism dollar; and ethical issues, including an increase in sex tourism, crime, gambling, and/or the exploitation of child workers.5
Environmental Impacts of Tourism
Tourism relies on, and greatly impacts, the natural environment in which it operates. In some destinations, there is a great appreciation of the environmental resources as the source of the tourism industry, and as such there are environmental protection policies and plans in place. Tourism has helped to save many delicate ecosystems and their flora and fauna. Preservation of these important resources benefits not only the tourist but also the local residents as well.
Even though many areas of the world are conserved in the form of parks and protected areas, tourism development can still have severe negative economic impacts. According to The United Nations Environment Programme, these can include the depletion of natural resources (water, forests, etc.), pollution (air pollution, noise, sewage, waste and littering), and physical impacts (construction activities, marina development, trampling, loss of biodiversity, and spread of disease).6
The environmental impacts of tourism can reach beyond local areas and have an effect on the global ecosystem. One example is increased air travel, which is often identified as a major contributor to climate change.
Whether positive or negative, tourism is a force for change around the world, and the industry is transforming at a staggering rate.
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Accommodation and Lodging
The Hospitality Industry
When looking at tourism it is important to consider the term hospitality. Some define hospitality as “the business of helping people to feel welcome and relaxed and to enjoy themselves.”7 Simply put, the hospitality industry is the combination of the accommodation and food and beverage groupings, collectively making up the largest segment of the industry.
The pineapple has long been the symbol of hospitality. The Caribs, indigenous people of the Lower Antilles in the Caribbean, first used it as such a symbol. The Spaniards knew they were welcome if a pineapple was placed at the entrance to the village. This symbolism spread across Europe and North America where it became the custom to carve the shape of a pineapple into the columns at the entrance of the plantation.8 Charles Carter added a three and a half foot wooden pineapple to the peak of the roof at Shirley Plantation, the first plantation in Virginia.9 It is now common to see the image of the pineapple as a sign of welcome, warmth and hospitality.
The types of employees and resources required to run an accommodation business — whether it be a hotel, motel, or even a campground — are quite similar. All these businesses need staff to check in guests, provide housekeeping, employ maintenance workers, and provide a place for people to sleep. As such, they can be grouped together under the heading of accommodationand lodging. Figure 16.4 summarizes the various groupings within the industry.
Figure 16.4: The scope of the hospitality industry
Category Examples
Accommodations and Lodging
Hotels & Motels
Resorts
Campgrounds/Cabins
AirBnB/ Home Away
Timeshare
Recreation and Entertainment
Gaming
Theme Parks
Adventure and Outdoor Recreation
Travel Services
Travel Agents/ OTA’s
Airlines
Cruise Ships
Rail/ Bus
Car
EcoTourism
Food and Beverage Services
Restaurants
Catering
Institutional
Conventions and Event Management
Meetings
Expositions
Social and Special Events
Clubs
City
Private Country Clubs
Hotel Types
Hotels are typically referred to by hotel type or other classifications. Hotel type is determined primarily by how it will function and what amenities will be included within the property. Size, location, service levels and type of business or targeted market segments are additional classifications. Industry also classifies hotels by chain scale…separating hotels into categories determined by their average daily rates. Various ownership structures and brand affiliations also differentiate hotels.
Classifications
Hotels may be classified on a number of different variables. Type of Hotel: There are numerous classifications by hotel type including all-inclusive hotels, all-suite properties, B&B/Inns, boutique, convention/conference centers, condo hotels, resort, extended stay, full service, casino, limited service and timeshare properties. Size and Complexity: A hotel can be classified by the number of guest rooms it has; hotel sizes can range from a small boutique hotel with fewer than 50 rooms to a large resort hotel with more than 1,000 rooms. The complexity of the hotel is determined by the volume and number of additional revenue generating functions such as the square feet of available conference space, number of F&B operations and additional services and amenities like pools, fitness centers, spas, golf, etc. Location: The location of a hotel can also determine the type of guest served. An airport hotel may be very different from a city-center property in an urban environment, or a remote island resort or a small quaint bed and breakfast located on top of a mountain. Hotels that specialize in conferences, may locate near entertainment destinations like Las Vegas or Disney theme parks to provide pre-post conference activities for attendees. Service Level: The level of service provided is also a key variable, ranging from an inexpensive budget or economy hotel, (Limited or Focused Service Hotels) which may have limited services and amenities, to upscale and luxury hotels (Full Service Hotels) with many services and a wide range of amenities. Market Segmentation: Figure 16.5 on the next page outlines the characteristics of specific hotel types that have evolved to match the needs of a particular traveler segment. As illustrated, hotels adapt and diversify depending on the markets they desire and need to drive occupancy levels and generate revenues. Some hotels will specialize in a specific market segment, but in today’s competitive environment, most hotels will target a combination of these segments.
Figure 16.5: Types of Hotel Market Segments and their key characteristics
Market Segment Traveler Type Characteristics
Commercial Individual Business Travel High-volume corporate accounts in city or airport properties
Stronger demand Monday through Thursday
Leisure Leisure Travelers – family, tourists
Purpose for travel includes sightseeing, recreation, or visiting friends and relatives
Stronger demand Friday and Saturday nights and all week during holidays and the summer
Meetings and groups Corporate groups, Associations, Social, Military, Education, Religious, and Fraternal groups (aka, SMERF)
Includes meetings, seminars, trade shows, conventions, and gatherings of over 10 people
Peak convention demand is typically spring and fall in most locations
Proximity to a conference center and meeting and banquet space increase this market
Extended stay Business and leisure
Often offers kitchen facilities and living room spaces
Bookings are typically more than five nights
Often business related (e.g., extended health care, construction projects, corporate projects)
Leisure demand driven by a variety of circumstances including family visiting relatives, home renovations, snowbirds escaping winter
There are several other industry related organizations, such as Forbes and AAA which provide Consumer Ratings for individual hotels….another form of classifying a property. Forbes has traditionally awarded 1 to 5 “Stars” and AAA, 1 to 5 “Diamond” ratings. Additionally, many social media applications like Trip Advisor offer hotel property ratings to consumers.
Chain Scale: Smith Travel Research (STR) is an organization that provides the lodging industry with global data benchmarking, analytics and marketplace insights. STR classifies the lodging industry into six chain scale segments according to their respective brand Average Daily Rate (ADR). The six segments are defined as Luxury; Upper Upscale; Upscale; Mid-Scale with F&B (Upper Mid-Scale); Mid-Scale without F&B (Mid-Scale) and Economy. Through STR’s 30 –plus years of service to the hospitality industry, they have developed vital benchmarking performance solutions, established market trend transparency and provided data used by the investment community to support hotel development projects. Their core product, the STAR report, provides hotel owners and operators with comparative performance data between their property and a defined set of market competitors and allows you to follow trends in hotel occupancy, average daily rate (ADR) and revenue per available room (RevPar). Developers, investors, industry analysts, hotel brands and management companies all utilize STR data when determine what type of hotel to build and what location would provide maximum opportunity for success.
The type of ownership, brand affiliation and management are also very important variables in the classification of hotels. Owners may manage their own hotels independently but in today’s competitive environment, they would likely sign a Franchise Agreement with a nationally recognized brand as well as a Management Contract with a hotel management company to manage the property. A hotel chain such as Marriott, Hilton, Hyatt or IHG (Intercontinental Hotel Group) is comprised of multiple brands: Marriott, following their recent merger with Starwood currently has 30 different hotel brands, with each name representing a different level of price, service or targeted market segments.
Branding Decision
Selecting a brand affiliation is one of the most significant decisions hotel owners must make.10 The brand affiliation selected will largely determine the cost of hotel development or conversion of an existing property to meet the standards of the new brand. The affiliation will also determine a number of things about the ongoing operation including the level of services and amenities offered, cost of operation, marketing opportunities or restrictions, and the competitive position in the marketplace. For these reasons, owners typically consider several branding options before choosing to operate independently or to adopt a brand affiliation.
Franchise Agreements
Another managerial and ownership structure is franchising. A hotel franchise enables individuals or investment companies (the franchisee) to build or purchase a hotel and then buy or lease a brand name to become part of a chain of hotels using the franchisor’s hotel brand, image, loyalty program, goodwill, procedures, cost controls, marketing, and reservations systems.11
A franchisee becomes part of a network of properties that use a central reservations system with access to electronic distribution channels, regional and national marketing programs, central purchasing, revenue management support, and brand operating standards. A franchisee also receives training, support, and advice from the franchisor and must adhere to regular inspections, audits, and reporting requirements.
Selecting a franchise structure may reduce investment risk by enabling the franchisee to associate with an established hotel company. Franchise fees can be substantial, and a franchisee must be willing to adhere to the contractual obligations with the franchisor.12 Franchise fees typically include an initial fee paid with the franchise application and continuing fees paid during the term of the agreement. These fees are usually a percentage of revenue but can be set at a fixed fee. The total percentage of sales ranges significantly for hotels from 3.3% – 14.7% with a median of 11.8%.13
Management Contracts
It is common for ownership to utilize a management contract, which is a service offered by a management company to manage a hotel or resort for its owners. Owners have two main options for the structure of a management contract. One is to enter into a management agreement with an independent third-party hotel management company to manage the hotel. There are hundreds of these companies, but some of the large organizations include Aimbridge, Benchmark Hospitality, Crescent Hotels, Interstate Hotels, and White Lodging. A slightly different option is for owners to select a single company to provide both the brand and the expertise to manage the property. Marriott, Hilton, and Hyatt, are companies that provide this second option to owners.
Food and Beverage Services
The food and beverage sector is commonly known to industry professionals by its initials F&B. The F&B sector grew from simple origins to meet the basic needs for food and beverage services to increasing demand for unique experiences and broader options. As the interests of the public became more diverse, so too did the offerings of the F&B sector. The increasing awareness and demand for organic, sustainable, local or craft options as well as special dietary needs in food and beverage continue to challenge this industry. In addition, in order to better attract and serve a diverse array of diners, the F&B industry now consists of a variety of segments. The following is a discussion of each.
Quick Service Restaurants
Formerly known as fast-food restaurants, examples of quick-service restaurants, or QSRs, include Chick-fil-A, Subway, and Pizza Hut. This prominent portion of the food sector generally caters to both residents and visitors, and it is represented in areas that are conveniently accessed by both. Brands, chains, and franchises dominate the QSR landscape. While the sector has made steps to move away from the traditional “fast-food” image and style of service, it is still dominated by both fast food and food fast; in other words, food that is purchased and prepared quickly, and generally consumed quickly as well.
Fast Casual Restaurants
Fast Casual restaurants focus on higher quality ingredients than QSR’s and provide made-to-order food in an environment that does not include table service. Customers usually queue and order at a counter. The seating area is more upscale and comfortable. Examples would include Chipotle Mexican Grill, Panera and Jason’s Deli.
Full-Service Restaurants
Full-service restaurants are perhaps the most fluid of the F&B operation types, adjusting and changing to the demands of the marketplace. Consumer expectations are higher here than with QSRs.14 The menus offered are varied, but in general reflect the image of the restaurant or consumer’s desired experience. Major segments include fine dining, family/casual, ethnic, and upscale casual. Fine dining restaurants are characterized by highly trained chefs preparing complex food items, exquisitely presented. Meals are brought to the table by experienced servers with sound food and beverage knowledge in an upscale atmosphere with table linens, fine china, crystal stemware, and silver-plate cutlery. The table is often embellished with fresh flowers and candles. In these businesses, the average check, which is the total sales divided by number of guests served, is quite high (often reviewed with the cost symbols of three or four dollar signs: \$\$ \$\$\$ or \$\$\$\$ \$\$.) Examples include the Inn at Little Washington, Ruth’s Chris Steakhouse and Capitol Grille.
Casual restaurants serve moderately-priced to upscale food in a more casual atmosphere. Casual dining comprises a market segment between fast casual establishments and fine dining restaurants. Casual dining restaurants often have a full bar with separate bar staff, a larger beer menu and a limited wine menu. This segment is full of chains such as Chili’s, Outback, Red Robin and Cracker Barrel as well as many independent restaurants in regional or local markets.
Family restaurants offer affordable menu items that span a variety of customer tastes. They also have the operational flexibility in menu and restaurant layout to welcome large groups of diners. An analysis of menus in family/casual restaurants reveals a high degree of operational techniques such as menu item cross-utilization, where a few key ingredients are repurposed in several ways. Both chain and independent restaurant operators flourish in this sector. Examples of chains in this category would be Golden Corral, Cici’s Pizza and Ponderosa Steakhouse.
Ethnic restaurants typically reflect the owner’s cultural identity, Vietnamese, Cuban, Thai, etc. The growth and changing nature of this sector reflects the acceptance of various ethnic foods within our communities. Ethnic restaurants generally evolve along two routes: toward remaining authentic to the cuisine of the country of origin or toward larger market acceptance through modifying menu items.15 Examples would be P.F. Chang’s, Tara Thai or Pei Wei.
The original version of this chapter contained H5P content. You may want to remove or replace this element.
Bars, Wineries, and Craft Distilling
The beverage industry continues to evolve as well with a strong focus on local craft beers, wines, cider and distilling. Wineries exist in almost every state, with over 250 in Virginia as of 2015.16 Wine, bourbon, cider trails and brew pub crawls, etc. are used to generate awareness and create experiences for customers. Wineries often use event space or festivals to take advantage of the beauty of the winery and supplement their revenues.
Institutional Food Service
Institutional food service is large scale and often connected to governmental (National Parks) or corporate level organizations. Often run under a predetermined contract, the institutional F&B sector includes:
• Hospitals
• Educational institutions
• Prisons and other detention facilities
• Corporate staff cafeterias
• National Park restaurants and concessions
• Cruise ships
• Airports and other transportation terminals and operations
Examples of companies who focus on Institutional Food Service are Compass, Sodexho, Aramark.
Accommodation Food Service
This sector includes hotel restaurants and bars, room service, and self-serve dining operations (such as a breakfast room). Hotel restaurants are usually open to the public and reliant on this public patronage in addition to business from hotel guests. Collaborations between hotel and restaurant chains have seen reliable pairings such as the combination of Shula’s Steakhouse and Marriott Hotels.
Restaurant Industry Profitability and Cost Control
According to the National Restaurant Association, QSRs have the highest pre-tax profit margin at 6.3%, while full-service restaurants have a margin of 4.7%. There will be significant variances from these percentages at individual locations, even within the same brand.17
Figure 16.14: Restaurant operating expenses as a percent of revenue18
Restaurant Operating Expenses % of Total Revenue
Cost of Food and Beverage Sales 33%
Salaries and Wages (including benefits) 31%
Fixed Costs (rent, taxes, property insurance) 6%
A number of costs influence the profitability of an F&B operation. Some of the key operating expenses (as a percentage of revenue) are detailed in Figure 16.16, above, where food cost and salaries & wages are the two major expenses, each accounting for approximately a third of the total. Other expenses include rental and leasing of venue, utilities, advertising, and depreciation of assets. These percentages represent averages, and will vary greatly by sector and location.
Cost control and containment is essential for all F&B businesses. Demanding particular attention are the labor, food, and beverage costs, also known as the operator’s primary costs. In addition to these big ticket items, there is the cost of reusable operating supplies such as cutlery, glassware, china, and linen in full-service restaurants.
Recreation and Entertainment
Recreation
Recreation can be defined as the pursuit of leisure activities during one’s spare time19 and can include vastly different activities such as golfing, sport fishing, and rock climbing. Defining recreation as it pertains to tourism, however, is more challenging.
Let’s start by exploring some recreation-based terms that are common in the tourism industry. Outdoor recreation can be defined as “outdoor activities that take place in a natural setting, as opposed to a highly cultivated or managed landscape such as a playing field or golf course.”20 This term is typically applied to outdoor activities in which individuals engage close to their community. When these activities are further away, and people must travel some distance to participate in them, they are often described as “adventure tourism”. According to the United Nations World Tourism Organization (UNWTO), adventure tourism is “a trip that includes at least two of the following three elements: physical activity, natural environment, and cultural immersion.”21
Ultimately, categorization is based on a combination of several factors, including manner of engagement in the activity (risk exposure, experience requirement, group or solo activity), the distance travelled to access the activity, and the type of environment (proximity to nature, level of challenge involved) in which the activity occurs.
A 2013 adventure tourism market study discovered that people who travel for adventure experiences tend to be well-educated, with 48% holding a four-year degree or higher credential. They value natural beauty and rank this factor highest when choosing a destination. The most cited reasons for their travel are “relaxation, exploring new places, time with family, and learning about different cultures.”22
Globally, it is estimated that the continents of Europe, North America, and South America account for 70% of adventure tourism, or US\$263 billion in adventure travel spending.23
Entertainment
Entertainment is a very broad category which overlaps with many of the areas discussed elsewhere in this chapter, like hotels and accommodation. Two major types of entertainment that we’ll discuss here are gaming and theme parks.
Gaming
Gaming has grown significantly in the U.S. and globally. The number of casinos in the U.S. has been growing since 2010, and in 2013, there were over 500 commercial casinos, as shown in Figure 16.16. Casinos are found all over the U.S. in major cities, riverboats, and on Native American lands. However, U.S. casino revenue has been relatively flat, while global gaming revenues have been on the increase, largely due to Asian market growth. Most casinos involve other facets of the Hospitality industry such as lodging, F&B, golf, entertainment, spas, etc., but they also have the added challenges of casino operations.
Theme Parks
Theme parks have a long history dating back to the 1500’s in Europe, and have evolved ever since. Today, it is hard not to compare any amusement park destination to Disneyland and Disney World. Opened in 1955 in sunny California, Disneyland set the standard for theme parks. Theme parks outside of California and Florida are often highly seasonable operations challenged with significant staffing and training requirements each year.
Convention and Event Management
A convention is a large meeting of people with similar interests who meet for a period of at least a few days to discuss their field. An event is a gathering at a given place and time, usually of some importance, often celebrating or commemorating a special occasion.
Both conventions and events can be extremely complex projects, which is why, over time, the role of meeting planners has taken on greater importance. The development of education, training programs, and professional designations such as CMPs (Certified Meeting Planners), CSEP (Certified Special Events Professional), and CMM (Certificate in Meeting Management) has led to increased credibility in this business and demonstrates the importance of the sector to the economy.
Meeting planners may be independent contractors hired to facilitate the planning process, work directly for the company full time to coordinate their meeting, or work for hotels, conference centers and event venues directly.
• The various tasks involved in meeting and event planning include:
• Conceptualizing/theming
• Site inspection & selection
• Logistics and planning
• Human resource management
• Security
• Marketing and public relations
• Budgeting and financial management
• Sponsorship procurement
• Management and evaluation
Event Categories
Mega Events
A mega-event is a large scale, highly prestigious event such as the Olympic Games, the FIFA World Cup, or a global economic summit. These events typically gain tremendous media coverage and have major economic impacts on the host location, both positive and negative. High levels of tourism (1 million+ visitors) associated with a mega-event brings revenue, but the revenue may be outweighed by substantial capital and social costs incurred by the host. The events are often awarded to host destinations through a bidding process and gain tremendous media coverage.
Special Events
A special event is a one-time or infrequent specific ritual, presentation, performance, or celebration. Special events are planned and created to mark a special occasion, such as a presidential inauguration or the Queen of England’s 90th birthday. Like mega-events, there may be significant media coverage and economic impact for the host city or destination.
Hallmark Event
A hallmark event is a unique event that is often identified with the location where it is held, like Carnival in Rio de Janeiro or Oktoberfest in Munich. Hallmark events contribute significant economic benefits and even can create a competitive advantage for the host city or destination that attracts tourists.
Festival
A festival is a themed public celebration that conveys, through a kaleidoscope of activities, certain meaning to participants and spectators. Festivals are often celebrations of community or culture and feature music, dance, or dramatic performances. Examples include Lollapalooza, the Cannes Film Festival, and Junkanoo in the Bahamas.
Local Community Events
A local community event is generated by and for locals; although it may attract tourists, its main audience is the local community. The community may experience measurable economic impacts, as might happen at The Steppin’ Out Street Fair in Blacksburg (think hotel stays and eating out). Fundraisers and community picnics are also examples in this category.
Meetings and Conventions
The tourism industry also has a long history of creating, hosting, and promoting meetings and conventions that draw business travelers. In fact, Convention and Visitor Bureau’s (CVB’s) work hard to attract these meetings and conventions to their city to drive economic benefit for hotels, restaurants, entertainment venues, etc.
There are several types of such events.
Conventions generally have very large attendance, and are held on a regular schedule but in different locations. They also often require a bidding process. Political conventions are one such example.
Association Meetings or Conferences are held regionally and nationally for hundreds of associations or events focused on specific themes. Examples would be the National Restaurant Association Annual Convention, ComicCon, or the National Auto Show.
Corporate Meetings will vary significantly in size and purpose and include regional or national sales meetings, shareholder meetings, training sessions, or celebrations. The location will vary depending on the nature of the meeting. They may be held at an airport property, a traditional corporate meeting facility or even an upscale resort.
Trade Shows and Trade Fairs can be stand-alone events, or adjoin a convention or conference.
Seminars, Workshops, and Retreats are examples of smaller-scale events.
As meeting planners have become more creative, meeting and convention delegates have been more demanding about meeting sites. No longer are hotel meeting rooms and convention centers the only type of location used; non-traditional venues have adapted and become competitive in offering services for meeting planners. These include architectural spaces such as airplane hangars, warehouses, or rooftops and experiential venues such as aquariums, museums, and galleries.24
Travel Services
Transportation and travel services are another large element of the tourism industry. This area includes cruise ships, airlines, rail, car rentals, and even ride sharing such as Uber and Lyft. Each of these segments is impacted significantly by fuel costs, safety issues, load factors and government regulation.
Cruises
If you’ve ever been on a cruise, you are in good company. According to CLIA (Cruise Lines International Association), 23 million passengers were expected to go on a cruise worldwide on 62 member lines in 2015.25 The industry employs over 900,000 people.26
Over 55% of the world’s cruise passengers are from North America, and the leading destinations (based on ship deployments), according to CLIA are:27
• The Caribbean (36%)
• The Mediterranean (20%)
• Northern Europe (11%)
• Australia/New Zealand (6%)
• Alaska (6%)
• Asia (5%)
• South America (3%)
Travel Services
The travel services sector is made up of a complex web of relationships between a variety of suppliers, tourism products, destination marketing organizations, tour operators, and travel agents, among many others. Under the North American Industry Classification System (NAICS), the travel services industry group includes “establishments primarily engaged in travel arrangement and reservation services. Examples … are tourist and travel agencies; travel tour operators and wholesale operators; convention and visitors’ bureaus; airline, bus, railroad and steamship ticket offices; sports and theatrical ticket offices; and airline, hotel and restaurant reservation offices.”28 Tourism services support industry development and the delivery of guest experiences.
Travel Agencies
A travel agency is a business that operates as the intermediary between the travel industry (supplier) and the traveler (purchaser). Part of the role of the travel agency is to market prepackaged travel tours and holidays to potential travelers. The agency can further function as a broker between the traveler and hotels, car rentals, and tour companies.29 Travel agencies can be small and privately owned or part of a larger entity.
Online travel agencies (OTAs)
Online travel agents (OTAs) are companies that aggregate accommodations and transportation options and allow users to choose one or many components of their trip based on price or other incentives. Examples of OTAs include Booking.com, Expedia.com, Hotwire.com, and Kayak.com. OTAs are gaining popularity with the travelling public; in 2012, they reported online sales of almost \$100 billion30 and almost triple that figure, upward of \$278 billion, in 2013.31 Over 40% of U.S. travelers booked flights online in 2014.32
Tour operators
A tour operator packages all or most of the components of an offered trip and then sells them to the traveler. These packages can also be sold through retail outlets or travel agencies.33 Tour operators work closely with hotels, transportation providers, and attractions in order to purchase large volumes of each component and package these at a better rate than the traveler could by purchasing individually.
Destination marketing organizations (DMOs)
Destination marketing organizations (DMOs) include national tourism boards, state/provincial tourism offices, and community convention and visitor bureaus around the world. DMOs promote “the long-term development and marketing of a destination, focusing on convention sales, tourism marketing and service”34.
Country Clubs
Country clubs are another part of the Hospitality industry with a very different service strategy focusing on serving members who will develop relationships with the staff compared to a more transactional service interaction in lodging, restaurants or airlines.
Country clubs do not focus as strongly on profit as they do on maximizing member satisfaction, retention and growth while maintaining an attractive fee structure. Country (or city) clubs, will typically have restaurant and bar operations, catered events and other amenities such as golf, tennis, pool, fitness facilities, etc. Depending on the type of club, family and youth events are important to maintain and grow membership.
Strong customer service, culinary, event management and general management skills are necessary to be successful in clubs.
Chapter Video
As in any other fast-moving industry, the landscape in Hospitality and Tourism is always changing. This video explores 10 of the more important current trends impacting the industry.
A YouTube element has been excluded from this version of the text. You can view it online here: pb.libretexts.org/biz3/?p=175
(Copyrighted material)
Key Takeaways
1. The Tourism industry is the largest industry in the world with significant benefit and costs to a region. The global competition for the tourism dollar is significant within the US and between countries.
2. Hotels vary significantly in size, quality, purpose, chain affiliation, and ownership. The complexity of the operation and leadership vary as well.
3. Food and Beverage is made up of a wide variety of restaurant types from QSR, Fast Casual, Fine Dining and Ethnic. Institutional food service in business, hospitals, education, parks and concessions are a significant part of the Food and Beverage industry.
4. The evolution of tastes and consumer expectations in food and beverage continue to provide opportunity and challenges in the industry for ethnic sustainable, organic, local, craft, and other unique experiences.
Chapter 16 References and Image Credits
Portions of this chapter were adapted from Westcott, Morgan (Ed) Introduction to Tourism and Hospitality in BC. CC BY 4.0 https://opentextbc.ca/introtourism Available for free at: http://open.bccampus.ca
Image Credits: Chapter 16
Figure 16.1: JackMac34 (2015). “Untitled.” Public domain. Retrieved from: pixabay.com/en/italy-burano-postcards-971575/
Figure 16.2: “The Impact of Global Tourism.” (2016) Data retrieved from: www2.unwto.org/content/why-tourism
Figure 16.3: Yellowute (2007). “Shirley Plantation.” Public domain. Retrieved from: https://commons.wikimedia.org/wiki/File:Shirley_Plantation_2006.jpg
Figure 16.6 “Example of a Hotel Market segmentation by STR’s chain scale” Author’s own work. Licensed CC BY 4.0.
Figure 16.7: Christina Hsu (2009). “San Diego City and Bay at Night.” CC BY-NC-SA 2.0. Retrieved from: https://flic.kr/p/6KZ5Cv
Figure 16.8: Anastasia Cortes (2016). “The Inn at Virginia Tech.” Public domain. Provided by author.
Figure 16.9: Dale Cruse (2014). “New Zealand langoustines at Troquet.” CC BY-NC-SA 2.0. Retrieved from: https://www.flickr.com/photos/dalecruse/8551895022/
Figure 16.10: Imzadi1979 (2012). “An example of a typical American logo sign.” Public domain photograph. Retrieved from: en.Wikipedia.org/wiki/Logo_sign#/media/File:Logo_Sign.svg
Figure 16.11: J. Winters (2008) “A Red Robin Restaurant in Tukwila, Washington.” Public domain photograph. Retrieved from: https://commons.wikimedia.org/wiki/File:Red_Robin_in_Tukwila,_Washington.jpg
Figure 16.12: “Le Procope.” © Michael Rys. CC BY-NC-SA 2.0. Retrieved from: en.m.Wikipedia.org/wiki/Restaurant#/media/File%3AInside_Le_Procope.jpg
Figure 16.13 “The restaurant industry career path” Author’s own work. Licensed CC BY 4.0.
Figure 16 .15 : JohnSM (2013). “Rafting in Turkey.” Public domain. Retrieved from: https://pixabay.com/en/rafting-turkey-travel-1125213/
Figure 16 .16 : Graph data sources: Statista (2016). “ Number of commercial casinos in the United States from 2005 to 2013.” Retrieved from: http://www.statista.com/statistics/187972/number-of-us-commercial-casinos-since-2005/ and “ Global casino gaming revenue from 2006 to 2015 (in billion U.S. dollars).” Retrieved from: http://www.statista.com/statistics/271577/global-casino-gaming-market-revenue/ and “ U.S. casino gaming market revenue from 2004 to 2015 (in billion U.S. dollars) .” Retrieved from: http://www.statista.com/statistics/271583/casino-gaming-market-in-the-us/
Figure 16 .17 : Josh Hallett (2009). “ The ‘Big Bang’ at Wishes – Magic Kingdom – Walt Disney World .” CC BY-NC-SA 2.0 . Retrieved from: https://www.flickr.com/photos/hyku/3830182777
Figure 16.18: Peter23 (2011). “Beijing National Stadium.” CC BY-SA 3.0. Retrieved from: en.Wikipedia.org/wiki/Beijing_National_Stadium#/media/File:Beijing_national_stadium.jpg
Figure 16.19: Skeeze (2014). “Mardi Gras in New Orleans.” Public domain. Retrieved from: pixabay.com/en/mardi-gras-new-orleans-festival-1176483/
Figure 16 . 20 : Roger W. (2012). “ Charlotte Amalie – Panorama (Postcard) CC BY-NC-SA 2.0 . Retrieved from: https://www.flickr.com/photos/24736216@N07/7170231567
Figure 16.21: Dan Perry (2006). “Riviera Country Club in Pacific Palisades, California.” CC BY-NC-SA 2.0. Retrieved from: en.Wikipedia.org/wiki/Country_club#/media/File:Riviera_Country_Club,_Golf_Course_in_Pacific_Palisades,_California_(168828797).jpg
Video Credits: Chapter 16
Sisyanti, Ling Ling, Wasim Amsal,Ella Qiu, and Rebecca Catherine Stephany. “10 trends in Hospitality and Tourism Industry.” February 6, 2015. Retrieved from: https://www.youtube.com/watch?v=SJ8Momwv7Qk | textbooks/biz/Business/Introductory_Business/Book%3A_Fundamentals_of_Business_(Skripak)/16%3A_Hospitality_and_Tourism.txt |
Learning Objectives
1. Define accounting and explain the differences between managerial accounting and financial accounting.
2. Identify some of the users of accounting information and explain how they use it.
3. Explain the function of the income statement.
4. Explain the function of the balance sheet.
5. Calculate a break-even point given the necessary information.
6. Evaluate a company’s performance using financial statements and ratio analysis.
Apple Inc. is the most valuable company in the world. This statement is based on market value, which in June 2016 was roughly $500 billion. Although markets can fluctuate, sometimes wildly, if you are reading this chapter for a course later in 2016 or in 2017, it is not unlikely that Apple will have retained its leadership position. Its value as of June 2016 was more than$40 billion greater than that of the next largest company, Alphabet, the parent company of Google. Apple has briefly ceded the leadership position to Alphabet on a couple of occasions, but for the most part, it has been the leader for quite some time.1
You may wonder what kind of information is used to make these determinations. How does the market know that Apple should be valued more than $100 billion higher than Exxon-Mobil, for example?2 Do investors just make their decisions on instinct? Well, some do, but it’s not a formula for sustained success. In most cases, in deciding how much to pay for a company, investors rely on published accounting and financial information released by publicly-traded companies. This chapter will introduce you to the subject of accounting and financial information so you can begin to get an understanding for how the valuation process works. The Role of Accounting Accounting is often called “the language of business” because it communicates so much of the information that owners, managers, and investors need to evaluate a company’s financial performance. These people are stakeholders in the business—they’re interested in its activities because they’re affected by them. The financial futures of owners and other investors may depend heavily on strong financial performance from the business, and when performance is poor, managers may be replaced or laid off in a downsizing. In fact, a key purpose of accounting is to help stakeholders make better business decisions by providing them with financial information. You shouldn’t try to run an organization or make investment decisions without accurate and timely financial information, and it is the accountant who prepares this information. More importantly, accountants make sure that stakeholders understand the meaning of financial information, and they work with both individuals and organizations to help them use financial information to deal with business problems. Actually, collecting all the numbers is the easy part. The hard part is analyzing, interpreting, and communicating the information. Of course, you also have to present everything clearly while effectively interacting with people from every business discipline. In any case, we’re now ready to define accounting as the process of measuring and summarizing business activities, interpreting financial information, and communicating the results to management and other decision makers. Fields of Accounting Accountants typically work in one of two major fields. Management accountants provide information and analysis to decision makers inside the organization in order to help them run it. Financial accountants furnish information to individuals and groups both inside and outside the organization in order to help them assess its financial performance. Their primary focus, however, is on external parties. In other words, management accounting helps you keep your business running while financial accounting tells the outside world how well you’re running it. Management Accounting Management accounting, also known as managerial accounting, plays a key role in helping managers carry out their responsibilities. Because the information that it provides is intended for use by people who perform a wide variety of jobs, the format for reporting information is flexible. Reports are tailored to the needs of individual managers, and the purpose of such reports is to supply relevant, accurate, timely information that will aid managers in making decisions. In preparing, analyzing, and communicating such information, accountants work with individuals from all the functional areas of the organization—human resources, operations, marketing, etc. Financial Accounting Financial accounting is responsible for preparing the organization’s financial statements—including the income statement, the statement of owner’s equity, the balance sheet, and the statement of cash flows—that summarize a company’s past performance and evaluate its current financial condition. If a company is traded publicly on a stock market such as the NASDAQ, these financial statements must be made public, which is not true of the internal reports produced by management accountants. In preparing financial statements, financial accountants adhere to a uniform set of rules called generally accepted accounting principles (GAAP)—the basic principles for financial reporting issued by an independent agency called the Financial Accounting Standards Board (FASB). Users want to be sure that financial statements have been prepared according to GAAP because they want to be sure that the information reported in them is accurate. They also know that when financial statements have been prepared by the same rules, they can be compared from one company to another. While companies headquartered in the United States follow U.S.-based GAAP, many companies located outside the United States follow a different set of accounting principles called International Financial Reporting Standards (IFRS). These multinational standards, which are issued by the International Accounting Standards Board (IASB), differ from U.S. GAAP in a number of important ways, but we’re not at the point yet of exploring these sometimes fine distinctions. Bear in mind, however, that, according to most experts, a single set of worldwide standards will eventually emerge to govern the accounting practices of both U.S. and non-U.S. companies. Who Uses Financial Accounting Information? The users of managerial accounting information are pretty easy to identify—basically, they’re a firm’s managers. We need to look a little more closely, however, at the users of financial accounting information, and we also need to know a little more about what they do with the information that accountants provide them. Owners and Managers In summarizing the outcomes of a company’s financial activities over a specified period of time, financial statements are, in effect, report cards for owners and managers. They show, for example, whether the company did or didn’t make a profit and furnish other information about the firm’s financial condition. They also provide some information that managers and owners can use in order to take corrective action, though reports produced by management accountants offer a much greater level of depth. Investors and Creditors Investors and creditors furnish the money that a company needs to operate, and not surprisingly, they want to know how that business is performing. Because they know that it’s impossible to make smart investment and loan decisions without accurate reports on an organization’s financial health, they study financial statements to assess a company’s performance and to make decisions about continued investment. According to the world’s most successful investor, Warren Buffett, the best way to prepare yourself to be an investor is to learn all the accounting you can. Buffett, chairman and CEO of Berkshire Hathaway, a company that invests in other companies, turned an original investment of$10,000 into a net worth of $66 billion3 in four decades, and he did it, in large part, by paying close attention to financial accounting reports. Government Agencies Businesses are required to furnish financial information to a number of government agencies. Publicly-owned companies, for example—the ones whose shares are traded on a stock exchange—must provide annual financial reports to the Securities and Exchange Commission (SEC), a federal agency that regulates stock trades and which is charged with ensuring that companies tell the truth with respect to their financial positions. Companies must also provide financial information to local, state, and federal taxing agencies, including the Internal Revenue Service (IRS). Other Users A number of other external users have an interest in a company’s financial statements. Suppliers, for example, need to know if the company to which they sell their goods is having trouble paying its bills or may even be at risk of going under. Employees and labor unions are interested because salaries and other forms of compensation are dependent on an employer’s performance. Figures 17.2 and 17.4 illustrate the main users of management and financial accounting and the types of information produced by accountants in the two areas. In the rest of this chapter, we’ll learn how to prepare a set of financial statements and how to interpret them. We’ll also discuss issues of ethics in the accounting communities and career opportunities in the accounting profession. The original version of this chapter contained H5P content. You may want to remove or replace this element. Understanding Financial Statements We hope that, so far, at least one thing is clear: If you’re in business, you need to understand financial statements. The law no longer allows high-ranking executives to plead ignorance or fall back on delegation of authority when it comes to responsibility for a firm’s financial reporting. In a business environment tainted by episodes of fraudulent financial reporting and other corporate misdeeds, top managers are now being held responsible for the financial statements issued by the people who report to them. Top managers need to know how well the company is performing. Financial information helps managers identify signs of impending trouble before it is too late. The Function of Financial Statements Put yourself in the place of Connie in Figure 17.5 on the next page, who runs Connie’s Confections out of her home. She loves what she does, and she feels that she’s doing pretty well. In fact, she has an opportunity to take over a nearby store at very reasonable rent, and she can expand by getting a modest bank loan and investing some more of her own money. So it’s decision time for Connie: She knows that the survival rate for start-ups isn’t very good, and before taking the next step, she’d like to get a better idea of whether she’s actually doing well enough to justify the risk. The basic financial statements will give her some answers. Since this book is for an introductory course, we will focus our attention on the income statement and balance sheet only, even though we mentioned other financial statements earlier in the chapter. Toying with a Business Idea To bring this concept closer to home, let’s assume that you need to earn money while you’re in college and that you’ve decided to start a small business. Your business will involve selling stuff to other college students, and to keep things simple, we’ll assume that you’re going to operate on a “cash” basis: you’ll pay for everything with cash, and everyone who buys something from you will pay in cash. You may have at least a little cash on you right now—some currency, or paper money, and coins. In accounting, however, the term cash refers to more than just paper money and coins. It also refers to the money that you have in checking and savings accounts and includes items that you can deposit in these accounts, such as money orders and different types of checks. Your first task is to decide exactly what you’re going to sell. You’ve noticed that with homework, exams, social commitments, and the hectic lifestyle of the average college student, you and most of the people you know always seem to be under a lot of stress. Sometimes you wish you could just lie back between meals and bounce a ball off the wall. And that’s when the idea hits you: Maybe you could make some money by selling a product called the “Stress-Buster Play Pack.” Here’s what you have in mind: you’ll buy small toys and other fun stuff—instant stress relievers—at a local dollar store and pack them in a rainbow-colored plastic treasure chest labeled “Stress-Buster.” The Accounting Equation To begin keeping track of your company financially, you’ll first need to understand the fundamental accounting equation: Assets = Liabilities + Owner’s Equity Think of assets as things owned by your business – cash in the bank, product inventory, etc. And think of liabilities as the amounts owed – perhaps you’ve had a job where your pay check came a couple of weeks after you did the work; during that unpaid window, the amount due to you was a liability to your employer. Owner’s equity represents the value of the firm according to your financial statements; obviously it is good to own more than you owe. This simple but important equation highlights the fact that a company’s assets came from somewhere: either from investments made by the owners (owner’s equity) or from loans (liabilities). This means that the asset section of the balance sheet on the one hand and the liability and owner’s-equity section on the other must be equal, or balance. Let’s say you have$200 in cash and borrow $400 from your parents and plan to buy a month’s worth of plastic treasure chests and toys. After that, you’ll use the cash generated from sales of Stress-Buster Play Packs to replenish your supply. You open a bank account for your new business and create your opening financial statement – the balance sheet. The Balance Sheet A balance sheet reports the following information: • Assets: the resources from which it expects to gain some future benefit • Liabilities: the debts that it owes to outside individuals or organizations • Owner’s equity: the investment in the business At the time you open the account, your balance sheet would look like this: Figure 17.6: Stress-Buster’s balance sheet as of September 1, 2019 Stress-Buster Company Balance Sheet As of September 1, 2019 Assets Cash$600
Liabilities and Owner’s Equity
Liabilities 400
Owner’s Equity 200
Total Liabilities and Owner’s Equity $600 The amount you owe your parents is a liability to you, and your own investment of$200 in the business is represented by your owner’s equity.
Now it is time to start buying toys, repackaging them, and selling your Stress-Busters. Each plastic chest will cost $1.00, and you’ll fill each one with a variety of five simple toys, all of which you can buy for$1.00 each.
You plan to sell each Stress-Buster Play Pack for $10 from a rented table stationed outside a major dining hall. Renting the table will cost you$20 a month. In order to make sure you can complete your school work, you decide to hire fellow students to staff the table at peak traffic periods. They’ll be on duty from noon until 2:00 p.m. each weekday except Fridays, and you’ll pay them a generous $7.50 an hour. Wages, therefore, will cost you$240 a month (2 hours × 4 days × 4 weeks = 32 hours × $7.50). Finally, you’ll run ads in the college newspaper at a monthly cost of$40. Thus your total monthly costs will amount to $300 ($20 + $240 +$40).
The Income Statement
Let’s say that during your first month, you sell one hundred play packs. Not bad, you say to yourself, but did I make a profit? To find out, you prepare an income statement showing revenues, or sales, and expenses—the costs of doing business. You divide your expenses into two categories:
• Cost of goods sold: the total cost of the goods that you’ve sold
• Operating expenses: the costs of operating your business except for the costs of things that you’ve sold.
Now you need to do some subtracting:
• The difference between sales revenue and cost of goods sold is your gross profit, also known as gross margin.
• The difference between gross profit and operating expenses is your net income or profit, which is the proverbial “bottom line.” Note we’ve assumed you’re making money, but businesses can also have a net loss.
Figure 17.7 is your income statement for the first month. (Remember that we’ve made things simpler by handling everything in cash.)
Figure 17.7: Stress-Buster’s income statement for September 2019
Stress-Buster Company
Income Statement
Month Ended September 30, 2019
Sales (100x$10.00)$1,000
Less cost of goods sold (100x$6) 600 Gross profit (100x ($10 -$6)) 400 Less operating expenses Salaries 240 Advertising 40 Table rental 20 300 Net income (Profit) ($400-$300)$100
Did You Make Any Money?
What does your income statement tell you? It has provided you with four pieces of valuable information:
You sold 100 units at $10 each, bringing in revenues or sales of$1,000.
Each unit that you sold cost you $6—$1 for the treasure chest plus 5 toys costing $1 each. So your costofgoodssold is$600 (100 units × $6 per unit). Your gross profit—the amount left after subtracting cost of goods sold from sales—is$400 (100 units × $4 each). After subtracting operatingexpenses of$300—the costs of doing business other than the cost of products sold—you generated a positive netincome or profit of $100. Whereas your balance sheet tells you what you have at a specific point in time, your income statement tells you how much income you earned over some period of time, in this case, the month of September. The original version of this chapter contained H5P content. You may want to remove or replace this element. Companies prepare financial statements on at least a twelve-month basis—that is, for a fiscal year which ends on December 31 or some other logical date, such as June 30 or September 30. Fiscal years can vary because companies generally pick a fiscal-year end date that coincides with the end of a peak selling period; thus a crabmeat processor might end its fiscal year in October, when the crab supply has dwindled. Most companies also produce financial statements on a quarterly or monthly basis. For Stress-Buster, you’ll want to prepare them monthly to stay on top of how your new business is doing. Let’s prepare a new balance sheet to how things have changed by the end of the month. Recall that Stress- Buster earned$100 during the month of September and that you decided to leave these earnings in the business. This $100 profit increases two items on your balance sheet: the assets of the company (its cash) and your investment in it (its owner’s equity). Figure 17.8 shows what your balance sheet will look like on September 30. You now have$700 in cash: $400 that you borrowed plus$300 that you’ve invested in the business (your original $200 investment plus the$100 profit from the first month of operations, which you’ve kept in the business).
Figure 17.8: Stress-Buster’s balance sheet at the end of September 2019
Stress-Buster Company
Balance Sheet
As of September 30, 2019
Assets
Cash (original $600 plus$100 earned) $700 Liabilities and Owner’s Equity Liabilities 400 Owner’s Equity ($200 invested by owner plus $100 profits retained) 300 Total Liabilities and Owner’s Equity$700
A Quick Word About Credit
Because the money you borrowed came from your trusting parents, they loaned it to you on the basis of you signing a simple note promising to pay it back. Such a loan is considered unsecured credit. But what if you had borrowed the money from a bank? The banker would probably have required collateral, which is property or some other asset that would become the property of the lender if you failed to pay. If you know someone who had a car loan, you probably know that if the loan went unpaid, the bank could repossess the car. This type of loan is called secured credit, because the bank makes it with the security that if the borrower cannot or will not pay, they can take possession of the collateral, sell it, and recover their money that way.
Breakeven Analysis
Let’s take a short detour to see how Stress Buster’s financial information might be put to use. As you look at your first financial statements, you might ask yourself: is there some way to figure out the level of sales you need to avoid losing money—to “break even”? This can be done using breakeven analysis. To break even (have no profit or loss), your total sales revenue must exactly equal all your expenses (both variable and fixed). Variable costs depend on the quantity produced and sold; for example, each Stress-Buster includes the treasure chest and the toys inside. Fixed costs don’t change as the quantity sold changes; for example, you’ll pay for your advertising whether you sell Stress-Busters or not. The balance between revenue and expenses will occur when gross profit equals all other (fixed) costs. To determine the level of sales at which this will occur, you need to do the following (using data from the previous example):
1. Determine your total fixed costs:
• Fixed costs = $240 salaries +$40 advertising + $20 table =$300
2. Identify your variable costs on a per-unit basis:
• Variable cost per unit = $6 ($1 for the treasure chest and $5 for the toys) 3. Determine your contribution margin per unit: selling price per unit – variable cost per unit: • Contribution margin =$10 selling price – $6 variable cost per unit =$4
4. Calculate your breakeven point in units: fixed costs / contribution margin per unit:
• Breakeven in units = $300 fixed costs /$4 contribution margin per unit = 75 units
Your calculation means that if you sell 75 units, you’ll end up with zero profit (or loss) and will exactly break even. To test your calculation, you can prepare a what-if income statement for
75 units in sales (your breakeven number). The resulting statement is shown in Figure 17.9.
Of course you want to do better than just break even, so you could modify this analysis to a targeted level of profit by adding that amount to your fixed costs and repeating the calculation. Breakeven analysis is rather handy. It enables you to determine the level of sales that you must reach to avoid losing money and the level of sales that you have to reach to earn a certain profit. Such information will be vital to planning your business.
Figure 17.9: Stress-Buster’s breakeven income statement
Stress-Buster Company
Income Statement
Month Ended September 30, 2019
(at breakeven level of sales=75 units)
Sales (75x$10.00)$750
Less cost of goods sold (75x$6) 450 Gross profit ($75x ($10 -$6)) 300
Less operating expenses
Salaries 240
Advertising 40
Table rental 20
300
Net income (Profit) ($300-$300) $0 Financial Statement Analysis Now that you know a bit about financial statements, we’ll spend a little time talking about they’re used to help owners, managers, investors, and creditors assess a firm’s performance and financial strength. You can glean a wealth of information from financial statements, but first you need to learn a few basic principles for “unlocking” it. Types of Financing Used by Companies Before we go any further, let’s outline two basic forms of financing – i.e., how do companies get the money they need in order to operate? One way is to borrow the money, which is known as debt financing. A business might take a loan from a commercial bank, or it might issue bonds which pay a particular rate of interest over a set period of time. At the end of the life of the bond, the borrower would repay the principal, i.e., the amount borrowed, to the holders of those bonds. Another form of financing would be to sell an ownership stake in the company, which is known as equity financing. Many business owners are reluctant to part with an ownership stake in the company because they then have to share the profits with those who have purchased a share of the company. However, lenders will only provide so much financing before they begin to get concerned about the borrower’s ability to repay, so in practice, most businesses use some combination of debt and equity financing to fund the operations of the company. Trend Analysis from the Income Statement Now let’s look at some of the things we can learn from analyzing financial statements. Figure 17.10 is an abbreviated financial statement for Apple for 2014 taken directly from their website. You will note that instead of showing only the current year’s results, the company has shown data for the prior two years as well. From this relatively simple exhibit, considerable information about Apple’s performance can be obtained. For example: • Apple sales grew at 6.95% from 2013 to 2014, not bad for a company with such a large base of sales already, but certainly not the rapid-growth company it once was. • Net income as a percent of sales (a ratio also known as return on sales) was 21.6% – or in other words, for every$5 in sales, Apple turned more than $1 of it into profit. That is substantial! Many other calculations are possible from Apple’s data, and we will look at a few more as we explore ratio analysis. Apple Inc. – Consolidated Statement of Operations (Income Statement) (In millions, except number of shares which are reflected in thousands and per share amounts) Figure 17.10: Apple statement of operations, 2014 Years ended September 27, 2014 September 28, 2013 September 29, 2012 Net sales$182,795 $170,910$156,508
Cost of sales $112,258$106,606 $87,846 Gross margin$70,537 $64,304$68,662
Operating expenses:
Research and development $6,041$4,475 $3,381 Selling, general and administrative$11,993 $10,830$10,040
Total operating expenses $18,034$15,305 $13,421 Operating income$52,503 $48,999$55,241
Other income/(expense), net $980$1,156 $522 Income before provision for income: Taxes$53,483 $50,155$55,763
Provision for income taxes $13,973$13,118 $14,030 Net income$39,510 $37,037$41,733
Earnings per share:
Basic $6.49$5.72 $6.38 Diluted$6.45 $5.68$6.31
Shares used in computing earnings per share:
Basic $6,085,572$6,477,320 $6,543,726 Diluted$6,122,663 $6,521,634$6,617,483
Debt Ratios
Apple’s debt to equity ratio: $\frac{\ 120.3 Billion}{\ 111.5 Billion} = 1.08$
A key debt ratio, which tells us how the company is financed, is the debt-to-equity ratio, which calculates the relationship between funds acquired from creditors (debt) and funds invested by owners (equity). For this ratio calculation, we use Apple’s total liabilities, not just the line on the balance sheet that says long-term debt, because in effect, Apple is borrowing from those who it owes but has not yet paid. Apple’s total liabilities at the end of its 2014 fiscal year were $120.3 billion versus owner’s equity of$111.5 billion, a ratio of 1.08, which means Apple has borrowed more than it has invested in the business.
To some investors, that high level of debt might seem alarming. But remember that Apple has \$130.2 billion invested in marketable securities. If it wished to do so, Apple could sell some of those securities and pay down its debts, thus improving its ratio. It’s likely that anyone thinking about lending money to Apple and seeing these figures would be confident that Apple has the ability to pay back what they borrow.
Efficiency and Effectiveness Ratios
There are many more ratios which we could apply to Apple to more completely understand its performance. Yet going deeper into ratios would be beyond the scope of an introductory business course. If you continue your study of business, you will get ample exposure to these ratios in your accounting and finance courses. So we’ll leave the rest for another day.
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Key Takeaways
1. Accounting is the process of measuring and summarizing business activities, interpreting financial information, and communicating the results to management and other decision makers
2. Managerial accounting deals with information produced for internal users, while financial accounting deals with external reporting.
3. The income statement captures sales and expenses over a period of time and shows how much a firm made or lost in that period.
4. The balance sheet reflects the financial position of a firm at a given point in time, including its assets, liabilities, and owner’s equity. It is based on the following equation: assets – liabilities = owner’s equity.
5. Breakeven analysis is a technique used to determine the level of sales needed to break even—to operate at a sales level at which you have neither profit nor loss.
6. Ratio analysis is used to assess a company’s performance and financial condition over time and to compare one company to similar companies or to an overall industry.
7. Categories of ratios include: profitability ratios, liquidity ratios, debt ratios, and efficiency and effectiveness ratios.
Chapter 17 Text References and Image Credits
Image Credits: Chapter 17
Figure 17.1: Joe Ravi (2011). “Apple’s headquarters at Infinite Loop in Cupertino, California, USA.” CC BY-SA 3.0. Retrieved from: https://en.Wikipedia.org/wiki/Apple_Inc.#/media/File:Apple_Headquarters_in_Cupertino.jpg
Figure 17.3: Medill DC (2011). “Medal of Freedom Ceremony.” CC BY-NA 2.0. Retrieved from: https://www.flickr.com/photos/medilldc/5448739443/in/photostream/
Figure 17.10 and 17.11: Apple Inc. (2015). “Financial Information: 10-K Annual Report 2014.” Retrieved from: http://investor.apple.com/financials.cfm
2 Exxon Mobil data retrieved from: finance.yahoo.com/q?s=XOM. Comparison date: June 27, 2016. 3 Forbes Magazine (2016). “The Richest Person in Every State: Warren Buffett.” Forbes.com. Retrieved from: http://www.forbes.com/profile/warren-buffett/ | textbooks/biz/Business/Introductory_Business/Book%3A_Fundamentals_of_Business_(Skripak)/17%3A_Accounting_and_Financial_Information.txt |
Learning Objectives
1. Develop strategies to avoid being burdened with debt.
2. Explain how to manage monthly income and expenses.
3. Define personal finances and financial planning.
4. Explain the financial planning life cycle.
5. Discuss the advantages of a college education in meeting short- and long-term financial goals.
6. Explain compound interest and the time value of money.
7. Discuss the value of getting an early start on your plans for saving.
The World of Personal Credit
Do you sometimes wonder where your money goes? Do you worry about how you’ll pay off your student loans? Would you like to buy a new car or even a home someday and you’re not sure where you’ll get the money? If these questions seem familiar to you, you could benefit from help in managing your personal finances, which this chapter will seek to provide.
Let’s say that you’re twenty-eight and single. You have a good education and a good job—you’re pulling down \$60K working with a local accounting firm. You have \$6,000 in a retirement savings account, and you carry three credit cards. You plan to buy a condo in two or three years, and you want to take your dream trip to the world’s hottest surfing spots within five years. Your only big worry is the fact that you’re \$70,000 in debt, due to student loans, your car loan, and credit card debt. In fact, even though you’ve been gainfully employed for a total of six years now, you haven’t been able to make a dent in that \$70,000. You can afford the necessities of life and then some, but you’ve occasionally wondered if you’re ever going to have enough income to put something toward that debt.1
Now let’s suppose that while browsing through a magazine in the doctor’s office, you run across a short personal-finances self-help quiz. There are six questions:
You took the quiz and answered with a B or C to a few questions, and are thereby informed that you’re probably jeopardizing your entire financial future.
Personal-finances experts tend to utilize the types of questions on the quiz: if you answered B or C to any of the first three questions, you have a problem with splurging; if any questions from four through six got a B or C, your monthly bills are too high for your income.
Building a Good Credit Rating
So, you have a financial problem. According to the quick test you took, you splurge and your bills are too high for your income. If you get in over your head and can’t make your loan or rent payments on time, you risk hurting your credit rating—your ability to borrow in the future.
How do potential lenders decide whether you’re a good or bad credit risk? If you’re a poor credit risk, how does this affect your ability to borrow, or the rate of interest you have to pay? Whenever you use credit, those from whom you borrow (retailers, credit card companies, banks) provide information on your debt and payment habits to three national credit bureaus: Equifax, Experian, and TransUnion. The credit bureaus use the information to compile a numerical credit score, called a FICO score; it ranges from 300 to 850, with the majority of people falling in the 600–700 range. In compiling the score, the credit bureaus consider five criteria: payment history—paying your bills on time (the most important), total amount owed, length of your credit history, amount of new credit you have, and types of credit you use. The credit bureaus share their score and other information about your credit history with their subscribers.2
So what does this do for you? It depends. If you pay your bills on time and don’t borrow too heavily, you’d likely have a high FICO score and lenders would like you, probably giving you reasonable interest rates on the loans you requested. But if your FICO score is low, lenders won’t likely lend you money (or would lend it to you at high interest rates). A low FICO score can even affect your chances of renting an apartment or landing a particular job. So it’s very important that you do everything possible to earn and maintain a high credit score.
As a young person, though, how do you build a credit history that will give you a high FICO score? Based on feedback from several financial experts, Emily Starbuck Gerson and Jeremy Simon of CreditCards.com compiled the list in Figure 18.4 of ways students can build good credit.3
If you meet the qualifications to obtain your own credit card, look for a card with a low interest rate and no annual fee.
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Secured vs. Unsecured Credit
On some types of loans, the lender (likely a bank) will require the borrower to offer collateral in order to be approved for the loan. Anyone who has taken out a car loan or bought a house using a mortgage loan has likely pledged the car or the home as a way to ensure the bank that they will be repaid – if the borrower fails to repay, the bank can repossess the car or foreclose on the house, taking ownership of it temporarily and reselling it in order to recover the amount of the loan. In these cases, the car or the house serve as collateral – security pledged to the lender in order to make it more likely that the amount of the loan will be repaid. Loans that involve this type of security are referred to as secured loans or secured credit.
Not all types of loans involve collateral. For example, many families take out student loans when their children go off to college. Credit cards are a form of loan as well. Neither case involves collateral; the lender makes the loans based, at least in part, on the credit worthiness of the borrower. When no collateral is involved, the loans are called unsecured. Since the bank takes more risk in lending when no collateral can be pledged, unsecured loans will often require higher interest rates in order for it to be worth the bank taking the risk in making this type of loan.
A Few More Words about Debt
What should you do to turn things around—to start getting out of debt? According to many experts, you need to take two steps:
1. Cut up your credit cards and start living on a cash-only basis.
2. Do whatever you can to bring down your monthly bills.
Although credit cards can be an important way to build a credit rating, many people simply lack the financial discipline to handle them well. If you see yourself in that statement, then moving to a pay-as-you go basis, i.e., cash or debit card only, may be for you. Be honest with yourself; if you can’t handle credit, then don’t use it.
Bringing Down Those Monthly Bills
So what can you can to bring down your monthly bills? If you want to take a gradual approach, one financial planner suggests that you perform the following “exercises” for one week:4
• Keep a written record of everything you spend and total it at week’s end.
• Keep all your ATM receipts and count up the fees.
• Take \$100 out of the bank and don’t spend a penny more.
• Avoid gourmet coffee shops.
You’ll probably be surprised at how much of your money can quickly become somebody else’s money. If, for example, you spend \$3 every day for one cup of coffee at a coffee shop, you’re laying out nearly \$1,100 a year just for coffee. If you use your ATM card at a bank other than your own, you’ll probably be charged a fee that can be as high as \$3. The average person pays more than \$60 a year in ATM fees. If you withdraw cash from an ATM twice a week, you could be racking up \$300 in annual fees.5 Another idea – eat out as a reward, not as a rule. A sandwich or leftovers from home can be just as tasty and can save you \$6 to \$10 a day, even more than our number for coffee! In 2013, the website DailyWorth asked three women to try to cut their spending in half. After tracking her spending, one participant discovered that she had spent \$175 eating out in just one week; do that for a year and you’d spend over \$9,000!6 If you think your cable bill is too high, consider alternatives like PlaystationVue or Sling. Changing channels is a bit different, but the savings can be substantial.
You may or may not be among the American consumers who buy thirty-five million cans of Bud Light each day, or 150,000 pounds of Starbucks coffee, or 2.4 million Burger King hamburgers. Yours may not be one of the 70 percent of U.S. households with an unopened consumer-electronics product lying around.7 Bottom line – if, at age twenty-eight, you have a good education and a good job, a \$60,000 income, and a \$70,000 debt—by no means an implausible scenario—there’s a very good reason why you should think hard about controlling your debt: your level of indebtedness will be a key factor in your ability—or inability—to reach your longer-term financial goals, such as home ownership, a dream trip, and, perhaps most importantly, a reasonably comfortable retirement.
Financial Planning
Before we go any further, we need to nail down a couple of key concepts. First, just what, exactly, do we mean by personal finances? Finance itself concerns the flow of money from one place to another, and your personal finances concern your money and what you plan to do with it as it flows in and out of your possession. Essentially, then, personal finance is the application of financial principles to the monetary decisions that you make either for your individual benefit or for that of your family.
Second, as we suggested earlier, monetary decisions work out much more beneficially when they’re planned rather than improvised. Thus our emphasis on financial planning—the ongoing process of managing your personal finances in order to meet goals that you’ve set for yourself or your family.
Financial planning requires you to address several questions, some of them relatively simple:
• What’s my annual income?
• How much debt do I have, and what are my monthly payments on that debt?
Others will require some investigation and calculation:
• What’s the value of my assets?
• How can I best budget my annual income?
Still others will require some forethought and forecasting:
• How much wealth can I expect to accumulate during my working lifetime?
• How much money will I need when I retire?
The Financial Planning Life Cycle
Another question that you might ask yourself—and certainly would do if you worked with a professional in financial planning—is: “How will my financial plans change over the course of my life?” Figure 18.6 illustrates the financial life cycle of a typical individual—one whose financial outlook and likely outcomes are probably a lot like yours.8 As you can see, our diagram divides this individual’s life into three stages, each of which is characterized by different life events (such as beginning a family, buying a home, planning an estate, retiring).
At each stage, there are recommended changes in the focus of the individual’s financial planning:
• Stage 1 focuses on building wealth.
• Stage 2 shifts the focus to the process of preserving and increasing wealth that one has accumulated and continues to accumulate.
• In Stage 3, the focus turns to the process of living on (and, if possible, continuing to grow) one’s saved wealth after retirement.
At each stage, of course, complications can set in—changes in such conditions as marital or employment status or in the overall economic outlook, for example. Finally, as you can also see, your financial needs will probably peak somewhere in stage 2, at approximately age fifty-five, or ten years before typical retirement age.
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Choosing a Career
Until you’re on your own and working, you’re probably living on your parents’ wealth right now. In our hypothetical life cycle, financial planning begins in the individual’s early twenties. If that seems like rushing things, consider a basic fact of life: this is the age at which you’ll be choosing your career—not only the sort of work you want to do during your prime income-generating years, but also the kind of lifestyle you want to live. What about college? Most readers of this book, of course, have decided to go to college. If you haven’t yet decided, you need to know that college is an extremely good investment of both money and time.
Figure 18.7 summarizes the findings of a study conducted by the U.S. Census Bureau.9 A quick review shows that people who graduate from high school can expect to enjoy average annual earnings about 28 percent higher than those of people who don’t, and those who go on to finish college can expect to generate 76 percent more annual income than high school graduates who didn’t attend college. Over the course of the financial life cycle, families headed by those college graduates will earn about \$1.6 million more10 than families headed by high school graduates. (With better access to health care—and, studies show, with better dietary and health practices—college graduates will also live longer. And so will their children.)11
Figure 18.7: Average earnings by education level
Education Average income Percentage increase over previous level
High school dropout \$28,796
High school diploma \$36,831 28%
Associate’s degree \$44,890 22%
Bachelor’s degree \$64,849 44%
Advanced degree \$88,187 36%
What about the student-loan debt that so many people accumulate? For every \$1 that you spend on your college education, you can expect to earn about \$35 during the course of your financial life cycle.12 At that rate of return, you should be able to pay off your student loans (unless, of course, you fail to practice reasonable financial planning).
Naturally, there are exceptions to these average outcomes. You’ll find some college graduates stocking shelves at 7-Eleven, and you’ll find college dropouts running multibillion-dollar enterprises. Microsoft cofounder Bill Gates dropped out of college after two years, as did his founding partner, Paul Allen. Though exceptions to rules (and average outcomes) certainly can be found, they fall far short of disproving them: in entrepreneurship as in most other walks of adult life, the better your education, the more promising your financial future. One expert in the field puts the case for the average person bluntly: educational credentials “are about being employable, becoming a legitimate candidate for a job with a future. They are about climbing out of the dead-end job market.”13
Time Is Money
The fact that you have to choose a career at an early stage in your financial life cycle isn’t the only reason that you need to start early on your financial planning. Let’s assume, for instance, that it’s your eighteenth birthday and that on this day you take possession of \$10,000 that your grandparents put in trust for you. You could, of course, spend it; in particular, it would probably cover the cost of flight training for a private pilot’s license—something you’ve always wanted but were convinced that you couldn’t afford right away. Your grandfather, of course, suggests that you put it into some kind of savings account. If you just wait until you finish college, he says, and if you can find a savings plan that pays 5 percent interest, you’ll have the \$10,000 plus about another \$2,000 for something else or to invest.
The total amount you’ll have— \$12,000—piques your interest. If that \$10,000 could turn itself into \$12,000 after sitting around for four years, what would it be worth if you actually held on to it until you did retire—say, at age sixty-five? A quick trip to the Internet to find a compound-interest calculator informs you that, forty-seven years later, your \$10,000 will have grown to \$104,345 (assuming a 5 percent interest rate). That’s not really enough for retirement on, but it would be a good start. On the other hand, what if that four years in college had paid off the way you planned, so that once you get a good job you’re able to add, say, another \$10,000 to your retirement savings account every year until age sixty-five? At that rate, you’ll have amassed a nice little nest egg of slightly more than \$1.6 million.
Compound Interest
In your efforts to appreciate the potential of your \$10,000 to multiply itself, you have acquainted yourself with two of the most important concepts in finance. As we’ve already indicated, one is the principle of compound interest, which refers to the effect of earning interest on your interest.
Let’s say, for example, that you take your grandfather’s advice and invest your \$10,000 (your principal) in a savings account at an annual interest rate of 5 percent. Over the course of the first year, your investment will earn \$500 in interest and grow to \$10,500. If you now reinvest the entire \$10,500 at the same 5 percent annual rate, you’ll earn another \$525 in interest, giving you a total investment at the end of year 2 of \$11,025. And so forth. And that’s how you can end up with \$81,496.67 at age sixty-five.
Time Value of Money
You’ve also encountered the principle of the time value of money—the principle whereby a dollar received in the present is worth more than a dollar received in the future. If there’s one thing that we’ve stressed throughout this chapter so far, it’s the fact that most people prefer to consume now rather than in the future. If you borrow money from me, it’s because you can’t otherwise buy something that you want at the present time. If I lend it to you, I must forego my opportunity to purchase something I want at the present time. I will do so only if I can get some compensation for making that sacrifice, and that’s why I’m going to charge you interest. And you’re going to pay the interest because you need the money to buy what you want to buy now. How much interest should we agree on? In theory, it could be just enough to cover the cost of my lost opportunity, but there are, of course, other factors. Inflation, for example, will have eroded the value of my money by the time I get it back from you. In addition, while I would be taking no risk in loaning money to the U.S. government, I am taking a risk in lending it to you. Our agreed-on rate will reflect such factors.14
Finally, the time value of money principle also states that a dollar received today starts earning interest sooner than one received tomorrow. Let’s say, for example, that you receive \$2,000 in cash gifts when you graduate from college. At age twenty-three, with your college degree in hand, you get a decent job and don’t have an immediate need for that \$2,000. So you put it into an account that pays 10 percent compounded and you add another \$2,000 (\$167 per month) to your account every year for the next eleven years.15 The blue line in Figure 18.8 graphs how much your account will earn each year and how much money you’ll have at certain ages between twenty-four and sixty-seven.
As you can see, you’d have nearly \$52,000 at age thirty-six and a little more than \$196,000 at age fifty; at age sixty-seven, you’d be just a bit short of \$1 million. The yellow line in the graph shows what you’d have if you hadn’t started saving \$2,000 a year until you were age thirty-six. As you can also see, you’d have a respectable sum at age sixty-seven—but less than half of what you would have accumulated by starting at age twenty-three. More important, even to accumulate that much, you’d have to add \$2,000 per year for a total of thirty-two years, not just twelve.
Here’s another way of looking at the same principle. Suppose that you’re twenty years old, don’t have \$2,000, and don’t want to attend college full-time. You are, however, a hard worker and a conscientious saver, and one of your financial goals is to accumulate a \$1 million retirement nest egg. As a matter of fact, if you can put \$33 a month into an account that pays 12 percent interest compounded,16 you can have your \$1 million by age sixty-seven. That is, if you start at age twenty. As you can see from Figure 18.9, if you wait until you’re twenty-one to start saving, you’ll need \$37 a month. If you wait until you’re thirty, you’ll have to save \$109 a month, and if you procrastinate until you’re forty, the ante goes up to \$366 a month.17 Unfortunately in today’s low interest rate environment, finding 10 to 12% return is not likely. Nevertheless, these figures illustrate the significant benefit of saving early.
The reason should be fairly obvious: a dollar saved today not only starts earning interest sooner than one saved tomorrow (or ten years from now) but also can ultimately earn a lot more money in the long run. Starting early means in your twenties—early in stage 1 of your financial life cycle. As one well-known financial advisor puts it, “If you’re in your 20s and you haven’t yet learned how to delay gratification, your life is likely to be a constant financial struggle.”18
Figure 18.9: What does it take to save a million dollars?
How to save a million dollars by age 67
Make your first payment at age: And this is what you’ll have to save each month
20 \$33
21 \$42
23 \$47
24 \$53
25 \$60
26 \$67
27 \$76
28 \$85
30 \$109
35 \$199
40 \$366
50 \$1,319
60 \$6,253
Suppose you want to save or invest – do you know how or where to do so? You probably know that your branch bank can open a savings account for you, but interest rates on such accounts can be pretty unattractive. Investing in individual stocks or bonds can be risky, and usually require a level of funds available that most students don’t have. In those cases, mutual funds can be quite interesting. A mutual fund is a professionally managed investment program in which shareholders buy into a group of diversified holdings, such as stocks and bonds. Companies like Vanguard and Fidelity offer a range of investment options including indexed funds, which track with well-known indices such as the Standard & Poors 500, a.k.a. the S&P 500. Minimum investment levels in such funds can actually be within the reach of many students, and the funds accept electronic transfers to make investing more convenient. One key to keep in mind when investing is diversification – a fancy way of saying not to put all your eggs in one basket. We’ll leave a more detailed discussion of investment vehicles to your more advanced courses.
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Chapter Video
If you ask graduates who came before you what they wish they had known when they were first out of school, many would probably say “how to handle my personal finances”. While these two videos and this chapter won’t make you financially literate, hopefully they will whet your appetite to learn more.
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Key Takeaways
1. Credit worthiness is measured by the FICO score – or credit rating – which can range from 300-850. The average ranges from 680-719.
2. To maintain a satisfactory score, pay your bills on time, borrow only when necessary, and pay in full whenever you do borrow.
3. 81% of financial planners recommend eating out less as a way to reduce your expenses.
4. Personal finance is the application of financial principles to the monetary decisions that you make.
5. Financial planning is the ongoing process of managing your personal finances in order to meet your goals, which vary by stage of life.
6. Time value of money is the principle that a dollar received in the present is worth more than a dollar received in the future due to its potential to earn interest.
7. Compound interest refers to the effect of earning interest on your interest. It is a powerful way to accumulate wealth.
Chapter 18 Text References and Image Credits
Image Credits: Chapter 18
Figure 18.1: Brett Hondow (2015). Untitled photo of wallet. Public domain. Retrieved from: pixabay.com/en/wallet-cash-money-billfold-dollar-669458/
Figure 18.2 “Financial quiz” Designed for Virginia Tech Libraries by Brian Craig. Utilizes several sentences from: http://www.saylor.org/site/textbooks/Exploring%20Business.docx. Licensed CC BY 4.0.
Figure 18.3: Information for graphic: Colin Robertson (2015). “Credit Score Range – Where Do You Fit In?” Thetruthaboutcreditcards.com. Retrieved from: http://www.thetruthaboutcreditcards.com/credit-score-range/.
Figure 18.4: Information for graphic: Emily Starbuck Gerson and Jeremy M. Simon (2016). “10 Ways Students Can Build Good Credit.” CreditCards.com. Retrieved from: http://www.creditcards.com/credit-card-news/help/10-ways-students-get-good-credit-6000.php
Figure 18.5: Poolie (2008). “Chillin’ at Starbucks.” CC BY-SA 2.0.Retrieved from: www.flickr.com/photos/poolie/2611738444
Figure 18.6: Figure adapted from: Timothy J. Gallager and Joseph D. Andrews Jr. (2003). Financial Management: Principles and Practice, 3rd ed. Upper Saddle River, NJ: Prentice Hall. Pp. 34, 196.
Figure 18.7: Table data source: The U.S. Census Bureau (2015). “PINC-03. Educational Attainment-People 25 Years Old and Over, by Total Money Earnings, Work Experience, Age, Race, Hispanic Origin, and Sex.” Census.gov. Retrieved from: http://www.census.gov/data/tables/time-series/demo/income-poverty/cps-pinc/pinc-03.html
Video Credits: Chapter 18
“What College Students Need to Know About Money!” (Cambridge Credit Counseling Corp.). November 19, 2010. Retrieved from: https://www.youtube.com/watch?v=ToyLXa0ULaM
“Compound interest.” (Reserve Bank of New Zealand). September 3, 2012. Retrieved from: https://www.youtube.com/watch?v=pysohj7GsBI
2 Colin Robertson (2015). “Credit Score Range – Where Do You Fit In?” Thetruthaboutcreditcards.com. Retrieved from: http://www.thetruthaboutcreditcards.com/credit-score-range/. 3 Emily Starbuck Gerson and Jeremy M. Simon (2016). “10 Ways Students Can Build Good Credit.” CreditCards.com. Retrieved from: http://www.creditcards.com/credit-card-news/help/10-ways-students-get-good-credit-6000.php 4 USA Today and Elissa Buie (2005). “Exercise 1: Start small, watch progress grow.” USA Today.com. Retrieved from: http://usatoday30.usatoday.com/money/perfi/basics/2005-04-14-financial-diet-excercise1_x.htm 5 Mindy Fetterman (2005). “You’ll be amazed once you fix the leak in your wallet.” USA Today.com. Retrieved from: http://usatoday30.usatoday.com/money/perfi/basics/2005-04-14-financial-diet-little-things_x.htm 6 Cynthia Ramnarace (2013). “Could you cut your spending in half?” DailyWorth.com. Retrieved from: https://www.dailyworth.com/posts/2046-could-you-cut-your-spending-in-half/2 7 Michael Arrington (2008). “Ebay Survey Says Americans Buy Crap They Don’t Want.” TechCrunch.com. Retrieved from: https://techcrunch.com/2008/08/21/ebay-survey-says-americans-buy-crap-they-dont-want/ 8 See Timothy J. Gallager and Joseph D. Andrews Jr.(2003). Financial Management: Principles and Practice, 3rd ed. Upper Saddle River, NJ: Prentice Hall. Pp. 34, 196. 9 The U.S. Census Bureau (2015). “PINC-03. Educational Attainment-People 25 Years Old and Over, by Total Money Earnings, Work Experience, Age, Race, Hispanic Origin, and Sex.” Census.gov. Retrieved from: http://www.census.gov/data/tables/time-series/demo/income-poverty/cps-pinc/pinc-03.html 10 Katherine Hansen (2016). “What Good is a College Education Anyway? The Value of a College Education.” Quintessential Live Career. Retrieved from: https://www.livecareer.com/quintessential/college-education-value 11 Ibid. 12 Ibid. 13 Ibid. 14 See Timothy J. Gallager and Joseph D. Andrews Jr.(2003). Financial Management: Principles and Practice, 3rd ed. Upper Saddle River, NJ: Prentice Hall. Pp. 34, 196. 15 The 10% rate is not realistic in today’s economic market and is used for illustrative purposes only. 16 Again, this interest rate is unrealistic in today’s market and is used for illustrative purposes only. 17 See Arthur J. Keown (2007). Personal Finance: Turning Money into Wealth, 4th ed. Upper Saddle River, NJ: Pearson Education. P. 23. 18 AllFinancialMatters (2006). “An Interview with Jonathan Clements – Part 2.” Allfinancialmatters.com. Retrieved from: allfinancialmatters.com/2006/02/10/an-interview-with-jonathan-clements-part-2/ | textbooks/biz/Business/Introductory_Business/Book%3A_Fundamentals_of_Business_(Skripak)/18%3A_Personal_Finances.txt |
Why discuss the role of business in society?
Are you up for a challenge as you start this course?
As you embark on your study of business, you may be thinking that so much of what you will learn in school isn’t applicable to your career or future—you aren’t really going into business, for instance. Here’s a challenge that may change your mind.
Stop what you are doing and take a minute to look around you. What do you see? Perhaps you see your living room, where you’re sitting at your desk doing your homework. You might be at a local coffee shop, hanging out with some friends who are going to help you study. Or maybe you’re sitting on the beach, reading this on your tablet or phone while you listen to the sounds of the ocean and children playing in the sand.
Now, look around again but this time consider everything within your view and ask yourself what all of these things have in common? If you said that they are all the product of business, then you’re right! How can that be, you ask? Business is everywhere, in everything we touch, we eat, we see, we smell, and we feel. Oh, not always directly, but in one way or another business is there. It’s like the air that we breathe—mostly invisible, but always present.
The next part of the challenge is this: As you work through this first section, keep trying to think of something, anything, that you can say with certainty has no relationship to business. We will check back later and see what you came up with!
1.02: What is Business
What you’ll learn to do: explain the concept of business
The concept of business has enough definitions and applications that we could almost say that everything is business. Throughout this course we will explore the various functions, roles, and characteristics of business while keeping in mind that business is like the air we breathe—it’s everywhere!
Learning Objectives
• Distinguish between profit, loss, and value
• Distinguish between goods and services
Getting Down to Business
Today’s Business Environment
The world of business today can be summed up in a single word: change. And not just change, but rapid change. in order to remain profitable and competitive, businesses today are finding that they need to be more responsive than ever to customer demands. This is not only true of big companies like Apple, Nike, and Whole Foods but of smaller businesses, too—like your local hardware or grocery store. The rapidly changing business environment affects them all.
What is the business environment? In some ways it resembles the natural environment in which we live: It’s all around us but not always noticeable. It includes things like technology, competitors (other businesses), advertising, regulations, consumer demands, and money. When these elements of the business environment change—in the same way that seasons and weather change—companies need to be able to predict, react, and adapt accordingly. Those who fail to do so may find themselves out in the rain or cold and struggling to survive.
Although the environment in which businesses operate is always changing, the accelerated pace of change presents special challenges and opportunities for businesses today. To get a sense of this rapid and dramatic change, consider something that’s fairly routine for Americans: getting a prescription filled. A couple of decades ago, you would have taken a written prescription from your doctor to your local drugstore and presented it to the pharmacist. Then, while waiting for it to be filled, you might have leafed through magazines or browsed the store for extra items—perhaps shampoo or a greeting card. When your name was called, you probably paid in cash or wrote a check. All such transactions took place during normal business hours—Monday–Friday, 9 am–5 pm; larger pharmacies may have been open for a few hours on Saturday.
What about now? Think about the last time you had a prescription filled. Did you ever even see it? Chances are you went to the doctor, and at the end of your visit she faxed the prescription straight to the pharmacy (perhaps a Rite-Aid, Walgreen’s, or Duane Reed). A little while later, you may have received a text message notifying you that your prescription was ready. Since it wasn’t convenient for you to pick it up during the workday, and because it’s a 24-hour pharmacy, you went at night. You pulled up to the drive-through window and paid using Apple Pay or Google Wallet. Afterward you verified that you received points on your customer loyalty card, which means savings or cash that can be applied to future purchases. You never set foot inside the store.
Alternatively, you may have gotten your prescription filled online and mailed right to your home by a national discount supplier or maybe chosen to pick it up at Walmart or Target when you stopped in to shop for a new garden hose.
You can see from this example that the way companies “do business” is very different today. Some of these changes are the result of developments in technology, while others are the result of shifting consumer demands and trends. Regardless of the particular cause, though, all businesses have to cope with the changing nature and pressures of the business environment. A large part of this course will focus on the ways in which they do just that.
Defining Business
So, what is this thing we call “business”? A business is any activity that provides goods or services to consumers for the purpose of making a profit. Examples of goods provided by a business are tangible items such as cars, televisions, or soda. A service is a consumable, one-time benefit. Services include things such as haircuts, hotel stays, or roller-coaster rides. Business can generate profits from the sale of goods and/or services, and profits are the financial reward that comes from taking the risk of running or owning a business. More specifically, profit is the amount of revenue or income that a business owner retains after paying all the expenses associated with the operation of the business. If the expenses of the business exceed the revenue or income generated from operations, then the business will suffer a loss. Businesses that suffer extraordinary losses during a short period of time, or slowly see their profits decline, may end up closing or filing for bankruptcy.
Clearly the goal of most businesses is to generate a profit by increasing revenue while holding expenses in check, and one of the chief ways they do this is by providing their customers with value. When businesses talk about value, they are referring to the relationship between the price a customer pays for the good or service and the perceived benefits the customer receives in exchange for his or her time and money. Value has become such a key component of today’s business model that if you go to almost any fast-food restaurant you’ll find a “value meal” or “value menu” advertised. Such businesses are sending the message to their customers that they’ll receive the most “bang for the buck” or the highest value in terms of quantity obtained in exchange for money spent. It’s a business model based on the belief that if you give your customers value, the profit will follow. As you’ll see in the next section, while all businesses seek to increase their revenue, what a business actually does with those funds can vary and depends on whether it’s a for-profit or nonprofit organization. | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/01%3A_The_Role_of_Business/1.01%3A_Why_It_Matters-_Role_of_Buisness.txt |
What you’ll learn to do: distinguish between for-profit and nonprofit businesses
We defined business earlier as an organization that provides goods, service, or both to their customers, clients, or consumers in order to make a profit. That definition, although accurate, does not account for those organizations and businesses that aren’t driven by the “bottom line” or profitability. Instead, some organizations provide their goods and services in order to generate revenues (income) that can be used to further their purpose or mission. It is highly likely that you have been involved with a nonprofit organization, and though it may not have seemed like it at the time, you were actually working with a business! In this section we’ll dig a little deeper into this idea of for-profit versus nonprofit business.
Learning Objectives
• Explain the purpose of for-profit businesses
• Explain the purpose of nonprofit businesses/organizations
• Distinguish between for-profit and nonprofit businesses
Profits and Purpose
A nonprofit or not-for-profit business is one that provides goods or services to consumers, but its primary goal is not to return profit to the owners of the business (as is the case with a for-profit business). Instead, it uses those profits to provide a public service, advance a cause, or assist others. The American Red Cross, the local SPCA, and the American Cancer Society are all examples of nonprofit businesses. They use any revenue generated from operations to support the continued mission of the organization. In addition, most nonprofits also rely on donations from individuals and businesses, grants, and government funding to help fund their work, since the revenue they raise rarely covers all their operating costs.
Much of what differentiates a for-profit business from a nonprofit business goes on behind the scenes and isn’t very visible to the customer. For example, a nonprofit organization is subject to government regulation and oversight in ways that differ significantly from a for-profit business: Nonprofits do not pay taxes on their revenue, but how their funds are disbursed and their operations are managed is tightly regulated.
Profit and non-profit Lemonade stands
Profit and Non-Profit Lemonade Stands
Despite their differences, nonprofits and for-profits have some fundamental business principles and practices in common. Let’s explore these shared aspects by comparing two businesses—one for-profit and one nonprofit.
Molly opens a lemonade stand in front of a local museum and intends to use her profits to purchase a new bike at the end of the summer. There are expenses associated with Molly’s business such as lemons, sugar, cups, and ice. She also spends money on advertising when she prints up flyers and makes directional signs to alert customers to her location. She hires Jamie to help her on busy weekends and pays her a percentage of the stand’s revenue on the days she works. She has T-shirts printed at a local shop with her slogan on the back: “When life gives you lemons, Molly makes lemonade.” She sells the shirts at her stand for \$10 each. A local bakery owner sees that Molly’s business is thriving and asks if she can sell her cookies at the lemonade stand. Molly arranges to sell the cookies for the bakery and keep 25 percent of the revenue generated from cookie sales.
Molly is running a for-profit business and generates revenue from several sources (lemonade, T-shirts, and cookies). Every day, after packing up her stand, she goes home and calculates her profit by subtracting her expenses (wages to Jamie, advertising, T-shirts, and supplies) from her revenue. She takes the profit and deposits it in the bank account her father helped her open.
At the end of the summer, Molly can withdraw the money from the bank account and buy the bike she wants. If she has profits left after she buys the bike, she can do whatever she wants with that money. As a for-profit business owner, she owns all the profits.
Emma opens a lemonade stand in front of a local museum and intends to donate her profits to the local Humane Society to support their Feline Hope program. Besides that difference of purpose, Emma’s business is nearly identical to Molly’s: There are expenses associated with Emma’s business such as lemons, sugar, cups, and ice. Emma spends money on advertising when she prints up flyers and makes directional signs to alert customers to her location. She hires Linda to help her on busy weekends and pays her a percentage of the stand’s revenue on the days she works. She has T-shirts printed at a local shop with her slogan on the back: “When life gives you lemons, Emma makes lemonade.” She sells the shirts at her stand for \$10 each. A local bakery owner sees that Emma’s business is thriving and asks if she can sell her cookies at the lemonade stand. Emma arranges to sell the cookies for the bakery and keep 25 percent of the revenue generated from cookie sales.
Emma is running a not-for-profit business and generates revenue from several sources (lemonade, T-shirts, and cookies). Like Molly, after packing up her stand, she goes home and calculates her profit by subtracting her expenses (wages to Linda, advertising, T-shirts, and supplies) from her revenue. She takes the profit and deposits it in the bank account her father helped her open.
At the end of the summer, Emma can withdraw the money from the bank account and deliver a check to the Humane Society. If the business has profits in excess of what she promised to donate to the Humane Society, Emma can pay herself a small wage for running the business all summer, but the majority of the profits will either need to stay in the bank account to fund future causes or be used to expand the business to support charitable or social causes later on. Emma isn’t really a business “owner,” because she doesn’t own the profit generated by the business. We’d expect to hear Emma say that she’s running a not-for-profit (or nonprofit) organization—in contrast to Molly, who would probably say that she owns a business.
Although these may be very simple examples, they show that, from a customer’s perspective, there is virtually no difference in the way the two businesses operate. Emma might decide to advertise that her proceeds support an important cause (the Humane Society’s Feline Hope program) as a way of attracting
Although these may be very simple examples, they show that, from a customer’s perspective, there is virtually no difference in the way the two businesses operate. Emma might decide to advertise that her proceeds support an important cause (the Humane Society’s Feline Hope program) as a way of attracting customers. If not, the two lemonade stands would seem nearly identical from the outside.
It’s not until you look behind the scenes that you will see the differences between a for-profit and nonprofit business. The following table compares the attributes of for-profit and not-for-profit businesses and highlights some of the “hidden” differences.
For-Profit Not-for-Profit/Nonprofit
Incurs expenses for operations Incurs expenses for operations
Provides goods and services to customers Provides goods and services to customers
Generates revenue from sales Generates revenue from sales and/or contributions
Owned by individuals, partners, or shareholders Operated by board of directors, trustees, and managers
Profit is used to pay owners, partners, or shareholders Profit is used to further the mission of the organization
Pays salaries to employees and managers Pays salaries to employees and managers
Profits are subject to taxation by local, state, and federal authorities Profits are NOT subject to taxation by local, state, and federal authorities | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/01%3A_The_Role_of_Business/1.03%3A_For-Profit_vs._Nonprofit.txt |
What you’ll learn to do: list and explain the four factors of production required to sustain a business
When businesses use resources to produce things we call these factors of production. In this section we will examine the factors of production and see how they contribute to the outputs of a business.
learning Objectives
• Explain the four factors of production
Factors of Production
All businesses, both for-profit and nonprofit, need resources in order to operate. Simply put, resources are the inputs used to produce outputs (goods and/or services). Resources are also called factors of production. What makes something a resource? For one thing, it needs to be productive.
The following video will give you an overview of what economists mean when they talk about resources or factors of production.
There are four categories of resources, or factors of production:
• Natural resources (land)
• Labor (human capital)
• Capital (machinery, factories, equipment)
• Entrepreneurship
Natural Resources
Natural resources have two fundamental characteristics: (1) They are found in nature, and (2) they can be used for the production of goods and services. In order to provide benefit, people first have to discover them and then figure out how to use them in the the production of a good or service. Examples of natural resources are land, trees, wind, water, and minerals
A key feature of natural resources is that people can’t make them. They also tend to be limited. New natural resources—or new ways of extracting them (such as fracking, for example)—can be discovered, though. These natural resources can be renewable, such as forests, or nonrenewable, such as oil or natural gas. It’s also possible to invent new uses for natural resources (using wind to generate electricity, for example). Resources that are cultivated or made with human effort can’t be considered natural resources, which is why crops aren’t natural resources.
Labor
Labor refers to human resources (also called human capital)—physical or intellectual. You’re adding to your own human resources right now by learning. You may possess certain human resources already—perhaps you have an athletic gift that enables you to play professional ball to earn a living, for example—but you can also develop them through job training, education, experience, and so on.
The word labor often calls to mind physical labor—working in a factory or field, constructing a building, waiting tables in a restaurant—but it can refer to any human input (paid or unpaid) involved in the production of a good or service. This broader definition of labor is particularly important in today’s technology-driven business environment, which has come to rely much more on the intellectual contributions of the labor force than the physical labor required of, say, working in a production line. Intellectual contributions include experience in and out of school, training, skills, and natural abilities. In order to remain competitive, businesses place a premium on employees who bring these “soft skills” to the table. Many of the advances in our world today are the result of the application of intellectual human resources.
Finally, labor brings creativity and innovation to businesses. Businesses use human creativity to address changes in consumer preferences and to invent goods and services that consumers haven’t even imagined yet. Without creativity, innovation would stall, and economies would stagnate.
Capital
Before we discuss capital, it’s important to point out that money is not a resource. Remember that resources need to be productive. They have to be used to make something else, and money can’t do that. Money certainly helps the economy move along more efficiently and smoothly, like grease for the economic machine. But in and of itself, it can’t produce anything. It’s used to acquire the productive resources that can produce goods and services. This confusion is understandable, given that businesspeople frequently talk about “financial capital,” or “investment capital,” which does mean money.
In contrast to natural resources, capital is a resource that has been produced but is also used to produce other goods and services. This factor of production includes machinery, tools, equipment, buildings, and technology. Businesses must constantly upgrade their capital to maintain a competitive edge and operate efficiently. In the last couple decades or so, businesses have faced unprecedented technological change and have had to meet the demands of consumers whose lives increasingly take place in a virtual world. Almost every business has a Web presence, and many customers are more accustomed to interacting with a virtual version of the business than a brick and mortar store.
Entrepreneurship
Thus far we have looked at natural resources, human resources, and capital as three inputs needed to create outputs. The last one we need to consider is perhaps the most important: entrepreneurship. This resource is a special form of labor provided by an entrepreneur. An entrepreneur is someone who is willing to risk his or her time and money to start or run a business—usually with the hope of earning a profit in return. Entrepreneurs have the ability to organize the other factors of production and transform them into a business. Without entrepreneurship many of the goods and services we consume today would not exist.
Let’s return to the example given at the beginning of this section: baking a cake.
Table \(1\). Factor of Production
Natural Resource Wind is harnessed to produce electricity that powers the electric mixer and oven.
Human Resource The baker’s labor combined with the creativity and skills needed to actually bake and decorate it
Capital Ovens, cake pans, flour, sugar, butter, and other ingredients used to make the cake
Entrepreneurship An individual who starts the bakery or runs a home-based business baking and selling cakes to customers
If you consider just some of the factors of production involved in baking even a very simple cake, what would happen if one of the four inputs were missing? What if you lacked electricity or an oven? What if you lacked the skills to bake or decorate the cake? What if you had the first three factors of production but not the fourth, entrepreneurship? You can surmise that all four factors of production are required to create the outputs that would get you into the cake business—or any business. | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/01%3A_The_Role_of_Business/1.04%3A_Factors_of_Production.txt |
What you’ll learn to do: identify the primary functional areas within a business and describe their contribution to the organization
The decisions about how best to use the factors of production to provide the goods or services of the business require a team of people working in a variety of jobs. As businesses grow larger and their products and services become more complex, the number of functional areas within a business grows. Each functional area makes specific and valuable contributions to the organization as a whole. In this section we will explore some of the most common functional areas in a business and how each contributes to the overall success of the business.
Learning Objectives
• Identify key people and explain the activities within each functional area
Functional Areas of Business
Just as different functions in the human body are performed and regulated by different organs, different functions within a business are performed and controlled by different parts of the business. One of the reasons for separating business operations into functional areas is to allow each to operate within its area of expertise, thus building efficiency and effectiveness across the business as a whole. The key functional areas of a business are the following:
• Management
• Operations
• Marketing
• Accounting
• Finance
Management
The primary role of managers in business is to supervise other people’s performance. Most management activities fall into the following categories:
• Planning: Managers plan by setting long-term goals for the business, as well short-term strategies needed to execute against those goals.
• Organizing: Managers are responsible for organizing the operations of a business in the most efficient way, enabling the business to use its resources effectively.
• Controlling: A large percentage of a manager’s time is spent controlling the activities within the business to ensure that it’s on track to achieve its goals. When people or processes stray from the path, managers are often the first ones to notice and take corrective action.
• Leading: Managers serve as leaders for the organization, in practical as well as symbolic ways. The manager may lead work teams or groups through a new process or the development of a new product. The manager may also be seen as the leader of the organization when it interacts with the community, customers, and suppliers.
Operations
Operations is where inputs (factors of production) are converted to outputs (goods and services). Operations is like the heart of a business, pumping out goods and services in a quantity and of a quality that meets the needs of the customers. The operations manager is responsible for overseeing the day-to-day business operations, which can encompass everything from ordering raw materials to scheduling workers to produce tangible goods.
Marketing
Marketing consists of all that a company does to identify customers’ needs and design products and services that meet those needs. The marketing function also includes promoting goods and services, determining how the goods and services will be delivered, and developing a pricing strategy to capture market share while remaining competitive. In day’s technology-driven business environment, marketing is also responsible for building and overseeing a company’s Internet presence (e.g., the company Web site, blogs, social media campaigns, etc.). Today, social media marketing is one of the fastest growing sectors within the marketing function.
Accounting
Accountants provide managers with information needed to make decisions about the allocation of company resources. This area is ultimately responsible for accurately representing the financial transactions of a business to internal and external parties, government agencies, and owners/investors. Financial Accountants are primarily responsible for the preparation of financial statements to help entities both inside and outside the organization assess the financial strength of the company. Managerial accountants provide information regarding costs, budgets, asset allocation, and performance appraisal for internal use by management for the purpose of decision-making.
Finance
Although related to accounting, the finance function involves planning for, obtaining, and managing a company’s funds. Finance managers plan for both short- and long-term financial capital needs and analyze the impact that borrowing will have on the financial well-being of the business. A company’s finance department answers questions about how funds should be raised (loans vs. stocks), the long-term cost of borrowing funds, and the implications of financing decisions for the long-term health of the business.
1.06: Stakeholders
What you’ll learn to do: identify business stakeholders and describe their relationship with business organizations
Just as it takes many parts to make a business run smoothly, there are many people, organizations, and entities that have a “stake” in the success of a business. In this section we’ll take a look at who these stakeholders are and how they affect business.
Learning Objectives
• Describe stakeholders’ relationship with business organizations
What Is a Stakeholder?
A stakeholder is an individual or group that has a legitimate interest in a company, organization, or business; the Stanford Research Institute defines stakeholders as “those groups without whose support the organization would cease to exist. Stakeholders can affect or be affected by the actions (or inactions) of a business, and they can exist both within and outside of a business.
The impact of a business on its stakeholders is a bit like the effect of dropping a stone into a pond. The decisions and actions of the business have a ripple effect that can extend beyond the pond and even reach those who are standing far away on the shore.
Internal Stakeholders
Internal stakeholders are groups or people who work directly within the business, such as managers, employees, and owners. Managers and employees want to earn high wages and keep their jobs, so they have a vested interest in the financial health and success of the business. Owners want to maximize the profit the business makes as compensation for the risks they take in owning or running a business.
External Stakeholders
External stakeholders are groups outside a business or people who don’t work inside the business but are affected in some way by the decisions and actions of the business. Examples of external stakeholders are customers, suppliers, creditors, the local community, society, and the government. Customers want the business to produce quality products at reasonable prices. Shareholders have an interest in business operations since they are counting on the business to remain profitable and provide a return on their investment in the business. Creditors that supply financial capital, raw materials, and services to the business want to be paid on time and in full. Federal, state, and local governments need businesses to thrive in order to pay taxes that support government services such as education, police, and fire protection. The local community has a stake in the business because it provides jobs, which generate economic activity within the community. Society as a whole (as well as the local community) is concerned about the impact that business operations have on the environment in terms of noise, air, and water pollution. Society also has an interest in the business with regard to the safety of the goods and services produced by the business. Suppliers need the business to continue to buy their products in order to maintain their own profitability and long-term financial health. | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/01%3A_The_Role_of_Business/1.05%3A_Functional_Areas.txt |
What you’ll learn to do: identify the external forces that shape the business environment
You are probably aware that businesses do not operate in a vacuum, immune to the forces that shape our everyday life. Just like people, businesses interact with their surroundings, and just like people, businesses react differently to their environment. Later in the course, you will explore these external forces in greater depth when you complete modules covering topics such as the global business environment, business ethics, and marketing. For the time being, this section will introduce the external forces that have an impact on business operations and decisions and serve as a foundation for things to come.
Learning Objectives
• Give examples of how various external forces affect the participants in a business and its functional areas
External Forces That Shape Business Activities
Businesses do not operate in a vacuum, and they are influenced by forces beyond their control. How they respond—and how quickly they respond—to these external forces can make the difference between success and failure, especially in today’s fast-paced business climate. We can organize the external forces that affect business into the following six categories:
1. Economic environment
2. Legal environment
3. Competitive environment
4. Technological environment
5. Social environment
6. Global environment
Businesses operate in all of these environments simultaneously, and factors in one environment can affect or complicate factors in another.
Economic Environment
The economic environment of business has changed dramatically in recent years. After decades of growth and dominance, the US economy is now challenged by the developing economies of other nations, which are jockeying to be number one. Since the financial crisis in 2008, the US economy and businesses have struggled to recover from the greatest economic crisis since the Great Depression of the 1930s. Long-established companies have closed their doors, costing workers their jobs, retirement savings, and even their homes. Thus far the US economy has proven resilient, and since the Great Recession in 2008, progress has been made to stabilize the housing industry, maintain low and affordable interest rates, and provide additional incentives for businesses to open and/or expand. These economic events have all had a direct impact on businesses, regardless of size.
Legal Environment
The legal environment of business is by far the most complex and potentially dangerous external factor a business faces. There is a minefield of regulations, laws, and liabilities that companies must cope with in order to stay in business—just turn on the TV or listen to the news to verify this fact. Volkswagen teeters on the brink of ruin because it falsified data about its cars’ emissions. Tide is airing commercials not to promote the marvels of its laundry detergent but to warn parents to keep the Tide pods away from children, who may be tempted to eat them. These days it takes five minutes and a sharp instrument to open a bottle of Tylenol—the result of Johnson & Johnson’s move in 1982 to make the product more difficult to open after a tampering incident in 1982 caused a spate of deaths and illness. Legal developments in our culture at large—for instance, the legalization of marijuana and same-sex marriage or the strengthening of privacy laws—can and do have an enormous impact on the way companies do business, on everything from what companies sell to how their products are manufactured, labeled, and marketed.
Competitive Environment
How do businesses stay competitive and still maintain a level of profitability that allows them to be successful? The competitive environment has intensified with the development of new technologies, the opening up of foreign markets, and the rise of consumer expectations. The local hardware store now finds itself competing with “big box” stores such as Lowe’s and Home Depot. These larger stores have enough clout with suppliers that they can often sell a product to the consumer for less than an independent store can purchase it. Customers of these large chains can order online, get their items the same day, and receive loyalty rewards, free delivery, customization, and even service and installation. Staying competitive is a challenge for every business, and business owners are finding that benefits such as customer service, employee knowledge, and high quality can help them survive.
Technological Environment
Almost daily, businesses are driven to rethink the business technology they use to reach customers, produce their products, and provide their services. When we refer to business technology we mean digital tools such as computers, telecommunications, and the Internet. The expansion of Internet access to virtually every corner of the world has forced many traditional brick-and-mortar businesses into e-commerce or online sales. The advantage to businesses is that their customers no longer have to live in proximity to their stores in order to purchase goods and services. Consumers can conveniently shop for products and services without leaving their home, their desk, or their phone. The disadvantage to businesses is that consumers are also able to compare competitors’ prices, benefits, features, and services (which shows how one environment—technology—can affect another—the competitive environment). Today’s businesses have to be vigilant about spotting emerging trends not only in technology but in the way consumers use that technology.
Social Environment
The social environment of business encompasses the values, attitudes, beliefs, wants, and desires of the consuming public. The demographics that describe the American population by gender, age, ethnicity, location, occupation, education and income are constantly evolving. The American population is steadily becoming more ethnically diverse: The US Census Bureau estimates that the Hispanic and Asian populations in the United States will double by 2050. At the same time, America is aging, and with the current median above thirty-six years of age, it will not be long before the majority of Americans is ready to retire. In addition to ethnic diversity and age, the social environment brings forces such as Corporate Social Responsibility (CSR), which means that more and more consumers are demanding that businesses be “good corporate citizens” by supporting charitable causes and contributing to local communities, adhering to ethical standards in their treatment of workers and others, and adopting environmentally responsible practices. Combine these factors with the whirlwind of changing fads, trends, and “hot topics,” and you have some idea of why the social environment can present the greatest challenge to business.
Global Environment
From a business perspective, it is a small world, and it’s only getting smaller. Free trade among nations has allowed goods and services to flow across international borders more efficiently and cheaply. Formal trade agreements among nations have forged unprecedented links and interdependencies among economies. Look at the items on your desk, and you may see items from China, Mexico, Canada, or Japan. It’s possible that you drive a car that was made in the United States but was produced in a plant owned by a Japanese company. The growth of the Chinese economy has brought a flood of affordable goods into the United States and, along with those cheaper prices, created a reliance on foreign goods and materials. Now, when the Chinese economy slows down, the US economy is affected. When the price of foreign oil increases or decreases, businesses in the United States feel the impact. So, it’s not just the local economy or even the national economy that businesses must track—they must also keep an eye on the world economy in order to anticipate and adapt to changes that will impact their products and services. | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/01%3A_The_Role_of_Business/1.07%3A_External_Forces.txt |
Synthesis
Now that you have been exposed to some of the terms and definitions we use in business, have you been able to find something that doesn’t have a link back to business? Let’s go back to where we started.
If you were in your living room, then everything in your surroundings was most likely manufactured by a business for your use—chairs, television, computer, pens, pencils.
What if you had been at the coffee shop? Well, this one is easy because you were doing your studying in a business, surrounded by people working for a business who were serving the customers of the business.
The last possibility we suggested was the beach. Well, the ocean doesn’t have anything to do with business, does it? Remember in the module we talked about nonprofit organizations as business entities. Aren’t there organizations that use their profits to support clean water and preservation of the coastline? What about the lifeguards at the beach who are paid by a business to keep swimmers safe? Where did the children get the shovels and pails they were using to play in the sand?
By this time you should begin to see that even though you may not think of business as you go about your daily routine, it is always there, like the air we breathe. Throughout this text you will learn about how businesses operate, why they engage in the activities they do, and numerous other components that go into this thing we call “business.”
In the meantime, don’t stop looking for something that qualifies as “non-business related”—you might find something after all.
Summary
This module covered the role of business. Below is a summary of the topics covered in this module.
What Is Business?
We defined business as any kind of organization or action that creates goods or provides services. While this is usually undertaken with making a profit as the main goal, though this isn’t always the case.
For-Profit vs. Non-Profit
For-profit businesses focus on earning a profit. They are concerned with the company’s well-being and success above all else. Non-profit organizations, on the other hand, are more goal-oriented. They are concerned with communities or members. Instead of focusing on earning money, NPOs focus on their customers and their needs (e.g., credit unions, sports clubs, human service programs, aid and development programs).
Factors of Production
In order to produce services or goods, a business needs four resources: land (or other natural resources), labor, capital, and entrepreneurship. Natural resources are defined as resources found in nature unaltered by man; these include oil, wind, trees, and so on. Labor can be divided into two general categories: physical labor and mental labor. Both kinds of work are necessary for success. Capital includes things created by human beings that are used to make other goods: power tools, computers, and even art (which can be used to create museums or art shows). Money is not considered to be capital. An entrepreneur is the person who starts the company or business—without him or her, the business would not exist to begin with.
Functional Areas
Businesses are made up of functional areas—different activities that need to be done to maintain the business. These include management, operations, marketing, accounting, and finance. Management ensures employees are on task and that each employee is being leveraged in the way that makes the business most efficient. Operations watches over production and ensures quality of product. Marketing brings in customers, both by making the business look appealing to customer and by taking customer feedback and improving the business. Accounting keeps track of the money currently coming in and the money currently being spent. Finance plans for future expenses and income.
Stakeholders
There are two kinds of stakeholders (individuals who have a vested interest in a company): internal stakeholder and external stakeholders. Internal stakeholders include employees, managers, and owners. These individuals are vested in the company because they directly depend on it for income. External stakeholders include customers, shareholders, creditors, suppliers, and others. These people have a legitimate interest in the company for various reasons and can all be affected by actions the business takes.
External Forces
A business is not just influenced by itself—everything in the world around it can impact a business. A business may create a fun new toy, but if the economy is suffering and consumers aren’t buying a lot of things they do not need, the business most likely won’t succeed. Business can be affected by the economy, consumer trends, government regulations, and many other things. | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/01%3A_The_Role_of_Business/1.08%3A_Putting_it_Together-Role_of_Business.txt |
Why learn about fundamental economic principles?
Economics is about choices: namely, how we choose to allocate scarce resources and how our choices impact others. Beyond that, it’s about the choices made by businesses, government, and other countries. Let’s begin with ice cream—something familiar and tasty to most people—and use it as a framework for thinking about economics.
Let’s say you live in Boise, Idaho, and decide to go out for ice cream with your friend Charlie, who has been reading about ice cream flavored with Persian saffron. That’s the kind he wants, but none of the five ice-cream shops you visit has it. Why not? Why can’t they meet his demand? Because Charlie is the only person in Boise who has ever asked for it, and none of the shops has decided to carry something so expensive (the saffron costs nearly \$1,000 per ounce) and, frankly, strange. They have chosen to offer ice cream that is low-cost, high-demand, and easy to manufacture.
The next day, Charlie is still obsessed with saffron ice cream, and he’s discovered a shop in Dubai, where, for the mere price of \$816 (per scoop, fancy toppings included), one can try this exotic treat. Now Charlie has some economic choices to make. Including the \$1,800 airfare, plus the other travel expenses (hotel, cabs, etc.), the trip to Dubai will cost \$2,600—at least. It will also cost Charlie time: the time it takes to plan the trip, the days off work, and travel time. Then, there’s the opportunity cost. While he is planning, traveling, and eating his ice cream, Charlie’s giving up the opportunity to do other things with his time and money. And there are unforeseen choices and expenses: What if he gets to Dubai and they’ve run out of saffron ice cream? Does he hang around in Dubai, investing more resources and waiting for them to restock? What if he tries Persian saffron ice cream and says, “Yuck!”—and wishes he’d bought banana ice cream back in Boise?
This is an extreme, unlikely situation, of course. However, the choices that ice-cream manufacturers, ice-cream shops, and people like Charlie make every day are all examples of economic decisions: at every turn, a choice has to be made about the allocation of limited resources. What economic decisions do you make in your life?
The purpose of this module is to give you an understanding of the fundamental principles of economics, some of the factors that drive economies, and how economics shapes the business environment. You will likely learn more about economics as you continue your education, but this section should serve as an excellent introduction and give you some tools to think about the impact of economics on your daily life.
2.02: What is Economics
What you’ll learn to do: explain what economics is and why it’s important
In order to understand economics it’s important to master a set of key concepts and understand how they interconnect. We’ll cover these concepts next.
Learning Objectives
• Explain opportunity cost
• Distinguish between macroeconomics and microeconomics
Understanding Economics and Scarcity
Watch it
Throughout this module you’ll encounter short videos that explain complex economic concepts in very simple terms. Take the time to watch them! They’ll help you master the basics before heading to the readings (which tend to cover the same information in more depth).
As you watch the video, consider the following key points:
1. Scarcity exists when human wants for goods and services exceed the available supply.
2. People make decisions in their own self-interest, weighing benefits and costs.
Scarcity
The resources that we value—time, money, labor, tools, land, and raw materials—exist in limited supply. There are simply never enough resources to meet all our needs and desires. This condition is known as scarcity.
At any moment in time, there is a finite amount of resources available. Even when the number of resources is very large, it’s limited. For example, according to the U.S. Bureau of Labor Statistics, in 2016, the labor force in the United States contained more than 158 million workers—that’s a lot, but it’s not infinite. Similarly, the total area of the United States is 3,794,101 square miles—an impressive amount of acreage, but not endless. Because these resources are limited, so are the numbers of goods and services we can produce with them. Combine this with the fact that human wants seem to be virtually infinite, and you can see why scarcity is a problem.
Economics
When faced with limited resources, we have to make choices. Again, economics is the study of how humans make choices under conditions of scarcity. These decisions can be made by individuals, families, businesses, or societies.
Let’s consider a few decisions that we make based on limited resources. Take the following:
Question 1: What classes are you taking this term?
Are you the lucky student who is taking every class you wanted with your first-choice professor during the perfect time and at the ideal location? The odds are that you have probably had to make trade-offs on account of scarcity. There is a limited number of time slots each day for classes and only so many faculty available to teach them. Every faculty member can’t be assigned to every time slot. Only one class can be assigned to each classroom at a given time. This means that each student has to make trade-offs between the time slot, the instructor, and the class location.
Question 2: Where do you live?
Think for a moment, if you had all the money in the world, where would you live? It’s probably not where you’re living today. You have probably made a housing decision based on scarcity. What location did you pick? Given limited time, you may have chosen to live close to work or school. Given the demand for housing, some locations are more expensive than others, though, and you may have chosen to spend more money for a convenient location or to spend less money for a place that leaves you spending more time on transportation. There is a limited amount of housing in any location, so you are forced to choose from what’s available at any time. Housing decisions always have to take into account what someone can afford. Individuals making decisions about where to live must deal with limitations of financial resources, available housing options, time, and often other restrictions created by builders, landlords, city planners, and government regulations.
The Problem of Scarcity
Every society, at every level, must make choices about how to use its resources. Families must decide whether to spend their money on a new car or a fancy vacation. Towns must choose whether to put more of the budget into police and fire protection or into the school system. Nations must decide whether to devote more funds to national defense or to protecting the environment. In most cases, there just isn’t enough money in the budget to do everything.
Economics helps us understand the decisions that individuals, families, businesses, or societies make, given the fact that there are never enough resources to address all needs and desires.
Practice question \(1\)
Suppose that a family decides to spend all of their available money on a fancy vacation instead of purchasing a much needed new automobile. From an economist’s perspective, which of the following statements about this decision is likely to be true?
1. The decision is irrational because anyone can see that choosing a vacation over a much needed new automobile is an improper use of scarce resources
2. The decision is rational in the sense that it reflects the family's preference for vacations over new automobiles.
3. The decision must have been made haphazardly and is therefore irrational.
Answer
b is correct - Economists have to make board assumptions about behavior and therefore choices of individual agents under conditions of scarcity. If the family decides to take the vacation instead of the automobile economists must assume that it reflects their preferences even if the decision may seem irrational to outside observers
a is incorrect - Explaining economic behavior should not include qualitative judgements of decisions made by individuals or households. The family has revealed its preference for vacations over automobiles and economists must assume that this is rational behavior.
c is incorrect - While it could be that the family drew lots to make their choice, economists must assume that even the choosing of lots to decide on what to do with their scarce resources is rational behavior
The Concept of Opportunity Cost
Since resources are limited, every time you make a choice about how to use them, you are also choosing to forego other options. Economists use the term opportunity cost to indicate what must be given up to obtain something that’s desired. A fundamental principle of economics is that every choice has an opportunity cost. If you sleep through your economics class (not recommended, by the way), the opportunity cost is the learning you miss. If you spend your income on video games, you cannot spend it on movies. If you choose to marry one person, you give up the opportunity to marry anyone else. In short, opportunity cost is all around us.
The idea behind opportunity cost is that the cost of one item is the lost opportunity to do or consume something else; in short, opportunity cost is the value of the next best alternative.
Since people must choose, they inevitably face trade-offs in which they have to give up things they desire to get other things they desire more.
Opportunity Cost and Individual Decisions
In some cases, recognizing the opportunity cost can alter personal behavior. Imagine, for example, that you spend \$8 on lunch every day at work. You may know perfectly well that bringing a lunch from home would cost only \$3 a day, so the opportunity cost of buying lunch at the restaurant is \$5 each day (that is, the \$8 that buying lunch costs minus the \$3 your lunch from home would cost). Five dollars each day does not seem to be that much. However, if you project what that adds up to in a year—250 workdays a year × \$5 per day equals \$1,250—it’s the cost, perhaps, of a decent vacation. If the opportunity cost were described as “a nice vacation” instead of “\$5 a day,” you might make different choices.
practice Question \(2\)
Take a stab at this question (you’ll need to do some multiplication). Every day, 500,000 drivers in Los Angeles incur an additional 30 minutes of traffic delays when commuting by car to their jobs. In Boston, the delays amount to 45 minutes for 200,000 drivers. If the price of time is \$15/hour in Los Angeles and \$25/hour in Boston, which city incurs the largest opportunity cost?
1. Boston
2. Neither
3. Los Angeles
Answer
b. is correct - Costs in Los Angeles = 0.50 hours x 500,000 drivers at \$15/hour implies a cost of \$3,750,000. In Boston, 0.75 hours x 200,000 drivers at \$25 per hour implies the same \$3,750,000
Opportunity Cost and Societal Decisions
Opportunity cost also comes into play with societal decisions. Universal health care would be nice, but the opportunity cost of such a decision would be less housing, environmental protection, or national defense. These trade-offs also arise with government policies. For example, after the terrorist plane hijackings on September 11, 2001, many proposals, such as the following, were made to improve air travel safety:
• The federal government could provide armed “sky marshals” who would travel inconspicuously with the rest of the passengers. The cost of having a sky marshal on every flight would be roughly \$3 billion per year.
• Retrofitting all U.S. planes with reinforced cockpit doors to make it harder for terrorists to take over the plane would have a price tag of \$450 million.
• Buying more sophisticated security equipment for airports, like three-dimensional baggage scanners and cameras linked to face-recognition software, would cost another \$2 billion.
However, the single biggest cost of greater airline security doesn’t involve money. It’s the opportunity cost of additional waiting time at the airport. According to the United States Department of Transportation, more than 800 million passengers took plane trips in the United States in 2012. Since the 9/11 hijackings, security screening has become more intensive, and consequently, the procedure takes longer than in the past. Say that, on average, each air passenger spends an extra 30 minutes in the airport per trip. Economists commonly place a value on time to convert an opportunity cost in time into a monetary figure. Because many air travelers are relatively highly paid businesspeople, conservative estimates set the average “price of time” for air travelers at \$20 per hour. Accordingly, the opportunity cost of delays in airports could be as much as 800 million (passengers) × 0.5 hours × \$20/hour—or, \$8 billion per year. Clearly, the opportunity costs of waiting time can be just as substantial as costs involving direct spending.
practice question \(3\)
Raising public transportation fares _________.
1. increases the opportunity costs of driving one's car.
2. increases the opportunity cost of taking public transportation
3. reduces the opportunity cost of driving one's car
Answer
c. is correct - An increase in public transport fares reduces the cost of driving ones car relative to taking public transportation
a is incorrect - Higher fares imply a reduction in the opportunity cost of driving.
b is incorrect - It increases the direct cost of taking public transportation but reduces the opportunity cost of taking any other alternative mode of transpor
Watch this video to see some more examples and to develop a deeper understanding of opportunity cost.
Division of Labor and Specialization
We have learned that there aren’t enough resources to fulfill all of our wants and this reality forces us to make choices that have opportunity costs. How do we get the most we can from the resources we have? Over time, markets and trade have come into existence and have become highly efficient mechanisms for optimizing our use of resources and bringing us the most and best combination of goods and services.
Think back to pioneer days, when the average person knew how to do so much more on his or her own than someone today—everything from shoeing a horse to growing, hunting, and preserving food to building a house and repairing equipment. Most of us don’t know how to do all—or any—of those things. It’s not because we’re not capable of learning them. It’s because we don’t have to. The reason for this is something called the “division and specialization of labor,” a production innovation first put forth by Adam Smith.
The formal study of economics began when Adam Smith (1723–1790) published his famous book, The Wealth of Nations, in 1776. Many authors had written about economics in the centuries before Smith, but he was the first to address the subject in a comprehensive way.
In the first chapter of the book, Smith introduces the idea of the division of labor, which means that the way a good or service is produced is divided into a number of tasks that are performed by different workers, instead of all the tasks being performed by the same person. To illustrate the division of labor, Smith counted how many tasks were involved in making a pin: drawing out a piece of wire, cutting it to the right length, straightening it, putting a head on one end and a point on the other, packaging pins for sale, and so on. Smith counted eighteen distinct tasks that were typically performed by different people—all for a pin!
Modern companies divide tasks, too. Even a relatively simple business like a restaurant divides up the task of serving meals into a range of jobs: top chef, sous chefs, less-skilled kitchen help, host/hostess, waiters/waitresses, janitors, a business manager to handle accounts and paychecks, etc. A complex business like a large manufacturing factory or a hospital can have hundreds of job classifications.
practice question \(4\)
Smith's theory of division and specialization of labor implies that a worker skilled in engineering will
1. improve economic output
2. negatively affect economic output if employed in anything but engineering
3. yield economic output that is sub-optimal if she were employed in something other than engineering-type functions
Answer
c. is correct - According to Smith, output is optimal when workers specialize in a part of the production process that they do best.
a is incorrect - There is no reason to suspect that the engineer is better at any task other than engineering such that output would increase.
b is incorrect - If the engineer works in some part of the production process that is other than engineering, output will be less than it could be but it will decline only if the engineer's skills are so poor in anything but engineering that the production process is interrupted.
Why the Division of Labor Increases Production
When the tasks involved with producing a good or service are divided and subdivided, workers and businesses can produce a greater quantity of those goods or services. In his study of pin factories, Smith observed that one worker alone might make twenty pins in a day, but that a small business of ten workers (some of whom would need to do two or three of the eighteen tasks involved in pin making), could make forty-eight thousand pins in a day. How can a group of workers, each specializing in certain tasks, produce so much more than the same number of workers who try to produce the entire good or service by themselves? Smith offered three reasons.
First, specialization in a particular small job allows workers to focus on the parts of the production process in which they have an advantage. People have different skills, talents, and interests, so they will be better at some jobs than at others. The particular advantages may be based on educational choices, which are shaped, in turn, by interests and talents. Only those with medical training qualify to become doctors, for instance. For some goods, specialization will be affected by geography—it’s easier to be a wheat farmer in North Dakota than in Florida, but easier to run a tourist hotel in Florida than in North Dakota. If you live in or near a big city, it’s easier to attract enough customers to operate a successful dry-cleaning business or movie theater than if you live in a sparsely populated rural area. Whatever the reason, if people specialize in the production of what they do best, they will be more productive than if they produce a combination of things, some of which they are good at and some of which they are not.
Second, workers who specialize in certain tasks often learn to produce more quickly and with higher quality. This pattern holds true for many workers, including assembly-line laborers who build cars, stylists who cut hair, and doctors who perform heart surgery. In fact, specialized workers often know their jobs well enough to suggest innovative ways to do their work faster and better. A similar pattern often operates within businesses. In many cases, a business that focuses on one or a few products is more successful than firms that try to make a wide range of products.
Third, specialization allows businesses to take advantage of economies of scale, which means that, for many goods, as the level of production increases, the average cost of producing each individual unit declines. For example, if a factory produces only one hundred cars per year, each car will be quite expensive to make on average. However, if a factory produces fifty thousand cars each year, then it can set up an assembly line with huge machines and workers performing specialized tasks, and the average cost of production per car will drop. Economies of scale implies that production is becoming more efficient as the scale of production rises.
The ultimate result of workers who can focus on their preferences and talents, learn to do their specialized jobs better, and work in larger organizations is that society as a whole can produce and consume far more than if each person tried to produce all of their own goods and services. The division and specialization of labor has been a force against the problem of scarcity.
practice question \(5\)
Use the information you just read in the text to think about the following scenario. The computer software industry is more likely to achieve economies of scale if it is located
1. in or close to large cities with large numbers of technology workers.
2. in highly populated areas with an abundance of low skill workers
3. in geographical areas with the highest prevailing wages
Answer
a is correct - Being close to large cities will provide software makers with easier access to skilled labor than if located in a sparsely populated or rural area. This would enable software producers to build larger production facilities and therefore increase the likelihood of achieving economies of scale.
b is incorrect - Low skills imply that these workers are probably not well-matched to software production type jobs and therefore the software producers would face a labor shortage.
c is incorrect - While high wages may suggest a highly skilled workforce, it does not necessarily imply that such workers are well-suited to software production or that there are sufficient numbers of them.
Trade and Markets
Specialization only makes sense, though, if workers (and other economic agents such as businesses and nations) can use their income to purchase the other goods and services they need. In short, specialization requires trade. You do not have to know anything about electronics or sound systems to play music—you just buy an iPod or MP3 player, download the music, and listen. You don’t have to know anything about textiles or the construction of sewing machines if you need a jacket—you just buy the jacket and wear it. Instead of trying to acquire all the knowledge and skills involved in producing all of the goods and services that you wish to consume, the market allows you to learn a specialized set of skills and then use the pay you receive to buy the goods and services you need or want. This is how our modern society has evolved into a strong economy.
practice question \(6\)
An economy is composed entirely of two equally sized farms A and B producing both eggs and milk. Farm A is better at producing eggs than Farm B which is better at producing milk. Then in order to maximize output, Farm A should
1. Abandon the production of milk to fully specialize in the production of eggs and then trade with Farm B for milk
2. Produce both eggs and milk on its own and sell its excess eggs to B for additional milk.
3. Reduce its production of eggs in order to commit resources to learn how to better produce milk.
Answer
a is correct - According to Smith's theory Farm A should fully specialize in the production of eggs then trade eggs for milk. Since it can produce eggs more cheaply than B and B can produce milk more cheaply than A all resources are being efficiently utilized to maximize output.
b is incorrect - Any milk that Farm A produces is an inefficient use of its resources. In addition, when Farm A produces milk it prevents Farm B from realizing its full cost savings by limiting trade with A in milk. Recall that if Farm B has economies of scale in the production of eggs, its average costs will fall as output of milk rises. If these cost savings are unrealized the economy is worse off.
c is incorrect - By reducing its production of eggs, Farm A is undermining output for the entire economy. Farm B would need to increase its output of eggs but because it is not good at egg production, such an outcome would imply a proportionally large reduction in the output of milk.
Microeconomics and Macroeconomics
Economics is such a broad field of study that it is broken down into two subfields: microeconomics and macroeconomics. Microeconomics covers topics related to the actions of individual people or businesses within the economy while macroeconomics examines the larger economy and broader issues like GDP, inflation, growth rates, and trade. Watch this video to learn about the distinction between the two perspectives.
It should be clear by now that economics covers a lot of ground. That ground can be divided into two parts: Microeconomics focuses on the actions of individual agents within the economy, like households, workers, and businesses; macroeconomics looks at the economy as a whole. It focuses on broad issues such as growth, unemployment, inflation, and trade balance. Microeconomics and macroeconomics are not separate subjects but are, rather, complementary perspectives on the overall subject of the economy.
To understand why both microeconomic and macroeconomic perspectives are useful, consider the problem of studying a biological ecosystem like a lake. One person who sets out to study the lake might focus on specific topics: certain kinds of algae or plant life; the characteristics of particular fish or snails; or the trees surrounding the lake. Another person might take an overall view and instead consider the entire ecosystem of the lake from top to bottom: what eats what, how the system remains in balance, and what environmental stresses affect this balance. Both approaches are useful, and both researchers study the same lake, but the viewpoints are different. In a similar way, both microeconomics and macroeconomics study the same economy, but each has a different starting point, perspective, and focus.
Whether you are looking at lakes or economics, the micro and the macro insights should illuminate each other. In studying a lake, the “micro” insights about particular plants and animals help us to understand the overall food chain, while the “macro” insights about the overall food chain help to explain the environment in which individual plants and animals live.
In economics, the micro decisions of individual businesses are influenced by the health of the macroeconomy—for example, firms will be more likely to hire workers if the overall economy is growing. In turn, the performance of the macroeconomy ultimately depends on the microeconomic decisions made by individual households and businesses.
Microeconomics
What determines how households and individuals spend their budgets? What combination of goods and services will best fit their needs and wants, given the budget they have to spend? How do people decide whether to work, and if so, whether to work full time or part time? How do people decide how much to save for the future, or whether they should borrow to spend beyond their current means?
What determines the products, and how many of each, a firm will produce and sell? What determines what prices a firm will charge? What determines how a firm will produce its products? What determines how many workers it will hire? How will a firm finance its business? When will a firm decide to expand, downsize, or even close? In the microeconomic part of this text, we will learn about the theory of consumer behavior and the theory of the firm.
Macroeconomics
What determines the level of economic activity in a society or nation?—that is, how many goods and services does it actually produce? What determines how many jobs are available in an economy? What determines a nation’s standard of living? What causes the economy to speed up or slow down? What causes firms to hire more workers or lay them off? Finally, what causes the economy to grow over the long term?
An economy’s macroeconomic health can be assessed by a number of standards or goals. The most important macroeconomic goals are the following:
• Growth in the standard of living
• Low unemployment
• Low inflation
Macroeconomic policy pursues these goals through monetary policy and fiscal policy:
• Monetary policy, which involves policies that affect bank lending, interest rates, and financial capital markets, is conducted by a nation’s central bank. For the United States, this is the Federal Reserve.
• Fiscal policy, which involves government spending and taxes, is determined by a nation’s legislative body. For the United States, this is the Congress and the executive branch, which establishes the federal budget.
To keep the differences between these policies straight, remember that the term monetary relates to money, and the term fiscal relates to government revenue or taxes.
practice question \(7\)
Government expenditures on public schools is classified as _______ policy.
1. monetary
2. fiscal
3. microeconomic
Answer
b is correct - it is still classified as fiscal policy since it is a government purchase of goods and services
practice question \(8\)
Economic policy decisions taken by individual states within the U.S. are classified as ________ decisions.
1. microeconomic
2. macroeconomic
3. neither microeconomic or macroeconomic
Answer
b is correct - It is tempting to say microeconomic because it is one State making an economic decision within the broader national economy. However, the decision of the State affects all economic actors that live or operate within the State and therefore should be classified as macroeconomic. | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/02%3A_Economic_Environment/2.01%3A_Why_it_Matters-_Economic_Environment.txt |
What you’ll learn to do: describe and differentiate between major different economic systems
In this section, you’ll learn about the basic organizing principles of different types of economies. Understanding the characteristics of a competitive market, in particular, is an important foundation for understanding the mechanisms of supply and demand, which you’ll learn about later in this module.
Learning Objectives
• Distinguish between market, planned, and mixed economies
Economic Systems
Consider how complex a modern economy is. It includes all production of goods and services, all buying and selling, all employment. The economic life of every individual is interrelated, at least to a small extent, with the economic lives of thousands or even millions of other individuals. Who organizes and coordinates this system? Who insures that, for example, the number of televisions a society produces is the same as the amount it needs and wants? Who insures that the right number of employees works in the electronics industry? Who makes sure that televisions are produced in the best way possible? How does it all get done? The answer to these important questions depends on the kind of economic system a society uses.
On the right : Figure \(1\) Legoland, Billund, Denmark: Picture of a Planned Economy?
In the modern world today, there is a range of economic systems, from market economies to planned (or command) economies.
Market Economies
A market is any situation that brings together buyers and sellers of goods or services. Buyers and sellers can be either individuals or businesses. In a market economy, economic decision-making happens through markets. Market economies are based on private enterprise: the means of production (resources and businesses) are owned and operated by private individuals or groups of private individuals. Businesses supply goods and services based on demand. Which goods and services are supplied depends on what products businesses think will bring them the most profit. The more a product is demanded by consumers or other businesses, the higher the price businesses can charge, and so the more of the product will be supplied. Consumer demand depends on peoples’ incomes. A person’s income is based on his or her ownership of resources (especially labor). The more society values the person’s output, the higher the income they will earn (think Lady Gaga or LeBron James).
Examples of free-market economies include Hong Kong, Singapore, and to a large extent, New Zealand, and the United States.
Free Markets
In a market economy, decisions about what products are available and at what prices are determined through the interaction of supply and demand. A competitive market is one in which there is a large number of buyers and sellers, so that no one can control the market price. A free market is one in which the government does not intervene in any way. A free and competitive market economy is the ideal type of market economy, because what is supplied is exactly what consumers demand.
Price controls are an example of a market that is not free. When government intervenes, the market outcomes will be different from those that would occur in a free and competitive market model. When markets are less than perfectly competitive (e.g., monopolistic), the market outcomes will also differ.
practice question \(1\)
Which of the following is a defining feature of free markets?
1. There is a large number of buyers and sellers.
2. The government does not interfere in any way with the economic decisions of buyers and sellers
3. The means of production are owned by government, not private individuals.
Answer
b is correct - This is the key defining feature of free markets. The government allows the forces of supply and demand to determine quantity and price.
a is incorrect - This is not a necessary feature for a free market. A market in which a limited number of buyers or sellers control the market would still be a free market just not a competitive market.
c is incorrect - Private ownership of the means of production (labor, factories, businesses,etc.) is a defining feature of market economies and therefore free markets.
practice question \(2\)
The economy of Atlantia is defined by the private ownership of the means of production by Atlantia’s citizens. While owners are usually free to utilize their property as they see fit, the government does intervene to ban certain harmful products (i.e. addictive drugs, lead paint, etc) from entering the market. Atlantia’s parliament has recently passed a minimum wage law setting minimum hourly compensation at \$5.00 per hour. Atlantia is an example of a ________ economy.
1. mixed market
2. free market
3. command
Answer
a is correct - Private ownership of the means of production along with limited government intervention are characteristics of a market economy.
Planned (or Command) Economies
Command economies operate very differently. In a command economy, economic effort is devoted to goals passed down from a ruler or ruling class. Ancient Egypt was a good example: A large part of economic life was devoted to building pyramids (like the one at the left), for the pharaohs. Medieval manor life is another example: The lord provided the land for growing crops and protection in the event of war. In return, vassals provided labor and soldiers to do the lord’s bidding. In the last century, communism emphasized command economies.
In a command economy, resources and businesses are owned by the government. The government decides what goods and services will be produced and what prices will be charged for them. The government decides what methods of production will be used and how much workers will be paid. Some necessities like health care and education are provided for free, as long as the state determines that you need them. Currently, North Korea and Cuba have command economies.
The primary distinction between a free and command economy is the degree to which the government determines what can be produced and what prices will be charged. In a free market, these determinations are made by the collective decisions of the market itself (which is comprised of producers and consumers). Producers and consumers make rational decisions about what will satisfy their self-interest and maximize profits, and the market responds accordingly. In a planned economy, the government makes most decisions about what will be produced and what the prices will be, and the market must follow that plan.
Most economies in the real world are mixed; they combine elements of command and market systems. The U.S. economy is positioned toward the market-oriented end of the spectrum. Many countries in Europe and Latin America, while primarily market-oriented, have a greater degree of government involvement in economic decisions than in the U.S. economy. China and Russia, while they are closer now to having a market-oriented system than several decades ago, remain closer to the command-economy end of the spectrum.
practice question \(3\)
Jane Doe is a shop owner in the fictional country of Xanadu. Every month the government’s planning ministry sends her a large booklet (which resembles a phone book) regulating the price of essential commodities including milk, flour, and eggs. In response to these regulations Jane Doe has reduced her inventory of essential goods and switched to selling luxuries such as cakes, pies, and soft drinks. Luxury goods are not price controlled. Does Jane Doe reside in a command economy? Why or why not?
1. Jane resides in a command economy, as the government regulates some prices
2. Jane does not reside in a command economy. Prices and money have no real place in a real command economy.
3. Jane does not reside in a command economy. She owns her own business and is free to make some production and price decisions
Answer
c is correct - The government's extensive intervention in the economy combined with private ownership and limited independent market activity allows us to best characterize Xanadu's economy as 'mixed'.
a is incorrect - While Xanadu's government intervenes extensively in the economy, Jane's business is still privately owned and free to make some independent decisions. These are not features of a total command economy.
b is incorrect - While Jane does not reside in a command economy, lack of money is not a defining feature of command economies.
practice question \(4\)
You are the leader of a revolutionary movement which has recently overthrown the government of the tiny country of Tropico. During the 3rd Party Congress, which was held shortly before your glorious victory, the party committee decreed that “to free Tropico’s struggling masses from the jackboots of capitalism and reactionary imperialism, it is necessary to immediately enforce a command economy upon realization of our final victory.” Which of the following actions would betray your mandate to create a command economy in Tropico?
1. Create a Ministry of Planning which will set prices, wages, and production targets.
2. Immediately expropriating all private property, which will now be state-owned
3. Maintain private ownership, but legalize labor unions which will now be free to bargain with private businesses for improved wages and benefits.
Answer
c is correct - This form of government intervention is limited and allows for the continued independence of privately owned businesses and resources. Their continued existence is a betrayal of the decrees issued during the 3rd Party Congress.
The following Crash Course video provides additional information about the broad economic choices that countries make when they decide between planned and market economies. The narrators talk fast, so you’ll need to listen closely and possibly watch the video a second time!
To recap, economic systems determine the following:
• What to produce?
• How to produce it?
• Who gets it?
In a planned economy, government controls the factors of production:
• In a true communist economy, there is no private property—everyone owns the factors of production. This type of planned economy is called a command economy.
• In a socialist economy, there is some private property and some private control of industry.
In a free-market (capitalist) economy, individuals own the factors of production:
• Privately owned businesses produce products.
• Consumers choose the products they prefer causing the companies that product them to make more profit.
Even in free markets, governments will
• Maintain the rule of law
• Create public goods and services such as roads and education
• Step in when the market gets things wrong (e.g., setting minimum wage, establishing environmental standards)
In reality, economies are neither completely free-market nor completely planned. Neither exists in “pure” form, since all societies and governments regulate their economies to varying degrees. Throughout this course we will consider a number of ways in which the U.S. government influences and controls the economy. | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/02%3A_Economic_Environment/2.03%3A_Economic_Systems.txt |
What you’ll learn to do: explain the law of demand
Imagine that the price of Ben & Jerry’s ice cream decreases by 25 percent during the next summer. What do you think will happen to the amount of Ben & Jerry’s ice cream that people will want to buy? Clearly, the demand for ice cream will increase. By the same token, if the price of the ice cream were to rise by 25 percent, then the demand for the ice cream would fall. In this section, you will examine the law of demand and see why this simple concept is essential to understanding economics.
Learning Objectives
• Explain a demand curve
• Explain the factors that can change demand
The Law of Demand
Demand describes the amount of goods or services that consumers want to (and are able to) pay to purchase that good or service. Before learning more about the details of demand, watch this video to get a basic understanding about what it is and its importance to understanding economic behavior.
The law of demand states that, other things being equal,
• More of a good will be bought the lower its price
• Less of a good will be bought the higher its price
Ceteris paribus means “other things being equal.”
Demand for Goods and Services
Economists use the term demand to refer to the amount of some good or service consumers are willing and able to purchase at each price. Demand is based on needs and wants—a consumer may be able to differentiate between a need and a want, but from an economist’s perspective, they are the same thing. Demand is also based on ability to pay. If you can’t pay for it, you have no effective demand.
What a buyer pays for a unit of the specific good or service is called the price. The total number of units purchased at that price is called the quantity demanded. A rise in the price of a good or service almost always decreases the quantity of that good or service demanded. Conversely, a fall in price will increase the quantity demanded. When the price of a gallon of gasoline goes up, for example, people look for ways to reduce their consumption by combining several errands, commuting by carpool or mass transit, or taking weekend or vacation trips closer to home. Economists call this inverse relationship between price and quantity demanded the law of demand. The law of demand assumes that all other variables that affect demand are held constant.
An example from the market for gasoline can be shown in the form of a table or a graph. (Refer back to “Reading: Creating and Interpreting Graphs” in module 0 if you need a refresher on graphs.) A table that shows the quantity demanded at each price, such as Table 1, is called a demand schedule. Price in this case is measured in dollars per gallon of gasoline. The quantity demanded is measured in millions of gallons over some time period (for example, per day or per year) and over some geographic area (like a state or a country).
Table \(1\). Price and Quantity Demanded of Gasoline
Price (per gallon) Quantity Demanded (millions of gallons)
\$1.00 800
\$1.20 700
\$1.40 600
\$1.60 550
\$1.80 500
\$2.00 460
\$2.20 420
A demand curve shows the relationship between price and quantity demanded on a graph like Figure 1, below, with quantity on the horizontal axis and the price per gallon on the vertical axis. Note that this is an exception to the normal rule in mathematics that the independent variable (x) goes on the horizontal axis and the dependent variable (y) goes on the vertical. Economics is different from math! Note also that each point on the demand curve comes from one row in Table \(1\). For example, the upper most point on the demand curve corresponds to the last row in Table \(1\), while the lower most point corresponds to the first row.
Figure \(PageIndex{1}\). A Demand Curve for Gasoline (derived from the data in Table \(1\).
The demand schedule (Table \(1\) shows that as price rises, quantity demanded decreases, and vice versa. These points can then be graphed, and the line connecting them is the demand curve (shown by line D in the graph, above). The downward slope of the demand curve again illustrates the law of demand—the inverse relationship between prices and quantity demanded.
The demand schedule shown by Table \(1\) and the demand curve shown by the graph in Figure \(|PageIndex{1}\) are two ways of describing the same relationship between price and quantity demanded.
Demand curves will look somewhat different for each product. They may appear relatively steep or flat, or they may be straight or curved. Nearly all demand curves share the fundamental similarity that they slope down from left to right. In this way, demand curves embody the law of demand: As the price increases, the quantity demanded decreases, and conversely, as the price decreases, the quantity demanded increases.
practice question \(1\)
Which of the following demand curve for tomatoes violates the law of demand?
Answer
b is the answer because as the price drops from \$4 to \$3 the quantity demanded is shown to fall, which is not consistent with the law of demand.
practice question \(2\)
You are given the following demand schedule for used cars. Which of the following demand curves accurately represents this demand schedule and has proper formatting?
The demand schedule for used cars:
Price (\$) Quantity Demanded
1000 7600
2000 6500
3000 5400
4000 4300
5000 3200
6000 2100
7000 1000
8000 300
Answer
b is correct - Price is displayed on the vertical axis, quantity on the horizontal, and all points are faithfully plotted according to the demand schedule.
demand vs. quantity demand
In economic terminology, demand is not the same as quantity demanded. When economists talk about demand, they mean the relationship between a range of prices and the quantities demanded at those prices, as illustrated by a demand curve or a demand schedule. When economists talk about quantity demanded, they mean only a certain point on the demand curve, or one quantity on the demand schedule. In short, demand refers to the curve and quantity demanded refers to the (specific) point on the curve.
Change in Demand vs. Change in Quantity Demanded
It’s hard to overstate the importance of understanding the difference between shifts in curves and movements along curves. Remember, when we talk about changes in demand or supply, we do not mean the same thing as changes in quantity demanded or quantity supplied.
A change in demand refers to a shift in the entire demand curve, which is caused by a variety of factors (preferences, income, prices of substitutes and complements, expectations, population, etc.). In this case, the entire demand curve moves left or right.
A change in quantity demanded refers to a movement along the demand curve, which is caused only by a chance in price. In this case, the demand curve doesn’t move; rather, we move along the existing demand curve.
Factors Affecting Demand
We defined demand as the amount of some product that a consumer is willing and able to purchase at each price. This suggests at least two factors, in addition to price, that affect demand. “Willingness to purchase” suggests a desire to buy, and it depends on what economists call tastes and preferences. If you neither need nor want something, you won’t be willing to buy it. “Ability to purchase” suggests that income is important. Professors are usually able to afford better housing and transportation than students, because they have more income. The prices of related goods can also affect demand. If you need a new car, for example, the price of a Honda may affect your demand for a Ford. Finally, the size or composition of the population can affect demand. The more children a family has, the greater their demand for clothing. The more driving-age children a family has, the greater their demand for car insurance and the less for diapers and baby formula.
These factors matter both for demand by an individual and demand by the market as a whole. Exactly how do these various factors affect demand, and how do we show the effects graphically? To answer those questions, we need the ceteris paribus assumption.
The Ceteris Paribus Assumption
A demand curve or a supply curve (which we’ll cover later in this module) is a relationship between two, and only two, variables: quantity on the horizontal axis and price on the vertical axis. The assumption behind a demand curve or a supply curve is that no relevant economic factors, other than the product’s price, are changing. Economists call this assumption ceteris paribus, a Latin phrase meaning “other things being equal.” Any given demand or supply curve is based on the ceteris paribus assumption that all else is held equal. (You’ll recall that economists use the ceteris paribus assumption to simplify the focus of analysis.) Therefore, a demand curve or a supply curve is a relationship between two, and only two, variables when all other variables are held equal. If all else is not held equal, then the laws of supply and demand will not necessarily hold.
Ceteris paribus is typically applied when we look at how changes in price affect demand or supply, but ceteris paribus can also be applied more generally. In the real world, demand and supply depend on more factors than just price. For example, a consumer’s demand depends on income, and a producer’s supply depends on the cost of producing the product. How can we analyze the effect on demand or supply if multiple factors are changing at the same time—say price rises and income falls? The answer is that we examine the changes one at a time, and assume that the other factors are held constant.
For example, we can say that an increase in the price reduces the amount consumers will buy (assuming income, and anything else that affects demand, is unchanged). Additionally, a decrease in income reduces the amount consumers can afford to buy (assuming price, and anything else that affects demand, is unchanged). This is what the ceteris paribus assumption really means. In this particular case, after we analyze each factor separately, we can combine the results. The amount consumers buy falls for two reasons: first because of the higher price and second because of the lower income.
practice question \(3\)
Below is the demand curve for oranges in a Florida supermarket. Select the demand schedule that best corresponds to this demand curve.
1. Demand Schedule for Oranges
Quantity (thousands) Price (per pound)
8 \$10
7 \$9
6 \$8
5 \$7
4 \$6
3 \$5
2 \$4
1 \$3
2. Demand Schedule for Oranges
Quantity (thousands) Price (per pound)
1 \$20
2 \$18
3 \$16
4 \$14
5 \$12
6 \$10
7 \$8
8 \$6
3. Demand Schedule for Oranges
Quantity (thousands) Price (per pound)
1 \$10
2 \$9
3 \$8
4 \$7
5 \$6
6 \$5
7 \$4
8 \$3
Answer
C.
practice question \(4\)
You are the chief data analyst of the U.S. Fish and Wildlife Service for the Northeast region. Recently the agency has become concerned about overfishing in the North Atlantic fisheries, and you are charged with estimating the demand curve for tuna as part of the agency’s mitigation efforts.
From public surveys you know that when the price of a freshly caught tuna is \$400, the public will demand a quantity of 1 million fish. If the price is \$275 then the public will demand 4 million fish. Finally, if the price was \$185 consumers will demand a quantity of 8 million fish.
Which curve below could be the correct demand curve for North Atlantic tuna given these three data points?
1. the blue curve
2. the silver curve
3. the orange curve
Answer
A is correct - only the blue curve passes through all three data points given
The Effect of Income on Demand
Let’s use income as an example of how factors other than price affect demand. Figure 4 shows the initial demand for automobiles as D0. At point Q, for example, if the price is \$20,000 per car, the quantity of cars demanded is 18 million. D0 also shows how the quantity of cars demanded would change as a result of a higher or lower price. For example, if the price of a car rose to \$22,000, the quantity demanded would decrease to 17 million, at point R.
The original demand curve D0, like every demand curve, is based on the ceteris paribus assumption that no other economically relevant factors change. Now imagine that the economy expands in a way that raises the incomes of many people, making cars more affordable. How will this affect demand? How can we show this graphically?
Return to Figure \(1\). The price of cars is still \$20,000, but with higher incomes, the quantity demanded has now increased to 20 million cars, shown at point S. As a result of the higher income levels, the demand curve shifts to the right to the new demand curve D1, indicating an increase in demand. Table \(1\), below, shows clearly that this increased demand would occur at every price, not just the original one.
Table \(1\). Price and Demand Shifts: A Car Example
Price Decrease to D2 Original Quantity Demanded D0 Increase to D1
\$16,000 17.6 million 22.0 million 24.0 million
\$18,000 16.0 million 20.0 million 22.0 million
\$20,000 14.4 million 18.0 million 20.0 million
\$22,000 13.6 million 17.0 million 19.0 million
\$24,000 13.2 million 16.5 million 18.5 million
\$26,000 12.8 million 16.0 million 18.0 million
Now, imagine that the economy slows down so that many people lose their jobs or work fewer hours, reducing their incomes. In this case, the decrease in income would lead to a lower quantity of cars demanded at every given price, and the original demand curve D0 would shift left to D2. The shift from D0 to D2 represents such a decrease in demand: At any given price level, the quantity demanded is now lower. In this example, a price of \$20,000 means 18 million cars sold along the original demand curve, but only 14.4 million sold after demand fell.
When a demand curve shifts, it does not mean that the quantity demanded by every individual buyer changes by the same amount. In this example, not everyone would have higher or lower income and not everyone would buy or not buy an additional car. Instead, a shift in a demand curve captures a pattern for the market as a whole: Increased demand means that at every given price, the quantity demanded is higher, so that the demand curve shifts to the right from D0 to D1. And, decreased demand means that at every given price, the quantity demanded is lower, so that the demand curve shifts to the left from D0 to D2.
We just argued that higher income causes greater demand at every price. This is true for most goods and services. For some—luxury cars, vacations in Europe, and fine jewelry—the effect of a rise in income can be especially pronounced. A product whose demand rises when income rises, and vice versa, is called a normal good. A few exceptions to this pattern do exist, however. As incomes rise, many people will buy fewer generic-brand groceries and more name-brand groceries. They are less likely to buy used cars and more likely to buy new cars. They will be less likely to rent an apartment and more likely to own a home, and so on. A product whose demand falls when income rises, and vice versa, is called an inferior good. In other words, when income increases, the demand curve shifts to the left.
practice question \(5\)
Alexis owns a small business selling power tools. This past month she has noticed that the quantity demanded for high-end electric drills has decreased by 25%. Which of the following demand curve shifting events is a possible explanation for this change?
1. The price of electric drills has increased.
2. Customers' incomes have decreased.
3. Customers' incomes have increased.
Answer
b is correct - Falling incomes would lead to a leftward shift of the demand curve causing less quantity demanded at any given price.
a is incorrect - While this would explain the decrease in quantity demanded, it will not have occurred because of a shift in the demand curve, rather movement along the existing curve.
c is incorrect - This would cause an increase in quantity demanded at any given price level rather than a decrease.
practice question \(6\)
Over the past century the quantity of potatoes purchased by Irish consumers has fallen significantly, while incomes have grown exponentially. Meanwhile potatoes are still the cheapest source of calories available to the consumer. From this information it would be correct to assume that potatoes are a(n) ________ good.
1. essential
2. normal
3. inferior
Answer
c is correct - An inverse relationship between demand and incomes in the hallmark of an inferior good.
a is incorrect - Whether a good is 'essential' or not has no bearing on the evidence presented.
b is incorrect - We would expect to see demand increases as incomes rose if potatoes are a normal good.
Other Factors That Shift Demand Curves
Income is not the only factor that causes a shift in demand. Other things that change demand include tastes and preferences, the composition or size of the population, the prices of related goods, and even expectations. A change in any one of the underlying factors that determine what quantity people are willing to buy at a given price will cause a shift in demand. Graphically, the new demand curve lies either to the right (an increase) or to the left (a decrease) of the original demand curve. Let’s look at these factors.
Changing Tastes or Preferences
From 1980 to 2012, the per-person consumption of chicken by Americans rose from 33 pounds per year to 81 pounds per year, and consumption of beef fell from 77 pounds per year to 57 pounds per year, according to the U.S. Department of Agriculture (USDA). Changes like these are largely due to shifts in taste, which change the quantity of a good demanded at every price: That is, they shift the demand curve for that good—rightward for chicken and leftward for beef.
Changes in the Composition of the Population
The proportion of elderly citizens in the United States population is rising. It rose from 9.8 percent in 1970 to 12.6 percent in 2000 and will be a projected (by the U.S. Census Bureau) 20 percent of the population by 2030. A society with relatively more children, like the United States in the 1960s, will have greater demand for goods and services like tricycles and day care facilities. A society with relatively more elderly persons, as the United States is projected to have by 2030, has a higher demand for nursing homes and hearing aids. Similarly, changes in the size of the population can affect the demand for housing and many other goods. Each of these changes in demand will be shown as a shift in the demand curve.
Changes in the Prices of Related Goods
The demand for a product can also be affected by changes in the prices of related goods such as substitutes or complements. A substitute is a good or service that can be used in place of another good or service. As electronic books, like this one, become more available, you would expect to see a decrease in demand for traditional printed books. A lower price for a substitute decreases demand for the other product. For example, in recent years as the price of tablet computers has fallen, the quantity demanded has increased (because of the law of demand). Since people are purchasing tablets, there has been a decrease in demand for laptops, which can be shown graphically as a leftward shift in the demand curve for laptops. A higher price for a substitute good has the reverse effect.
Other goods are complements for each other, meaning that the goods are often used together, because consumption of one good tends to enhance consumption of the other. Examples include breakfast cereal and milk; notebooks and pens or pencils, golf balls and golf clubs; gasoline and sport utility vehicles; and the five-way combination of bacon, lettuce, tomato, mayonnaise, and bread. If the price of golf clubs rises, since the quantity of golf clubs demanded falls (because of the law of demand), demand for a complement good like golf balls decreases, too. Similarly, a higher price for skis would shift the demand curve for a complement good like ski resort trips to the left, while a lower price for a complement has the reverse effect.
Changes in Expectations About Future Prices or Other Factors That Affect Demand
While it is clear that the price of a good affects the quantity demanded, it is also true that expectations about the future price (or expectations about tastes and preferences, income, and so on) can affect demand. For example, if people hear that a hurricane is coming, they may rush to the store to buy flashlight batteries and bottled water. If people learn that the price of a good like coffee is likely to rise in the future, they may head for the store to stock up on coffee now. These changes in demand are shown as shifts in the curve. Therefore, a shift in demand happens when a change in some economic factor (other than the current price) causes a different quantity to be demanded at every price.
practice question \(7\)
Natalie runs a fast food stand selling hot dogs and soft drinks. A decrease in the price of which good below is likely to negatively impact her bottom line?
1. hamburgers
2. t-shirts
3. mustard
Answer
a is correct - Hamburgers and hot dogs are likely to be substitutes, so if the price of hamburgers falls this will likely shift the demand curve for hot dogs to the left, decreasing her sales of hot dogs.
practice question \(8\)
Over the past 10 years consumer incomes have grown by 15%, while the price of automobiles has increased by over 20%. Tires and automobiles are complement goods. What would be a reasonable expectation regarding the demand for tires today compared to 10 years ago?
1. The demand for tires will shift to the left because the price of the complement good-automobiles-has increased
2. The demand for tires will shift to the right because of the income effect.
3. It is impossible to know with the given information
Answer
c is correct - The income effect will increase demand for tires, while the increase in the price of automobiles will decrease demand. It is impossible to know at the present time which effect is strong.
a is incorrect - While increasing the price of a complement good would decrease demand for tires, the impact of income on tires and automobiles must also be considered.
b is incorrect - While the income effect is likely to increase demand for automobiles and therefore tires, the effect of a price increase for the complement good automobiles must also be considered.
Summary
Six factors that can shift demand curves are summarized in Figure \(5\), below. The direction of the arrows indicates whether the demand curve shifts represent an increase in demand or a decrease in demand. Notice that a change in the price of the good or service itself is not listed among the factors that can shift a demand curve. A change in the price of a good or service causes a movement along a specific demand curve, and it typically leads to some change in the quantity demanded, but it does not shift the demand curve.
practice question \(9\)
You are a consultant analyzing the American car market for the new Toyota Prius. Your chief competitor Tesla has recently dropped the list price of their vehicles by 20%. When illustrating shifts of the demand curve it is customary to draw arrows to show the direction of change. Which directions should the arrows be drawn in the graph below? Which curve represents old demand and which curve the new demand?
1. The arrows should be drawn pointing leftwards. The curve on the right represents the new demand and the curve on the left old demand.
2. The arrows should be drawn pointing rightwards. The curve on the right represents new demand and the curve on the left old demand.
3. The arrows should be drawn pointing leftwards. The curve on the right represents the old demand and the curve on the left new demand.
Answer
C
practice question \(10\)
You are in charge of data analytics for Home Depot’s South Florida division. Recently you have observed a change in the market for power generators illustrated below. Which explanation best corresponds with the observed data?
1. The price of a competitor's generators has fallen.
2. The price of Home Depot generators has dropped 20%.
3. A hurricane is expected to arrive next week.
Answer
c is correct - Expectations of an impending storm are likely to increase short-run demand, which is consistent with what we observe in the demand curves here.
a is incorrect - A drop in the price of substituted goods will cause a leftward shift of the demand curve.
b is incorrect - A price change would cause a movement along the demand curve, not a shift in demand. Step 2. Suppose income increases. As a result of the change, are consumers going to buy more or less pizza? The answer is more. Draw a dotted horizontal line from the chosen price, through the original quantity demanded, to the new point with the new Q1. Draw a dotted vertical line down to the horizontal axis and label the new Q1. An example is provided in Figure 6.
Shift in demand due to income increase
A shift in demand means that at any price (and at every price), the quantity demanded will be different than it was before. Following is a graphic illustration of a shift in demand due to an income increase.
Step 1. Draw the graph of a demand curve for a normal good like pizza. Pick a price (like P0). Identify the corresponding Q0. An example is shown in Figure \(6\).
Step 2. Suppose income increases. As a result of the change, are consumers going to buy more or less pizza? The answer is more. Draw a dotted horizontal line from the chosen price, through the original quantity demanded, to the new point with the new Q1. Draw a dotted vertical line down to the horizontal axis and label the new Q1. An example is provided in Figure \(7\).
Step 3. Now, shift the curve through the new point. You will see that an increase in income causes an upward (or rightward) shift in the demand curve, so that at any price, the quantities demanded will be higher, as shown in Figure \(8\).
Simulation: Demand for Food Trucks
Play the simulation below multiple times to see how different choices lead to different outcomes. All simulations allow unlimited attempts so that you can gain experience applying the concepts. | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/02%3A_Economic_Environment/2.04%3A_Demand.txt |
What you’ll learn to do: explain the law of supply
So far you’ve learned about the role of demand in economics—which is the consumer side of the story. In this section, you’ll learn about the producer side of economics to see what factors impact the amount of goods supplied in a market. For example, suppose the global price of petroleum falls significantly. What do you think will happen to the supply of gasoline? How are supply and price connected? In the following readings you’ll examine the law of supply and see why this counterpart to “demand” is also essential to understanding economics.
Learning Objectives
• Explain a supply curve
• Explain the factors that can change supply
The Law of Supply
The law of supply states that more of a good will be provided the higher its price; less will be provided the lower its price, ceteris paribus. There is a direct relationship between price and quantity supplied. Watch this video to learn more.
Supply of Goods and Services
When economists talk about supply, they mean the amount of some good or service a producer is willing to supply at each price. Price is what the producer receives for selling one unit of a good or service. A rise in price almost always leads to an increase in the quantity supplied of that good or service, while a fall in price will decrease the quantity supplied. When the price of gasoline rises, for example, it encourages profit-seeking firms to take several actions: expand exploration for oil reserves; drill for more oil; invest in more pipelines and oil tankers to bring the oil to plants where it can be refined into gasoline; build new oil refineries; purchase additional pipelines and trucks to ship the gasoline to gas stations; and open more gas stations or keep existing gas stations open longer hours. Economists call this positive relationship between price and quantity supplied—that a higher price leads to a higher quantity supplied and a lower price leads to a lower quantity supplied—the law of supply. The law of supply, like the law of demand, assumes that all other variables that affect supply (to be explained in the next reading) are held equal.
supply vs. quantity supplied
In economic terminology, supply is not the same as quantity supplied. When economists refer to supply, they mean the relationship between a range of prices and the quantities supplied at those prices, a relationship that can be illustrated with a supply curve or a supply schedule. When economists refer to quantity supplied, they mean only a certain point on the supply curve, or one quantity on the supply schedule. In short, supply refers to the curve, and quantity supplied refers to the (specific) point on the curve.
Figure \(1\), below, illustrates the law of supply, again using the market for gasoline as an example. Like demand, supply can be illustrated using a table or a graph. A supply schedule is a table—like Table \(1\), below—that shows the quantity supplied at a range of different prices. Again, price is measured in dollars per gallon of gasoline, and quantity demanded is measured in millions of gallons. A supply curve is a graphic illustration of the relationship between price, shown on the vertical axis, and quantity, shown on the horizontal axis. You can see from this curve (Figure \(1\)) that as the price rises, quantity supplied also increases and vice versa. The supply schedule and the supply curve are just two different ways of showing the same information. Notice that the horizontal and vertical axes on the graph for the supply curve are the same as for the demand curve.
Table \(1\). Price and Supply of Gasoline
Price (per gallon) Quantity Supplied (millions of gallons)
\$1.00 500
\$1.20 550
\$1.40 600
\$1.60 640
\$1.80 680
\$2.00 700
\$2.20 720
The shape of supply curves will vary somewhat according to the product: steeper, flatter, straighter, or curved. Nearly all supply curves, however, share a basic similarity: They slope up from left to right and illustrate the law of supply. As the price rises, say, from \$1.00 per gallon to \$2.20 per gallon, the quantity supplied increases from 500 gallons to 720 gallons. Conversely, as the price falls, the quantity supplied decreases.
practice question \(1\)
Michael is the owner of a steel refinery in Pittsburgh, PA. In October the price for a ton of steel was \$400, which increased to \$600 by November. According to the law of supply, what would be a rational response by Michael to this change in market price for steel?
1. Shut down 2 out of the 4 smelters at his steel plant.
2. Hire additional workers.
3. Layoff workers and reduce output.
Answer
b. The law of supply postulates a positive relationship between quantity supplied and price. If price increases, so must steel output.
practice question \(2\)
Joshua operates a small information technology business which supplies advanced microchips to local businesses. His supply schedule for microchips is displayed below. Which supply curve shown more accurately reflects his supply schedule?
Price and Supply of Computer Chips
Price Quantity Supplied
\$100.00 120
\$120.00 150
\$140.00 180
\$160.00 210
\$180.00 240
\$200.00 270
\$220.00 300
Answer
a.
Factors Affecting Supply
How Production Costs Affect Supply
A supply curve shows how quantity supplied will change as the price rises and falls, assuming ceteris paribus, so that no other economically relevant factors are changing. If other factors relevant to supply do change, then the entire supply curve will shift. Just as a shift in demand is represented by a change in the quantity demanded at every price, a shift in supply means a change in the quantity supplied at every price.
In thinking about the factors that affect supply, remember what motivates firms: profits, which are the difference between revenues and costs. Goods and services are produced using combinations of labor, materials, and machinery, or what we call inputs (also called factors of production). If a firm faces lower costs of production, while the prices for the good or service the firm produces remain unchanged, a firm’s profits go up. When a firm’s profits increase, it’s more motivated to produce output (goods or services), since the more it produces the more profit it will earn. So, when costs of production fall, a firm will tend to supply a larger quantity at any given price for its output. This can be shown by the supply curve shifting to the right.
Take, for example, a messenger company that delivers packages around a city. The company may find that buying gasoline is one of its main costs. If the price of gasoline falls, then the company will find it can deliver packages more cheaply than before. Since lower costs correspond to higher profits, the messenger company may now supply more of its services at any given price. For example, given the lower gasoline prices, the company can now serve a greater area, and increase its supply.
Conversely, if a firm faces higher costs of production, then it will earn lower profits at any given selling price for its products. As a result, a higher cost of production typically causes a firm to supply a smaller quantity at any given price. In this case, the supply curve shifts to the left.
Consider the supply for cars, shown by curve S0 in Figure \(2\), below. Point J indicates that if the price is \$20,000, the quantity supplied will be 18 million cars. If the price rises to \$22,000 per car, ceteris paribus, the quantity supplied will rise to 20 million cars, as point K on the S0 curve shows. The same information can be shown in table form, as in Table \(1\).
Table \(1\). Price and Shifts in Supply: A Car Example
Price Decrease to S1 Original Quantity Supplied S0 Increase to S2
\$16,000 10.5 million 12.0 million 13.2 million
\$18,000 13.5 million 15.0 million 16.5 million
\$20,000 16.5 million 18.0 million 19.8 million
\$22,000 18.5 million 20.0 million 22.0 million
\$24,000 19.5 million 21.0 million 23.1 million
Now imagine that the price of steel—an important component in vehicle manufacturing—rises, so that producing a car has become more expensive. At any given price for selling cars, car manufacturers will react by supplying a lower quantity. This can be shown graphically as a leftward shift of supply, from S0 to S1, which indicates that at any given price, the quantity supplied decreases. In this example, at a price of \$20,000, the quantity supplied decreases from 18 million on the original supply curve (S0) to 16.5 million on the supply curve S1, which is labeled as point L.
Conversely, if the price of steel decreases, producing a car becomes less expensive. At any given price for selling cars, car manufacturers can now expect to earn higher profits, so they will supply a higher quantity. The shift of supply to the right, from S0 to S2, means that at all prices, the quantity supplied has increased. In this example, at a price of \$20,000, the quantity supplied increases from 18 million on the original supply curve (S0) to 19.8 million on the supply curve S2, which is labeled M.
Other Factors That Affect Supply
In the example above, we saw that changes in the prices of inputs in the production process will affect the cost of production and thus the supply. Several other things affect the cost of production, too, such as changes in weather or other natural conditions, new technologies for production, and some government policies.
The cost of production for many agricultural products will be affected by changes in natural conditions. For example, the area of northern China that typically grows about 60 percent of the country’s wheat output experienced its worst drought in at least fifty years in the second half of 2009. A drought decreases the supply of agricultural products, which means that at any given price, a lower quantity will be supplied; conversely, especially good weather would shift the supply curve to the right.
When a firm discovers a new technology that allows it to produce at a lower cost, the supply curve will shift to the right, as well. For instance, in the 1960s a major scientific effort nicknamed the Green Revolution focused on breeding improved seeds for basic crops like wheat and rice. By the early 1990s, more than two-thirds of the wheat and rice in low-income countries around the world was grown with these Green Revolution seeds—and the harvest was twice as high per acre. A technological improvement that reduces costs of production will shift supply to the right, so that a greater quantity will be produced at any given price.
Government policies can affect the cost of production and the supply curve through taxes, regulations, and subsidies. For example, the U.S. government imposes a tax on alcoholic beverages that collects about \$8 billion per year from producers. Taxes are treated as costs by businesses. Higher costs decrease supply for the reasons discussed above. Other examples of policy that can affect cost are the wide array of government regulations that require firms to spend money to provide a cleaner environment or a safer workplace; complying with regulations increases costs.
A government subsidy, on the other hand, is the opposite of a tax. A subsidy occurs when the government pays a firm directly or reduces the firm’s taxes if the firm carries out certain actions. From the firm’s perspective, taxes or regulations are an additional cost of production that shifts supply to the left, leading the firm to produce a lower quantity at every given price. Government subsidies reduce the cost of production and increase supply at every given price, shifting supply to the right.
practice question \(3\)
As an economist at the USDA you observe there has been a change in the market for processed corn this past year (displayed below). Which option below can best explain this recent market shift?
1. There has been an exceptionally short growing season this past year.
2. The cost of farm labor has decreased
3. The price of wheat, a substitute, has increased
Answer
b is correct - Lower input costs are one factor that can shift the supply curve rightwards.
a is incorrect - Unfavorable natural conditions are likely to shift the demand curve leftwards, not rightwards.
c is incorrect - Higher substitute cost will shift the demand curve rightwards, not the supply curve.
Exercise \(4\)
Several unfavorable changes have occurred this past year for almond suppliers in California. A drought continues to ravage crops, and a recent strike by migrant farm laborers has sent production costs soaring. In response to these recent events the almond growers lobby has successfully petitioned the California state legislator for a significant subsidy to almond farmers.
Given these events, how would we expect the supply curve for almonds to react?
1. The supply curve would shift inwards
2. The supply curve would shift outwards
3. It is impossible to tell with the given information
Answer
C - A subsidy should shift supply rightwards, while the drought and labor strike has the opposite effect. We have no way of knowing which is stronger.
Summary
Changes in the cost of inputs, natural disasters, new technologies, and the impact of government decisions all affect the cost of production. In turn, these factors affect how much firms are willing to supply at any given price.
Figure \(|PageIndex{3}\), below, summarizes factors that change the supply of goods and services. Notice that a change in the price of the product itself is not among the factors that shift the supply curve. Although a change in price of a good or service typically causes a change in quantity supplied or a movement along the supply curve for that specific good or service, it does not cause the supply curve itself to shift.
Figure \(3\). Factors That Shift Supply Curves. (a) A list of factors that can cause an increase in supply from S0 to S1. (b) The same factors, if their direction is reversed, can cause a decrease in supply from S0 to S1.
Because demand and supply curves appear on a two-dimensional diagram with only price and quantity on the axes, an unwary visitor to the land of economics might be fooled into believing that economics is about only four topics: demand, supply, price, and quantity. However, demand and supply are really “umbrella” concepts: demand covers all the factors that affect demand, and supply covers all the factors that affect supply. Factors other than price that affect demand and supply are included by using shifts in the demand or the supply curve. In this way, the two-dimensional demand and supply model becomes a powerful tool for analyzing a wide range of economic circumstances.
Exercise \(5\)
List and explain three out of the four factors responsible for shifts in the supply curve.
Answer
The four factors that can shift the supply curve include natural conditions, input prices, technology, and government. Natural conditions include any natural event that may favorably or unfavorably impact production. Lower input costs will increase the profit margin of the supplier, encouraging them to provide more output at any given price. Improved technology can increase what a supplier can produce with a given set of inputs. Government intervention can either encourage or discourage production depending on the type of intervention (subsidy vs. tax, regulation vs. deregulation, etc).
worked example: Shift in supply due to production-cost increase
We know that a supply curve shows the minimum price a firm will accept to produce a given quantity of output. What happens to the supply curve when the cost of production goes up? Following is an example of a shift in supply due to an increase in production cost.
Step 1. Draw a graph of a supply curve for pizza. Pick a quantity (like Q0). If you draw a vertical line up from Q0 to the supply curve, you will see the price the firm chooses. An example is shown in Figure \(4\).
Figure \(4\). Supply Curve. The supply curve can be used to show the minimum price a firm will accept to produce a given quantity of output.
Step 2. Why did the firm choose that price and not some other? One way to think about this is that the price is composed of two parts. The first part is the average cost of production: in this case, the cost of the pizza ingredients (dough, sauce, cheese, pepperoni, and so on), the cost of the pizza oven, the rent on the shop, and the wages of the workers. The second part is the firm’s desired profit, which is determined, among other factors, by the profit margins in that particular business. If you add these two parts together, you get the price the firm wishes to charge. The quantity Q0 and associated price P0 give you one point on the firm’s supply curve, as shown in Figure \(5\).
Step 3. Now, suppose that the cost of production goes up. Perhaps cheese has become more expensive by \$0.75 per pizza. If that is true, the firm will want to raise its price by the amount of the increase in cost (\$0.75). Draw this point on the supply curve directly above the initial point on the curve, but \$0.75 higher, as shown in Figure \(6\).
Step 4. Shift the supply curve through this point. You will see that an increase in cost causes a leftward shift of the supply curve so that at any price, the quantities supplied will be smaller, as shown in Figure \(7\).
Simulation: Supply of Food Trucks
Play the simulation below multiple times to see how different choices lead to different outcomes. All simulations allow unlimited attempts so that you can gain experience applying the concepts. | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/02%3A_Economic_Environment/2.05%3A_Supply.txt |
What you’ll learn to do: explain market equilibrium, surplus, and shortage
In this section, you’ll learn how supply and demand interact to determine the price in a market.
Learning Objectives
• Explain equilibrium price and quantity
• Explain equilibrium price and quantity
Surpluses and Shortages
In order to understand market equilibrium, we need to start with the laws of demand and supply. Recall that the law of demand says that as price decreases, consumers demand a higher quantity. Similarly, the law of supply says that when price decreases, producers supply a lower quantity.
Because the graphs for demand and supply curves both have price on the vertical axis and quantity on the horizontal axis, the demand curve and supply curve for a particular good or service can appear on the same graph. Together, demand and supply determine the price and the quantity that will be bought and sold in a market. These relationships are shown as the demand and supply curves in Figure \(1\), which is based on the data in Table \(1\), below.
Table \(1\). Price, Quantity Demanded, and Quantity Supplied
Price (per gallon) Quantity demanded (millions of gallons) Quantity supplied (millions of gallons)
\$1.00 800 500
\$1.20 700 550
\$1.40 600 600
\$1.60 550 640
\$1.80 500 680
\$2.00 460 700
\$2.20 420 720
If you look at either Figure \(1\) or Table \(1\), you’ll see that at most prices the amount that consumers want to buy (which we call the quantity demanded) is different from the amount that producers want to sell (which we call the quantity supplied). What does it mean when the quantity demanded and the quantity supplied aren’t the same? The answer is: a surplus or a shortage.
Surplus or Excess Supply
Let’s consider one scenario in which the amount that producers want to sell doesn’t match the amount that consumers want to buy. Consider our gasoline market example. Imagine that the price of a gallon of gasoline were \$1.80 per gallon. This price is illustrated by the dashed horizontal line at the price of \$1.80 per gallon in Figure \(2\), below.
At this price, the quantity demanded is 500 gallons, and the quantity of gasoline supplied is 680 gallons. You can also find these numbers in Table \(1\), above. Now, compare the quantity demanded and quantity supplied at this price. Quantity supplied (680) is greater than quantity demanded (500). Or, to put it in words, the amount that producers want to sell is greater than the amount that consumers want to buy. We call this a situation of excess supply (since Qs > Qd) or a surplus. Note that whenever we compare supply and demand, it’s in the context of a specific price—in this case, \$1.80 per gallon.
With a surplus, gasoline accumulates at gas stations, in tanker trucks, in pipelines, and at oil refineries. This accumulation puts pressure on gasoline sellers. If a surplus remains unsold, those firms involved in making and selling gasoline are not receiving enough cash to pay their workers and cover their expenses. In this situation, some firms will want to cut prices, because it is better to sell at a lower price than not to sell at all. Once some sellers start cutting prices; others will follow to avoid losing sales. These price reductions will, in turn, stimulate a higher quantity demanded.
How far will the price fall? Whenever there is a surplus, the price will drop until the surplus goes away. When the surplus is eliminated, the quantity supplied just equals the quantity demanded—that is, the amount that producers want to sell exactly equals the amount that consumers want to buy. We call this equilibrium, which means “balance.” In this case, the equilibrium occurs at a price of \$1.40 per gallon and at a quantity of 600 gallons. You can see this in Figure \(2\) (and Figure \(1\)) where the supply and demand curves cross. You can also find it in Table \(1\) (the numbers in bold).
practice question \(1\)
The market for cement in a small town is defined by a demand curve that passes through the points (\$50/ton, 300 tons), (\$100/ton, 200 tons), (\$150/ton, 100 tons). Meanwhile we know the supply curve passes through the points (\$150/ton, 300 tons), (\$100/ton, 200 tons), (\$50/ton, 100 tons).
If the market starts in a surplus of 200 tons, how much must the price change before the market is in equilibrium?
1. decrease by \$50/ton
2. increase by \$50/ton
3. decrease by \$100/ton
Answer
A. If there is a surplus of 200 tons then the price must be \$150 (300 tons supplied - 100 tons demanded = 200 ton surplus). Equilibrium occurs at \$100/ton, so the price must decrease by \$50.
practice question \(2\)
Consider the combined yearly onion supply and demand schedules for one local supermarket below. Currently the market is at the equilibrium price A. Fill in the values for A and B that would cause market equilibrium to occur at that price.
Price (per Onion) Quantity demanded (thousands of onions) Quantity supplied (thousands of onions)
\$0.50 100 10
\$0.70 90 D?
A? B? 80
\$1.10 70 120
\$1.30 C? 160
\$1.50 50 200
\$1.70 40 220
1. A: \$0.90; B: 90
2. A: \$1.50; B: 80
3. A: \$0.90; B: 80
Answer
C. To find the free market equilibrium set the quantity demanded B equal to the quantity supplied (80). The equilibrium price A must be in between \$0.70 and \$1.10 (i.e. \$0.90)
Shortage or Excess Demand
Let’s return to our gasoline problem. Suppose that the price is \$1.20 per gallon, as the dashed horizontal line at this price in Figure 3, below, shows. At this price, the quantity demanded is 700 gallons, and the quantity supplied is 550 gallons.
Quantity supplied (550) is less than quantity demanded (700). Or, to put it in words, the amount that producers want to sell is less than the amount that consumers want to buy. We call this a situation of excess demand (since Qd > Qs) or a shortage.
In this situation, eager gasoline buyers mob the gas stations, only to find many stations running short of fuel. Oil companies and gas stations recognize that they have an opportunity to make higher profits by selling what gasoline they have at a higher price. These price increases will stimulate the quantity supplied and reduce the quantity demanded. As this occurs, the shortage will decrease. How far will the price rise? The price will rise until the shortage is eliminated and the quantity supplied equals quantity demanded. In other words, the market will be in equilibrium again. As before, the equilibrium occurs at a price of \$1.40 per gallon and at a quantity of 600 gallons.
Generally any time the price for a good is below the equilibrium level, incentives built into the structure of demand and supply will create pressures for the price to rise. Similarly, any time the price for a good is above the equilibrium level, similar pressures will generally cause the price to fall.
As you can see, the quantity supplied or quantity demanded in a free market will correct over time to restore balance, or equilibrium.
Equilibrium, Price, and Quantity
Equilibrium: Where Supply and Demand Intersect
Figure \(4\). Equilibrium is the point where the amount that buyers want to buy matches the point where sellers want to sell.
When two lines on a diagram cross, this intersection usually means something. On a graph, the point where the supply curve (S) and the demand curve (D) intersect is the equilibrium. The equilibrium price is the only price where the desires of consumers and the desires of producers agree—that is, where the amount of the product that consumers want to buy (quantity demanded) is equal to the amount producers want to sell (quantity supplied). This mutually desired amount is called the equilibrium quantity. At any other price, the quantity demanded does not equal the quantity supplied, so the market is not in equilibrium at that price. It should be clear from the previous discussions of surpluses and shortages, that if a market is not in equilibrium, market forces will push the market to the equilibrium.
If you have only the demand and supply schedules, and no graph, you can find the equilibrium by looking for the price level on the tables where the quantity demanded and the quantity supplied are equal (again, the numbers in bold in Table \(1\) indicate this point).
Finding equilibrium with algebra
We’ve just explained two ways of finding a market equilibrium: by looking at a table showing the quantity demanded and supplied at different prices, and by looking at a graph of demand and supply. We can also identify the equilibrium with a little algebra if we have equations for the supply and demand curves. Let’s practice solving a few equations that you will see later in the course. Right now, we are only going to focus on the math. Later you’ll learn why these models work the way they do, but let’s start by focusing on solving the equations. Suppose that the demand for soda is given by the following equation:
Qd = 16 – 2P ,
where Qd is the amount of soda that consumers want to buy (i.e., quantity demanded), and P is the price of soda. Suppose the supply of soda is
Qs = 2 + 5P ,
where Qs is the amount of soda that producers will supply (i.e., quantity supplied). (Remember, these are simple equations for lines). Finally, recall that the soda market converges to the point where supply equals demand, or
Qd = Qs ,
We now have a system of three equations and three unknowns (Qd, Qs, and P), which we can solve with algebra. Since
$Qd$=Qs$ ,
we can set the demand and supply equations equal to each other:
Qd = Qs
16 − 2P = 2 + 5P
Step 1: Isolate the variable by adding 2P to both sides of the equation, and subtracting 2 from both sides.
16 − 2P = 2 + 5P
−2 + 2P = −2 + 2P
14 = 7P
Step 2: Simplify the equation by dividing both sides by 7.
$\begin{array}{c}\frac{14}{7}\end{array}$\begin{array}{c}=\ \frac{7P}{7}\end{array}$
2 = P
The equilibrium price of soda, that is, the price where Qs = Qd will be \$2. Now we want to determine the quantity amount of soda. We can do this by plugging the equilibrium price into either the equation showing the demand for soda or the equation showing the supply of soda. Let’s use demand. Remember, the formula for quantity demanded is the following:
Qd = 16 − 2P
Taking the price of \$2, and plugging it into the demand equation, we get
Qd = 16 – 2(2)
Qd = 16 – 4
Qd = 12
So, if the price is \$2 each, consumers will purchase 12. How much will producers supply, or what is the quantity supplied? Taking the price of \$2, and plugging it into the equation for quantity supplied, we get the following:
Qs = 2 + 5P
Qs = 2 + 5(2)
Qs = 2 + 10
Qs = 12
Now, if the price is \$2 each, producers will supply 12 sodas. This means that we did our math correctly, since
Qd = Q$s$
and both Qd and Qs are equal to 12. That confirms that we’ve found the equilibrium quantity.
Watch this video for a closer look at market equilibrium:
Equilibrium occurs at the point where quantity supplied = quantity demanded.
Equilibrium and Economic Efficiency
Equilibrium is important to create both a balanced market and an efficient market. If a market is at its equilibrium price and quantity, then it has no reason to move away from that point, because it’s balancing the quantity supplied and the quantity demanded. However, if a market is not at equilibrium, then economic pressures arise to move the market toward the equilibrium price and equilibrium quantity. This happens either because there is more supply than what the market is demanding or because there is more demand than the market is supplying. This balance is a natural function of a free-market economy.
Also, a competitive market that is operating at equilibrium is an efficient market. Economists typically define efficiency in this way: when it is impossible to improve the situation of one party without imposing a cost on another. Conversely, if a situation is inefficient, it becomes possible to benefit at least one party without imposing costs on others.
Efficiency in the demand and supply model has the same basic meaning: the economy is getting as much benefit as possible from its scarce resources, and all the possible gains from trade have been achieved. In other words, the optimal amount of each good and service is being produced and consumed.
practice Quesion \(3\)
The market for corn is defined by the graph below. If the price is set at \$20/ton will this result in a surplus or shortage? What is the magnitude of this surplus or shortage?
1. shortage of 120 million tons
2. surplus of 80 million tons
3. shortage of 80 million tons
Answer
C - At \$20/ton the quantity supplied is 140 million tons, while the quantity demanded is 220 million tons. Since the quantity demanded is greater than the quantity supplied at the given price, then there is a shortage of 220-140=80 million tons
practice question \(4\)
As member of the “Hungry for Apples?” national advertising campaign you are charged with analyzing future trends in Apple prices. The estimated demand and supply curve for apples is displayed below. If the current price is \$100/ton, by how much must prices change before the market is in equilibrium? Is there currently a surplus or shortage in the current market for apples?
1. There is a shortage. The price must increase by \$10/ton.
2. There is a shortage. The price must drop by \$10/ton.
3. There is a surplus. The price must drop by \$10/ton
Answer
C - The equilibrium price displayed above occurs at \$90/ton. If the current price is \$100/ton then there must be a surplus. Therefore the price must drop by \$10/ton to arrive at equilibrium.
Finding Equilibrium using the Four-Step Process
We know that equilibrium is the place where the supply and demand curves intersect, or the point where buyers want to buy the same amount that sellers want to sell. Let’s take a closer look at how to find the equilibrium point using the four-step process. These steps explain how to first, draw the demand a supply curves on a graph and find the equilibrium. Next, consider how an economic change (e.g. a natural disaster, a change in production technology, a change in tastes and preferences, income, etc.) might affect supply or demand, then make adjustments to the graph to identify the new equilibrium point.
Step 1. Draw demand and supply curves showing the market before the economic change took place. Think about the shift variables for demand, and the shift variables for supply. Using this diagram, find the initial equilibrium values for price and quantity.
Step 2. Decide whether the economic change being analyzed affects demand or supply. In other words, does the event refer to something in the list of demand shift variables or supply shift variables?
Step 3. Determine whether the effect on demand or supply causes the curve to shift to the right or to the left, and sketch the new demand or supply curve on the diagram. In other words, does the event increase or decrease the amount consumers want to buy or the amount producers want to sell?
Step 4. Identify the new equilibrium, and then compare the original equilibrium price and quantity to the new equilibrium price and quantity.
Let’s consider one example that involves a shift in supply and one that involves a shift in demand. Then we will consider an example where both supply and demand shift.
Exercise \(1\): Good weather for salmon fishing
Let’s suppose that during the summer of 2015, weather conditions were excellent for commercial salmon fishing off the California coast. Heavy rains meant higher than normal levels of water in the rivers, which helps the salmon to breed. Slightly cooler ocean temperatures stimulated the growth of plankton, the microscopic organisms at the bottom of the ocean food chain, providing everything in the ocean with a hearty food supply. The ocean stayed calm during fishing season, so commercial fishing operations did not lose many days to bad weather. How did these climate conditions affect the quantity and price of salmon?
Let’s consider this situation using the four-step process and the data below.
Table 1. Salmon Fishing
Price per Pound Quantity Supplied in 2014 Quantity Supplied in 2015 Quantity Demanded
\$2.00 80 400 840
\$2.25 120 480 680
\$2.50 160 550 550
\$2.75 200 600 450
\$3.00 230 640 350
\$3.25 250 670 250
\$3.50 270 700 200
Let’s walk through the four steps together using this example, and see how the graph changes. Use the interactive graph below (Figure \(6\)) by clicking on the arrows at the bottom of the activity to navigate through the steps.
Figure \(6\) (Interactive Graph). Good Weather for Salmon Fishing: The Four-Step Process.
In short, good weather conditions increased supply of the California commercial salmon. The result was a higher equilibrium quantity of salmon bought and sold in the market at a lower price.
Exercise \(2\): newspapers and the internet
According to the Pew Research Center for People and the Press, more and more people, especially younger people, are getting their news from online and digital sources. The majority of U.S. adults now own smartphones or tablets, and most of those Americans say they use them in part to get the news. From 2004 to 2012, the share of Americans who reported getting their news from digital sources increased from 24 percent to 39 percent. How has this trend affected consumption of print news media and radio and television news? Figure \(7\) and the text below illustrate the four-step analysis used to answer this question.
Figure \(7\) Graph depicting the changing market for print news.
Step 1. Draw a demand and supply model to think about what the market looked like before the event.
The demand curve D0 and the supply curve S0 show the original relationships. In this case, the curves are drawn without specific numbers on the price and quantity axis.
Step 2. Did the change described affect supply or demand?
Answer
A change in tastes, from traditional news sources (print, radio, and television) to digital sources, caused a change in demand for the former
Step 3. Was the effect on demand positive or negative?
Answer
A shift to digital news sources will tend to mean a lower quantity demanded of traditional news sources at every given price, causing the demand curve for print and other traditional news sources to shift to the left, from D0 to D1.
Step 4. Compare the new equilibrium price and quantity to the original equilibrium price.
Answer
The new equilibrium (E1) occurs at a lower quantity and a lower price than the original equilibrium (E0).
The decline in print news reading predates 2004. Print newspaper circulation peaked in 1973 and has declined since then due to competition from television and radio news. In 1991, 55 percent of Americans indicated that they got their news from print sources, while only 29 percent did so in 2012. Radio news has followed a similar path in recent decades, with the share of Americans getting their news from radio declining from 54 percent in 1991 to 33 percent in 2012. Television news has held its own during the last fifteen years, with the market share staying in the mid to upper fifties. What does this suggest for the future, given that two-thirds of Americans under thirty years old say they don’t get their news from television at all?
practice question \(5\)
Note: Using a pen and paper to illustrate supply and demand shifts could be helpful for this question
A recent health study reveals that red wine may be linked to increased longevity. At the same time, a severe drought is affecting wine production is Southern California. How will the new equilibrium quantity and price compare with the original equilibrium before the health study and drought?
1. The equilibrium price and quantity in the wine market will increase relative to the old equilibrium.
2. The equilibrium price in the wine market will increase relative the old equilibrium, yet the effect on quantity is impossible to determine.
3. The equilibrium quantity in the wine market will increase relative the old equilibrium, yet the effect on price is impossible to determine
Answer
b - A severe drought will shift the supply curve for wine to the left, while the health study will shift the demand curve right. This will result in higher equilibrium prices yet the effect on quantity is ambiguous, and depends on the magnitude of the supply and demand shifts.
practice question \(6\)
In the past year the price of pork, the main ingredient in hot dogs, has decreased by 20%. At the same time the price of hot dog buns has also dropped 20%. How will the new equilibrium quantity and price for hot dogs compare with the original equilibrium before these price changes?
Hint: Using a pen and paper to illustrate supply and demand shifts could be helpful for this question
1. The equilibrium quantity in the hot dog market will increase relative the old equilibrium, yet the effect on price is impossible to determine.
2. The equilibrium price in the hot dog market will increase relative the old equilibrium, yet the effect on quantity is impossible to determine.
3. The equilibrium price and quantity in the hot dog market will increase relative the old equilibrium.
Answer
A. Lower cost of hot dog input pork will shift the supply curve to the right, while a drop in the price of hot dog buns, a complement, shifts the demand curve right. The resulting equilibrium quantity will have increased, while the effect on equilibrium price is ambiguous, and depends on the magnitude of supply and demand shifts.
Try It
Play the simulation below multiple times to see how different choices lead to different outcomes. All simulations allow unlimited attempts so that you can gain experience applying the concepts.
Practice: Equilibrium
You have seen how changes in weather can influence supply and changes in consumer preferences can reduce demand, but what happens when both supply and demand are changing? Often changes in an economy affect both the supply and the demand curves, making it more difficult to assess the impact on the equilibrium price. Let’s review one such example.
Figure \(8\). Money and Mail. How do changes at the post office impact other aspects of the economy?
First, consider the following questions:
1. Suppose postal workers are successful in obtaining a pay raise from the U.S. Postal Service. Will this affect the supply or the demand for first-class mail? Why? Which determinant of demand or supply is being affected? Show graphically with before and after curves on the same axes. How will this change the equilibrium price and quantity of first-class mail?
2. How do you imagine the invention of email and text messaging affected the market for first-class mail? Why? Which determinant of demand or supply is being affected? Show graphically with before and after curves on the same axes. How will this change the equilibrium price and quantity of first-class mail?
3. Suppose that postal workers get a pay raise and email and text messaging become common. What will the combined impact be on the equilibrium price and quantity of first-class mail?
In order to complete a complex analysis like this it’s helpful to tackle the parts separately and then combine them, while thinking about possible interactions between the two parts that might affect the overall outcome. Let’s use the four-step process.
Exercise \(3\): Postal service
Part 1: A Pay Raise for Postal Workers
Step 1. Draw a demand and supply model to illustrate what the market for the U.S. Postal Service looks like before this scenario starts. The demand curve D and the supply curve S show the original relationships.
Step 2. Will a pay raise for postal workers affect supply or demand?
Answer
Labor compensation is a cost of production. A change in production costs cause a change in supply for the Postal Service.
Step 3. Is the effect on supply positive or negative?
Answer
Higher labor compensation leads to a lower quantity supplied of postal services at every given price, causing the supply curve for postal services to shift to the left, from S to S1.
Step 4. Compare the new equilibrium price and quantity to the original equilibrium price.
Answer
The new equilibrium occurs at a lower quantity and a higher price than the original equilibrium.
A pay raise for postal workers would represent an increase in the cost of production for the Postal Service. Production costs are a factor that influences supply; thus, the pay raise should decrease the supply of first-class mail, shifting the supply curve vertically by the amount of the pay raise. Intuitively, all else held constant, the Postal Service would like to charge a higher price that incorporates the higher cost of production. That is not to say the higher price will stick. From the graph (Figure \(9\)), it should be clear that at that higher price, the quantity supplied is greater than the quantity demanded—thus there would be a surplus, indicating that the price the Postal Service desires is not an equilibrium price. Or to put it differently, at the original price (P1), the decrease in supply causes a shortage driving up the price to a new equilibrium level (P2). Note that the price doesn’t rise by the full amount of the pay increase. In short, a leftward shift in the supply curve causes a movement up the demand curve, resulting in a lower equilibrium quantity (Q2) and a higher equilibrium price (P2).
Part 2: The Effect of Email and Text Messaging
Step 1. We’ve already seen how a pay raise will shift the supply curve to the left. Now let’s consider how the invention of email and text messaging affects the market for first-class mail. Begin by drawing a demand and supply model reflecting this relationship.
Step 2. Does email and text messaging affect supply or demand?
Answer
A change in tastes away from snail mail toward digital messages will cause a change in demand for the Postal Service.
Step 3. Is the effect on demand positive or negative?
Answer
A change in tastes away from snail mail toward digital messages causes lower quantity demanded of postal services at every given price, causing the demand curve for postal services to shift to the left, from D to D1.
Step 4. Compare the new equilibrium price and quantity to the original equilibrium price.
Answer
The new equilibrium occurs at a lower quantity and a lower price than the original equilibrium.
To summarize, since many people find email and texting more convenient than sending a letter, we can assume that tastes and preferences for first-class mail will decline. This decrease in demand is shown by a leftward shift in the demand curve and a movement along the supply curve, which creates a surplus in first-class mail at the original price (shown as P2). The shortage causes a decrease in the equilibrium price (to P3) and a decrease in the equilibrium quantity (to Q3). Intuitively, less demand for first-class mail leads to a lower equilibrium quantity and (ceteris paribus) a lower equilibrium price.
Part 3: Combining Factors
Parts 1 and 2 are straightforward, but when we put them together it becomes more complex. Think about it this way: in Part 1, the equilibrium quantity fell due to decreased supply. In Part 2, the equilibrium quantity also fell, this time due to the decreased demand. So putting the two parts together, we would expect to see the final equilibrium quantity (Q3) to be smaller than the original equilibrium quantity (Q1). So far, so good.
Now consider what happens to the price. In Part 1, the equilibrium price increased due to the reduction in supply. But in Part 2, the equilibrium price decreased due to the decrease in demand! What will happen to the equilibrium price? The net effect on price can’t be determined without knowing which curve shifts more, demand or supply. The equilibrium price could increase, decrease, or stay the same. You just can’t tell from graphical analysis alone. This is not unusual. When both curves shift, typically we can determine the overall effect on price or on quantity, but not on both. In this case, we determined the overall effect on the equilibrium quantity, but not on the equilibrium price.
practice Question \(7\)
The past year has had very favorable growing conditions for oranges in California. At the same time, a new study reports that eating citrus fruits are linked to better health and longevity. As an economist, what movements in equilibrium quantity and price do you predict given the above information?
1. Equilibrium quantity and price will increase.
2. Equilibrium quantity will increase while price cannot be determined.
3. Equilibrium price will increase while quantity cannot be determined.
Answer
B. While rightward shifts of supply and demand will lead to a greater equilibrium quantity, it is impossible to determine the new equilibrium price without knowing which curve shifts more. You cannot tell from graphical analysis alone.
practice Question \(8\)
Due to the negative health effects of smoking the number of cigarette consumers has steadily decreased over the past decade. During the same time period more permissive immigration laws has allowed for cheaper tobacco harvesting using migrant labor. As an economist, what movements in equilibrium quantity and price do you predict given the above information?
1. Equilibrium quantity will decrease while price cannot be determined.
2. Equilibrium price will decrease while quantity cannot be determined.
Answer
C. Lower production costs will shift the supply curve rightwards, while fewer consumers will move demand leftwards. This results in a lower equilibrium price, yet quantity cannot be determined without knowing which curve shifts more.
practice Questions \(9\)
Here are the equations for the demand and supply curves:
Demand curve: Qd = 3300− 2 P
Supply curve: Qs = 500 + 8P
Compute the equilibrium price value.
Answer
280
Compute the equilibrium quantity value:
Answer
2740
Suppose Congress cuts personal income tax rates. How would this affect the market for air conditioners?
1. Supply curve shifts right.
2. Supply curve shifts left.
3. Demand curve shifts right.
4. Demand curve shifts left.
Answer
c. Demand Curve shifts right
Why does the demand or supply curve shift the way it does and what element of demand caused the shift? How does that affect the equilibrium price and quantity?
Answer
A decrease in tax rates effectively increases your income. An increase in income generally increases demand. Therefore demand curve shifts to the right to show an increase in the equilibrium price and quantity.
Suppose that air conditioner workers accept a pay cut of 2 dollars per hour. How would this affect the market for air conditioners?
1. Supply curve shifts right.
2. Supply curve shifts left.
3. Demand curve shifts right.
4. Demand curve shifts left.
Answer
a. Supply curve shifts right
Why does the demand or supply curve shift the way it does and what element of demand caused the shift? How does that affect the equilibrium price and quantity?
Answer
A pay cut decreases production costs for the firm. A decrease in production cost generally increases supply. Therefore supply curve shifts to the right to show a decrease in the equilibrium price and an increase in the equilibrium quantity. | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/02%3A_Economic_Environment/2.06%3A_Equilibrium.txt |
What you’ll learn to do: describe how economists evaluate the health of an economy
This section will help you understand why economists use terms like GDP, CPI, and unemployment rates to assess how an economy is doing.
Learning Objectives
• Explain the use of GDP as an economic indicator
Health of the Economy
Economic Indicators
When you go to the doctor with the flu, one of the first things they do is they take your temperature. If your temperature is much above 98.6 degrees, they declare you to have a fever. Depending on your other symptoms, they may prescribe you medication to bring down your fever and fight the infection. How might you (or an economist) take the temperature of an economy, so to speak, to check for health or sickness? No single measurement like body temperature will give a complete picture, so instead economists rely on what are called economic indicators. An economic indicator is a statistic that provides valuable information about the economy. There is no shortage of economic indicators, and trying to follow them all would be an overwhelming task. Many different economic indicators are tracked in order to evaluate the economy in different ways or from different perspectives.
Statistics that report the status of the economy a few months in the past are called lagging economic indicators. One such lagging indicator is the average length of unemployment. If unemployed workers have remained out of work for a long time, we may infer that the economy has been slow. Indicators that predict the status of the economy three to twelve months into the future are called leading economic indicators. For example, the number of building permits issued is often a good way to assess the strength of the housing market. An increase in this statistic—which tells us how many new housing units are being built—indicates that the economy is improving because increased building brings money into the economy not only through new home sales but also through sales of furniture and appliances to furnish these homes. If such a leading indicator rises, the economy is likely to expand in the coming year. If it falls, the economy is likely to slow down.
Governments, businesses, and investors use economic indicators as a measure of how well an economy is meeting its goals.
Economic Goals
The world’s market-based economies all share the following three main goals:
1. Growth
2. High employment
3. Price stability
Economic indicators reveal information about how the economy is doing relative to these goals. Let’s look more closely at growth, employment, and price stability and the means used to measure them.
Growth
GDP
The size of a nation’s overall economy is typically measured by its gross domestic product (GDP), which is the value of all officially recognized final goods and services produced within a country in a given period of time (usually a year). Intermediate goods (goods such as steel or plywood that are used as inputs in the production of other goods) are not included because they would cause double-counting to occur. GDP only refers to goods produced within a particular country. For instance, if a firm is located in one country but manufactures goods in another, those goods are counted as part of the manufacturing country’s GDP, not the firm’s home country. BMW is a German company, but cars manufactured in the U.S. are counted as part of the U.S. GDP.
The measurement of GDP involves counting up the production of millions of different goods and services—smart phones, cars, music downloads, computers, steel, bananas, college educations, and all other new goods and services produced in the current year—and summing them into a total dollar value. This task is straightforward: Take the quantity of everything produced, multiply it by the price at which each product sold, and add up the total. In 2014, the U.S. GDP totaled \$17.4 trillion, the largest GDP in the world.
When a country’s GDP grows, its economy is likewise considered to be expanding and growing. Increases in GDP are expressed as a percentage rate of increase, and they are often expressed as GDP per capita (per person). In order to calculate GDP per capita, the GDP is divided by the total population of a country. Also, when measuring economic growth, agencies use “real GDP,” which is adjusted for inflation. If the GDP figures were not adjusted for inflation, then steep rises in prices (inflation) could be mistaken for growth. Likewise, if GDP is not expressed per capita, then a country like India with a massive population would always be regarded as having one of the largest, fastest growing economies. The map, below, shows the world’s GDP per capita by country.
High Employment
A country’s employment level—as defined by cyclical, structural, and frictional unemployment—is one of the most important economic indicators. Unemployment has an enormous impact on business operations, from the largest multinational corporation to the smallest mom-and-pop gift shop. When people are unemployed, even temporarily, they stop spending money on nonessential goods and services, which slows down the economy. Such a slowdown leads to a decrease in revenue for businesses, which causes companies to lay off more workers, which means more unemployed people who can’t purchase their goods and services. Because of this spiraling effect, unemployment is a closely watched economic indicator.
The Unemployment Rate
There are three important categories of unemployment levels that need to be understood in order to evaluate the effect of employment levels on overall economic performance: cyclical unemployment, structural unemployment, and frictional unemployment.
1. Cyclical Unemployment
Cyclical unemployment occurs when there is not enough total demand in the economy to provide jobs for everyone who wants to work. When demand for most goods and services falls, less production is needed, and, as a result, fewer workers are needed; wages generally stay put and do not fall to meet the equilibrium level, and mass unemployment results. With cyclical unemployment, the number of unemployed workers exceeds the number of job vacancies, so that even if full employment were attained and all open jobs were filled, some workers would still be without jobs. In economics, full employment is the level of employment rate where there is no cyclical unemployment.
1. Structural Unemployment
Structural unemployment occurs when a labor market is unable to provide jobs for everyone who wants to work because there is a mismatch between the skills of the unemployed workers and the skills needed for the available jobs. Structural unemployment may develop or increase as a result of persistent cyclical unemployment: If an economy suffers from long-lasting low aggregate demand, many of the unemployed may become disheartened, and their skills (including job-searching skills) become rusty and obsolete. The implication is that sustained high demand may lower structural unemployment. Seasonal unemployment can be seen as a kind of structural unemployment, since it’s a type of unemployment that is linked to certain kinds of jobs (construction work or migratory farm work, for instance).
1. Frictional Unemployment
Frictional unemployment is the time period between jobs when a worker is searching for or transitioning from one job to another. It’s sometimes called “search unemployment” and can be voluntary depending on the circumstances of the unemployed individual. Frictional unemployment is always present in an economy, so the level of involuntary unemployment is really the unemployment rate minus the rate of frictional unemployment. Frictional unemployment exists because both jobs and workers are heterogeneous, and a mismatch can result between the characteristics of supply and demand. Such a mismatch can be related to any of the following reasons:
• Skills
• Payment
• Worktime
• Location
• Seasonal industries
• Attitude
• Taste
There can be a range of other factors, too. New entrants (such as graduating students) and reentrants (such as former homemakers) can also suffer a spell of frictional unemployment. Workers as well as employers accept a certain level of imperfection, risk, or compromise, but usually not right away; they will invest some time and effort to find a better match. This is in fact beneficial to the economy, since it results in a better allocation of resources.
practice Question \(1\)
Jane is an unemployed construction worker desperate to find employment so she can cover her mortgage and basic living expenses. She is willing to work for any wage, yet is unable to find any paid work given the poor state of the economy. She continues her search despite the lack of opportunities. Which of the following economic terms best describes Jane’s current predicament?
1. Cyclical Unemployment
2. Voluntary Unemployment
3. Shortage of Labor
Answer
A. Cyclical Unemployment
practice question \(2\)
Which of the following is an example of frictional unemployment as defined in the text?
1. An auto worker has received a job offer two states away, and must take off one month between jobs in order to relocate.
2. A nurse quits his job at a local hospital which is a poor fit personally. After a six month job search he becomes discouraged and exits the labor force.
3. During a severe economic downturn a large steel plant hands out redundancy notices to 1,000 employees.
Answer
a. Relocating to a new job offer is an example of frictional unemployment
Price Stability
The third major goal of all economies is maintaining price stability. Price stability occurs when prices remain largely unchanged and there isn’t rapid inflation or deflation. Inflation is a rise in the general price level of goods and services during a period of time; deflation is a decrease in the general price level of goods and services. Price stability means that the average price for goods and services either doesn’t change or changes very little. Most economists believe that steady levels of low-to-moderate inflation are ideal.
As inflation pushes prices higher (slowly), businesses increase their revenues, people put more money into the system, and assets increase in value, which are all positive economic indicators. This is why economists are careful to say that a steady level of low inflation is a positive sign in the economy. As inflation rises, prices rise and values rise, which both contribute to an increase in GDP—another measure of the health of an economy. During the past three decades, inflation has been relatively low (well below 10 percent) in the U.S. economy, and this has contributed to the general stability of the economy. Inflation doesn’t always increase slowly. A sudden, rapid rise in inflation is called hyperinflation. Argentina has recently (and repeatedly) experienced runaway inflation, with consumer prices increasing in some cases by 50 percent in a matter of days.
Figure \(\PageINdex{1}\), below, shows the U.S. inflation rate from 1989 to 2009. As you can see,. Looking back at the twentieth century, there have been several periods when inflation caused the price level to rise at double-digit rates, but nothing has come close to hyperinflation.
Consumer Price Index (CPI)
The most commonly cited measure of inflation in the United States is the consumer price index (CPI). The CPI measures changes in the price level of consumer goods and services purchased by households. The CPI in the United States is defined by the Bureau of Labor Statistics as “a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.”
The CPI market basket represents all the consumer goods and services purchased by urban households. Price data are collected for over 180 categories, which BLS has grouped into 8 major groups. These major groups, with examples of categories in each, are as follows:
• Food and beverages (ham, eggs, carbonated drinks, coffee, meals and snacks);
• Housing (rent of primary residence, fuel oil, bedroom furniture);
• Apparel (men’s shirts and sweaters, women’s dresses, jewelry);
• Transportation (new vehicles, gasoline, tires, airline fares);
• Medical care (prescription drugs and medical supplies, physicians’ services, eyeglasses and eye care, hospital services);
• Recreation (television sets, cable TV, pets and pet products, sports equipment, admissions);
• Education and communication (college tuition, postage, telephone services, computer software and accessories);
• Other goods and services (tobacco and smoking products, haircuts and other personal care services, funeral expenses)
The CPI simplifies the measurement of changes in prices over time. By selecting an appropriate reference base and setting the average index level for that time period equal to 100, it is possible to compare this month’s (or last year’s) price index level with the reference base period or to any other time period. The current standard reference base period is 1982–1984=100. That is, all price changes are measured from a base (100) that represents the average index level of the 36-month period encompassing 1982, 1983, and 1984.[1]
Consumer Price Index 2006 to Present (Source: US BLS)
Consumer Confidence Index
Another important economic indicator is the consumer confidence index. This indicator measures the degree of optimism that consumers feel about the overall state of the economy and their personal financial situation. How confident people feel about the stability of their incomes determines their spending activity and therefore serves as one of the key indicators for the overall shape of the economy. In essence, if the economy expands, causing consumer confidence to be higher, consumers will be making more purchases. On the other hand, if the economy contracts or is in bad shape, confidence is lower, and consumers tend to save more and spend less. A month-to-month diminishing trend in consumer confidence suggests that in the current state of the economy most consumers have a negative outlook on their ability to find and retain good jobs.
The ability to predict major changes in consumer confidence allows businesses to gauge the willingness of consumers to make new purchases. As a result, businesses can adjust their operations and the government can prepare for changing tax revenue. If confidence is dropping and consumers are expected to reduce their spending, most producers will tend to reduce their production volumes accordingly. For example, if manufacturers anticipate that consumers will reduce retail purchases, especially for expensive and durable goods, they will cut down their inventories in advance and may delay investing in new projects and facilities. The government will get ready for the reduction in future tax revenues. On the other hand, if consumer confidence is improving, people are expected to increase their purchases of goods and services. In anticipation of that change, manufacturers can boost production and inventories. Large employers can increase hiring rates. Government can expect improved tax revenues based on the increase in consumer spending.
Consumer confidence is formally measured by the Consumer Confidence Index (CCI), a monthly release designed to assess the overall confidence, relative financial health, and spending power of the average U.S. consumer. The CCI is an important measure used by businesses, economic analysts, and the government in order to determine the overall health of the economy.
practice Question \(3\)
The main economic indicators include
1. the misery index and consumer confidence index
2. gross domestic product, employment, and trade balance.
3. gross domestic product, inflation, and unemployment
Answer
c
the misery index which combines inflation and unemployment is one of the main economic indicators along with GDP but the consumer confidence index is not and neither is trade balance.
1. Source: US Bureau of Labor Statistics http://www.bls.gov/cpi/ | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/02%3A_Economic_Environment/2.07%3A_The_Health_of_the_Economy.txt |
What you’ll learn to do: identify and explain the four stages of an economy (expansion, peak, contraction, and trough), and describe their impact on business operations
Spring, summer, fall and winter: the four seasons of the year. Expansion, peak, contraction, trough: the four seasons of an economy. In this next section you’ll learn about the cyclical nature of economies and how each of these “seasons” affects business operations.
Learning Objectives
• Differentiate between expansion, recession, and depression
Stages of the Economy
Economic Cycle
The term economic cycle (or boom-bust cycle) refers to economy-wide fluctuations in production, trade, and general economic activity. From a conceptual perspective, the economic cycle is the upward and downward movements of levels of GDP (gross domestic product) and refers to periods of expansion and contraction in the level of economic activities (business fluctuations) around a long-term growth trend.
Stages of the Economy
Economic cycles are identified as having four distinct economic stages: expansion, peak, contraction, and trough.
An expansion is characterized by increasing employment, economic growth, and upward pressure on prices. A peak is the highest point of the business cycle, when the economy is producing at maximum allowable output, employment is at or above full employment, and inflationary pressures on prices are evident. Following a peak, the economy typically enters into a correction which is characterized by a contraction where growth slows, employment declines (unemployment increases), and pricing pressures subside. The slowing ceases at the trough and at this point the economy has hit a bottom from which the next stage of expansion and contraction will emerge. In the United States, it is generally accepted that the National Bureau of Economic Research (NBER) is the final arbiter of the dates of the peaks and troughs of the economic cycle.
Since the economy is made up of businesses (both private and public), businesses are impacted by the stages of the economy or perhaps they cause the stages of the economy – or maybe a little of both! When we move from talking about stages of the economy, the terms used to describe the business cycle differ slightly, but you will see that they are almost mirror images of the economic stages.
Business Cycle Fluctuations
Business cycle fluctuations occur around a long-term growth trend just like economic cycles, but unlike economic cycles they are measured in terms of the growth rate of real gross domestic product (Real GDP). This does not mean that the GDP is imaginary, but rather that GDP does not take into account inflation. Instead, real gross domestic product is the inflation adjusted value of the goods and services produced by labor and property located in the United States.
An expansion is the period from a trough to a peak, and a recession is the period from a peak to a trough. The NBER identifies a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production.” This is significantly different from the commonly cited definition of a recession being signaled by two consecutive quarters of decline in real GDP. If the economy does not begin to expand again, then the economy may be considered to be in a state of depression.
Impact of the Economic Cycle on Business Operations
How the economic cycle affects business operations may be best explained by looking at how one business responds to these cycles. Normal Maintenance is a small business that provides a variety of construction services to homeowners. They specialize in roofing, deck installations, siding, and general home maintenance. They employ three full-time workers, who typically work forty hours per week for an average of twelve dollars per hour. The company has been in business in the same town for than twenty years and has a solid reputation for quality work and reliability.
Expansion
Normal Maintenance is busy and has recently had to turn down jobs because it lacks the capacity to do all the work offered. Homeowners now want to make home repairs and improvements which they had had to put off during the sour economy. With the economy improving, others are fixing up their homes to sell. Faced with so much demand, the owner of Normal Maintenance must decide whether to pay his existing workers overtime (which will increase the costs for each job and reduce profits) or hire additional workers. The competition for qualified construction labor is steep, and he is concerned that he will have to pay more than his usual rate of twelve dollars per hour or possibly get workers who are not as qualified as his current crew. He is, however, able to charge higher prices for his work because homeowners are experiencing long waits and delays getting bids and jobs completed. The owner purchases a new truck and invests in additional tools in order to keep up with the demand for services. Customers are willing to pay more than usual so they can get the work done. Business is expanding to such an extent that Normal Maintenance and its suppliers are starting to have trouble obtaining materials such as shingles and siding because the manufacturers have not kept pace with the economic expansion. In general, business is great for Normal Maintenance, but the expansion brings challenges.
Peak
At the peak of the business cycle, the economy can be said to be “overheated.” Despite hiring additional workers, the owner and crews of Normal Maintenance are working seven days a week and are still unable to keep up with demand. They can’t work any harder or faster. As a result, the crews are exhausted and the quality of their work is beginning to decline. Customers leave messages requesting work and services, but the owner is so busy he doesn’t return phone calls. Jobs are getting started and completed late as the crews struggle to cover multiple job sites. As a result, customer complaints are on the rise, and the owner is worried about the long-term reputation of the business. Neither the business nor the economy can sustain this level of activity, and despite the fact that Normal Maintenance is making great money, everyone is ready for things to let up a little.
Contraction
As the economy begins to contract, business begins to slow down for Normal Maintenance. They find that they are caught up on work and they aren’t getting so many phone calls. The owner is able to reduce his labor costs by cutting back on overtime and eliminate working on the weekends. When the phone does ring, homeowners are asking for bids on work—not just placing work orders. Normal Maintenance loses out on several jobs because their bids are too high. The company begins to look for new suppliers who can provide them with materials at a cheaper price so they can be more competitive. The building material companies start offering “deals” and specials to contractors in order to generate sales. In general, competition for work has increased and some of the businesses that popped up during the expansion are no longer in the market. In the short term the owner is confident that he has enough work to keep his crew busy, but he’s concerned that if things don’t pick up, he might have to lay off some of the less experienced workers.
Trough
On Monday morning, the crew of Normal Maintenance show up to work and the owner has to send them home: there’s no work for them. During the week before, they worked only three days, and the owner is down to his original crew of three employees. Several months ago he laid off the workers hired during the expansion. Although that was a difficult decision, the owner knows from hard experience that sometimes businesses fail not because their owners make bad decisions, but because they run out of money during recessions when there isn’t enough customer demand to sustain them. Without enough working capital to keep the doors open, some are forced to close down.
Representatives from supply companies are stopping by the office hoping to get an order for even the smallest quantity of materials. The new truck and tools that the owner purchased during the boom now sit idle and represent additional debt and costs. The company’s remaining work comes from people who have decided to fix up their existing homes because the economy isn’t good enough for them to buy new ones. The owner increases his advertising budget, hoping to capture any business that might be had. He is optimistic that Normal Maintenance will weather this economic storm—they’ve done it before—but he’s worried about his employees paying their bills over the winter.
The owner of Normal Maintenance has been in business for a long time, so he’s had some experience with the economic cycle. Though each stage has its stressors, he has learned to plan for them. One thing he knows is that the economy will eventually begin to expand again and run through the cycle all over again.
practice question \(1\)
If the economy is currently experiencing high growth and inflation combined with low unemployment, it is likely to be at which phase of the business cycle?
1. trough
2. expansion
3. recession or contraction
Answer
b. Expansions tend to be characterized by positive GDP growth and decreased unemployment and increasing inflation. | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/02%3A_Economic_Environment/2.08%3A_Economic_Stages.txt |
Synthesis
In this module you learned about the fundamental economic principles that affect the environment in which businesses operate. Understanding the economy is like getting the weather forecast before you head out the door. Might you need to pack a sweater or an umbrella or grab some sunscreen? Perhaps, like Dorothy in the Wizard of Oz, head for the nearest cellar? If you ignore the forecast, you can find yourself unprepared and caught in a storm. Of course economic forecasts aren’t totally reliable—sometimes there’s a freak weather event that no one saw coming. Nonetheless, having a basic understanding of how supply and demand work, how different economic systems function, and how the business cycle connects to the economy can help you make informed decisions—and make the best out of a rainy day.
Summary
In this module you learned about the fundamental principles of economics and how they shape the business environment. Below is a summary of the key points covered.
What Is Economics?
Economics focuses on the ways in which people, businesses, and governments make decisions when faced with scarce resources. Economists study the economy at either the microeconomic level (focus on individuals) or the macroeconomic level (focus on systems).
Economic Systems
Economic systems can be organized as traditional, planned, or market economies. Traditional systems are hunter-gatherer economies in which people consume what they produce. In command economies such as communism and socialism, the government exercises a high degree of control over production and pricing. In market economies such as capitalism, free-market supply and demand drives what is produced and consumed. The increasing complexity of the world has led to mixed economic systems that have characteristics of both command and market economies.
Demand
Demand is the amount that consumers are willing and able to purchase of a good or service at a given price. Quantity demanded is a specific quantity that will be supplied at a single point (price) on the demand curve.
Supply
Supply is the amount of a good or service that a business is willing to produce at a given price. Quantity supplied refers to a specific quantity that will be supplied at a single point (price) on the supply curve.
Equilibrium
Equilibrium is said to exist at the point where quantity supplied equals the quantity demanded, and therefore there is no excess or shortage in the market. The market is “in balance.” The equilibrium price is the price where the amount that consumers want to purchase is equal to the quantity that the producers are willing to supply. The equilibrium quantity is the quantity supplied and demanded at the equilibrium price.
Health of the Economy
Economists use several measures to evaluate the health of an economy. Among the most important are GDP (Gross Domestic Product), the unemployment rate, and the CPI (Consumer Price Index). These three key economic indicators are used to measure how well the economy is achieving the goals of growth, high employment, and price stability.
Economic Stages
The business environment is cyclical, meaning it goes through a cycle of stages, each of which is characterized by a different set of economic conditions. The four stages of the business environment are expansion, peak, contraction, and trough. | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/02%3A_Economic_Environment/2.09%3A_Putting_It_Together-_Economic_Environment.txt |
Why describe the characteristics, opportunities, and challenges of the global business environment?
Grab your book bag, backpack, briefcase or whatever you carry your school supplies in, and open it up. Sort the contents into two piles: items made in the United States and items made anywhere else. Now, how large is the stack of things made in the United States compared to the imported items? Some may be labeled with the store brand and say something like “Manufactured in China for Company X.” Others may simply have a tag that reads “Made in the Philippines.” How many different countries are represented by the contents of your book bag? Do you realize that you just identified a small sample of countries that are United States trading partners?
You should now have two stacks of items (made in the United States and made elsewhere). Now, take everything that is not made in the United States and put it aside. From this point forward all you have access to are the things left in the “100 percent made in the U.S.A.” stack. What do you have left? You will be lucky if you have a pencil and an eraser. It is global business and global trade that gives you access to everything else in your backpack.
Understanding the global business environment is critical to everyone who consumes any good, service or resource. Until we understand how the global business environment operates, why businesses and nations trade, and the forces at work in the global marketplace, we are naive consumers. You need to be informed so that you can make decisions about where you will work, who you will work for, who you will vote for, and what foreign policies you will either support or oppose. Without understanding the global business environment, you might find yourself facing daily life with nothing more than a pencil and an eraser.
3.02: Globalization
What you’ll learn to do: explain why nations and U.S. firms engage in global business
In this section you’ll learn about the drivers of the global economy and how companies and countries evaluate whether or not to pursue global opportunities.
Learning Objectives
• Differentiate between comparative and absolute advantage
• Explain the roles of absolute and comparative advantage in global business
Globalization and Business
Globalization
There was a time when consumers only had access to goods and services that were available locally. Their choices were limited by what they could access on foot, by horse, or by carriage. This is still the case for many people around the world, and in rural and remote parts of the U.S., it’s still necessary for families to make weekly trips to town to stock up on food, household items and other necessities. However, with the rise of Internet-based business (think Amazon), there’s been an explosion of international trade, and more and more consumers essentially have the world at their door. Of course international trade isn’t just a twentieth-century phenomenon. Trade across borders and between cultures has been a feature of human civilization for centuries—there’s evidence of this dating back as far as the nineteenth century BCE. The Silk Road, one of the best-known and most enduring “international” trade routes, began sometime around 200 BCE and for centuries was central to cultural interaction from China through regions of the Asian continent all the way to the Mediterranean Sea.
So, if cultures and nations have been trading with one other for four thousand years, what makes today’s business landscape different? The answer lies in the distinction between international business and globalization.
International business refers to commerce in which goods, services, or resources cross the borders of two or more nations. This is what the Egyptians were doing when they sent goods across the Red Sea to Assyria. Globalization is broader than international business and describes a shift toward a more integrated world economy in which culture, ideas, and beliefs are exchanged in addition to goods, services, and resources. Globalization implies that the world is “getting smaller”: As a result of new transportation and communication technologies, people around the world can more readily connect with one another—both virtually and geographically.
The following video provides a good introduction to the causes and consequences of globalization.
Impact of Globalization on Global Business
The video, above, provides a good bird’s eye view of the affect of globalization on business—from opening up new markets to increasing the level of competition within markets and industries. Let’s take a look at particular example, though, to think through the various implications of conducting business on a global scale. Consider McDonald’s, which was started by two brothers in San Bernadino, California, sixty-eight years ago. As a result of globalization, nearly 69 million people in 118 different countries eat at McDonald’s every day. The first McDonald’s outside the U.S. and Canada was established in Costa Rica in 1970, and since the 1990s, most of the company’s growth has taken place in foreign countries. The process of building a global presence, entering new markets, and capitalizing on growing international demand for American fast food has enabled McDonald’s to expand from a single location to a global corporation with revenues in excess of U.S. \$25.4 billion in 2015. [1] However, entering new markets—whether at home or abroad—means contending with increased competition in those markets, including competition with other globally minded companies. In 2010, Subway surpassed McDonald’s to become the largest single-brand restaurant chain and the largest restaurant operator globally.
What is it like for companies that decide to take advantage of global opportunities as McDonald’s and Subway have? Return to the discussion of “external forces” in module 1, but now consider them from a global business perspective. Globalization certainly means that businesses can reach consumers around the word more rapidly and efficiently—thanks to cell phones, airplanes, and the Internet, we are all so much more interconnected and “accessible” now. But globalization also means incredible complexity. The list below sketches out just a few of the complexities and challenges that an American fast-food company like McDonald’s faces when it takes on the global business environment.
The Global Economic Environment
McDonald’s is a corporation based in the United States, where all business transactions are conducted using the U.S. dollar, but there are 167 official national currencies in the world, each with a different value and purchasing power. Imagine trying to balance the corporate checkbook at McDonald’s when your deposits have been made in more than a hundred different currencies.
The Global Legal Environment
In Greece, there is a \$650 fine for eating ice cream at certain historic, artistic, and culturally important sites. If you are the operator of a McDonald’s near the Parthenon, should you remove the ice cream cones and McFlurries from your menu to protect your customers against being fined, or not?
The Global Competitive Environment
McKebab, a fast-food restaurant in Slovakia whose name and golden “M” bear a striking resemblance to McDonald’s.
How does McDonald’s recapture the number-one position it lost to Subway in 2010? The company may need to make substantial changes to its operations, menu offerings, and/or marketing tactics. This is a steep, uphill climb in the United States alone, but consider trying to accomplish it in 118 different countries in 188 different markets—where you are competing not only with other global U.S. fast-food companies like Subway and KFC but with local ones, like “McKebab,” as well!
The Global Technological Environment
What does technology have to do with fast food or McDonald’s? Consider the company’s presence in China, where there are nearly 1.3 billion mobile users, and say hello to “McDonald’s Next,” a “modern and progressive” version of the restaurant that first opened in Hong Kong, featuring mobile-phone-charging platforms, free Wi-Fi, and self-ordering kiosks. This next generation of McDonald’s is a response to increased expectations around speed, service, economy, and availability across established and developing economies, mostly fueled by consumers’ growing access to affordable technology. As global businesses respond to demands created by technology, they must also leverage technology to move products, people, and supplies around the globe in a cost-effective and efficient manner.
The Global Social Environment
McDonald’s Maharaja Mac
McDonald’s has had to adapt in countless ways to meet the demands of its customers around the world. While it prides itself on offering a consistent, internationally recognizable menu and brand, the company has also had to cater to local dining preferences and customs. In 1995, for example, the first kosher McDonald’s opened in a Jerusalem suburb. In Arab countries, the restaurant chain offers “halal” menus, which comply with Islamic laws governing the preparation of meat. In 1996, McDonald’s entered India for the first time, where it offered a Big Mac made with lamb called the Maharaja Mac.[2]
McDonald’s is not a complex business—after all, it sells inexpensive burgers and fries, not automobiles or airplanes or pharmaceuticals—but clearly the global environment presents challenges even for them. You may be wondering why nations and businesses decide to take on such challenges, given the ongoing difficulty, risk, and uncertainty. We’ll investigate this question throughout the remainder of this module.
Absolute and Comparative Advantage
Consider the humble banana. Even if you’re not a big fan of this yellow fruit, you’ve surely seen them in the grocery store or in a market somewhere. If you walked through a US city with a banana and asked people to identify it, it’s unlikely you would encounter anyone who had no idea what it was. What if you did the same thing with a picture of a banana tree? How many people could identify it? Maybe some, but not all. Why is that? In the United States, bananas are grown in Hawaii, and not everyone has been to Hawaii. In fact, most of the bananas in the world are grown in Ecuador. If we Americans love bananas and don’t live in Hawaii and can’t get to Ecuador regularly, without global trade, we’re out of luck: no bananas for cereal in the morning or as snacks during the day and, worse, no banana splits at the local ice cream parlor. Why do Ecuador and Hawaii trade away their bananas instead of keeping them all to themselves? Probably because, although bananas are delicious and nutritious, it’s hard to build houses out of them. Instead, the state of Hawaii and nation of Ecuador choose to trade their bananas for things they lack, while considering the cost and profitability of exporting their product.
Ecuador and Hawaii offer an example of comparative advantage. Because bananas are not grown or readily available everywhere in the world, Ecuador and Hawaii can profitably export theirs to banana-less places like Iowa and Canada. At the same time, Ecuador may need computer systems to keep track of all of those bananas they are selling, but Ecuador is not a technologically advanced economy like the United States. The United States has a comparative advantage in computers, so we sell our computers to Ecuador and let them concentrate on selling us bananas.
The Concept of Advantage
In order to understand why businesses are willing to operate in a complex global environment, we must first understand two fundamental concepts that drive almost all business decisions: absolute and comparative advantage. Countries and companies are willing to assume the risk of engaging in global trade because they believe that they have an advantage over the competition that they can turn into profits. Not all countries have the same natural resources, infrastructure, labor force, or technology. These differences create advantages that can be exploited in global trade, to a country’s (or company’s) benefit.
Absolute Advantage
An entity (country, region, company, or individual) is considered to have an absolute advantage if either of the following conditions exists:
1. It is the only source of a particular product, good, or service. This kind of absolute advantage is very rare and usually depends on a particular natural resource being available only within a certain region or country. An example might be the coveted edible red bird’s nests found only in the caves of Thailand (and prized in Chinese cooking as the main ingredient in bird’s nest soup). Similarly, if Ecuador were the only place in the world where bananas could be grown, it would have an absolute advantage. However, suppose some sneaky banana spy goes to Ecuador and pilfers some banana tree seedlings and takes them back to her home country and begins growing and exporting bananas. At that point Ecuador no longer has an absolute advantage on the basis of the “only-source” condition.
2. An entity is also considered to have an absolute advantage if it is able to produce more of something than another entity while using the same amount of resources (factors of production). When the sneaky banana spy started growing bananas in her home country, she didn’t actually take away Ecuador’s absolute advantage, because Ecuador can produce more bananas using the same amount of resources (labor, land, water, equipment, etc.). Put another way, Ecuador’s direct cost of producing bananas is lower than the banana spy’s. Assuming that the bananas can be grown in the new country, it will take that country a very long time to match Ecuador’s skill, efficiency, and output level, and until it does, Ecuador will retain its absolute advantage.
Comparative Advantage
An entity (country, region, company, or individual) is considered to have a comparative advantage over another in producing a particular good or service if it can produce the good or service at a lower relative opportunity cost.
You’ll recall from the economic environment module that opportunity cost is the value of the next best alternative. (The video, below, also includes a refresher on this concept.) Since countries and businesses have limited resources, they are forced to make choices about how they allocate those resources. As a student, you understand opportunity cost better than you think. You have a limited amount of time, and you must choose between reading this module and going out with your friends, because you can’t do both. If you choose to go out with your friends, then the opportunity cost might be failure on your next exam because you did not use the time to prepare.
Ecuador has a comparative advantage in bananas over a long list of countries, including the United States. This comparative advantage is even better understood when you consider that their next best alternative product is oil. The Middle Eastern countries have been pumping oil from the ground for as long as Ecuador has been growing bananas. It makes as much sense for Kuwait to attempt to export bananas as it does for Ecuador to export oil. It’s the reality of comparative advantage that encourages countries and businesses to do what they do best—leaving the production of other goods and services to other countries or companies—and in so doing, focusing on producing goods and services where they have advantage, thus maximizing their opportunities in a global environment.
The following video provides an excellent illustration of comparative and absolute advantage and explains why they are such important considerations in how countries decide to specialize and trade.
practice question \(1\)
Consider an economy that has an absolute advantage in producing a given product, then it ________ have a comparative advantage in producing that same product.
1. must
2. might or might not
3. definitely
Answer
b. Absolute advantage means the economy can produce a given product with a lower resource cost and comparative advantage means the economy can product a given product with a lower opportunity cost. Absolute advantage meaning being better at something relative to something else. Specialization allows for everyone benefiting from producing under comparative advantage and then trading.
practice question \(2\)
If Kate can make more tacos in an hour than Bill, but Bill can make more tacos at a lower opportunity cost then Bill has a(n) ________.
1. absolute advantage in making tacos.
2. both an absolute and comparative advantage in making tacos.
3. comparative advantage in making tacos.
Answer
c. Kate has an absolute advantage because she can make more tacos and Bill has a comparative advantage because he can make more tacos at a lower opportunity cost.
Game: Absolute and Comparative Advantage
It’s one thing to talk and read about global business and another to actually engage in global trade. The following interactive provides a brief introduction to doing just that, with a focus on just how countries behave to create a more productive global economy.
learn more
Now that you’ve learned about specialization, you can try playing this trade game to explore trade in a fictional world: Play the Trade Ruler Game. Note that this game is Flash-based, so you’ll need to enable Flash in your browser in order to see it.
Global Markets
Global Markets and Business Opportunity
Increasingly nations and business use their comparative or absolute advantages to enter global markets driven by the same factor: the immense size of these markets.
Let’s return to the banana for a moment. In 2015, Ecuador exported 6.55 million metric tons of bananas. Without a large global demand for bananas, every man, woman, and child in Ecuador would have to eat 834 pounds of them per year to consume all of the production. Of course that wouldn’t happen: Instead, the country would simply cut back on the production of bananas—but, in so doing, it would lose an export that now accounts for more than 10 percent of its gross domestic product (GDP). Ecuador needs a large and vibrant global market to keep up with its tremendous supply of bananas, and it relies on the revenue from those bananas to purchase the other things it needs (in the same way that you traded cell phones for blue jeans in the island trader simulation).
Later in this module we’ll discuss how nations like Ecuador enter foreign markets, but for now let’s look more closely at the size of the world’s largest markets. The following table shows population and GDP data for the top five economies in the world as of 2015.[3] You’ll recall from the economic environment module that GDP, or gross domestic product, is a monetary measure of the market value of all final goods and services produced in a period, and the GDP growth rate is the increase or decrease in GDP over a period of time, expressed as a percentage.
Country GDP Population GDP Growth Rate
China \$19,390,000,000,000 1,367,485,388 6.90%
European Union \$19,180,000,000,000 513,949,445 2.20%
United States \$17,950,000,000,000 321,368,864 2.40%
India \$7,965,000,000,000 1,251,695,584 7.30%
Japan \$4,830,000,000,000 126,919,659 0.50%
Looking at the figures in this table, it isn’t hard to imagine that a country or company would like to have a foothold in one or all of these markets. Taken together, these five economies represent a lot of people, a lot of purchasing power, and a lot of economic growth. However, the immensity of the global market offers more than just new target customers. Consider some of the following benefits nations and firms realize by entering foreign markets.
Access to Factors of Production
You will recall that the factors of production required for a successful business venture are natural resources, capital, human capital, and entrepreneurship. Access to global markets enables countries and companies to acquire these factors of production when they are nonexistent, scarce, or just too costly at home. For example, India is one of the largest providers of telephone-based customer service (labor) worldwide, which makes sense given that its population is second only to China and almost four times that of the United States. In addition, labor costs in India are significantly lower than in the U.S.
Innovation and Ideas
Many companies enter global markets and, once there, discover unmet needs or unique products and services. They are then able to use their discoveries to expand an existing product line or introduce new products in other markets or at home. For example, many people credit the United Kingdom with inspiring the development of the craft beer industry in the United States.
Risk Reduction
Given the complexity of operating a business globally, it may seem like a contradiction that risk reduction is one of the benefits of a large global market, but it’s actually true. If a country or a company trades or does business with multiple foreign partners, they are less dependent on the success of any single partnership. Likewise, if a nation or business has multiple global sources for factors of production, then if one source “dries up,” they will still have access to what they need. For example, in 2010 China halted its export of rare earth minerals to Japan after the two countries were unable to resolve a territory dispute. Japan used these minerals in the production of everything from cars to computer chips, and to say that the Japanese were in a state of distress is an understatement. As a result of this albeit brief reduction in Chinese supply, Japan established a trade agreement with India for the import of the needed materials. They will no longer be totally dependent upon the Chinese for these important resources.
In summary, globalization makes business on a global scale possible, and the size of the global market makes it attractive. By using their absolute and comparative advantages, countries and companies can leverage their resources to produce and trade the things that benefit them the most.
The following video provides a recap of the main reasons why countries and businesses engage in global trade.
1. https://en.Wikipedia.org/wiki/McDonald%27s
2. en.Wikipedia.org/wiki/History_of_McDonald
3. CIA World FactBook https://www.cia.gov/library/publications/the-world-factbook/rankorder/2001rank.html#ch | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/03%3A_Global_Environment/3.01%3A_Why_It_Matters-_Global_Environment.txt |
What you’ll learn to do: describe how nations measure global trade
In the same way that nations measure their own economic productivity, they use specific tools to measure their trade with other nations. In this section you’ll learn what some of those tools are and how they’re used.
Learning Objectives
• Differentiate between trade deficits and trade surpluses
• Explain how countertrade contributes to the measure of global trade
Balance of Trade and Balance of Payments
Nations and businesses that trade back and forth, buy and sell companies, loan one another money, and invest in real estate around the globe need to have a way to evaluate the impact of these transactions on the economy. They need to make decisions about trade policies, regulations, and trade agreements, and until they can get a snapshot of what global trade is doing to hurt or help its economy, they can’t make these decisions. It’s a lot like your own finances, just on a much larger scale. At the end of the month have you spent more than you earned? Do you have a large positive balance in your bank account as a result of receiving a financial aid check? Did you need to borrow money from your parents to buy books or clothes? Until you really examine where your money is coming from and balance your checkbook, it’s hard to make long-term financial plans—like, say, deciding whether or not to buy a new car or purchase a home. This is very similar to what countries do when they measure the impact of trade on their economy.
In this section we’ll look at two key measurements of trade: balance of trade and balance of payments.
Balance of Trade
One of the ways that a country measures global trade is by calculating its balance of trade. Balance of trade is the difference between the value of a country’s imports and its exports, as follows:
value of exports – value of imports = balance of trade
Note
It’s important to use this formula just as it’s presented, without altering the sequence of values.
The calculation of the balance of trade yields one of two outcomes: a trade deficit or a trade surplus. A trade deficit occurs when a nation imports more than it exports. Since 1976, the United States has consistently run trade deficits due to high imports of oil and consumer products. In recent years, the biggest trade deficits were recorded with China, Japan, Germany, and Mexico. This shouldn’t come as a surprise to you if you emptied your backpack and counted up all the items not made in the United States. In contrast, a trade surplus occurs when a nation exports more than it imports. Although the United States has run an overall trade deficit since 1976, it doesn’t mean that we import more from every country than we export. On the contrary, the United States records trade surpluses with Hong Kong, the Netherlands, the United Arab Emirates, and Australia. Because the balance of trade is calculated using all imports and exports, it’s possible for the United States to run a surplus with some nations and a deficit with others. As with your checkbook, the balance reflects the difference between total exports (“deposits”) and total imports (“withdrawals”).
candyland's balance of trade
Let’s look at the balance of trade for “Candyland.”
Candyland is located in a region that lacks phosphate as a natural resource. However, it does have an abundance of sugarcane. As a result of its comparative advantages, Candyland imports phosphate from Christmas Island (it’s a real place in Australia—look it up!) to fertilize the sugarcane it grows, and it uses the sugarcane to manufacture saltwater taffy, which it exports to Christmas Island. The following table shows Candyland’s imports and exports with Christmas Island in 2014.
Imports (phosphate) Exports (taffy)
2014 \$45,000,000 \$75,000,000
Using these figures, we can easily calculate Candyland’s balance of trade in 2014:
\$75,000,000 (exports) − \$45,000,000 (imports) = \$30,000,000
This means that Candyland had a trade surplus of \$30,000,00 with Christmas Island, since exports exceeded imports. We can also say that Candyland was a “net exporter,” meaning they exported more than they imported.
However, the picture changed in 2015 when the Australian government closed the phosphate mine on Christmas Island. Candyland had to import phosphate from Morocco, instead, and was not able to get the same favorable pricing as before. Consequently, sugarcane farmers paid more for fertilizer, the price of sugarcane went up, and Candyland had to raise the price on its saltwater taffy. Sadly, the people of Morocco aren’t really big fans of saltwater taffy, so exports fell. The following table shows Candyland’s imports and exports with Morocco in 2015.
Imports (phosphates) Exports (Taffy)
2015 \$65,000,000 \$55,000,000
We can use the figures to calculate Candyland’s balance of trade:
\$55,000,000 (exports) − \$65,000,000 (imports) = −\$10,000,000
The negative number indicates a trade deficit of \$10,000, showing that Candyland’s imported more from Morocco than it exported. We would say that Candyland became a “net importer”—importing more than it was exporting.
Obviously this is a simple example. A country’s global business doesn’t amount to just trading phosphate and taffy or cell phones and blue jeans. It includes all kinds of financial transactions: goods and services imported and exported, foreign investments, loans, transfers, and so on. Tracking all these payments provides another way to measure the size of a country’s international trade: the balance of payments.
Balance of Payments
Balance of Payments is the difference between the total flow of money coming into a country and the total flow of money going out of a country during a period of time. Although related to the balance of trade, balance of payments is the record of all economic transactions between individuals, firms, and the government and the rest of the world in a particular period. Thus the balance of payments includes all external transactions of a country, including payments for the country’s exports and imports of goods, services, foreign investments, loans and foreign aid, financial capital, and financial transfers.
• For instance, if a US company buys land or a factory in another country, that investment is included in the US balance of payments as an outflow. Likewise, if a US company is sold to a foreign company, it’s included in the balance of payments. Just recently, Didi Chuxing, the Chinese ride-hailing service, bought Uber’s subsidiary in China in a deal valued at \$35 billion. This sale will create a cash inflow to the United States, but over the long term it will decrease the revenue flowing in from China through Uber.
• If a nation receives foreign aid or borrows money from another country, this amount is also reflected in its balance of payments as a cash inflow. For example, the bailout Greece received from the Eurozone and IMF in 2010 to help stabilize its failing economy affected the balance of payments for all of the nations involved. Greece recorded the €110 billion loan as an inflow in its balance of payments, while the Eurozone members recorded it as an outflow in their balance of payments.
A country’s balance of payments is calculated as follows:
total money coming into a country (inflow)− total money going out (outflow) = balance of payments
Note
It’s important to use this formula just as it’s presented, without altering the sequence of values.
Candyland's balance of payments
Let’s examine Candyland’s balance of payments in 2015. The following table shows all of its external transactions during the year.
Imports (phosphates) Exports (taffy) Foreign aid (loan) from Hooperland Purchase of Wandaland assets
2015 \$65,000,000 \$55,000,000 \$25,000,000 \$30,000,000
When we calculated Candyland’s balance of trade in 2015, we did not take into account the following two transactions:
1. Candyland invested in a factory in Wandaland and purchased the factory from the government for \$30,000,000. This outflow of funds will affect Candyland’s balance of payments.
When we calculate Candyland’s 2015 balance of payments, by taking the inflows (revenue from exports and foreign aid) and subtracting the outflows (payments for imports and purchase of foreign assets), the balance is negative, as shown below:
(\$55,000,000 + \$25,000,000) (total inflow) – (\$65,000,000 + \$30,000,000) (total outflow) = −\$15,000,000
What effect will this have on Candyland? Well, when Candyland’s leader is briefed by her council of international economic advisers, they will inform her that the country currently has an “unfavorable balance of payments.” That is, less money is coming into the country than is going out. If, on the other hand, the balance of payments were a positive number (inflow exceeded outflow), Candyland could say that it has a “favorable balance of payments.”
At this point it’s tempting to make judgments about these different types of trade measurements and conclude that trade surpluses and favorable balance of payments are always indicators of a strong economy, but unfortunately it’s not so cut and dried. Balance of trade and balance of payments are starting points—much in the way that an individual’s credit rating might be a starting point for seeking a loan. How the numbers are interpreted and viewed by the country’s leaders, other countries, and the world depends on many factors, such as where a country is in its economic development, the factors contributing to the balance of trade or payments, the health of the overall global economy, what the country is doing with its imports, and so on. As you might guess, assessments of these factors can be intensely political. You’ll learn more about these considerations later in this module when we discuss how nations attempt to restrict or control trade.
Countertrade
So far we have discussed global trade measured in dollars, euros, or other traditional currency, which is the way that everyone assumes business is conducted today. For example, here in the United States, we express the size of the global market, or Global World Product (GWP), as U.S. \$107.5 trillion. If we lived in Japan, we’d measure GWP using Japanese currency, yen (¥).
However, when we measure global trade only in terms of currency-based transactions, we omit a portion of the market known as countertrade. Countertrade is a system of exchange in which goods and services are used as payment rather than money. There are many types of countertrading. Some of the most common types are described below:
1. Barter: Exchange of goods or services directly for other goods or services without the use of money as means of purchase or payment. Example: One party trades salt for sugar from another party.
2. Switch trading: Practice in which one company sells to another its obligation to make a purchase in a given country. Example: Party A and Party B are countertrading salt for sugar. Party A may switch its obligation to pay Party B to a third party, known as the switch trader. The switch trader gets the sugar from Party B at a discount and sells it for money. The money is used as Party A’s payment to Party B.
3. Counterpurchase: Sale of goods and services to one company in another country by a company that promises to make a future purchase of a specific product from the same company in that country. Party A sells salt to Party B. Party A promises to make a future purchase of sugar from Party B.
4. Buyback: This occurs when a firm builds a plant in a country, or supplies technology, equipment, training, or other services to the country, and agrees to take a certain percentage of the plant’s output as partial payment for the contract. Example: Party A builds a salt-processing plant in Country B, providing capital to this developing nation. In return, Country B pays Party A with salt from the plant.
5. Offset: Agreement that a company will offset a hard-currency purchase of an unspecified product from that nation in the future. Agreement by one nation to buy a product from another, subject to the purchase of some or all of the components and raw materials from the buyer of the finished product, or the assembly of such product in the buyer nation. Example: Party A and Country B enter a contract where Party A agrees to buy sugar from Country B to manufacture candy. Country B then buys that candy.
Countertrading is common among countries that lack sufficient hard currency (i.e., cash) or where other types of market trade are impossible. In developing countries, whose currency may be weak or devalued relative to another country’s currency, bartering may be the only way to trade. For example, if the value of Venezuela’s currency, the bolívar fuerte, falls relative to the U.S. dollar (as it has in recent years), the exchange rate makes it unfavorable for Venezuela to sell its oil to the United States. Countertrade may be a much more financially beneficial arrangement. | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/03%3A_Global_Environment/3.03%3A_Measuring_Global_Trade.txt |
What you’ll learn to do: evaluate common strategies used to reach global markets
Globalization introduces a number of challenges that are unique to operating simultaneously in different countries and global markets. What is the best way to enter or take advantage of a global market? When should you adjust a product’s features to customize it to consumer needs in a different global market? How do you manage the costs and complexities of producing and/or promoting products in different locations, with different languages, cultural sensitivities, and consumer expectations?
While this next section doesn’t attempt to answer all of these questions, it explains common strategies and approaches used by multinational corporations to take advantage of global business opportunities.
Learning Objectives
• Explain how firms use licensing and franchising to reach global markets
• Explain how firms use joint ventures and foreign strategic alliances to reach global markets
Global Business Strategies
In today’s economy, once a nation or business has developed an advantage—either comparative or absolute—it’s likely to look beyond its own borders or storefront to seek greater economic opportunity. But how do you enter a global market? It’s certainly not as simple as loading up your products in a van, driving to the next town, and knocking on doors. Below are some of the common strategies companies and countries use to get their goods and services into global markets.
Exporting/Importing
Figure \(1\). Shipping Containers
Exporting is the easiest and most straightforward way to engage with the global market. Exporting is taking goods that were produced within a company’s home country and shipping them to another country. The party sending the good is called an exporter. It is impossible to discuss exporting without mentioning its complement, importing. Importing is the process by which a good is brought into a jurisdiction, especially across a national border, from an external source. The party bringing in the good is called an importer. Simply put, one country’s exports become another country’s imports. Examples of U.S. imports are everywhere: Take a look at the labels in your clothes or the contents of your backpack. From our vantage point, U.S. exports may be a little harder to see, but they exist all the same and are plenty visible in other countries. According to World’s Top Exports, the following export product groups represent the highest dollar value in American global shipments during 2015. In parentheses is the percentage share each export category represents in terms of overall U.S. exports:
1. Machines, engines, pumps: US\$205.8 billion (13.7% of total exports)
2. Electronic equipment: \$169.8 billion (11.3%)
3. Aircraft, spacecraft: \$131.1 billion (8.7%)
4. Vehicles: \$127.1 billion (8.4%)
5. Oil: \$106.1 billion (7.1%)
6. Medical, technical equipment: \$83.4 billion (5.5%)
7. Plastics: \$60.3 billion (4%)
8. Gems, precious metals, coins: \$58.7 billion (3.9%)
9. Pharmaceuticals: \$47.3 billion (3.1%)
10. Organic chemicals: \$38.8 billion (2.6%)[1]
Advantages and Disadvantages
Since exporting doesn’t require a company to manufacture its products in the target country, the company doesn’t have to invest in factories, equipment, or other production facilities located halfway around the globe. Most of the costs involved in exporting are associated with finding a buyer or distributor in the destination market. For these reasons, exporting is considered to be the quickest and least expensive means to enter the global market. However, there are disadvantages, too.
Once products arrive in the destination market, the business loses control of them, which can result in products being misrepresented, copied by other manufacturers, or even sold on a black market. In addition, because the business isn’t active in the new market, it can’t gain insight into or experience with local consumer preferences and demand. This lack of information can create uncertainty and potentially cost the company opportunities down the road. As you will learn later in this module, businesses operating in other countries may find themselves subject to taxes, regulations, and/or restrictions that can substantially affect the profitability of the entire export venture.
Outsourcing/Offshoring
Figure \(2\). Garment factory, Jiaxing, China
Outsourcing and offshoring are two additional strategies that a business can use in order to take advantage of the global market. Outsourcing contracts out a business process to another party and may include either or both foreign and domestic contracting. You may be familiar with outsourcing if your college has outsourced the bookstore to a national chain such as Barnes & Noble, or the food services are provided by a company such as Starbucks or Aramark. Although the employees work on your college campus, they are not college employees. Offshoring, on the other hand, is the actual relocation of a business process from one country to another—typically it’s an operational process, such as manufacturing, or sometimes a supporting process, such as accounting. In the case of offshoring, the employees still work for the company that’s offshoring its operations, but instead of working in a facility within the United States, they are located in a foreign country. In general, outsourcing and offshoring are strategies that companies use to try to lower their costs.
If a business chooses outsourcing as a way to engage with the global market, it might have a single component part manufactured in, say, Tibet and then shipped back to Iowa, where the factory workers in Iowa would use the outsourced part in the assembly of the final product. The business would have a contract with the company making the component part at an agreed-upon price, but it would not have an employer-employee relationship with the workers in Tibet. On the other hand, if the business wants to take advantage of offshoring, it would move the entire plant from Iowa to Tibet and hire workers in Tibet who would work directly for the business.
The following video is an example of how a small business is outsourcing its manufacturing to China. Especially for small start-up companies, using established manufacturing facilities located outside of the U.S. allows them to enter the global marketplace. Cost, logistics, finances, and speed are just some of the things that this type of arrangement can bring to businesses looking to take advantage of the growing global demand for U.S.-branded products.
Advantages and Disadvantages
Offshoring and outsourcing are both the subject of ongoing heated public debate—both in the U.S. and in other countries. Those in favor assert that these strategies benefit both sides of the arrangement: Free trade is enhanced, the destination country gains jobs, and the origin country gets cheaper goods and services. Some supporters go further and assert that outsourcing and offshoring raise the gross domestic product (GDP) and increase the total number of jobs domestically, too. This claim is based on the idea that workers who lose their jobs will move to higher-paying jobs in industries where the origin country has a comparative advantage.
On the other hand, job losses and wage erosion “at home” have sparked opposition to offshoring and outsourcing. Many argue that the jobs that are shipped overseas are not replaced by better, higher-paying ones. And it’s not just low-skilled workers who are feeling the pain. Increasingly, critics say, even highly trained workers (such as software engineers) with high-paying jobs are finding themselves replaced by cheaper workers in India and China. Some firms, while realizing financial gains from lowering their production costs, are finding that offshoring and outsourcing are very costly in terms of lack of control over product quality, working conditions, and labor relations. For example, companies like Nike and Apple have come under fire by human rights organizations and consumers over reports of worker abuse, dangerous working conditions, and ridiculously low wages. It was recently reported that apparel workers in Bangladesh are sometimes paid as little as \$0.21 per hour. We will explore some of the ethical issues raised by offshoring and outsourcing later in the course in the business ethics module.
Licensing and Franchising
Figure \(3\). The Star Wars Cookbook
Increasingly, businesses are getting their products and services into global markets via licensing and franchise agreements. Under a licensing agreement, the licensor agrees to let someone else (the licensee) use the property of the licensor in exchange for a fee. License agreements usually cover property that is intangible, such as trademarks, images, patents, or production techniques. Since its debut in the late 1970s, Star Wars remains the most lucrative source of licensing in the entertainment business, generating more than \$42 billion from the sale of licensed merchandise.
A longer-term and more comprehensive way to access the global market is through franchising. Under the terms of a franchise agreement, a party (franchisee) acquires access to the knowledge, processes, and trademarks of a business (the franchisor) in order to sell a product or service under the business’s (franchise’s) name. In exchange for the franchise, the franchisee usually pays the franchisor both initial and annual fees. McDonald’s, Holiday Inn, Hertz Car Rental, and Dunkin’ Donuts have all expanded into foreign markets through franchising.
Advantages and Disadvantages
Licensing and franchising both offer advantages for the involved parties: The licensee and franchisee both gain a competitive advantage in the market. The licensee/franchisee gets immediate brand recognition and may quickly overtake the competition by offering a product or service for which there is existing unmet demand. For example, a local sandwich shop may have a hard time competing when a Subway franchise opens because the brand is so well known. Also, because franchises are usually “turnkey” operations in which processes, supply chains, training, and products are already in place, the new business can quickly begin efficient and profitable operations. For the franchisor, this arrangement enables them to gain inexpensive access to a new market, since the initial cost of the franchise is borne by the franchisee. Under a licensing agreement, all of the costs of production, sales, and distribution are the responsibility of the licensee. If financial capital is scarce, both approaches allow companies to have a global presence without heavy investments.
These methods do contain some risks and disadvantages, however. They are typically the least profitable way of entering a foreign market, since the profits go to the franchisee or licensee. Although the licensor or franchisor receives up-front money and/or a small percentage of future sales, the majority of the revenue remains in the destination country with the licensee or franchisee. Franchising entails a long-term commitment on the part of the franchisor to provide ongoing support in the form of training, logistics, product development, and brand marketing. Once a business begins to establish a global franchise presence, the pressure to maintain brand integrity and fiscal responsibility becomes more intense as the failure of the franchise now has global consequences. For companies selling licensing rights there is a risk that their intellectual property may be misrepresented or used in a manner that could tarnish the brand’s image. Also, once a license to use an image or other intellectual property has been granted to a company in another country, the probability that knock-off products will enter the market goes up. For both franchisors and licensors, maintaining quality standards on a global scale is a massive undertaking, and for this reason many companies are choosing to exert a higher degree of control over their products, brands, and intellectual property than they have in the past.
Joint Ventures/Strategic Alliances
Figure \(4\). Honey Nut Cheerios
There are times when businesses have opportunities within the global market that are better undertaken with a partner. Sometimes these projects are extremely large and capital-intensive or are so comprehensive that it makes sense to include multiple businesses or even governments. These large-scale, global projects usually take one of two forms: strategic alliances or joint ventures.
A joint venture establishes a new business that is jointly owned by two or more otherwise independent businesses. The most common joint ventures involve two companies that are equal partners in the new firm, investing money and resources while sharing control of the newly formed firm. Often, the foreign partner provides expertise on the new market, business connections and networks, and access to other in-country aspects of business such as real estate and regulatory compliance. For example, in 2015 Fiat Chrysler entered into a joint venture with Tata Motors of India to expand the production of Jeeps in India. The company created in this joint venture is Fiat India Automobiles Private Limited.
Joint ventures require a greater commitment from firms than other global strategies, because they are riskier and less flexible. Joint ventures may afford tax advantages in many countries, particularly where foreign-owned businesses are taxed at higher rates than locally owned businesses. Some countries require all business ventures to be at least partially owned by domestic business partners.
A less permanent, but equally effective way to enter the global market is through a strategic alliance. A strategic alliance is formed between two or more corporations, each based in their home country, for a specified period of time. Unlike a joint venture, a new company is not formed. Generally, strategic alliances are pursued when businesses find that they have gained all they can from exporting and want to expand into a new geographic market or a related business. This approach can be particularly useful when a government prohibits imports in order to protect domestic industry. The cost of a strategic alliance is usually shared equitably among the corporations involved, and it’s generally the least expensive way for all concerned to form a partnership. An example of this is the alliance between General Mills and Nestlé: Honey Nut Cheerios are manufactured in bulk by General Mills in the United States and then shipped to Nestlé Europe, where they are packaged and shipped to France, Spain, and Portugal.
Advantages and Disadvantages
The greatest advantage of joint ventures and strategic alliances is the knowledge and experience of the market offered by the local partner—on everything from consumer preferences to cultural differences, language, and political/economic systems. Another advantage is that the risk of entering the market with a new product is shared by more than one firm, thereby reducing each company’s exposure to potential losses.
However, these types of partnerships also have their drawbacks. When companies share their technology and industry know-how, they run the risk that the partner firm will take that technology or innovation and use it to become a competitor in the future. This was a primary concern when Boeing collaborated with Mitsubishi (it was ultimately resolved in the legal details of the partnership agreement, which both companies signed). Conflicts over control of these partnerships can also arise if the owners of the partner firms do not agree on key business decisions.
Of all of the ways that a business can reach the global market, the most intensive approach is through foreign direct investment or FDI. Foreign direct investment is an investment in the form of a controlling ownership in a business enterprise in one country by an entity based in another country. FDI can take one of two forms: Greenfield ventures or mergers/acquisitions.
In a Greenfield venture, the company enters a foreign market and establishes a new subsidiary as a start-up business. A good example of this is the BMW US Manufacturing Company, a vehicle-assembly facility located in Greer, South Carolina, that is part of the BMW Group. Although it’s BMW’s only assembly plant in the United States, it represents a direct investment inside the United States by the German manufacturer, and it’s one of the most successful Greenfield ventures in the U.S.
Businesses that are not ready to take on the challenge of establishing a new facility or subsidiary in a foreign country will usually choose either a merger or acquisition as a means of expanding their global reach. Mergers and acquisitions represent the vast majority of FDI and range from 50 percent to 80 percent of all FDI in some industries. According to Forbes,
"U.S. companies completed 116 emerging market acquisitions in the first half of 2013, up from 110 in the second half of 2012. . . . The most popular geographic targets for U.S. companies in the first half of 2013 were Brazil (25 deals), India (18 deals), South American countries excluding Brazil (15), South and East Asia (15), and Central America and Caribbean (14).[2]"
Mergers and acquisitions aren’t just carried out by U.S. companies, either—it’s an incredibly pervasive global business strategy, and ownership of many well-known products and brands has long been separated from the country of origin. For example, the Chinese just bought Smithfield Foods, Stolichnaya (“Stoli”) Russian vodka is actually owned by a company in the United Kingdom, Anheuser-Busch is owned by Belgian-Brazilian conglomerate InBev, and 7-Eleven is owned by the Japanese.[3]
Advantages and Disadvantages
Because the level of commitment and investment associated with FDI is so high, companies expend a great deal of time and effort scrutinizing potential opportunities. With Greenfield ventures, the amount of time it takes to build a presence in the foreign country is substantial. If a business is not already established in other global locations and lacks experience with FDI, it may be in for a series of unpleasant surprises in the form of regulations, licensing, taxes, and other “red tape”—much of which we will look at later in this module.
On the other hand, mergers and acquisitions are faster to execute than Greenfield ventures, and by merging with or acquiring an existing foreign company already in the market, outside companies can quickly take advantage of that presence. Another benefit is that a merger or acquisition involves the purchase of assets such as property, plants, and equipment that are already producing a product with a known revenue stream. The key to a successful merger or acquisition is paying the right price for the company, because, no matter how successful the business was before it was acquired (or merged), overpaying can turn a formerly profitable operation into a money pit.
1. United States Top 10 Exports. (2016). Retrieved August 17, 2016, from http://www.worldstopexports.com/united-states-top-10-exports/
2. Rapoza, K. (2013, September 13). U.S. Companies Buying up Foreign Competition. Retrieved August 18, 2016, from http://www.forbes.com/sites/kenrapoza/2013/09/15/u-s-companies-buying-up-foreign-competition/#7a6b71ef2177
3. Frohlich, T. C., & Sauter, M. B. (n.d.). Ten Classic American Brands That Are Foreign-Owned. Retrieved August 19, 2016, from http://247wallst.com/special-report/...foreign-owned/ | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/03%3A_Global_Environment/3.04%3A_Global_Buisness_Strategies.txt |
What you’ll learn to do: identify and describe forces that affect global trade
In this section you’ll learn about the range of forces that affect global trade. These forces include everything from culture and politics to the natural environment.
Learning Objectives
• Describe the impact of political and economic forces on global trade
• Describe the impact of physical and environmental forces on global trade
• Describe the impact of tariff and nontariff restrictions on global trade
Sociocultural Differences
Culture refers to the influence of religious, family, educational, and social systems on people, how they live their lives, and the choices they make. Business always exists in an environment shaped by culture. Organizations that intend to sell products and services in different countries must be sensitive to the cultural factors at work in their target markets. Even cultural differences between different countries—or between different regions in the same country—can seem small, but businesses that ignore them risk failure in their ventures.
Culture is complex, and fully appreciating its influence takes significant time, effort, and expertise. Certain features of a culture can create an illusion of similarity, but businesses need to delve deeply to make sure they truly understand the people and environments in which they work. Even a common language does not guarantee similarity of interpretation. For example, in the U.S. we purchase “cans” of various grocery products, but the British purchase “tins.” In India, where English is one of a number of officially recognized languages, “matrimonial” is used as a noun in casual conversation, referring to personal ads in newspapers seeking marriage partners.
Several dimensions of culture that require particular attention from global businesses are listed below.
Language
The importance of language differences can’t be overemphasized, and there are nearly three thousand languages in the world. Language differences can be a challenge for businesses designing international marketing campaigns, product labels, brand and product names, tag lines, and so on. Finding a single brand name that works universally in terms of pronunciation, meaning, and “ownability” is a monumental challenge. Of course, correct and grammatical use of language in business communication is essential for a product, brand, or company to be viewed as credible, trustworthy, and of high quality.
The language issue becomes more complicated when a country has more than one officially recognized language. To illustrate, in Canada, national law requires that labels include both English and French. In India and China, more than two hundred different dialects are spoken. India has more than twenty officially recognized languages. Mainland China’s official spoken language is Standard Chinese, and several autonomous regions have designated other additional official languages. Meanwhile in Hong Kong and Macau, Cantonese Chinese, English, and Portuguese are the official languages. Clearly language can quickly become a very challenging issue for businesses!
Finally, businesses should be attuned to what they communicate when they choose which languages to use—or not use. In Eastern Europe, for example, the long history of Soviet occupation during the Cold War has left many inhabitants with a negative perception of the Russian language. Products that carry Russian labeling may suffer accordingly.
Customs and Taboos
All cultures have their own unique sets of customs and taboos. It’s important for businesses to learn about these customs and taboos so they’ll know what is acceptable and unacceptable for their foreign operations. For example, in Japan, the number four is considered unlucky, and products packages containing four items are avoided by many consumers. In Middle Eastern countries where Islamic law is strictly observed, images displaying the uncovered arms or legs of the female body are considered offensive. Meanwhile in Egypt, where many women wear the headscarf or hijab in public, an increasing number of younger women are in work and educational settings where gender segregation does not exist. Businesses struggle with whether to portray women with or without the hijab, knowing that they risk offending some of their target audience with either choice. Businesses should seek guidance from native experts familiar with local culture and customers.
Values
The role of values in society is to dictate what is acceptable or unacceptable. Values are part of the societal fabric of a culture, and they can also be expressed individually, arising from the influence of family, education, moral, and religious beliefs. Values are also learned through experiences. As a result, values can influence consumer perceptions and purchasing behavior. For example, consumers in some countries, such as the United States, tend to be individualistic and make many purchasing decisions based on their own personal preferences. In other countries, such as Japan, the well-being of the group is more highly valued, and buying decisions are more influenced by the well-being of the group, such as the family. Based on these differences in values, it is not surprising that ads featuring individuals tend to do better in countries where individualism is an important value, and ads featuring groups do better in countries where the group’s well-being is a higher value.
Time and Punctuality
Different cultures have different sensitivities around time and punctuality. In some countries, being slightly late to a meeting is acceptable, whereas in other countries it’s very insulting. For cultures that highly value punctuality, being on time is a sign of good planning, organization, and respect. In cultures where precise punctuality is less important, there is often a greater emphasis on relationships. The fact that a meeting happens is more important than when it happens.
While there are cultural stereotypes about time management (such as the laid-back “island time” many residents of island nations refer to), the best rule of thumb in business is to be punctual and meet deadlines as promised. You will not insult people by following this rule. Also, it’s wise not to apply popular stereotypes to individual people for whom the cultural stereotype may or may not be true. You should let a person’s behavior speak for itself, and always treat others with the same level of courtesy you would expect from them.
Business Norms
Business norms vary from one country to the next and may present challenges to foreigners not used to operating according to the particular norms of the host country. In business meetings in Japan, for example, it’s expected that the most senior person representing an organization will lead the discussion, and more junior-level colleagues may not speak at all. The role of alcohol in business meetings varies widely by culture: In Middle Eastern cultures where alcohol is forbidden, it may be insulting to serve or even offer an alcoholic beverage. In China, many rounds of toasts are customary as part of formal dinner meetings.
Likewise, business norms around greetings and physical contact also vary. American-style handshakes have become accepted as a business norm in many cultures, but this custom is not universal. In Japan and some other Asian cultures, a respectful bow is the traditional business greeting, although the handshake is becoming more common. In Islamic cultures, contact between men and women is a sensitive issue, even in business settings. In those regions and cultures, it’s best to shake hands with a woman only if she extends her hand first. Similarly, Western women may avoid causing embarrassment by shaking hands only if a hand is extended to her. In India, the namaste (a slight bow with hands brought together on the chest) remains a respectful, if traditional, business greeting particularly when interacting with women and older people.
Always seek guidance from a trusted colleague or friend who has experience in the local customs and can offer coaching on proper etiquette.
Religious Beliefs and Celebrations
As discussed earlier in this module, religious beliefs and practice can strongly influence what consumers buy (or don’t buy), when and where they shop, and how they conduct business. It’s important for companies to understand the influence of religion on consumer culture in the markets where they operate, so that their business activities can be appropriately sensitive. Failing to respect religious beliefs or cultures can seriously undermine the reputation of a company or brand. At the same time, businesses that are attuned to the impact of religion on culture can more easily integrate their operations and employees into the local culture.
For example, all the major world religions observe holidays that include feasting and gift giving. These festival seasons tend to be prime shopping seasons as well. Holidays originating from the prominent religion of a country or region create sensitivities about certain products: in the Hindu religion, cows are considered sacred and people refrain from eating beef. Observant Jews and Muslims consider pork unclean, and they consume only kosher or halal meats, respectively. Many religions eschew alcohol: for example, devout Sikhs, Muslims, Mormons, Buddhists, and conservative Southern Baptists all refrain from drinking.
Religious beliefs may cause sensitivities around revealing images or sexually suggestive material. Religious beliefs associated with the symbolism of different colors may create either preferences for or rejection of certain products. The link between religious practice and gender roles may affect which members of the family influence which types of buying decisions. It is important, however, for businesses not to oversimplify how decision making happens in these settings. Even if a woman, for example, is not the primary buyer, she may exercise strong influence of many consumer decisions. Here, as in other areas of cultural impact, is it crucial for businesses to educate themselves about the people and cultures they are targeting for business in order to use cultural knowledge to their advantage.
Political and Economic Differences
The political economy of a country refers to its political and economic systems, together. The political system includes the set of formal and informal legal institutions and structures that comprise the government or state and its sovereignty over a territory or people. As you know, political systems can differ in the way they view the role of government and the rights of citizens (compare, for example, the democratic political system of Canada with the communist system of North Korea). As you’ll recall, the economic system refers to the way in which a country organizes its economy: most are command, market, or mixed economies.
The nature of a country’s political economy plays a big role in whether it is attractive to foreign business and entrepreneurship. Historically, there has been a direct relationship between the degree of economic freedom in a country and its economic growth—the more freedom, the more growth, and vice versa. For decades, the Chinese government maintained an ironclad grip on all business enterprise, which effectively prevented foreign businesses from fully engaging with the Chinese market. That climate has tempered, however, and now the political economy of China is much more open to foreign investment, though it is still not as open as Europe or the U.S.
Businesses seeking global opportunities must consider other economic factors beyond a country’s political economy. For one thing, they will want to target the markets and countries where people have the highest incomes and the most disposable income. The world map below shows just how much variation there is in the gross national income (GNI) per person among the nations of the world.
However, often those markets are not where new opportunity exists, so businesses have to pursue what economists refer to as “emerging markets.” The four largest emerging and developing economies are the BRIC countries (Brazil, Russia, India, and China). One means of measuring a country’s level of economic development is by its purchasing power parity (PPP), which enables economists to compare countries with very different standards of living. The PPP for a given country is determined by adjusting up or down as compared to the cost of living in the United States.
India has the world’s second-largest mobile-phone user base: 996.66 million users as of September 2015. Shown here is a rooftop mobile phone tower in Bangalore.
However, there is often more to a country’s economic story than its PPP or GNI. Consider India: As an emerging market, India is attracting significant attention from businesses all around the globe. It has the second-fastest-growing automotive industry in the world. According to a 2011 report, India’s GDP at purchasing power parity could overtake that of the United States by 2045. During the next four decades, Indian GDP is expected to grow at an annualized average of 8 percent, making it potentially the world’s fastest-growing major economy until 2050. The report highlights key growth factors: a young and rapidly growing working-age population; growth in the manufacturing sector because of rising education and engineering skill levels; and sustained growth of the consumer market driven by a rapidly growing middle class.
At the same time, surveys continue to emphasize the chasm between two contrasting pictures of India—on one side, an urban India, which boasts of large-scale space and nuclear programs, billionaires, and information technology expertise, and a rural India on the other, in which 92 million households (51 percent) earn their living by manual labor. In 2014, a report by the Indian Government Planning Commission estimated that 363 million Indians, or 29.5 percent of the total population, were living below the poverty line.
Another aspect of a country’s political economy is the stability of its current government. Business activity tends to grow and thrive when a country is politically stable. When a country is politically unstable, multinational firms can still conduct business profitably, but there are higher risks and often higher costs associated with business operations. Political instability makes a country less attractive from a business investment perspective, so foreign and domestic companies doing business there must often pay higher insurance rates, higher interest rates on business loans, and higher costs to protect the security of their employees and operations. Alternatively, in countries with stable political environments, the market and consumer behavior are more predictable, and organizations can rely on governments to enforce the rule of law.
As you can see, the desirability of a country as a potential market or investment site depends on a host of complex, interrelated factors. To further complicate matters, once a business arrives in a foreign market, it must also contend with the uncertainty of exchange rates. An exchange rate is the value of one country’s currency relative to the value of another country’s currency. For example, an exchange rate of 119 Japanese yen (JPY, ¥) to the United States dollar (US\$) means that ¥119 will be exchanged for each US\$1, or US\$1 will be exchanged for ¥119.
Each country, using various mechanisms, manages the value of its currency. A market-based exchange rate will change whenever the value of either of the two component currencies change. A currency will tend to become more valuable whenever demand for it is greater than the available supply. It will become less valuable whenever demand is less than the available supply (this does not mean that people no longer want money, only that they prefer to hang on to their wealth in some other form, possibly another currency).
The video below will provide a complete picture of exchange rates and how they impact trade:
Clearly, exchanges rates are an important consideration for companies wanting to take their business global, since they will likely have to buy and sell even the most mundane commodities once they arrive in the foreign market. Local labor wants to be paid in its nation’s currency, and if the exchange rate of that currency changes in a way that makes it more valuable, then the business’s costs rise unexpectedly. Although businesses try to anticipate and plan for fluctuations in exchange rates, currency values are determined by supply and demand, and businesses are at the mercy of market forces beyond their control.
Legal Differences
Governments around the world maintain laws that regulate business practices. In some countries, these laws are more heavy-handed, and in others, the business climate is less regulated and structured. Some laws and regulations, such ones governing property rights and contracts, are designed to create a stable environment for business (both domestic and international)—by establishing the establishment and enforcement of property rights and contracts, for example. Others are designed to protect consumers and the environment, requiring businesses to adhere to responsible, safe, and ethical practices. Still other laws and regulations privilege domestic businesses and protect or partially shield them from foreign competition. There are even laws and regulations that affect what marketers are allowed to include in marketing communications, although these are more strict in some countries than in others. And of course, some laws and regulations deal with taxation and other costs of conducting business.
Businesses must understand and conform to the legal and regulatory environments of the countries and regions in which they operate. The following is a short list of common regulatory areas that affect businesses globally:
• Contract law governing agreements about the supply and delivery of goods and services
• Trademark registration and enforcement for brand names, logos, tag lines, and so forth
• Labeling requirements for consumer safety, protection, and transparency
• Patents to enforce intellectual property rights and business rights associated with unique inventions and “ownable” business ideas
• Decency, censorship, and freedom-of-expression laws to which marketing communications are subject
• Price floors, ceilings, and other regulations regarding the prices organizations can charge for certain types of goods and services
• Product safety, testing, and quality-control
• Environmental protection and conservation regulations and permits governing acceptable and responsible business practices
• Privacy, including laws governing data collection, storage, use, and permissions associated with consumers and their digital identities
• Financial reporting and disclosure to ensure that organizations provide transparency around sound business and financial practices
In some cases, international laws and regulations designed to simplify these issues among regional allies and economic partners may also apply.
Physical and Environmental Differences
Physical and environmental factors can have a significant impact on a company’s ability to do business in a foreign country. Some developing countries lack the infrastructure such as roads, railways, and port systems needed to transport goods, or they may not have adequate storage facilities. You can imagine that this would be a major barrier for businesses trying to sell fresh food or perishable goods. Add to that the limited access to electricity, clean water, and sanitation in many parts of the world, and you begin to understand some of the practical and logistical challenges of doing business globally.
A country’s natural environment and the surrounding regulations aimed at protecting it may pose additional challenges. Many governments require foreign companies to undergo a complex permitting process if any of their planned activities will adversely affect the environment. Even in developing countries, minimum standards for air emissions, waste disposal, and hazardous-material handling are becoming the norm, and in places where such regulations are weak or lacking, companies often face considerable pressure from local residents and consumer groups to clean up their act or leave. While all of these challenges can make companies think twice about setting up shop in a foreign country, the growing trend of corporate social responsibility shows that more companies are devising creative, collaborative solutions to doing global business more sustainably.
Tariff and Nontariff Trade Restrictions
Although many people find it hard to imagine, not every nation welcomes the expansion of businesses into their country. When a nation seeks to restrict the flow of incoming foreign goods and services, economists refer to this as trade protectionism. Protectionism is the economic policy of restraining trade between countries through methods such as tariffs on imported goods, restrictive quotas, and a variety of other government regulations designed to foster fair competition between imports and domestically produced goods and services.
According to proponents, protectionist policies protect the businesses and workers within a country by restricting or regulating trade with foreign nations. The doctrine of protectionism contrasts with the doctrine of free trade, according to which governments reduce the barriers to trade as much as possible. There is a broad consensus among economists that the impact of protectionism on economic growth and prosperity is largely negative.
Let’s take a closer look at several of the most common tools used by nations hoping to protect local industry through trade restrictions.
Import Tariffs
Import tariffs are are simply a type of tax that is levied on goods and services coming into a country. They increase the price of imported goods and services, since the businesses pass the cost of the tariff on to consumers. Tariffs benefit local producers of goods and services while generating revenue for the government. They are one of the oldest form of trade protectionism, one of the easiest to implement, and the most common subject in trade-agreement negotiations.
Nontariff Restrictions
Import quotas are another means of restricting the flow of foreign goods into a local economy. An import quota is exactly what its name implies: a limit on the amount or quantity of a particular good or service that can be imported into a country. Although not as common today as they have been historically, import quotas seek to protect local businesses from a flood of cheap foreign imports. Many countries have passed “antidumping” laws aimed at foreign imports that they believe are priced below fair market value. Dumping is when a company exports a product at a price lower than the price it normally charges in its own home market. The economic impact of an import quota is similar to that of a tariff, except that the tax revenue generated by a tariff is instead paid to those who possess import licenses.
When a country is reluctant to impose quotas and tariffs, another way it can protect domestic markets is with local content requirements. Local content requirements are set by the government and require foreign businesses to use a certain quantity of local labor, resources, and/or suppliers in their operations. This kind of trade restriction has been a point of contention in recent trade negotiations between the United States and India. India’s government has been aggressive about using local content requirements to its “Made in India” program, which it hopes will establish India as an international manufacturing hub. The United States and other countries argue that India’s policies are detrimental to foreign competition. The situation is currently under review by the World Trade Organization, and given the size of the Indian economy, the rest of the world is watching.
The most extreme form of trade restriction is the embargo. An embargo is an official ban on trade or other commercial activity with a particular country. The reasons for a country to place an embargo on another country range from human rights violations to ideological differences to national security interests. Embargoes are considered strong diplomatic measures imposed in an effort, by the imposing country, to elicit a given national-interest result from the country on which it is imposed. Although trade and commercial activities are barred under an embargo, medical and humanitarian supplies are usually exempt. The most enduring of all trade embargoes is the United States’ embargo against Cuba, which, after fifty-five years, appears to be coming to an end.
As you can see, global trade restrictions can be as narrow as a tariff on a particular imported good or as broad as an embargo, which stops the flow of goods and services between countries altogether. Since these types of restrictions are imposed by governments, businesses have no choice but to follow their rules—even when it means walking away from a lucrative opportunity.
The following video discusses the effects of different kinds of trade restrictions. | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/03%3A_Global_Environment/3.05%3A_Global_Trade_Forces.txt |
What you’ll learn to do: describe global trade agreements and economic organizations that regulate and promote global trade
In this section, you’ll learn about the organizations that oversee global economic cooperation and help facilitate global trade agreements.
Learning Objectives
• Describe the role of the World Bank in promoting global economic development
• Describe the role of trade agreements in global business
The World Trade Organization (WTO)
In the post–World War II environment, countries came to realize that a major component of achieving any degree of global peace was global cooperation—politically, economically, and socially. The intent was to level the trade playing field and reduce economic areas of disagreement, since inequality in these areas could lead to more serious conflicts. Nations agreed to work together to promote free trade and, with the help of key international organizations like the World Trade Organizations, they entered into bilateral and multilateral agreements.
GATT: How the World Trade Organization Got Its Start
Before you begin your reading on the World Trade Organization (WTO), take a few minutes to watch the following video that will give you some background on General Agreement on Tariffs and Trade (GATT) and explain how it grew into the WTO we know today. Remember, the world is much smaller today than when your parents and grandparents were growing up, and international trade hasn’t always been the norm. After watching the video, consider how impossible world trade would be without some type of agreement among nations.
Enjoy!
As you saw in the video, what began with one agreement (GATT) eventually evolved into the WTO. In fact, GATT was the only multilateral instrument governing global trade from 1946 until 1995. Given the difficulty of trying to regulate trade among more than one hundred nations according to a single document, it’s easy to see why the WTO came into existence. It became clear to the participating nations that GATT was incapable of adapting to an increasingly globalized world economy. Moreover, when the Uruguay Round of GATT negotiations was launched in September 1986, it marked the largest global effort to structure trade in history. Today, GATT still exists as the WTO’s umbrella treaty for trade in goods, but it’s no longer the only legally binding global-trade agreement.
What does the WTO actually do? Among its various functions, the most important are the following:
• Oversees the implementation and administration of the agreements between nations that fall under the WTO’s scope of authority
• Provides a forum for negotiations and settling disputes among nations.
In recent years, the WTO has also made it a priority to assist developing nations as they come under WTO regulation. Many developing countries and emerging markets lack the experience and technical expertise needed to deal with large and very comprehensive trade agreements. The WTO provides them with critical training and support, thereby ensuring that the WTO is inclusive and equitable toward both the wealthiest and the poorest nations in the world.
Part of the nondiscrimination mandate of the WTO is most-favored-nation (MFN) status. Most-favored-nation status requires that a WTO member must apply the same terms and conditions to trade with any and all other WTO members. In other words if a country grants another country (even a non-WTO member) a special favor, then every other WTO member must get the same treatment. You probably experienced a version of most-favored-nation status as a child, when an adult told you that if you were going to take gum or candy to class, you had to bring enough for everyone. In other words you couldn’t just give gum or candy to your best friends, and if you didn’t have enough for everyone in the class, then nobody got any. That, in effect, is how most-favored-nation status works.
One of the other key elements to the success of the WTO is its transparency requirement. WTO members are required to publish their trade regulations and follow a system that allows external parties to review and evaluate any administrative decisions and their impact on trade regulations. When a WTO nation changes its trade policies, those changes must be reported to the WTO.
Overall, the WTO’s mission is to improve the stability and predictability of global trade. As a result, it tends to support free-trade, as opposed to protectionist, policies, and strongly discourages the use of quotas and other such restrictions on imports.
Whether or not the WTO is doing its duty and accomplishing its mission is a matter of ongoing debate. Nonetheless, the WTO currently has 104 members and twenty observer governments. WTO member states account for almost 97 percent of global trade and 98 percent of global GDP. Once the twenty observer governments become members, it is possible that the WTO will oversee the entire world economy. What began in 1947 in Geneva, with twenty-three nations focused solely on tariff reduction, has grown into a truly global organization that deals with agriculture, labor standards, environmental issues, competition, and intellectual property rights.
The World Bank
World Bank Group president Jim Yong Kim visits an integrated child development services and skills center in Delhi, India.
Created in 1944 at the Bretton Woods Conference in New Hampshire, the World Bank is an international financial institution that provides loans for capital programs to developing countries. It comprises two institutions: the International Bank for Reconstruction and Development (IBRD), and the International Development Association (IDA). Originally, the IBRD was tasked with supporting post-war reconstruction, but it has evolved to include the present-day mandate to alleviate poverty worldwide. The World Bank is a component of the World Bank Group, which is part of the United Nations system. The World Bank is comprised of 189 member countries represented by a board of governors. Although headquartered in Washington DC, the World Bank has a presence in almost every nation in the world.
The World Bank has set two goals to achieve by 2030:
1. End extreme poverty by decreasing the percentage of the world’s population that live on less than US\$1.90 per day to no more than 3 percent
2. Promote shared prosperity by fostering the income growth of the bottom 40 percent in every country
The World Bank’s primary function is providing low-interest loans and grants to developing countries. It tends to fund projects focused on education, infrastructure, natural-resource management, and public health. In many instances, the World Bank provides technical assistance as well as research and policy advice to developing nations. One of the projects currently underway is the Education Sector Support Project for the Republic of the Congo. The primary objective of this project is to improve education outcomes for primary- and secondary-school children by providing quality education in an appropriate teaching and learning environment. Other World Bank projects are aimed at improving basic infrastructure, such as building and maintaining safe water supplies and sanitary sewer systems in Africa and parts of Asia. For developing nations, many of these improvements would be impossible without the World Bank’s help. Although the World Bank has come under fire in the past for budget overruns and poor project oversight, its role in promoting economic development has been undeniable.
The following video shows how a World Bank project works:
The International Monetary Fund (IMF)
The International Monetary Fund (IMF) is an international organization headquartered in Washington, D.C., comprised of 189 member countries. The IMF works to foster global growth and economic stability by providing policy, advice, and financing to its members. It also works with developing nations to help them reduce poverty and achieve macroeconomic stability. Formed in 1944 at the Bretton Woods Conference in New Hampshire, it came into formal existence in 1945 with twenty-nine member countries and the goal of reconstructing the international payment system. It now plays a central role in the management of balance-of-payments difficulties and international financial crises.
IMF member countries contribute funds to a pool, from which they can borrow if they are experiencing balance-of-payments problems. The rationale for this arrangement is that private international capital markets function imperfectly, and many countries have limited access to financial markets. Without access to IMF financing, many countries can only correct large external payment imbalances through drastic measures that can have adverse effects on their own economies and the world’s. The IMF provides alternate sources of financing to countries in need that would not otherwise be available to them.
When the IMF was founded, its primary functions were to provide short-term capital to aid the balance of payments and to oversee fixed-exchange-rate arrangements between countries, thus helping national governments manage their exchange rates and prioritize economic growth. This assistance was meant to prevent the spread of international economic crises. The IMF was also formed to help put the pieces of the international economy back together after the Great Depression and World War II. In addition, it also sought to provide capital investments for economic growth and infrastructure projects.
The IMF’s role was fundamentally altered by floating exchange rates post-1971. At that point the organization began examining the economic policies of its loan recipients to determine whether a shortage of capital was due to economic fluctuations or economic policy. The IMF also researched what types of government policy would ensure economic recovery. The current challenge is to help countries implement economic policies that reduce the frequency of crises among the emerging-market countries, especially the middle-income countries that are vulnerable to massive capital outflows. In order to meet this challenge, the IMF’s activities have expanded beyond the oversight of exchange rates to surveillance of the overall macroeconomic performance of its member countries. Today it plays an active role in shaping and managing economic policy around the world.
The following video gives a good overview of the IMF and its role in promoting global trade.
Trade Agreements
So far you have seen how international organizations such as the WTO, IMF, and World Bank support global trade, but this is only part of the story. Where global trade really gets a boost is from trade agreements (also called trade blocs). This where the term “global economic integration” gets its legs— from the process of modifying barriers among and between nations to create a more fully integrated global economy. Trade agreements vary in the amount of free trade they allow among members and with nonmembers; each has a unique level of economic integration. We will look at four: regional trade agreement (RTA) (also called a “free trade area”), customs unions, common markets, and economic unions.
Regional trade agreements are reciprocal trade agreements between two or more partners (nations). Almost all countries are part of at least one RTA. Under an RTA, countries “huddle together,” forming an international community that facilitates the movement of goods and services between them. For example, the North American Free Trade Agreement (NAFTA) enacted between Canada, the U.S., and Mexico facilitates trade among these countries through tariff reductions and elimination. The Association of Southeast Asian Nations (ASEAN), shown below, provides for the free exchange of trade, service, labor, and capital across ten independent member nations to provide a balance of power to China and Japan. The Central American Free Trade Agreement (CAFTA) (Costa Rica, Dominican Republic, Guatemala, Honduras, Nicaragua, and El Salvador) eliminated tariffs on more than 80 percent of U.S. exports and opened U.S. trade restrictions for Central American sugar, textiles, and apparel imports, thereby reducing costs on these products for American consumers[1].
The Association of Southeast Asian Nations (ASEAN) as of 2015.
Customs unions are arrangements among countries whereby the parties agree to allow free trade on products within the customs union, and they agree to a common external tariff (CET) on imports from the rest of the world. It is this CET that distinguishes a customs union from a regional trade agreement. It is important to note that although trade is unrestricted within the union, customs unions do not allow free movement of capital and labor among member countries. An example is the customs union of Russia, Belarus, and Kazakhstan, which was formed in 2010. These countries eliminated trade barriers among themselves but have also agreed to some common policies for dealing with nonmember countries.
Common markets are similar to customs unions in that they eliminate internal barriers between members and adopt common external barriers against nonmembers. This difference is that common markets also allow free movement of resources (e.g., labor) among member countries. An example of a common market is the Economic Community of West African States (ECOWAS), comprised of Benin, Burkina Faso, Cape Verde, Gambia, Ghana, Guinea, guinea-Bissau, Ivory Coast, Liberia, Mali, Niger, Nigeria, Senegal, Sierra Leone, and Togo.
An even more economically integrated arrangement is the economic union. Economic unions eliminate internal barriers, adopt common external barriers, permit free movement of resources (e.g., labor), AND adopt a common set of economic policies. The best-known example of an economic union is the European Union (EU). EU members all use the same currency, follow one monetary policy, and trade with one another without paying tariffs.
The following video further explains and compares the different types of trade agreements:
1. USTR, CAFTA-DR Dominican Republic-Central America FTA | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/03%3A_Global_Environment/3.06%3A_Global_Trade_Agreements_and_Organizations.txt |
What you’ll learn to do: describe ethical challenges that businesses face in a global environment
The ethical landscape of international business is cloudy, and the diverse nature of cultural, political, and legal systems around the world often makes the line between ethical and unethical business practices difficult to negotiate. In this section you will learn about some of the ethical challenges and issues that businesses face in global markets.
Learning Objectives
• Explain why forms of corruption such as bribery are so widespread and difficult to regulate
• Summarize the key parts of the Foreign Corrupt Practices Act
Labor Abuses
The term sweatshop refers to a factory that is guilty of some sort of labor abuse or violation, such as unsafe working conditions, employment of children, mandatory overtime, payment of less than the minimum wage, unsafe working conditions, abusive discipline, sexual harassment, or violation of labor laws and regulations. The U.S. Government Accounting Office has chosen to define a sweatshop as any manufacturing facility that is guilty of two or more of the above types of labor abuses. However, it is important to understand that the term sweatshop is not just a legally defined term but a word that is used broadly and has entered the general lexicon.
Rana Plaza
Garment factory collapse, Rana Plaza, Bangladesh.
On April 24, 2013, at Rana Plaza on the outskirts of Dhaka, Bangladesh, a building containing apparel factories collapsed, trapping and killing more than 1,100 employees. It was not only the worst industrial disaster in the history of the garment industry, it was also the world’s most fatal industrial building collapse. News reports soon emerged that the factory owners had ignored ominous warning signs, such as visible cracks in the wall, and had illegally added several stories to the top of the building, creating a weight the building could not bear. Many of the factories operating in the building were producing apparel for well-known Western brands, such as Walmart, Joe Fresh, and Mango.
Rescue workers struggled for more than a week to reach trapped survivors, while hospitals tended to the more than 2,500 workers who had escaped, many with severe injuries. Survivors told heart-rending tales of having lost mothers and sisters who had worked in the same factories. The deaths of so many innocent workers created a firestorm of controversy in Bangladesh and around the world. Accusations and recriminations were leveled at corporations and government officials. A period of intense and profound soul-searching ensued for the global fashion companies that relied on outsourced factory labor in Bangladesh. Within a few months, two major initiatives were announced, one American and one European, to increase safety and accountability in Bangladeshi factories.
How did this situation arise?
Thanks to international efforts to lower import tariffs, such as those instituted by GATT in 1947 and by the WTO in 1995, an outsourcing movement was born, and many companies saw the opportunity to lower their production costs by moving them overseas. Fashion and apparel companies were among the first to take advantage of the benefits of outsourcing—namely, gaining access to cheap foreign labor markets. Throughout the period from 1970 to the present, employment in American apparel factories dropped sharply as companies moved production to countries like Indonesia, Vietnam, China, Mexico, and the Dominican Republic.
The outsourcing movement was accompanied by increasing reports of sweatshop abuses. As a result, a number of nongovernmental organizations (NGOs), such as the National Labor Committee, became involved in anti-sweatshop activities. Throughout the 1990s, a number of sweatshop-related abuses came to light in factories used by American brands. Several of these involved the island of Saipan, a small American protectorate in the Pacific. A number of factory owners discovered that since Saipan is technically American territory, clothing produced in Saipan could enter the United States duty-free and carry the label “Made in America.” Since Saipan is much closer to Vietnam and the Philippines than to the United States, a number of these factories recruited Vietnamese and Filipino natives as factory workers. Upon their arrival in Saipan, however, some of these workers were exposed to flagrant human rights abuses and, in the worst of cases, outright slavery. In one notorious case, workers were literally imprisoned in the factory and forced to work without pay. Eventually, these abuses were revealed and U.S. prosecutors filed charges against factory owners, some of whom were sentenced to substantial prison sentences.
In the early 1990s, one of America’s most prominent footwear brands, Nike, also came under attack as reports emerged from Indonesia and Vietnam of worker abuse. In Vietnam, a young female factory employee was working on basketball shoes when her machine exploded and sent a bolt through her heart. At first, Nike refused to accept responsibility, pointing out that Nike had never manufactured its own footwear and apparel. Nike’s contracts with its sourcing factories required the factories to obey labor regulations and, in Nike’s view, this meant that any abuses were the factories’ responsibility. However, by 1998, the continuing negative publicity obliged Nike to reverse its course by instituting a strict code of conduct for its factories.
By 2000, as a result of continued scrutiny from various watchdog organizations like the Worker Rights Consortium, the National Labor Committee, and other international groups such as the Clean Clothes Campaign, most large apparel brands developed and publicized their own internal codes of conduct for suppliers. Such codes of conduct were contractually imposed on all suppliers and required that factories comply with all local labor laws, refrain from employing children, and maintain safety programs. In addition, most brands began to require that factories make themselves available for inspections to make sure that they were complying with the standards set forth in the codes of conduct. A number of inspection companies sprang up to service the needs of the corporations and groups of young inspectors soon scanned the globe, moving from factory to factory, checking them for fire violations, reviewing records to make sure that rules on overtime were respected, and so forth.
Despite all these efforts, reports of violations continued to be heard. The American consumer seemed to have wearied of the sweatshop issue to some extent, and companies like Walmart and Nike, which had often been accused of sweatshop abuses, saw their sales and stock valuations continue to rise. Many companies began to focus more on environmentalism and anti–global-warming issues, and a number of brands began to require that their supply factories obtain some sort of environmental certification, such as the Bluesign certification that was established in Germany under the auspices of SGS S.A., the world’s largest inspection company. Then, in 2012 and 2013, a horrific series of accidents reminded the world’s consumers that the sweatshop issue was still with us.
In 2012, a fire broke out at an apparel factory in Pakistan, killing some 270 Pakistani workers. Among the Western companies sourcing from that factory were the UK retailer Tesco and the German apparel brand Kix. Kix’s offer to compensate the victims’ families \$2,000 per fatality was viewed by many Pakistanis as insulting. Then, just a few months later, at the Tazreen Fashions factory in Dhaka, Bangladesh, another 112 factory workers perished in a fire. Again, it was discovered that well-known Western brands such as Walmart, Disney, and the Gap had sourced products from the factory. The world’s attention was squarely focused on Pakistan and Bangladesh when the building collapse at Rana Plaza in Bangladesh became the worst industrial catastrophe in the history of apparel manufacturing.
Corruption
In the following video, Joseph R. DesJardins discusses the concept of ethics and asks whether international standards of behavior are possible. What do you think?
When a large corporation decides to enter a foreign market, it must usually secure a number of licenses, permits, registrations, or other government approvals. Certain types of business may be even be impossible or illegal unless the corporation is first able to obtain a change or adjustment to the nation’s laws or regulations. Since the power to authorize the foreign corporation’s activities is vested in the hands of local politicians and officials, and since corporations have access to large financial resources, it should not be surprising that some corporate executives resort to financial incentives to influence foreign officials. While certain financial incentives, such as promises to invest in local infrastructure, may be legitimate, any form of direct payment to the foreign official that is intended to influence that official’s public decisions will cross the line into bribery.
Bribery is one of the archetypal examples of a corporation engaged in unethical behavior. A number of problems can be attributed to business bribery. First, it is obviously illegal—all countries have laws that prohibit the bribery of government officials—so the foreign company engaging in bribery exposes its directors, executives, and employees to grave legal risks. Second, the rules and regulations that are circumvented by bribery often have a legitimate public purpose, so the corporation may be subverting local social interests and/or harming local competitors. Third, the giving of bribes may foment a culture of corruption in the foreign country, which can prove difficult to eradicate. Fourth, in light of laws such as the U.S. Foreign Corrupt Practices Act (FCPA) and the Organization of Economic Cooperation and Development (OECD) Convention on Anti-Bribery (discussed in greater detail below), bribery is illegal not only in the target country, but also in the corporation’s home country. Fifth, a corporation that is formally accused or convicted of illicit behavior may suffer a serious public relations backlash.
Despite these considerable disincentives, experts report that worldwide business corruption shows little signs of abating. Transparency International (TI), a leading anticorruption organization based in Berlin, estimates that one in four people worldwide paid a bribe in 2009. It appears that the total number of bribes continues to increase annually. The World Economic Forum calculated the cost of corruption in 2011 at more than five percent of global GDP (US\$2.6 trillion) with more than \$1 trillion paid in bribes each year.
Governments and intergovernmental organizations have redoubled their efforts to combat the perceived increase in international business corruption. Globalization, which accelerated in the final decades of the twentieth century, is often cited by specialists as contributing to the spread of corruption. Corporations and businesses in every nation have become increasingly dependent on global networks of suppliers, partners, customers, and governments. The increased interaction between parties in different countries has multiplied the opportunities for parties to seek advantage from illicit incentives and payoffs. Although outright bribery is clearly unethical and illegal, there is great deal of behavior that falls into a gray zone that can be difficult to analyze according to a single global standard. When does a business gift become a bribe? What level of business entertainment is “right” or “wrong”? Over the past two decades, governments and regulators have sought to clearly define the types of behavior that are considered unethical and illegal.
Another factor that has heightened the sense of urgency among regulators is the magnitude of recent cases of corruption (several of which are described in greater detail below). The cost to shareholders as well as stakeholders and society has proven enormous. Governments and international organizations have ramped up their enforcement of anticorruption laws and sought increasingly severe penalties, sometimes imposing fines amounting to hundreds of millions of dollars. Largely as a result of these efforts, most multinational corporations have developed internal policies to ensure compliance with anticorruption legislation.
The following are recent examples of large-scale corruption in international business.
Walmart in mexico
According to a report issued by the Mexican Employers Association in 2011, companies operating in Mexico spend more than 10 percent of their revenue on corrupt acts. One of the most well-known cases was the Walmart scandal that came to light in September 2005 and resulted in the company’s stock value dropping by as much as \$4.5 billion. Evidence unearthed by internal and external investigations revealed a widespread use of bribes, alleged to total more than \$24 million. The bribes were paid to facilitate the construction of Walmart stores throughout Mexico. The country is a huge market for Walmart—one in every five Walmart stores is in Mexico. As of October 2014, the investigation continued, having implicated Walmart senior level management of complicity or awareness.
glaxosmithkline in china
In September 2013, China’s Xinhua news agency reported that a police investigation into bribes paid by drug manufacturer GlaxoSmithKline (GSK) indicated that the bribes were organized and paid by GSK China and not by individuals operating on their own prerogative as had been reported by the company initially. Police also alleged that the corporate parent merely went through the motions of an internal audit process, indicating a knowledge and acceptance of the bribery. This very recent case suggests that the Chinese government’s widely publicized arrests and convictions for bribery have not yet served as a sufficient deterrent to corrupt practices by foreign corporations.
alcatel in costa rica
In January 2010, mobile-device manufacturer Alcatel agreed to pay Costa Rica \$10 million in reparations for social damage caused by Alcatel’s payment of \$2.5 million in bribes to get a contract to provide mobile phone services in that country. This case is notable for its application of the concept of social damage and the resulting order of compensation to the citizens of Costa Rica.
Anticorruption Laws and Regulations
The first major international anticorruption law was the United States’ Foreign Corrupt Practices Act (FCPA), adopted in 1977. The FCPA criminalized bribery of foreign public officials by American business enterprises. Initially, the FCPA was not well received. Few other countries followed suit and US companies complained that the FCPA shut them out of the competition for billions of dollars’ worth of overseas business contracts. Slowly, however, the push for concerted anticorruption measures gathered momentum, and intergovernmental institutions such as the OECD, the African Union, and the United Nations eventually adopted anticorruption conventions. Further support for a global anticorruption agenda was provided by lending institutions such as the World Bank, by NGOs such as Transparency International, and by the rapidly evolving corporate social responsibility movement. Notable among these efforts was the Communist Party of China’s promulgation of a code of ethics to fight the widespread corruption within the Communist Party of China.
The FCPA applies only to bribes paid (or offered) to foreign government officials to obtain or retain business or to develop an unfair competitive advantage. The concepts of bribe and foreign government official can be interpreted broadly. While companies and executives charged with FCPA violations have often sought to characterize their payments as business “gifts,” this has not shielded them from liability when there was evidence that the payments were intended as a means of obtaining illicit objectives. However, where payments have been characterized as “facilitation” or “lubrication” payments, meaning that they merely created an incentive for an official to promptly execute legal actions, such as mandatory customs inspections, the payments have been allowed. In numerous countries, the state owns all or part of commercial enterprises, so a great number of business executives could be classified as foreign government officials.
In 1997, the Organization for Economic Cooperation and Development (OECD) established legally binding standards for defining bribery in international business transactions. Similar to the FCPA, the OECD Anti-Bribery Convention focuses on the bribery of public officials. Like the FCPA, the OECD also potentially creates the opportunity for companies to circumvent the regulations by hiring consultants or agents. Notably excluded from the scope of the OECD Convention is a prohibition against bribing private parties. Despite such loopholes, the OECD Convention was an important step in the right direction. By 2012, forty-three countries had ratified the agreement and begun its implementation.
Corruption from a Cross-Cultural Perspective
Compliance with anticorruption legislation raises complex ethical dilemmas for corporations. It remains difficult to regulate ethical behavior when social and cultural norms vary significantly from country to country. Acts that are considered unethical in one country may represent a traditional way of doing business in another. One legal scholar explains the difference as follows:
"A common misconception, held in both Western and developing countries, and even among many researchers on corruption, is to confuse what is corrupt with what is legal. Laws are defined by values, as are ethical norms, but the two are not equivalent.[1]"
The West tends to be universalist in its outlook: That is, every society works, or should work, essentially the same way. Its business practices, for example, should be based on a market system that is characterized by transparency and regulated by laws that apply to everyone. A country that fails to conform to this model is seen as underdeveloped or dysfunctional. It follows from this view that that corruption is basically the same in Sweden as in Sudan.
The reality, however, is that different cultures use radically different systems to get things done. Whereas Western cultures are primarily rule based, most of the world’s cultures are relationship based. Westerners tend to trust the system, while non-Westerners are cemented by personal honor, filial duty, friendship, or long-term mutual obligation. Loyalty to cronies is suspect behavior in the West but represents high moral character in much of the world.
What is corrupt in the West may be acceptable elsewhere. The classic example of the purchasing agent illustrates this point. The Western purchasing agent is expected to award contracts based on the quality of bids and transparently available financial information about the bidders. An agent who favors personal friends is viewed as corrupt, because cronyism subverts this transparency-based system. It creates a conflict of interest: A choice that is good for the agent and his or her cronies may not be good for the company.
In much of the world, however, cronyism is a foundation for trust. A purchasing agent does business with friends because friends can be trusted. He or she may not even ask to see the company financials, since this could insult the other’s honor. It is assumed that cronies will follow through on the deal, not because they fear a lawsuit, but because they do not wish to sacrifice a valuable relationship in an economy where relationships are the key to business. In such a system it is in the company’s interest for the agent to do business with friends, and cronyism may therefore present no conflict of interest.
1. Sharon Eiher, “Corruption in International Business: The Challenge of Cultural and Legal Diversity,” Wichita, KS: Friends University, accessed October 29, 2013, www.ashgate.com/pdf/SamplePag...siness_Ch1.pdf. | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/03%3A_Global_Environment/3.07%3A_Ethical_Challenges_in_the_Global_Environment.txt |
Synthesis
Remember the humble banana we talked about at the start of this module? Now you know at least some of what it takes to get bananas from Brazil to your local grocery store: trade agreements, currency exchange rates, compliance with federal laws, bribery and possible corruption, national comparative advantages, tariffs, trade restrictions, cultural differences, and more. Those are just a few of the things that had to fall into place to get those bananas into your local market and ultimately into a banana split served at the local ice cream shop!
What is the future of globalization? Take a look at the following video for some ideas . . .
Summary
This module covered the global environment of business. Below is a summary of the topics covered in this module.
Globalization
Why do countries trade? Shouldn’t a strong country such as the United States produce all of the computers, television sets, automobiles, cameras, and VCRs it wants rather than import such products from Japan? Why do the Japanese and other countries buy wheat, corn, chemical products, aircraft, manufactured goods, and informational services from the United States? Because countries have different natural, human, and capital resources and different ways of combining these resources, they are not equally efficient at producing the goods and services that their residents demand. The decision to produce any good or service has an opportunity cost, which is the amount of another good or service that might otherwise have been produced. Given a choice of producing one good or another, it is more efficient to produce the good with the lower opportunity cost, using the increased production of that good to trade for the good with the higher opportunity cost.
Measuring Global Trade
A nation has a comparative advantage at producing something if it can produce it at a lower cost than another. A competitive advantage is a term describing attributes that allows a nation to outperform competing nations. These attributes may include access to natural resources, such as high-grade ores or inexpensive power, highly skilled personnel, geographic location, high entry barriers, etc.
Global Business Strategies
The main strategies that companies use to enter the global market are exporting/importing, outsourcing/offshoring, licensing and franchising, joint ventures/strategic alliances, and foreign direct investment (FDI). Each has different advantages and disadvantages that must be weighed carefully.
Global Trade Forces
Firms desiring to enter international business many forces and barriers. Common barriers to effective global business are cultural, social, and political barriers, and tariffs and trade restrictions.
Ethical Challenges in the Global Environment
Culture plays a big role in shaping and defining ethical behavior. As a result, what may be considered ethical in one country may be seen as unethical in another. In a global business context, such ethical challenges often arise in the form of corruption and labor abuse.
Global Trade Agreements and Organizations
The goal of the GATT is to make trade freer, and thus the promises countries make must involve reductions in trade barriers. The WTO’s main purpose is to monitor the trade liberalization agreements reached by GATT-member countries in the Uruguay Round. The most important “power” of the WTO is its ability to adjudicate disputes between member countries regarding compliance with the agreements. The IMF’s key roles are the following: promote international monetary cooperation; facilitate the expansion and balanced growth of international trade; promote exchange stability; and assist in the establishment of a multilateral system of payments. The World Bank has one central purpose: to promote economic and social progress in developing countries by helping raise productivity so that their people can live a better and fuller life. | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/03%3A_Global_Environment/3.08%3A_Putting_it_Together-_Global_Environment.txt |
Why explain the institutions and markets that comprise the financial system, and explain how they impact the economy and the money supply?
All of the words in the word-cloud image, shown at the left, refer to the same thing: money.
Have you heard the saying “Money makes the world go around”? In many ways money drives almost all of our endeavors. Consider why you are here taking this course. You are obtaining knowledge in order to get a better job, to obtain a degree or other credential, or to be more informed in your daily life so that you can support yourself and provide for those you love. Even if you are interested in charitable endeavors to improve the human condition, such efforts to support a cause will require money—even indirectly. Understanding how money functions—the different forms it takes and where it goes—is the first step in being able to comprehend our financial system.
4.02: Market
What you’ll learn to do: explain what money is and what makes it useful
When we think of money, the paper bills in our wallet or the coins that are in our pockets come to mind. But money is much more than that, and how we define money determines where and how we use it to obtain the goods and services that businesses offer the consumer. In this section we’ll look at what money is, why it’s useful, and what may be the future of money.
Learning Objectives
• Discuss the advantages of using money versus barter
• Discuss alternatives to traditional currency used today
What Is Money?
Money is really anything that people use to pay for goods and services and to pay people for their work. Historically, money has taken different forms in different cultures—everything from salt, stones, and beads to gold, silver, and copper coins and, more recently, virtual currency has been used. Regardless of the form it takes, money needs to be widely accepted by both buyers and sellers in order to be useful.
Barter and the Double Coincidence of Wants
To understand the usefulness of money, we must consider what the world would be like without money. How would people exchange goods and services? Economies without money typically engage in the barter system. Barter—literally trading one good or service for another—is highly inefficient for trying to coordinate the trades in a modern advanced economy. In an economy without money, an exchange between two people would involve a double coincidence of wants, a situation in which two people each want some good or service that the other person can provide. For example, if a hairstylist wants a pair of shoes, she must find a shoemaker who has a pair of shoes in the correct size and who is willing to exchange the shoes for a certain number of hairdos. Such a trade is likely to be difficult to arrange. Think about the complexity of such trades in a modern economy, with its extensive division of labor that involves thousands upon thousands of different jobs and goods.
Another problem with the barter system is that it doesn’t allow people to easily enter into future contracts for the purchase of many goods and services. For example, if the goods are perishable, it may be difficult to exchange them for other goods in the future. Imagine a farmer wanting to buy a tractor in six months using a fresh crop of strawberries. Also, while the barter system might work all right in small economies, it will keep those economies from growing. The time that individuals might otherwise spend producing goods and services and enjoying leisure time is spent bartering.
Functions of Money
Money solves the problems created by the barter system. First, money serves as a medium of exchange, which means that money acts as an intermediary between the buyer and the seller. Instead of exchanging hairdos for shoes, the hairstylist now exchanges hairdos for money. This money is then used to buy shoes. To serve as a medium of exchange, money must be very widely accepted as a method of payment in the markets for goods, labor, and financial capital.
In addition, money needs to have the following properties:
1. It must be divisible—that is, easily divided into usable quantities or fractions. A \$5 bill, for example, is equal to five \$1 bills. If something costs \$3, you don’t have to tear up a \$5 bill; you can pay with three \$1 bills.
2. It must be portable—easy to carry; it can’t be too heavy or bulky.
3. It must be durable. It can’t fall apart or wear out after a few uses.
4. It must be difficult to counterfeit. It won’t have much value if people can make their own.
Second, money must serve as a store of value. Consider the barter between the hairstylist and shoemaker again. The shoemaker risks having his shoes go out of style, especially if he keeps them in a warehouse for future use—their value will decrease with each season. Shoes are not a good store of value. Holding money is a much easier way of storing value. You know that you don’t need to spend it immediately, because it will still hold its value the next day or the next year. This function of money doesn’t require that money is a perfect store of value. In an economy with inflation, money loses some buying power each year, but it remains money.
Third, money serves as a unit of account, which means that it’s the ruler by which other values are measured. For example, a hairstylist may charge \$30 to style someone’s hair. That \$30 can buy two shirts (but probably not a pair of shoes). Money acts as a common denominator, an accounting method that simplifies thinking about trade-offs.
So money serves all of these functions—it’s a medium of exchange, store of value, and unit of account.
Uninscribed electrum coin from Lydia, 6th century BCE.
Commodity versus Fiat Money
Commodity money consists of objects that have value in themselves as well as value in their use as money. Gold, for example, has been used throughout the ages as money, although today it is not used as money but rather is valued for its other attributes. Gold is a good conductor of electricity and is used in the electronics and aerospace industry. Gold is also used in the manufacturing of energy efficient reflective glass for skyscrapers and is used in the medical industry as well. Of course, gold also has value because of its beauty and malleability in the creation of jewelry.
As commodity money, gold has historically served its purpose as a medium of exchange, a store of value, and as a unit of account. Commodity-backed currencies are dollar bills or other currencies with values backed up by gold or another commodity held at a bank. During much of its history, the money supply in the United States was backed by gold and silver. Interestingly, antique dollars dated as late as 1957 have “Silver Certificate” printed above the portrait of George Washington, as shown below. This meant that the holder could take the bill to the appropriate bank and exchange it for a dollar’s worth of silver.
A Silver Certificate and a Modern U.S. Bill. Until 1958, silver certificates were commodity-backed money—backed by silver, as indicated by the words “Silver Certificate” printed on the bill. Today, U.S. bills are backed by the Federal Reserve, but as fiat money.
As economies grew and became more global in nature, the use of commodity monies became more cumbersome. Countries moved toward the use of fiat money. Fiat money is legal tender whose value is backed by the government that issued it. The United States’ paper money—like the dollar bill, for instance—carries this statement: “This note is legal tender for all debts, public and private.” In other words, by government decree, if you owe a debt, then legally speaking, you can pay that debt with the U.S. currency, even though it’s not backed by a commodity. The only backing of our money is widespread faith and trust that the currency has value—and nothing more.
The following video discusses some additional characteristics of money:
Alternatives to Traditional Currency
Whoever said that “cash is king” hasn’t been paying attention to how consumers choose to pay for their purchases, particularly in developed economies. Take a look at the following chart:
Is a cashless future in the cards? A 2013 MasterCard report found that, in 2011, cashless payments made up 66 percent of global spending. Consumers in Belgium, France, and Canada used cash the least in 2011, as cashless payments made up 93 percent, 92 percent, and 90 percent of payments respectively. In the United States, 80 percent of payments were cashless in 2011.
Consumers expect to make fewer cash payments in the future, while also cutting back on credit- and debit-card use in favor of other forms of payments. In an Accenture survey, 66 percent of North Americans said they used cash daily or weekly in 2014 while only 54 percent expected to do so by 2020.
Money is an abstraction built on trust. As such, alternatives to the most tangible form of money—currency or cash—and its replacement with cashless payments have become possible. In this new emerging landscape, no transaction requires money in the form of notes and coins, and value can be exchanged through the transfer of information between transacting parties. There have been multiple waves of such alternatives.
Established alternatives to cash include checks, credit cards, debit cards, and prepaid debit cards. More recently, innovative options have sprung up that not only threaten to imperil the ubiquity of cash but also upend the traditional payment ecosystem. These include smartphone-enabled credit-card acquirers, such as Square, and Automated Clearing House or ACH acquirers, such as PayPal and Dwolla. And then there are even more ambitious alternatives to cash that have been proposed, such as Bitcoin, a Web-based cryptocurrency.
Unlike traditional money, such alternatives do not derive their value from government fiat—i.e., the government has not established their legitimacy or value. Each of these alternatives has an evolved network within which it is uniformly accepted as a means of payment; the more established alternatives, of course, have the widest networks.[1]
We will examine this trend further by taking a look at Bitcoin and Mobile Commerce.
Bitcoin
Today, there are more than seven hundred digital currencies in existence. Entering the marketplace is undertaken by so many due to the low cost of entry and the profit opportunity. In 2014, the European Banking Authority defined virtual currency as “a digital representation of value that is neither issued by a central bank nor a public authority, nor necessarily attached to a fiat currency, but is accepted by natural or legal persons as a means of payment and can be transferred, stored, or traded electronically.” The first and most widely known instance of such digital, virtual, or cryptocurrency is Bitcoin.
Bitcoin Background
Bitcoin, a peer-to-peer digital currency or cryptocurrency, operates without the involvement of traditional financial institutions, and it provides a direct digital alternative to physical currencies. Bitcoin transactions take place online directly between the buyer and seller, with each transaction having a unique encryption. Transactions are recorded on a decentralized public ledger available for network users to verify valid transactions. Special users on the network (“miners”) oversee this verification process. After verifying a block of transactions, miners are paid with twenty-five newly generated Bitcoins and the transactions are processed and approved; this is how the total number of Bitcoins grows. The number in circulation as of January 2015 was approximately 13.7 million, with the maximum set at 21 million. As of April 2015, their total value was \$3 to \$4 billion.
Governments worldwide generally do not yet see it and other digital currencies as a destabilizing “threat,” and some scholars have argued that it may best be seen as a speculative investment. Bitcoin has certainly had its ups and downs: As of April 1, 2015, its value stood at \$242 per Bitcoin, after a January 14 low of \$177 and a March 11 high of \$296. The currency has also had a long run of troubles with hackers and fraud, most spectacularly in 2014 when the exchange Mt. Gox declared bankruptcy after Bitcoins worth \$460 million at the time were apparently stolen. Bitcoin’s decentralized model and degree of anonymity have also raised concerns over its use in illegal money transfers, fueling potential illicit commerce across the “dark Web” and on sites such as Silk Road.
The organization Bitcoin.org, meanwhile, touts the currency’s potential for opening up a “whole new platform for innovation”:
Advantages and Disadvantages
A 2015 Congressional Research Service (CRS) report, “Bitcoin: Questions, Answers and Analysis of Legal Issues, explores the following technical, functional, and legal issues associated with Bitcoin—and, by extension, all virtual currencies.
Bitcoin advantages:
• Lower transaction costs: Because Bitcoin operates without a third-party intermediary, merchants are able to avoid the fees traditionally charged by payment systems such as credit cards.
• The possibility of increased privacy: Bitcoin provides a heightened degree of privacy for purchases and transactions, though by the system’s nature, a complete list of all transactions is forever recorded to each user’s encrypted identity.
• Protection from inflation: Since Bitcoin’s circulation is not linked to currency or government regulation, it is not subject to standard inflation. However, it more than makes up for this in volatility.
Bitcoin disadvantages:
• Severe price volatility: The value of a Bitcoin is determined by supply and demand and, as a result, can fluctuate rapidly. The value was as high as \$1,100 in December 2013, then hit a low of \$177 in January 2015. This extreme fluctuation is more characteristic of a commodity than a currency.
• Not legal tender: Debtors are not required to accept it, and without any formal backing other than the computer program to which it is linked, Bitcoin can be seen as an “unattractive vehicle” for holding and accumulating wealth.
• Uncertain security against theft and fraud: While the counterfeiting of Bitcoins is allegedly impossible, the system has at times found itself vulnerable to large security breaches and cyberattacks. Most recently, Bitstamp, a large European Bitcoin exchange, lost 19,000 Bitcoins (valued at about \$5 million) in a digital security breach. This follows the massive problems with Mt. Gox in 2014 and the collapse of other exchanges in 2011.
• Vulnerability of Bitcoin “wallets”: Purchased or mined Bitcoins are stored in a digital wallet on the user’s computer or mobile device, and digital keys can be lost, damaged, or stolen. Paper or offline storage is an option, but it’s not always practiced.
Federal banking regulators have yet to issue guidance or regulations governing how banks are to deal with Bitcoins. In a February 2014 statement, Federal Reserve chair Janet Yellen said: “Bitcoin is a payment innovation that’s taking place outside the banking industry. . . . There’s no intersection at all, in any way, between Bitcoin and banks that the Federal Reserve has the ability to supervise and regulate.” Some state financial authorities have taken steps to devise regulations, with New York’s Department of Financial Services (NYDFS) in the lead.
The responsibility to oversee digital currency falls upon Congress. As of now, Congressional actions remain in the exploratory phase. The tax code lacks clarity on how such currency should be treated: Is it digital currency, property, barter, or foreign currency? Early concerns have focused more on tackling consumer-protection issues than tax ambiguities, and as a result, the Consumer Financial Protection Bureau has become involved regarding questions related to Bitcoin.
The following video explains further some of the gray areas in which this virtual currency is operating.
Whether it’s Bitcoin or another cryptocurrency, the fact that more than seven hundred of these unregulated digital currencies have emerged in just the last two years is just one more indication that consumers may be breaking off their longstanding love affair with traditional cash.
Mobile Commerce and Mobile Payment Systems
The term mobile commerce was first coined in 1997 by Kevin Duffey at the launch of the Global Mobile Commerce Forum to mean “the delivery of electronic commerce capabilities directly into the consumer’s hand, anywhere, via wireless technology.” Many think of mobile commerce as “a retail outlet in your customer’s pocket.”
Mobile commerce is worth US\$230 billion annually, with Asia representing almost half of the market, and it’s expected to reach US\$700 billion in 2017. According to BI Intelligence, in January 2013, 29 percent of mobile users have now made a purchase with their phones. Walmart estimated that 40 percent of all visits to their Internet shopping site in December 2012 was from a mobile device. Bank of America projected that \$67.1 billion in purchases would be made from mobile devices by European and U.S. shoppers in 2015.
Mobile Payment
Mobile payment, also referred to as mobile money, mobile money transfer, and mobile wallet, generally refers to payment services operated under financial regulation and performed from or via a mobile device. Instead of paying with cash, check, or credit cards, a consumer can use a mobile phone to pay for a wide range of services and digital or hard goods. Although the concept of using non-coin-based currency systems has a long history, only recently has the technology to support such systems become widely available.
Mobile payment is being adopted all over the world in different ways. In 2008, the combined market for all types of mobile payments was projected to reach more than \$600 billion globally by 2013, which would be double the figure as of February, 2011. The mobile payment market for goods and services, excluding contactless Near Field Communication or NFC transactions and money transfers, exceeded \$300 billion globally in 2013. Investment on mobile money services is expected to grow by 22.2 percent during the next two years across the globe. It will result in revenue share of mobile money reaching up to 9 percent by 2018. Asia and Africa will observe significant growth for mobile money, with technological innovation and focus on interoperability emerging as prominent trends by 2018.
In developing countries, mobile payment solutions have been deployed as a means of extending financial services to communities known as the “unbanked” or “underbanked,” which are estimated to represent as much as 50 percent of the world’s adult population, according to Financial Access’s 2009 Report “Half the World is Unbanked.”
Forms of Mobile Payment
Apple Pay is a mobile payment service that lets certain Apple mobile devices make payments at retail and online checkout. It digitizes and replaces the credit or debit magnetic stripe card transaction at credit card terminals. The service lets Apple devices wirelessly communicate with point of sale systems using a near field communication (NFC) antenna, a “dedicated chip that stores encrypted payment information” (known as the Secure Element), and Apple’s Touch ID and Passbook.
The service keeps customer payment information private from the retailer, and creates a “dynamic security code [ . . .] generated for each transaction.” Apple added that they would not track usage, which would stay between the customers, the vendors, and the banks. Users can also remotely halt the service on a lost phone via the Find My iPhone service.
Google Wallet is a mobile payment system developed by Google that allows its users to store debit cards, credit cards, loyalty cards, and gift cards among other things, as well as redeeming sales promotions on their mobile phone. Google Wallet can use near field communication (NFC) to “make secure payments fast and convenient by simply tapping the phone on any PayPass-enabled terminal at checkout.”
Where this new technology will lead the world economy and what its impact on the existing monetary system will be remain to be seen, but we are certain it will continue to evolve rapidly!
1. Chakravorti, B., & Mazzotta, B. (2013, September). The Cost of Cash in the United States. Retrieved September 8, 2016, from fletcher.tufts.edu/CostofCash...icrosites/Cost of Cash/CostofCashStudyFinal.pdf | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/04%3A_Financial_Markets_and_System/4.01%3A_Why_It_Matters-_Financial_Markets_and_System.txt |
What you’ll learn to do: explain the role of banks in the U.S. monetary system
In this section you’ll learn how banks serve as intermediaries for the flow of money between lenders and borrowers. You’ll also learn about the system in which which banks operate: the Federal Reserve System.
Learning Objectives
• Explain how banks act as intermediaries between savers and borrowers
• Explain how the Federal Reserve System implements monetary policy
• Explain how the Federal Reserve System implements monetary policy
Measuring and Tracking the Money Supply
Now that you have a good understanding of money, what qualifies as money, and how money facilitates exchanges between buyers and sellers, we need to look at how money evolves from a medium of exchange to a system. There was a time in the United States when there was no monetary system, and buyers and sellers who traveled from state to state had to carry multiple currencies. The Confederate States of America dollar was issued by the newly formed confederacy just before the outbreak of the American Civil War. It wasn’t backed by hard assets (i.e., commodities) but simply by a promise to pay the bearer after the war, on the prospect of Southern victory and independence.[1] Alabama, Arkansas, Florida, Georgia, Louisiana, Mississippi, South Carolina, Tennessee, Texas, and Virginia each printed and circulated currency that had value only within the state. It was not until 1863 when President Lincoln signed the National Banking Act that the federal dollar was established as the sole currency in the United States.
What about other kinds of currency? Cash in your wallet certainly serves as money, but how about checks or credit cards? Are they money, too? Rather than trying to determine a single way of measuring money, economists offer broader definitions of money based on liquidity. Liquidity refers to how quickly a financial asset can be used to buy a good or service. For example, cash is very liquid. Your \$10 bill can easily be used to buy a hamburger at lunchtime. However, \$10 that you have in your savings account is not so easy to use. You must go to the bank or ATM machine and withdraw that cash to buy your lunch. Thus, \$10 in your savings account is less liquid.
The Federal Reserve Bank, which is the central bank of the United States, is a bank regulator. It’s responsible for monetary policy, and it defines money according to its liquidity. You will learn more about the Federal Reserve System in the next section. There are two definitions of money: M1 and M2 money supply. M1 money supply includes those monies that are very liquid such as cash, checkable (demand) deposits, and traveler’s checks. M2 money supply is less liquid in nature and includes M1 monies plus savings and time deposits, certificates of deposits, and money market funds.
M1 money supply includes coins and currency in circulation—the coins and bills that circulate in an economy that are not held by the U.S. Treasury, at the Federal Reserve Bank, or in bank vaults. Closely related to currency are checkable deposits, also known as demand deposits. These are the amounts held in checking accounts. They are called demand deposits or checkable deposits because the banking institution must give the deposit holder his money “on demand” when a check is written or a debit card is used. These items together—currency, and checking accounts in banks—comprise the money defined as M1, which is measured daily by the Federal Reserve System. Traveler’s checks are also included in M1 but have recently decreased in use.
M2 is a broader category of money. It includes everything in M1 but also adds other types of deposits. For example, M2 includes savings deposits in banks, which are bank accounts on which you cannot write a check directly, but from which you can easily withdraw the money at an automatic teller machine or bank. Many banks and other financial institutions also offer a chance to invest in money market funds, where the deposits of many individual investors are pooled together and invested in a safe way, such as in short-term government bonds. Another portion of M2 are the relatively small (that is, less than about \$100,000) certificates of deposit (CDs) or time deposits, which are accounts that the depositor has committed to leaving in the bank for a certain period of time, ranging from a few months to a few years, in exchange for a higher interest rate. In short, all these types of M2 are money that you can withdraw and spend, but which require a greater effort to do so than the items in M1. Figure 1, below, should help you visualize the relationship between M1 and M2. Note that M1 is included in the M2 calculation.
The Federal Reserve System is responsible for tracking the amounts of M1 and M2 and prepares a weekly release of information about the money supply. For example, according to the Federal Reserve Bank’s measure of the U.S. money stock, at the end of February 2015, M1 in the United States was \$3 trillion, while M2 was \$11.8 trillion. A breakdown of the portion of each type of money that comprised M1 and M2 in February 2015, as reported by the Federal Reserve Bank, is provided in Table 1.
Table \(1\). M1 and M2 Federal Reserve Statistical Release, Money Stock Measures
Components of M1 in the U.S. (February 2015, seasonally adjusted) \$ billions
Currency \$1,271.8
Traveler’s checks \$2.9
Demand deposits and other checking accounts \$1,713.5
Total M1 \$2,988.2 (or \$3 trillion)
Components of M2 in the U.S. (February 2015, seasonally adjusted) \$ billions
M1 money supply \$2,988.2
Savings accounts \$7,712.1
Time deposits \$509.2
Individual money market mutual fund balances \$610.8
Total M2 \$11,820.3 (or \$11.8 trillion)
The lines separating M1 and M2 can become a little blurry. Sometimes elements of M1 are not treated alike; for example, some businesses will not accept personal checks for large amounts but will accept traveler’s checks or cash. Changes in banking practices and technology have made the savings accounts in M2 more similar to the checking accounts in M1. For example, some savings accounts will allow depositors to write checks, use automatic teller machines, and pay bills over the Internet, which has made it easier to access savings accounts. As with many other economic terms and statistics, the important point is to know the strengths and limitations of the various definitions of money, not to believe that such definitions are as clear-cut to economists as, say, the definition of nitrogen is to chemists.
Where does “plastic money” like debit cards, credit cards, and smart money fit into this picture? A debit card, like a check, is an instruction to the user’s bank to transfer money directly and immediately from your bank account to the seller. It is important to note that in our definition of money, it’s checkable deposits that are money, not the paper check or the debit card. Although you can make a purchase with a credit card, it is not considered money but rather a short term loan from the credit card company to you. When you make a purchase with a credit card, the credit card company immediately transfers money from its checking account to the seller, and at the end of the month, the credit card company sends you a bill for what you have charged that month. Until you pay the credit card bill, you have effectively borrowed money from the credit card company. With a smart card, you can store a certain value of money on the card and then use the card to make purchases. Some “smart cards” used for specific purposes, like long-distance phone calls or making purchases at a campus bookstore and cafeteria, are not really all that smart, because they can only be used for certain purchases or in certain places.
In short, credit cards, debit cards, and smart cards are different ways to move money when a purchase is made. But having more credit cards or debit cards does not change the quantity of money in the economy, any more than having more checks printed increases the amount of money in your checking account.
One key message here is that counting and tracking the money in a modern economy doesn’t just involve paper bills and coins; instead, money is closely linked to bank accounts. Indeed, the macroeconomic policies concerning money are largely conducted through the banking system. The next section explains how banks function as an intermediary to financial transactions.
Banks As Financial Intermediaries
The late bank robber named Willie Sutton was once asked why he robbed banks. He answered: “That’s where the money is.” While this may have been true at one time, from the perspective of modern economists, Sutton is both right and wrong. He is wrong because the overwhelming majority of money in the economy is not in the form of currency sitting in vaults or drawers at banks, waiting for a robber to appear. Most money is in the form of bank accounts, which exist only as electronic records on computers. From a broader perspective, however, the bank robber was more right than he may have known. Banking is intimately interconnected with money and, consequently, with the broader economy.
Banks make it far easier for a complex economy to carry out the extraordinary range of transactions that occur in goods, labor, and financial capital markets. Imagine for a moment what the economy would be like if all payments had to be made in cash. When shopping for a large purchase or going on vacation, you might need to carry hundreds of dollars in a pocket or purse. Even small businesses would need stockpiles of cash to pay workers and to purchase supplies. A bank allows people and businesses to store this money in either a checking account or savings account, for example, and then withdraw this money as needed through the use of a direct withdrawal, writing a check, or using a debit card.
Banks are a critical intermediary in what is called the payment system, which helps an economy exchange goods and services for money or other financial assets. Also, people with extra money that they’d like to save can store their money in a bank rather than look for an individual who is willing to borrow it from them and then repay them at a later date. Those who want to borrow money can go directly to a bank rather than trying to find someone to lend them cash. Thus, banks act as financial intermediaries—they bring savers and borrowers together.
An intermediary is one who stands between two other parties. Banks are a financial intermediary—that is, an institution that operates between a saver who deposits money in a bank and a borrower who receives a loan from that bank. All the funds deposited are mingled in one big pool, which is then loaned out. Figure 2 illustrates the position of banks as financial intermediaries, with deposits flowing into a bank and loans flowing out.
For some concrete examples of what banks do, watch the following video from Paul Solman’s Making Sense of Financial News.
The Federal Reserve System
Figure \(3\). Marriner S. Eccles Federal Reserve Headquarters, Washington, DC. Some of the most influential decisions regarding monetary policy in the United States are made behind these doors.
Money, loans, and banks are all tied together. Money is deposited in bank accounts, which is then loaned to businesses, individuals, and other banks. When the interlocking system of money, loans, and banks works well, economic transactions in goods and labor markets happen smoothly, and savers are connected with borrowers. If the money and banking system does not operate smoothly, the economy can either fall into recession or suffer prolonged inflation.
The government of every country has public policies that support the system of money, loans, and banking. But these policies do not always work perfectly. In this section we will explore how monetary policy works and what may prevent it from working perfectly.
In making decisions about the money supply—that is, the total amount of monetary assets available in an economy at a specific time—a central bank decides whether to raise or lower interest rates and, in this way, to influence macroeconomic policy, whose goal is low unemployment and low inflation. The central bank is also responsible for regulating all or part of the nation’s banking system to protect bank depositors and insure the health of the bank’s finances.
The organization responsible for conducting monetary policy and ensuring that a nation’s financial system operates smoothly is called the central bank. Most nations have central banks or currency boards. Some prominent central banks around the world include the European Central Bank, the Bank of Japan, and the Bank of England. In the United States, the central bank is called the Federal Reserve—often abbreviated as “the Fed.” This section explains the organization of the U.S. Federal Reserve and identifies the major responsibilities of a central bank.
Structure/Organization of the Federal Reserve
Unlike most central banks, the Federal Reserve is semi-decentralized, mixing government appointees with representation from private-sector banks. At the national level, it is run by a board of governors, consisting of seven members appointed by the president of the United States and confirmed by the Senate. Appointments are for fourteen-year terms and they are arranged so that one term expires January 31 of every even-numbered year. The purpose of the long and staggered terms is to insulate the board of governors as much as possible from political pressure so that policy decisions can be made based only on their economic merits. In addition, except when filling an unfinished term, each member only serves one term, further insulating decision-making from politics. Policy decisions of the Fed do not require congressional approval, and the president cannot ask for the resignation of a Federal Reserve governor as the president can with cabinet positions.
One member of the board of governors is designated as the chair. For example, from 1987 until early 2006, the chair was Alan Greenspan. From 2006 until 2014, Ben Bernanke held the post. The current chair, Janet Yellen, has made many headlines already. Why? See the following feature to find out.
Who has the most immediate economic power in the world
With a PhD in economics from Yale University, Yellen has taught macroeconomics at Harvard, the London School of Economics, and most recently at the University of California at Berkeley. From 2004–2010, Yellen was president of the Federal Reserve Bank of San Francisco.
Not an ivory-tower economist, Yellen became one of the few economists who warned about a possible bubble in the housing market, more than two years before the financial crisis occurred. Yellen served on the board of governors of the Federal Reserve twice, most recently as vice chair. She also spent two years as chair of the President’s Council of Economic Advisors. If experience and credentials mean anything, Yellen is likely to be an effective Fed chair.
The Fed chair is first among equals on the board of governors. While he or she has only one vote, the chair controls the agenda, and is the public voice of the Fed, so he or she has more power and influence than one might expect.
The Federal Reserve is more than the board of governors. The Fed also includes twelve regional Federal Reserve banks, each of which is responsible for supporting the commercial banks and economy generally in its district. The Federal Reserve districts and the cities where their regional headquarters are located are shown in Figure \(5\). The commercial banks in each district elect a board of directors for each regional Federal Reserve bank, and that board chooses a president for each regional Federal Reserve district. Thus, the Federal Reserve System includes both federally and private-sector appointed leaders.
What Does a Central Bank Do?
The Federal Reserve, like most central banks, is designed to perform the following three important functions:
1. To conduct monetary policy
2. To promote stability of the financial system
3. To provide banking services to commercial banks and other depository institutions, and to provide banking services to the federal government
The Federal Reserve provides many of the same services to banks as banks provide to their customers. For example, all commercial banks have an account at the Fed where they deposit reserves, and they can obtain loans from the Fed through the “discount window,” which will be discussed in the next reading. The Fed is also responsible for check processing. When you write a check to buy groceries, for example, the grocery store deposits the check in its bank account. Then, the physical check (or an image of that actual check) is returned to your bank, after which funds are transferred from your bank account to the account of the grocery store. The Fed is responsible for how these transactions are handled once the check leaves the cash register and is deposited into the store’s bank account. Does that mean that your check to the grocery store goes all the way to Washington, DC.? No. Instead the regulations that govern how banks handle checks, deposits, withdrawals are regulated by The Federal Reserve Act. This act is the reason that a bank must start paying you interest on a savings deposit the day it is received. It’s also the reason that if you deposit a large check, your bank may tell you that the funds will not be available for three to five business days.
On a more mundane level, the Federal Reserve ensures that enough currency and coins are circulating through the financial system to meet public demands. For example, each year the Fed increases the amount of currency available in banks around the Christmas shopping season and reduces it again in January.
Finally, the Fed is responsible for assuring that banks are in compliance with a wide variety of consumer protection laws. For example, banks are forbidden from discriminating on the basis of age, race, sex, or marital status. Banks are also required to publicly disclose information about the loans they make for buying houses and how those loans are distributed geographically, as well as by sex and race of the loan applicants.
How a Central Bank Executes Monetary Policy
The most important function of the Federal Reserve is to conduct the nation’s monetary policy. Article I, Section 8 of the U.S. Constitution gives Congress the power “to coin money” and “to regulate the value thereof.” As part of the 1913 legislation that created the Federal Reserve, Congress delegated these powers to the Fed. Monetary policy involves managing interest rates and credit conditions, which influence the level of economic activity, as described in more detail below.
A central bank has the following three traditional tools to implement monetary policy in the economy:
1. Open market operations
2. Changing reserve requirements
3. Changing the discount rate
In discussing how these three tools work, it is useful to think of the central bank as a “bank for banks”—that is, each private-sector bank has its own account at the central bank. We will discuss each of these monetary policy tools in the sections below.
Open Market Operations
The most commonly used tool of monetary policy in the U.S. is open market operations. Open market operations take place when the central bank sells or buys U.S. Treasury bonds in order to influence the quantity of bank reserves and the level of interest rates. The specific interest rate targeted in open market operations is the federal funds rate. The name is a bit of a misnomer since the federal funds rate is the interest rate charged by commercial banks making overnight loans to other banks. As such, it is a very short-term interest rate, but one that reflects credit conditions in financial markets very well.
The Federal Open Market Committee (FOMC) makes the decisions regarding these open market operations. The FOMC is made up of the seven members of the Federal Reserve’s board of governors. It also includes five voting members who are drawn, on a rotating basis, from the regional Federal Reserve Banks. The New York district president is a permanent voting member of the FOMC and the other four spots are filled on a rotating, annual basis, from the other eleven districts. The FOMC typically meets every six weeks, but it can meet more frequently if necessary. The FOMC tries to act by consensus; however, the chairman of the Federal Reserve has traditionally played a very powerful role in defining and shaping that consensus. For the Federal Reserve, and for most central banks, open market operations have, over the last few decades, been the most commonly used tool of monetary policy. The following video explains how these operations work.
Is it a sale of bonds by the central bank that increases bank reserves and lowers interest rates, or is it a purchase of bonds by the central bank? The easy way to keep track of this is to treat the central bank as being outside the banking system. When a central bank buys bonds, money is flowing from the central bank to individual banks in the economy, increasing the supply of money in circulation. When a central bank sells bonds, then money from individual banks in the economy is flowing into the central bank—reducing the quantity of money in the economy.
Changing Reserve Requirements
A second method of conducting monetary policy is for the central bank to raise or lower the reserve requirement, which is the percentage of each bank’s deposits that it is legally required to hold either as cash in their vault or on deposit with the central bank. If banks are required to hold a greater amount in reserves, they have less money available to lend out. If banks are allowed to hold a smaller amount in reserves, they will have a greater amount of money available to lend out. The following video will explain how changing the reserve requirement alters the money supply.
In early 2015, the Federal Reserve required banks to hold reserves equal to 0% of the first \$14.5 million in deposits, then to hold reserves equal to 3% of the deposits up to \$103.6 million, and 10% of any amount above \$103.6 million. Small changes in the reserve requirements are made almost every year. For example, the \$103.6 million dividing line is sometimes bumped up or down by a few million dollars. In practice, large changes in reserve requirements are rarely used to execute monetary policy. A sudden demand that all banks increase their reserves would be extremely disruptive and difficult to comply with, while loosening requirements too much would create a danger of banks being unable to meet the demand for withdrawals.
Changing the Discount Rate
The Federal Reserve was founded in the aftermath of the Financial Panic of 1907 when many banks failed as a result of bank runs. As mentioned earlier, since banks make profits by lending out their deposits, no bank, can withstand a bank run. As a result of the Panic, the Federal Reserve was founded to be the “lender of last resort.” In the event of a bank run, sound banks could borrow as much cash as they needed from the Fed’s discount “window” to cover the bank run. The interest rate banks pay for such loans is called the discount rate. They are so named because loans are made against the bank’s outstanding loans “at a discount” of their face value. Once depositors became convinced that the bank would be able to honor their withdrawals, they no longer had a reason to make a run on the bank. In short, the Federal Reserve was originally intended to provide credit passively, but in the years since its founding, the Fed has taken on a more active role with monetary policy.
So, the third traditional method for conducting monetary policy is to raise or lower the discount rate. If the central bank raises the discount rate, then commercial banks will reduce their borrowing of reserves from the Fed, and instead call in loans to replace those reserves. Since fewer loans are available, the money supply falls and market interest rates rise. If the central bank lowers the discount rate it charges to banks, the process works in reverse.
The following video explains the impact of changes to the Fed’s discount rate.
In recent decades, the Federal Reserve has made relatively few discount loans. Before a bank borrows from the Federal Reserve to fill out its required reserves, the bank is expected to first borrow from other available sources, like other banks. This is encouraged by the Fed charging a higher discount rate than the federal funds rate. Given that most banks borrow little at the discount rate, changing the discount rate up or down has little impact on their behavior. More important, the Fed has found from experience that open market operations are a more precise and powerful means of executing any desired monetary policy.
Chair the Fed
Achieve Low Unemployment and Low Inflation Rates
We have now seen that the Fed has three primary goals and a set of tools at its disposal to help it achieve these goals. If you were the chairperson of the Federal Reserve, do you think that you could accomplish these goals? Let’s find out!
After reading the following information, click on the Chair the Fed link below, which will take you to the Federal Reserve Bank of San Francisco Web site, where YOU will act as the Chair of the Fed. By manipulating the fed funds rate, you will try to keep inflation and unemployment at target rates.
Instructions for Playing the Game
The game puts the player in the role of setting monetary policy as Chair of the Fed. The goals are as follows: inflation (2 percent) and unemployment (5 percent). Remember that the fed funds rate is the primary tool for monetary policy and is shown on the game screen (green line in the chart area is initially set at 4 percent rate).
Record the starting levels for inflation, unemployment, and the fed funds rate (2.11 percent, 4.68 percent, and 4.00 percent, respectively) in your notes by making a small table with four columns labeled: Quarters Remaining, Inflation, Unemployment, and Fed Funds Rate.
Review the “rules” and functions of the simulation by clicking on “YOUR JOB.” Once you have familiarized yourself with the way the simulation works, you are ready to “GO.”
Start the game by clicking on the “Go” button. Once the first quarter is completed (fifteen quarters remaining), record all three rates. Using the “raise” and “cut” buttons, make adjustments to the fed funds rate. The information in the headline reflects changes in the levels of inflation and unemployment.
Work through the remaining fifteen quarters, pausing to review each headline and record the new values of inflation and unemployment.
The game ends on an announcement screen indicating “Congratulations” if the Chair has kept the economy on track (close to the goals for inflation and unemployment) or “Sorry” if the goals have not been met.
Good Luck!
Play the Chair the Fed Simulation | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/04%3A_Financial_Markets_and_System/4.03%3A_Role_of_Banks.txt |
What you’ll learn to do: describe common ways in which businesses obtain financial capital (money) to fund operations
In this section you will learn about some of the options businesses have to obtain capital and how they decide which form of capital best meets their needs.
Learning Objectives
• Distinguish between bonds and bank loans as methods of borrowing
• Define “stock”
How Businesses Raise Financial Capital
Firms often make decisions that involve spending money in the present and expecting to earn profits in the future. Some examples are: when a firm buys a machine that will last ten years, or builds a new plant that will last for thirty years, or starts a research and development project. They need economic resources—also known as financial capital—to do this. Firms can raise the financial capital they need to pay for such projects in four main ways: (1) from early-stage investors; (2) by reinvesting profits; (3) by borrowing through banks or bonds; and (4) by selling stock. As you’ll see, each financial option has different implications for the business in terms of operations and profits.
Early-Stage Financial Capital
Firms that are just beginning often have an idea or a prototype for a product or service to sell, but they have few customers, or even no customers at all, and thus are not earning profits. Banks are often unwilling to loan money to start-up businesses because they’re seen as too risky. Such firms face a difficult problem when it comes to raising financial capital: How can a firm that has not yet demonstrated any ability to earn profits pay a rate of return to financial investors?
For many small businesses, the original source of money is the owner of the business. Someone who decides to start a restaurant or a gas station, for instance, might cover the start-up costs by dipping into his or her own bank account or by borrowing money (perhaps using a home as collateral). Alternatively, many cities have a network of well-to-do individuals, known as “angel investors,” who will put their own money into small new companies at an early stage of development, in exchange for owning some portion of the firm.
Venture capital firms make financial investments in new companies that are still relatively small in size but have substantial growth potential. These firms gather money from a variety of individual or institutional investors, including banks, institutions like college endowments, insurance companies that hold financial reserves, and corporate pension funds. Venture capital firms do more than just supply money to small start-ups. They also provide advice on potential products, customers, and key employees. Typically, a venture capital fund invests in a number of firms, and then investors in that fund receive returns according to how the fund performs as a whole.
The amount of money invested in venture capital fluctuates substantially from year to year: As one example, venture capital firms invested more than \$48.3 billion in 2014, according to the National Venture Capital Association. All early-stage investors realize that the majority of small start-up businesses will never hit it big; indeed, many of them will go out of business within a few months or years. They also know that getting in on the ground floor of a few huge successes like a Netflix or an Amazon.com can make up for a lot of failures. Early-stage investors are therefore willing to take large risks in order to be in a position to gain substantial returns on their investment.
Profits As a Source of Financial Capital
If firms are earning profits (their revenues are greater than costs), they can choose to reinvest some of these profits in equipment, structures, and research and development. For many established companies, reinvesting their own profits is one primary source of financial capital. Companies and firms just getting started may have numerous attractive investment opportunities but few current profits to invest. Even large firms can experience a year or two of earning low profits or even suffering losses, but unless the firm can find a steady and reliable source of financial capital so that it can continue making real investments in tough times, the firm may not survive until better times arrive. Firms often need to find sources of financial capital other than profits.
Borrowing: Banks and Bonds
When a firm has a record of at least earning significant revenues or, better still, of earning profits, the firm can make a credible promise to pay interest, and so it becomes possible for the firm to borrow money. Firms have two main methods of borrowing: banks and bonds.
A bank loan for a firm works in much the same way as a loan for an individual who is buying a car or a house. The firm borrows an amount of money and then promises to repay it, including some rate of interest, over a predetermined period of time. If the firm fails to make its loan payments, the bank (or banks) can often take the firm to court and require it to sell its buildings or equipment to make the loan payments.
Another source of financial capital is a bond. A bond is a financial contract: A borrower agrees to repay the amount that was borrowed and also a rate of interest over a period of time in the future. A corporate bond is issued by firms, but bonds are also issued by various levels of government. For example, a municipal bond is issued by cities, a state bond by U.S. states, and a Treasury bond (T-bond) by the federal government through the U.S. Department of the Treasury. A bond specifies an amount that will be borrowed, the interest rate that will be paid, and the time until repayment.
A large company, for example, might issue bonds for \$10 million; the firm promises to make interest payments at an annual rate of 8 percent (\$800,000 per year), and then, after ten years, it will repay the \$10 million it originally borrowed. When a firm issues bonds, the total amount that is borrowed is divided up. A firm that seeks to borrow \$50 million by issuing bonds might actually issue 10,000 bonds of \$5,000 each. In this way, an individual investor could, in effect, loan the firm \$5,000, or any multiple of that amount. Anyone who owns a bond and receives the interest payments is called a bondholder. If a firm issues bonds and fails to make the promised interest payments, the bondholders can take the firm to court and require it to pay, even if the firm needs to raise the money by selling buildings or equipment. However, there is no guarantee that the firm will have sufficient assets to pay off the bonds. The bondholders may get back only a portion of what they loaned the firm.
Bank borrowing is more customized than issuing bonds, so it often works better for relatively small firms. The bank can get to know the firm extremely well—often because the bank can monitor sales and expenses quite accurately by looking at deposits and withdrawals. Relatively large and well-known firms often issue bonds instead. They use bonds to raise new financial capital that pays for investments, or to raise capital to pay off old bonds, or to buy other firms. However, the idea that banks are usually used for relatively smaller loans and bonds for larger loans is not an ironclad rule: Sometimes groups of banks make large loans, and sometimes relatively small and lesser-known firms issue bonds.
Corporate Stock and Public Companies
A corporation is a business that “incorporates”—it is owned by shareholders that have limited liability for the debt of the company but share in its profits (and losses). Corporations may be private or public and may or may not have stock that is publicly traded. They may raise funds to finance their operations or new investments by raising capital through the sale of stock or the issuance of bonds.
Those who buy the stock become the owners, or shareholders, of the firm. Stock represents ownership of a firm; that is, a person who owns 100 percent of a company’s stock, by definition, owns the entire company. The stock of a company is divided into shares. Corporate giants like IBM, AT&T, Ford, General Electric, Microsoft, Merck, and Exxon all have millions of shares of stock. In most large and well-known firms, no individual owns a majority of the shares of the stock. Instead, large numbers of shareholders—even those who hold thousands of shares—each have only a small slice of the overall ownership of the firm.
When a company is owned by a large number of shareholders, three important questions emerge:
1. How and when does the company get money from the sale of its stock?
2. What rate of return does the company promise to pay when it sells stock?
3. Who makes decisions in a company owned by a large number of shareholders?
First, a firm receives money from the sale of its stock only when the company sells its own stock to the public (the public includes individuals, mutual funds, insurance companies, and pension funds). A firm’s first sale of stock to the public is called an initial public offering (IPO). The IPO is important for two reasons. For one, the IPO, and any stock issued thereafter, such as stock held as treasury stock (shares that a company keeps in their own treasury) or new stock issued later as a secondary offering, provides the funds to repay the early-stage investors, like the angel investors and the venture capital firms. A venture capital firm may have a 40 percent ownership in the firm. When the firm sells stock, the venture capital firm sells its part ownership of the firm to the public. A second reason for the importance of the IPO is that it provides the established company with financial capital for a substantial expansion of its operations.
Most of the time when corporate stock is bought and sold, however, the firm receives no financial return at all. If you buy shares of stock in General Motors, you almost certainly buy them from the current owner of those shares, and General Motors does not receive any of your money. This pattern should not seem particularly odd. After all, if you buy a house, the current owner gets your money, not the original builder of the house. Similarly, when you buy shares of stock, you are buying a small slice of ownership of the firm from the existing owner—and the firm that originally issued the stock is not a part of this transaction.
Second, when a firm decides to issue stock, it must recognize that investors will expect to receive a rate of return. That rate of return can come in two forms. A firm can make a direct payment to its shareholders, called a dividend. Alternatively, a financial investor might buy a share of stock in Walmart for \$45 and then later sell that share of stock to someone else for \$60, for a gain of \$15. The increase in the value of the stock (or of any asset) between when it is bought and when it is sold is called a capital gain.
Third: Who makes the decisions about when a firm will issue stock, or pay dividends, or reinvest profits? To understand the answers to these questions, it is useful to separate firms into two groups: private and public.
A private company is owned by the people who run it on a day-to-day basis. A private company can be run by individuals, in which case it is called a sole proprietorship, or it can be run by a group, in which case it is a partnership. A private company can also be a corporation, but the stock is not sold to the public. Instead, the company’s stock is offered, owned, and traded or exchanged privately. A small law firm run by one person, even if it employs some other lawyers, would be a sole proprietorship. A larger law firm may be owned jointly by its partners. Most private companies are relatively small, but there are some large private corporations, with tens of billions of dollars in annual sales, that do not have publicly issued stock, such as farm-products dealer Cargill, the Mars candy company, and the Bechtel engineering and construction firm.
When a firm decides to sell stock, which in turn can be bought and sold by financial investors, it is called a public company. Shareholders own a public company. Since the shareholders are a very broad group, often consisting of thousands or even millions of investors, the shareholders vote for a board of directors, who in turn hire top executives to run the firm on a day-to-day basis. The more shares of stock a shareholder owns, the more votes that shareholder is entitled to cast for the company’s board of directors.
In theory, the board of directors helps to ensure that the firm is run in the interests of the true owners—the shareholders. However, the top executives who run the firm have a strong voice in choosing the candidates who will be on their board of directors. After all, few shareholders are knowledgeable enough or have enough of a personal incentive to spend energy and money nominating alternative members of the board.
How Firms Choose between Sources of Financial Capital
There are clear patterns in how businesses raise financial capital. These patterns can be explained partly by the fact that buyers and sellers in a market do not both have complete and identical information. Those who are actually running a firm will almost always have more information about whether the firm is likely to earn profits in the future than outside investors who provide financial capital.
Any young start-up firm is a risk; indeed, some start-up firms are only a little more than an idea on paper. The firm’s founders inevitably have better information about how hard they are willing to work, and whether the firm is likely to succeed, than anyone else. When the founders put their own money into the firm, they demonstrate a belief in its prospects. At this early stage, angel investors and venture capitalists try to get all the information they need, partly by getting to know the managers and their business plan personally and by giving them advice.
As a firm becomes at least somewhat established and its strategy appears likely to lead to profits in the near future, knowing the individual managers and their business plans on a personal basis becomes less important, because information has become more widely available regarding the company’s products, revenues, costs, and profits. As a result, other outside investors who do not know the managers personally, like bondholders and shareholders, are more willing to provide financial capital to the firm.
At this point, a firm must often choose how to access financial capital. It may choose to borrow from a bank, issue bonds, or issue stock. The great disadvantage of borrowing money from a bank or issuing bonds is that the firm commits to scheduled interest payments, whether or not it has sufficient income. The great advantage of borrowing money is that the firm maintains control of its operations and is not subject to shareholders. Issuing stock involves selling off ownership of the company to the public and becoming responsible to a board of directors and the shareholders.
The benefit of issuing stock is that a small and growing firm increases its visibility in the financial markets and can access large amounts of financial capital for expansion, without worrying about paying this money back. If the firm is successful and profitable, the board of directors will need to decide upon a dividend payout or how to reinvest profits to further grow the company. Issuing and placing stock is expensive, requires the expertise of investment bankers and attorneys, and entails compliance with reporting requirements to shareholders and government agencies, such as the federal Securities and Exchange Commission.
Financial Markets
In 2006, housing equity in the United States peaked at \$13 trillion. That means that the market prices of homes, less what was still owed on the loans used to buy these houses, equaled \$13 trillion. This was a very good number, since the equity represented the value of the financial asset most U.S. citizens owned.
However, by 2008 this number had gone down to \$8.8 trillion, and it declined further still in 2009. Combined with the decline in value of other financial assets held by U.S. citizens, by 2010, U.S. homeowners’ wealth had declined by \$14 trillion! This is a staggering loss, and it affected millions of lives: people had to alter their retirement decisions, housing decisions, and other important consumption decisions. Just about every other large economy in the world suffered a decline in the market value of financial assets, as a result of the global financial crisis of 2008–2009.
This section will explain why people buy houses (other than as a place to live), why they buy other types of financial assets, and why businesses sell those financial assets in the first place. The section will also give us insight into why financial markets and assets go through boom-and-bust cycles like the one described here.
When a firm needs to buy new equipment or build a new facility, it often must go to the financial market to raise funds. Usually firms will add capacity during an economic expansion when profits are on the rise and consumer demand is high. Business investment is one of the critical ingredients needed to sustain economic growth. Even in the sluggish economy of 2009, U.S. firms invested \$1.4 trillion in new equipment and structures, in the hope that those investments would generate profits in the years ahead.
Between the end of the recession in 2009 through the second quarter 2013, profits for the S&P 500 companies grew to 9.7 percent despite the weak economy, with much of that amount driven by cost cutting and reductions in input costs, according to the Wall Street Journal. Figure \(1\), below, shows corporate profits after taxes (adjusted for inventory and capital consumption). Despite the steep decline in quarterly net profit in 2008, profits have recovered and surpassed pre-Recession levels.
Many firms, from huge companies like General Motors to start-up firms writing computer software, do not have the financial resources within the firm to make all the investments they want. These firms need financial capital from outside investors, and they are willing to pay interest for the opportunity to get a rate of return on the investment for that financial capital.
On the other side of the financial capital market, suppliers of financial capital, like households, wish to use their savings in a way that will provide a return. Individuals cannot, however, take the few thousand dollars that they save in any given year, write a letter to General Motors or some other firm, and negotiate to invest their money with that firm. Financial capital markets bridge this gap: That is, they find ways to take the inflow of funds from many separate suppliers of financial capital and transform it into the funds desired by demanders of financial capital. Such financial markets include stocks, bonds, bank loans, and other financial investments. | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/04%3A_Financial_Markets_and_System/4.04%3A_Financial_Markets_and_Business.txt |
Synthesis
Still have that dollar bill handy that you pulled out earlier when you learned about the Federal Reserve System? Do you think about it the same way you did before you completed this module? Perhaps you do, but now you should have a better understanding of what that dollar bill represents, how it came into existence, and where its value comes from. Money will always exist in some form, whether it’s based on NFC technology in your iPhone or we go back to a barter system where we trade seashells for bread. It will still motivate people to work, study, achieve, and unfortunately even break the law. But, as you consider everything you have read and heard in this module, is it the money itself that is the motivator or the “store of value” that we work to obtain? In fact, you can look at that dollar bill and, really, it’s just a piece of paper with a picture of a dead president on its face—it has no intrinsic value. So where is the value in the dollar bill you’re holding? Is it that our society recognizes it as having value, and business and individuals are willing to “trade” you dollars for shoes, cars, houses, food, and the other things that you need or want in your day-to-day life? Yes, we could go back to trading chickens for shoes, but technology is pushing us further and further away from that model, and as the monetary system evolves, it’s unlikely that it will become less complex. That’s one big reason you’ve spent all this time understanding this thing that “makes the world go ’round.”
Summary
This module covered the financial markets and system. Below is a summary of the topics covered in this module.
Money
Money serves three basic functions:
• Medium of exchange: because you can use it to buy the goods and services you want, everyone’s willing to trade things for money.
• Measure of value: it simplifies the exchange process because it’s a means of indicating how much something costs.
• Store of value: people are willing to hold on to it because they’re confident that it will keep its value over time.
• Virtual currencies, such as BitCoin, are using the traditional concept of “money” but as an alternative to the established Federal Reserve System. Although gaining in popularity, these virtual currencies are unregulated and pose some serious risks to those using this medium of exchange.
• Cashless payment systems such as Google Wallet and ApplePay allow consumers to carry their “cash” in their mobile devices. As more retailers move to “tap to pay” or scanning QR codes to complete transactions, the need to carry conventional paper money and coin diminishes. The question raised by this technology is not whether it will lead to a cashless society, but rather which mobile payment service will rise to the top and capture the market.
Role of Banks
• The government uses two measures to track the money supply: M-1 includes the most liquid forms of money, such as cash and checking-account funds. M-2 includes everything in M-1 plus near-cash items, such as savings accounts and time deposits below \$100,000.
• Financial institutions serve as financial intermediaries between savers and borrowers and direct the flow of funds between the two groups.
• Financial institutions offer a wide range of services, including checking and savings accounts, ATM services, and credit and debit cards. They also sell securities and provide financial advice.
• A bank holds on to only a fraction of the money that it takes in—an amount called its reserves—and lends out the rest to individuals, businesses, and governments. In turn, borrowers put some of these funds back into the banking system, where they become available to other borrowers. The money multiplier effect ensures that the cycle expands the money supply.
• Most large banks are members of the central banking system called the Federal Reserve System (commonly known as “the Fed”).
• The Fed’s goals include price stability, sustainable economic growth, and full employment. It uses monetary policy to regulate the money supply and the level of interest rates.
• To achieve these goals, the Fed has three tools:
• it can raise or lower reserve requirements—the percentage of its funds that banks must set aside and can’t lend out;
• it can raise or lower the discount rate—the rate of interest that the Fed charges member banks to borrow “reserve” funds;
• it can conduct open market operations—buying or selling government securities on the open market.
Financial Markets and Business
The four main ways that businesses raise financial capital are:
• Early-stage capital: business owner uses his/her own money or seeks money from an angel investor or venture capital firm
• Profits: profits from the business are reinvested in equipment, structures, research and development, etc.
• Bonds: a way to raise capital through borrowing, used by corporations and governments; an investment for the bondholder that creates return through regular, fixed, or floating interest payments on the debt and the repayment of principal at maturity; traded on bond exchanges through brokers.
• Stocks: a way to raise capital by selling ownership or equity; an investment for shareholders that creates return through the distribution of corporate profits as dividends or through gains (losses) in corporate value; traded on stock exchanges through member brokers. | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/04%3A_Financial_Markets_and_System/4.05%3A_Putting_It_Together-_Financial_Markets_and_System.txt |
Why summarize the role of the legal system in governing and shaping the climate for business?
Imagine yourself in the following story: When you were in high school, you sometimes worked for your father, a house painter. Now that you’re in college, you’ve decided to take advantage of that experience to earn some extra money during your summer vacation. You’ve set yourself up as a house-painting business and hired your college roommate to help you out.
One fine summer day, the two of you were putting a coat of Misty Meadow acrylic latex on the exterior of a two-story Colonial. You were working on the ground floor around the door of the house while your roommate was working from scaffolding over the garage. Looking up, you noticed that—despite several warnings—your roommate had placed his can of paint at his feet rather than having fixed it to the ladder bracing the platform. You were about to say something yet again, but it was too late: He accidentally kicked the bucket (so to speak), which then bounced off the homeowner’s red sports car, denting the hood, and splattering it with Misty Meadow.
As luck would have it, the whole episode was witnessed by the homeowner’s neighbor, who approached the scene of the disaster just as your roommate climbed down from the scaffold. “Man, you must be dumber than a bag of hammers,” the neighbor said to your roommate, who was in no mood for unsolicited opinions—and before you knew what was happening, he broke the neighbor’s nose with a single well-placed punch.
The homeowner sues you and your roommate for negligence, and the neighbor sues you and your roommate for assault and battery.
In this module, we will discuss how our legal system shapes the business environment. We will explore how legal situations like this and others could impact your business.
5.02: The Meaning and Purpose of Law
What you’ll learn to do: explain the meaning and purpose of law
In this section you’ll be introduced to the terms and concepts needed to understand how law applies to business.
Learning Objectives
• Explain the purposes of law
• Explain “rule of law”
Understanding Law
Law has been defined as “a body of rules of action or conduct prescribed by a controlling authority, and having binding legal force. That which must be obeyed and followed by citizens subject to sanctions or legal consequence is a law.”[1]
Although intended to protect the fundamental rights and liberties of U.S. citizens, the legal system and its laws are not always readily understood by the average citizen. At what point do we cross that fine line between legal and illegal, and on what basis is that line even drawn in the first place? Most people understand (and accept) laws prohibiting acts of murder, thievery, physical harm, and financial malfeasance, but there are plenty of other laws that might give us pause. For example, in Minnesota, any game in which participants attempt to capture a greased or oiled pig is illegal. The same laws also prohibits turkey scrambles.[2] Don’t attempt to substitute a ferret for a hunting dog in West Virginia. Anyone who hunts, catches, takes, kills, injures, or pursues a wild animal or bird with a ferret will face a fine of no less than \$100 (but no more than \$500) and no fewer than 10 (but no more than 100) days in jail.[3]
While you may never have considered taking part in a turkey scramble or hunting with a ferret, chances are good that you have broken some law at some time—perhaps even in the last twenty-four hours. Did you exceed a speed limit while driving? Roll through a stop sign at an empty intersection while riding your bike? Drive to the minimart without wearing your seatbelt? Although unlikely that you will be prosecuted and jailed for these minor traffic offenses, the fact is that you broke the law. Why do we have so many laws? Let’s take a closer look at the role of law in society and why laws are created in the first place.
Purposes of Law
In a society such as the United States, the law informs everyday life in a wide variety of ways and is reflected in numerous branches of law. For example, contract law regulates agreements to exchange goods, services, or anything else of value, so it includes everything from buying a bus ticket to trading options on a derivatives market. Property law defines people’s rights and duties toward tangible property, including real estate (i.e., real property, such as land or buildings,) and their other possessions (i.e., personal property, such as clothes, books, vehicles, and so forth), and intangible property, such as bank accounts and shares of stock. Tort law provides for compensation when someone or their property is harmed, whether in an automobile accident or by defamation of character. Those are fields of civil law, which deals with disputes between individuals. Offenses against a federal, state, or local community itself are the subject of criminal law, which provides for the government to punish the offender.
origins of law
The establishment of a system of laws was not invented by the founding fathers of the United States. The idea of written laws goes back to ancient Mesopotamian culture that prospered long before the Bible was written or the civilizations of the Greeks or Romans flowered.
In fact, the oldest known evidence of a law code is tablets from the ancient city Ebla (Tell Mardikh in modern-day Syria). They date to about 2400 BCE. However, most scholars credit Hammurabi’s Code as the origin of written laws and a formal legal system. If you haven’t heard of Hammurabi, you have certainly heard one of his laws: “An eye for an eye, and a tooth for a tooth.” Hammurabi’s Code, a collection of 282 laws inscribed on an upright stone pillar, contains many fundamental legal concepts we would recognize in today’s legal system.
In fact, Hammurabi’s reasoning for creating this code is not that far removed from the rationale for our current legal system. In his preface, Hammurabi writes that he sets forth these laws “to bring about the rule of righteousness in the land, to destroy the wicked and the evil-doers; so that the strong should not harm the weak.”
Establishing Standards
The law is a guidepost for minimally acceptable behavior in society. Some activities, for instance, are crimes because society (through a legislative body) has determined that it will not tolerate certain behaviors that injure or damage persons or their property. For example, under a typical state law, it is a crime to cause physical injury to another person without justification—doing so generally constitutes the crime of assault.[4]
Maintaining Order
This is an offshoot of establishing standards. Some semblance of order is necessary in a civil society and is therefore reflected in law. The law—when enforced—provides order consistent with society’s guidelines. Wildlife management laws, for example, (such as West Virginia’s prohibition against using ferrets for hunting,) were first passed in an effort to conserve game that had nearly been hunted into extinction during the nineteenth century. Such laws reflect the value society places on protecting wildlife for future generations to enjoy.[5]
Resolving Disputes
Disputes are unavoidable in a society comprised of persons with different needs, wants, values, and views. The law provides a formal means for resolving disputes—the court system.[6]
Protecting Liberties and Rights
The constitutions and statutes of the United States and its states provide for various liberties and rights. One function of the law is to protect these various liberties and rights from violations or unreasonable intrusions by persons, organizations, or government. For example, subject to certain exceptions, the First Amendment to the Constitution prohibits the government from making a law that prohibits the freedom of speech. Someone who believes that his free speech rights have been prohibited by the government may pursue a remedy by bringing a case in the courts.[7]
Rule of Law
What is the rule of law? Aren’t laws and rules the same thing? You can think of the rule of law as the rules that govern the law. The rule of law is the legal principle that law should govern a nation, as opposed to being governed by arbitrary decisions of individual government officials. It primarily refers to the influence and authority of law within society, particularly as a constraint upon behavior, including behavior of government officials. The phrase can be traced back to sixteenth-century Britain, and in the following century, the Scottish theologian Samuel Rutherford used the phrase in his argument against the divine right of kings. The concept, if not the phrase, was familiar to ancient philosophers such as Aristotle, who wrote, “Law should govern.”
Rule of law implies that every citizen is subject to the law, including lawmakers themselves. In this sense, the rule of law stands in contrast to an autocracy, dictatorship, or oligarchy, in which the rulers are held above the law. Lack of the rule of law can be found in both democracies and dictatorships, because of neglect or ignorance of the law, for example, and the rule of law is more apt to deteriorate if a government has insufficient corrective mechanisms for restoring it. If you’ve ever read Alice’s Adventures in Wonderland (or seen the movie), and you can recall the Queen of Hearts yelling, “Off with their heads!” at the slightest infraction or offense, you have some idea of what it would be like to live in a society that is not governed by the rule of law.
The rule of law system in the United States is established in the U.S. Constitution. The U.S. Constitution itself became the law of the land well over two hundred years ago, and the tenets set forth in the document remain in full force today. The way in which the Constitution is applied, though, has always been subject to court interpretation. As circumstances and public opinion evolve through the years, so too do the interpretations offered by the courts. From time to time, it even becomes necessary to amend the Constitution to keep pace with changes in the country’s beliefs and values.
1. Black’s Law Dictionary, 6th ed., s.v. “law.”
2. www.revisor.mn.gov/statutes/?id=343.36&year=2013&keyword_type=all&keyword=greased+pig
3. http://www.legis.state.wv.us/legisdocs/code/20/WVC%2020%20%20-%20%202%20%20-%20%20%205%20%20.htm
4. http://www.businesslawbasics.com/chapter-3-purposes-and-functions-law-1
5. http://www.businesslawbasics.com/chapter-3-purposes-and-functions-law-1
6. http://www.businesslawbasics.com/chapter-3-purposes-and-functions-law-1
7. http://www.businesslawbasics.com/chapter-3-purposes-and-functions-law-1 | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/05%3A_Legal_Environment/5.01%3A_Why_It_Matters-_Legal_Environment.txt |
What you’ll learn to do: differentiate between statutory and common law
In this section you’ll learn about the differences between statutory and common law.
Learning Objectives
• Define common law
Statutory vs. Common Law
At both the federal and state levels, the law of the United States can be traced back to the common law system of English law, which was in force in the American colonies during the time of the Revolutionary War. Since then, U.S. law has diverged greatly from its English roots both in terms of substance and procedure. The main departure occurred when the United States ratified the Constitution in 1789. In effect, the Constitution and federal statutes and laws made in furtherance of the Constitution were established as “the supreme Law of the Land.” From that point on, the law of the land was no longer based on legal practices in England but became distinctly American and home grown. When the individual states ratified their state constitutions, the state legislatures obtained the power to establish state law, or the “Law of the State.” Together, this collection of federal and state laws constitutes something we often refer to as the “body of law.” This body of law governs the behavior of individuals, businesses, and even governments. Just like the human body, the “body of law” is comprised of multiple parts, each performing an individual function while simultaneously working together as a whole. In this section, we will examine two of the most fundamental types of laws, followed by nearly every nation in the world: statutory law and common law.
A statute is a law passed by a legislature; and statutory law is the body of law resulting from statutes. A statute—or the statutory law—may also be referred to as legislation. One of the benefits of statutory law is that whether it’s federal or state law, it’s a written law that you can locate and read at the law library or online. This is not true of common law, which is also known as “unwritten law, because it’s not collected in a single source.
Suppose you are headed over to a friend’s house to watch football on Sunday, and on your way you stop in at the local supermarket to buy some beer and pretzels for the gang. You carry your six-pack and snacks up to the counter to pay, and the clerk tells you that she’s sorry, but she can’t sell you the beer. At first you think it’s because she suspects you’re underage, but before you can show her your ID, she explains that she can’t sell alcohol before noon because (1) it’s Sunday and (2) you are in the State of North Carolina. Shocked, you think she’s joking until she refers you to the following NC Statute: N.C. General Statute 18B-1004(c) states, “It shall be unlawful to sell or consume alcoholic beverages on any licensed premises from the time at which sale or consumption must cease on Sunday morning until 12:00 noon on that day.” No amount of begging or pleading will get you the beer, because the owner of the supermarket knows that if she violates N.C. General Statute 18B-1004(c), the store’s ABC license could be revoked and its alcohol sales ended permanently. This is an example of statutory law.
However, when the federal and state constitutions were written, it wasn’t possible to anticipate and include every possible law in those documents. For instance, in 1789 there was no reason to write laws prohibiting people from operating motor vehicles while intoxicated, because there were no motor vehicles yet—people still rode horses. Instead, the Constitution made provisions for law to evolve as society evolved. In 1803, U.S. Supreme Court Chief Justice John Marshall stated that “[i]t is emphatically the province and duty of the Judicial Department to say what the law is.” This kind of judge-made law is common law. Case law is developed by judges, courts, and similar tribunals, and, over time, the decisions in individual cases establish precedents for future cases. Precedent means that the decisions judges have made in earlier cases guide how future cases are decided. In common law systems, this principle is called stare decisis, and it has a binding effect on judges and courts: Stare decisis holds that cases should be decided according to consistent principled rules so that similar facts will yield similar results. If the court finds that the current dispute is fundamentally distinct from previous cases, judges have the authority and duty to make law by creating precedent. Thereafter, the new decision becomes precedent and will bind future courts.
William Frantz Elementary School, New Orleans, 1960. “After a Federal court ordered the desegregation of schools in the South, U.S. marshals escorted a young Black girl, Ruby Bridges, to school.”
In Brown v. Board of Education, the landmark case concerning racial segregation in U.S. public schools, the Supreme Court ultimately handed down a decision that established a new legal precedent. At the heart of the case was the contention that the separate school systems for blacks and whites were inherently unequal and thus violated the Equal Protection Clause of the Fourteenth Amendment to the U.S. Constitution.
After the case was reheard in 1953, Chief Justice Warren was able to persuade all of the justices to support a unanimous decision declaring segregation in public schools to be unconstitutional. On May 14, 1954, he delivered the opinion of the Court: “We conclude that in the field of public education the doctrine of ‘separate but equal’ has no place. Separate educational facilities are inherently unequal. . .”
Although it would be many years before all U.S. public schools were desegregated, the Supreme Court’s ruling in Brown was the legal turning point that paved the way for the this change. Under common law, the precedent it established was that separate educational facilities for different races are inherently unequal. | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/05%3A_Legal_Environment/5.03%3A_Statutory_and_Common_Law.txt |
What you’ll learn to do: define tort law, and explain the role of product liability in tort law
In this section you’ll learn about an area of the law that’s especially important for business: tort law and product liability.
Learning Objectives
• Explain the concept of negligence as it relates to tort law
• Explain the three major bases for product liability claims
• Differentiate between compensatory and punitive damages
Tort Law
In common law jurisdictions, a tort is a civil wrong that unfairly causes someone else to suffer loss or harm, resulting in legal liability for the person who commits the tortious act. Although crimes may be torts, the cause of legal action is not necessarily a crime, as the harm may be due to negligence. The following video explains what negligence is.
The victim of the harm can recover his or her loss as damages in a lawsuit. In order to prevail, the plaintiff in the lawsuit, commonly referred to as the injured party, must prove that a breach of duty (i.e., either an action or lack of action) was the legally recognizable cause of the harm.
Legal injuries are not limited to physical injuries and may include emotional, economic, or reputational injuries, as well as violations of privacy, property, or constitutional rights. Torts include such varied topics as auto accidents, false imprisonment, defamation, product liability, copyright infringement, and environmental pollution (toxic torts). While many torts are the result of negligence, tort law also recognizes intentional torts, in which a person has intentionally acted in a way that harms another. In addition, when it comes to product liability, the courts have established a doctrine of “strict liability” for torts arising from injury caused by the use of a company’s product and/or service. Under “strict liability,” the injured party does not have to prove that the company was negligent in order to win a claim for damages.
Tort law is different from criminal law in two ways: (1) torts may result from negligent as well as intentional or criminal actions, and (2) tort lawsuits have a lower burden of proof, such as “preponderance of evidence” rather than “beyond a reasonable doubt.” Sometimes a plaintiff may prevail in a tort case even if the person who allegedly caused harm was acquitted in an earlier criminal trial. For example, O. J. Simpson was acquitted in criminal court of murder but later found liable for the tort of wrongful death.
For businesses, torts that arise from product liability can have devastating consequences. Let’s examine product liability in greater detail.
Product Liability
Product liability is the area of law in which product manufacturers, distributors, and sellers are held responsible for the injuries caused by their products. Traditionally, product liability cases were decided according to the theory of negligence. Negligence is behavior that results in an unintentional injury or causes unintentional harm. Product liability law has evolved, however, and most states have extended product liability into the category of strict liability tort, too. Strict liability torts involve actions that are inherently dangerous and for which a party may be liable no matter how carefully he or she (or it) performs those actions. Regardless of whether the product liability claim is based upon negligence or strict liability, a product liability claim results from either a design defect, a manufacturing defect, or a failure to warn. To better appreciate the issues involved in cases of strict liability, let’s return to where we left you and your summer house-painting business at the beginning of this module.
Having escaped the house-painting business relatively unscathed, you head back home to rethink your options for gainful employment during your summer vacation. You’ve stored your only remaining capital assets—the two ladders and the platform that you’d used for scaffolding—in your father’s garage. One afternoon, your uncle notices them.
Examining one of the ladders, he asks you how much weight it’s designed to hold, and you tell him what the department manager at Ladders ’n’ Things told you: three hundred pounds per rung. Sensing that he might want to buy them, you hasten to add that, although you got them at a cut-rate price because of a little rust, they’re virtually brand-new. As it turns out, your uncle doesn’t want to buy the ladders, but he does offer to pay you \$35 an hour to take them to his house and help him put up new roofing. He’s easygoing, he’s family, and he probably won’t sue you for anything, so you jump at the opportunity.
Everything goes smoothly until day two, when you’re working on the scaffolding two stories off the ground. In the process of unwrapping a bundle of shingles, one of the ladders buckles, and the entire platform comes down—landing you on your uncle’s stone patio with a cervical fracture.
Fortunately, there’s no damage to your spinal cord, but you’re in pain and you need surgery. Now it’s your turn to sue somebody. But whom? And for what?
Pursuing a Claim of Product Liability
Not surprising, your lawyer advises you to file an action for product liability—a claim of injury suffered because of a defective product (in your case, the ladder, of course). He goes on to say that in cases of product liability, there are three major bases for product liability claims. Section 2 of the Restatement (Third) of Torts: Products Liability identifies the following: manufacturing defect, design defect, failure to warn (also known as marketing defects). These are explained below:
• Manufacturing defects are those that occur in the manufacturing process and usually involve poor-quality materials or shoddy workmanship.
• Design defects occur where the product design is inherently dangerous or useless (and hence defective) no matter how carefully manufactured; this may be demonstrated either by showing that the product fails to satisfy ordinary consumer expectations as to what constitutes a safe product or that the risks of the product outweigh its benefits.
• Failure-to-warn defects arise in products that carry inherent non-obvious dangers that could be mitigated through adequate warnings to the user, and these dangers are present regardless of how well the product is manufactured and designed for its intended purpose.
In most states, these defects are not legal claims in and of themselves, but they are the grounds for the action (negligence or strict liability). For example, a plaintiff might plead negligent failure to warn or strict liability for defective design.
Grounds of Strict Liability
For the sake of argument, let’s say that your lawyer isn’t very confident about pursuing a claim of negligence against the manufacturer of your ladder. The company doesn’t appear to have been careless in any of the three forms prescribed by law, and it will in any case be difficult to demonstrate the elements required in negligence cases. He suggests instead that you proceed on grounds of strict liability.
In tort law, strict liability is the imposition of liability on a party without a finding of fault (such as negligence or tortious intent). The claimant need only prove that the tort occurred and that the defendant was responsible. The law imputes strict liability to situations it considers to be inherently dangerous. It discourages reckless behavior and needless loss by forcing potential defendants to take every possible precaution. It also has the effect of simplifying and thereby expediting court decisions in these cases. In short, strict liability is based on the following legal theories:
1. Certain products put people at risk of injury no matter how much care is taken to prevent injury.
2. Consumers should have some means of seeking compensation if they’re injured while using these products.
A classic example of strict liability is the owner of a tiger rehabilitation center. No matter how strong the tiger cages are, if an animal escapes and causes damage and injury, the owner is held liable. Another example is a contractor hiring a demolition subcontractor that lacks proper insurance. If the subcontractor makes a mistake, the contractor is strictly liable for any damage that occurs.
In strict liability situations, although the plaintiff does not have to prove fault, the defendant can raise a defense of “absence of fault”: that is, the defense can argue that the defect was the result of the plaintiff’s actions—not of the product—and that no inference of defect should be drawn solely because an accident occurs. On the other hand, if the plaintiff can prove that the defendant knew about the defect before the damages occurred, in some jurisdictions additional punitive damages can be awarded to the victim.
Compensatory and Punitive Damages
When someone pursues a claim under a tort, the goal (or legal remedy) is usually the award of damages. Damages in tort are generally awarded to restore the plaintiff to the position he or she was in had the tort not occurred.
In law, damages are an award, typically of money, to be paid to a person as compensation for loss or injury. Damages are classified as compensatory (or actual) damages and punitive damages. Compensatory damages are further categorized into special damages, which are economic losses such as loss of earnings, property damage, and medical expenses, and general damages, which are noneconomic damages such as pain and suffering and emotional distress.
Generally, punitive damages are not awarded in order to compensate the plaintiff but to reform or deter the defendant and similar persons from pursuing a course of action such as that which damaged the plaintiff. Punitive damages are awarded only in special cases where a defendant acted in a blatantly negligent, malicious, or grossly reckless manner.
In the case of Liebeck v. McDonald’s Restaurants (1994), for example, 79-year-old Stella Liebeck spilled McDonald’s coffee in her lap, which resulted in second- and third-degree burns on her thighs, buttocks, groin, and genitals. The burns were severe enough to require skin grafts. Liebeck attempted to have McDonald’s pay her \$20,000 medical bills as indemnity for the incident. McDonald’s refused, and Liebeck sued. During the case’s discovery process, internal documents from McDonald’s revealed that the company had received hundreds of similar complaints from customers claiming that McDonald’s coffee caused severe burns. At trial, this led the jury to find that McDonald’s knew their product was dangerous and injuring their customers and that the company had done nothing to correct the problem. The jury decided on \$200,000 in compensatory damages, but attributed 20 percent of the fault to Liebeck, reducing her compensation to \$160,000. The jury also awarded Liebeck \$2.7 million in punitive damages, which, at the time, represented two days’ of McDonald’s coffee sales revenue. The judge later reduced the punitive damages to \$480,000. The case is often criticized for the very high amount of damages the jury awarded.
The following videos also explain compensatory and punitive damages. | textbooks/biz/Business/Introductory_Business/Book%3A_Introduction_to_Business_(Lumen)/05%3A_Legal_Environment/5.04%3A_Tort_Law.txt |
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