The Cambridge International AS & A Level Business series consist of a Student’s Book,
Boost eBook, Skills Workbook and Teacher’s Resource Pack.
Cambridge
International AS &
A Level Business
Second Edition
9781398308114
Cambridge
International AS &
A Level Business
Second Edition
Boost eBook
9781398308206
Cambridge
International AS &
A Level Business
Skills Workbook
9781398308152
Cambridge
International AS &
A Level Business
Teacher’s Resource
Pack
9781398308138
To explore the entire series, visit www.hoddereducation.com/cambridge-alevel-Business
Practice and apply what you have studied and
develop independent learning skills by answering a
range of questions and activities that are clearly
linked to the content of the Student’s Book.
● Build confidence with extra practice to ensure that
a topic is thoroughly understood before moving on.
● Explore and analyse international businesses
through data response questions based on real
case studies.
● Keep track of your work with ready-to-go write-in
exercises.
● Answers can be found at
hoddereducation.com/cambridgeextras.
Save time marking and get support for delivering
the revised Cambridge International AS & A Level
Business syllabus (9609).
● Confidently deliver the revised syllabus with expert
author guidance and the subject specific skills
students will need, including how to interpret
quantitative data.
● Familiarise students with the command words and
improve their confidence with exam-style questions
including sample answers.
● Save time marking and assess student progress
with answers to all questions in the Student Book.
Cambridge
International AS & A Level
Business
Second edition
Malcolm Surridge
Andrew Gillespie
9781398308114.indb 1
05/03/21 11:06 AM
Acknowledgements
p.118 © Charlie Box/Dyson; p.131 © Courtesy of L’Oreal; p.262 © Abel, G. J. (2018). Estimates of global
bilateral migration flows by gender between 1960 and 2015. International Migration Review, 52(3), 809-852;
p.282 © Berkeley Earth. Retrieved from http://berkeleyearth.org/wp-content/uploads/2020/01/2019_Time_
Series.png; p.283 © Toshiba Corporation (2019). Environmental Report. Retrieved from https://www.toshiba.
co.jp/env/en/communication/report/pdf/env_report19_all_e.pdf; p.290 © Acha Leke, Mutsa Chironga, and
Georges Desvaux, Africa’s overlooked business revolution. McKinsey & Company. November 15, 2018. Retrieved
from https://www.mckinsey.com/featured-insights/middle-east-and-africa/africas-overlooked-businessrevolution; p.292 © Colgate-Palmolive Company. Retrieved from https://investor.colgatepalmolive.com/staticfiles/a65490ac-2442-41e3-8751-e18a1471bd92; p.472 © BP p.l.c. Energy with Purpose. BP Annual Report and
Form 20-F 2019. Retrieved from https://www.bp.com/content/dam/bp/business-sites/en/global/corporate/pdfs/
investors/bp-annual-report-and-form-20f-2019.pdf
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ISBN: 978 1 3983 0811 4
© Malcolm Surridge and Andrew Gillespie 2021
First edition published in 2014.
This edition published in 2021 by
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A catalogue record for this title is available from the British Library.
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Contents
Introduction
vii
AS LEVEL
1 Business and its environment
1.1
1.2
1.3
1.4
1.5
Enterprise
1
1.1.1 The nature of business activity
1.1.2 The role of entrepreneurs and intrapreneurs
1.1.3 Business plans
1
8
13
Business structure
16
1.2.1 Economic sectors
1.2.2 Business ownership
Size of business
1.3.1 Measurements of business size
1.3.2 Significance of small businesses
1.3.3 Business growth
Business objectives
1.4.1 Business objectives in the private sector and public sector
1.4.2 Objectives and business decisions
Stakeholders in a business
1.5.1 Business stakeholders
1.5.2 The relative importance and influence of stakeholders on
business activities
16
18
27
27
27
30
33
33
38
41
41
43
2 Human resource management
2.1
Human resource management
2.1.1
2.1.2
2.1.3
2.1.4
2.1.5
2.1.6
2.1.7
2.2
2.3
Purpose and roles of human resource management
Workforce planning
Recruitment and selection
Redundancy and dismissal
Morale and welfare
Training and development
Management and workforce relations
Motivation
2.2.1 Motivation as a tool for management and leadership
2.2.2 Human needs
2.2.3 Motivation theories
2.2.4 Motivation methods in practice
Management
2.3.1 Management and managers
47
47
48
50
54
56
59
62
66
66
66
68
76
83
83
3 Marketing
3.1
The nature of marketing
3.1.1 Role of marketing and its relationship with other
business activities
3.1.2 Demand and supply
3.1.3 Markets
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93
93
95
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Contents
3.1.4
3.1.5
3.1.6
3.1.7
3.2
3.3
Consumer and industrial marketing
Mass marketing and niche marketing
Market segmentation
Customer-relationship marketing
Market research
3.2.1 Purposes of market research
3.2.2 Primary research and secondary research
3.2.3 Sampling
3.2.4 Market research data
The marketing mix
3.3.1 Elements of the marketing mix
3.3.2 Products
3.3.3 Product portfolio analysis
3.3.4 Pricing methods
3.3.5 Promotion methods
3.3.6 Place (channels of distribution)
101
102
103
104
106
106
107
110
111
115
115
116
117
123
127
134
4 Operations management
4.1
The nature of operations
4.1.1
4.1.2
4.1.3
4.1.4
4.2
4.3
The transformational process
Efficiency, effectiveness, productivity and sustainability
Capital-intensive and labour-intensive operations
Operations methods: job, batch, flow, mass customisation
Inventory management
4.2.1 Managing inventory
4.2.2 Just in time
Capacity utilisation and outsourcing
4.3.1 Significance and measurement of capacity utilisation
4.3.2 Outsourcing
142
142
144
148
149
151
151
155
157
157
160
5 Finance and accounting
5.1
5.2
5.3
5.4
5.5
Business finance
5.1.1 The need for business finance
5.1.2 Working capital
Sources of finance
5.2.1 Business ownership and sources of finance
5.2.2 Internal and external sources of finance
5.2.3 Factors affecting sources of finance
5.2.4 Selecting the source of finance
Forecasting and managing cash flows
5.3.1 Cash-flow forecasts
Costs
5.4.1 Cost information
5.4.2 Approaches to costing
5.4.3 Uses of cost information
5.4.4 Break-even analysis
Budgets
5.5.1 The meaning and purpose of budgets
5.5.2 Variances
162
162
166
169
169
170
176
178
180
180
187
187
189
194
199
205
205
209
iv
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Contents
A LEVEL
6 Business and its environment
6.1
6.2
External influences on business activity
6.1.1 External influences on business activity: Political and legal
6.1.2 External influences on business activity: Economic
6.1.3 External influences on business activity: Social and
demographic
6.1.4 External influences on business activity: Technological
6.1.5 External influences on business activity: Competitors and
suppliers
6.1.6 External influences on business activity: International
6.1.7 External influences on business activity: Environmental
Business strategy
6.2.1 Developing business strategy
6.2.2 Corporate planning and implementation
214
214
227
255
266
271
274
281
287
287
304
7 Human resource management
7.1
Organisational structure
7.1.1
7.1.2
7.1.3
7.1.4
7.1.5
7.1.6
7.2
Business communication
7.2.1
7.2.2
7.2.3
7.2.4
7.2.5
7.3
7.4
Relationship between business objectives and structure
Types of structure
Delegation and accountability
Control, authority and trust
Centralisation and decentralisation
Line and staff
Purposes of communication
Methods of communication
Channels of communication
Barriers to communication
Role of management in facilitating communication
Leadership
7.3.1 Leadership
7.3.2 Theories of leadership
7.3.3 Emotional intelligence/emotional quotient
Human resource management strategy
7.4.1 Approaches to human resource management
7.4.2 Flexible workforces
7.4.3 Measurement, causes and consequences of poor employee
performance
7.4.4 Strategies for improving employee performance
7.4.5 Roles of IT and AI in human resource management
313
313
316
321
323
324
325
328
328
330
334
335
336
341
341
343
346
349
349
352
358
360
363
8 Marketing
8.1
Marketing analysis
8.1.1 Elasticity
8.1.2 Product development
8.1.3 Sales forecasting
366
366
371
375
v
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Contents
8.2
Marketing strategy
8.2.1 Planning the marketing strategy
8.2.2 Approaches to marketing strategy
8.2.3 Strategies for international marketing
383
383
384
387
9 Operations management
9.1 Location and scale
9.1.1
9.1.2
Location
Scale of operations
9.2 Quality management
9.2.1
9.2.2
Quality control and quality assurance
Benchmarking
9.3 Operations strategy
9.3.1
9.3.2
9.3.3
9.3.4
9.3.5
Operations decisions
Flexibility and innovation
Enterprise resource planning
Lean production
Operations planning
394
394
400
406
406
410
412
412
414
416
417
422
10 Finance and accounting
10.1 Financial statements
10.1.1
10.1.2
10.1.3
10.1.4
Statement of profit or loss
Statement of financial position
Inventory valuation
Depreciation
430
430
435
438
440
10.2 Analysis of published accounts
444
Liquidity ratios
Profitability ratios
Financial efficiency ratios
Gearing ratios
Investment ratios
445
448
450
452
453
10.2.1
10.2.2
10.2.3
10.2.4
10.2.5
10.3 Investment appraisal
10.3.1
10.3.2
10.3.3
10.3.4
The concept of investment appraisal
Basic methods
Discounted cash-flow methods
Investment appraisal decisions
10.4 Finance and accounting strategy
10.4.1 Using accounting data to enable strategic
decision-making
10.4.2 Using accounting data and ratio analysis in strategic
decision-making
457
457
458
460
462
467
467
471
Index
481
Photo credits
488
vi
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This book introduces you to Business. It has been written to
meet the requirements of the Cambridge International AS &
A Level Business syllabus (9609) for examination from 2023.
The syllabus (9609)
The Cambridge International AS & A Level Business syllabus
is based on five topics which are studied at both AS Level
and A Level. These are:
» Business and its environment
» Human resource management (HRM)
» Marketing
» Operations management
» Finance and accounting.
The AS section of the syllabus gives you the opportunity to
understand what happens inside businesses and introduces
you to key business terminology. It also looks at the four
internal functions of businesses providing an understanding
of how they operate and how businesses manage workforces,
research and satisfy customer needs, manage the process of
creating goods and services and manage their finances. You
are encouraged to consider the working of these internal
functions in different business contexts.
The A-Level material builds on AS content and is based around
the concept of strategy. It looks in detail at the external
influences on business activity and encourages you to take
account of what is happening in the real world. The syllabus
looks at ways in which businesses can develop, plan and
implement corporate strategies. It also covers the strategic
elements of the four business functions introduced at AS and
encourages you to think about these in business-wide contexts.
The features of the book
The book will guide you through the Cambridge International
AS & A Level Business programme of study, although you
should supplement it with research into businesses in your
own and other countries. You are fortunate that there is an
immense amount of information available about businesses,
their behaviour and the environments in which they operate.
The internet is an enormous and valuable resource and you
will also find that newspapers, magazines and television
contain a lot of relevant information. However, business
activity takes place around you all the time: when you
are shopping, travelling to and from school or college or
enjoying leisure activities such as visiting the cinema. There
are many opportunities for you to see the operation of some
of the models and theories you will study.
This textbook includes the following features:
Chapter overview
At the outset of each chapter there is guidance on the
material that is covered in the chapter. This shows the
knowledge that can be gained from studying this chapter.
The syllabus (9609)
Introduction
Glossary terms
These boxes contain descriptions of highlighted glossary
terms used throughout the book to help explain additional
concepts.
Handling data
This feature is designed to help to develop relevant
numerical skills such as conducting calculations and
interpreting numerical data.
Case study
There is a diverse range of case studies to illustrate how
theories and concepts operate in the real world. These all
have questions to help you to develop the skills needed in
preparation for your examinations.
Study tip
These appear throughout the book and are designed to help
you to understand the material that you have studied and to
prepare for your examinations.
Test your learning
At the end of each chapter there is a range of questions
and activities to help you to reinforce your learning and to
develop the necessary skills.
The key concepts
The syllabus is based on the six key concepts set out
below which should underpin your study of the subject
matter. Familiarity with these key concepts can help you to
understand the material in this resource and the syllabus,
and help you think about how these can be applied to
diverse business scenarios and questions.
As these concepts are an essential aspect of the syllabus,
they have been signposted throughout the textbook using
the associated icons. The syllabus definitions of these
key concepts can be found within the syllabus on the
Cambridge International website, but we discuss these
further here:
Change
All businesses are subject to change and have to respond to
it regularly and frequently. Change may be internal, perhaps
following the appointment of a new leader which could,
for example, result in a new organisational culture, new
methods of production and the targeting of new markets.
Alternatively, it may be external, perhaps as a consequence
of a change in the business environment; the UK’s recent
decision to leave the European Union is a prime example.
Managing change effectively contributes to business success.
vii
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Introduction
Context
Businesses operate in diverse contexts and these have a
major influence on decision-making. A decision that might be
appropriate and successful for a small family-owned business
facing a drop in sales may be entirely unsuitable for a large
multinational manufacturer facing the same problem. You
need to understand the importance and impact of context.
Decision-making
Change can create a need for decision-making. Decisions
can be taken by stakeholders within the business as well as
those outside of it. Decisions may be based on instinct or a
‘hunch’, or on the analysis of the available quantitative and
qualitative data. Decisions can be taken at different levels
within an organisation and may impact on part or all of it.
Enterprise
Enterprise is the ability to make new ideas work and thus
enables businesses to take advantages of opportunities that
may exist. Enterprise is not simply limited to start-ups; in a
changing world, enterprise is vital for competitiveness.
Innovation
Innovative businesses are more able to develop new products
or better ways of producing them. This helps to enhance
competitiveness and strengthen performance by leading
the field rather than being a more passive follower.
Strategy
A business’s strategy is its long-term plan to achieve its
objectives. Successful businesses are able to develop and
implement effective strategies through analysing the
business environment and the opportunities available and
making appropriate choices.
The structure of the AS- and
A-Level examinations
There are two examination papers for AS and two for A Level
Business. The subject content of AS Business is assumed
knowledge for the A-Level papers.
AS Level Paper 1: Business Concepts 1
• This paper carries a total of 40 marks and has a duration
of 1 hour 15 minutes.
• It tests the entire AS element of the syllabus.
• It comprises two sections:
• Section A contains four short answer questions. The
first three questions are split into two parts each.
• Section B contains two essay questions, one of
which must be answered. The essays are split into
two parts each.
• Section A and Section B each carry a maximum of
20 marks.
AS Level Paper 2: Business Concepts 2
• This paper carries a total of 60 marks and has a duration
of 1 hour 30 minutes.
• It tests the entire AS element of the syllabus.
• It comprises two data response questions which may be
based on text and numerical data. Each question is split
into six parts.
• Each of the two data response questions will carry a
maximum of 30 marks.
A Level Paper 3: Business Decision-Making
• This paper carries a total of 60 marks and has a duration
of 1 hour 45 minutes.
• It tests the entire A Level syllabus and builds on AS
knowledge and understanding.
• It is based on a case study which includes prose, tables
of data and numerical or diagrammatic appendices.
• The case study will normally have five questions
attached to it.
A Level Paper 4: Business Strategy
• This paper carries a total of 40 marks and has a duration
of 1 hour 15 minutes.
• It tests the entire A Level syllabus, and builds on AS
knowledge and understanding.
• It comprises two questions, each worth 20 marks, based
on a series of numerical and non-numerical data relating
to a case study.
The information in this section is based on the 9609 syllabus
for examination from 2023. You should always refer to the
appropriate syllabus document for the year of your examination
to confirm the details and for more information. The syllabus
document is available on the Cambridge International website
at http://www.cambridgeinternational.org.
Preparing for Business examinations
The Business syllabus requires you to understand the
relevant theories and concepts set out in the syllabus
and covered in this book. However, you will also need
to know how to organise ideas, construct arguments,
make decisions, solve problems, conduct calculations
and interpret data. Finally, it is important for you to
ensure you know how to apply your knowledge to business
scenarios, such as those set out in questions that relate to
data response materials or case studies.
This textbook contains numerous questions throughout, and
at the end of, each chapter which have been designed to
help you to develop these essential skills.
Malcolm Surridge & Andrew Gillespie
A note on the exam-style questions
Exam-style questions (and sample answers) have been
written by the authors. In examinations, the way marks
are awarded may be different. References to assessment
and/or assessment preparation are the publisher’s
interpretation of the syllabus requirements and may
not fully reflect the approach of Cambridge Assessment
International Education. Cambridge International
recommends that teachers consider using a range of
teaching and learning resources in preparing learners for
assessment, based on their own professional judgement of
their students’ needs. Third-party websites and resources
referred to in this publication have not been endorsed by
Cambridge Assessment International Education.
viii
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1 Business and its environment
AS LEVEL
1.1
Enterprise
1.1.1 The nature of business activity
Chapter overview
In this chapter we examine:
★ the nature and purpose of business activity; for example, we look at factors of production, the business environment,
what businesses do and the concept of adding value
★ the differences between local, national, international and multinational businesses
★ the role of the entrepreneur and intrapreneur; for example, we consider why entrepreneurs are important to the
economy, and barriers to entrepreneurship
★ business risk and uncertainty
★ business plans; for example, we consider the purpose of business plans, their key elements and their limitations.
1.1.1 The nature of business activity
The purpose of business activity
What will you do this weekend? Have you got a part-time
job to earn some money? Are you going to go out to a café
or go shopping in the town centre? Whatever you do, you
will come into contact with many different businesses,
either as a consumer buying and using their products or
as an employee working to create them. Businesses are
everywhere! Just think of the last time you went shopping
– the outlet where you shop is a business, it has bought
the products from a supplier, they were transported by
a delivery business and the firm probably uses another
business to help promote itself. In every transaction
between a customer and a business, many other businesses
will have been involved to bring about that exchange.
There are many different definitions of a business, but what
they tend to have in common is the idea of someone (or a
group of people) working in an organised way to achieve
a given target. Notice the key elements of this definition
– firstly, the activities of those involved are organised in
some way and, secondly, the business is created with a
specific purpose in mind: often the business objective
is profit but, as we shall see later, there are many other
reasons why people set up in business. Using a definition of
organised activities and a given target, many organisations
such as hospitals and even schools could be classified as
businesses. They may not have profit as a target, but they
do involve many different people working together, planning
and organising what they do in order to achieve targets,
such as helping people get better more quickly or improving
the quality of students’ education.
The transformation process
All businesses are involved in the transformation process.
They take inputs and transform them in some way to
produce outputs that they hope consumers will want.
INPUTS
• land
• labour
• capital
• enterprise
TRANSFORMATION
PROCESS
CREATES VALUE
OUTPUTS
• goods
• services
• by-products
FEEDBACK
▲ Figure 1.1 The transformation process
Inputs
The inputs into a business are also called the factors of
production. These are:
» land
» labour
» capital
» enterprise.
GLOSSARY TERMS
Business objectives are measurable targets set by the
business, such as sales or profits that have to be achieved
within a given time period.
The factors of production are the inputs into the
transformation process of a business; namely land, labour,
capital and enterprise.
The transformation process involves converting inputs into
outputs.
1
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Land
AS LEVEL 1.1 Enterprise
1.1
This involves choosing the location of the business. This is
critically important for businesses such as shops and cafés.
For other businesses such as farming, what will matter
is the quality of the land in terms of the ability to grow
different crops or rear livestock. The success of a farming
business will be directly affected by changes to the quality
of the land and the weather. For some businesses, what will
matter is access to resources; for example, oil drilling and
mining businesses need to be near the natural resources.
The significance of land as an input will be particularly high
in the primary sector.
Under the heading of land we also include premises.
The amount of space available to a business can affect
how much can be produced or how many customers can
physically fit in the restaurant or store. The nature of the
premises can also affect the working environment and
people’s motivation. For example, working in a modern
office with a good canteen, parking spaces and a central
location might be appealing to employees.
GLOSSARY TERM
The primary sector is the first stage of production and
includes extracting or growing resources. Farming,
mining and fishing are all part of the primary sector.
Labour
Organisations will need staff. The quality of employees
in terms of their skills, their attitudes (for example, to
customers), their willingness to work and their natural
abilities will have an influence on the success of any
business. What makes a film a great success? The quality of
the writing, the acting and the production – people play
a key role in the success of any film. Many films therefore
promote themselves on the basis of who the actors are or
who the director is. Similarly, universities promote their
professors. Music labels promote their bands. Publishers
promote their author list. So people can be a crucial
element of the transformation process.
Capital
The word ‘capital’ has many meanings. In this instance,
we mean the equipment used by businesses. The coffee
machines in the coffee shop, the ovens in the fast-food
restaurants, and the scanning equipment in shops are all
examples of capital equipment. The amount and quality of
the capital equipment in a business can affect the service it
provides. For example, the online retailer Amazon is admired
for the efficiency with which it processes an order and is
able to make suggestions to customers of what else they
might like to buy. These rely on the quality of Amazon’s
warehousing facilities and computer programs.
Enterprise
Enterprise refers to a set of skills that develops new ways
of doing things or new things to do. Enterprise refers to the
ability to be creative and innovative, to come up with new
ideas, to combine resources in different ways and to be willing
to take risks. Enterprise brings together the other factors of
production to create and make a business idea competitive.
The choice of inputs
The choice of inputs into the business and who supplies
them can affect:
» the costs of a business
» the quality of the final product (and therefore sales).
In recent years, customers have become increasingly
interested in what resources are used in a production
process and where they have come from. Firms may
highlight the fact that they use recycled materials, that
their supplies come from local businesses or that their
ingredients are ‘natural’ or ‘organic’.
Firms will also face the choice of whether to buy in some
materials or produce them themselves. Tyrrells uses the fact
that it grows its own potatoes when it promotes its potato
crisp products. Most other crisp manufacturers buy in their
potatoes.
Outputs
The output of a business is a product. A product may be a
good or a service, or a combination of the two.
» A good (or a product) is a tangible physical item, such
as a car or a laptop computer. Businesses can produce
and stock them. This means that they can produce or
purchase the goods that they sell in advance of demand;
for example, a store may stockpile new electrical goods
before a busy selling period.
» A service is intangible. Examples of services
are education, creating music, hairdressing and
physiotherapy. Most businesses in more developed
economies are in the service sector. Services cannot be
stored; they have to be produced for customers as they
are needed. This can create problems, because if there is
a rush of customers, there are no products stockpiled and
so queues form or waiting lists have to be introduced.
In many cases, a business provides a combination of goods
and services. For example, you may choose a restaurant
because of the food you can eat there (the goods) but also
because of the waiters, the environment and the way you
are treated (the service).
Most outputs are intended for sale. A firm produces
goods and services to sell to customers. However, there
may also be by-products from the transformation process;
for example, a firm’s production may create waste and
pollution. Many customers pay attention to these issues
and, increasingly, firms are considering the effects
of their production on other groups, such as the local
community. Some by-products may also form the inputs
to other industries.
For most products there is a series of stages in the
transformation process which are involved in taking the
initial materials and ending up with the final product. The
author JK Rowling took her imagination and a computer
and turned her ideas into magical manuscripts for her Harry
Potter books. The publishing company worked with the
author, designers, editors, a marketing team, a printing
business and a distribution business and turned the
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CASE STUDY
1.1
Dabbawalla
1.1.1 The nature of business activity
a ‘doer of something’ and a ‘dabba’ is a stainless steel
lunchbox. The lunchbox is picked up from the customer’s
home and taken to a sorting station. The lunchboxes are
then divided up according to destination and delivered
on bike, on foot or taken on the train. After lunch, the
box is collected and taken back to the customer’s home.
This is an incredibly efficient but very labour-intensive
and low-technology process, with almost no boxes going
missing or to the wrong address. The price is so low that it
is easier to pay for the delivery than to take your lunchbox
with you on your journey to and from work.
Questions
1
▲ Figure 1.2 A busy dabbawalla delivery in Mumbai
Every day in Mumbai, India, around 250 000 people get
their lunches delivered by ‘dabbawallas’. A ‘walla’ means
manuscripts into a series of books. Bookstores take a range
of books and transform them into a retail experience for the
customer. A series of transformations has gone on to get
the idea from the author’s mind into a book and into the
hands of the reader.
Managing the
inputs
Managing the
transformation
process
Managing the
outputs
TRANSFORMATION
INPUTS
OUTPUTS
PROCESS
FEEDBACK
▲ Figure 1.3 Chain of operations
Businesses need to identify exactly what they want to
provide in terms of the range and quality of products they
offer. For example, do they want to specialise in a few types
of items or provide a wide range of goods and services?
Businesses also need to decide on the resources they will
need in order to provide the product to the standard they
want for their customers. There are a number of questions
involved here: How many people are needed? What skills are
needed? Will they be trained? What materials will be used?
What equipment? And so on. Businesses need to find a way of
generating a product that customers value so much that they
will pay more for it than it costs the business to produce.
Adding value
Adding value occurs in a transformation process when
outputs are produced that are worth more than the inputs
brought in to provide them.
2
Explain one way in which the dabbawallas transform
[3]
inputs into outputs.
Evaluate how you would measure the success of
[12]
this transformation process.
For example, artists such as Andy Warhol, Vincent van Gogh,
David Hockney and Rembrandt took their imagination, paint
and canvas and produced amazing works of art that now
sell for millions of dollars: far more than the cost of the
items used up in their production. They added value via the
transformation process.
Jamie Oliver, a famous chef, takes standard ingredients
such as meat, herbs and vegetables, puts them together in
a unique way and comes up with a fantastic meal. He takes
ingredients that many others may use but transforms them
in a way that appeals to customers, sells books and attracts
viewers for his TV series. Clearly, he has added value by
using his talent, creativity and personality.
GLOSSARY TERM
Adding value occurs in a transformation process when
outputs are produced that are worth more than the inputs
brought in to provide them.
Adding value can be done in ways that may seem odd to
some. Here are some examples:
» Some companies buy new jeans and then stretch
them, batter them and fray them to make them look
distressed while, at the same time, more than doubling
their price.
» Bottled water that sells for $10 a bottle comes from
King Island, near Tasmania. It is called ‘Cloud Juice’ and
is claimed to be the purest in the world. It is rainwater
that has been collected from a plastic roof and then
bottled. It is supposed to be so pure because it comes
from rain clouds that travel 7000 miles from South
America without passing over any land, and therefore
not encountering pollution.
» One of the most expensive coffees in the world is
Luwak Coffee. This is made from coffee cherries that
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1.1
the brand or developing a unique selling proposition
(USP). A USP is a feature of the product that makes it
different from competitors’ products for the customer; for
example, a product may be perceived as better quality,
better designed, more reliable or more user-friendly than
competitors’ products.
have been eaten and digested by common palm
civets (a type of animal). The civets use their keen
sense of smell to select the choicest and ripest beans.
The beans are supposed to be much sweeter as a
result of the digestion process and, having passed
through the animal, they are hand-collected from the
jungle floor.
To increase the value it adds, a business might aim to:
STUDY TIP
cutting back on waste, ensuring the best price for the
supplies and making sure that mistakes are not made. All
activities that do not create value need to be examined
to see if they are truly necessary.
» increase the perceived benefit of the product in the
eyes of the customer. This could be through building
When answering questions, you may need to think about
how different firms create value. What can businesses do
to add more value? Should they focus on the benefits they
are providing, or try to control costs more effectively?
AS LEVEL 1.1 Enterprise
» reduce the costs of producing the product. This means
CASE STUDY
FedEx
FedEx connects people with goods, services, ideas
and technologies. By doing this, FedEx says it creates
opportunities that drive innovation, energise businesses
and help communities improve their standard of living.
FedEx says it does far more than deliver packages. It says
it delivers joy in the holidays, provides hope to survivors
of natural disasters and solves business problems. Its
network extends to over 220 countries and territories.
Its 490 000 team members are united behind the FedEx
promise to ‘make every FedEx experience outstanding’.
FedEx has over 180 000 vehicles and nearly 680 planes. It
delivers over 15 million packages on an average day and
deals with over 250 requests linked to package tracking
each day.
Source: www.fedex.com/en-us/about/company-structure.html
Question
1
Explain one way in which FedEx can add value in its
transformation process.
[3]
CASE STUDY
IKEA
IKEA is a furniture producer and retailer. The value chain
of a product describes all the stages of operations, from
the initial raw materials through to the sale of the actual
goods. In IKEA’s case, it owns and manages nearly all the
stages of its value chain. IKEA says that the starting point
for any value chain is the product itself, and the idea for
this starts with ‘listening to people’s needs and dreams,
so we understand how we can make a difference’.
Typically, IKEA turns this initial idea based on customers’
needs into a sketch of how the product might look. This
sketch is then discussed with its suppliers, who consider
how it might be made, transported and stored in-store.
IKEA will be looking for ways of producing a product with
a high-quality design and finish while keeping costs low.
IKEA is always trying to improve the product at each stage
of discussion and review. Improvements are welcomed
from the various people involved in production; for
example, designers and technicians. One such suggestion
might be using a more sustainable material.
Listen to
customers
Sell
Package and
distribute to
stores
Design and
create
the product
Manufacture
the product
▲ Figure 1.4 The value chain of a product
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Much of IKEA’s furniture is produced and packaged in the
form of a flat-pack, which lowers transport costs because
it is easy to put large quantities on lorries and on shelves
in-store. This helps keep prices low for IKEA’s customers,
who then take the products home and build the products
themselves. Collaboration between customers, partners
and co-workers aids IKEA’s pursuit ‘to add value to
people’s everyday lives’ by producing good-quality
furniture at low prices.
Questions
1
2
Analyse one way in which IKEA adds value in its
transformation process.
[4]
Evaluate the importance of the customer in IKEA’s
value chain.
[12]
1.1
GLOSSARY TERMS
A brand is a name, design, logo, symbol or indeed anything
that makes a product recognisable and distinguishes it
from the competition in the eyes of the customer.
Market forces are the forces of supply and demand which
determine the price of a product and the quantity bought
and sold in a market.
Opportunity cost measures the sacrifice made by
choosing one option in terms of the next best alternative
foregone.
Businesses and economic activity
Businesses make up an important part of any economy.
They are important because they employ people, they pay
employees’ wages and salaries and they provide goods
and services. Businesses provide the products we buy and
give us the jobs and earnings we need to buy them. When
businesses are doing well and expanding they employ
more people and generate more income for the economy.
Businesses innovate to win more customers: they create
new goods and services and this can improve the quality
of our lives, by providing better food, better clothes
and better electronic goods. Businesses therefore drive
economies forward, and this is why governments are eager
to help new firms start up and compete, and why they often
try to help businesses grow.
Choice and opportunity cost
In any economy there is a fixed amount of resources at any
moment and therefore decisions have to be made about how
these resources are used. Given the scarcity of resources,
choices are inevitable in terms of what should be produced
in the economy, how these products should be produced and
who should receive them. Some of these decisions will be
made by market forces of supply and demand: it will be the
result of bargaining between consumers and businesses. If,
for example, demand for a particular product increases, this
will encourage businesses to use their resources to produce
this instead of something else. Imagine you were a farmer
and had limited land. You have to decide what to grow on
it. This will depend in part on demand: if the demand for a
particular crop increases, you may switch to this and away
from something less in demand.
Some decisions about what to produce and how to produce
may be made by the government. For example, the
1.1.1 The nature of business activity
Source: https://about.ikea.com/en/about-us/the-ikea-value-chain
government may provide some or all of the health services,
the transport system, the police or the education system in
a country.
Governments tend to take control of goods and services
they think are vital to their economy and where they want
to ensure access for most people.
However, whenever decisions are made about what
to produce – whether it be the free market or the
government – it will involve an opportunity cost. Given
that resources are limited, if they are used to produce
more of one item, then this is at the expense of something
else. Opportunity cost measures the sacrifice you make if
you choose one course of action in terms of the next best
alternative. For example, if a business decides to use its
labour force to increase output of soft drinks, then the
opportunity cost is what could have been produced if the
labour force had been used to produce something different.
Whenever a business makes a decision it should consider the
opportunity cost. A project that earns a profit of $100 000
may seem attractive, but if the resources could have been
used to earn $250 000 it is not so appealing. When judging
the success of a business you should also consider the
opportunity cost. If Walmart, the huge US retailer, made
a profit of $10 million, this would not be that impressive
given the people, stores and equipment it has; these
resources could be used elsewhere to earn more than that.
Walmart’s profit before tax in 2020 was actually over $20
billion, so you can see why its investors wouldn’t be very
happy it if only made $10 million!
The dynamic business environment
Businesses do not operate in isolation. Whatever they do
is linked to what other businesses do; for example, their
suppliers, the firms that distribute and promote their
products, the banks that lend them money. They are also
affected by many other external factors such as:
» Political and legal issues For example, new laws by
a government can prevent the way some products are
promoted (such as cigarettes) and can affect the way
employees must be treated and the way a business
produces (perhaps to reduce its environmental impact).
» Economic issues For example, the amount of income
in an economy can change over a period of time,
affecting demand; the value of one currency in terms
of another can alter, affecting the cost of importing
supplies; and the cost of borrowing can go up,
increasing costs.
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» Social issues For example, an increase in the size of the
1.1
population or the average age of the population in a
country can affect the level of demand and the types of
products people buy.
» Technological issues For example, changes in the
availability and speed of the internet can make it easier
to find suppliers and sell across the world.
AS LEVEL 1.1 Enterprise
These external factors (known as PEST – political, economic,
social and technological) will continually be changing and
this will affect what businesses produce and the resources
they use. These factors can all have an impact on a business,
as shown in Figure 1.5. External factors can affect:
» the demand for products
» the costs and availability of inputs
» the nature of the transformation process.
and, if necessary, managers will need to change some of
their decisions about inputs, the transformation process or
the outputs they produce accordingly.
Economic
Social
Political
Technological
Business
▲ Figure 1.5 External influences on a business
STUDY TIP
If labour costs in one country become more expensive, for
example, businesses might switch production to another
country or start to use more machinery instead. If a
government signs a treaty with another country to make
trade easier, its businesses might start to sell more to
customers in the new partner country. New laws may make
certain products or production techniques impossible.
Businesses therefore need to monitor their external
business environment because it is dynamic (ever-changing)
Remember that the key external factors in the
environment of a business will vary between industries.
In the health sector, demographics may be very
significant; in the computer sector, technological changes
may be critical. You need to assess the key issues for any
given industry.
CASE STUDY
Lockdown
In 2020, the Coronavirus (COVID-19) pandemic affected
countries all over the world. Governments reacted in
different ways, but in many countries shops were forced
to close and people were ‘locked down’ at home for
several weeks. Many businesses such as restaurants
simply could not operate at all. Others such as food shops
were forced to change the way they operated to ensure
that people kept a suitable distance from each other. A
limited number of people would be allowed in shops and,
once inside, they could not get too close to each other.
Staff were often serving behind screens. In the first few
What does a business need to do
to succeed?
To succeed, a business needs to be more competitive than
its rivals. This means it needs to provide better value for
money. Its ability to achieve this depends on:
» the benefits it offers. For example, what does its
product do relative to those of its competitors? Is it
faster? Easier to use? Smaller? Bigger? Longer lasting?
» what price is being charged relative to the competition.
Businesses will aim to outperform their rivals by offering
the same benefits for less, or more benefits for the
same price. The difficult part is deciding what it is that
customers actually regard as a benefit, working out how
to provide them and somehow doing this more cheaply
than competitors, or finding additional benefits without
increasing the price. How businesses try to do this is
weeks of lockdown, there was often panic-buying, with
products such as hand sanitiser, toilet rolls and some
food products in high demand. When lockdown was over
there were concerns over how well economies would
recover. Businesses had closed down and people had lost
their jobs.
Questions
1
Evaluate the possible effects of the COVID-19 pandemic
on the transformation process of retail stores.
[12]
examined in the rest of this book. Even if a business does
manage to become competitive, it cannot afford to be
complacent because competitors will soon follow its lead;
this means it needs to keep improving and seeking ways of
becoming more competitive. Many once-famous businesses
have now disappeared and those that are still successful can
only stay that way by constantly improving.
STUDY TIP
Remember that businesses often compete in different
ways. Some may offer premium products and be able to
justify high prices. Others may offer more basic products
at low prices. An important thing to think about is how
sustainable this approach is in the long term – will others
be able to imitate the idea easily or can the business
protect its success?
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Why do businesses fail?
In fact, many businesses fail early on in their life. This is
because:
» the people managing them may not have had much
experience of business. Often people who start up a
business have an interest in a product but have not
necessarily run a business before. They may be good at
making things, for example, but not so good at dealing
with customers or managing money. It may also be
difficult to recruit experienced staff to join the business
because they may want the security of a bigger business
that has been around for longer and has a track record
of success. This means that those making the business
decisions may not be very good at it.
» new businesses do not have much market power, which
can make it difficult to survive. For example, suppliers
may be worried whether they will be paid and demand
payment in advance, which can cause cash-flow
problems. Meanwhile, buyers may have a lot of power.
Imagine being a new small supplier trying to sell to a big
supermarket. The buyer (the supermarket) may push the
price down and be slow to pay, causing further financial
problems for the new business. Given its lack of power,
it may have to pay more for supplies and advertising
than more established businesses, making it difficult to
compete on price.
HANDLING DATA
Imagine 60 per cent of new businesses in a country fail
in the first two years. Of those that survive, another 40
per cent fail in the next three years.
Imagine 400 000 businesses start up in one year; how
many would you expect to be left after five years?
Local, national, international and
multinational businesses
1.1
The scope of business activity can vary significantly. Some
businesses operate very much within a local market; for
example, a local hairdresser or local café. Their customers
will come from the local area. The success of these
businesses will be affected by the number of potential
customers in the local area and their spending power. A
shop in a rural area, for example, may struggle to attract
enough customers. Local laws introduced by the city or
town will affect what the business can do.
1.1.1 The nature of business activity
Businesses fail when they stop being competitive. This
means that they stop providing good value for money
relative to their competitors. This can be due to external
reasons (perhaps they have a high level of borrowing and
so their costs are hit badly when the cost of borrowing
rises) or internal reasons (such as poor training of staff
leading to poor customer service). Businesses fail when
they end up providing relatively low benefits given the
price they charge. This can be because of their choice of
inputs, their choice of outputs or the way they manage the
transformation process. We hope that reading this book
will help you avoid some of these problems if you decide
to manage a business. Having said that, while many of
the problems of business are avoidable, some – such as an
earthquake – may be more difficult to plan for!
Other businesses may have more of a national market. There
may be a national bus company offering routes within the
country or a national energy business. In this case, the
business has a wider customer base that may be based
all over the country. These businesses will be affected by
national laws and by decisions of the national government.
For example, changes in national government spending may
affect demand for products.
In other instances, businesses may operate around the
world. These businesses are international – they export
products to other countries. These businesses will be
affected by changes in the value of their currency compared
to other currency (this is known as the exchange rate) and
by trading agreements between countries. For example,
national governments may sign a treaty making it easier
to sell products in each other’s countries. By becoming
an international business, an organisation may have more
places to find the best suppliers and resources; this can
allow it to access better quality supplies are a lower price.
Going international means a business may also have more
markets to sell to; this can lead to faster growth and reduce
the risk of being dependent on one market. In recent
years there has tended to be more co-operation between
countries, making it easier to be an international business.
This has also been helped by better communications and
better transport systems.
If businesses have bases abroad (for example, they have
shops or factories in other countries) they are known as a
multinational. Whereas international businesses trade with
or buy from other countries, multinationals actually have
production bases or offices in these other countries. This
means multinationals can benefit from incentives (such as
subsidies) provided by other governments to locate there.
It also means the business is closer to its market, which
may mean it understands it better. In some cases, there are
limits to the products coming from abroad into a country, or
a tax is placed on them which makes them more expensive;
by being based within a country these restrictions can be
overcome. Another benefit of being multinational is that it
spreads risk by having bases in different countries. If there
is a problem with production in one country – for example,
due to a natural disaster – production may be switched to
the other location.
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1.1
1.1.2 The role of entrepreneurs
and intrapreneurs
Entrepreneurs
AS LEVEL 1.1 Enterprise
An entrepreneur is someone who is willing to take a
risk to start a new project or a new business. Enterprise
refers to the skills needed to do this, such as creativity.
An entrepreneur has an idea and then tries to make it
work. Entrepreneurs see the resources that are available
and the possibilities of combining them in a particular
way to provide a product or service. Entrepreneurs create
new businesses and in so doing provide new products and
services. Some entrepreneurs, such as Sir Richard Branson
of Virgin and Stelios Haji-Ioannou of easyGroup, continually
have ideas for new businesses and set up many different
ones during their careers. Such people are called ‘serial
entrepreneurs’.
GLOSSARY TERMS
Entrepreneurs are individuals who take the risk to create
or start a new business or project.
According to the Royal Bank of Scotland (RBS) a successful
entrepreneur is usually:
» well-rounded Someone who can make the product,
promote it, sell it and count the money
» able to bounce back A person who can cope with
mistakes and have the confidence to try again
» innovative Not an ‘inventor’ in the traditional sense,
but a person who is able to carve out a new niche in the
market, often a niche that is invisible to others
» results-oriented To make a business successful requires
a drive that only comes from setting goals and targets
and getting pleasure from achieving them
» a professional risk-taker To succeed means taking
measured risks. Often, successful entrepreneurs use
a step-by-step approach to risk-taking, at each stage
exposing themselves to only a measured amount of
personal risk and moving from one stage to the next
only as each decision is proved
» totally committed Hard work, energy and singlemindedness are essential elements in the entrepreneurial
profile.
CASE STUDY
Enterprise is the skill needed to make a new idea work.
What qualities is an entrepreneur likely
to need for success?
There is no single set of qualities that has been identified
that will definitely make someone a successful entrepreneur.
Entrepreneurs can differ enormously in terms of their
backgrounds, skills, interests and personalities. However, it
is likely that a successful entrepreneur is someone who:
» is prepared to work very hard, especially in the initial
stages of setting up the business. This means you need
determination and the ability to cope with stress and
setbacks
» has a vision. Many entrepreneurs have stories about
the various problems they encountered when they first
started up. Problems with money, suppliers, equipment
and so on are all fairly common. It is also quite usual
for others around you to be more cautious and less
certain that your project will work than you are. To be
successful, you need faith in your idea and a belief in
your own vision, even when there are initial problems
» is willing to take a risk. It takes a lot of nerve to give up
your existing job and start out on your own and yet this
is what many people do. You may have to give up the
salary, the company car, the support from head office and
the pension just to pursue your dream. You may also have
to go through quite a long period of time with relatively
low rewards before you make it a success (if you ever do!).
Hirka
In 2017, an entrepreneur in Indonesia started a business
that turned scraps of skin from chicken feet into leather,
which is then made into shoes. These ‘chicken’ shoes
are marketed as alternatives to ones made from reptile
skin, such as snake and crocodile, as ‘reptile’ shoes
have been increasingly criticised by customers and
animal rights supporters. The ‘chicken’ shoes do not
rely on breeding animals for purpose, as they are made
from scraps and waste material that comes from dimsum and fast-food restaurants.
The transformation process that turns these inputs
into shoes begins by dyeing the chicken skins and then
sewing pieces together. It takes about 10 days and up to
45 chicken feet to make a single pair of shoes. The
business employs six people.
Hirka’s most popular style of shoes are sneakers, and
the company makes only 70 pairs per month to ensure
quality is kept high. These sell for Rp500 000 ($31) and
above.
Questions
1
2
Explain one reason why someone might set up in
business for themselves.
[3]
Evaluate the factors that might determine the
success of this shoe business.
[12]
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Why become an entrepreneur?
someone else then the rewards belong to them. You may
work very hard and very successfully and get a bonus,
but the major rewards will usually go to the owners. If
you are an entrepreneur, you are the owner and so any
rewards belong to you. The downside is that if anything
goes wrong, the losses are yours as well.
» You have more control of what you do and when you do
it compared to working for someone else. Many people
become self-employed because of a desire for more
flexible working and an improved balance between work
and their social lives.
1.1
1.1.2 The role of entrepreneurs and intrapreneurs
There are many attractions to being an entrepreneur:
» You will experience a great feeling of satisfaction if your
idea is successful. Imagine being able to look at a large
business and know that you created it and helped it to
grow.
» You will be your own boss. Fed up with being told what
to do? Dislike orders? Then being an entrepreneur may
be the way forward. Setting up on your own means it
is your business, to do with as you wish. This can be
challenging and demanding but it does mean you are
more in control of your own destiny. Some people prefer
this to working for others: they like their independence.
» You keep the rewards. If you work in a business for
CASE STUDY
Awfully Chocolate
year. As people not from the baking industry, they tried
innovative methods to create a recipe they loved – and
Awfully Chocolate was born.
The first Awfully Chocolate store opened in 1998 in Katong
in Singapore, in an old side street. It offered only one type
of chocolate cake for sale. It was also unconventional
in that the cake was not displayed, so the store did not
look like a typical cake shop. This enhanced the quirky
character of how Awfully Chocolate made its mark.
Friends and family thought the business would not
last three months and even her supplier warned her
about over-ordering boxes. But Awfully Chocolate
gained a reputation for delicious handmade chocolate
cakes and quirky design, and demand proved high.
Cakes sold out every day and its reputation grew
beyond Singapore.
But Lyn wanted Awfully Chocolate to grow on its own
slowly, so she only opened her second store in 2004,
using the profits from her first shop. Awfully Chocolate’s
products now include more cakes, tarts, ice cream and
truffles. It also owns the brands Everything with Fries,
Sinpopo and Ninethirty by Awfully Chocolate, and now has
17 stores across Asia.
Lyn says that ‘every city has got its own bit of character,
bit of personality, its own quirks’, so you need to
understand these to make it work.
▲ Figure 1.6 Lyn Lee
Living in Singapore – a very cosmopolitan city – Lyn
Lee was amazed that she could not find a simple dark
chocolate cake! Most chocolate cakes in the market were
either too sweet and creamy or not chocolatey enough.
So she decided to set up a business to make the perfect
everyday chocolate cake – soft, moist, very chocolatey
but not too sweet or creamy. With some friends, she tried
different recipes and techniques every weekend for a
According to Lyn, although people say the success is due
to luck, it’s actually due mainly to hard work!
Source: www.bbc.co.uk/news/business-11701575
Questions
1
2
Analyse one reason why demand for Awfully
Chocolate’s products may have been high.
[4]
Evaluate whether the success of a new product is
likely to be mainly due to luck.
[12]
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AS LEVEL 1.1 Enterprise
1.1
CASE STUDY
Government regulations
Governments regulate businesses to protect different
groups. For example, laws may be introduced to prevent
employees from being exploited, to protect customers
from unsafe products and to protect businesses
from other businesses using unfair tactics. However,
regulations can make it more difficult to set up and run
a business, which can deter entrepreneurs or make it
difficult to do business. This can lead to entrepreneurs
not starting up a business or doing so in another
country. In Uruguay, for example, entrepreneurs have
to deposit a significant sum of money in the bank and a
new business has to pay many taxes.
Questions
1
2
Explain one reason why people want to set up in
[3]
business.
Evaluate the problems that regulations can play
in determining the success of a new business. [12]
The role of intrapreneurs
An intrapreneur is an entrepreneur within an existing
business. As businesses get bigger, they often worry that
they lose some of the creativity and risk-taking that they
had when they first started. The danger is that to control
a larger business, the managers introduce many rules and
policies which potentially limit innovation.
Intrapreneurship occurs when the business encourages
people within the organisation to think and act like
entrepreneurs. The business wants existing staff to challenge
the way things are done, to question whether there are
better ways of doing what they do and to take business
risks; they want intrapreneurs. The aim is to keep established
businesses moving forwards, being flexible and keeping
ahead of competitors. To help people be intrapreneurs, the
business needs to empower them to make decisions and give
them the resources they need to try things out. The business
needs to encourage an approach where it is perfectly
acceptable to try and fail in order to ensure that employees
are willing to take risks. Intrapreneurship can be critical to
the ongoing success of a business.
Entrepreneurs and intrapreneurs create change and
challenge the way things are done. They find and create new
markets, generate income and employment and bring about
innovation. They are extremely important to the growth
of an economy and to improving the quality and range of
goods and services on offer.
GLOSSARY TERM
Intrapreneurs are people within an established business
who think and act like entrepreneurs.
Barriers to entrepreneurship
Entrepreneurship may be limited in a country because of a
number of factors:
» The financial system may not be good at supporting
start-up businesses. Banks, for example, might think
starts-ups are too risky and avoid them, or make it
difficult and expensive for them to borrow.
» There may be many different regulations involved in
setting up a business, which discourage people from
doing this or make it complex and slow to do.
» The culture in the country may not favour entrepreneurs;
failure may not be accepted socially and those who do
fail may find it difficult to find financial backers when
they want to start a second venture.
» The government may prefer state provision and not
want to encourage entrepreneurs; there might be some
goods or services that have to be provided by the
government.
CASE STUDY
Ease of starting up
The Doing Business Index produced by the World Bank
measures the number of procedures, such as the time
and cost, involved for a small to medium-sized company to
start up and formally operate in each economy’s largest
business city.
The table below shows the data for the top five and bottom
five countries identified in May 2019. The top five are
the countries where it is easiest to do business and the
bottom five are the countries where it is most difficult to
do business.
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▼ Table 1.1 Ease of doing business by country
Location
Starting a business rank
Starting a business score
New Zealand
1
100
Georgia
2
99.6
Canada
3
98.2
Singapore
4
98.2
Hong Kong, China
98.2
186
52.5
Cambodia
187
52.4
Somalia
188
46.0
Haiti
189
36.4
Venezuela
190
25.0
Source: www.doingbusiness.org/en/rankings
Questions
1
Explain one factor that might influence the ease of
doing business in a country.
[3]
Business risk and uncertainty
Uncertainty is a feature of business life. Businesses have to
make decisions based on what they know and, in many cases,
their best estimate of a situation. Decision-making is often
focused on preparing for the future and, obviously, we do
not know exactly what is going to happen then. Businesses
can look at what is happening now, what has happened in
the past and they can research what different scenarios
might look like in the future, but they will not know with
100 per cent certainty. This means decisions will involve a
risk. Risk occurs when there is a danger that the outcomes
will be unfavourable. Businesses will want to assess the risk
and, where they can, take actions to reduce the risk.
Entrepreneurs are people who are prepared to take risks
to start up and develop a business. They are investing
time, money and effort into a new project that may or may
not work. The danger is that it will not work and all their
investment will be lost. Many new businesses fail. Look at
the main shopping street in your nearest village or town.
How long have the shops been there? Have some opened
up recently? Have some closed down in the last year? The
landscape of the centre of most towns is changing all the
time as some business ideas fail and others rise to take
their place. The real risk to entrepreneurs is that they will
lose much or even everything they have put into a project
because the business idea eventually fails.
Some of the causes of risk are external. For example, there
could be a change in the economy, meaning people have
less money to spend than entrepreneurs had expected (and
so demand for their products is lower than they hoped), or
competitors may have changed their behaviour, making it
more difficult for similar businesses to survive.
Alternatively, the causes of risk could be internal. It may be
that an entrepreneur’s understanding of the market is not as
good as they had thought and they make some bad pricing
decisions. It may be that their judgement of people is poor
2
Evaluate the implications of the data above if you
were going to set up a business abroad.
[12]
and they hire the wrong people, with the result that the
quality of service is not as good as hoped.
Entrepreneurs may sometimes undertake a project ‘because
it is there to be done’. They may be driven by a desire to
do something new. This in itself may be a reward in terms
of self-satisfaction or a sense of self-achievement: they
can hopefully look back on their career and be proud of
what they have achieved. However, entrepreneurs may also
be interested in other rewards from setting up, such as
the financial gain from owning their own business. These
rewards can be high! For example, YouTube was set up in
February 2005 by Chad Hurley, Steve Chen and Jawed Karim.
The website includes music videos, movie and TV clips, as
well as material posted by the general public. In 2006, the
founders of YouTube sold their business to Google for $1.65
billion! Not a bad return in less than two years.
1.1.2 The role of entrepreneurs and intrapreneurs
5
Chad
1.1
To go ahead with any venture, the expected rewards must
justify the risk involved. In an ideal world, a project would
have a high reward and low risk, but typically new ventures
are very risky because there are so many things that can
go wrong. In fact, many ideas do not even get launched.
Entrepreneurs hit so many setbacks or face so many
difficulties that the project does not go ahead.
▼ Table 1.2 Risks and rewards matrix: analysing projects
Risk
Reward
Low
High
Low
These are safe projects
but do not generate
high returns.
These projects are not of
interest because of the
high risk relative to the
low rewards.
High
These projects are
ideal: low risk but high
rewards. However, it
may not be easy to find
projects like these!
These projects are of
interest but risky. To go
ahead, entrepreneurs
must believe the rewards
outweigh the risks.
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1.1
HANDLING DATA
If you estimate that a project has a 55 per cent
probability of succeeding, what is the probability of
failure?
AS LEVEL 1.1 Enterprise
CASE STUDY
Banyan Tree
Historically, a banyan tree gave shelter to weary
travellers. Its name is now the brand of a chain of
luxury hotels and resorts around the world, founded by
multimillionaire Ho Kwon Ping.
Ho Kwon Ping attended Stanford University after he left
school, and later protested against the Vietnam War. In his
time as a journalist for the Far East Economic Review, he
wrote controversial articles that resulted in him spending
two months in a Singapore jail. He continued working as
a journalist after his release and settled with his wife
on an island off the shore of Hong Kong. He joined the
family business after his father became ill, deciding that
it needed to do more than manufacture products for other
companies. Producing for others, he realised, limited your
profits and eliminated your brand presence.
This fuelled his decision to move the company into the
hotel industry, but he struggled to generate customer
interest in their planned new hotel in Phuket, Thailand.
Ho Kwon Ping resolved that the Banyan Tree should offer
STUDY TIP
Remember that any decision has a risk attached to it, but
the key question is whether this risk is worth it. Managers
must try to assess the probability of any outcome and
decide whether the business should pursue any course of
action given the risk involved.
Why do governments like
entrepreneurs?
Governments like entrepreneurs because they set up new
businesses in an economy. This means that entrepreneurs:
» create jobs and help keep unemployment low in the economy
» earn money and pay taxes
» create competition for the existing providers in markets
and provide new products and services. This is good for
customers, who get more choice, and this is likely to lead
to better service.
Given the benefits of entrepreneurship, many governments
are willing to help entrepreneurs to start up and grow their
businesses.
a different type of hotel, designed to stand out from the
competition, with a luxury spa and villa format instead
of the typical hotel building with rooms. He insisted on
decisions others thought would not work because he was
sure they would. For example, the staff at the spa did not
wear shoes because being barefoot in Asia is a sign of
respect, and they wore Asian clothes rather than the white
uniforms that staff in Europe tended to wear.
Banyan Tree Hotels & Resorts has now grown into one of
the leading providers of resorts and spas, operating in 28
countries with 47 resorts and hotels around the world,
64 spas, 72 retail centres and three championship golf
courses.
Questions
1
2
Analyse one external factor that might have helped the
success of Banyan Tree.
[4]
Evaluate the features you think make a successful
[12]
entrepreneur.
The role of business enterprise in the
development of a country
Enterprise involves taking risks to develop new ideas. This is
important to businesses and the country as a whole because
a business enterprise finds solutions to problems, and new
and better ways of doing things. This can help the business
reduce costs and offer more benefits at a lower price than
competitors.
For the country as a whole, enterprise leads to innovation,
which creates new products and economic growth.
Enterprise challenges established ways of doing things and
provides competition to existing providers. This can lead to
more choice, better quality and lower prices for customers.
How can governments help
entrepreneurs?
There are many ways in which governments can help
entrepreneurs. They can provide:
» access to advice and useful information to help them get
started. For example, a new entrepreneur may have little
experience of financial matters and appreciate some
advice in this area
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» funding such as grants to help with the initial start-up
HANDLING DATA
costs
» legal protection for new ideas. For example, a patent
Imagine you need to raise $250 000 to start your
business. The government will provide 3 per cent, and
your savings equal 6 per cent. How much money do you
still need to raise?
provides legal protection for an invention. This means
that inventors can make profits without their ideas
being ‘stolen’ by others.
EY World Entrepreneur of the Year
In 2020, Dr Kiran Mazumdar-Shaw of Biocon Limited, India,
won the award for the EY World Entrepreneur of the Year.
Kiran graduated from a brewing school in Australia in
1975 and returned to India to begin her career. However,
as a woman in a very male-dominated industry, she
struggled to get a job. Instead, she started her own
business and founded Biocon in 1978 with a mere $500
from investors. Today, Biocon is a leading biotech company
and one of the largest employers in Asia, with a workforce
of over 11 000. Kiran has been named on both the Forbes
100 Most Powerful Women list and Time magazine’s 100
Most Influential People in the World list. She is known for
her determination and proactive approach.
Led by Kiran, Biocon has gone from manufacturing
pharmaceuticals, such as immunosuppressants, to
discovering, developing and producing medicines for
chronic diseases such as diabetes. Biocon has been
consistently ranked as one of the highest investors in
research and development in India. Kiran is very focused
on helping society. Through her business, she aims to
develop affordable medicines that can help save millions
of lives.
Questions
1
2
Analyse one factor that might have contributed to
the success of Kiran’s business.
[4]
Evaluate the importance of spending on research
and development of new products to the success
of Kiran’s business.
[12]
1.1.3 Business plans
» a financial section which would include a cash-flow
A business plan is a written document that sets out
key aspects of a business idea. A business plan is often
produced by entrepreneurs when setting up a business to try
and anticipate any potential problems and opportunities,
and to put in place appropriate actions. A business plan
is a useful document to have to show potential business
partners, investors or banks. This is because it shows the
business is thinking ahead, is researching the risks and has
suitable plans. A business plan should have information
and data to support the ideas and plans of the business and
reduce the risks to those lending money to it.
The benefits and limitations of
business plans
A business plan should be a working document: as
conditions change it should be updated to reflect this and
the plans changed accordingly. A business plan is not just
for when a business starts up; the business should keep it
relevant as the business grows.
Key elements of business plans
A business plan will typically have the following elements:
» an outline of the owners and their background and
experience
» an overview of the business idea and its products
» an analysis of market conditions and the positioning of
the business and its products within the market
» an outline of how the business is to be promoted
» an estimate of the sales of the business
1.1.3 Business plans
CASE STUDY
1.1
forecast, a profit forecast and a statement of what the
business owns and owes
» details of the human resource requirements of the
business.
To produce a business plan, an entrepreneur will undertake
market research and make plans for the different functional
areas of the business. To produce a business plan, managers
must think carefully about what has to be done. This will
help the business to identify the degree of risk involved in
any aspect of the business and take appropriate actions to
manage this risk. The plan is a way of co-ordinating all the
different activities of the business so that everyone knows
what has to be done when, and how this fits with what is
happening elsewhere within the business. The plan sets
‘milestones’ of what is to be achieved by when. It can set
targets so everyone in the business knows how to measure
success and understands how what they do contributes
to the overall success of the business. At any moment,
the progress of the plan can be checked and, if necessary,
action can be taken. Even if things start to go wrong,
having a plan is valuable because managers can assess
where they are compared to where they should be and then
decide what to do. Without a plan, they may not recognise
that things have gone wrong until far too late.
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AS LEVEL 1.1 Enterprise
1.1
However, a plan is simply a statement of what the business
intends to do. How useful it is will depend on how accurate
its forecasts are, whether the right actions are planned in
the given circumstances and whether they are implemented
effectively. Simply having a plan does not guarantee
success – it depends how good it is and how well it is
carried out.
However, for all of these businesses, planning can
help prevent mistakes by identifying difficulties early,
co-ordinating actions across departments and helping to
take action quickly to get back on track. Even so, plans
must always be reviewed because external and internal
conditions will change, and therefore the plan may need to
be flexible to keep relevant and competitive.
The nature of the plan will differ for a start-up business
compared to an established business (for example, because
the start-up will have limited experience compared to a
business that has been going for some time). Similarly, it
will differ for a small business compared to a big business
in that the latter’s plan is likely to be more complex and
involve more money, more products and more markets.
STUDY TIP
Remember that producing a business plan is only part of
the challenge of managers. To make it work, it has to be
implemented effectively.
CASE STUDY
TikTok
TikTok, the 15-second video app, is a technology start-up
that has grown incredibly fast. Within two years, TikTok
was rivalling Netflix, YouTube, Snapchat and Facebook
with more than 1 billion downloads in 150 markets
worldwide and operating in 75 languages. TikTok had a
value of nearly $80 billion within two years of starting
up. Through the app, users create and share homemade
videos on their phones. This content has proved incredibly
attractive to young audiences all over the world.
Virtually no translation is needed, as TikTok’s content is
primarily visual. This allows it to reach larger consumer
audiences more easily than other successful Chinese
apps, such as Tencent’s messaging app WeChat. WeChat
is used extensively within China but is mainly used by
Chinese communities outside of China. Within China,
TikTok is known as Douyin.
Founder Zhang Yiming, who is in his thirties, was inspired
by the early success of China’s technology pioneers of the
late 1990s, such as Robin Li of Baidu, Jack Ma of Alibaba,
and Pony Ma of Tencent.
TikTok makes money through adverts and from the sale
of virtual goods, such as emojis and stickers, to fans. It is
easy to use and is designed to exactly match what users
want to see, rather than recommending content based on
people’s viewing habits and ‘likes’.
Questions
1
2
Analyse one factor that might determine the
success of a new app.
Evaluate the value of having a business plan to a
business such as TikTok.
[4]
[12]
TEST YOUR LEARNING
b
Short answer questions
1
2
3
4
5
6
Define the term ‘factors of production’.
a Explain one possible purpose of business apart
from profit.
b Explain one reason a business might want to
make a profit.
a Define the term ‘scarcity and choice’.
b Define the term ‘opportunity cost’.
a Define the term ‘business plan’.
b Explain one reason why producing a business
plan is useful for a business.
Explain one way in which growth in the economy
might affect the costs of a business.
a Explain one reason why a business might fail.
[2]
7
a
b
8
a
b
9
a
b
[3]
[3]
[2]
[2]
[2]
[3]
10 a
[3]
[2]
b
Explain one effect of business failure on an
economy.
[3]
Define the term ‘intrapreneurship’.
[2]
Explain one reason intrapreneurship is
important to business.
[3]
Define the term ‘adding value’.
[2]
Explain one way a business might try to add
more value.
[3]
Define the term ‘multinational business’.
[2]
Explain one reason why a business might
become a national rather than a local business. [3]
Explain one likely feature of a successful
entrepreneur.
[3]
Explain one reason why entrepreneurs are
important to an economy.
[3]
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Data response question
Me & the Bees Lemonade was set up by Mikaila Ulmer
when she was aged four!
1.1
From the very beginning, Mikaila invested some of the
profits from the sale of her lemonade to organisations
fighting hard to save bees. Me & the Bees encourages
everyone to ‘Buy a Bottle ... Save the Bees’.
Most recently, Mikaila launched her own non-profit,
Healthy Hive Foundation. Through research, education
and preservation, the Healthy Hive Foundation is
dedicated to increasing bee awareness and the number of
safe environments for bees to survive and thrive.
Questions
1
2
3
4
Explain one reason why Mikaila set up in business. [3]
Explain one factor that influences demand for
[3]
Mikaila’s products.
Analyse one skill that Mikaila would have needed
to be such a successful entrepreneur.
[4]
Evaluate the challenges that Mikaila’s business
might face in the future.
[12]
1.1.3 Business plans
Mikaila’s interest in bees started when she got stung
twice within a week. She started to research bees to find
out more about them and became fascinated. Around
that time, her family had encouraged her to enter some
children’s business competitions, and her grandmother
had sent her a cookbook which contained a special
recipe for flaxseed lemonade. Mikaila decided to adapt
the recipe and use honey from the honeybee rather than
sugar. That was the start of her business. It was originally
going to be known as Be Sweet Lemonade but Mikaila
had to change the name as it was already being used by
another business. She decided to call her business Me &
the Bees Lemonade because a percentage of sales are
donated to help save the bees. The company has now
been in ‘buzzness’ for more than 10 years! Its products
are sold in many different retailers, such as Whole Foods
Market across Texas and Kroger stores in Houston. The
product range now includes lip balm and different types
of lemonade.
Bee Fearless, Dream Like a Kid. The business has some
high-profile investors, including $800 000 from a group of
National Football League players.
Mikaila gives many talks about the importance of saving
the bee population. She has also written her first book,
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1 Business and its environment
AS LEVEL
AS LEVEL 1.2 Business structure
1.2
Business structure
Chapter overview
In this chapter we examine:
★ the different economic sectors in an economy, that is, the difference between primary, secondary, tertiary and
quaternary sectors and the private and public sectors, including the concepts of unlimited liability and limited liability
★ the advantages and disadvantages of different forms of legal structure, such as sole traders, partnerships,
companies, co-operatives, franchises, joint ventures and social enterprises.
1.2.1 Economic sectors
There are many types of businesses and it is useful to be
able to categorise them to analyse their performance and
the different issues they face. Typical ways of categorising
business include by sector and by legal status.
Primary, secondary, tertiary and
quaternary sector businesses
The many businesses that exist in an economy operate in
one of three sectors:
» Primary sector This is the first stage of production
and involves acquiring or extracting raw materials. For
example, oil has to be extracted from the under the
ground, coal has to be mined, fish have to be caught
and crops have to be grown. Oil, mining, fishing and
agriculture are all in the primary sector of the economy.
Raw materials can be renewable resources, such as fish
and wind power; this means they can be replenished.
Or raw materials may be non-renewable, such as oil and
coal; this means the total stock available is reduced as
they are consumed.
» Secondary sector This is the part of the economy
that manufactures and assembles products using
raw materials. For example, cars are manufactured
using many different parts and materials, and so car
manufacturing is part of the secondary sector. Similarly,
the construction industry uses many parts to produce
houses and office space.
» Tertiary sector This is made up of businesses that
provide services. These services are intangible – that
is, the service they provide cannot be physically
touched (unlike manufactured goods, for example).
Examples of businesses in the tertiary sector include
retailers, transportation businesses and providers of
financial services, such as insurance. This is often the
biggest sector in developed economies in terms of both
employment and the value of the output.
– Quaternary sector This is a subset of the tertiary
sector which represents organisations that are
based on knowledge and the skills of employees;
for example, information service businesses, such
as management consultancies, and research and
development businesses.
The more developed an economy is, the more resources are
diverted into the tertiary and quaternary sectors. Economies
begin by being very agriculturally based (primary sector).
Investment in capital equipment leads to more factories and
equipment and the development of the secondary sector. As
investment continues, resources tend to move away from
the mass-production processes towards higher value-adding
sectors based on services and knowledge. For example,
developed economies may focus on sectors such as design,
programming, creative work, and research and development
more than mass production.
The public and private sectors
We can also distinguish between businesses that are owned
by private individuals, which are in the private sector,
and those that are owned by governments, which are in
the public sector. Local supermarkets, clothes shops and
hairdressers are likely to be in the private sector (although
not always); the provision of electricity, water and health
services is often in the public sector (although, again, this
will vary from country to country). Some products may
be provided by both the public and private sectors; for
example, there may be government-run schools and private
schools.
If a government takes control of a private sector business,
this is called nationalisation. If a government sells one
of its organisations to the private sector, this is called
privatisation.
Typically the government is likely to run organisations:
» that have a strategic importance to the country, such as
defence, in order to protect the country
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» that provide essential services, such as energy and
water, that the government wants to make sure everyone
has access to regardless of income
» whose benefits may not be fully appreciated by
individuals, such as education and health. These are
called merit goods.
GLOSSARY TERMS
Nationalisation occurs when a government takes
ownership of a business from the private sector into the
public sector (see Chapter 6.1.1).
Privatisation occurs when a government transfers
ownership of a business from the public sector to the
private sector (see Chapter 6.1.1).
Merit goods are goods or services, such as education
and health, whose benefits individuals may not fully
appreciate. For example, when thinking about how much
to spend on healthcare, people will think of the benefits
to themselves rather than the benefits that being healthy
also bring to those around them.
Reasons for the changing relative
importance of private and public
sectors
The extent to which a government intervenes and the public
sector is involved in an economy will vary from country to
country and depends a great deal on political views about
the role of the state. In countries such as North Korea,
there has been a belief that the government should mostly
decide how resources are allocated and so there is a large
public sector and small private sector.
Cuba is one of the world’s most centrally planned
economies, meaning that the government still runs most of
the organisations that exist on the island. According to the
CIA World Factbook, the Cuban government employed nearly
73 per cent of all Cuban workers in 2017. Although there
have been some changes in recent years to encourage more
private sector businesses, the number remains very small
and the government still controls the majority of business
activities. By comparison, countries such as the USA allow
market forces to allocate resources to a greater extent, so
the public sector is smaller and the private sector is bigger.
1.2
The reasons why there might be less government
intervention, and therefore a bigger private sector, include
a desire that people own their own businesses. This is
because it gives a great focus on running them well. If
individuals own all or part of an organisation, they will
want it to make a profit because they will benefit from
this financially. This encourages people to identify and
meet customers’ needs – to provide them with the goods
and services and the quality they need and want. It also
encourages people to be efficient and not waste resources
because they want to generate more profits. By comparison,
if an organisation is owned by the government, those
working within it may not be concerned with whether their
products are in demand or not, and they may not be focused
on increasing revenue or reducing costs because they do not
benefit directly.
1.2.1 Economic sectors
Public sector organisations can have social objectives, not
just profit objectives. This means they may provide nonprofit-making services, such as transport to remote areas. A
private sector business would probably not be interested if
there were not enough passengers, but the government may
provide this service for the welfare of its citizens.
However, the role of government may change over time; for
example, in China the government has been intervening less
in the economy and the private sector has been growing in
recent years, whereas in Venezuela government intervention
has increased in the last 20 years.
The reasons why there might be more government
intervention, and therefore a bigger public sector, is
because people do not trust the private sector. For example:
» They may want more provision of healthcare and
education for everyone. In the private sector, this will
only be provided for those who can pay.
» They may want to provide a full range of services,
including some that are not profitable; for example, rail
or bus links to remote areas or a postal delivery service
to distant locations within the country.
» They may want to use some businesses to help maintain
employment levels in a region or economy, even if it is
not as efficient as it could be.
» They may worry that the private sector is misleading
customers, or selling products which are cheap to make
but not safe, in order to make more profits.
▼ Table 1.3 Benefits of the private and public sectors
Benefits of private sector
Benefits of public sector
Focus on profits means
Focus on what is beneficial
businesses want to provide
for society rather than what
what is demanded and ensure is profitable
quality is good
Focus on profits means
businesses want to be
efficient and not waste
resources
Will not try to exploit or
mislead customers
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1.2
CASE STUDY
Cuba
AS LEVEL 1.2 Business structure
retail services to entrepreneurs. Over half a million Cuban
workers are now self-employed. Other changes include
the private ownership and sale of property, and private
farming and non-agricultural co-operatives.
▲ Figure 1.7 A street in Havana, Cuba
Since 1965, Cuba has been governed by the Communist
Party. It has been one of the most centrally planned,
state-run economies in the world since then. However,
although the government in Cuba retains a high level of
political control, it is gradually opening up markets to
allow competition. For example, Cubans can now set up
private businesses to sell electronic devices and mobile
phones, run hotels, and buy and sell used cars. The
government has reduced the number of state sector jobs
as part of its reform process and has opened up some
1.2.2 Business ownership
When setting up in business, the founders must consider
the most appropriate legal form for their enterprise. There
are several different types of business organisation, each
of which has its own legal structure. These include sole
traders, partnerships, private limited companies and public
limited companies, co-operatives, franchises, joint ventures
and social enterprises.
Sole traders
Despite the increasing opportunities for UK companies in
Cuba, the market still offers challenges, which include:
l very slow decision-making, with most important
business decisions being referred to high-level
government
l all sales in Cuba are public sales, controlled by heavy
regulation
l commonality of payment delays
l the standard practice for the Cuban state to expect to
buy on credit terms of 1–2 years
l potentially increased market competition due to easing
of US sanctions, which will make it easier for Cubans
to trade in the USA.
Sources: CIA World Factbook; UK government, Department for
International Trade
Questions
1
2
Analyse one potential benefit of a centrally planned
economy.
[4]
Evaluate the possible impact for businesses in
Cuba of having more privately owned businesses. [12]
hairdressers are often sole traders. The people running these
businesses work for themselves. In some cases, sole traders
hire other people to help them out, but they are the owners
and remain responsible for the overall business. Sole traders
are actively involved in the running of it on a daily basis.
What does it take to be a successful
sole trader?
As a sole trader you need to be someone who is willing
to work on your own, who has the confidence to make
your own decisions and who can turn your hand to almost
any aspect of your business. As a sole trader, you may
have to serve customers, decide what equipment to buy,
deal with suppliers and keep accurate and up-to-date
business records. This requires a wide range of skills and an
enormous degree of flexibility.
Sole traders have to be used to working hard: running your
own business is no easy task. You must also be good at
managing stress. All the decisions of the business are yours
alone, so if you get it wrong the responsibility is yours. On
the other hand, if it is successful, the sense of achievement
and the rewards are yours too!
▲ Figure 1.8 Sole traders run their own businesses
When individuals run a business on their own, they are known
as ‘sole traders’. Plumbers, decorators, window cleaners and
Becoming a sole trader requires a high level of selfdiscipline, because you are your own boss: there is no one
to tell you what to do. This can be very exciting, because
you decide what is going to happen. However, it also means
that you have to motivate yourself to get things done. For
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example, you have to organise your day properly and use
your time effectively.
» receive a more regular income
» be able to call on experts to help you solve problems.
The advantages of being a sole trader
On the other hand, there is not quite the same sense of
achievement and satisfaction of having created something
for yourself.
Many people also enjoy not having to take orders from other
people. They like the freedom to make their own decisions,
to decide when and where to work, what to do and how to
do it. You can also make decisions quickly as you don’t have
to check with anyone to get permission to do something. It
can be incredibly motivating to be your own boss. Another
important advantage of being a sole trader is that you keep
all the rewards of the business. You don’t have to share the
profits with anyone else.
Many entrepreneurs begin as sole traders for these reasons.
The challenges of being a sole trader
While being a sole trader can be very fulfilling, it also
brings with it many challenges. Making all the decisions can
be exciting, but you carry all the responsibility if anything
goes wrong. If you work for someone else and there is a
real problem, you have someone to work with to solve it.
Being a sole trader can be quite lonely: some people find it
difficult to cope with the pressure. The hours may be quite
demanding too. This is particularly likely to be an issue in
the early years, when you are trying hard to build up enough
business. Also, you may not be able to take much time off
for holidays because you may not be able to afford to close
the business and risk losing customers.
Another difficulty is raising finance to set up the business
and expand it. You generally have to rely on your own money
or money from friends and family (plus the money from
the business itself, once it is up and running). Of course,
it is possible to borrow from a bank or other financial
institution, but they often charge smaller businesses quite
high interest rates because they are worried about the risk
of failure and want to cover their losses.
Unlimited liability and its importance
Being a sole trader is also quite risky if anything goes
wrong. This is because sole traders have unlimited liability.
The sole trader keeps any rewards the business makes,
but is also personally responsible for any losses. If their
business has problems, a sole trader can lose their personal
possessions.
In many ways, working for other people in a large
organisation is much easier because you are likely to:
» have other people to share ideas with
▼ Table 1.4 Advantages and disadvantages of being a sole
trader
Advantages
Disadvantages
• Making your own
decisions can be
motivating.
• You can make decisions
quickly and respond
rapidly to changes in the
market.
• You have direct contact
with the market.
• Setting up is easy.
• Sources of finance are
limited.
• You rely heavily on your
own ability to make
decisions.
• You may work long hours
and have limited holidays,
leading to stress.
• You are subject to
unlimited liability.
1.2.2 Business ownership
One of the main advantages of being a sole trader is that
it is so easy to start up in business. Unlike starting other
types of organisation, you do not need to register with
anyone or fill in any special forms: you can just start trading
(provided you declare your profits to the government tax
office at the end of each financial year!). If you suddenly
decide you want to be a gardener, a web designer, an artist,
an interior decorator or a cleaner, you could start up in
business tomorrow. It may be wise, however, to do some
planning and get some training first!
1.2
GLOSSARY TERM
Unlimited liability occurs when an individual or groups of
individuals are personally responsible for all the actions
of their business. With sole traders, there is no distinction
in law between the individuals and the business, and so
they could lose their personal assets if the business has
financial problems.
Partnerships
If you join with other people and set up a business together,
this is known as a partnership. This is common in professions
such as accountancy, medicine and law. The benefits of
forming a partnership over being a sole trader include:
» You have other people to share ideas with.
» There are more people to invest in the business and help
finance it.
» You can benefit from each other’s specialist skills; for
example, if you have a legal practice, you could have one
partner specialising in tax law, another in marital law,
another in company law, and so on. This enables you to
offer a wide service to customers.
» You can cover for each other if someone is ill or on holiday.
However, a partnership can present challenges:
» You need to consult with others and there may be
disagreements between the partners over the policies
and direction of the business.
» You are dependent on the actions of others. If, for
example, one of the partners makes a mistake or brings
the partnership into disrepute, it will have an impact on
all the partners. Each partner is liable for the actions of
the other partners’ actions, which can be risky.
» In most partnerships, the partners have unlimited
liability, which means that there is no distinction
between the individuals and the business. If the
business is sued, for example, the individuals may lose
their personal possessions. This is a risk that some
people may not be prepared to take.
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AS LEVEL 1.2 Business structure
1.2
To reduce some of the possible problems of a partnership,
the individuals involved are advised to write a ‘deed of
partnership’. This document sets out the ‘rules’ of the
partnership; for example, it sets out:
» how the partnership would be dissolved if someone wanted
to leave. It would set out how the partnership would be
valued and therefore what the person leaving would receive
» how to resolve disputes if the number voting for and
against is equal
» how profits will be divided up; if this is not specified,
the profits are divided up equally.
▼ Table 1.5 Advantages and disadvantages of setting up as
a partnership
Advantages
Disadvantages
• Share resources, ideas and
workload
• More sources of finance
than a sole trader
• Cover if someone is ill or
on holiday
• Share profits
• May disagree over decisions
• Unlimited liability
HANDLING DATA
You have four other partners in your business. You have
agreed to share profits. If your profits are $240 000, how
much does each partner receive?
Companies
To avoid some of the problems of being a sole trader or
a partnership, you may decide to establish a company
instead. To set up a company, the owners have to complete
various documents. In the UK these documents are kept at
Companies House. This process is known as incorporation.
A company is owned by shareholders. Each share in the
business represents a part of the company. The more shares
someone owns, the more of the company belongs to them.
A company has its own legal identity, separate from that of
its owners. The company can own property, equipment and
other goods in its own right and is responsible for its own
debts. If the company fails, the shareholders can lose the
money that they invested in the business when they bought
shares, but they cannot lose more than this. This is because
shareholders have limited liability.
GLOSSARY TERMS
A company is a business organisation which has its own
legal identity and which has limited liability.
Shareholders are persons or organisations that own a
part of a company.
Limited liability means that investors can lose the money
they have invested into the business but their personal
possessions are safe. There is a limit to their risk.
A franchise occurs when a franchisor sells the rights to
use or sell their products to a franchisee.
Limited liability and its importance
Limited liability means that a company is responsible for
the money it owes but that the personal possessions of its
owners are safe. This is different from a sole trader, who has
unlimited liability and could lose everything if the business
has financial problems.
Having limited liability is essential for companies to be able
to raise money by selling shares. Without it, investors would
be far less likely to buy shares because of the risk to their
personal possessions. If you invested in a business with
unlimited liability, it would mean giving money to others to
use and risking everything you owned. With limited liability,
you know what the maximum amount is that you could lose;
this means that the risk is limited.
Having company status means that:
» the business must pay to have its accounts checked
annually by independent accountants (called auditors)
» the company accounts must be made public, so that
outsiders can see the revenue and profits of the
business, as well as what it owns. This means that there
is less privacy of affairs than if you are a sole trader.
Private limited companies
Private limited companies have ‘ltd’ after their names.
They are owned by shareholders and the owners can place
restrictions on who the shares are sold to in the future.
For example, many (but not all) private limited companies
are owned by families who limit the sale of shares to other
members of the family: this makes sure that outsiders do
not become involved. Owners of shares in private limited
companies cannot advertise their shares for sale; they have
to sell them privately.
Public limited companies
Public limited companies have ‘plc’ after their names.
Once again, they are owned by shareholders but, unlike
private companies, restrictions cannot be placed on the
sale of these shares. Shareholders in public companies
can sell their shares to whoever wants to buy them. This
can cause problems if another firm starts to buy up shares
in the business in an attempt to gain control of it. Some
of the shareholders may want to resist this takeover,
but they cannot stop fellow shareholders from selling
their shares.
Another difference between plcs and ltd companies is that
shares in plcs can be advertised in the media. This is why
you can see the share prices of public companies listed in
the newspapers, but not those of private companies. Most
companies become public because they want to advertise
their shares to the general public and raise relatively large
sums of money. Most public companies (but not all) are
bigger than most private companies.
If the owners of a private company do not need to raise
large sums via the sale of shares and want to maintain
control over their company then they probably would not
want to make it a public company.
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HANDLING DATA
1.2
There are 250 000 shares in a company. You have 400
shares. What percentage of the company do you own?
CASE STUDY
In 2020, there was a massive drop in the amount of
dividends paid by companies in the UK – and indeed
around the world – amid the Coronavirus (COVID-19)
pandemic. UK dividends were more than 60 per cent lower
in 2020 than in 2019. To give a context, dividend payments
globally fell by only 20 per cent during the financial crisis
in 2008.
Banks cancelled their dividend payments indefinitely to
hold on to their cash. Retailers, hotel groups, airlines,
travel groups and many manufacturers did the same.
The oil giants BP and Shell – which according to Citywire
accounted for nearly 30 per cent of UK dividends in
2020 between them – faced severe pressure to reduce
dividends because the oil price collapsed with less
demand for energy from businesses because they had
shut down. Shell announced it would stop dividends for
the first time since 1945.
began, businesses such as high street stores were
already under pressure from e-commerce. Oil companies
were trying to survive given the long-term decline in
hydrocarbon consumption. Car makers and airlines were
generally struggling in highly competitive industries for
decades, making little, if any, profit. Even the industries
which typically offered relatively high dividends, such as
utilities and telecommunications, now face increasing
regulation and weak long-term growth.
1.2.2 Business ownership
UK dividends
However, even amidst such difficult times there were
some business sectors that offered opportunities, such as
insurance businesses and delivery companies.
Questions
1
2
The ability of many companies to pay dividends may be
affected for years to come. Even before the pandemic
Explain one factor that might influence the amount of
dividends paid by a business.
[3]
An investor wants to know what shares to buy. Advise
her on an industry you think is likely to do well in your
country in the next few years.
[12]
CASE STUDY
Tesla and Toyota
In 2020, the share price of Tesla, the electric car maker,
went so high that the company became the world’s most
valuable car maker, overtaking Japan’s Toyota. Tesla’s
share price went to over $1100, which gave the company a
market capitalisation of $209.47 billion (£165 billion). This
meant that Tesla was worth approximately $4 billion more
than Toyota, even though the Japanese producer sold
around 30 times more cars in 2019 and its revenues were
more than ten times higher. The price of shares in Tesla
increased as investors began to feel more confident about
the future of electric vehicles. Many analysts believe
that Tesla is significantly ahead of its rivals in terms of
its product range, capacity and technology. The value of
Tesla in 2020 was approximately three times the combined
value of General Motors and Ford.
Franchises
If you do not have an idea for your own business or do
not want to risk setting up completely on your own, you
might want to buy a franchise. A franchise occurs when
one business (the franchisor) sells the right to use and
sell its products and/or services to another business (the
franchisee). Imagine you were interested in setting up a
▼ Table 1.6 A comparison of Tesla and Toyota
Sales volume 2019 Sales revenue 2019 ($bn)
Toyota
10.46 million
281.20
Tesla
367 000
24.6
Questions
1
2
Analyse one factor that may determine the demand
for electric cars.
[4]
Evaluate the factors that affect the price of Tesla
shares.
[12]
fast-food business. You could sit down and develop your
own idea from scratch. However, it could prove to be
difficult to come up with something that would capture
demand and then decide on a brand image, a way of
producing the food, a menu and decor for your stores. An
alternative would be to buy the rights to sell, for example,
McDonald’s products in a given area. In this case, you would
be buying a McDonald’s franchise.
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How do franchises work?
AS LEVEL 1.2 Business structure
1.2
There are many different forms of franchise, but the basic
elements of a franchise agreement are:
» The franchisor sells the right to the product in return
for an initial fee and a percentage of the franchisee’s
turnover.
» The franchisee receives the right to the name and the
systems used by the franchisor. This may include access
to materials and training methods.
In the case of the McDonald’s example, the company will
want to keep close control over its brand name, products
and reputation. Therefore, if you buy a McDonald’s
franchise, you have to follow very close rules in terms of
what you sell, how you sell it, the pricing, the way the
food is cooked, where it is bought, how you use the logo,
and so on.
Well-known franchises include:
» Ben and Jerry’s ice cream
» Domino’s Pizza
» McDonald’s fast-food restaurants.
▲ Figure 1.9 An example of a well-known franchise
Buying a franchise
If you buy a franchise, you are buying a product that has
already been on sale and therefore has a track record. This
means you can see whether or not it works. You can also
learn from other franchisees who are already established
and benefit from their experience.
The advantages of buying a franchise
The advantages of buying a franchise include:
» Because you are joining other franchisees, as a group
you may have more bargaining power than you would
have on your own. This may mean you get better deals
with suppliers or when buying advertising space.
Franchisees will often pool money to promote the brand
on a regional or national scale. Any advertisement for
the brand helps all the franchisees.
» You have the support of the franchisor and this can
help you with decisions such as pricing, choosing
suppliers and planning ahead. This should reduce the
risk of something going wrong because there is more
experience, joint power and support than if you were
setting up alone.
» Buying a franchise may be less risky than setting up
completely on your own. This is because there is past
data for you to analyse before deciding whether or not
to go ahead with the idea. At the same time, it will be
your own business and so there is still the incentive to
make it successful, as you will benefit directly.
The problems of buying a franchise
The most obvious problem with buying a franchise is that
it costs you money! This reduces the profits you make.
However, you hope that by buying a franchise you will do
better than you would have done on your own. Whether
you are better off with a franchise therefore depends on its
success and the terms and conditions of the contract.
Although one of the main benefits of buying a franchise is
that you are linked to other franchisees, this can also be
a problem. If, for example, the quality of service in other
franchises falls, it may damage the overall brand and hit
your sales as well. You become dependent on others and
vulnerable if there are problems elsewhere.
How much should you pay for a franchise?
Usually, there are several different types of payments
involved in buying a franchise. For example, there may
be an initial purchase fee plus a percentage of turnover
each year. On top of this there may be money you have
to invest each year to cover marketing and management
expenses. The amount you pay for a franchise will
depend on:
» the likely turnover of the business
» the typical profits
» whether you have the exclusive rights to a particular
geographical area and, if so, how big and attractive
this area is
» the amount of training and support provided.
HANDLING DATA
A franchisor asks for a $12 000 fixed fee each year plus 2
per cent of profits after this fee and other costs are paid.
Your revenue this year is $650 000. Your costs (not
including any costs associated with the franchise) are
$420 000. What are the profits this year?
Selling a franchise
One advantage of being a franchisor is that you benefit
from the income generated from the franchisees. They will
pay a fee to buy the franchise and a percentage of turnover.
This generates earnings for the franchisor.
Franchising is also a way of growing fast. If you were trying
to grow a business on your own, you would have to fund it
all yourself; for example, you would have to find the funds
to buy more premises and refurbish more shops. If you sell
franchises then the costs of opening a particular outlet falls
to the franchisee. This may make fast growth much more
feasible because individual franchisees are all funding their
own enterprises. Domino’s Pizza, for example, was founded
in 1960 by Tom Monaghan. His ambition was to grow the
business to three stores – that’s why there are three dots
on the company logo. However, through franchising, the
business has grown to become the world leader in pizza
delivery.
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Another benefit of being a franchisor is that it may lead to
more motivated managers because they are running their
‘own’ stores or businesses, rather than just being employees
of a bigger business. This may help the business as a whole
to be more successful.
STUDY TIP
When studying franchises, you need to compare this way
of starting up your own business with the alternatives.
What are its advantages and disadvantages compared
to other ways of starting up? What would determine
whether an individual did this, rather than ‘going it alone’?
Toni&Guy
Together, Toni and Guy (whose real name was Gaetano)
continued to open more salons, and established the TIGI
brand in 1979. Under this brand name they launched
gel, rollers, scissors and many more products and sold
franchises to grow the business. The TONI&GUY video
library supports teaching in their salons, emphasising the
dedication of Toni and Guy to the development and further
education of their employees.
▲ Figure 1.10 Toni&Guy hairdressers, UK
Toni&Guy started in 1963, when Toni Mascolo opened a
salon with his brother in Clapham, London. Today, the
company has over 475 salons in 48 different countries,
many of which are franchises.
Toni grew up in Italy. When he was a boy, he would walk
past his father’s hair salon every day on his way home
from school. ‘I had a stool where I would sit and would
wash hair, which made my father very proud. By the age of
12, 13, I was doing perms. It was a hobby. It’s always been
a hobby.’
Toni (whose real name was Giuseppe) had wanted to
become a lawyer, but that changed when the family
migrated to London when he was 14. Although he had
excelled at school in Italy, he couldn’t speak English, so
his only option was to work for his father.
1.2.2 Business ownership
CASE STUDY
1.2
Toni&Guy’s business interests, apart from the salons
themselves, include:
l the production and distribution of products used and
sold in the salons
l the Toni&Guy branded products, which have been
developed with Alliance Boots
l another hairdressing chain called essensuals
l hairdressing training academies
l a business that supplies the salons with fixtures and
fittings
l an IT business
l an in-house media agency.
The company has developed other brands which now
include TONI&GUY, label.m and essensuals.
Source: www.independent.co.uk/news/people/profiles/
toni-mascolo-wash-and-grow-6230921.html
Questions
1
2
Analyse one factor you think is important to make a
hairdressing business a success.
[4]
A hairdresser has asked you whether they should
adopt the same model as Toni&Guy. Advise them
[12]
on whether to do this.
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AS LEVEL 1.2 Business structure
1.2
CASE STUDY
7-Eleven
7-Eleven is the world’s largest convenience retailer. Its
business model is that of franchising its name and way of
operating; it is one of the biggest franchises in the world.
The company has grown fast and says its success is based
around the saying of its founder Joe C Thompson Junior,
which was: ‘Give the customers what they want, when and
where they want it’.
the initial franchise fee
the expenses to train staff according to the 7-Eleven way
cost of inventory to open the store
spending on business supplies
purchases of business licences and permits
insurance costs.
l
l
l
l
l
l
Source: https://corp.7-eleven.com/corp/about#corp_about_intro;
https://franchise.7-eleven.com/franchise/the-financials
7-Eleven says that it is ‘customer-obsessed. We always
poll customers to ensure we are bringing them solutions
they can’t even imagine.’
Questions
If you want to be a franchisee for 7-Eleven, the investment
required will include:
2
1
Analyse one reason why 7-Eleven might franchise
[4]
its business.
A friend has asked you whether they should buy a
franchise in 7-Eleven. Advise them on whether to
do this.
[12]
Co-operatives
Another form of business is known as a co-operative.
Co-operative businesses are owned and run by and for
their members, whether they are customers, employees or
residents. The members of a co-operative have one vote
each and so it is a democracy. Members, such as farmers or
freelancers, tenants or taxi drivers, can often do better by
working together. Sharing the profit is a way to keep it fair
and make it worthwhile.
Rather than rewarding outside investors, a co-operative
shares its profits among the members. When someone leaves
the co-operative they give up their shares. According to
the International Co-operative Alliance, nearly 300 million
people around the world are employed by co-operatives,
while over 1 billion are members.
There are different forms of co-operative, such as:
» Employee co-operatives These occur when the business
is owned equally by all the employees who work there.
Each employee has a vote in the business decisions
and shares in the profits. The advantage of this is
that employees may be more motivated to make the
business a success because they are part-owners. One
of the problems, however, is that decision-making
may be difficult if everyone has an equal vote but
disagrees. Also, you cannot sell shares to those outside
the business to raise finance, which might limit access
to funds.
» Community co-operatives These are owned by members
of a community to provide a local service, such as a
post office.
» Retail co-operatives These occur when independent
retailers join together. A group of independent stores
may come together and operate under one brand name.
This means they can get better deals from suppliers by
buying in bulk and can share marketing costs.
CASE STUDY
Co-operative facts and figures
‘At least 12 per cent of people on Earth [belong to one]
of the 3 million co-operatives on Earth. Co-operatives
provide jobs or work opportunities to 10 per cent of the
employed population, and the 300 largest co-operatives
or mutuals generate $2034.98 billion in turnover ...’
Source: https://ica.coop/en/co-operatives/facts-and-figures
Questions
1
2
Explain one benefit of being part of a co-operative.
[3]
Evaluate the reasons why the co-operative
[12]
approach is so popular around the world.
Joint ventures
A joint venture occurs when businesses collaborate on a
project but do not formally join together all their activities.
For example, in the car industry a number of manufacturers
might share the research costs of developing an electric
car but they would still compete with their other models.
In the pharmaceutical industry, two businesses may share
their research skills for a new medicine. When entering a
new market overseas, a company may set up a venture with
a local business to help make the contacts and develop the
networks it needs to distribute its products.
The benefits of a joint venture are that:
» businesses can share skills, resources, expertise and
experience; this can benefit both parties
» businesses can collaborate on projects that are
mutually beneficial without having to merge all their
operations. This makes the process easier, less difficult
to manage and less expensive than a full joining
together (called a merger).
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However, there may still be difficulties, such as:
» agreeing on the division of the profits; there may be
disagreements over the relative contribution of each
business
» different views on how decisions should be made and
what the priorities are
» different views on whether and how to end the venture.
CASE STUDY
1.2
Wikipedia
Social enterprises
Not all enterprises are set up to make a profit. Local sports
clubs, government organisations and charities, for example,
do not have profit as the main objective. They are set up for
other purposes.
‘The Wikimedia Foundation provides the essential
infrastructure for free knowledge. We host Wikipedia,
the free online encyclopedia, created, edited, and
verified by volunteers around the world, as well as many
other vital community projects. All of which is made
possible thanks to donations from individuals.’
Social enterprises are businesses that have social aims and
which trade in order to benefit the community or society
in general. Examples of social aims are job creation and
training, providing community services and ‘fair trade’ with
developing countries. Well-known social enterprises in the
UK include Cafédirect, The Big Issue, The Co-operative Group
and the Eden Project, but there are many others (more than
55 000) operating in a wide range of industries, from farmers’
markets and recycling companies to transport providers and
childcare. The number of social enterprises is increasing as
people become more concerned about issues such as the
environment and inequality.
Source: https://wikimediafoundation.org
1.2.2 Business ownership
Wikipedia was created in 2001. It is a multilingual, webbased, free-content encyclopedia project and is now
one of the largest online encyclopedias. It is written by
volunteers all over the world. Its articles can be edited
by anyone with internet access. Articles are continually
updated and improved by online contributors. The
website was created by the not-for-profit Wikimedia
Foundation, who says:
Questions
1
2
Explain one way in which Wikipedia transforms
inputs into outputs.
[3]
Evaluate the ways in which the success of
Wikipedia might be measured.
[12]
CASE STUDY
The Big Issue
The Big Issue Group is a social enterprise in the UK aimed
at reducing poverty by creating opportunities for people.
The group has grown over the years and now includes:
l a magazine which offers employment opportunities to
people living in poverty
l a fund that invests millions of pounds to support
enterprises that bring about social change
l a charity shop that sells social enterprise products.
In 1991, The Big Issue magazine launched with the aim of
providing homeless people with an opportunity to earn
money by selling copies to the public. The magazine’s
sellers are from a wide range of backgrounds, but all
of them struggle with poverty. Sellers buy The Big Issue
magazine for £1.50 and then sell it on to their customers
for £3. This means the seller is earning money and is not
begging for it. Not only that, but the act of having to organise
themselves and manage their money as well as interacting
with the public to sell the magazine all help individuals to
build up their self-confidence and self-reliance.
The magazine has won numerous awards and led to the
creation of over 120 similar magazines in 35 different
countries.
Key facts about The Big Issue include:
l over 200 million copies of the magazine have been sold
l 92 000 people have sold The Big Issue.
Source: www.bigissue.com/about
Questions
1
2
Analyse one way in which The Big Issue helps
society.
Discuss the ways in which The Big Issue would
measure its success.
[3]
[12]
Changing legal structure
» publish details of its accounts such as revenue and
It is relatively common for someone to set up in business as
a sole trader and then to change the business into a private
limited company (ltd) later on, when they want to raise funds
from selling shares or want the benefits of limited liability.
» publish administrative details, such the address of the
To operate as a ltd company, a business must:
» have its accounts checked by an independent accountant
(called an auditor) each year
profits each year
company and names of its directors.
This means the business affairs of a private company are
more open than those of a sole trader. If you want to keep
your earnings private, you would want to remain as a sole
trader.
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AS LEVEL 1.2 Business structure
1.2
It may be that the owners of a private company want to
make it public, as did Facebook in 2012. This gives the
company access to more potential investors. To do this,
the business must make more information available to the
public and there is greater regulation of the way it operates
and the information it provides. Becoming a public company
opens a business to even greater scrutiny and even bigger
legal and accountancy bills. However, it does enable its
shares to be sold more easily on the stock exchange and this
makes the shares more attractive to more investors, because
they know they should be able to sell them, if needs be, to
someone else (this means the shares of a plc are relatively
easy to sell).
TEST YOUR LEARNING
Short answer questions
1
2
3
4
5
6
7
8
9
Define the terms ‘primary sector’, ‘secondary sector’,
‘tertiary sector’ and ‘quaternary sector’.
[8]
Define the term ‘public sector’.
[2]
Explain one advantage of a partnership compared
with a sole trader.
[3]
a Define the term ‘limited liability’.
[2]
b Explain one way that limited liability can benefit
a company.
[3]
Explain one advantage of creating a company
rather than operating as a sole trader.
[3]
a Define the term ‘franchise’.
[2]
b Explain one reason for buying a franchise.
[3]
Explain one benefit of being part of a co-operative
compared with a company.
[3]
Explain one advantage of being a sole trader
compared with a partnership.
[3]
Explain one way a company can raise finance.
[3]
with over 1.4 million copyrights, is one of the world’s
largest. Publishing is more secure and profitable than
recorded music, although the majority of Warner Music’s
income is generated by the latter.
Warner Music had previously been bought by billionaire Sir
Len Blavatnik for $3.3 billion (£2.5 billion) in 2011, when the
industry was not doing well. The value of music companies
rose after that, aided by the fast emergence and growth of
paid streaming services such as Spotify. In 2019, its profit
was $256 million and its revenue was $4.5 billion. By 2020,
Warner Music was worth around $6 billion. Warner had
initially intended to sell its shares in February 2020, but
when the Coronavirus (COVID-19) pandemic took hold, it
delayed the sale. It then intended to sell the shares on 3
June 2020, but delayed this for a few days because it did not
want to distract attention away from the Black Lives Matter
movement that was in the news.
Questions
1
Data response question
In 2020, Warner Music Group decided to sell shares to
the general public. Warner Music included some of the
world’s biggest record labels including Warner, Atlantic,
Elektra and Parlophone. The company had many major
recording artists signed to it, including Ed Sheeran and
Katy Perry, representing over 80 000 songwriters and
composers, from Beethoven to Madonna. The company
also owns the music publisher Warner Chappell which,
2
3
4
Define the terms:
a ‘company’
[2]
b ‘private sector’.
[2]
Calculate Warner Music’s profit as a percentage of
[2]
its revenue in 2019.
Analyse one reason why investors would buy
shares in Warner Music.
[4]
Evaluate the extent to which the price of a share in
Warner Music depends on when it is sold.
[12]
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1 Business and its environment
AS LEVEL
1.3
Size of business
In this chapter we examine:
★ how the size of a business can be measured
★ the significance of small and family businesses for the economy
★ business growth.
1.3.1 Measurements of
business size
The size of a business can be measured in many ways such as:
» the turnover (revenue) of the business
» the number of employees
» the value of the assets of the business shown on its
statement of financial position
» the market value of the business (for example, the value
of all of its shares)
» other indicators such as the number of stores or even
the number of vehicles (for example, for a bus company).
The best measure will depend on the sector you are
considering. For example, public sector organisations might
not generate revenue (for example, if the health service is
provided for free) so it may be more appropriate to measure
the number of employees.
It is also important when considering the size of a business
to think about its ownership. What seems like a ‘small’
business may actually be part of a much bigger ‘parent’
organisation and therefore have access to its funds and
expertise. When governments are considering policies,
such as subsidies and tax allowances, they will examine the
ownership of a business and whether it is part of a bigger
parent organisation.
HANDLING DATA
Your company has 30 000 shares. The share price
increases from $2.50 to $2.80.
a Calculate the old and new market values.
b Calculate the percentage change in the market value
of the company.
1.3.2 Significance of small businesses
Chapter overview
1.3.2 Significance of small
businesses
Advantages and disadvantages of being
a small business
The advantages of small businesses are that:
» they are relatively easy to set up
» they are flexible because decisions can be made quickly
(without having to consult lots of other people)
» they are often run by very motivated individuals
because they probably set up and own the business, and
so they want it to succeed because they personally gain
the rewards
» they are often very creative because it is easy for those
involved to communicate with each other and share
ideas.
STUDY TIP
Note that profit measures the success of the activities
of a business. It is not in itself a measure of the size of a
business.
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1.3
CASE STUDY
Businesses in the EU
AS LEVEL 1.3 Size of business
Shown below is the way in which the size of businesses
is categorised within the European Union (a grouping of
27 European countries). This is important because it can
affect the government support that is available and which
regulations apply to them.
When determining a business’ size, the number of
employees is always taken into account and either the
annual turnover or the annual statement of financial
position total.
Micro, small and medium-sized businesses account for
99 per cent of businesses in the European Union.
Question
1
Analyse two benefits these businesses bring to the
[8]
EU economy.
▼ Table 1.7 Measuring the size of businesses within the European Union
Enterprise category
Number of employees
Annual turnover (€m) OR
Annual statement of financial
position total (€m)
Medium-sized
< 250
≤ 50
OR
≤ 43
Small
< 50
≤ 10
OR
≤ 10
Micro
< 10
≤2
OR
≤2
However, small businesses do have disadvantages:
» They lack power in the market (for example, with suppliers
and customers) and so can find it difficult to survive.
» They may lack much experience compared to more
established firms.
» They may find it difficult to raise finance because of the
high risk involved as so many small businesses fail.
This is why governments sometimes try to help small
businesses by providing advice, lower taxes and less
regulation to help them survive.
CASE STUDY
Small business finance
Small and medium-sized enterprises (SMEs) face
challenges getting finance, said the Vietnam Chamber
of Commerce and Industry (VCCI). It said that finance
was expensive because the banks themselves are
paying high interest rates of more than 13 per cent to
get savers to provide them with funds. The banks also
prefer to offer loans to large companies and state-run
enterprises as they are a safer investment.
Family businesses have some strengths:
» The family members may share values, leading to fewer
disagreements.
» Those involved may work hard so that the family as
a whole prospers; their ties to the business will be
emotional as well as financial, which may make them
more committed to the survival and success of the
business. This may mean they will work harder and for
longer than outsiders.
» Individuals may be very supportive of each other
because they are family members.
» Family members may be willing to plan for the long term
because they will be looking for the benefits they can
bring for future generations.
» A number of family members may be involved in
providing finance and expertise.
» There may be decreased costs as family members may be
willing to work for less than outside employees, at least
in the short term.
The Vietnamese government has ordered the banks to
lend more to SMEs.
Questions
1
2
Analyse two ways that high interest rates might
make it difficult for SMEs to survive.
[8]
Evaluate why the Vietnamese government might
beeager to lend more to SMEs.
[12]
Strengths and weaknesses of family
businesses
A number of businesses in an economy will be run by families.
This is especially true in countries such as India, where the
culture tends to encourage families to work together.
▲ Figure 1.11 Family businesses are common in some
countries, such as India.
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However, there may also be weaknesses:
» Sometimes in a family business, decisions may be made
for emotional reasons rather than rational ones. It may
be that the correct thing is to do ‘A’ but because we
don’t want to upset a family member we do ‘B’ instead.
» The family members may lack the right experience
but there may be reluctance to bring in outsiders.
Sometimes the wrong people may be doing jobs but
family ties keep them in that role.
» It may be difficult to manage your relationship with
others in the business easily because you will be
influenced by emotional issues as well as business
factors.
» The biggest difficulty for any family-run business is
handing over power to the next generation when the
current head of the family retires.
A family business
Nelson Assemany and his four brothers opened a shop
together in Rio de Janeiro in 1967. Now employing their
sons, today they have two shops: one selling fabrics, the
other selling imported consumer goods.
Family businesses are also more likely to be focused on
long-term growth, because the aim is to pass them on to
the next generation, while large companies are often too
concerned with short-term results and shareholder profits.
While outsiders often think Brazilian business is dominated
by big companies such as the mining business Vale and
oil group Petrobras, in reality 85 per cent of the country’s
companies are much smaller, family-run operations.
These businesses can adapt easily in a crisis compared to a
company managed by a board of directors, where you have
to consult other people and get approval for everything.
Questions
The importance of small businesses
and their role in the economy
In most economies, the majority of businesses are quite
small, often one-person businesses. For example, plumbers,
hairdressers, restaurateurs, lawyers and photographers
are often sole traders. Although these small businesses
are the most significant in terms of number, the larger
businesses tend to dominate in terms of the total number
of people they employ and the value of the output they
produce. There may only be one Google or one Ford, for
example, but they each employ a lot of people and have a
very high turnover! Nevertheless, the small business sector
is very important to any economy. This is because small
businesses:
» create jobs, reducing unemployment
» provide competition for established businesses to ensure
they remain competitive
» provide new sources of ideas. Small businesses are often
very creative and many innovations start in smaller
organisations
» can go on to grow in the future.
Small businesses and the economy
Small businesses are important to economies because they
help create jobs and are often sources of innovation. Many
new products or new ideas come from small businesses,
so they are a source of entrepreneurial thinking. Small
businesses create competition and provide momentum to
an economy to promote economic growth. However, the
founders and owners often need support. Governments may
provide this support through:
1
2
Define what is meant by the term ‘company’.
[2]
Evaluate the advantages and disadvantages of family
businesses.
[12]
1.3.2 Significance of small businesses
CASE STUDY
1.3
» better business and enterprise training at school and
university
» access to support and advice
» access to finance
» making it easier to start up and run a business; for
example, by removing regulations that add to costs and
make it difficult to operate.
The role of small businesses as part
of the industrial structure in some
industries
Small businesses are often very innovative. In industries
such as pharmaceuticals and computers, many of the
breakthroughs are made by small businesses; bigger
businesses then often take over or work with the smaller
organisations to develop the ideas further. Bigger, more
established businesses often provide the finance and
capacity to produce and sell the product on a large scale.
Small businesses can also provide specialist services
that bigger organisations might not be interested in
providing for themselves; for example, while the larger
firm concentrates on its core business, the small firm
might specialise in, say, digital marketing, specialist legal
advice or provide expertise on a new market overseas.
Small businesses can concentrate on small segments of
the market (called niches) and sell their services to bigger
organisations who buy in this expertise.
GLOSSARY TERM
A niche is a small segment of a market.
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1.3
CASE STUDY
Businesses in the UK private sector
The data below shows the composition of the UK economy in 2019 in terms of the size of businesses.
AS LEVEL 1.3 Size of business
▼ Table 1.8 Estimated number and size of businesses in the UK, 2019
Business
Employment (thousands)
Turnover (£ millions)
All businesses
5 867 770
27 498
4 149 973
SMEs (0–249 employees)
5 860 085
16 630
2 168 005
Small businesses (0–49 employees)
5 824 500
13 157
1 528 684
With no employees
4 457 820
4 835
304 508
All businesses with employees
1 409 950
22 663
3 845 465
1–9 employees
1 155 385
4 206
595 013
10–49 employees
211 295
4 116
629 163
50–249 employees
35 585
3 473
639 321
250+ employees
7 685
10 868
1 981 968
of which:
Source: UK government, Department for Business, Energy & Industrial Strategy
Question
1
Evaluate the contribution of small businesses to the UK economy in 2019.
HANDLING DATA
The market as a whole is worth $960 000. Your niche is
worth $60 000. What percentage of the market is this?
1.3.3 Business growth
Business growth is a common objective of any business. By
growing:
» a business can get more power over suppliers and
customers, which might help it to make more profits
» a business can reach more customers and there is the
possibility of more profit through more sales
» the owners can eventually own something that is worth
more
» the owners can have a sense of achievement because
they can look back and be proud of having grown the
business
» a business can raise its profile.
Why and how a business might grow
internally (organic growth)
The size of a business is not fixed – it can change over time.
One way to grow is to expand your existing operations. This
is called internal or organic growth.
To do this a business may:
» try to grow sales of its existing products in its existing
markets
[12]
» develop new products for its customers
» find new markets where it can sell its existing
products.
External growth
External growth occurs when a business expands by buying
up another business or joining with another business. This
is known as integration. The process of integration is
sometimes called a merger and sometimes a takeover. In
a merger, two or more businesses mutually agree to join
together to form one new one. Alternatively, one business
may unilaterally decide to acquire another; this is known as
a takeover.
In the case of a takeover, one business buys control of
another one by gaining the majority of its shares. It can do
this by offering shares in its business (which is called a paper
offer) or by paying to buy the shares (which is a cash offer) or
a combination of the two. The directors of the company being
targeted may welcome the bid and advise their shareholders
to sell; this is a friendly takeover, which could be called a
merger. However, the directors of the target company may
resist the bid and advise their shareholders not to sell; this
then becomes a hostile takeover.
There are different forms of integration:
» Horizontal This occurs when one business joins with
another at the same stage of the same production
process; for example, a car manufacturer acquires
another car manufacturer.
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» Vertical This occurs when a business acquires another
The motives for these different types of integration may
vary; likely reasons for them are shown in Table 1.9.
▼ Table 1.9 Motives for different forms of integration
Type of integration
Likely motives
Horizontal
Greater market power; economies of
scale
Forward vertical
Gaining access to the market, for
example, by joining with retailer
Backward vertical
Gaining control over supplies – this
may improve co-ordination, improve
quality and reduce costs
Conglomerate
Spreading risks by operating in
different markets; less vulnerable
to a change in conditions in one
market
Integration and stakeholders
The coming together of businesses will have an impact on
stakeholders. The precise effect will depend on the nature
of and success of the deal. However, some of the potential
implications are:
» Investors The deal is likely to cost money initially
but, if it works, bring higher returns in the long term.
If investors generally approve of the deal, the share
price of the bidder will rise and, if profits do increase,
dividends may as well. However, in reality many mergers
and takeovers do not do as well as expected, in which
case the shareholders of the bidding company may be
disappointed.
» Managers The effect on managers will depend on
the deal, but in some cases it will mean there is a
duplication of roles. Company A may have a marketing
manager and so might company B. With integration
there may be an opportunity to save money by only
having one marketing manager.
» Suppliers They may benefit if the combined business
does well and grows. However, the new, bigger business
may have more power to push down prices from suppliers.
Why a merger/takeover may or may not achieve
objectives
1.3
Many businesses like the idea of external growth. This is
because it is a way of growing rapidly. By joining with
an existing business, it is possible to quickly enter a new
market or to achieve a much bigger presence in a market.
However, often these deals are not as successful as
expected. Problems of mergers and takeovers include:
» the costs of doing the deal itself. Integration may involve
legal costs, finance costs and reorganisation costs
» the clashes that may occur when the businesses start
to try and work together. There can often be significant
differences in the way that people work, what they
prioritise and how they make decisions, and this can
lead to friction, higher costs and mistakes being made
» inefficiency because the business is too big. This can
cause problems co-ordinating it, communicating to staff
and building a common sense of purpose.
1.3.3 Business growth
business at a different stage of the same production
process. Backward vertical integration occurs when
the business joins with a supplier; forward vertical
integration occurs when a business joins with a business
closer to the customer, such as a distributor or retailer.
» Conglomerate diversification This occurs when a
business joins with another business operating in a
different sector; for example, a car manufacturer joins
with a confectionery business.
Joint ventures and strategic alliances
Another form of external growth occurs when a business
forms a joint venture or establishes a strategic alliance
with another business. This means they agree to co-operate
in specific areas but do not fully join together in all aspects
of their operations. In the case of a joint venture, the
businesses create a new legal entity to collaborate together.
The joint venture agreement will specify all the details of
the contract, including the rights of the partner businesses,
the objective of the venture, how day-to-day operations
will be carried out and how profits will be distributed. In
the case of a strategic alliance, they remain completely
independent businesses but collaborate on a given project.
The advantage of joint ventures and strategic alliances is
that businesses share their expertise and assets in areas
where they feel this will bring benefits. However, they
can avoid some of the problems that come with trying to
integrate whole businesses together. Strategic alliances will
often be used when co-operating on a project allows the
businesses involved to benefit from each other’s resources
and expertise and to make more profits.
Joint ventures are often used when businesses enter
new markets. The ‘outside’ business can join with a local
business and use its expertise and contacts. In this
situation, a joint venture can reduce risks by making
use of the local business’ inside knowledge, contacts
and awareness of the country’s culture and business
environment. In some countries, foreign businesses can only
operate in conjunction with local ones and so joint ventures
are a common way of entering the market.
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1.3
TEST YOUR LEARNING
Short answer questions
AS LEVEL 1.3 Size of business
1
a
State two ways of measuring the size of a
business.
[2]
b Explain one possible advantage of being a big
business compared with being a small business.[3]
2 Explain one problem of being a small business.
[3]
3 Explain one reason why a government might want
[3]
to support small businesses.
[2]
4 Define the term ‘internal growth’.
5 State two ways in which a business might try to
grow.
[2]
6 Explain one advantage of being a family business. [3]
7 a Explain one reason why a business might want
to grow internally.
[3]
[3]
b Explain one problem of internal growth.
8 a Explain one reason why a business might want
[3]
to grow externally.
b Explain one benefit of horizontal integration.
[3]
9 Explain one reason why a merger or takeover may
not achieve its objective.
[3]
10 Explain one benefit of a using a joint venture to
enter an overseas market.
[3]
Data response question
Family businesses in Asia
From Samsung in South Korea, Reliance Industries in
India, to Hon Hai, the Taiwanese maker of the iPad, family
businesses dominate Asia’s (and increasingly the world’s)
business environment. They make up half of Asia’s public
limited companies and a third of the market capitalisation
value of all companies on the stock exchange, and they
employ millions of people. However, many of these
businesses are failing to plan for the transition to a public
limited company with external shareholders. This can
lead to uncertainty, at best, and potentially ruinous family
disputes. For example:
l Lee Kun-hee, the 70-year-old chairman of electronics
giant Samsung, was sued by both his brother and sister
over company shares left by their late father.
l India’s richest man, Mukesh Ambani, was involved
in a five-year dispute with his brother Anil over their
father’s vast Reliance empire.
l In Hong Kong, a row emerged over the future of
billionaire Stanley Ho’s Macau casino business, which
led to Mr Ho arguing against some of his own children.
l Winston Wong, eldest son of the late Taiwanese tycoon
Wang Yung-ching, sued to recover $4 billion worth
of disputed assets that he claimed were taken by
members of his father’s third family. Wang founded
Formosa Plastics, one of Taiwan’s biggest companies.
Given that many of Asia’s most successful businesspeople
are now in their eighties and nineties, the next decade
will probably see a number of contentious leadership
successions.
Asia’s biggest family businesses
l
l
l
l
l
l
l
l
l
l
Samsung Electronics (South Korea)
Reliance Industries (India)
Hon Hai Precision Industries/Foxconn (Taiwan)
Sun Hung Kai Properties (Hong Kong)
Tata Consulting (India)
Cheung Kong (Hong Kong)
Hutchison Whampoa (Hong Kong)
Wilmar International (Singapore)
Bharti Airtel (India)
Formosa Petrochemical (Taiwan)
A recent study tracked the market performance of
250 family companies that underwent a succession. It
found that, on average, these companies’ market values
declined by almost 60 per cent during the period starting
five years before the succession and up to three years
afterwards. The performance of a family firm is often
down to the skills, charisma and connections of the
founder, something that subsequent generations may find
hard to replicate.
Questions
1
2
3
Define the terms:
a ‘public limited company’
[2]
b ‘market capitalisation’.
[2]
Explain two reasons why family businesses are so
important to the economy.
[6]
Evaluate whether family businesses are ‘ultimately
[12]
doomed to fail; it is just a question of time’.
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1 Business and its environment
AS LEVEL
1.4
Business objectives
1.4.1 Business objectives in the private sector and public sector
Chapter overview
In this chapter we examine:
★ business objectives in the private and public sectors
★ objectives and business decisions.
1.4.1 Business objectives in the
private sector and public sector
GLOSSARY TERMS
An objective is a target. A good objective will state what
is to be achieved (for example, an increase in profit), how
much the business wants it to be (for example, $25 000)
and when it wants this to be done by (for example, in three
years). This means a good objective should be:
» specific in terms of what the target is
» quantifiable (measurable)
» time-specific in terms of when it should be completed.
Labour productivity measures the output per time period
of an employee.
A business will have an overall objective, such as a target of
doubling its profits within five years. This will then give the
business’ managers the opportunity and information to set
departmental targets. For example:
» The marketing department may have to increase sales by
40 per cent over an agreed period.
» The operations management department may need to
reduce costs by 20 per cent over the next three years.
» The human resources department may have a target to
increase labour productivity by 8 per cent over the
same time period.
Within each department every individual should also have
their own objective. For example, to reduce costs by 20 per
cent, the person responsible for ordering supplies for the
business may be set a target of finding a supplier that is 5 per
cent cheaper. The manager in charge of sales for the southeast of the country may be asked to increase sales in their
area by 30 per cent to help overall sales rise by 40 per cent.
Those objectives which relate to the entire business, such
as growth, are also termed corporate objectives.
The setting and pursuit of objectives of a business helps
it to co-ordinate its activities, whether it operates within
the private sector or the public sector. It provides goals for
employees at all levels within the organisation and helps
managers to co-ordinate the activities of all employees. The
Starbucks case study on page 34 emphasises the importance
of objectives within large and growing organisations.
Corporate
objectives
Departmental
objectives
▲ Figure 1.12 Business objectives
Individual
objectives
An objective is a target that is measurable and has a given
timescale.
A corporate objective is a target set for the business as a
whole.
Business objectives in the private
sector
We saw in Chapter 1.2 that private sector businesses are
owned by individuals. Businesses in the private sector can
have a number of objectives, including the following.
Profits and profit maximisation
Profits are maximised when the difference between sales
revenue and total costs is at its greatest. Some firms set
objectives which involve achieving a minimum level of
profit, allowing the business and its managers to focus
on other objectives. This approach, known as satisficing,
may be pursued by smaller family-owned organisations.
Satisficing allows the owners of these businesses to achieve
other targets, such as entering new markets or increasing
the size of the business.
Other businesses may seek to earn the greatest possible
profits to satisfy their shareholders’ desire for high
dividends. This might be a shorter-term objective. Others
may pursue the longer-term objective of providing acceptable
levels of dividends, but they may also look for growth in the
value of the company and therefore in its share price. This
can provide shareholders with long-term financial benefits.
Growth
Many businesses have an objective of growth because their
managers believe that the organisation will not survive
otherwise. If a firm grows, it should be able to exploit
its market position and earn higher profits. This benefits
business owners (in the long term) by providing greater
dividends, as well as offering better salaries and more job
security to the employees and managers of the business.
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1.4
The case study on Starbucks shows that the company has
set itself the aim of growth. This will have been expressed
in quantified objectives, possibly relating to sales figures or
market share in other countries.
CASE STUDY
AS LEVEL 1.4 Business objectives
Starbucks’ objectives
Starbucks is an American multinational company. In 2019,
it operated 30 600 stores in 80 countries selling coffee,
other drinks and food.
at cafés open for at least a year have increased by 6 per
cent globally. In 2019, its sales reached a record figure of
$6.8 billion.
Starbucks sets out its objectives clearly on its website and
one of these is growth. Starbucks has put in place a range
of plans to achieve its growth objective. The company has
opened new restaurants, improved its use of technology
within its stores and developed new products for its
customers.
Questions
These decisions appear to have been successful, as
Starbucks has improved its financial performance. Sales
1
2
Explain one reason why making Starbucks’ employees
responsible for its marketing might help the company
to achieve its objective of growth.
[3]
Evaluate the benefits that Starbucks might receive
from its clearly stated business objectives.
[12]
Survival
Diversification
This objective is for the business to continue to trade over a
defined period of time, rather than to submit to some form
of commercial pressure and be forced to cease trading. This
is an important objective, even for the largest of businesses
at certain times. However, it is a more common one for
small and newly established businesses. Survival is likely to
become a key objective during:
» periods of recession or intense competition
» times of crisis, such as during the 2020 Coronavirus
(COVID-19) pandemic.
Diversification is an objective where a firm produces an
increased range of unrelated goods and services. Adopting
this objective allows a business to spread its risk by selling
a range of products (rather than one) or through trading in
different markets. Thus, if one product becomes obsolete
or a market becomes significantly more competitive, then
the alternative products or markets will provide a secure
source of revenue for the business while it seeks new
projects. Diversification allows a business to avoid relying
on one or two products and has been the principle behind
the creation of conglomerate businesses – those that sell
a range of products in different markets. PepsiCo Inc., the
multinational soft drink and snack producer, has pursued
the objective of diversification to extend its product range
beyond soft drinks. This is intended to help it to compete
with its powerful rival, The Coca-Cola Company.
Cash flow
For most businesses, cash flow is a vital element of success
as it is essential to be able to pay debts on time. This is
especially true of businesses that have long cash cycles.
A cash cycle is the time that elapses between the outflow
of cash to pay for the resources needed to produce a
product and the receipt of cash following the sale of the
product. Businesses in industries such as pharmaceuticals
and construction may have long cash cycles.
Walt Disney, the global entertainment company, has an
objective to strengthen its cash-flow position. The failure
to set an objective relating to cash flow could have dire
consequences for a business if it is unable to pay its debts
as they fall due. In the worst case, a shortage of cash could
result in a business having to cease trading.
GLOSSARY TERMS
The market share of a business measures its sales as a
percentage of the total market sales.
Cash flow is the movement of cash into and out of a
business over a time period.
Ethics are moral principles that can shape the way a
business behaves.
Social responsibility is a philosophy under which
businesses consider the interests of all groups in society
as a central part of their decision-making.
Business objectives in the public sector
Providing a service to the community
Businesses in the public sector are owned by the government.
Usually a major objective of businesses in this sector is
to provide a service to all of the country’s population. For
example, if a transport system is owned by the government,
it may operate bus services to remote areas where few
people live. Private sector businesses may not be willing to
do this as it may not be profitable due to the low number of
passengers. In India, the government has set public sector
businesses the target of constructing 11 000 kilometres of
roads each year to improve transport services.
Similarly, it may be necessary for public sector businesses to
provide some products that otherwise may not be available.
Private sector businesses may not be willing to make the
huge investments necessary to develop systems needed
to supply utilities such as gas, water and electricity. In
many countries these services are supplied by the public
sector. For example, in Pakistan there are publicly owned
businesses supplying electricity in many localities including
Lahore, Faisalabad and Multan.
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Social objectives
Businesses in the public sector do not seek to maximise
profits, unlike many of those in the private sector. In many
countries, public sector organisations are expected to at
least cover their operating costs, to avoid needing financial
support from the government. Public sector businesses in
some countries have an objective to generate a financial
surplus which is reinvested to improve the service offered
by the business. In 2020, businesses in the public sector in
Indonesia were reviewed by the government, and some were
merged with others or closed due to very weak financial
performance.
Social objectives include targets that relate to matters
such as providing employment for people or improving
facilities for local people (for example, building a play park
for local children). Social enterprises frequently reinvest
their profits to help to meet their social objectives. A study
by the University of Pennsylvania showed that many social
enterprises have ambitious goals of having more clients and
expanding their operations but that few set quantifiable
targets.
Development of relatively poor regions
Many countries operate public sector businesses in regions
with low incomes. This can help to raise standards of living
in less affluent parts of the nation. In New Zealand, the
government is making changes to ensure that public sector
organisations meet the needs of the country’s indigenous
Maori population.
Private sector business
(e.g. Lenovo, Tata Group)
Profits and
profit
maximisation
Growth
Survival
Cash flow
Diversification
Public sector businesses
(e.g. electricity supply)
Providing a
service
Financial
objectives
Regional
development
Social enterprises
(e.g. Wikipedia)
Social objectives
Ethical objectives
▲ Figure 1.13 Objectives for different business sectors
The objectives of social enterprises
Social enterprises are businesses which operate to benefit
the community or society in general. As a result, they
normally set themselves social and ethical objectives.
Social and ethical objectives have received much attention
recently. In part, this is the result of widespread access
to the internet, making it easier for the public to discover
information about the behaviour of businesses. Some
investors will only invest in companies that trade with
ethical or social objectives. Importantly, a significant
proportion of customers seek to purchase products from
businesses with social and ethical objectives. Pursuing such
objectives, and publicising the fact, can offer a business a
distinctive and attractive image.
1.4
1.4.1 Business objectives in the private sector and public sector
Financial objectives
Ethical objectives
Ethical objectives are those that are based on moral
principles. Examples of ethical objectives include protecting
the environment through the use of sustainable production
techniques and ensuring that suppliers receive fair and
prompt payment.
The importance of business objectives
Business objectives set out what the business wants to
achieve. This provides a focus for all decisions. Employees
know what they are supposed to achieve and can then make
suitable decisions. Without objectives, employees do not
know the priorities and do not know how success will be
measured. This can lead to a loss of focus and a wasteful
use of resources. Objectives can:
» motivate employees by providing targets
» provide a measure of control, as progress can be
reviewed against these targets.
Corporate social responsibility as a
business objective
A business may have many objectives relating to different
areas. For example, it may want to boost profits but, at the
same time, may be aware of its impact on society as a whole
and the environment in particular. Any business will have
certain responsibilities to other groups by law. For example,
there are laws in many countries determining the minimum
an employee can be paid, the information businesses have
to provide about their products, and the procedures to be
taken to make the working environment safe. All businesses
should have an objective of acting legally. However, some
may accept obligations to society over and above the legal
minimum; this type of behaviour is known as corporate
social responsibility (CSR). For example, a business may
believe:
» it should ensure that work is interesting and that
employees have a good career path within the
organisation
» it has a responsibility to keep people in work as much as
possible and therefore be reluctant to force anyone to
leave the business
» it is important to pay suppliers quickly rather than
taking as long as possible and holding on to money
» it should invest in its local community to improve the
area and quality of life of the community where it is
based.
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AS LEVEL 1.4 Business objectives
1.4
CASE STUDY
The Good Hotel
The Good Hotel is part of the Good Group, set up by
Marten Dresen. The Good Group is a social enterprise,
offering customers luxury accommodation in wonderful
locations. In 2020, the business operated hotels in London
and Antigua de Guatemala. By 2021, it plans to open hotels
in five new locations.
The Good Hotel operates in an environmentally conscious
way. It sources its food locally and treats suppliers fairly.
It offers vegetarian and vegan meals and does not use
plastic straws in any of its hotels. It does not put TVs in its
hotel rooms, opting to instead provide spaces that facilitate
connection and conversation. The Good Hotel believes that
‘conversation is the key to community’.
All the business’ profits are invested into educational
projects in Guatemala to provide skills and training to those
A business that acts responsibly believes it is a corporate
citizen with obligations to society. This type of business
will set targets to do more for society than it is obliged to
by law.
who really need it. According to its website, a one-night stay
can finance one week’s education for a child in Guatemala.
In its first year of trading, Good Group donated approximately
$80 000 to its causes in Guatemala, and is on target to
donate more than $500 000 per year. This has financed the
building of three schools, providing quality education
for over 500 students in impoverished Guatemalan
communities.
Source: www.good.community
Questions
1
2
Explain one way in which operating as a social
enterprise has shaped The Good Hotel’s objectives. [3]
Evaluate whether The Good Hotel can be expected to
compete successfully with other hotels operated by
businesses in the private sector.
[12]
of people and its impact on the planet. This is known
as the triple bottom line (profit, planet, people) and it
encourages sustainable production, allowing it to continue
in the long term without damaging the environment.
CSR and the triple bottom line
While many organisations see profit as important, they
may also be concerned about how this profit is made and
the impact of the business on others. This means that
businesses often have social and environmental objectives
relating to how they treat suppliers, how they treat staff
and the impact of their activities on the environment and
other groups, such as the local community. A business may
be willing to accept lower profits if it significantly reduces
pollution, if it ensures only recycled resources are used and
if it helps the local community, for example.
This increasing interest in social and environmental
issues may be because there is more information available
about such things and so managers are making betterinformed decisions. It may also be a response to the fact
that consumers, employees and investors are increasingly
interested in such issues. Not only that, if competitors are
demonstrating their environmental and social awareness,
then other businesses may have to follow in order to retain
their competitiveness. John Elkington, a business author
and advisor, suggested a business’ performance should be
measured by examining three Ps: its profits, its treatment
Profit
Planet
Sustainable
production
People
▲ Figure 1.14 Elkington’s triple bottom line
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CASE STUDY
1.4
Social objectives at Intel
Intel’s 2018 corporate social report states: ‘In celebration of
Intel’s 50th anniversary, we set a goal to engage 50 000 of our
employees to volunteer more than 1 million hours in 2018.
We exceeded that goal, with more than 68 000 employees
(or 64 per cent of our employees) volunteering approximately
1.5 million hours of service throughout the year. To support
our goal, each business group achieved a participation rate
of over 50 per cent. Over the past 10 years, our employees
have generously donated their skills, technology expertise
and more than 10 million hours of service to tackle
environmental challenges, improve education and help
meet community needs around the world.’
Intel’s volunteer groups have worked in many countries
including Malaysia, Japan, Namibia and Puerto Rico.
Source: Corporate Social Responsibility at Intel, 2018–19 Report
Questions
1
▲ Figure 1.15 The Intel organisation believes in corporate
social responsibility
Mission statement, aims, objectives,
strategy and tactics
The mission of a business is the fundamental reason why
it exists. A mission statement sets out the purpose of
the business. For example, an airline may exist to be the
‘best airline in the world’; a computer manufacturer may
aim ‘to help people work more effectively’, and a cosmetics
business may intend ‘to bring beauty to everyone’. The
mission will be determined by the owners of the business.
A business’ aims are its long-term goals and are often
referred to as its corporate aims, meaning that they
relate to the whole business. Businesses do not normally
state aims as numerical targets but rather in qualitative
terms. For example, a housebuilder might set itself an
aim of building environmentally friendly homes. Both
corporate aims and mission statements are set by senior
managers within the business. They are designed to
provide guidance for setting objectives and to assist junior
managers in decision-making.
The mission and aims are rather general statements and,
unlike objectives, whether or not they have been achieved
cannot easily be measured. What exactly does a business
measure to decide if it is the best airline? It could be the
number of planes it operates, or the number of passengers,
or perhaps the level of customer satisfaction. This is why
corporate objectives exist, to turn the mission and aims
into measurable, specific and time-related targets.
2
Define the terms:
a ‘mission’
b ‘objectives’.
Evaluate the extent to which Intel benefits from
having a widely publicised mission statement.
[2]
[2]
[12]
Once these targets have been set, the business has to
decide how to achieve them most effectively. The longterm plan to achieve an objective is known as a strategy.
For example, if a business wanted to increase profits by
30 per cent in three years, the strategy might be to target
overseas markets. However, this strategy has to be put
into action; in this example, a decision has to be taken on
which countries will be targeted. However, other decisions
have to be made too: In what order will the new markets
be entered? What products will be offered in each? The
shorter-term action plans that combine to make up the
strategy are known as tactics.
Mission
statement
Aims
Objectives
Target
Strategy
1.4.1 Business objectives in the private sector and public sector
Intel is one of the world’s largest manufacturers of
semiconductors, a component used in many electrical
products including telephones and computers. In 2019,
it employed more than 110 200 people across the world.
The company’s mission statement is ‘to bring smart,
connected devices to every person on Earth.’ It believes
that technology can help to improve living standards.
Tactics
▲ Figure 1.16 From mission to tactics
GLOSSARY TERMS
A mission statement sets out the overall purpose of a
business.
An aim is a long-term goal that determines the objectives
that an organisation sets itself.
Strategy is the long-term plan to achieve the objective of a
business.
Tactics are the short-term actions needed to implement
the strategy.
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1.4
1.4.2 Objectives and business
decisions
AS LEVEL 1.4 Business objectives
The role of objectives in the stages of
business decision-making
Managing a business involves many different decisions;
for example, deciding on the objectives, deciding the best
way of achieving these (which is set out in the company’s
strategy), and deciding how to bring the strategy about on
time and at an acceptable cost through use of appropriate
tactics. Making the right decisions is therefore an important
part of good management. Decision-making involves:
» Setting the objectives This is essential because
the success of a plan can only be judged against the
objectives that were set. Making a profit of $100 000
may be disappointing if the objective was $300 000,
but not if the target was $80 000! It is important to set
realistic and achievable targets.
» Gathering information Before you decide what to do,
you need information on where you are at the moment,
what else is happening and what your options are in
order to analyse the situation.
» Selecting a suitable strategy Having analysed the
information, you can decide on the best strategy; for
example, targeting domestic or overseas markets.
» Implementing the strategy This is where the tactics
come in to make sure the plan works well.
» Reviewing This is essential to see how you have got
on and what, if anything, needs to be changed. After
the review you can consider whether the objectives are
still appropriate or not; you may need to set higher or
different targets, for example.
Implementing
the
strategy
Decision-making is a continuous process in which decisions
are being taken and reviewed and new objectives are set.
Translating objectives into targets
and budgets
The overall objectives of a business need to be cascaded
down into departmental and then individual targets for
people. Using objectives throughout the organisation helps
to ensure everyone is working towards the same aim. With
each objective there should be a strategy of how it is to be
achieved and specific tactical targets showing the details of
the activities that need to be undertaken. A plan will show:
» who is in charge of what
» what they have to do
» when it must be done
» how much they have to spend; that is, what budget has
been agreed.
A budget is a financial target that might set out expected
revenues and also anticipated expenditure. This helps with
financial planning. The size of the budget will depend on
what the objective is and what has to be done to achieve it.
GLOSSARY TERMS
A target is a goal pursued by a business, such as achieving
a particular market share or rate of growth of sales.
Budgets are financial plans setting out a business’ future
revenues and expenditure.
Setting
objectives
Reviewing
want the business to grow faster, for example, or are
more concerned about the environmental record of the
business than the previous owners.
» External Perhaps the economy has gone into decline and
so the organisation needs to reduce its growth target.
Perhaps competitors have entered the market, which
means the profit target was too ambitious and needs to
be amended downwards.
Ethical behaviour is behaviour that is thought to be
morally correct and not necessarily the most profitable.
Gathering
information
Selecting a
suitable
strategy
▲ Figure 1.17 The process of decision-making
How objectives might change over time
Over time, the objectives of a business may change. This
can be for many reasons, both internal (inside the business)
and external (outside the business):
» Internal A business may have new owners or managers
who want to achieve different things. Perhaps they
The communication of objectives and
their likely impact on the workforce
When setting objectives, this should be done in discussion
with the people who will be responsible for achieving them.
This should help make sure the objectives are realistic and
that the people involved are committed to achieving them.
If a target is forced on an employee, they may not try very
hard to achieve it because they may not think it is feasible
or even possible to hit.
Having an objective can be very motivating because it
provides a sense of direction, so that employees know
what they are doing and why, and how this fits in with
the overall strategy of the business. It can also motivate
because it sets workers a target, so they have something to
aim for and something that can be reviewed.
However, objectives may be demotivating if the person who
is set them does not believe in them and has no sense of
ownership. If an employee feels they have been set a target
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that cannot be reached, or they do not have the budget to
make it possible, they will probably feel demotivated. This
means that how an objective is set and what resources are
allocated to it are very important.
STUDY TIP
SMART objectives
To be effective, objectives should be SMART. SMART
objectives must be:
» Specific They must define exactly what the firm is
measuring, such as sales or profits.
» Measurable They must include a quantifiable target; for
example, a 10 per cent increase in sales revenues.
» Agreed If targets are simply imposed on people, they
are likely to resent them. If, however, the targets are
discussed and mutually agreed, people are more likely to
be committed to them.
» Realistic If the objectives are unrealistic (for example,
they are too ambitious), people may not even bother to
try and achieve them. To motivate people, the targets
must be seen as attainable.
» Time-specific Employees need to know how long they
have to achieve the target; for example, is it two or
three years?
1.4
How ethics may influence business
objectives and activities
Business ethics refers to what is considered to be right
or wrong in terms of business behaviour. For example, is
it ethical behaviour to sell cigarettes if you know they
can damage people’s health? Is it ethical to produce a
good or service if the process of producing it damages
the environment? Is it ethical to show advertisements for
children’s toys between children’s television programmes to
get the children to pester their parents to buy them?
Managers face ethical issues all the time, in all areas
of business. Sometimes the objectives of the business
can encourage unethical behaviour. If employees are set
extremely high sales targets, they might decide to sell
products to people who don’t really need them or to avoid
telling people some of the problems that might occur with
the product if they don’t ask. The drive to boost sales can
lead a business’ employees to behave badly. In recent years
there have been many sales scandals; for example, insurance
companies have sold people policies that were unlikely to
ever pay out and banks have not told people they could be
earning higher returns if they changed to a different type
of bank account. This behaviour is usually driven by a desire
to hit high targets, in order either to keep a job or to earn
bonuses.
1.4.2 Objectives and business decisions
Remember that some of the businesses you will
encounter in question papers may be large ones, and this
can pose a challenge for the business to communicate
corporate objectives clearly. This problem can be more
serious if the business operates in different countries
with different languages and time zones.
An example of a good objective might be ‘to increase profits
by 25 per cent over the next four years’. By comparison, a
bad objective would be ‘to do much better’ – it is not clear
what ‘doing better’ actually means, how it will be measured
or how long you have to achieve it.
CASE STUDY
Ethics at Texas Instruments
Texas Instruments (TI) is based in Dallas, Texas, and
makes a diverse range of electrical products including
military equipment and calculators. In 2020, it employed
30 000 people in 30 countries.
TI’s board of directors adopted ethical principles very
early. The company established an ethics office in 1987
and appointed the company’s first ethics director. Its
ethics director and staff have three primary functions:
l to ensure that business policies and practices are
continuously aligned with ethical principles
l to clearly communicate ethical expectations
l to provide multiple channels for feedback, through
which stakeholders may ask questions, voice concerns
and seek resolution of ethical issues.
Of course, unethical behaviour does not have to be the case,
but businesses must be clear on the behaviour they expect
from employees in terms of how they reach their targets.
The company’s website makes its ethical position clear.
‘Our challenge ... is to provide the tools employees may
need to make tough but appropriate decisions quickly.
We work to ensure they have a clear understanding of the
global rules and regulations that govern our operations, as
well as our own values, principles and ethical expectations.’
Source: Adapted from www.ti.com
Questions
1
2
Explain two reasons why Texas Instruments sets out
its ethical objectives on its website.
[6]
Evaluate the case for and against Texas Instruments
operating with ethical behaviour as a key objective at
all levels in the business.
[12]
This is why some businesses have a ‘code of ethics’ or a
‘code of conduct’ to make it clear to employees what is and
what is not regarded as acceptable behaviour.
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AS LEVEL 1.4 Business objectives
1.4
TEST YOUR LEARNING
Short answer questions
Data response question
1
A different bank
a
b
a
b
Define the term ‘business objective’.
[2]
Explain one feature of a good objective.
[3]
Define the term ‘mission statement’.
[2]
2
Explain one benefit to a multinational business of
[3]
having a mission statement.
[2]
3 a Define the term ‘corporate responsibility’.
b Explain one reason why corporate responsibility
is important to an oil company such as BP.
[3]
4 Explain two differences between strategy and
tactics.
[6]
5 Explain one type of strategy a business that is
entering new markets overseas might adopt.
[3]
6 a Explain one stage of decision-making.
[3]
b Explain one reason why it is important to review
[3]
decisions.
7 a Define the term ‘ethics’.
[2]
b Explain one reason why businesses try to take
ethical decisions.
[3]
8 Explain one reason why a marketing manager might
consider ethics when making a decision.
[3]
9 a Define the term ‘budget’.
[2]
b Explain one advantage to a business of setting a
budget.
[3]
10 Explain two reasons why a growing business’
objectives might change over time.
[6]
New Zealand has four major banks which dominate its
banking market, holding a market share of around 80 per
cent. Two years ago, Provident Bank opened its first
branches in Auckland and Wellington amid great publicity.
The new bank’s corporate objectives include achieving high
rates of growth and establishing 20 branches through the
country within its first three years of trading.
The bank has a mission statement which sets out its
commitment to a high standard of customer service. This
figures prominently on its website and is used in much of
its publicity, including its recruitment materials.
Provident Bank has set out to differentiate itself from its
rivals by adopting strongly ethical corporate objectives
which influence its strategy and tactics. It does not invest
in businesses whose actions damage the environment
or those that supply armaments. It is a carbon-neutral
business. Its charges are higher than the large,
established banks, but its marketing is distinctive and
research suggests that it is appealing to wealthy New
Zealanders.
Questions
1
2
3
Define the terms:
[2]
a ‘corporate objectives’
b ‘tactics’.
[2]
Analyse one reason why Provident Bank considers
its mission statement to be important.
[4]
Evaluate the case for and against Provident Bank
adopting ethical corporate objectives.
[12]
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1 Business and its environment
AS LEVEL
1.5
Stakeholders in a business
In this chapter we examine:
★ the different groups affected by business behaviour
★ the relative importance and influence of stakeholders on a business.
1.5.1 Business stakeholders
Individuals or groups with an interest in
the activities of a business
All businesses involve and affect many other people and
groups by their activities. These individuals and groups are
called stakeholders. Stakeholders include:
» the owners of a business, such as the shareholders of a
company
» the business’ employees
» the business’ managers, who take tactical and strategic
decisions
» the suppliers of goods and services
» the banks and other organisations that provide finance
» customers, who buy the products
» the local community, which may be concerned about
issues such as employment and pollution
» the government, which collects tax revenues and hopes
for high employment levels.
Stakeholders may not have formal authority over a
business, but it may be in the business’ best interests to
take their needs into account when making decisions. It has
become more common for businesses to attempt to meet
the needs of as many of their stakeholders as possible in
order to generate a positive image.
STUDY TIP
When responding to questions about stakeholders, do not
be too ambitious and write about too many stakeholders.
This will make it difficult to develop arguments fully and
to write analytically. Instead, you should select the two
or three stakeholder groups that are most relevant in the
circumstances and focus exclusively upon these.
Internal and external stakeholders
1.5.1 Business stakeholders
Chapter overview
The stakeholders of any business can be divided into two
categories: those who are part of the business and those
who operate outside it.
Internal stakeholders include:
» the owners of the business – this covers sole traders,
partners and shareholders
» the business’ employees, such as managers and shopfloor workers.
External stakeholders include:
» suppliers. These are the individuals and other
organisations that provide businesses with the goods
and services that are needed to carry out production
» customers who purchase the goods and services that are
sold by the business
» the government, both local and national
» banks who provide businesses with a range of financial
services, such as giving loans
» the community, including people who live near to any of
the business’ facilities.
Internal stakeholders
(e.g. owners,
managers,
other employees)
Stakeholders
External stakeholders
(e.g. suppliers,
customers,
the government,
the bank,
the community)
▲ Figure 1.18 Internal and external stakeholders
GLOSSARY TERMS
Stakeholders are groups or individuals who have an interest
in a business.
Internal stakeholders are individuals and groups within a
business; for example, employees.
Authority is the power or ability to carry through a task or
action.
External stakeholders are groups outside a business; for
example, people who live near to the business’ premises.
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AS LEVEL 1.5 Stakeholders in a business
1.5
Roles, rights and responsibilities of
the stakeholders
Each of the stakeholder groups above will have their own
objectives. Some examples are:
» Employees may want good rewards for the work done,
job security, a safe working environment and some
opportunities for promotion.
» Shareholders will want financial rewards in return for the
risk of their investment.
» Suppliers will want to be paid on time and to be kept
well-informed of any changes in orders.
» The government will want the business to act legally; for
example, to pay its taxes on time.
Each stakeholder will have certain legal rights. Employees
may have an employment contract that the business must
adhere to, while the owners or shareholders are entitled
to be kept informed of the business’ activities. These
stakeholders may also have responsibilities to the business.
In return for their wages, employees are expected to
complete their tasks competently; in return for payment for
their products, suppliers should supply goods and services
of an appropriate quality and quantity. Businesses are
therefore in a two-way relationship with their stakeholders.
▼ Table 1.10 Summary of stakeholders’ roles, rights and responsibilities
Stakeholders
Possible rights include
Possible responsibilities include
Employees
• To be treated fairly
• To be paid fairly
• To be kept informed
• To work effectively
• To turn up for work on time
Suppliers
• To be paid on time
• To be informed of any potential changes in orders
in the future
• To provide good quality products meeting the set
specifications at the time set
Owners/
shareholders
• To receive a share of profits
• To be kept informed by management
• To treat management fairly
Customers
• To be supplied the right quality products on time
• To pay on time
Government
• To be paid taxes
• To have businesses obey the law
• To protect businesses, customers, employees and
the environment
Managers
• To be rewarded appropriately for responsibilities
• To have duties commensurate with seniority
• To carry out duties to best of ability
• To be discrete in handling sensitive business data
Banks and other
lenders
• To be repaid promptly and on time
• Not to charge excessive interest rates or to
withdraw loans without a reasonable period of
notice
The local
community
• To live in an area that is free from excessive noise
or other forms of pollution
• To have a say in decisions which impact the local
community
• To benefit from employment
• To co-operate with the business in its daily
activities
CASE STUDY
Gold Fields Limited engages stakeholders
Gold Fields Limited operates eight mines in Australia,
Chile, South Africa, Peru and Ghana. The business’
mining operations in Ghana make it the country’s largest
producer of gold and the largest private sector employer
with approximately 5200 direct and 83 000 indirect
employees. It uses a forum to discuss issues and listen to
its stakeholders. The aim is to engage with and update key
stakeholders on its operations and activities.
Those invited include government ministers, members
of the community, financial institutions, investors and
the media. The company is committed to sustainable
development and has invested in socio-economic
development projects in the community where it operates.
Its investment focuses on education, health, water
and sanitation, and development. A world-class water
treatment plant has recently been constructed at Tarkwa
and this provides communities with access to clean water.
The company has also tried to employ locals wherever
it can – a high proportion of the company’s workforce in
Ghana are locals.
Questions
1
2
Explain one reason why employees and customers
might be Gold Fields’ major stakeholders in Ghana. [3]
Evaluate the extent to which Gold Fields Ghana
may have benefited from holding its ‘stakeholder
forum’.
[12]
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Why become a shareholder?
Shareholders can also influence the policy of the business.
Most types of shares grant their owners voting rights. Each
share is worth one vote. By buying more shares, people can
get more votes and have a greater influence over what the
firm actually does. If someone owns more than 51 per cent
of the shares, they control the business and, therefore, can
decide company policy.
All companies must have an annual general meeting (AGM)
to which the shareholders are invited and every shareholder
must receive a copy of the company’s annual report. The
annual report reviews the performance of the business over
the last year. At the AGM, the directors and managers give
an overview of the company’s position and respond to any
questions that shareholders might have.
In the UK, financial institutions such as banks, pension
funds and insurance companies own most company shares.
These organisations buy shares to make a profit through the
dividends they receive and by selling the shares at a higher
price later on. They can then pass their profits on to their
own investors.
GLOSSARY TERM
Dividends are money that is paid out of profits to
shareholders. It is a reward to the owners of the business.
1.5.2 The relative importance
and influence of stakeholders on
business activities
The interaction between a business’
decisions and its stakeholders’
responses
Any business decision can impact on stakeholders. Examples
include:
» Employees may be affected by a decision to reduce the
size of the business.
» Shareholders will be affected if the profits of the
business are low.
» Suppliers may be affected by an increase in orders and
be able to grow their businesses.
» The community may benefit from the expansion of the
business and greater income being earned and spent in
the area.
jobs and more taxes being paid.
1.5
The impact of business activity can be positive or negative.
Sometimes one group may benefit and another may suffer.
For example, a decision to cut wages would not be popular
with staff but may enable higher rewards for the investors.
A decision to shift production abroad would not benefit
the government of the original country but may benefit the
community where production now occurs.
If stakeholders do not welcome changes, they can take
various actions to avoid the effects of them. The following
are examples of possible responses from stakeholders:
» Shareholders can sell their shares and invest elsewhere.
» Banks can refuse to lend more or charge more for
businesses to borrow.
» Employees can leave and work elsewhere or, as a group,
they may take strike action, which means they withdraw
their labour, hoping to get the business to change its
policy.
» Suppliers can refuse to supply the business or demand
better payment terms, such as payment on delivery.
The impact of stakeholder aims on
business decisions
Most stakeholder groups have aims in their relationship with
the business. We shall consider some examples.
1 Employees This stakeholder group is likely to have aims
such as improving working conditions, maximising pay
and other benefits, and seeking secure employment.
Businesses have to take these aims into account
when making decisions. For example, Google employs
many highly skilled people. When taking decisions on
investing in expansion, the company would ensure that
it budgets for attractive pay rates, provides working
conditions that encourage and promote creativity and
that it offers job security. If Google failed to take these
decisions, it would experience difficulties in recruiting
the most talented and productive employees.
2 Customers Arguably this stakeholder group has the
greatest impact on business decisions, particularly when
the customer has a wide choice of suppliers of a product.
If, for example, a supermarket takes a decision to raise
prices, it may find that many of its customers buy
their groceries elsewhere. The decisions taken by many
managers in businesses will be intended to provide the
best possible value and service to their customers. In
this way, customers are a major force shaping business
decisions.
3 Suppliers Businesses depend on suppliers to deliver
raw materials, components and other services.
Without receiving the correct supplies at the right
time, a business may not be able to continue trading.
Businesses would normally seek to take decisions which
do not impact adversely on suppliers, such as delaying
payments or changing orders at short notice. A supplier
is more likely to have a significant impact on business
decisions if it is a major supplier and if there are few or
no alternative sources of supply.
1.5.2 The relative importance and influence of stakeholders on business activities
By investing in a company, shareholders become the
owners of the business. This means that, if the business
is successful, the value of their shares should increase.
Shareholders should also receive some of the profits that
the company makes each year. The part of the profits paid
out to shareholders is called the dividends. The more profit
a firm makes, the bigger the dividends are likely to be.
Each year the shareholders will decide on the amount of
dividends to be paid per share; the more shares a person
has, the more dividends they receive in total.
» The government may be affected by the creation of more
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AS LEVEL 1.5 Stakeholders in a business
1.5
4 Owners and shareholders Shareholders can be a
very influential group on business decisions taken by
companies. Shareholders in the UK can vote to remove
directors of a company if the directors take decisions of
which the shareholders disapprove. The owners of small
businesses (sole traders and partners) are more likely to
be the people who are taking the business decisions.
Thus, there is less chance of any disagreement occurring.
How and why a business needs to be
accountable to its stakeholders
The shareholder concept
Businesses have certain legal responsibilities to their
stakeholders. For example, there are laws controlling the
ways in which businesses can promote their products and,
for food manufacturers, the ingredients that can be used.
Some businesses simply do what they have to by law and no
more. They focus mainly on rewarding their owners. They
will pay employees what they need to get the job done
but do not think they have any more responsibilities other
than this. They will try to get the lowest price for supplies,
perhaps by threatening to use different suppliers. They will
pay governments the taxes they have to but will not think
they have any obligation to invest more in their region or
country. This is known as the shareholder concept, where
rewarding owners is the key business objective.
The stakeholder concept
However, increasingly, organisations are trying to work with
their stakeholders and regard them much more as partners.
This co-operative approach is known as the stakeholder
concept. This view believes that it is better in the long
term to treat stakeholders well.
For example, working closely with suppliers and paying
them a fair reward for their work (even if this is more
than the business would have to pay) will lead to better
quality suppliers and much greater flexibility by suppliers
to help out when needed. Focusing on employees’ careers
and showing concern about their welfare could lead to
greater loyalty and commitment and, as a result, a better
quality of work. Being interested in the environment could
help save costs through initiatives such as recycling,
but it could also make the business more attractive to
employees, customers and investors. The stakeholder
concept fits in with corporate social responsibility in
that it stresses the benefits of accepting obligations to
stakeholders over and above what the law requires.
CASE STUDY
Hitachi: contributing to a sustainable society as a good corporate citizen
Hitachi is a multinational company, based in Japan,
that produces a range of products including trains,
construction equipment and power tools.
was due to its stakeholders. The company has a good
relationship with its different stakeholder groups such as
customers, suppliers and national governments.
Climate change is a priority for Hitachi, and we are
striving to reduce CO2 [carbon dioxide] emissions ... We
announced our long-term environmental targets, called
Hitachi Environmental Innovation 2050, which include a CO2
reduction target of 80 per cent ... by 2050 (compared to 2010).
To achieve a resource efficient society, we are responding to
the issue of water scarcity and promoting the efficient use
of water and other resources. We are also promoting the
effective use of plastic and other resources to minimise our
impact on [the] natural [environment] ...
Hitachi believes it is important to be a good corporate
citizen. For example, it says that environmental issues
such as climate change are becoming a priority, and there
is increasing awareness of the relationship between
businesses and human rights. The United Nations has
asked companies to make broad contributions to society,
mainly through corporate activities, with an eye on the
environment but also alleviating poverty and protecting
human rights. Hitachi is eager to do just this.
Hitachi has faced a range of natural disasters, such as
an earthquake in Japan in 2011. Hitachi City in north
Tokyo, which is the headquarters of the company,
was particularly badly affected by the disaster. These
problems did disrupt the company’s supply chain but
the business continued to achieve good results. The
managers believe its ability to survive such disasters
A business is made up of people with different opinions
and, sometimes, very different views on what they want
to achieve and how they think it should be achieved. Any
major decision is likely to make some better off and others
worse off; it is therefore likely to meet with opposition from
some stakeholders.
Every decision will involve different stakeholders and
will consider their objectives and their relative power. Do
Source: Hitachi Sustainability Report 2019, www.hitachi.com/
sustainability/download/pdf/en_sustainability2019.pdf
Questions
1
2
Explain two ways in which Hitachi could claim to be a
good corporate citizen.
[6]
‘Working with stakeholders helps Hitachi.’ Evaluate
this statement.
[12]
managers want to listen to them? Do managers need to
listen to them? What will happen if managers ignore them?
This means the managers of a business need to think about
their relative power. A well-organised workforce that is
unionised, for example, may be able to negotiate for more
consultation and participation in decision-making than
individual employees could on their own. Managers may
want to pay more attention to an investor who owns 65
per cent of the company compared with one who owns
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1 per cent. A key supplier of a business’ major component
will have more influence than the supplier of a component
that can be bought in thousands of different stores. So,
the more well-organised a stakeholder group is, the more
managers need that particular stakeholder, and the more
that managers like or agree with the stakeholders and their
objectives, the more likely the stakeholders are to influence
a manager’s decision.
Level of interest
How conflict might arise from
stakeholders having different aims
and objectives
▲ Figure 1.19 A stakeholder map and how a business may
view different stakeholders
One of the issues when dealing with stakeholders is that
their aims might conflict; it might not be possible to please
all of the groups all of the time. For example:
» Investors may push for lower costs to increase their
profits and rewards and this may lead to fewer or lower
pay increases for employees.
» In order to meet customer demands for cheaper
products, the business may relocate to cheaper
production facilities overseas, thus upsetting the local
community.
» In order to meet government demands for more
environmentally friendly operations processes, the
business may change its production system, leading to
higher costs and higher prices for customers.
Groups in quadrant D are likely to influence decisions a lot.
They are interested in what is going on in the business and
A business may have to juggle different demands and
compromise on occasion.
High
Low
A
Minimal
effort
B
Keep
informed
High
C
Keep
satisfied
D
Key
players
Power
Low
CASE STUDY
Foxconn and Amazon
The Foxconn Technology Group manufactures technology
products for well-known multinational companies such
as Apple and Amazon. The company has been criticised
for reducing wages and not operating according to local
labour laws. In response, Foxconn dismissed two senior
managers at one of its factories where work is carried out
to fulfil orders from Amazon.
Foxconn has received a lot of criticism in the past for its poor
working conditions. Amazon and Foxconn have previously
attracted attention for allegations of poor treatment of
Chinese workers. The pressure group China Labor Watch
(CLW) published allegations in 2018 that Foxconn had
forced employees to engage in long – and illegal – periods
of overtime working. In response the company announced
that it had taken disciplinary action against the managers
responsible for mistreating employees.
‘Amazon and Foxconn responded that they would make
improvements to the factory’s working conditions,’ CLW
stated. ‘However, CLW’s 2019 investigation found that
How changing business objectives
might affect stakeholders
As the objectives of a business change, this may well
affect the way it treats its stakeholders. For example,
Foxconn’s working conditions did not improve, and instead
deteriorated.’
CLW also reported that Foxconn’s wages, which were
already very low, had been cut by a further 16 per cent.
This, the pressure group reported, had led to such low
rates of pay that the company experienced significant
labour shortages. These labour shortages resulted in the
company recruiting very young employees, a number of
whom had to work overtime.
1.5
1.5.2 The relative importance and influence of stakeholders on business activities
The role of different stakeholders can be shown using a
stakeholder map, as in Figure 1.19.
are very powerful (for example, major investors); managers
will need to keep this group happy. By comparison,
stakeholders in quadrant A are not very interested and are
not powerful (for example, your milk delivery service or
local newsagent); you do not need to worry much about
this group.
Source: www.digitalcommerce360.com/2019/08/09/amazon-isunder-fire-for-factory-hiring-practicesand-treatment-of-workers
Questions
1
2
Explain two reasons why some of Foxconn’s
stakeholders might not have approved of the actions
that the company has taken.
[6]
Evaluate whether Foxconn has done the right thing
by taking these actions.
[12]
a greater emphasis on environmental issues may lead
to more concern for society as a whole and future
generations, in addition to a focus on recycling, reusing
and less waste and pollution. A focus on better quality
might lead to better treatment of suppliers. On the other
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1.5
hand, greater pressure for profits may mean managers
start to cut back on training, career development and wage
increases in order to reduce costs; they might also bargain
hard to push down suppliers’ prices.
It is very difficult for managers to take decisions to satisfy
all stakeholders simultaneously, especially at a time of
change when major strategic decisions may be forced upon
them. It may be that the best they can do is to satisfy as
many stakeholders as possible.
AS LEVEL 1.5 Stakeholders in a business
TEST YOUR LEARNING
Short answer questions
Data response question
1
A change of approach
a
b
Define the term ‘stakeholder’.
[2]
Explain one reason why the Malaysian government
might be a stakeholder of a Malaysian retailer.
[3]
2 Explain one way in which businesses and employees
have responsibilities to one another.
[3]
3 Explain two possible responsibilities that a business
that manufactures chemicals might have to its local
community.
[6]
4 a Explain one responsibility that a business may
have to its suppliers.
[3]
b Explain one likely reaction of a retailer’s
stakeholders to a decision to close 10 per cent of
its shops to increase profitability.
[3]
5 a Explain one responsibility of the Indian
government to its businesses.
[3]
b Explain one way in which the adoption of an
objective of growth might affect an airline’s
customers.
[3]
6 a Define the term ‘social responsibility’.
[2]
b Explain one reason why a business might wish
to be accountable to its bank.
[3]
7 Explain two reasons why a large manufacturer might
experience difficulty in meeting the objectives of its
shareholders and its customers simultaneously.
[6]
8 a Explain one reason why a business might wish
to be accountable to its employees.
[3]
b Explain one way in which a retailer could be
accountable to its employees.
[3]
9 Define the term ‘internal stakeholder’.
[2]
10 Explain the possible effect of a hotel’s decision
to increase its prices significantly on two of its
stakeholder groups.
[6]
Multan Textiles Ltd has had a change of heart. Its new
management team has decided to implement a range
of policies intended to meet the needs of all of its
stakeholders, rather than solely its shareholders. The
adoption of policies based on the stakeholder concept
has significant implications for all of the company’s
stakeholders.
The company has agreed to raise its employees’ wages
over the next few years, at a rate in excess of the current
rate of inflation, and to improve working conditions. It
also has offered its suppliers more favourable credit
terms to encourage a long-term relationship. It is also
reviewing its manufacturing processes to minimise the
impact of the chemicals on its employees and the local
community.
The company has a long tradition of manufacturing textiles
in the region and a good reputation. It is profitable, although
its shareholders have expressed some dissatisfaction at
declining profit levels over the last few years.
Questions
1
2
3
Define the terms:
a ‘shareholder’
b ‘stakeholder concept’.
Analyse one benefit to Multan Textiles Ltd of
implementing policies based on the stakeholder
concept.
Evaluate the case for and against Multan Textiles
Ltd retaining its original approach based on the
shareholder concept.
[2]
[2]
[4]
[12]
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2 Human resource management
AS LEVEL
2.1
Human resource management
In this chapter we examine:
★ the purpose and roles of human resource management (HRM)
★ why and how businesses prepare workforce plans and the importance of labour turnover
★ how businesses recruit employees, including the process and key documents
★ how businesses select employees
★ the nature and use of employment contracts
★ the ways in which businesses make employees redundant and dismiss them
★ issues affecting staff morale and welfare
★ the purpose, methods and importance of training and developing employees
★ key elements of management and workforce relations.
What is human resource management?
Human resource management (HRM) comprises the
acquisition, training, motivation and reward of human
resources within the business.
Over recent years, the influence of Japanese management
techniques, and their evident success in managing
people, has encouraged the adoption of human resource
management by companies across the globe.
GLOSSARY TERM
Human resource management (HRM) is the process
of making the most efficient use of an organisation’s
employees.
2.1.1 Purpose and roles of human
resource management
Human resource management can help businesses to
generate a significant competitive advantage over rivals
and to achieve organisational objectives, such as growth
and increased profitability. Many companies use HRM to
enhance organisational performance.
If implemented fully and operated properly, HRM recognises
the individual rather than producing personnel policies for the
whole workforce. All the elements of HRM (such as recruitment
and selection, training and development, redundancy and
dismissal) are geared to fulfilling the needs of the individual
as well as those of the organisation. All aspects of the HRM
‘package’ should be co-ordinated to ensure coherence and to
assist the attainment of strategic targets.
If an organisation is successful in operating its HRM policy,
one outcome could be motivated and creative employees who
are committed to the firm and who do not seek to leave. Such
employees should be aware of the goals of the organisation and
understand how they can contribute towards the attainment of
organisational targets, such as growth in market share.
Under this scenario, a business should incur lower
recruitment costs and enjoy higher levels of productivity
and a reduction in faulty products. It may attract top-class
applicants to vacancies because of its reputation as a caring
and enlightened employer. All of these factors should make
the organisation more competitive and better able to cope
with the rigours of operating in international markets.
2.1.1 Purpose and roles of human resource management
Chapter overview
However, in reality the case for HRM is not so clear-cut. Many
businesses in the UK differ in their interpretation of HRM.
Some see it as a confirmation of the value of employees who
have to be developed to meet the needs of the organisation.
Others take a ‘harder’ attitude, viewing employees as simply
another resource to be used as effectively as possible. The
latter approach has a much more short-term focus and may
help a business to meet objectives, such as becoming the
lowest-cost producer in the market.
The fact that different interpretations of the policy exist make it
more difficult to assess its contribution to achieving objectives
and overall competitiveness. We will look at these two
approaches to HRM more fully in Chapter 7.4 later in this book.
The role of HRM in meeting
organisational objectives
We saw in Chapter 1.4 that an organisational or business
objective is a target that is normally specific in terms of what
the target is, how it is measured and the time by which it must
be completed. A business might set itself targets such as:
» achieving a certain growth rate in terms of sales (for
example, 10 per cent per year)
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» becoming the lowest-cost producer in a market, enabling
AS LEVEL 2.1 Human resource management
2.1
rewarding employees are, it is argued, best done by
managers and colleagues close to the employee in
question. Empowered teams can play a role in recruiting
employees and identifying training needs. This approach
to HRM embodies a philosophy entirely in harmony with
modern management techniques such as delayering and
teamworking. This approach to HRM can help a business
to meet challenges through possessing workforces which
are more efficient and responsive to customers’ needs
than those of competitors.
it to charge low prices
» attaining social objectives, including protecting the
natural environment or maintaining employment levels
in low-income communities.
Two key arguments exist which mean that the use of HRM
within businesses is vital to meet organisational objectives.
1 The nature of the workforce has changed over recent
years. Greater use of part-time and peripheral workers,
for example, has encouraged human resource managers
to view people as a resource to be deployed as
effectively as possible. Simultaneously, the existence of
a better-educated workforce, along with the expectation
that workers should carry out more complex tasks and
duties, has led managers to view employees as valuable
assets to be developed to make the organisation more
competitive and able to outperform rivals.
2 Changes in organisational structure have led to many
managers taking on responsibility for managing people
within the organisation. Techniques such as delayering
and the development of empowered teams have been an
integral part of the implementation of human resource
management. Acquiring, developing, motivating and
GLOSSARY TERMS
Delayering is a reduction in the number of levels of
hierarchy within an organisational structure.
Teamworking is the process of breaking down production
into large units and using groups of employees to
complete these tasks.
A workforce (or human resource) plan assesses the
current workforce and actions necessary to meet the
business’ future labour needs.
Labour turnover is the percentage of a business’
workforce that leaves a business over a given period of
time (usually one year).
CASE STUDY
The First State Bank
In 2020, the First State Bank announced that it was to
introduce a human resource management package to
improve the productivity of its 44 000 employees. This
programme is intended to develop employees’ skills and
to ensure suitable candidates are available for future
promotions.
The Bank will use technology to automate many of
the functions of its HR department, including paying
employees, booking holidays and repayment of some
expenses. Senior managers at the Bank estimate that this
will save approximately 5000 employee days of work each
month, resulting in a substantial cost reduction for the
publicly owned Bank.
2.1.2 Workforce planning
The reasons for and role of a
workforce plan
Before a business recruits, selects or trains employees, it
must establish future labour needs. This is not simply a
matter of recruiting sufficient employees. Those recruited
must have the right skills and experience to help the
organisation achieve its corporate objectives. Managers
will draw up a workforce plan or human resource plan
to detail the number and type of workers the business
needs to recruit, as well as the location where they will be
employed.
The automation of the HR function offers other benefits
to senior managers. The new HR system gives managers
instant access to all employees’ qualifications,
experience, performance appraisals and positions held.
This will help the Bank’s managers to manage the talent
available more effectively and will ease the process of
planning its future workforces.
Questions
1
2
Explain two reasons why HRM might be an
important issue within the First State Bank.
[6]
Evaluate whether the advantages of the
introduction of new technology into the Bank’s HR
department will outweigh the disadvantages.
[12]
Workforce plans plays an important role in making
businesses competitive and enabling them to meet their
organisational objectives. For example:
» They help businesses to deal with changes (such as the
impact of new technology or changes in consumers’
tastes) by ensuring that they have the right employees
in terms of numbers, work locations and skills.
» Workforce plans help businesses to prepare for changes
in the workforce, such as the introduction of new
production-line machinery or a significant proportion of
employees leaving through retirement.
Workforce plans are designed to help businesses to prepare
for changes in their environments and not simply to respond
to them.
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Labour turnover
turnover =
number of staff leaving during the year
× 100
average number of staff
This ratio measures the proportion of a workforce leaving
their employment at a business over some period of time,
usually one year. Low wages and inadequate training leading
to poor morale among employees may cause high levels of
labour turnover. Another cause is ineffective recruitment
procedures, resulting in the appointment of inappropriate
staff. Other reasons include redundancy and retirement.
HANDLING DATA
Last year, 45 employees at Kenya Fuels Ltd left
the company. The company had an average of 900
employees during the year. The company’s HR manager
had forecast that the company’s labour turnover figure
would be 4 per cent.
1 Calculate the labour turnover figure for this company.
2 How many employees would have left if the HR
manager’s forecast had been accurate?
Some level of labour turnover is inevitable. Managers seek
some labour turnover to bring new ideas into a business,
but not so much as to impose excessive recruitment costs.
A survey in the UK in 2017 by the Chartered Institute of
Personnel and Development (CIPD) revealed that labour
turnover in the UK was 16.5 per cent and that it has risen
steadily for some years. Businesses attempt to manage
labour turnover to achieve a balance between the costs of
recruitment and the potential for disruption to production
on the one hand, and bringing new employees with
enthusiasm and ideas into the business on the other.
The implications of different rates of labour
turnover
Surveys in the UK have shown that labour turnover for most
businesses surveyed has a negative impact on performance
and their ability to achieve organisational objectives. This
suggests that most businesses face a higher labour turnover
than desired or that they face unexpected recruitment
costs. If the rate of labour turnover continues to rise in
the UK, this may result in businesses incurring significant
additional costs to recruit and train new employees. They
may also face additional wage costs if they have to increase
pay to reduce the level of labour turnover.
However, it may be that a business suffers a rate of labour
turnover that is too low. For example, in creative industries
such as marketing, it is often helpful for a business to
have a stable and steady rate of turnover. This can help to
develop ideas for new products and more effective ways of
working.
The implications of different labour turnover rates depend
on the industry in which the business operates and the type
of labour in question. For example, a seasonal business that
hires a high proportion of unskilled employees may not be
concerned by high rates of labour turnover. It can recruit
during the off-season and its expenditure on training
is likely to be low. The same would not be true of an
organisation that employs highly skilled employees who are
difficult to replace. A hospital might be an example of this
type of organisation.
2.1
2.1.2 Workforce planning
Businesses require a range of information when developing
human resource plans:
» They need to research to provide sales forecasts for the
next year or two. This will help identify the quantity and
type of labour required.
» Data will be needed to show the number of employees
likely to be leaving the labour force in general (labour
turnover). Information will also be required on potential
entrants to the labour force.
» If wages are expected to rise then businesses may
reduce their demand for labour and seek to make greater
use of technology.
» The plan will reflect any anticipated changes in the
output of the workforce due to changes in productivity
or the length of the working week.
» Technological developments will impact on planning the
workforce. Developments in this field may reduce the
need for unskilled employees while creating employment
for those with technical skills.
CASE STUDY
Labour turnover and restaurants in the
USA
Hotels and restaurants across the world face very
high rates of labour turnover. Restaurants in the USA
experienced rates of nearly 75 per cent in 2018, meaning
that around three-quarters of business employees are
leaving each year. The equivalent figure for 2010 was
57 per cent.
The restaurant industry is the US economy’s largest
employer of teenagers, as one-third of all working
teenagers in the USA are employed in a restaurant. The
industry also employs a high proportion of students,
who may only work part of the year and tend to leave
employment once they finish studying. This helps
to reduce costs and to allow restaurants to charge
competitive prices for meals.
Restaurant guests also develop a comfort level with an
employee with whom they regularly interact. Appointing
new employees can affect regular operations which are
vital to the smooth running of any restaurant, especially in
the kitchen. Having skilled and experienced staff is vital in
the American restaurant industry, where competitiveness
is based heavily upon employee performance.
Questions
1
2
Explain two reasons why labour turnover rates
of ‘nearly 75 per cent’ might cause problems for
managers in restaurants in the USA.
[6]
Evaluate the possible actions the managers of
restaurants in the USA might take to reduce rates
of labour turnover.
[12]
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2.1
2.1.3 Recruitment and selection
The process of recruitment
AS LEVEL 2.1 Human resource management
The process of workforce planning, in which a business
analyses its expected future labour needs and compares this
to its current workforce, may identify the need for recruiting
new employees. Alternatively, the need for recruitment
may arise because an existing employee opts to leave. The
recruitment process is summarised in Figure 2.1.
Use HR plan to decide
number and type of employees needed
Prepare:
1 Job adverts
2 Job descriptions
3 Person specifications
Advertise outside the
business (external recruitment)
Advertise inside the
business (internal recruitment)
recruitment difficulties. The key reason cited was a lack of
suitable candidates. Recruiting is expensive. The average
recruitment cost of filling a vacancy in the UK in 2020 was
£3000 and took nearly 28 days, during which output and
sales may have been lost. However, many managers would
argue that these figures are less costly than appointing the
wrong employee and perhaps having to repeat the process.
Two very important documents used in the process of
recruitment are job descriptions and person (or job)
specifications.
GLOSSARY TERMS
Recruitment and selection is the process of filling an
organisation’s job vacancies by appointing new staff.
Job descriptions list the duties and responsibilities
associated with a particular job.
Person (or job) specifications outline the skills,
knowledge and experience necessary to fill a given
position successfully.
An employment contract is a legal agreement between
an employer and an employee setting forth the terms and
conditions of the employment arrangement.
Job descriptions
Receive job applications
Prepare shortlist for selection,
matching applications and person
specifications
Select employees using interviews, etc.
▲ Figure 2.1 The process of recruitment and selection
Source: CIPD Resources and Talent Planning Survey
Recruitment is likely to be a more important activity in a
business that is expanding or one which is developing new
products or entering new markets. In such cases, the business
may require a substantial number of new employees and these
may come from inside the business (existing employees) but
are more likely to be recruited from outside it.
STUDY TIP
It is easy to get bogged down in the detail of recruitment
and selection procedures. While such knowledge is
fundamental, it is vital to think about how successful
different approaches to recruitment and selection might
be in helping the business to achieve its organisational
objectives.
In 2018, more than 70 per cent of businesses taking
part in a UK survey said that they were experiencing
Once managers know the type and number of employees
required, job descriptions can be prepared. These relate
to the position rather than the person. Typically, job
descriptions might contain the following information:
» the title of the post
» employment conditions
» some idea of tasks and duties
» the key aims and responsibilities of the job
» where the job fits into the organisation.
A job description is likely to form the basis of the
employment contract, which we consider below. It also
offers other important information to employers and
employees.
» It helps employers by allowing them to consider exactly
what should make up the job and how this job relates
to others within the organisation. It can also be used
to judge performance of an employee at some point
following their appointment. Employees can be set
targets based on the information included in the job
description. During an interview, the job description
might form the basis for the interviewer’s questions.
» It provides potential employees with essential
information to help them to decide whether or not to
apply for a job. For example, the descriptions of tasks
and duties will help them to decide whether they would
enjoy the role.
Person specifications
Person or job specifications set out the qualifications
and qualities required in an employee. They relate to the
employee, whereas job descriptions relate to the job. They
include:
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» educational and professional qualifications required
» character and personality needed
» skills and experience wanted.
Candidates’ applications should be compared against the
person specification and those applicants with the ‘best fit’
should be invited to interview or other selection procedure.
This document, therefore, plays a vital role in helping an
organisation decide which of the applicants for a post
should progress to the next stage of selection.
Once managers have prepared job descriptions and person
specifications, a decision has to be made as to how to recruit
the necessary employees. A number of options are available.
Job advertisements
The start of recruitment is often drawing up an advert
for the vacant position. This advert could be placed in
newspapers, magazines or on the internet. The advert
needs to be targeted so as to attract suitable applicants
while dissuading unsuitable candidates from applying.
For example, if an international airline such as Pakistan
International Airlines was recruiting a senior manager, it
may advertise the vacancy globally. In contrast, a retailer
seeking to advertise a vacancy for a shop assistant would
be more likely to advertise the job in a local newspaper.
In part, the choice of where to advertise a job will also be
determined by cost; generally, businesses are willing to
spend more heavily on recruiting senior employees.
2.1
Online recruitment
Online recruitment allows businesses and other
organisations to use their websites to recruit potential
employees cheaply and from any part of the world.
This method of recruitment can increase the number of
applicants and the quality of employees who are eventually
employed. Online advertising can reach much larger
audiences, increasing the number of applicants. Equally,
this form of advertising can be targeted, as relevant
groups help to improve the quality of applicants. Websites
operated by both businesses and governments bring
together those seeking work and businesses intending
to recruit. Examples include the privately owned Rozee
website (www.rozee.pk) in Pakistan and the New Zealand
government’s jobs website (www.jobs.govt.nz).
2.1.3 Recruitment and selection
Methods of recruitment
together employers and potential candidates. Businesses
may use employment agencies to recruit highly specialist
employees or those with skills that are scarce. Although
this is a costly method of recruitment, agencies often have
skills and contacts that many businesses do not possess.
CASE STUDY
Job advertisement
An effective job advertisement should contain sufficient
information to attract and engage potential employees
but not too much so as to discourage them from applying.
Figure 2.2 contains a checklist of possible information to
include in a job advertisement.
BUILDING A BETTER WORLD
OSEEC provides a platform for social, economic and environmental
communication and collaboration, with the aim of creating and supporting
policies that increase development in these sectors, enriching quality of life for
people across the globe. Our platform enables global organisations, charities
and governments to share information, co-ordinate resources and collaborate
efforts to tackle shared social, economic and environmental problems.
Director – Environment Directorate
Job title
www.oseec.org/ed
A Berlin-based position with a competitive salary and benefits
The Environment Directorate (ED) oversees global communication on
environmental objectives, including design, collaboration and implementation
of multinational policies to combine economic efficiency with sustainable
environmental practice. The ED also provides information, analysis and
advice to support emerging and transition economies currently engaged in
development, promoting inclusivity and environmental sustainability.
Location of job
Brief description of business, its products and markets
Outline of job role
This position provides intellectual and strategic leadership in the areas of
biodiversity and biosafety, natural resource management, climate change and
environmental indicators, resource efficiency and waste reduction, and
sustainable environmental practice. This position is responsible for ensuring
that current and future policies fully reflect the aims of OSEEC in this
Directorate and for providing effective support for OSEEC members.
Any special features of the job such as part-time or
flexible hours
Some indication of qualifications and experience
required
The successful candidate will have significant knowledge and experience in
the aforementioned policy areas, with attestable powers of analysis,
communication, planning and organisation. They will be expected to
promote the intrinsic value of OSEEC in bringing together world partners
to multiple audiences, obtaining wide-reaching media coverage.
Salary or salary guide
Other reward details such as a company car
Explanation of how to apply and the recruitment
process
This position requires fluency in either English or German and a partial
knowledge of, or willingness to learn, the other. Full details of the position can
be found at www.oseec.org/careers/vacancies (ref. 93752). Applications
must be submitted online by 23 March 2020.
Contact details for the business
▲ Figure 2.2 A checklist for writing job advertisements
▲ Figure 2.3 An example job advertisement
Employment agencies
Question
Employment agencies provide employers with details
of suitable applicants for posts they may have vacant.
Agencies usually charge considerable fees for bringing
1
Evaluate whether or not this is an effective job
advert.
[12]
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AS LEVEL 2.1 Human resource management
2.1
Other methods of recruitment
Internal and external recruitment
Firms headhunt employees who are currently working for
other organisations in order to offer them employment.
Those employees who are headhunted are usually either
senior managers or people with specialist skills, perhaps in
short supply. Specialist executive recruitment agencies exist
which can target precisely the right type of candidates, but
they normally charge high fees.
Firms may recruit internally through promotion or
redeployment of existing employees. Internal recruitment
offers a number of benefits:
» Candidates will have experience of the business and its
culture and will be familiar with the firm’s procedures.
» Internal candidates may not require induction training.
» Internal recruitment provides employees with
opportunities for promotion.
» It avoids the need for expensive external advertising.
» Selection may be easier as more is known about the
candidates.
Governments operate a number of training schemes to
improve the skills and knowledge of the workforce. In the
USA, the Department of Labor’s Employment and Training
Administration funds job-training programmes to improve
the employment prospects of adults, youths and workers
who have lost their jobs. Its training is designed to boost
workers’ employability and earnings. This provides a source
of employees for American businesses that are seeking to
recruit workers.
However, internal candidates are drawn from a limited pool
of employees and the skills and experience of this group of
people may be insufficient to meet the business’ needs. This
limitation is more likely in the case of smaller businesses and
with senior appointments or for rapidly growing businesses.
CASE STUDY
IHG uses online recruitment in Dubai
The InterContinental Hotels Group (IHG) is about to open
a new hotel in Dubai. Many of the guests at this new
hotel will be from countries other than the United Arab
Emirates (UAE), as Dubai is a major tourist destination
and its airport is a hub for flights from a large number
of countries. The Indigo Dubai Downtown has launched a
recruitment campaign to attract employees with a range
of skills and experience. The intention is to appoint people
in a range of roles within the hotel including finance,
reception, cleaning, as well as bar and restaurant staff.
The company has a reputation for providing
accommodation within a relaxed setting. It has designed
a number of eye-catching adverts intended to attract
candidates with the skills and personalities that match its
needs.
IHG has used online recruitment to enable it to recruit
employees from any part of the world. This could
provide the company’s managers with a large number
of applicants from which to choose. One requirement
from any selected applicants will be to record a video
describing the place in which they live.
Source: Adapted from www.hoteliermiddleeast.com/
business/115326-hotel-indigo-dubai-downtown-launchesrecruitment-campaign
Questions
1
2
Explain two reasons why some potential applicants
may not apply for jobs using the IHG’s website.
[6]
Evaluate the case for and against companies based
in the UAE relying increasingly on their websites to
recruit new employees.
[12]
Managers may be keen to have a wider choice of candidates
and may seek to recruit externally. This can result in
applications from higher-quality candidates, especially if
recruitment is through national media or nationally based
recruitment agencies. External recruits may bring fresh
ideas and enthusiasm into the business. This can be a vital
factor in an organisation with a low level of labour turnover.
investing more resources and time in the recruitment and
selection process.
However, external recruitment is likely to be very expensive.
It also carries a greater risk as candidates are not known to
the business.
GLOSSARY TERM
A business culture is the attitudes, values and beliefs that
normally exist within an organisation.
Selection
A number of selection techniques exist. Because of the high
costs resulting from recruiting the wrong people, firms are
▼ Table 2.1 Methods of selection used by a sample of UK
businesses in 2015 and 2017
2015
survey (%)
2017
survey (%)
Competency-based interviews
77
78
Interview following contents
of CV/application form
83
74
Online tests
24
23
Personality/attitude
questionnaires
36
35
Assessment centres
38
39
Group exercises (e.g. roleplaying)
27
24
Method of selection
Source: Resourcing and Talent Planning Survey, 2017 (CIPD)
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Question
1
Evaluate whether the data in Table 2.1 suggests that
UK businesses are attempting to minimise costs of
selection.
[12]
and provide potential employers with a further indication
of the applicant’s suitability for the post. References are
not always accurate. For instance, an employer may give an
employee an undeservedly good reference if they want to
get rid of them.
2.1
Testing
Methods of selection
Curriculum vitae (CVs) take various forms but are all designed
to record key information about potential employees, such as
their education, professional qualifications and experience in
previous employment. This is designed to help managers to
match employees to person specifications which detail the
requirements of the job. Thus, they can form an important
element of the early stages of the selection process.
Résumés are very similar. A résumé normally summarises
the applicant’s relevant job experience, education and
training. The résumé is usually sent to employers with a
covering letter which may contain additional information.
Some businesses supply application forms for prospective
employees to complete. These are normally used in place of
CVs and résumés. They offer the advantage that businesses
can ensure that all applicants have the chance to supply the
information that is required to make the selection decision.
Also, because the application forms are in a standard
format, it can be easier to compare candidates’ applications.
CVs, résumés and application forms all tend to be used
early in the selection process, and they can be a useful
means of screening candidates and deciding which to
invite to interview or other method of selection. They are
particularly valuable if a business receives a large number of
applications for a position.
Interviews
These remain a popular form of selection technique and
are the most common in the UK, as shown in Table 2.1.
Interviews can involve one or two interviewers or even
a panel. Candidates can be asked a series of questions
designed to test their knowledge of, and suitability for, the
job. Some interviews (sometimes called competency-based
interviews) may require candidates to undertake specific
job-related tasks to assess their skills.
They are relatively cheap and allow the two-way exchange
of information, but are unreliable as a method of selection.
Some people perform well at interview, but that does not
necessarily mean they will perform well at work.
References
Many employers ask candidates to supply references at some
stage in the recruitment and selection process. These are
written by former employers or by other people in a position
of authority who may know the candidate well. They will set
out the candidate’s strengths and possibly their weaknesses
Assessment centres
2.1.3 Recruitment and selection
Curriculum vitae, résumés and application
forms
Testing as part of the selection process can take a variety
of forms. Psychometric tests are very common; these can
take two forms. An aptitude test provides candidates with
opportunities to demonstrate their skills and abilities
in relation to the job. For example, an aptitude test
for a sales role might involve the candidate making a
sales presentation. Personality tests examine the likely
behaviour of potential employees and how they might
respond to certain situations in the workplace. They
involve numerical and written questions and can help to
assess how well the applicant might fit in with existing
employees.
Managers are aware of the high costs of poor selection
decisions and this has led to the heavy use of assessment
centres. Many managers believe that this is a more
reliable method of selection. In such centres, a number
of candidates are subjected to a variety of selection
techniques over a period of between two and four days.
These might include some or all of the following:
» simulations of circumstances that might occur within
the job
» a variety of interviews
» group exercises, such as role-plays involving a number of
the candidates and assessment centre staff
» tests of candidates’ personalities.
Employment contracts
An employment contract is a legal agreement between
an employer and an employee, setting forth the terms
and conditions of the employment arrangement. It is a
legally binding agreement designed to protect the rights
of employers and employees. In the UK, the Employment
Rights Act requires employers hiring workers for more
than a month to issue an employment contract. A contract
does not have to be issued immediately upon an employee
starting work, but its conditions are in force from the
time an employee commences employment. Employees’
contracts may be verbal, implied (for example, through
previous practice) or written, though the latter is more
common and preferable in many ways.
The laws relating to employment contracts vary between
countries. Here we refer to those that apply within the
UK. An employment contract in the UK should contain the
following information:
1 the employee’s and employer’s names
2 date when employment began
3 the scale (and rate) at which the employee will be paid
and the frequency of payment
4 the employee’s usual hours of work
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AS LEVEL 2.1 Human resource management
2.1
5 the employee’s entitlement to holidays – how many days
and whether they can only be taken at certain times of
the year
6 rules relating to absences due to sickness or injury,
including sick-pay conditions
7 the employee’s right to a pension (if any) and employer’s
and employee’s contributions
8 the notice from either side to terminate the employment
contract. This states the period of time that must elapse
between the employee stating their intention to leave
the job and doing so. Similarly, it may record the time
period to be given to employees before making them
redundant or dismissing them
9 the job title and a summary of duties
10 the location or locations of the work
11 details of any trade union agreements relating to the job
12 disciplinary procedures – this sets out the rules
establishing standards of conduct at work and how the
employer may respond to any breach of these rules
13 grievance procedures – this will state how an employee
can make a complaint against other staff or their
treatment at work.
shall examine each of these situations in turn and explain
the difference between the two.
An employment contract may include implied terms which are
not directly stated. Examples of implied terms include:
» employees not stealing from employers
» employers providing a safe and healthy working
environment
» employers meeting legal requirements, such as giving a
minimum of a certain number of days of paid holidays
» employees should have essential qualities and
qualifications to carry out the job; for example, lorry
drivers should have a relevant category of driving licence.
Voluntary and involuntary redundancies
If either the employer or the employee suffers financial loss
because the other party has breached the contract, they
can claim compensation in a court of law. For example,
an employee who leaves before the end of a fixed-term
contract and thereby causes disruption to the employer may
be sued for damages. In many cases in the UK, an employee
may take an employer to an employment tribunal to settle a
certain range of disputes relating to employment.
Employment tribunals
Employment tribunals in the UK hear claims about matters
to do with employment. These may include unfair dismissal,
redundancy payments and discrimination. Employment
tribunals are similar to law courts, but they are less formal.
No one in an employment tribunal wears a wig or gown.
Almost all hearings are open to the public, and evidence is
given under oath or affirmation.
2.1.4 Redundancy and dismissal
It is only possible for an employer to legally terminate
the employment of a worker for specific reasons and
having followed certain procedures. It may be that the
employer takes disciplinary action against an employee;
this may result in the employee being dismissed. Similarly,
employment may be ended as a result of redundancy. We
GLOSSARY TERMS
A dismissal occurs when an employer terminates the
employee’s contract.
Redundancies take place when an employee is dismissed
because a job no longer exists.
Redundancy
Redundancy is a legal reason for an employer to dismiss an
employee, but it can only occur if a job no longer exists.
Redundancies can take place for a variety of reasons, including:
» A business closes down and all its employees are made
redundant.
» The jobs of some employees are replaced by new
technology.
» A business moves some of its operations overseas and
some jobs are lost as a consequence.
Voluntary redundancy occurs when an employer, wishing
to make redundancies, invites employees to apply for
redundancy in return for a financial compensation
package. This is often the first choice for a business
wishing to make redundancies. This form of redundancy can
help to maintain the morale of a workforce at what can
be a very difficult time for a business. Offering voluntary
redundancies means that employees choose to leave. Some
employees, for example, those near to retirement or those
who might find it easy to obtain alternative employment,
might find the offer of financial compensation very
attractive.
By contrast, involuntary (or compulsory) redundancy is
where employees are selected for redundancy. They have
no choice in the matter. This is likely to occur when a
large number of employees are to be made redundant
and insufficient people are willing to take voluntary
redundancy. Involuntary redundancies often damage the
morale and performance of the workforce. We shall see in
the next chapter that job security is an important factor
affecting motivation at work. Customers may also be less
willing to purchase products from businesses that are using
involuntary redundancies.
The law requires that use of involuntary redundancy must
follow set procedures. These are explained below.
Procedures for redundancy
If a business in the UK intends to make 20 or more
employees redundant, it is obliged to consult with any
relevant trade union or other employee organisation at
least 30 days before any redundancies occur. The employer
must also consult with individual employees. If 100 or more
employees are to be made redundant, consultations must
take place at least 90 days before the process of making
people redundant can commence.
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Part of this consultation may involve agreeing a procedure
by which those employees who are to be made redundant
are to be selected. It is likely to be beneficial to involve
employees and their representatives in making such
decisions. Businesses commonly seek to reduce the number
of employees who have to be made redundant by:
» asking for volunteers for redundancy
» banning any overtime to maximise the number of jobs
that are retained
» not replacing employees who leave for other reasons.
If, despite these measures, employees have to be made
redundant, there must be clear and agreed criteria for
selecting them. The criteria for redundancy could be based
upon employees’ skills and experience (that is, the business
would retain the most skilled and experienced) or on
absence and disciplinary performance (those with the best
records keeping their jobs). Employees who are selected for
redundancy must be given between one and twelve weeks’
notice of their impending redundancy, depending on how
long they have been employed by the business.
Airline makes redundancies
Philippine Airlines (PA) announced that it has cut 300
jobs as a result of continued financial losses. The
airline said that this will help the company to reduce its
costs, adding that it was offering voluntary redundancy
packages to long-serving employees. Those who accept
will receive benefits including flight pass privileges and
career counselling assistance. The company’s workforce
currently totals 6087 employees.
causing the cancellation of flights to mainland China,
Hong Kong and Macau.
Other cost-reducing initiatives include:
● increasing revenues from flights and other products
● a vigorous cost-management approach
● investment in digital technology.
Questions
The announcement was made after Philippine Airlines
posted its biggest ever loss ($208 million) in 2019. The
company blamed these losses on high levels of interest
payments on debts and on unexpected global crises,
Redundancy pay
Employees in the UK who have been continuously employed
by the business for two years and who are made redundant
due to the closure of the business or reduced need for
employees are entitled to compensation in the form
of redundancy payments. The calculation for statutory
redundancy pay is:
» half a week’s pay for each full year of service where the
employee is aged under 22
» one week’s pay for each full year of service where the
employee is aged between 22 and 41
» one and a half week’s pay for each full year of service
where the employee is 41 or over.
The maximum number of years that can be taken into account
in calculating redundancy pay is 20 years. Some employers
may choose to pay higher levels of redundancy pay.
Many employers will have a set of redundancy guidelines with
which they will comply to ensure that they do not break any
employment laws relating to the process of redundancy.
Dismissal
Dismissal takes place when an employer terminates an
employee’s employment contract. We saw above that
redundancy is one reason for dismissal. Thus, dismissal is a
more general term than redundancy, which is a specific form
of dismissal.
As part of its statement on the redundancies, the airline
said that it would be acquiring new aircraft and launching
new routes between Cebu and Los Angeles, as well as
routes to Perth, Pagadian, Kota Kinabalu and Manado.
2.1.4 Redundancy and dismissal
CASE STUDY
2.1
Source: Adapted from www.ch-aviation.com/portal/news/86974
1
2
Explain two reasons why Philippine Airlines might
prefer to use voluntary redundancies, rather than
involuntary redundancies, to achieve the desired
[6]
reduction in its workforce.
Evaluate the case for and against Philippine Airlines
[12]
making 300 employees redundant.
Apart from redundancy, there are a number of reasons why
employees may be dismissed legally in the UK. The reasons
for ‘fair’ dismissal include:
» when employees are unable to do their jobs properly,
perhaps because they do not have the necessary skills or
qualifications to be competent
» as a result of persistent or long-term illness (but not
because of a person’s disability)
» for ‘gross misconduct’ – theft or violence towards
colleagues or customers may be considered gross
misconduct
» a ‘substantial reason’ such as not agreeing to reasonable
changes in employment terms or if an employee is given
a prison sentence.
Employees should receive an explanation in writing of the
reason for their dismissal within 14 days of it happening.
Employees may also be entitled to receive up to 12 weeks’
notice of dismissal, depending upon how long they have
been employed by the business.
If employees in the UK are dismissed for other reasons,
this can be classed as ‘unfair dismissal’. Dismissals are
classed as ‘automatically unfair’ if the reason for dismissal
is connected with an employee exercising rights relating to
factors such as the following:
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2.1
» pregnancy: including all reasons relating to maternity
» family reasons: including parental leave, paternity leave
(birth and adoption), adoption leave or time off to care
for dependants, such as children who are ill
» trade union membership: including being a member of a
union and union recognition.
AS LEVEL 2.1 Human resource management
STUDY TIP
Do make sure that you distinguish between redundancy
and dismissal. Redundancy is just one of the reasons
why a business can dismiss employees fairly and legally.
Dismissal is a more general term.
2.1.5 Morale and welfare
At its most basic, every employer is required by law to
provide essential amenities such as toilets, sinks and clean
drinking water for employees. Most employees also hope to
find additional facilities, such as a cloakroom and a clean
and hygienic seating area for workers to use during meal
breaks. There should be facilities nearby for heating food or
water for hot drinks.
A ‘good’ employer who is concerned about employee
welfare may also consider other issues besides the physical
working environment. For example, such employers will seek
to develop their employees as fully as possible to improve
their performance at work.
Employee morale is the level of satisfaction, as well as the
overall sense of well-being, of a business’ employees. An
employee who is satisfied and content at work usually tends to
co-operate with colleagues and managers and to perform well.
GLOSSARY TERMS
Employee welfare is a broad term covering a wide range
of facilities that are essential for the well-being of a
business’ employees.
Employee morale is the satisfaction felt by employees
within the workplace.
Work–life balance refers to the obligations placed on
employees by employers that determine the amount of
time that employees spend on work-related activities.
HRM, welfare and employee morale
Human resource management can play a central role
in developing and improving the morale and welfare
of employees. Recruiting people with the intention of
developing their skills and improving their performance
throughout a long-term relationship is at the heart of
what is called ‘soft’ human resource management. Such
an approach to HRM may well seek to develop the skills of
employees and to encourage them to work with the business
for long periods of time. Using this ‘soft’ approach to HRM
also offers benefits to the business of providing good
facilities for employees.
CASE STUDY
Working at Google
Here’s a taste of what Google offer their employees:
● On-site physicians and nurses, convenient medical
services, and comprehensive health care coverage help
keep you healthy and happy. (Varies by location.)
● Googlers and their families have travel insurance and
emergency assistance, even on personal vacations.
● New parents get time off and some extra spending money
to help them welcome their new bundle of joy.
● We’ll reimburse you for classes or degree courses
that help you with what you do. Google is committed to
continuous learning among its employees.
● Googlers get legal advice at no cost and, in the USA, also
get common legal services at a generous group discount.
▲ Figure 2.4 More time with your baby (image for
illustration purposes only)
Source: www.google.com
Questions
1
2
Explain two reasons why Google’s employees might
benefit from the company’s commitment to continuous
learning.
[6]
Evaluate the benefits Google might receive from
treating its employees in this way.
[12]
▲ Figure 2.5 Travel without worries (image for
illustration purposes only)
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Work–life balance is a topic of increasing importance for
employers as well as employees. The term work–life balance
refers to the time an employee spends on work-related
duties compared with time spent on non-work activities.
Non-work activities include leisure interests and time spent
with family and friends.
Some governments have become concerned about the
possible adverse implications for the health of employees
and for rates of labour productivity of excessive working
hours. The European Union has implemented a working
time directive intended to limit working hours to a
maximum of 48 per week, although exceptions can be
made.
2.1
CASE STUDY
2.1.5 Morale and welfare
International working hours
Despite concerns about the work–life balance of many
employees, average working hours in many countries
have declined since 2012, as shown in Table 2.2 (below).
Many countries have laws to restrict the number of hours
people may work, though these are not always enforced.
For example, China has legislation imposing a 44-hour
maximum normal working week with overtime payments
for hours beyond this. However, surveys suggest that this
limit is ignored by many employers.
Foxconn is a major company in China which manufactures
large numbers of mobile phones for Apple and other
businesses. A report released in September 2019, by
China Labor Watch, alleged that Foxconn did not always
follow Chinese labour laws. This investigation found that
its Apple 11 factory ‘routinely’ and ‘repeatedly’ ignored
laws that were put in place to regulate the employment of
temporary workers.
Research has shown that long working hours can damage
the health of employees, endanger their safety at work and
increase levels of stress. A few countries have long average
working weeks. In Columbia, the average working week is
47.7 hours, reportedly the longest in the world. However,
long working weeks do not always lead to high levels of
productivity.
▼ Table 2.2 Weekly working hours in a selection of OECD
countries, 2012 and 2019
Country
2012
2019
Australia
33.2
32.9
Chile
39.0
36.8
Mexico
42.8
41.1
Spain
32.4
32.4
Turkey
35.7
35.2*
Average of OECD members
33.9
33.2
* 2018 data
It also reported that Foxconn failed to follow laws
concerning its permanent staff, including claims that
employees were not permitted to resign during peak
season, needed to provide three days’ notice if they
wished to quit during their probationary period, and
needed permission to not work overtime.
Source: www.theregister.com/2019/09/09/
foxconns_apple_11_ factory_clw_report/
Questions
1
2
Explain two reasons why many governments have
passed laws to impose limits on the number of
hours employees may work each week.
[6]
Evaluate the case for and against Foxconn
requiring its employees to work very long hours
each week.
[12]
Many employers are concerned about long working
hours and their impact on the work–life balance of the
people who work for them. Long working hours can
harm the performance of employees, which may have a
significant impact on the performance of the business
itself.
Some major businesses have implemented policies designed
to relieve the pressure on employees and to help them to
achieve a sensible balance between work and non-work
activities. The Colgate-Palmolive company is an American
multinational manufacturer of consumer products such
as soaps and detergents. It has acquired a reputation
for employment practices that set realistic expectations
for employees, and it encourages the development of
time-management skills. Colgate-Palmolive also offers
its employees the chance to work flexible hours and to
telecommute. It provides nearby back-up childcare facilities
to assist parents who work at home. As a result, ColgatePalmolive has a low rate of labour turnover, which offers it a
range of benefits.
Source: OECD data,
https://data.oecd.org/emp/hours-worked.htm
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AS LEVEL 2.1 Human resource management
2.1
The impact of diversity and equality in
the workplace
Although the terms ‘diversity’ and ‘equality’ are frequently
used together, and sometimes interchangeably, they have
different meanings.
Diversity, in a workplace context, refers to recognising the
differences between individual employees and also the
differences that may exist between different groups of
employees. Businesses that operate diversity policies will
treat people as individuals and will value the benefits that
diverse individuals and groups in a workplace may offer to a
business. Employee diversity could be based upon gender, race
and ethnicity, disability, religion, sexuality, class and age.
In contrast, policies related to equality are intended to
create a fairer society where all employees can contribute
and fulfil their potential. One key aspect of this is to operate
policies that allow all employees the opportunity to reach
senior positions in a business, irrespective of their age,
gender, ethnicity or sexual orientation. This is considered
necessary as many groups, such as women and minority
ethnic groups, are under-represented in senior positions
in businesses. This can mean that the skills and abilities
of such employees are wasted. By including such groups,
businesses can become more competitive and successful.
A number of governments have enacted employment
legislation to ensure that businesses design and implement
policies to encourage diversity and to promote equality.
For example, the UK government passed the Equalities
Act in 2010. This offered protection to employees on the
grounds of:
» direct and indirect discrimination
» harassment
» victimisation.
The Act identifies a number of ‘protected characteristics’.
These are:
» age
» disability
» gender reassignment
» marriage and civil partnership
» pregnancy and maternity
» race
» religion or belief
» gender
» sexual orientation.
Operating an effective policy for equality offers benefits
to businesses. Drawing on all people within the local
community when recruiting offers the best opportunity to
employ the most talented employees, which will enhance
the performance of the business. Similarly, promoting the
most able employee, regardless of personal characteristics,
secures the greatest level of talent for the business. Any
other approach is likely to harm the business.
The elements of a policy designed to promote diversity can
also bring benefit to the business. A diverse workforce may
allow the business to understand the needs of a market
which may comprise diverse consumers. This will assist
the organisation in meeting the needs of its consumers
more effectively. A business that acquires a reputation for
operating an effective diversity and equality policy may
become an attractive employer to potential employees.
This process is called employer branding and can
help businesses to attract highly talented and skilled
employees, whatever their personal characteristics.
CASE STUDY
Equality and diversity at the University of Cambridge
The University of Cambridge, in the UK, is one of the bestknown universities in the world. It was founded in 1209.
In 2020, it had over 11 000 staff and 23 000 students from
countries throughout the world.
The University of Cambridge is committed in its pursuit
of academic excellence to equality of opportunity and to a
proactive and inclusive approach to equality, which supports
and encourages all under-represented groups, promotes an
inclusive culture, and values diversity.
The commitment applies to all protected groups and is
underpinned by the University’s Equal Opportunities Policy
and Combined Equality Scheme (CES). It is managed by the
University’s Equality & Diversity Committee.
The University’s Equality & Diversity essential online
training module:
Firms take positive decisions on welfare and training
because they have the potential to improve the morale and
motivation of employees. We shall see in Chapter 2.2 that
there are different views on what motivates employees.
Some writers on motivation argue that physical faculties
aims to help staff understand the main principles of equality
and diversity, their impacts on the University and how members
of staff and students can access support and other resources.
The module, which can be accessed on a variety of platforms,
including tablets and laptops, is Cambridge-specific and
takes about 30 minutes to complete.
Source: www.equality.admin.cam.ac.uk
Questions
1
2
Explain two ways in which training might assist
Cambridge University to implement its equality and
diversity policy.
[6]
Evaluate the extent to which the benefits of the
University of Cambridge’s equality and diversity
policy outweigh its costs.
[12]
are important. Other writers on motivational theory would
argue that providing training and allowing employees to
develop themselves and to fulfil their potential are powerful
motivators.
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GLOSSARY TERMS
Diversity, in an employment context, refers to recognising
the differences between individual employees and also the
differences that may exist between groups of employees.
Equality is the circumstance in which all people are equal,
particularly in relation to rights and opportunities in the
workplace.
Training is a process whereby an individual acquires jobrelated skills and knowledge.
2.1.6 Training and development
Training and development can help employees to improve
their performance at work. Employees who are offered
opportunities for training and development are often more
motivated. In the next chapter we will look at some of
the motivational theories that explain this relationship.
Businesses that offer good-quality training and
development often have very loyal workforces, and it
can help to develop a reputation as a ‘good’ employer.
Improvements in the performance of a business’ labour
force can assist the organisation in achieving its
objectives. Training and other development activities
can result in higher levels of productivity or fewer faulty
Development is a broader term than training and refers to
a wider range of activities intended to improve employee
performance at work. It includes attendance on courses
studied at colleges and universities, performance tracking
and improvement, coaching and mentoring, as well as
training.
Types of training
Almost all employees receive training at some point during
their working lives and this training comes in different
forms.
Induction training
Employees may receive training when commencing a new
job. This is known as induction training and is intended to
introduce an employee to the business. Induction training
may provide employees with information on the following:
» important policies such as health and safety, and
disciplinary procedures
» the layout of the factory or office
» their new colleagues
» the basic duties of the job.
2.1
2.1.6 Training and development
Development refers to activities designed to increase
employees’ skills, education, knowledge and abilities in
the workplace.
products. Both factors can help businesses to reduce their
costs.
Induction training enables a new recruit to become more
productive quickly. It can prevent costly errors resulting
from employee ignorance and can make a new employee feel
welcome, thereby reducing labour turnover.
CASE STUDY
Center Parcs
apartments and lodges. Each village offers an extensive
range of sports and leisure activities, plus numerous
restaurants, bars and retail outlets and an Aqua Sana
Spa facility. Woodland, water and a natural healthy
environment are the essential elements of a Center Parcs
break.
The company employs about 9500 people and values its
staff. It has the following statement on its UK website:
▲ Figure 2.6 Center Parcs is a business that offers its
employees regular opportunities for training.
Center Parcs opened its first UK village at Sherwood
Forest in July 1987, offering short-break holidays at any
time of year. Since then it has expanded its operations and
currently operates six villages across the UK and Ireland.
Each UK holiday village is set in a forest environment,
typically 400 acres (162 hectares) in size, and provides
high-quality accommodation in fully equipped villas,
... we encourage our employees to develop their skills
and reward them when they are successful. Our training
and development programme offers our employees the
opportunity to develop their technical and professional skills
as well as their leadership potential, from entry level through
to managers.
Source: www.centerparcs.co.uk/company-information/ourresponsibilities/our-people.html
Questions
1
2
Explain two possible reasons why Center Parcs
might have such a clear and highly prominent
statement on its website.
Evaluate the benefits of effective systems of
training to Center Parcs, which is expanding.
[6]
[12]
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2.1
Off-the-job training
The impact of training and development
This involves training outside the workplace, at a college,
university or some other training agency. Off-the-job
training can take the form of a range of activities in
which job-related skills and knowledge are acquired. These
activities can include external courses such as lectures and
seminars, self-study or open learning.
Some businesses, for example, Center Parcs, invest heavily
in training and development, often regarding it as a core
element of their human resource management. Some
managers value it highly because they believe it improves
employee attitude, motivation and performance. Others
are less eager to spend money in this way, taking the view
that ‘if they cannot do the job already, why are we paying
them?’ Managers may be especially suspicious of off-the-job
training, which can be very expensive.
AS LEVEL 2.1 Human resource management
On-the-job training
This form of training does not require the employee to leave
the workplace. They learn from experienced employees
through observation and work shadowing. The trainee may
work through instruction manuals or receive guidance from
senior employees.
Training and development activities offer benefits and
drawbacks to businesses. These activities can be expensive
and disruptive but can improve employee performance. The
possible impact, in terms of benefits and drawbacks, is
summarised in Table 2.3.
▼ Table 2.3 The impact of training and development
Drawbacks
Benefits
• Training and development activities use up valuable resources
that could be utilised elsewhere in the organisation.
• Attendance at training and development activities may mean
that employees are unavailable to the organisation for a period
of time. Production may suffer as a consequence.
• Employees, once trained, may leave for other, possibly betterpaid jobs.
• The beneficial effects of these activities may vary because
some managers might seek to avoid training and developing
their staff as it can lessen the degree of control they have over
their subordinates.
• It can improve employee performance, and hence the
competitive position of the business, by developing new
skills and knowledge.
• Training and development should improve employee
morale and productivity.
• Training and development are core components of HRM
and assist organisations in having the right workforce to
achieve strategic objectives.
• A reputation for training and developing employees
will assist businesses in attracting and retaining highquality, creative and productive employees.
The impact of training and development of employees is
potentially greater if the market in which the firm operates
is subject to fierce competition. For example, firms may
operate extensive development activities in an attempt
to improve rates of creativity and/or productivity to gain
an advantage over competitors. Businesses manufacturing
motor vehicles have tended to invest more heavily in
such activities over recent years for these reasons. When
products are similar, price is often a very important
factor influencing consumers’ buying decisions. In such
circumstances, minimising costs (and prices) is vital. A key
part of this is making sure that labour is as productive as
possible.
GLOSSARY TERMS
An emphasis on training and development may have an
impact on the management style used in the business.
Managers who engage in large-scale development and
training activities will be more likely to value techniques
such as delegation and teamworking. Partly, this is a
question of philosophy: democratic and communicative
managers are more likely to value employees and therefore
will aim to develop them as much as possible. However,
there are practical reasons why training and development
will be needed in these circumstances. Businesses cannot
expect to benefit from granting employees greater
authority without preparing them for such roles.
Delegation means passing authority down the
organisational hierarchy. This is only genuine if the
manager relinquishes some control to the subordinate.
Intrapreneurship occurs when individuals within
organisations are being entrepreneurial – taking risks and
generating new ideas.
Employee development to encourage
intrapreneurship, multi-skilling and
flexibility
Intrapreneurship
We saw in Chapter 1.1 that entrepreneurs are individuals
who take risks to develop business ideas and start their own
businesses. Some larger organisations attempt to encourage
entrepreneurial approaches among their employees to
improve the organisation’s performance. This is termed
intrapreneurship. Such organisations encourage individuals
to develop ideas for new products or ways of producing
goods and services within their own departments or
sections of the business. In effect, employees are supported
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to behave as entrepreneurs within a large business. One
well-known example of successful intrapreneurship is
Spencer Silver, who developed the Post-It note while
working at 3M, an American multinational company. He was
a chemist who developed the glue used in Post-It notes.
His innovative type of glue was strong enough to hold
papers together, but easily pulled apart without tearing the
documents. It could also be used repeatedly.
The need for learning and development activities in an
intrapreneurial organisation will be continuous as markets,
products, technology and consumer needs change over time.
In addition, labour turnover will mean that new employees
are recruited who lack the necessary skills to operate
as effective intrapreneurs. Learning and development
activities will be needed throughout the careers of
intrapreneurs.
2.1
2.1.6 Training and development
Employees cannot simply be expected to become
intrapreneurs overnight. A range of learning and
development activities are required to prepare employees to
fulfil the role of an intrapreneur successfully.
» Personal skills Intrapreneurs need many of the
strengths associated with entrepreneurs. They should
be creative, confident and pursue their ideas with
persistence. They should be good at solving problems
and willing to take calculated risks. Thus, they need
to be able to analyse risk to avoid making damaging
decisions. Ongoing training and development activities
can help to develop and improve such knowledge and
skills.
» Technical skills Successful intrapreneurs must be
able to analyse markets, organisations and consumer
behaviour to uncover problems. These may take
the form of unfulfilled or unrecognised needs or
production bottlenecks. Intrapreneurs then apply a
range of skills to solve these ‘problems’. Developing
the knowledge and skills to undertake this analysis and
subsequent problem-solving are central to success as an
intrapreneur. These skills may need to be supported by
relevant technical skills such as engineering or, as in the
case of Spencer Silver, those of a chemist.
» Senior employees The learning and development
activities are not limited just to employees engaged in
intrapreneurial activities. It is important that managers
and leaders also have the intrapreneurial spirit and
that this exists throughout the organisation. They
should encourage risk-taking, innovative activities and
ensure sufficient resources (human and non-human) are
provided. They may require training and development to
fulfil such roles effectively.
Simply recruiting some very talented individuals and
hoping this will be sufficient to promote intrapreneurship
within the organisation will not be enough. Businesses
need to develop a learning and development plan to build
innovation throughout the organisation.
CASE STUDY
Facebook
Facebook has over 2 billion users worldwide and nearly
45 000 employees. It is expanding and recently recruited
800 employees in the UK. It is an important company in
the global technology industry.
The company describes itself as constantly solving
problems. It hires people with different backgrounds and
viewpoints to help it make better products. The company
supports its employees to become bold and confident and
to seek to solve the problems they care most about. Its
employees work together in small teams to develop new
products quickly. The company offers high-quality training
and operates its own university.
Over time, Facebook has extended its product range,
sometimes by buying other businesses; for example,
Multi-skilling and flexibility
Multi-skilled workers have the skills to perform roles in more
than one area of a business’ activities. For example, in a
manufacturing business, multi-skilled workers may receive
training in all aspects of constructing the product, as well
as the ability to perform inspections to ensure products are
of suitable quality. Having multi-skilled employees allows a
business to switch workers to where they are needed over time.
WhatsApp in 2014. The company’s range now
includes:
● Instagram
● WhatsApp
● Messenger
● Augmented Reality
● Virtual Reality
● Facebook Connectivity.
Questions
1
2
Explain two reasons why Facebook encourages its
employees to be intrapreneurs.
[6]
Evaluate the extent to which training and
development at Facebook is essential to encourage
[12]
intrapreneurship among its workforce.
A company with multi-skilled employees has the potential
to have a flexible workforce. This enables managers to use
workers where needed to match the business’ needs. This
flexibility assists businesses in:
» meeting unexpected increases in demand for their
products
» covering for employees who are absent
» dealing with crises, such as delays in production.
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AS LEVEL 2.1 Human resource management
2.1
Labour flexibility arising from multi-skilling allows the business
owner to maintain production levels under circumstances that
would otherwise leave workers idle and reduce profits.
Training and development play critical roles in creating a
multi-skilled workforce and the flexibility that arises from
this. Without enhanced skills and knowledge, employees
will be unable to carry out a variety of roles. Training and
development activities will be required on a long-term basis
in industries where the skills required change and develop
over time.
GLOSSARY TERMS
Multi-skilling exists when employees have the skills to
carry out several roles within an organisation.
A trade union is an organisation of workers established
to protect and improve the economic position and working
conditions of its members.
Collective bargaining is negotiation between employers
and representatives of employees, normally trade union
officials.
2.1.7 Management and workforce
relations
The benefits of co-operation between
management and the workforce
Co-operation between management and the workforce can
reduce the number of disputes that may occur between the
two sides. Disputes can result in strikes (where workers
withdraw their labour) or other measures, such as banning
overtime working.
One way of considering how co-operation between
management and the workforce benefits both parties is to
consider the costs that may arise from any sort of dispute
(see Table 2.4).
▼ Table 2.4 The costs of industrial disputes
Employers
Employees
• The business may lose revenue from selling its products if the dispute • Employees may lose pay if the industrial dispute
results in industrial action, such as a strike, and production is halted.
takes the form of a strike.
• The business may lose future sales if its customers believe that it is • The dispute may weaken the employer’s finances,
an unreliable supplier.
putting employees’ job security at risk.
• The business’ relationship with its employees may be damaged in the • A financially weakened employer may not be able
long term, with negative implications for morale and productivity.
or willing to pay for training and development for
• The business may be regarded as a more risky investment and may
employees, denying them the chance to improve and
encounter more difficulty in raising finance, or it may be expected
update their skills and knowledge.
to pay higher interest rates for loans
• The employer may respond to the threat of, or actual,
• The business’ image may be damaged if it is involved in a dispute with
industrial action by replacing people with technology
its employees and this may result in the loss of some of its customers.
in the production process or by moving overseas.
The benefits to employers
Employers benefit in a range of ways from co-operation
with employees.
» Helping to develop a strong employer brand Employers
who avoid disputes with employees and who have effective
mechanisms to resolve any disputes quickly will be viewed
more favourably by potential employees. This will assist
them in attracting more able and productive employees.
» Enhancing employee morale Having a workforce with
high morale is a valuable asset for any business. Poor
employer relations are likely to lead to employees
believing they are not valued and will reduce their sense
of well-being and morale. Such factors can damage
employee performance severely.
» Improving the business’ corporate image Avoiding
disputes or settling them quickly helps a business to
develop or maintain a reputation as a fair and reasonable
employer. This can have positive effects on a range of
stakeholders, including customers and investors.
» Strengthening competitiveness Good employer–
employee relations can be a powerful competitive
weapon. They can reduce costs by eliminating lost
production, adding to a business’ reliability as a supplier
as its production is not interrupted, and can enhance
labour productivity (thereby lowering labour costs), as
workers are motivated by what they regard as fair pay
and working conditions.
The benefits to employees
Equally there are a number of advantages to employees from
the maintenance of good relations with their employers.
» Financial benefits Employees avoid loss of pay during
periods of industrial disputes if good relations are
maintained. However, because the employer may also
be financially stronger as a result of avoiding wasteful
disputes, there is a greater possibility of future
improvements in pay and conditions.
» Job security An employer is less likely to consider
replacing employees with technology or moving overseas
to locations where industrial action rarely or never occurs.
» The possibility of greater participation in decisionmaking Involving employees in decision-making is one
way of helping to maintain good relations, but it is also
a possible benefit to employees from doing their part
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in maintaining a positive relationship. Where amicable
relationships exist, employers may be more willing
to offer opportunities for employee involvement in
decision-making.
The impact on employers and
employees of trade union involvement
in the workplace
Trade unions
Trade union membership has declined in many countries
around the world. Figure 2.10 shows that the percentage
of national workforces belonging to a trade union varies
significantly. OECD – the Organisation for Economic
Co-operation and Development – has 32 member countries.
In 1985, average trade union membership in OECD
countries was 30 per cent. By 2019, that had fallen to just
16 per cent.
Iceland
Sweden
Belgium
Italy
Canada
Ireland
United Kingdom
Japan
Germany
Australia
Mexico
South Korea
United States
Turkey
France
25.9
24.2
23.2
17.1
16.7
13.7
12.0
10.5
10.1
8.6
7.9
34.3
54.2
66.1
90.4
Source: Forbes, https://bit.ly/3n5cncW
▲ Figure 2.7 Trade union membership as a percentage of
the total workforce in a selection of countries
Most OECD countries have seen a decline in trade union
membership. The only ones that have seen increases since
1985 are Iceland, Belgium, Spain and Italy. Iceland remains
the most unionised country in the OECD, with 90.4 per cent
of its workers being members of a trade union.
Trade unions are normally organised on a regional basis.
For example, in the UK, Unite operates in ten regions
throughout the UK and Eire and is the UK’s largest
trade union. Each region has a regional office staffed
Most trade unions across the world have similar objectives.
These focus on improving the economic position of their
members by fulfilling the following objectives.
» Maximising pay Trade unions engage in collective
bargaining to provide their members with the highest
possible rates of pay.
» Achieving safe and secure working conditions Unions
often provide training for safety representatives who
can advise employers on health and safety issues.
Creating a workplace in which there is a focus on health
and well-being can be an important factor in creating
employee engagement.
» Attaining job security Arguably this is the most
important objective of a modern trade union, and it is
one that is difficult to fulfil in the light of pressures
resulting from globalisation and the increasing use of
technology in the workplace.
» Participating in and influencing decisions in the
workplace Trade unions may achieve this through
collective bargaining or through having representatives
on any employer–employee committees. Trade unions
may play a role in decisions ranging from a change in
fringe benefits, such as free lunches, to the closure of
one or more parts of the business.
2.1
2.1.7 Management and workforce relations
The value of co-operation between employers and
employees is probably greatest where the costs of industrial
disputes are most significant. This might be where the
business is in a weak competitive or financial position, and
it is vulnerable to losing its customers to rivals or at risk of
financial failure. Similarly, industrial disputes might be risky
for employees in areas of high unemployment and for those
who are relatively unskilled. If a prolonged dispute results
in a loss of jobs, they may experience difficulty in finding
alternative employment.
by full-time union employees (called organisers or officers).
The region is made up of a number of branches (more
than 6000 in the case of Unite) and each branch has an
elected shop steward. The shop steward communicates with
employers on behalf of the union’s members and reports
back to members regarding management decisions. The
union head office has administrative, statistical and legal
staff, as well as the senior officials of the union. Other
trade unions operate similar structures.
Collective bargaining
Collective bargaining between employers and trade unions
usually covers issues such as wages and salaries, holidays,
the length of the working week and employee pensions.
Because the negotiation is collective, any agreement
that is reached applies to all those represented by the
trade union. The rules for collective bargaining are usually
agreed between the trade unions and each individual firm.
Trade unions are in a better position to negotiate than
individuals as they have better collective negotiating skills.
Furthermore, the threat of taking industrial action (such as
strikes) gives them increased power in negotiations, helping
them to achieve higher rates of pay.
STUDY TIP
Do not assume that trade unions do not offer any benefits
to employers. The case study below outlines some of
the benefits that they can offer and you should be able to
argue the positive and negative impact of trade unions on
employers.
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AS LEVEL 2.1 Human resource management
2.1
CASE STUDY
Airbus and European works councils
European Union laws relating to European works councils
affect any organisation with at least 1000 employees, of
which least 150 employees are located in two or more
member states of the EU. European works councils (which
operate on behalf of employees) bring together employee
representatives in a multinational company from across
Europe. The works councils inform and consult employees
on the group’s activities and future prospects. European
works councils help trade union members to respond to
the decisions that employers take on a global basis.
A European works council is made up of at least one
elected employee from each country in which the
multinational operates, along with representatives from
senior management. They normally meet annually and
discuss issues affecting employees throughout the
organisation. These include health and safety, merger
proposals, the closure of plants and the implementation
of new working practices, such as teamworking.
company operates factories in the UK, Germany, France
and Spain. In 2020, it announced plans to consult its
European works council over plans to cut 2362 jobs in
its factories. The jobs are under threat due to reduced
levels of demand for its aircraft. The company said it
wanted to manage the implications of the job losses for its
workforce ‘in a responsible manner’. The company said
it hoped to consult on opportunities for those employees
who are affected. The matters to be discussed include
transferring affected employees to work in other locations
within the company.
Questions
1
2
Airbus, the multinational plane manufacturer, has its
headquarters in Toulouse in Southern France. The
Employees can receive significant benefits from being
represented by trade unions. In the UK in 2018, those
employees who were represented by trade unions earned
approximately 7.9 per cent more than people carrying out
similar work who were not members of a trade union.
Trade unions bring other benefits for employees. For
example, they can play a major part in monitoring health
and safety issues to protect the workforce. This can help to
provide a more secure working environment and reduce the
number of accidents.
It may appear that trade unions only offer disadvantages
to employers. They are able to use collective bargaining
to negotiate higher wages than would be paid in a
Explain two reasons why Airbus might prefer to
transfer employees in Europe rather than make them
[6]
redundant.
Evaluate whether or not Airbus’ employees benefit
overall from the existence of the company’s European
[12]
works council.
non-unionised workplace. This wage differential is known
as the trade union premium. This can increase the business’
costs of production. As a consequence, profits may be lower
or prices may have to be higher, reducing the business’
competitiveness. This can be a serious disadvantage in an
industry where competition is based on low prices, such as
the airline industry. Despite this, employers can also benefit
from the existence of trade unions for the following reasons:
» They act as a communications link between management
and employees and can reduce the chance of industrial
action occurring.
» Professional negotiation on behalf of a large number of
employees can save time and lessen the likelihood of
disputes occurring.
TEST YOUR LEARNING
Short answer questions
1
2
3
4
5
a
b
Define the term ‘human resource management’. [2]
Explain one activity that forms part of human
resource management.
[3]
Explain two possible benefits to a business of an
effective system of human resource management. [6]
a Define the term ‘workforce plan’.
[2]
b Explain one factor that might influence the
workforce plan of an international retailer.
[3]
a Explain one possible effect of a high level of
labour turnover in a business.
[3]
b A business has 9500 employees. During the year,
190 leave its employment. Calculate its rate of
labour turnover.
[3]
a Explain one difference between recruitment
and selection.
[3]
Explain one method of selection.
[3]
Explain one difference between internal and
external recruitment.
[3]
b Define the term ‘job description’.
[2]
7 a State three items that might be included in an
employment contract.
[3]
b Define the term ‘person specification’.
[2]
8 Explain one benefit a business might receive from
preparing and using a person specification.
[3]
9 a Explain one difference between redundancy and
dismissal.
[3]
b Explain one reason why an employee may be
made redundant.
[3]
10 Explain two reasons why businesses invest in
training and development despite the high costs.
[6]
6
b
a
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Data response question
The company behind the soaps and shampoos in
hotel bathrooms
2.1
Questions
1
2
3
Define the terms:
a ‘induction training’
[2]
b ‘redundancy’.
[2]
Analyse one reason why Cannell Ltd should be
[4]
concerned about its rate of labour turnover.
Evaluate whether or not the managing director is
correct to argue that the company should double its
spending on training and development.
[12]
2.1.7 Management and workforce relations
Cannell Ltd manufactures soaps, shampoos and other
complimentary toiletries that are available in hotel
bathrooms. The company operates two factories with
acombined workforce of 380, and labour costs are
47 percent of its total costs. The company is relatively
small and, selling throughout Europe, faces intense
price competition from larger rivals. Recently the
company has had to reduce its prices to retain some
major customers. Profitability has declined in recent
years – last year it fell by 14.5 per cent. The company
has a highly skilled workforce, although its labour
turnover figure rose to 23.4 per cent last year from
14.9 per cent the previous year.
Cannell Ltd’s managing director believes strongly in
the importance of training and development, including
induction training. He has proposed doubling the
company’s expenditure on training. Employees work
in teams and the company updates its production-line
technology whenever it can afford to do so. The company
has never had to use redundancy to manage its workforce.
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2 Human resource management
2.2
AS LEVEL 2.2 Motivation
AS LEVEL
Motivation
Chapter overview
In this chapter we examine:
★ the nature and importance of motivation as a management and leadership tool
★ the needs of employees while at work
★ some of the theories of motivation that can be applied in the workplace
★ the practical methods of motivation used by businesses, both financial and non-financial.
2.2.1 Motivation as a tool for
management and leadership
There are two ways we can think about motivation at work
and what causes it:
» Motivation can be the will to work due to enjoyment of
the work itself. This implies that motivation comes from
within an individual employee.
» An alternative view is that it is the will or desire to
achieve a given target or goal that is the result of
external factors, such as the promise of a reward, or to
avoid the threat of punishment.
The first of these views assumes that motivation lies within
the individual employee and the second assumes that it is
the result of some external factor. People in the workplace
have differing views on the sources of motivation. A survey
revealed that nearly 90 per cent of employers believe that
money is the main motivator, while employees rank pay
fourth, behind an interesting job, security and achievement.
This distinction is an important one, and you should
remember it when considering theories of motivation and
how, in practice, leaders and managers can motivate other
people.
Whatever causes it, motivation is an important factor
for all businesses. Having a well-motivated workforce is
vital to assist all businesses in achieving their objectives.
Organisations whose workforces possess high levels of
motivation tend to show the following characteristics:
» a low level of absenteeism by employees at all levels
within the business
» relatively few employees deciding to leave the
organisation, giving a low level of labour turnover
» good relations between managers and other employees
» high levels of labour productivity from the workforce.
A business that enjoys the benefits of a highly motivated
workforce is also likely to have a productive workforce. Low
production costs offer firms two opportunities:
» to sell their products more cheaply
» to maintain price levels and enjoy greater profits.
Thus, well-motivated workforces offer managers and
leaders the means to achieve a range of common business
objectives, including those below.
» Growth High levels of labour productivity and low
labour turnover will support businesses in increasing
the volume of sales by providing increased output
cost-effectively.
» Higher profits Having well-motivated and very
productive employees assists businesses in producing
products more cheaply per unit. This is an important
means of increasing profits.
GLOSSARY TERMS
Motivation describes the factors that arouse, maintain and
channel behaviour towards a goal.
Absenteeism describes a situation in which an employee
is absent from work without a good reason.
Human needs can be defined as the elements required for
survival and good mental and physical health.
2.2.2 Human needs
Fundamental human needs are relatively few and finite.
They are likely to be similar – or the same – for all countries
and cultures and to change little over time. A list of human
needs is likely to include the following:
» physical needs. For example, having enough income to
meet essential needs e.g. food, drink and shelter
» safety needs e.g. job security, contract of employment,
reduced uncertainty, health and safety policies, and
good working conditions
» social needs e.g. team or group working, good
communication and involvement
» esteem needs e.g. recognition, status, responsibility,
respect and feedback on performance
» self-actualisation needs e.g. fulfilment of potential,
challenging work, sense of achievement and
development of new skills.
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CASE STUDY
2.2
Al Rashed International Shipping Company
on the quality of its staff. The company aims to have an
effective workforce and has carefully thought-through
systems of recruitment and selection, as well as
training. The company has strict policies to avoid any
discrimination and encourages teamworking.
The company was established in 1911 and is currently
a major player in shipping markets in the Persian
Gulf. It supplies a range of services including ocean
freight, international air freight and land transport both
domestically and internationally.
Training is organised by each department within the
business. Training focuses heavily on communication and
customer service. The company responds quickly and
positively to any customer complaints.
In its vision statement, the company says that it is
‘committed to consistently deliver extraordinary value to
our customers and stakeholders through the building of
passionate, empowered teams [of employees]’.
Ravi Varrier is Al Rashed’s chief executive officer (CEO).
He has worked for the company for more than 30 years
and believes that the company’s success has been based
How human needs may or may not be
satisfied at work
Employment does offer the possibility of satisfying some,
but possibly not all, of these human needs. The following
needs could be met through employment, but this may not
always be the case.
» Subsistence Employment can provide an income
sufficient to allow people to have shelter, food and
clothes so that their lives are not threatened by the lack
of these basic items. However, this need is only met
if employees have an employment contract that offers
them regular and sufficient hours of work to meet their
basic needs.
» Protection Work can satisfy this need in a number
of ways. A permanent employment contract may
provide the security of knowing that the income from
employment will be received for the foreseeable future.
Some forms of employment also provide health care
and pensions to give employees an income in old age.
However, many forms of employment do not offer much
in the way of protection. Some employees have no
guaranteed hours of work and no pensions.
» Participation This can be achieved through working
in teams, from teams of shop assistants through to
membership of the board of directors of a large public
company. Participation can also take the form of
responsibilities within an organisation.
2.2.2 Human needs
The Kuwait-based Al Rashed International Shipping
Company trades in international markets and has
benefited from high rates of recent sales growth and is
planning further growth. The company depends on highly
motivated staff to achieve its ambitious expansion plans.
Source: https://al-rashedgroup.com/handbook/
Questions
1
2
Explain two ways in which having highly motivated
employees might offer advantages to the
shareholders of the Al Rashed International Shipping
Company.
[6]
Evaluate the benefits that you think this company might
gain from having a well-motivated workforce.
[12]
» Creation Many working environments offer opportunities
for creativity and some may require this as an integral
part of employment. Others may offer few opportunities.
Working in advertising or architecture requires creativity
but this can also be an important part of manual work,
such as constructing houses. Creativity can take other
forms, including developing teams and building brands.
» Freedom Working in an organisation does offer
surprising numbers of opportunities for freedom. In
a democratically managed business, managers may
empower employees. This gives them control over their
working lives and a high degree of freedom not only to
take decisions but to decide which decisions to take.
It is important to remember that the extent to which
this need may be met at work depends on the way that
the business is managed. Some managers may opt to
retain control and offer little freedom to more junior
employees.
Some other human needs may also be met through working.
For example, many businesses provide leisure facilities
for their employees, and it is not unusual for people to
engage in leisure activities with their colleagues from
work. However, this may not be the case for people such as
farmers or lorry drivers who often work alone.
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2.2
CASE STUDY
Working at Google
AS LEVEL 2.2 Motivation
Though Google has grown a lot since it opened in 1998, we
still maintain a small-company feel.
At lunchtime, almost everyone eats in the office café, sitting
at whatever table has an opening and enjoying conversations
with Googlers from different teams. Our commitment to
innovation depends on everyone being comfortable with
sharing ideas and opinions. Every employee is a hands-on
contributor and everyone wears several hats. Because we
believe that each Googler is an equally important part of our
success, no one hesitates to pose questions directly to Larry
or Sergey in our weekly all-hands (‘TGIF’) meetings – or
throw a volleyball across the net at a corporate officer.
Our corporate headquarters, fondly nicknamed the
Googleplex, are located in Mountain View, California, USA.
While our offices are not identical, they tend to share
some essential elements. Here are a few things that you
might see in a Google workspace:
● bicycles or scooters for efficient travel between
meetings, dogs, lava lamps, massage chairs, large
inflatable balls
2.2.3 Motivation theories
Many different views exist on motivation, and they differ
because it is not clear why people work. Is it to gain money,
to enjoy social interaction with other humans, or to fulfil
personal needs such as achievement and recognition? Or is
it a combination of some or all of these?
● Googlers sharing cubes, yurts and huddle rooms – and
very few single offices
● laptops everywhere – standard issue for mobile
coding, emails on the go and note-taking
● foosball, pool tables, volleyball courts, assorted video
games, pianos, ping-pong tables and gyms that offer
yoga and dance classes
● grassroots employee groups for all interests, such as
meditation, film, wine-tasting and salsa-dancing
● healthy lunches and dinners for all staff at a variety of
cafés
● staff-rooms packed with a variety of snacks and drinks
to keep Googlers going.
Source: Adapted from www.google.co.uk
Questions
1
2
Explain two ways in which the human needs of
participation and creation may be met by working
at Google.
[6]
Evaluate the extent to which human needs are met
by working at Google.
[12]
examine the process of motivation and are concerned with
‘how’ motivation occurs. Vroom studied motivation from a
process perspective.
Motivation theories can be classified broadly into two
different perspectives: content theories and process
theories. Content theories consider ‘what’ motivates people
and are concerned with individual needs and goals. Taylor,
Mayo, Maslow, Herzberg and McClelland studied motivation
from a content perspective. In contrast, process theories
GLOSSARY TERMS
Schools of thought are individuals and groups who hold
similar views on a particular matter – in this case on what
motivates employees.
Piece-rate is a system whereby employees are paid
according to the quantity of a product they produce.
Division of labour is the breaking down of production
into a series of small tasks, carried out repetitively by
relatively unskilled employees.
▼ Table 2.5 Schools of thought for content theories of motivation
School of thought
Key writers
Essential ideas
Scientific school
Frederick Winslow Taylor
(1856–1917)
Motivation is an external factor achieved through money. Employees
should be closely supervised and paid piece-rate. Time and motion
studies determine efficient means of production and workers are
trained and told how to operate.
Human relations school
Elton Mayo
(1880–1949)
This brought sociological theory into management and accepted
that employees could be motivated by meeting their social needs.
More attention was given to the social dimension of work (e.g.
communication, working as groups and consultation between
managers and employees).
The neo-human
relations school of
management
Abraham Maslow (1908–70),
Frederick Herzberg (1923–
2000) and David McClelland
(1917–1998)
This school highlighted the importance of fulfilling psychological
needs to improve employee performance. Motivation, according
to Maslow and Herzberg, depended upon designing jobs to fulfil
psychological needs.
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Content theories of motivation
The content theories of motivation can be divided into
three schools of thought. These are set out in Table 2.5.
The school of scientific management
1 Study the work process to
determine the most efficient
production methods
2 Observe and time the best
workers in these methods
Against this background, managers began to investigate
ways of increasing employee motivation to improve
competitiveness and employee satisfaction. Frederick
Winslow Taylor was the most notable of these early writers
on motivation and became known as ‘the father of scientific
management’.
3 Train the remaining workers
to the same standard
Taylor’s theories were based on a simple interpretation
of human behaviour, that people were motivated solely
by money – his term was ‘rational man’. He combined this
principle with a simple interpretation of the role of the
manager: to operate the business with maximum
efficiency.
The key elements of Taylorism
» The starting point of Taylor’s approach was work study.
He measured and analysed the tasks necessary to
complete the production process. He used a stopwatch
to measure how long various activities took and sought
the most efficient methods of completing tasks. He
encouraged the use of the division of labour, breaking
down production into small tasks.
» From this he identified the most efficient employees and
the approaches they adopted. Using these as a basis, he
then detailed ‘normal’ times in which duties should be
completed and assessed individual performance against
these norms.
» Employees were provided with the equipment necessary
to carry out their tasks. This principle extended to
giving stokers (men shovelling coal) a shovel of a
size appropriate to their physique to maximise their
efficiency. They were also given elementary training and
clear instructions on their duties.
» Because, according to Taylor, employees were only
motivated by money, the final stage of the system was
to design and implement a piece-rate pay system. Under
a piece-rate system, employees are paid according to
the amount they produce. Taylor, however, developed
differential piece-rate systems to encourage efficiency
among employees.
» Taylor also believed in close supervision of the workforce
to ensure that they continued to make the maximum
effort possible, motivated by pay.
Taylor’s views were unpopular with shop-floor employees.
Shop-floor employees are those who work on production
2.2
2.2.3 Motivation theories
Motivating workers became an important issue as the size
of businesses increased in the late-nineteenth century.
Managers developed the division of labour to its fullest
extent in an attempt to increase efficiency and improve
competitiveness. The introduction of mass-production
methods, along with the use of division of labour, increased
the numbers of people working in factories. At the same
time, their tasks became monotonous.
lines in factories and do not have any management or
supervisory role. His systems forced them to work hard
and, by raising productivity levels, placed the jobs of the
less efficient workers under threat. Taylor’s approach raised
efficiency and productivity, so businesses did not need as
many employees. His ideas resulted in strikes and other
forms of industrial action by dissatisfied workers.
4 Implement differential pay
rates and close supervision
to increase productivity
▲ Figure 2.8 The essential features of Taylorism
Taylor’s legacy
It is easy to dismiss Taylor and his ideas. His entire
philosophy was based on the belief that employees were
motivated only by money. He ignored any social dimension
of employment and made employees work very hard for what
was a meagre wage. His ideas resulted in workers endlessly
completing monotonous tasks. There was considerable
hostility towards his ideas and opposition from politicians
and the business community.
However, Taylor made a significant and enduring
contribution to the management of business organisations.
He established management as a scientific subject worthy
of research and study. His approach was adopted by many
premier figures in the business community in the early
decades of the twentieth century, including Henry Ford.
His techniques encouraged the use of mass production and
the conveyor-belt system. Furthermore, his work provided a
starting point for a later and more people-centred approach
to management.
STUDY TIP
Avoid considering Taylor simply in negative terms.
Certainly, many of his ideas would not be acceptable in
modern businesses, but others (for example, simple
piece-rate pay and work study) have endured. A balanced
assessment of Taylor should take into account the lasting
elements of his approach, as well as the shortcomings.
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AS LEVEL 2.2 Motivation
2.2
CASE STUDY
Salary packages important for Indian employees
A survey carried out by TJinsite, research division of
TimesJobs.com, revealed that 77 per cent of employees
in India judge salaries to be more important than the
location of the job. However, the respondents rated
salary and job status to be of equal importance, although
financial rewards are considered important by most
people taking part in the survey.
The importance of pay varies between older and younger
employees. Younger employees consider pay to be more
important, while older workers tend to rate job status
more highly.
Employees in most industries in India rate salaries
as important – there was minimal variation between
different industries. Respondents said that factors such
as job titles, location and status are significant, but an
attractive salary is always a critical factor in persuading
employees to apply for jobs.
Questions
1
2
Explain two reasons why salaries are an important
[6]
element for younger people in choosing jobs.
Evaluate other possible situations in which
salary might be considered very important by
employees.
[12]
The human relations school
The implications of the ‘Hawthorne effect’
A fundamental weakness of the scientific school was that
it ignored the social needs of employees. This, and the
obvious unpopularity of the ideas of Taylor, led to the
development of the human relations school. This school
of thought concentrated on the sociological aspects of
work, and its foremost member was an Australian-born
psychologist, Elton Mayo (1880–1949). Initially, Mayo was
one of Taylor’s disciples, believing in the importance of
scientific management to business efficiency.
Following the publication of Mayo’s findings, managers
gradually became more aware of the importance of meeting
the social needs of individuals at work. Social environments
at work and informal working groups were recognised
as having positive influences upon productivity. The
acceptance of Mayo’s views led to a number of developments
in businesses during the 1940s and 1950s, many of which
remain today.
» Personnel departments were established to ensure that
employees’ social needs were met at work wherever
possible.
» Employees were provided with a range of sporting and
social facilities to foster the development of informal
groups among employees.
» Works outings and trips became a familiar part of an
employee’s year (for example, multinational retailer
Marks and Spencer organises short-break weekends for
its employees).
» Managers gave more attention to teams and
teamworking.
The Hawthorne effect
Mayo’s views altered as a result of research he conducted
at the Western Electric Company in Chicago. The research
was to examine the effects of changes in lighting on the
productivity of workers at the company’s Hawthorne plant.
Previous experiments on lighting and productivity had
produced unexpected results. Researchers had anticipated
that improving lighting would increase productivity because
giving workers better working conditions would allow them
to work harder and earn more money. They were astonished
when productivity increased not only in the group who
were given improved lighting but also among a group whose
lighting had not changed.
It became apparent that the employees were responding
to the level of attention they were receiving as part of the
investigations and because they were working together as
a group. This became known as the ‘Hawthorne effect’. As
a result of this and similar experiments, Mayo stressed the
importance of ‘social man’ within the workplace.
From these experiments, Mayo concluded that motivation
was dependent upon:
» the type of job being carried out and the type of
supervision given to the employee
» group relationships, group morale and the sense of
worth experienced by individuals.
Mayo’s recognition of the importance of teamworking is
perhaps his most enduring testimony. Many firms have
organised their workforce into teams; for example, the
Japanese electronics manufacturer, Toshiba.
Mayo’s work took management forward in general and
motivation in particular. He moved the focus onto the needs of
employees, rather than just on the needs of the organisation.
STUDY TIP
Don’t just think of Mayo in terms of communicating
with bosses, and his emphasis on social and sporting
facilities. This is only part of his work. He advocated
the benefits to employers and employees of working
in teams: this aspect of his work is an important issue
within many businesses today.
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The neo-human relations school
This could also be called the new human relations school.
Abraham Maslow, Frederick Herzberg and David McClelland
are key members of this particular school and began to put
forward their views in the 1950s. The neo-human relations
school considered the psychological aspects of employment
and argued that motivation lies within each individual
employee; managers merely need the key to unlock the
motivational force.
By focusing on the psychological needs of employees,
Maslow, Herzberg and McClelland encouraged managers to
treat their employees as individuals, with different needs
and aspirations. Their work emphasised that, because
people are different, the techniques required to motivate
individuals will also differ.
Motivating accountancy graduates
Respondents to an internet survey have judged training
and development of skills to be more important than
salary, according to a survey by accountants Ernst and
Young. Most of the 1051 respondents were accountancy
graduates with additional experience in the industry. The
key elements of the survey were:
● Approximately 44 per cent rated training as the most
important factor attracting them to a job.
● A mere 18 per cent of respondents placed salary and
benefits as the most important factor.
● The reputation of the business was judged most
important by 12 per cent and 8 per cent identified the
business’ culture as the vital factor.
Questions
1
Explain two ways in which employees may be
motivated by pay.
[6]
Evaluate whether the results of this survey show
that pay as a motivator is outdated and irrelevant for
today’s employees.
[12]
2
2.2.3 Motivation theories
CASE STUDY
2.2
Maslow’s hierarchy of needs
In 1954, Maslow published his ‘hierarchy of needs’,
setting out the various needs that, he argued, everyone
attempted to meet through working. Maslow presented his
hierarchy of needs as a triangle with basic needs shown at
the bottom and his so-called higher needs towards the top
(see Figure 2.9).
GLOSSARY TERM
The hierarchy of needs is a theory that employees have
successive requirements that can be fulfilled through work.
5 Selfactualisation
e.g. fulfilling
potential
4 Esteem needs
e.g. recognition
and achievement
Higher
needs
3 Social needs
e.g. relationships with fellow employees
2 Security needs
e.g. employment contract, safe working conditions
Basic
needs
1 Physiological needs
e.g. food, drink, shelter
▲ Figure 2.9 Maslow’s hierarchy of needs
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2.2
Abraham Maslow established five levels of human needs
that can be satisfied through work. Maslow’s argument was
a relatively simple one. Employees, he argued, have a series
of needs they seek to fulfil at work. These are in a hierarchy
– once a lower level need is satisfied, individuals strive to
satisfy needs further up the hierarchy.
AS LEVEL 2.2 Motivation
The key point of Maslow’s argument was that a business
could motivate its employees by offering them the
chance to fulfil a higher level of need once a lower one
was satisfied (see Table 2.6). So once an employee’s basic
needs had been met, perhaps through a system of fair pay,
they could be motivated further by the offer of secure
and continuing employment. Similarly, a worker whose
social needs were met through employment could next
be motivated by the opportunity to satisfy self-esteem
needs. This could be achieved by taking responsibility for
a major project, offering the chance of achievement and
recognition.
▼ Table 2.6 An explanation of Maslow’s hierarchy of needs
Maslow’s level of need
1 Physiological needs
2 Security needs
3 Social needs
4 Esteem needs
5 Self-actualisation
Examples
Means of satisfying needs
Food, water, shelter, clothing
Through pay and a warm and dry working
environment
A safe and secure working environment for
employees
Implementing a proper health and safety
policy, providing employees with employment
contracts
Contact and friendships with other employees
Social and sporting facilities, opportunities to
work in groups
Achievement, recognition and self-respect
Delegating authority to junior employees,
offering promotion opportunities
To fulfil one’s potential completely
Providing opportunities to take new
responsibilities and to develop new skills
Maslow’s theory was attractive to managers from the
outset. It offered a more individualistic approach to
motivating employees, recognising that not all people are
the same. Managers had long realised that what motivated
one person would not necessarily motivate another.
Maslow’s theory offered an explanation and an alternative
approach for managers.
Frederick Herzberg’s two-factor theory
Herzberg’s two-factor theory was the result of a study
designed to test the view that people face two major sets
of influences at work. Herzberg’s resulting theory was based
on the results to questions asked of 200 accountants and
engineers in the USA.
Herzberg’s motivators – these satisfiers relate to the job itself and can create positive motivation
Personal
achievement
Potential
to satisfy
Recognition
Interest in
the work
itself
MOST
IMPORTANT
Responsibility
Growth and
advancement
LEAST
IMPORTANT
Relationship
with fellow
workers
Company
policy and
administration
Working
conditions
Salary
Supervision
Potential
to dissatisfy
Herzberg’s hygiene factors – these relate to the job environment and have the potential to dissatisfy
▲ Figure 2.10 Herzberg’s hygiene and motivational factors
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Herzberg’s crucial finding was that hygiene factors do
not lead to motivation, but without them employees may
become dissatisfied. So, according to Herzberg, an employee
cannot be motivated by pay, but they might be dissatisfied
by inadequate financial rewards. Hygiene factors were so
named because Herzberg believed attention to them would
prevent hygiene problems. It is important to note that
Herzberg’s research classified pay as a hygiene factor and,
therefore, as unable to motivate.
The second finding of Herzberg’s research established those
factors with the ability to motivate – the motivators. These
factors relate to the job itself and can be used to positively
motivate employees. He identified the following factors as
motivators:
» personal achievement of goals and targets
» recognition for achievement
» interest in the work itself
» responsibility for greater and more complex duties
» personal growth and advancement.
Herzberg believed that these approaches (hygiene and
motivation) must be used simultaneously. Employees
should be managed so they have a minimum of
dissatisfaction. They should get achievement, recognition
for achievement, take interest in their work and be given
responsibility to allow them to grow and develop within
their work.
GLOSSARY TERMS
2.2
2.2.3 Motivation theories
The first part of Herzberg’s motivation theory is related to
the environment of the job. He identified a range of factors
that shaped the environment in which people work; he
called these influences hygiene or maintenance factors.
These factors are all around the job but are not a part of
the job itself. Herzberg’s research identified a number of
hygiene factors, including the following:
» company policy and administration
» supervision of employees
» working conditions
» salary
» relationship with fellow workers (at the same level).
Hygiene factors (also called maintenance factors)
are a group of influences that may result in employee
dissatisfaction at work.
Motivators are a series of factors, such as promotion, that
may have positive influences on employee performance at
work.
CASE STUDY
Frederick Herzberg
Frederick Herzberg was born in Massachusetts in the
USA in 1923. He attended City College, New York, before
enlisting in the army. During his military service, he
witnessed the survivors at Dachau concentration camp.
Herzberg gained a PhD in Psychology at the University
of Pittsburg and began to turn his attention to business
management. He became Professor of Management at
Case Western Reserve University, where he established
the Department of Mental Health. In 1972 he joined the
University of Utah’s College of Business.
Herzberg developed a reputation as one of the most
influential thinkers on people at work and employee
motivation. He combined his deep knowledge of employee
psychology with a series of practical experiments in
the workplace. His book Work and the Nature of Man
(1966) was voted one of the ten most important books on
management theory and practice in the twentieth century.
He died in January 2000.
Questions
1
2
Using examples, explain two differences between
Herzberg’s motivators and hygiene factors.
[6]
Evaluate the possible reasons why a book on
employee motivation was voted one the twentieth
century’s most important management books.
[12]
▲ Figure 2.11 Frederick Herzberg
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▼ Table 2.7 Herzberg and Maslow compared
AS LEVEL 2.2 Motivation
2.2
Maslow
Herzberg
Motivation factors (higher needs)
• Self-actualisation needs
• Esteem needs (higher needs)
Maintenance factors (lower needs)
• Social needs
• Security needs
• Physiological needs (mainly lower
needs)
• Achievement
• Recognition
• Responsibility
• Interest in work
• Personal growth
• Company policy and administration
• Supervision
• Working conditions
• Relationship with fellow workers
Both Maslow’s and Herzberg’s theories have the major
advantage in that they were not simply theoretical
writings – practical implications for management were
within the theories. Both authors encouraged managers to
utilise their employees’ abilities by giving them challenging
tasks.
Weaknesses do exist within these theories, of course.
Herzberg’s assertion that pay cannot be used to motivate
might be true of many employees in wealthy, developed
economies. However, this may not be the case with workers
in poorer, developing countries. Equally, Maslow’s theory is
based upon a hierarchy and the assumption that individuals
move from one level to the next. His work has been
criticised on the grounds that people do not move through
these needs in the same order. It also assumes that, once
a need is fulfilled, it loses its power to motivate. This may
not be the case, especially with the higher needs.
STUDY TIP
Many answers to questions on motivation receive low
grades because students do not apply their knowledge
to the scenario in the question. Ensure that you do not
simply explain relevant theories – you must apply them to
the scenario.
David McClelland’s theory of needs
The American writer David McClelland was also a part of
the neo-human relations school of thought. He is perhaps
best known for his work on achievement motivation. In
his acquired needs theory, McClelland argued that an
individual’s motivation depends upon their needs and that
these needs are determined by the individual’s experience.
McClelland identified three types of motivational need:
» achievement motivation (n-ach)
» authority/power motivation (n-pow)
» affiliation motivation (n-affil).
McClelland believed that these three needs exist, to
differing extents, in all employees, irrespective of their role
or status within the business. McClelland’s work emphasised
that the combination of these three needs determines:
» each employee’s behaviour in terms of what motivates
them
» how they manage and motivate other employees.
The need for achievement
People who have a high need for achievement (n-ach) aim
for excellence. This means that they are likely to avoid
low-risk situations as they derive little satisfaction from
meeting targets that are not challenging. Equally, they tend
to avoid high-risk situations as they fear not achieving.
Therefore, this type of person aims to attain realistic but
challenging goals – ideally those in which they have a 50
per cent chance of success. This type of employee has a
strong need for feedback on achievement and progress, and
they have a need for a sense of accomplishment.
The need for authority and power
A need for power (n-pow) can fall into one of two
categories:
» a need for personal power and to direct or control other
employees – this is a need which may be considered
undesirable
» a need for institutional power – this is a need to
organise other employees to attain the organisation’s
objectives.
Managers and leaders with a need for institutional power
are likely to contribute more to a business enterprise than
someone whose need for power is a personal one. The
employee with a need for authority and power wants to
have an effect on an organisation and to have some degree
of control. They may also want to have more status within
the organisation.
The need for affiliation
Employees who have a need for affiliation (n-aff) generally
seek harmonious relationships with other people in the
organisation. They need to feel accepted and are motivated
to work with other people. This type of employee works
well as a member of a team and enjoys social interaction.
Employees who are motivated by the need for affiliation
often work successfully and effectively in marketing, sales
and customer service.
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CASE STUDY
2.2
Motivating generation Y employees
The Bank’s executive vice-president for HR management,
Latifa Pini, commented: ‘This bank is very serious about
management of our generation Y employees (those born
after about 1983) since they are certainly going to be our
future senior managers. If we don’t understand them then it
will be difficult to make the bank as successful as it might be.’
She continued to argue that generation Y employees dislike
being forced or ordered to do something, while employees
born between 1946 and 1964 (called baby boomers) prefer
to be in control and want others to follow them.
The implications of McClelland’s work
McClelland’s work has clear implications for leaders and
managers. The principle is that employees with different
needs require different roles and tasks if they are to be
motivated effectively.
» An employee with a high need for achievement Such
employees should be given tasks which are demanding
but which can be reasonably expected to be achieved.
Such employees require regular feedback, especially of a
positive nature.
» An employee with a high need for authority and
power This type of employee is most likely to flourish
and perform well when controlling others. For a junior
employee this could be a supervisory role, while more
senior employees may fulfil this need by managing large
teams of employees.
» An employee with a high need for affiliation Working
as part of a team, especially a co-operative one, is likely
to allow employees to meet their needs for affiliation.
Equally, this type of employee is likely to perform best
when interacting with other employees, and they should be
provided with opportunities to do this whenever possible.
Process theories of motivation
Process theories of motivation look at what people are
thinking about when they decide whether or not to put effort
into a particular activity. Examples of such theories include
expectancy and equity theories. They try to capture the
process that employees go through when making choices with
goals in mind. Unlike the other theories of motivation we
have considered, they see the individual as an active decisionmaker, rather than trying (in the case of the neo-human
relations school) to meet certain needs. Process theories
emphasise the actual process (or method) of motivation.
There are a number of process theories of motivation, but
we shall just consider the one developed by Victor Vroom.
Latifa Pini argued that generation Y employees perform
most effectively if given challenging work, rewards
related to performance and direct instructions. ‘Give them
challenging work, and if they achieve something, then
recognise them for that achievement. It does not have to
be a financial reward but something that will make them
feel proud to be part of the team and organisation,’ Pini
concluded.
2.2.3 Motivation theories
The Moresby Bank Ltd is based in Papua New Guinea and
provides a range of banking services. It is relatively small
with only 2850 employees. Despite this it experiences
problems with its labour turnover rates, particularly
among junior employees. In 2020, the Bank suffered an
average labour turnover rate of 23 per cent, while the
figure for junior employees reached 34 per cent.
Questions
1
2
Explain two differences between the need for
power and the need for achievement in McClelland’s
[6]
theory.
Evaluate the extent to which McClelland’s
explanation of the differing behaviour of the older
and younger employees at Moresby Bank Ltd is the
only valid one.
[12]
Victor Vroom’s expectancy theory
This theory, developed by Vroom in the early 1960s, argues
that motivation depends on employees’ expectations of
the results of their efforts. If employees know what they
want from an outcome and believe they can achieve that
particular outcome, they will be motivated. In brief, Vroom’s
theory argues that the behaviour of individuals is such as to
maximise pleasure and to minimise pain in whatever form it
may occur. Vroom’s model consists of three major elements,
as illustrated in Figure 2.12.
Expectancy
Expectancy
leads to
Performance
Instrumentality
leads to
Outcome
(reward)
Valence
Personal
objectives
▲ Figure 2.12 Victor Vroom’s expectancy theory
» Expectancy This refers to the confidence that
employees may have in their ability to complete a
particular activity or task to an acceptable standard.
Demotivation will result if an employee believes that
they are not capable of completing the task in question
satisfactorily.
» Instrumentality This is the belief of employees that
the completion of a particular activity will lead to a
desired outcome. In a situation of high instrumentality,
the employee has confidence that specific activities
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AS LEVEL 2.2 Motivation
2.2
will result in the achievement of a valued reward.
Instrumentality will be greater if employees recognise
a clear link between actions and rewards and have
confidence that they will receive the promised rewards
for achieving their targets.
» Valence This represents the strength of a person’s
desire to achieve a specific outcome. Valence is
positive if a person prefers the outcome to not
achieving it. If the person is indifferent to the
outcome then the valence will be zero. High values
of valence mean that an outcome is highly attractive
to employees and has great potential to motivate. In
such circumstances, managers can use the possibility
of attaining this outcome as a means of motivation.
For example, a salesperson may find the prospect of a
monetary bonus for achieving an agreed sales target
very desirable. The salesperson must have confidence
in their ability to achieve the number of sales
necessary to receive the bonus.
2.2.4 Motivation methods in
practice
The theories in practical situations
Reading the various theories of motivation, it can
appear that there are a number of straightforward
methods of motivating employees. However, in practice
this is not necessarily the case. Managers may lack
the resources or knowledge to be able to apply these
theories in the workplace. For example, a business
may not have sufficient financial resources to be
able to increase pay or offer promotions as a means
of motivating workers. Furthermore, workforces are
increasingly likely to contain diverse employees who may
be motivated by different factors. This can make the
task of improving levels of motivation more difficult for
a manager in a modern business.
Energage (a research and consulting firm based in
Philadelphia) has conducted research into employee
motivation in the USA. It surveyed more than 20 million
employees working for 60 000 businesses between 2004
and 2020. Across all sectors and populations within the
USA, appreciation of employees’ efforts is ranked among
the most important drivers of motivation, according to this
survey. Appreciation can take many forms, such as financial
rewards or praise, and is part of many of the theories we
have studied. This research suggests that in the workplace,
elements of many of the theories we have covered can be
very effective in increasing levels of motivation. It also
suggests that there are relatively simple ways to improve
employee motivation.
Financial motivators
Managers and organisations use a variety of pay systems in
an attempt to improve the performance of their workforce.
Despite attention given to the views of Herzberg, which
suggest that monetary methods of motivation are of limited
value, pay remains a major incentive.
▼ Table 2.8 Opinions on the motivational powers of pay
Writer
Opinions on the motivational power of pay
Frederick Taylor
Taylor saw pay as the primary motivating
factor for all workers. He referred to
workers as ‘economic animals’ and
supported the use of piece-rate.
Abraham
Maslow
He saw pay as a reward which permitted
employees to meet the lower needs on
their hierarchy.
Frederick
Herzberg
Herzberg saw pay as a hygiene factor
and a possible cause of dissatisfaction.
In a few circumstances pay might be a
motivator if, for example, it is used as a
recognition for merit.
Time-based pay
Some employees receive payments based on the number
of hours that they work each week or month. Their income
is based on an hourly rate of pay. Thus an employee may
be paid $11 an hour. If the employee works 36 hours in a
particular week, they will receive gross pay amounting to
$396 ($11 × 36 hours).
This payment system has the advantages of being simple
to understand and transparent. Many countries across
the world have minimum-wage laws based on specific
hourly rates of pay which can be increased over time to
compensate for inflation.
However, time-based pay can result in employees becoming
clock-watchers and not being prepared to carry out any
duties outside the hours for which they are paid.
Salaries and wages
Most employees receive their payment in the form of
salaries or wages. Salaries are expressed in annual terms
(for example, a production manager might be paid a salary
of $30 000 per year) and are normally paid monthly. Salaried
employees are not normally required to work a set number
of hours per week, though their employment contract may
state a minimum number of hours.
On the other hand, wages are usually paid weekly and
employees are required to be at work for a specified
number of hours. Employees on wages are normally paid a
higher rate (known as overtime) for any additional hours
worked.
Piece-rate
Under this pay system, employees are paid according to the
quantity they produce – a form of payment by results. Thus,
an employee on a production line might receive an agreed
amount for each unit of production they manufacture.
Piece-rate is common in a number of industries including
textiles, electronics and agriculture.
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Piece-rate offers businesses a number of advantages
and disadvantages. The introduction of piece-rate pay
can increase the productivity levels achieved by many
employees within a business. This can effectively reduce
the business’ labour costs for each unit of output that is
produced. However, this rise in productivity may be at the
expense of quality and customer complaints may increase.
A business using piece-rate may lose customers as a
consequence of its introduction, especially if quality is an
important factor in customers’ buying decisions.
Bonuses are additions to pay that are linked to individual
or team performance measured against targets or objective
criteria. Employers introduce bonus payments to reward
individuals for doing well. By definition, a bonus payment is
an extra and not part of basic pay. Bonuses can be paid to
employees in different industries and at different levels in
an organisation. Some examples are:
» profit-related bonus, for example, to a manager in a
retail organisation
» performance bonus payments to senior managers or
directors or investment bankers
» bonus payments for reaching production targets in
manufacturing.
Commission, like piece-rate, is the payment for the quantity
(or value) that is produced by an individual employee. In
some industries, such as telesales, an employee’s entire
income may be made up of commission, although it may
have to meet any conditions imposed by minimum-pay
laws. Employees can be paid a percentage of the value of
any products they sell as commission. This form of payment
has similar advantages and disadvantages to piece-rate.
However, in many countries it has become less common. One
explanation for this may be that its disadvantages outweigh
its advantages.
Profit sharing
Profit sharing is a reward system under which employees
receive some part of the business’ profits. This is a type
of performance-related pay (see opposite) but not one
which discriminates between the performances of individual
employees. Such payments, which may vary according to the
employee’s seniority within the organisation, are separate
from, and additional to, regular earnings.
Profits are paid to employees in the form of cash or
company shares. Profit-sharing schemes can improve an
employee’s loyalty to the business by breaking down the
‘us and them’ attitude. Under profit-sharing schemes, a
greater level of profit is regarded as being of benefit to all
employees, not just to senior managers. Employees may be
more willing to accept changes designed to improve the
business’ profitability.
The danger with profit-sharing schemes is that they can
provide rewards that are too small to represent a worthwhile
payment for employees. On the other hand, if they are too
generous, the business may lack sufficient funds for capital
investment.
2.2
Performance-related pay (PRP) exists where some
part of an employee’s pay is linked to the achievement of
targets at work. These targets might include sales figures
or achieving certain grades in an annual appraisal.
Variable pay is a reward for working that is based on
employee performance or results judged against some
targets.
Performance-related pay
Performance-related pay (or PRP) has become more
widely used over recent years and has developed
along with employee appraisal systems. PRP is only
paid to those employees who meet or exceed some
agreed targets. Under PRP, employees are paid for their
contribution to the organisation, rather than their
status within it.
Businesses of all sizes throughout the world have introduced
PRP. It is widely used in Hong Kong and Japan, with Nissan
as a prime example. Despite criticisms, PRP remains popular,
and many employees support linking some element of pay
to performance. However, there have been criticisms of the
huge rewards paid to some senior managers and directors of
moderately successful companies.
2.2.4 Motivation methods in practice
Bonuses and commission
GLOSSARY TERMS
Criticisms of PRP
A number of other criticisms of performance-related pay
have been put forward:
» Many employees perceive PRP as fundamentally unfair.
This is particularly true of those working in the services
sector, where individual employee performance is
difficult to measure.
» Employees fear that they might be discriminated against
because they do not get on with the manager who makes
a decision on their performance. This can result in their
performance worsening, not improving.
» A majority of businesses operating PRP systems
do not put sufficient funds into the scheme.
Typically, the operation of a PRP scheme adds 3–4 per
cent to a business’ wage bill. This only allows employees
to enjoy relatively small performance awards, which may
be inadequate to change employee performance.
Developments in PRP
Increasing numbers of businesses are implementing a
system known as variable pay. Some managers argue
that a business’ performance often depends upon the
achievements of the few.
Variable pay is really a development of PRP. It is similar
in that it rewards employee performance, but there are
differences. PRP operates according to a formula used
throughout the company. Variable pay is far more flexible
and the potential rewards for star employees are greater.
If the business performs well, employees benefit under
variable pay, but they can suffer financial penalties in a less
successful period.
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AS LEVEL 2.2 Motivation
2.2
Some managers remain unconvinced of the value of PRP, no
matter how sophisticated the scheme. The widespread use
of PRP may, in part, be an attempt by managers to keep pay
rates down for the majority of employees. PRP, or variable
pay, treats employees as individuals, limiting the ability of
trade unions to bargain collectively.
Targets set. These are
agreed between employee
and line manager. May take
the form of sales targets,
level of customer
satisfaction, etc.
Pay decision made. Those
meeting all performance
targets fully might receive
5% extra. Least effective
performers may receive 0%.
Fringe benefits
Fringe benefits (sometimes referred to as perks) are those
extras that an employee receives as part of their reward
package. Examples include:
» a company car (or a mileage allowance for an employee’s
own car)
» private health insurance
» employers’ contributions to pension schemes
» discounts for company products.
Firms tend to use fringe benefits to encourage employee
loyalty and to reduce the number of employees leaving the
firm. A danger of the widespread use of fringe benefits is
that costs can increase quickly, reducing profitability.
STUDY TIP
Evidence collected on
employee performance
through, for example,
observation of employee
at work.
Remember that PRP remains a highly topical and
controversial issue. While there are a number of
arguments in favour of it, a central weakness remains.
This can be explained in terms of the theory we covered
earlier. Writers such as Maslow and Herzberg argued that
money has limited power to motivate employees. PRP, no
matter how it is implemented, has more in common with
Frederick Taylor’s views of motivating employees.
▲ Figure 2.13 The operation of a typical performancerelated pay system
CASE STUDY
Profit-sharing at Ford
Ford is one of the world’s best-known manufacturers of
cars and other vehicles. In 2019, the company’s profits were
just $47 million, a very heavy fall compared with 2018.
The company said that the decline was due to a range of
operational reasons including unexpected costs associated
with the launch of Explorer, a new model of car.
The fall in profits led to a reduction in the company’s
profit-sharing payments to its employees. The company
revealed that these would be 13 per cent lower: $6600
per employee, compared to $7600 in the previous year.
Ford does not pay profit shares to all of its hourly paid
employees.
Some other vehicle manufacturers will pay their
employees larger sums as profit-sharing bonuses.
Employees at GM will be paid $8000 and employees at the
lorry manufacturer FCA will receive $7280.
Tim Stone, Ford’s chief financial officer, expressed
optimism about the company’s prospects for 2020, while
acknowledging that ‘results were not OK in 2019’.
Source: https://eu.freep.com/story/money/cars/ford/2020/02/04/
ford-profit-sharing-2020-checks-bonus/4644019002/
Questions
1
2
Explain two reasons why Ford might expect its profitsharing scheme to improve the performance of its
workforce.
[6]
Evaluate the possible problems Ford faces in
operating its profit-sharing scheme.
[12]
GLOSSARY TERMS
Fringe benefits (or perks) are those extras an employee
receives as part of their reward package.
Job enlargement is giving employees more duties of a
similar level of complexity. Also called horizontal loading.
Job redesign means changing the group of tasks or duties
which make up a specific job.
Job rotation is the regular switching of employees between
tasks of a similar degree of complexity.
Job enrichment occurs when employees’ jobs are
redesigned to provide them with more challenging and
complex tasks. Also called vertical loading.
Empowerment is a series of actions designed to give
employees greater control over their working lives.
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The main methods of non-monetary motivation attempt to
incorporate some of these features into the working lives of
employees.
Job redesign
Employers can change the design of employees’ jobs to
encompass more or different duties, or duties that are more
challenging. Job enrichment occurs when employees’ jobs
are redesigned to provide them with more challenging and
complex tasks. This process, also called vertical loading, is
designed to use all employees’ abilities. The intention is to
enrich the employee’s experience of work.
Frederick Herzberg was a strong supporter of job
enrichment. He believed that enrichment provided
employees with motivators that increased the satisfaction
they might get from working. Job enrichment normally
involves a number of elements:
» redesigning jobs so as to increase not just the range of
tasks but the complexity of them
» giving employees greater responsibility for managing
themselves
» offering employees the authority to identify and solve
problems relating to their work
» providing employees with the training and skills essential
to allow them to carry out their enriched jobs effectively.
Job enrichment involves a high degree of skill on the part
of the managers overseeing it. They must ensure that they
do not ask employees to carry out duties of which they are
not capable.
Job enlargement does not increase the complexity of tasks
carried out by an employee; instead it increases the number
of similar duties. It is also termed horizontal loading.
A number of firms operating a policy of job enlargement
simply require employees to carry out a number of similar
tasks. Thus, a receptionist might be asked to carry out a
number of duties in addition to dealing with telephone and
personal enquiries from customers. The receptionist may
also be asked to maintain records of petty cash and update
customer records, for example.
Job enlargement offers benefits to the employee in that
carrying out a range of duties, rather than a single one
repeatedly, may stimulate their interest. The business gains
Job rotation is a particular type of job enlargement. Under
this system employees switch regularly from one duty to
another. Thus, a supermarket may require employees to
spend one week on the checkout, one week stacking shelves
and one week dealing with customer enquiries. Job rotation
may reduce the level of monotony, but it does not increase
the challenge of the job.
Job enrichment
Increasing the
complexity of
tasks carried out
by an employee
or a group of
employees
Job enlargement
Increasing the number of tasks
of a similar level of complexity
Extent of tasks
2.2
2.2.4 Motivation methods in practice
Many non-monetary methods of motivation tend to focus
upon the design of employees’ jobs. Employees can be
motivated by asking them to do a job that is challenging
and interesting. A good job should have at least a number
of the features listed below.
» Employees carry out duties that result in a definite end
product.
» Clear and challenging goals give employees something to
aim at. Goals should be demanding but not unattainable.
» Employees should be able to identify easily their
contributions to the organisation.
» Jobs should be designed so that employees are involved
in planning their own schedules of work, choosing their
work methods and coping with problems as they arise.
an advantage from having an employee able to carry out a
wider range of duties, possibly reducing its labour costs.
Complexity of tasks
Non-financial motivators
▲ Figure 2.14 Job redesign: job enrichment and job
enlargement
Employee empowerment
Empowerment involves redesigning employees’ jobs
to allow them greater control over their working lives.
Empowerment gives employees the opportunity to decide
how to carry out their duties and how to organise their
work.
Empowerment can make work more interesting as it offers
opportunities to meet a number of individual needs.
Empowered workers can propose and implement new
methods of working as they bring a new perspective to
decision-making. They may spend a part of their working
lives considering the problems they face and proposing
solutions.
Empowerment would receive the approval of Maslow and
Herzberg. It provides motivators, as well as offering
employees the opportunity to fulfil higher needs.
Employees require training if they are to be empowered.
They are unlikely to have the skills necessary to schedule
tasks, solve problems, recruit new employees and introduce
new working practices. It takes time to implement
empowerment and teething problems are common.
Teamworking
Teamworking exists when an organisation breaks down its
production processes into large units instead of relying
upon the use of the division of labour. Teams are then given
responsibility for completing the large units of work. Team
members carry out a variety of duties including planning,
problem-solving and target-setting. A number of different
team types operate within businesses:
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» Production teams Many production lines have been
AS LEVEL 2.2 Motivation
2.2
organised into distinct elements called ‘cells’. Each of
these cells is staffed by teams whose members are multiskilled. They monitor product quality and ensure that
production targets are met.
» Quality circle teams These are small teams designed to
propose solutions to existing problems and to suggest
improvements in production methods. The teams contain
members drawn from all levels within the organisation.
» Management teams Increasingly, managers see
themselves as complementary teams, establishing
the organisation’s objectives and overseeing their
achievement.
There has been a major trend in businesses towards
teamworking over recent years. Teamworking is a major part
of the so-called Japanese approach to production and its
benefits have been extolled by major companies, such as
Honda.
Teamworking offers employees the opportunity to meet
their social needs, as identified by Maslow; Herzberg
identified relationships with fellow workers as a hygiene
factor and McClelland noted that some employees have a
high need for affiliation. However, much of the motivational
force arising from teamworking comes with the change
in job design that usually accompanies it. Teamworking
requires jobs to be redesigned, offering employees the
chance to fulfil some of the higher needs identified by
Maslow, such as esteem needs. Similarly, teamworking offers
some of the motivators; for example, achievement.
Training and development
Some businesses invest heavily in training and development,
often regarding it as a core element of managing their
workforces successfully. Managers value training because
they believe it improves employee motivation and
performance. They believe that training helps to motivate
employees because they feel valued by the business and this
fulfils what Maslow would have called their esteem needs.
However, training has drawbacks as a technique of
motivation. It can be very expensive, especially if it takes
place away from the workplace, and it may not be the most
cost-effective method of motivating employees. A further
danger is that employees may leave once they have acquired
new skills and higher levels of motivation, attracted by
higher pay elsewhere.
Employees may receive induction training when starting
a new job. This type of training is intended to introduce
a new employee to their job and working environment.
Induction training can give employees confidence in their
ability to do a job from the outset and this confidence may
boost their motivation and performance in the workplace.
Employee participation
Employee participation is the involvement of employees
in the process of decision-making within a business,
possibly through the appointment of worker directors. Many
businesses recognise the motivational and other benefits
of involving employees in decision-making within an
organisation. We consider employee participation more fully
below.
GLOSSARY TERMS
Job design is the process of grouping together individual
tasks to form complete jobs.
Employee participation is the involvement of employees in
the process of decision-making within a business.
Promotion and status
Promoting an employee to a more senior position within
the business is likely to prove motivational. Organisations
that offer clear paths for promotion are likely to have more
motivated employees, as promotion brings a number of
benefits including financial rewards, more opportunities for
taking responsibility, and recognition. Employees in such
organisations will be more able to identify a career path and
would be expected to be more motivated and committed to
achieving advancement.
Herzberg recognised that many employees needed
opportunities for advancement. McClelland identified a
group of employees with high needs for authority and
power. Both writers acknowledged that having clearly
defined routes for progression up the organisational
structure can be an effective means of meeting these needs
and can motivate employees and improve their performance
at work.
If employees believe that their employer offers no prospects
for advancement, they may seek alternative employment.
This can reduce a business’ retention rates and increase its
costs, including those for recruitment and training.
Businesses can gain a competitive advantage by
establishing and publicising clear promotion paths for
employees. This approach can assist managers in attracting
the most talented employees and in developing a strong
employer brand.
Similarly, granting someone higher status within an
organisation, perhaps through giving them their own office
or parking space, may motivate them by fulfilling their need
for self-esteem. However, some businesses have opted for a
policy of single status in recent years. Single status means
that businesses end discrimination between different grades
of employees within the organisation, by providing the
same facilities and benefits for all.
Methods of employee participation
As we have seen, employee participation is the involvement
of employees in the process of decision-making within
a business. Trade unions can be opposed to the use of
employee participation because techniques such as quality
circles can replace unions in the workplace. Employee
participation can take numerous forms, including:
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» Quality circles These are groups of workers who meet
» Employee shareholders Firms across the world operate
schemes whereby their employees can buy shares in the
company, often at discounted rates. Because employee
shareholders have a financial interest in the business’
performance, it may be that their motivation levels
and performance will improve as a consequence. If the
business performs well, its share prices should increase,
giving financial benefits to the employee.
» Autonomous work groups These are teams of employees
who are given a high level of control over their working
lives – in effect, another form of empowerment. Some
such groups elect their own leaders and can appoint new
staff, as well as having considerable authority over what
tasks to complete and in what sequence.
Elton MAYO
emphasised the importance of
social contact and human
interaction in motivation
Abraham MASLOW
argued that businesses should offer
employees the opportunity to fulfil
their ‘higher needs’ such as status
and recognition
Frederick HERZBERG
identified factors (which he called
‘motivators’) which are central in
improving employee performance
at work
encouraged use of
teamworking in business
Maslow’s theory
supports the use of
quality circles
the use of autonomous work
groups generate ‘motivators’
for those involved
2.2
2.2.4 Motivation methods in practice
regularly to identify methods of improving all aspects
of the quality of their work. Quality circles normally
involve four to ten employees, drawn from all levels
within the organisation, and focus on supplying
imaginative ideas.
» Works councils Managers and employees meet within
works councils to discuss issues such as working
conditions, pay and training. They are popular in many
countries, especially Germany. Employee representatives
on works councils are normally elected by the workforce
and works council representatives may also be appointed
to a company’s board of directors.
EMPLOYEE
PARTICIPATION
▲ Figure 2.15 Employee participation and motivational theory
CASE STUDY
Primark in Bangladesh
Primark is one of Europe’s largest retailers of clothes and
operates more than 230 shops. The company has a wellpublicised commitment to improve working conditions in
its suppliers’ factories in Bangladesh. It has established
committees to allow employees to participate in decisionmaking in a number of its factories, allowing employees to
make proposals to improve their working conditions. The
programme covered factories in Dhaka, Savar Gazipur
and Narayanganj. In preparation, Primark provided
training to 500 managers in the factories and more than
1000 employees to ensure they had the necessary skills
to implement decisions to enhance working conditions in
diverse environments.
Equipped with new skills, including those related to
bargaining, the factory workers have reduced working
hours and increased holiday entitlements, while
increasing hourly pay rates. The negotiations have also
led to a number of administrative changes, including
transparent pay rates and accurate and detailed pay slips.
Primark has also supported the creation and publication
of a range of posters setting out workers’ rights. The
whole scheme is designed to ensure that workers are
empowered, educated and effective communicators
dedicated to improving working conditions in one of the
world’s poorer economies.
Questions
1
2
Explain two difficulties that Primark might face in
establishing its worker-participation committees. [6]
Evaluate whether or not Herzberg’s theories of
motivation offer the best explanation of the benefits
that Primark might receive from setting up workerparticipation committees.
[12]
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2.2
TEST YOUR LEARNING
Short answer questions
AS LEVEL 2.2 Motivation
1
a
b
Define the term ‘motivation’.
[2]
Explain one characteristic of a highly
motivated workforce.
[3]
2 Explain one way in which a business may benefit
from having a highly motivated workforce.
[3]
3 a Identify two human needs.
[2]
b Explain two key elements of FW Taylor’s
theory of motivation.
[6]
4 Explain one difference between Frederick
Herzberg’s motivators and his hygiene factors.
[3]
5 a Define the term ‘process theory of motivation’. [2]
b Explain one difference between the need for
achievement and the need for affiliation.
[3]
6 a Explain one difference between piece-rate
pay and hourly pay.
[3]
b Explain one possible benefit to a business of
profit-sharing.
[3]
7 Explain two features that an employer should include
in the design of a job if it is to motivate employees. [6]
8 a Explain one difference between job enrichment
and job enlargement.
[3]
b Define the term ‘job design’.
[2]
9 Explain two different types of teams that may be
used within a business.
[6]
10 a Define the term ‘employee participation’.
[2]
b Explain two techniques that businesses may
use to encourage employee participation.
[6]
Data response question
A traditional business
Gibble Ltd is a long-established manufacturer of luxury
pens. It is a traditional business with a clear hierarchy and
many long-serving managers. Its products are recognised
as being of the highest quality and it charges premium
prices for them. Its most expensive pen sells for $1250.
Despite the company’s profits reaching record levels, its
managers are seeking ways to improve the performance
of its workforce. Some managers believe that pay
is the best way to improve motivation and employee
performance. Others would prefer more employee
participation allowing greater use of teams and
techniques, such as empowerment and job enrichment.
Questions
1
2
3
Define the terms:
a ‘empowerment’
b ‘job enrichment’.
Analyse one way in which Gibble Ltd might use
monetary methods of motivation to improve the
performance of its workforce.
Evaluate whether it is inevitable that Gibble Ltd
will use non-financial methods to motivate its
workforce.
[2]
[2]
[4]
[12]
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2 Human resource management
2.3
AS LEVEL
Management
In this chapter we examine:
★ the functions of management
★ the role of managers using the theories of Fayol and Mintzberg
★ the contribution of managers to business performance
★ a range of management styles
★ McGregor’s theory X and theory Y managers.
Di
ct
re
g
in
The
Manager
ng
isi
an
rg
O
Leaders, by comparison, are people who are followed, who
have a vision of the future and a clear sense of where they
are taking the business. A leader decides what needs to
be done and is prepared to shake things up to get it done.
According to a significant writer in this area, John Adair,
‘leadership is the process of motivating others to act in
particular ways’. We look at leadership in much more detail
in Chapter 7.3.
pany objectives
Com
g
Many business writers draw a distinction between a leader
and a manager. A manager is someone who gets things
done. Managers tend to focus on the present and the short
term and are responsible for implementing the decisions
of others. They manage but they also follow. Their role, in
many ways, is to maintain things the way they are.
The theorist Mary Parker Follett believed that management
was ‘the art of getting things done through other people’.
From Fayol onwards, various writers over the years have
argued that this involves different functions. However,
those set out in Figure 2.16 would be considered the key
functions that are carried out by most managers.
nt
ro
llin
We will consider both of these classifications in more detail
in this chapter.
The functions of management
Co
Describing management is a complex task, and there have
been a number of attempts by writers to classify what
managers do within an organisation. For example:
» Henri Fayol, writing in the early twentieth century, set
out the functions of management.
» In contrast, Henry Mintzberg identified ten roles carried
out by managers.
Do make sure that you distinguish between management
and leadership in your answers and avoid using these
two terms interchangeably. If the question is about
management, make sure that is what you write about!
an
ni
ng
What is management?
STUDY TIP
Pl
2.3.1 Management and managers
2.3.1 Management and managers
Chapter overview
GLOSSARY TERM
Leadership includes the functions of ruling, guiding and
inspiring other people within an organisation in pursuit of
agreed objectives.
Management is planning, organising, directing and
controlling all or part of a business enterprise.
Com
p a n y o bje cti v e
s
▲ Figure 2.16 The functions of management
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2.3
All businesses operate in different ways and may require
managers to undertake varying tasks and duties. However,
these various management duties and tasks can be
categorised into four basic functions – the functions of
management. The four principal functions of management are:
» planning
» organising
» directing
» controlling.
CASE STUDY
AS LEVEL 2.3 Management
Saudi Arabian company wins airport car park contract
Sharjah Airport is one of the busiest in the United Arab
Emirates. In the past, the managers at Sharjah Airport
Authority have managed parking by passengers and staff.
However, it was decided recently that another company
should be employed to take on this role. The contract was
won by Mawgif, a business based in Saudi Arabia.
Mawgif has promised to use technology to support its
management of parking at the airport in the hope of
improving the travel experience of passengers passing
through Sharjah Airport. It has significant experience in
this area as it already operates parking in more than ten
cities and has operations in Saudi Arabia and Jordan. It
also plans to offer drivers parking at Sharjah Airport new,
and more convenient, methods of paying parking charges.
Source: www.moodiedavittreport.com/national-parking-companymawgif-wins-15-year-sharjah-airport-parking-contract/
Questions
1
2
Explain two functions of the managers at Sharjah
Airport Authority.
[6]
Evaluate which of the functions of management will
be most important if Mawgif’s managers are to
respond effectively to winning this contract.
[12]
Planning
Organising
Planning is the first of the functions of management and
involves looking to the future. It is the foundation upon
which the other three functions of management should
be based. Planning requires management to evaluate
where the company is currently and where it would like to
be in the future. This allows managers to take decisions
so that the company moves forward in an organised and
coherent manner to give managers something against which
to judge their decisions. Planning may involve a variety of
tasks, including:
» establishing objectives or targets for the business
» gathering together forecasts of key data, such as costs
and revenues
» drawing up plans for functional areas within the
business such as finance, human resources or
marketing – these plans should fit together to help the
business achieve its objectives
» estimating the likely resource needs for any proposed
plans.
Management must assemble the resources that they need
to carry out the actions set out in the plan. Through the
process of getting organised, management will determine
the internal organisational structure, establish and
maintain relationships, as well as allocate necessary
resources.
The planning process is continual because external factors
(such as licences to operate telecommunications services
in many countries, for example) change all the time. These
changes may cause a company to adjust its course of action
to ensure that it achieves its objectives.
Planning helps managers to reduce the chance of projects
failing in the future. A plan can highlight problems and
encourage managers to develop solutions. It can help to
make sure that managers have the resources they need. A
plan can also be extended to help managers to overcome
emergencies or crises – these are called contingency plans.
For example, a company might draw up a contingency plan
to cover the consequences if a bid made to operate mobile
phone services is unsuccessful.
Global demand for palm oil is rising quickly. Worldwide
production of palm oil has been climbing steadily for
five decades. Between 1995 and 2015, annual production
quadrupled, from 15.2 million tonnes to 62.6 million tonnes.
By 2050, it is expected to quadruple again, reaching 240
million tonnes. Plantations have been established in Africa
and South America. In order to organise this expansion, the
managers will need a range of resources:
» land for palm oil plantations and oil mills
» labour to plant the trees, build the mills and, eventually,
harvest the fruit of the trees and process it
» capital to finance the plan.
The companies may also need to restructure their workforce
to operate plantations in Africa and South America to
ensure that their planned operations run efficiently. A wellmanaged business will use minimal resources to achieve its
objectives. (The palm-oil industry has a high environmental
impact which companies must also take into account – see
pages 233 and 257.)
Directing
The third function of management is directing. Through
directing, management is able to influence and oversee the
behaviour of the staff in achieving the company’s goals, as
well as assisting them by providing the necessary resources.
Directing employees effectively entails motivation and
communication.
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» Motivation is the willingness to achieve a target or
Controlling
Controlling involves setting standards using the company’s
objectives and then evaluating and reporting performance.
Once management has done both of these things, it should
compare the two to determine any necessary corrective
or preventive action. Managers can report on business
performance in a number of ways:
» Financial reports Many companies publish details
of their financial performance each year. This gives
interested parties information on their sales, revenues
and profits. In many countries there is a legal
requirement for companies to report on profits or losses
to assist governments in assessing whether the correct
amount of tax has been paid.
» Employee performance Such reports may provide
information on productivity (the quantity produced per
employee per week, for example), levels of absenteeism
or training costs. For many service businesses, these can
be vital measures of performance.
» Social performance Managers can measure a business’
performance in terms of behaving ethically, minimising
pollution and creating jobs.
Palm-oil producers may need information on each of the
above areas to assess whether their planned expansion
of palm-oil production in countries throughout the
world is progressing according to their plans. The
control process is a constant task for managers. Through
the process of control, a manager is able to identify
potential problems and take the necessary decisions to
overcome them.
▲ Figure 2.17 A newly established palm-oil plantation
Question
1
2.3
Evaluate why it might be necessary for palm-oil
producers to report on their social performance in
Africa to ensure that their activities are controlled
[12]
effectively.
Henri Fayol’s theories of management
Henri Fayol (1841–1925) was a French mining engineer. He
developed a theory of business administration and published
his ideas in his book, Industrial and General Administration,
originally published in France in 1916. Fayol created his
theory at roughly the same time as Frederick Winslow Taylor
developed his ideas about scientific management.
2.3.1 Management and managers
goal. Employees that are highly motivated generally
perform better, which assists businesses in achieving
objectives. For this reason, managers tend to put a lot of
focus on motivating their employees. For example, they
provide financial-incentive programmes to encourage
employees and may also grant them authority to take
decisions to help improve motivation and performance.
» Communication is the exchange of information between
one or more people. Effective communication can take
a number of forms. It may simply be praise or clear
guidance; alternatively, it could be detailed instructions.
Whatever form it takes it can help to achieve high levels
of productivity and encourages employees to use their
initiative as well as to solve problems.
As a director in a mining company, Henry Fayol established
what he thought were the fourteen key principles of
management. His work set out how managers should
organise and interact with employees. He also identified
five primary functions of management which supported his
fourteen principles.
Fayol was one of the earliest writers on management theory
and remains a very strong influence on management theory
and practice.
Fayol’s fourteen principles
1 Division of work Output can be increased if employees
are specialised in different areas of production. This
occurs because employees become increasingly skilled
and productive.
2 Authority Fayol believed that managers need authority
to give orders to subordinates. However, it is important
to remember that responsibility comes with authority.
3 Discipline This refers to obedience and is a core value in
an effective organisation.
4 Unity of command This means that an individual
employee should receive orders from one manager and
that the employee is answerable to that manager.
5 Unity of direction In a well-co-ordinated organisation,
teams with the same objective should be working under
the direction of one manager and following a single
plan.
6 Subordination of individual interests to the general
interest The interests of any one employee or group
of employees (including managers) should not be more
important than the interests of the organisation as a whole.
7 Remuneration Employee satisfaction occurs when all
employees are paid fairly. This covers financial and nonfinancial rewards.
8 Centralisation This refers to how close employees are to
the decision-making process. It is important to achieve
a balance between senior managers (at the centre)
and more junior employees being involved in decisionmaking.
9 Scalar chain Employees must know where they are in
the organisation’s structure. They should know who is
their manager and those people over whom they have
authority.
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AS LEVEL 2.3 Management
2.3
10 Order Employees must have the right resources to carry
out their jobs effectively. In addition, the workplace
should be clean, tidy and safe.
11 Equity Fayol believed that managers should be kind and
treat all employees fairly at all times.
12 Stability of tenure of personnel Managers should aim
to have the right staff in the right place and to minimise
the rate of labour turnover within the business.
13 Initiative Employees should be given the necessary
freedom to be creative and to develop new ideas. This
helps to encourage employees to be engaged and
motivated.
14 Esprit de corps Organisations should strive to promote
team spirit and unity and create good morale within the
workplace.
Interpersonal management
Fayol’s fourteen principles may have been written more than
one hundred years ago, but many of these principles are
now adopted by almost all managers, although they were
considered revolutionary when first published.
Informational management
Fayol’s functions of management
Fayol set out five functions of management. These are:
» planning
» co-ordinating
» organising
» controlling.
» commanding
You will see that Fayol’s functions of management are very
similar to the generic managers’ roles described earlier (on pages
84–85). Analysing the functions and principles of management
gives some insight into what managers have to do to be
effective and efficient. Some management writers have argued
that when Fayol’s writing on good management was accepted,
productivity and living standards in America increased. However,
this may have been the result of other factors too.
Mintzberg’s roles of management
Henry Mintzberg is Professor of Management Studies at
McGill University in Montreal, Canada, and a renowned
author on management. One of his most famous pieces
of writing, in 1990, set out the ten roles performed by
managers within businesses. He argued that management is
not about functions but about what managers do.
Mintzberg argued that managers performed ten roles and
that these fall into three categories, as shown in Table 2.9.
▼ Table 2.9 Mintzberg’s management roles and categories
Role
Category
1 Figurehead
2 Leader
3 Liaison
Interpersonal management
4 Monitor
5 Disseminator
6 Spokesperson
Informational management
7 Entrepreneur
8 Disturbance handler
9 Resource allocator
10 Negotiator
This category entails managing through other people.
» Figureheads represent their colleagues. They carry out
social, ceremonial and legal responsibilities and are
expected to be a source of inspiration. Figureheads are
considered to have authority.
» Leaders create and maintain an effective working
environment and motivate and develop more junior
employees. In this role, employees manage the
performance and responsibilities of everyone in their
team.
» Liaisons must communicate with internal and external
contacts. They need to network effectively to gather
information.
The roles in this category involve processing information.
» Monitors search for internal and external information
relevant to the business, looking for relevant changes in
the environment. Monitors also look after their teams in
terms of performance and welfare.
» Disseminators pass on valuable information to others in
the organisation. This is a central communication role.
» A spokesperson represents and speaks for their
organisation. In this role, they are responsible for
transmitting information about their organisation and
its goals to the people outside it.
Decisional management
This category of management role uses information to take
decisions.
» Entrepreneurs plan and initiate change as a manager
within a business organisation.
» Disturbance handlers deal with the unexpected and
also with crises. Managers should take control in such
circumstances and attempt to solve disputes.
» Resource allocators take decisions on the most
effective use of an organisation’s resources including
finance, staff and capital equipment.
» Negotiators engage in important negotiations within
and outside the business.
Mintzberg reached a number of conclusions from his studies.
» Senior managers are very busy and have heavy
workloads! There is little free time and trying to get
away from work is difficult.
» The work is fragmented; managers are moving from
one task to another. They need to focus on what really
matters and what really makes a difference (80 per cent
of results usually come from 20 per cent of the effort, so
they try to work out what that 20 per cent is).
» Managers focus on short-term, immediate problems. They
are often firefighting, dealing with the problem in front
of them; this pushes them away from long-term planning
and thinking.
Decisional management
This category of management role
uses information to take decisions.
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CASE STUDY
2.3
SF Airlines plans to enlarge fleet
Each week, SF Airlines operates an average of 959
flights to 65 airports. The airline plans to double its
fleet to 118 aircraft and to expand its network of routes
to 70 destinations during 2020. SF Airlines has also
expanded its fleet of aircraft by 16 per cent during 2019
and now operates 58 planes. In December 2019, it was
given approval by the US Department for Transportation
» Verbal contact is preferred to written as, with the latter,
lots of information is received but it takes longer to get
a response. Managers seldom get out and about; walking
around is useful because it makes you visible and more
aware of the issues within the business.
» Managers actually control little of what they do day to
day – things happen to them!
Mintzberg’s work on management roles was based on
observing senior managers, and this is both a weakness
and a strength of his theory. He did analyse what managers
really do, but he did not consider the working lives of
middle or junior managers, so, in this respect, his analysis
may be considered incomplete.
The contribution of managers to
business performance
Managers play a critical role in business activities and can
have a significant influence on their performance. There are
many elements of the work of managers which can impact
on the performance of the business. We will consider some
of these below (these are also summarised in Figure 2.18).
» Setting suitable objectives Managers play an important
role in setting objectives and monitoring the actions
taken to achieve these. Setting objectives which are
appropriate and achievable is an important part of
business success. If they are too challenging, employees
may be demotivated by failure; if too easy to achieve,
the business may underperform. Effective managers
also monitor the progress of the business towards
its objectives, ensuring, for example, that sufficient
resources are available to employees. Managers at
Volkswagen, the German car manufacturer, plan to
switch production from cars powered by internal
combustion engines to those with electric motors. By
2028, Volkswagen will sell 70 different electric vehicles
and the company will be carbon-neutral by 2050. Its
future success will depend on how effective managers
are in guiding the business to achieve these objectives.
to operate flights from China to any point in the USA. In
response to this, the airline will introduce flights from
Hangzhou to New York three times each week.
Source: www.ch-aviation.com/portal/news/85299-chinassf-airlines-fleet-to-top-60-aircraft-in-2020
Questions
1
2
Explain two reasons why planning will be an important
function for SF Airlines’ managers in the future.
[6]
This expansion represents a major challenge for SF
Airlines’ managers. Evaluate which of Mintzberg’s
roles would be most important in the management
of the company’s growth.
[12]
» Allowing subordinates to work to their full potential
Managers who can recognise and respond appropriately
to the needs and abilities of their workforce are more
likely to achieve success. Some employees will flourish
if managers relax control and empower employees
to make decisions and take greater control of their
working lives. In other situations, managers may need
to use more authority. If managers achieve the right
balance between the use of authority and freedom for
employees, the workforce, and hence the organisation, is
likely to perform better.
» Making good-quality decisions Managers tend to make
a lot of decisions. Some of these can have significant
implications for the performance of the business.
Effective managers will use their experience and skills,
as well as data, to make good-quality decisions. Modern
managers frequently have access to enormous amounts
of data on, for example, market trends and consumer
behaviour. This can be used to support and inform
decision-making and can help to reduce the risk in major
decisions, such as that taken by Volkswagen above.
Use workforce and other
resources as efficiently
as possible
2.3.1 Management and managers
SF Airlines is based in Shenzen, China, and was founded in
December 2009. It provides a service transporting cargo
and has transported around 2.5 million tonnes of cargo to
destinations in central and south-east Asia and Europe. It
only commenced flights between Frankfurt (Germany) and
Wuxi (China) in September 2019.
Increased sales
and profits
Achieve
objectives
on time,
enhancing
business’
performance
Set
challenging
but
achievable
objectives
Take informed decisions
using experience and data
Protecting and/or
increasing market
share
▲ Figure 2.18 Some ways in which managers can contribute
to business performance
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Styles of management
AS LEVEL 2.3 Management
2.3
There have been many studies looking at styles of
management and evaluating the extent to which they have
been successful. There is no simple answer to which style is
most effective, as it depends on the circumstances. Here,
we will consider a range of styles of management.
One classification of styles is to consider the extent
to which managers ‘tell’ or ‘listen to’ their staff. Using
this approach, managers have been classified as being
autocratic, paternalistic, democratic or laissez-faire
(literally meaning ‘leave alone’). However, there are many
more different styles of management that can be identified
using this approach. The Tannenbaum and Schmidt
continuum, shown in Figure 2.19, emphasises that there is
a range of management styles depending upon the extent
to which managers take decisions or whether subordinates
contribute significantly to decision-making.
A key factor in differentiating between these styles is
communication. At the autocratic end of the spectrum,
communication is likely to be downward only as the manager
‘instructs’ their subordinates as to their duties. Paternalistic
management is a ‘softer’ version of this, as we shall see.
Democratic management is more likely to result in two-way
communication, as consultation and ‘selling’ of the final
idea take place. Laissez-faire management may result in
relatively little communication, as the problem or task may
be outlined with subordinates having considerable freedom
thereafter.
Manager-centred management
Subordinate-centred management
Area of freedom for subordinates
Use of authority by the manager
Manager makes
decision and
announces it
Manager sells
decision to
subordinates i.e.
convinces them
Manager
presents
ideas and invites
questions
Manager
presents
tentative decision
subject to change
Manager presents
problem, gets
suggestions and
makes decision
Manager defines
limits and asks
group to make
decision
Range of behaviour
Manager pemits
group to function
independently
within defined
limits
▲ Figure 2.19 The Tannenbaum and Schmidt continuum
GLOSSARY TERMS
Autocratic management exists when managers keep
control of information and make major decisions alone.
Sometimes known as authoritarian management.
Paternalistic management is a style in which managers
take decisions in what they believe are the best interests
of their subordinates.
Democratic management occurs when information is
shared and team members participate in decision-making.
Sometimes known as participative management.
Laissez-faire management takes place when managers
allow subordinates freedom to make their own decisions.
Autocratic management
This is also sometimes termed authoritarian management.
It refers to a management or leadership style which assumes
that information and decision-making are best kept at the
top of the organisation. It is also characterised by:
» one-way communication (downward)
» minimal delegation or decentralisation
» close supervision of employees.
Martha Stewart, an American entrepreneur, built up a vast
global business venture including publishing, television
broadcasting and online commerce, despite (or perhaps
because of) her reputation as an autocratic manager.
Under this style, the manager determines objectives,
allocates tasks and expects obedience from subordinates.
In these circumstances, employees become very dependent
upon their managers, as they do not have the necessary
information (or confidence) to act on their own initiative.
Organisations managed in an authoritarian style can face
difficulties. People avoid making decisions, so that matters to
be decided are either passed up for the decisions to be made
at a higher level or decisions are made by committees – as it
is more difficult to dismiss all the members of a committee
for jointly making a wrong decision. Senior management
tends to be overworked and staff turnover tends to be high.
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This style of management becomes more difficult to operate
successfully as an organisation grows.
As with all of these management classifications, the
term ‘autocratic manager’ covers a spectrum of actual
styles. Extreme autocratic management will result in
subordinates having no freedom of action. More benevolent
autocratic leadership will allow for the possibility of some
discussion or persuasion. This implies that limited two-way
communication may occur.
2.3
▼ Table 2.10 Autocratic management – circumstances in which it may be applicable
Inappropriate
• When a rapid decision is needed – perhaps in an emergency
• When it is important that the same message is given out
by everyone in the organisation – maybe as part of crisis
management
• When managers are responsible for a large number of
(possibly unskilled) subordinates
• When taking highly complex decisions requiring diverse
knowledge and skills
• When leading a talented, self-motivated and creative group
of employees
• In circumstances in which junior managers are expected to
develop a full range of managerial skills
Paternalistic management
» the manager acts upon advice and explains the reasons
Paternalistic management is broadly autocratic, but this
type of manager takes into account the interests of the
workforce when making decisions. Paternalistic managers
consult with junior employees over decisions and may
take some notice of the views expressed by subordinates.
However, paternalistic managers retain control over most
decision-making and only delegate minor decisions (and
little freedom) to subordinates.
» subordinates have some control over their own working
A paternalistic manager regards their staff as an extended
family. Businesses using this style of management consider
it important to meet the social and leisure needs of their
staff. This approach was common in the UK in the past, and
Cadbury’s (a manufacturer of chocolate and similar products)
was a well-known example.
Paternalistic managers often develop very loyal subordinates
because subordinates feel protected and cared for. It is
not unusual for paternalistically managed businesses to
have a low rate of labour turnover. This can help to reduce
recruitment costs and improve competitiveness.
However, paternalistic managers do not encourage their
employees to use their creative and imaginative skills, nor
do they encourage the use of initiative. This can mean that
the business does not make the most effective use of the
human resources that it has available.
Democratic management
Democratic management (sometimes called participative
management) entails operating a business according to
decisions agreed by the majority. Decisions may be agreed
formally through a voting system, but they are more
likely to be the result of informal discussions. Typically,
democratic management encourages some or all of the
following:
» the manager delegates a great deal and encourages
decentralisation
» the manager and subordinates discuss issues and
employee participation is actively encouraged
for decisions
lives.
The successful operation of this style requires excellent
communication skills on the part of the manager and the
ability to generate effective two-way communication. A
considerable amount of management time may be spent on
communicating in one form or another. This approach helps
to develop the skills of subordinates and generally results in
a more satisfied workforce.
2.3.1 Management and managers
Appropriate
Democratically led groups usually have low dependency on
their manager, offer constructive ideas and suggestions
and derive great satisfaction from their employment.
As a consequence, such groups have high levels of selfmotivation and may require relatively little supervision.
There is evidence of a trend towards more democratic styles
of management, though this depends on many factors,
including the size of a business and its culture. The trend
towards democratic management has a number of possible
causes:
» Management theory has developed and provided
substantial evidence that people are more likely to
be motivated (and productive) through the use of a
democratic management style.
» Management has become more complex. Globalisation
means that businesses are larger and more complicated
organisations, and the environment in which they
operate is dynamic and subject to rapid change.
Individuals are more likely to need the support that
democratic management provides to succeed in these
circumstances.
STUDY TIP
Do learn the glossary terms in this chapter (and the other
chapters as well!), as understanding the terms that may
be used in questions is essential and you may be asked to
provide definitions.
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AS LEVEL 2.3 Management
2.3
CASE STUDY
Steve Jobs
Steve Jobs was an unconventional manager. His
management style was not the stuff of textbooks – he
wasn’t known for his democratic style or consensusbuilding approach. Jobs founded the American technology
company Apple with school friend Steve Wozniak in 1976,
and was effectively fired from it in 1985. However, he
returned to the company in 1997 and achieved greatness.
Under his control, the market value of Apple’s shares
increased from about $5 billion in 2000 to $351 billion in
2011, when ill-health forced his retirement. It remains one
of the most valuable companies globally; he also created
one of the world’s most valuable brands.
Sir Richard Branson, the founder of the Virgin Group of
companies, was a fan of Steve Jobs. He has described Jobs
as an autocratic manager with a ‘meticulous eye’ for detail.
Branson considered Jobs to be someone who wanted to
work with people who were like-minded and who would
follow his instructions. Jobs was not thought to be a good
delegator and tried to become involved in too many aspects
of the business. He was very demanding as a manager,
expecting a great deal from the people who worked for him.
Laissez-faire management
This approach is sometimes described as ‘mild anarchy’.
Under this approach, the manager has a minimal input into
the operation of the business. Employees take the majority
of the decisions with little reference to the manager. As a
consequence, the organisation can lack a sense of direction
as well as co-ordination and planning.
A laissez-faire style of management may occur because
of the personal shortcomings of the manager or a lack
of the essential skills needed to carry out the manager’s
role successfully. Alternatively, it may be a conscious and
brave policy decision to give staff the maximum scope for
showing their capabilities. It may be an appropriate style to
adopt in certain circumstances. For example, the manager
of a highly creative team may deliberately adopt this
Some analysts do not consider Jobs to have been the
best manager of people. There are times when clear
and decisive management is essential and a strength,
especially in times of crisis. However, it may be that
Jobs should have delegated more and listened more, as
subordinates often have great ideas.
Despite the criticisms of Jobs as a manager, he is
considered to have been an excellent communicator and
he was the public face of Apple for many years. He was
also passionate about his work. He loved finding gaps in
the market and developing products that people really
wanted. Jobs’ legacy lives on in Apple.
Questions
1
2
Explain two differences between autocratic and
democratic management styles.
[6]
Evaluate whether being passionate about your
business and a good communicator is more important
than the management style that is used.
[12]
style in the expectation of bringing out the best in their
subordinates.
Laissez-faire management may be successful in the
following circumstances:
» The manager is one among a number of equals in terms
of experience and qualifications.
» The workforce is self-motivated and understands the role
of the manager.
» The workforce understands and agrees with the
organisation’s objectives.
Laissez-faire management tends to result in highly
independent employees who are willing to voice their
opinions. Staff may be satisfied or dissatisfied with this
style of management, depending on their skills, the
complexity of the tasks to be completed and their own
personality.
▼ Table 2.11 The key features of a selection of management styles
Autocratic
Paternalistic
Democratic
Laissez-faire
Description
Keeps information and
decision-making among
the senior managers
Dictatorial, but
decisions are intended
to be in the best
interests of the
employees
Entails managing a
business on the basis
of decisions agreed by
the majority
Manager has a
peripheral role, leaving
staff to manage the
business
Decision-making
Sets objectives and
allocates tasks.
Manager retains control
throughout
Manager explains
decisions and ensures
social and leisure needs
are met
Encourages
participation
and makes use of
delegation
Manager evades duties
and unco-ordinated
delegation occurs
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Paternalistic
Democratic
Laissez-faire
One-way
communication
downwards from
manager to subordinate
Mainly downwards,
though feedback will
take place
Extensive, twoway. Encourages
contributions from
subordinates
Communication is
mainly between people
at the same level in the
organisation, though
little occurs
Uses
Useful when quick
decisions are required
Can appear democratic,
but is really ‘soft’
autocracy
When complex
decisions are made
requiring a range of
specialist skills
Can encourage
production of highly
creative work by
subordinates
Advantages
Decisions and direction
of business will be
consistent. May project
image of confident,
well-managed business
Can engender loyalty,
and frequently enjoys
low labour turnover due
to emphasis on social
needs
Commitment to
May bring the best out
business, satisfaction
of highly professional
and quality of work may or creative groups
all improve
Disadvantages
Lack of information,
so subordinates are
highly dependent on
managers; supervision
needed
An autocratic style
can result in groups
becoming highly
dependent. They may
become dissatisfied
with manager
Slow decision-making
and need for consensus
may avoid taking ‘best’
decisions
Communication
Style versatility
Building on the contention that there is not a single perfect
style of management, it is possible to argue that the best
managers are those who adopt a style suitable to the
circumstances. Thus, the most talented managers might
be the most versatile, able to call on one or more of the
styles we have discussed in order to assess the demands of
the situation. Therefore, a versatile manager might adopt
a democratic approach when reaching a decision on a
proposed marketing campaign with a small group of writers
and artists but they may demonstrate a more autocratic
style when dealing with a crisis.
Douglas McGregor’s Theory X and
Theory Y
Douglas McGregor was an American social psychologist
who researched into leadership and management in large
companies. His writing developed understanding of how
the attitude of a manager might shape their behaviour. His
book, The Human Side of Enterprise, was published in 1960
and has received much acclaim, particularly his celebrated
comparison of two types of manager as set out in Theory X
and Theory Y. McGregor’s theories were based on research he
had conducted into the attitudes of managers towards their
employees.
His research revealed that many managers assumed their
workers were motivated solely by money and had no real
desire to work. McGregor referred to this type of manager
as Theory X. He also discovered an alternative, and less
common, type of manager, which he termed a Theory Y
manager. Such managers, according to McGregor, believed
workers sought more than financial gain from employment.
Staff are likely to
lack focus and sense
of direction. Much
dissatisfaction among
subordinates is common
2.3
2.3.1 Management and managers
Autocratic
Thus, a poor performance by a group of workers may be
the result of a work environment lacking stimulation and
challenge for employees. The behaviour of employees,
argued McGregor, is often the result of the way they are
treated.
McGregor did not believe in the views expressed by Theory
X managers. He set the theory only to disprove it as part of
his support for the views expressed by Theory Y managers.
A Theory Y manager is more likely to be one who believes
the following to be true:
» Workers seek satisfaction from employment and not just
a pay cheque.
» Workers possess knowledge, creativity and imagination.
» Workers willingly commit themselves to organisational
objectives.
» Poor performance by employees is due to repetitive and
monotonous work or poor management.
» Employees wish to contribute to decision-making.
Theory X is derived from the work of FW Taylor and the
scientific school of management, who contended that
workers were ‘economic animals’ motivated solely by
money. Theory X managers seek to get the best from their
employees by use of techniques such as piece-rate pay and
close supervision.
Alternatively, Theory Y stems clearly from Mayo’s human
relations approach and Maslow’s work on human needs
(see pages 70–72 on motivation). It focuses on meeting
the social and psychological needs of individuals within
the workplace. McGregor’s work is, however, a theory of
management and not one of motivation.
If managers adopt a Theory Y style, the implications can be
significant for a business. These might include:
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» greater delegation within the organisation, allowing those
2.3
further down the hierarchy to have greater authority
» training for managers to encourage delegation and to
improve two-way communication
» reviewing the business’ culture to discourage managers
from retaining what they might see as their ‘authority’
» considering the organisation’s structure and approaches,
such as thinking about delayering.
Businesses moving towards a Theory Y approach to
management require planning, the support of managers and
shop-floor workers, and considerable training for all the
employees involved.
AS LEVEL 2.3 Management
TEST YOUR LEARNING
Short answer questions
Data response question
1
A growing business
2
3
4
5
6
7
8
a Define the term ‘authority’.
[2]
b Explain one function of management.
[3]
Explain two ways in which good communication
might help a manager to carry out the functions
[6]
involved in their job.
a Explain one reason why organising is an
[3]
important function of management.
b Explain one way in which managers can report
on business performance.
[3]
Explain one reason why most managers normally
focus on short-term problems.
[3]
a Explain one difference between autocratic and
[3]
laissez-faire styles of management.
b Explain one advantage of the use of democratic
management.
[3]
a Explain Henri Fayol’s fourth management
[3]
principle: unity of command.
b Explain one other management principle
[3]
identified by Fayol.
Explain one reason why managers who allow
employees to work to their full abilities may help to
improve a business’ performance.
[3]
a Explain one difference between McGregor’s
Theory X and Theory Y managers.
[3]
b Explain one way in which FW Taylor’s theory of
motivation might have influenced McGregor’s
Theory X management style.
[3]
Gadfly is a small, private limited company that designs
and manufactures bicycles. It competes with a number of
large multinationals and its unusual designs have proved
popular. The business is growing quickly (sales are rising
by an average of 19 per cent each year) and it now has two
factories, each with its own manager who is responsible
for production at their site. A major extension to one of the
factories is expected next year. The number of employees
is rising rapidly and last year reached 397, most of whom
are relatively unskilled.
The business was established by Ali ten years ago and he
hopes that it will continue to grow quickly. Ali is a natural
autocrat and likes to take all of the decisions using little
delegation. He is a good communicator, has 30 years’
experience as an entrepreneur and also understands the
bicycle manufacturing industry.
The business is changing as it grows. The company is
having to produce a larger range of bicycles, and it needs
more skilled employees to design new products and to
sell the bicycles in new markets – the company made its
first sales in Australia and Argentina earlier this year. Ali
is beginning to wonder whether his management style is
suitable for this changing company.
Questions
1
2
3
Define the terms:
a ‘delegation’
b ‘management’.
Analyse one reason why planning is an important
part of the managers’ role at Gadfly.
Evaluate whether Ali’s use of an autocratic
­management style is suitable in these
circumstances.
[2]
[2]
[4]
[12]
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3 Marketing
AS LEVEL
3.1
The nature of marketing
In this chapter we examine:
★ the role of marketing and its relationship with other business activities
★ marketing objectives
★ the factors influencing supply and demand, and how supply and demand interact
★ the features of different markets
★ market share and market growth
★ the difference between consumer and industrial markets
★ the differences between B2C and B2B marketing
★ the difference between mass and niche markets
★ different methods of market segmentation
★ the costs and benefits of customer-relationship marketing.
3.1.1 Role of marketing and its
relationship with other business
activities
All organisations need customers. The purpose of all
businesses is to understand and provide the goods and
services that customers want. Indeed, according to Peter
Drucker, a very influential management writer, there is
only one valid purpose for a business, which is ‘to create a
customer’.
Marketing is the function of the business that is
responsible for understanding customer needs and
developing the right products, setting the right price and
promoting and distributing products in the right way.
Marketing provides the link between the customer and the
production function of the business. Marketing ensures that
what is being provided is actually wanted and needed (that
is, it is something of value), communicates this and makes
the product available to customers.
Operations
Human
resources
Finance
Marketing
▲ Figure 3.1 Integrated business functions; for the
business to succeed, the activities of the different
business functions must be integrated effectively
GLOSSARY TERM
Marketing is the process of identifying, anticipating and
satisfying the needs of customers in a mutually beneficial
exchange process.
The importance of marketing
Effective marketing occurs when a firm fully understands
the requirements of its customers and is able to meet
these needs successfully. The marketing function helps the
organisation to provide a product that the customer wants,
is affordable, is perceived as good value and that leaves
the customer and the organisation itself satisfied with the
transaction. Marketing is an ongoing process because:
» customers’ needs change over time (for example, the
developing interest in health issues has increased
demand for health clubs and reduced demand for highfat foods)
» the business environment can change (for example, with
new laws, changes in technology, the economic climate
or the 2020 Coronavirus (COVID-19) pandemic)
» competitors enter the market with their own offerings,
and so businesses must respond to this
» a firm’s own strengths change and develop.
3.1.1 Role of marketing and its relationship with other business activities
Chapter overview
Effective marketing will, therefore, change over time to
ensure there remains a good match between customers’
needs and the business’ own strengths. Effective marketing
will lead to high levels of customer satisfaction, which
means that customers:
» are more likely to come back and buy more
» are more likely to tell their friends to try the products
» may be more willing to try new products by the business
» may become loyal to the product and less likely to
switch to competitors.
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3.1
CASE STUDY
Hugh Davidson
AS LEVEL 3.1 The nature of marketing
Offensive marketing can be defined as: ‘An openly
competitive marketing strategy involving one company
exposing and attacking the weaker points of another
company in order to take market share directly away from
the competition.’
Hugh Davidson is a marketing writer who has advised
many large companies around the world. One of his books
is called Offensive Marketing. According to Davidson,
‘Offensive marketing involves every employee in building
superior customer value very efficiently for above average
profits.’ This is an interesting definition of marketing in
that it highlights that:
● everyone is involved in marketing, because everyone
affects the quality of the service and the customer’s
impression of the product
Defining marketing
A formal definition of marketing should include the features
below.
» It is an exchange process – that is, it is two-way. The
business offers the customer a good or service and in
return receives something, usually payment.
» It is mutually beneficial because both sides should gain
from the exchange. Customers should be satisfied with
the product and firms should make a profit (assuming
that the firm is a profit-making organisation). Firms are
unlikely to give away products for nothing.
» It aims to identify and anticipate customer needs.
Entrepreneurs need to understand their customers to
know what to offer them. However, it is not always
enough just to identify customers’ needs: in fact,
sometimes the customers may not know themselves
what their needs and wants are. In some markets, such
as fashion and film, firms have to anticipate what
customers will want in the future. They have to predict
trends even before most customers know what these
trends will be.
» It aims to delight customers. Nowadays satisfying
customers may not be enough, as many other firms are
also doing this. It’s much better to delight the customer,
so that they are more than satisfied and more likely to
buy from you.
The purpose of marketing is to match the abilities and
strengths of the business to the needs of the market.
Marketing involves a whole range of activities, including
finding out what customers want, developing new products,
packaging and promoting the products, and setting
the price. All these activities are aimed at developing
and providing goods and services which will satisfy the
customer (so they will buy them), and make a profit for the
● it is important to develop value for money that is better
than your competitors’, not just the same
● it is important to use resources efficiently – that is, you
must think about how much you spend on marketing
and measure the returns from different types of
spending
● the aim is not just to do well but to achieve profits that
are above average – the mark of a truly successful
business.
Questions
1
2
Explain one feature of offensive marketing.
Evaluate the possible benefits of an offensivemarketing approach.
[3]
[12]
firm. The more effective the marketing, the better the value
provided for customers and the greater the rewards the
business should be able to make.
Marketing and other business functions
The purpose of marketing is to ensure that the organisation
meets the customers’ needs in the present and in the
future. Marketing is therefore a dynamic process. To be
effective it must work with the other functions of the
business to influence:
» what is produced, that is, the precise nature of the
firm’s offerings (for example, in terms of design, features
and quality)
» how many are produced – marketing must estimate
likely sales, which in turn will influence the quantity of
goods and services the business must be able to provide
» the range of products offered (for example, how
extensive the menu should be in a restaurant; how many
different models should be displayed in a store)
» the price at which products are sold – this therefore
determines how much can be spent on materials and the
transformation process if a profit is to be made.
Marketing will discuss and negotiate with:
» operations over how much can be produced, what
benefits can be offered and what the costs will be
» finance over the amount that can be spent on
developing, launching and promoting the product or
service
» human resources over the number and skills of staff
required.
There may be, for example, occasions when the business
does not have the money, skills or capacity to develop a
product.
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CASE STUDY
3.1
Amazon
Marketing objectives and corporate
objectives
Marketing objectives are the targets set for the marketing
function. Typically, these include:
» Sales targets These might be set in terms of sales volume
or value. Specific targets may be set for the business as a
whole and also for specific products or particular regions.
» Market share Increasing sales may not in themselves be
particularly impressive if the market as a whole is growing
fast and competitors’ sales are increasing faster than
yours. This is why a business may set targets in terms of
the share of the market. Market share measures the sales
of one product or business as a percentage of the total
sales in the market. A business may set a target such as
its sales being 5 per cent of the market in the next year.
» Brand awareness A business may want to increase people’s
awareness of its brand relative to the competition.
The marketing objectives will be linked to the overall
objectives of the business – the corporate objective.
For example, if the business has a target of growth,
the marketing department may have to increase sales.
If the corporate target is to boost the profits of the
business, the marketing team might focus on sales of
the most profitable products and place less emphasis on
others that sell but are not necessarily as profitable.
Corporate
objective
(e.g. increase
profits by 5%
next year)
Marketing
objective
(e.g. increase
market share to
12% next year)
▲ Figure 3.2 Corporate and marketing objectives
STUDY TIP
An objective should be quantifiable and include a time
element. For example, ‘to increase market share to 3 per
cent by 2025’.
Amazon’s approach is supported by its highly developed
systems that collect and analyse data, enabling Amazon to
understand customer needs and behaviours. The founder
of Amazon, Jeff Bezos, says that the most important thing
is to ‘focus obsessively on the customer’.
Questions
1
2
3
Analyse one benefit of being a customer-centric
company.
[4]
Analyse one way that Amazon’s focus on providing
products at a low price might affect one of the other
business functions.
[4]
Analyse one way that the needs of consumers and
sellers might differ.
[4]
Marketing strategy
= how to get there
3.1.2 Demand and supply
When Amazon.com was launched in 1995, it set out ‘to
be the Earth’s most customer-centric company, where
customers can find and discover anything they might want
to buy online … and this will be available at the lowest
price.’ Being customer-centric means the company
starts with what the consumer wants and then works
backwards. This goal still drives Amazon, although it
is now worldwide not just in the US and has millions of
sellers, consumers and content creators (for example,
selling their own books). Each of these groups has
different needs, and Amazon always works to meet these
needs by innovating new solutions to make things easier,
faster, better, and to be more cost-effective.
Marketing objectives
= where are we
heading for?
▲ Figure 3.3 Marketing objectives and strategy
GLOSSARY TERMS
A marketing objective is a marketing target for the
business, setting out what it wants to achieve and when.
A corporate objective is a target set for the business as a
whole.
A marketing strategy is a marketing plan to achieve the
marketing objective.
STUDY TIP
Remember that marketing is not just about making
customers happy. The business also needs to meet its
objectives, so think about issues such as the costs of any
marketing action compared to its likely returns. Also,
bear in mind what the business can actually deliver given
its capacity, employees and other resources.
3.1.2 Demand and supply
A market is made up of buyers and sellers. The sellers
supply the product and the buyers demand it. If markets
are allowed to work without government intervention, and
if they are competitive with many different sellers, then
the quantity produced and the price in the market will be
determined by the forces of supply and demand. This can be
shown in a graph.
A supply curve shows how much producers are willing and
able to supply at each and every price, with all other factors
constant. It is usually upward-sloping because as the price
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AS LEVEL 3.1 The nature of marketing
3.1
increases, producers are more willing and able to supply
more. They are more willing because of the higher price, and
they are more able because the higher price means they can
produce more even if their costs are slightly higher.
The supply of a product will depend on:
» the number of firms producing. With more firms
producing, the supply in the industry should increase
» the time period. Over time, more firms can move into
this market if it is attractive, which could increase supply
» technology. Technological developments will increase
the quantity supplied
» costs. If a business can reduce its costs (for example,
by using cheaper supplies or being more efficient in its
operations) this means it can produce more at each price
and supply can increase.
A demand curve shows how much customers are willing and
able to buy at each and every price with all other factors
unchanged. It is downward-sloping because as the price falls,
customers can afford to buy more with the same income.
The demand for a product will depend on factors such as:
» the income of buyers, as this will affect how much they
can afford
» the price of rivals’ products. If these are cheaper, this is
likely to reduce demand for your product
» the price of complementary products (for example, if
you buy a printer and print cartridges together, these
are complementary products). If a complement is
cheaper, customers might buy more of it and more of
the associated product as well
» marketing activities. Effective marketing by a business
should help increase demand for the product.
Look at Figure 3.5a. If the price was originally at P1 then, at
this price, the quantity supplied is greater than the quantity
demanded – because the price is high, producers want to
sell more than customers want to buy. This leads to excess
supply, or a surplus. In a free market with no intervention,
the price will fall. As it does, the quantity demanded
increases, the quantity supplied falls until P0 is reached.
P0Q0 is the equilibrium price and quantity; at this price the
quantity demanded and supplied is equal and there is no
incentive to change.
If the price was P2 then at this low price the quantity
demanded is greater than the quantity supplied and
there is excess demand. This is known as a shortage. In
a free market, the price will increase; this increases the
quantity supplied and reduces the quantity demanded until
equilibrium at P0Q0 is reached.
Price
Supply
P1
P0
P2
Demand
Q0
▲ Figure 3.5a
Promotional
activities
Competitors
(substitutes)
Changes in demand conditions
Population
Influences
on
demand
Complements
Price
Income
Quantity
A demand curve shows the quantity of a product demanded
at each and every price, with all other things unchanged.
The demand curve can shift if, at each price, the quantity
demanded changes. This may be because of:
» a change in consumer incomes
» a change in the price of rivals’ products
» a change in the price of complementary products
» a change in customers’ tastes and social values
» a change in the marketing activities of the business.
A change in price leads to a movement along a demand
curve. A change in one of these other factors changes the
quantity demanded at each and every price and shifts the
demand curve.
Changes in supply conditions
▲ Figure 3.4 Influences on demand
A supply curve shows the quantity that businesses are
willing and able to supply at each price, with all other
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factors unchanged. The supply curve will shift if, at each
price, there is a change in the quantity supplied. This may
be because of:
» an improvement in technology. This might increase the
quantity supplied at each price
» a reduction in costs. Again this would allow a business
to supply more at a given price
» government subsidies or taxes on producers.
Supply S2
Price
Supply S1
P4
P0
The effect on equilibrium of a decrease
in demand
Price
Supply
Demand
Q4
Q0
Quantity
▲ Figure 3.5c
▼ Table 3.1 Effects of shifts in supply and demand
Change
Equilibrium
price
Equilibrium
quantity
Increase in demand
Increases
Increases
Decrease in demand
Decreases
Decreases
Increase in supply
Decreases
Increases
Decrease in supply
Increases
Decreases
3.1.2 Demand and supply
A change in price leads to a movement along a supply curve.
A change in one of these other factors changes the quantity
demanded at each and every price and shifts the supply curve.
If demand conditions change and there is a decrease, the
quantity demanded at each price will shift demand inwards.
This is shown in Figure 3.5b as the demand curve moves to D2.
At the old price there is now excess supply and this leads to
a fall in the price. As the price decreases, this decreases the
quantity businesses will supply and increases the quantity
demanded until a new equilibrium is reached. The equilibrium
is now P3Q3; less demand leads to lower prices and output.
3.1
HANDLING DATA
P0
1
P3
D1
2
Demand D2
Q3
Q0
Quantity
▲ Figure 3.5b
The effect on equilibrium of a decrease
in supply
If there is less supply in a market, perhaps because of a bad
crop, the supply curve would move to S2 and equilibrium would
be at P4Q4 – as shown in Figure 3.5c. Less supply in the market
means that at the original price there is excess demand (that
is, a shortage) and this leads to higher prices. As the price
rises, there is a decrease in the quantity demanded and a rise
in the quantity supplied until the new equilibrium is reached.
This has a higher price and lower output.
The effects of shifts in supply and demand on the
equilibrium price and quantity are shown in Table 3.1.
Draw a diagram of supply and demand for cars for
a given year, showing the equilibrium price and
quantity.
Now show an increase in demand. What happens to
the equilibrium price and quantity?
CASE STUDY
Supply and demand
The Pacifica Super Penthouse apartment is located on
the top two floors of New Zealand’s tallest residential
building. It is for sale at a price of $40 million. This
makes it the most expensive single-family home in New
Zealand. The building is not yet completed, and so buyers
have the option to design the penthouse themselves or
leave the interior design to the tower’s developers. The
developer’s plans include a conservatory, an open-plan
area, a luxury kitchen and dining area, and a wine cellar.
The top floor (the 54th) includes a spa and sauna, five
guest bedrooms and a master bedroom.
Questions
1
2
Analyse one factor that might influence the supply of
apartments in the development.
[4]
Evaluate how an increase in demand for apartments
might affect the equilibrium price and quantity in
the short and long term.
[12]
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3.1
3.1.3 Markets
Consumer and industrial markets
AS LEVEL 3.1 The nature of marketing
There are different types of markets. In consumer markets,
the customer buys the product and it is consumed. For
example, you buy food, music and clothes and then use
(consume) these. If a business is selling products direct to the
consumers who will consume them, this will involve businessto-consumer marketing, often abbreviated as B2C.
These consumer items will have had to be produced and that
will have involved machinery, transport and technology.
When you are selling products to be used in the production
process for other products (for example, a production line or
raw materials), this is known as a producer (or an industrial)
market. When one business is marketing its products to
another business to buy, this is known as business-tobusiness marketing, or B2B.
▼ Table 3.2 Industrial and consumer markets
Industrial
markets
Consumer
markets
Number of buyers
Relatively small
Large
Nature of buyer
Professional
Individuals
level of competition then firms need to be market-oriented
to survive; if they are not, rivals will meet customer needs
more effectively and reduce their sales. Any entrepreneur
wanting to succeed should make sure there is demand for
their product. This will usually be done via market research
to try to identify the likely level of sales.
By comparison, a product-oriented (or product-led) business
focuses more on what it can produce and hopes that this
will fit with customer requirements. This is a very risky
approach because the firm may produce something the
customer does not want. If an entrepreneur assumes that
because they like the idea, everyone else will also like
it, this is being product-oriented. Not everyone thinks or
behaves in the same way, so entrepreneurs must check that
there is demand before starting out.
Although being product-oriented is less likely to succeed
than being market-oriented, it can work if the customer has
limited choice; for example, in some countries, governments
only allow a few firms to produce particular products and
so customers have to buy what is available. If it is lucky,
the business may produce a product that people want, or in
some cases people invent products that customers did not
know they wanted until the product arrived. However, over
time, as customers find alternatives, product-oriented firms
are likely to suffer.
Local, national and international markets
Some products, such as oil, are sold on worldwide markets.
There are international producers and the products are
demanded all over the world. Other products tend to
be more national; this means they are sold mainly or
exclusively in the domestic country, such as a chain of
clothes stores. Others may be traded only in the local area,
such as a local taxi business or hairdresser. The markets
in which a firm operates affect the likely sales, the nature
of the competition and the complexity of the marketing
challenge.
▼ Table 3.3 Examples of local, national and international
markets
Type of market
Possible examples
Local
Taxis, hairdressers, local food markets
National
National energy, national rail, national
water
International
Tobacco products, mobile phones,
pharmaceuticals
Customer (market) orientation versus
product orientation
A customer-oriented (or market-led) business is one that
bases its decisions on customers’ needs. It continually
monitors its environment to find out what customers
want, what competitors are offering and what changes
are occurring in the market. By being market-oriented, a
firm should be able to ensure that the product or service
it provides matches its customers’ needs. If there is a high
CASE STUDY
Amazon
Founded: Incorporated July 1994.
Mission: To be Earth’s most customer-centric company
where people can find and discover anything they want
to buy online.
Headquarters: Seattle, Washington, USA.
Websites: Amazon serves its consumers through its
retail websites. It operates websites in the USA, the UK,
Germany, Japan, France, Canada, China, Italy and Spain.
Selection: Amazon and more than 2 million third-party
sellers offer millions of unique, new, refurbished and
used items in categories such as:
● Kids & Baby
● Books
● Grocery
● Movies
● Health & Beauty
● Music
● Clothing, Shoes &
● Video Games
Jewellery
● Electronics &
● Health & Beauty
Computers
● Sports & Outdoors
● Home & Garden
● Automotive &
● Tools
Industrial.
● Toys
Questions
1
2
Define the term ‘customer-centric business’.
[2]
Visit the Amazon website (www.amazon.com).
Evaluate the ways in which Amazon tries to be the
world’s most customer-centric business.
[12]
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Measuring market share and growth
GLOSSARY TERMS
Business-to-consumer marketing (B2C) occurs when one
business is marketing its products to the final consumers.
Business-to-business marketing (B2B) occurs when one
business is marketing its products to other businesses.
The market size is the total number of items sold (this is
measuring volume) or the total value of sales.
Market growth measures the rate at which the market as
a whole is growing over a given time period.
Market share is measured by the sales of a business (or a
particular product) relative to the total market sales. Its
equation is:
market share =
sales of a business (or product)
× 100
total market sales
For example, if product A sells $40 000 and the total market
sales are $160 000, the market share of product A is:
$40 000
× 100 = 25%
$160 000
Measuring market share is not always easy. This is because
the data you have on the sales in general may not be easy
to collect; competitors, for example, may not want to
share information. It will certainly take time and, at best,
estimates of the market are likely to be a year or so out of
date. While you will know your sales this month, it may not
3.1
STUDY TIP
In some cases you may be asked to calculate the market
share as shown above. In other cases you may be asked
to calculate the size of the market given the market
share. For example:
Product A has sales of $20 000; this represents a market
share of 40 per cent.
3.1.3 Markets
Markets will differ in nature. For example, this could be in
terms of:
» Market size The size of a market can be measured in
terms of the volume of sales or the value of sales. For
example, there may be 20 000 products sold (volume) or
$100 000 sold (value). If the volume of sales increases, the
value will also usually increase, but this depends on what
is happening to the price. If the price falls, it is possible
that more units are sold but the value of sales declines.
» The number of competitors Some markets have many
thousands of competitors – just think of how many
hairdressers and cafés there are. In other markets there
are relatively few providers – how many electricity or
train companies are there, for example?
» Market growth Some markets do not change in size
very much, while others grow fast and some shrink.
The growth of a market is measured by the percentage
change in its size over a given period. Generally,
businesses will prefer fast-growing markets because they
can all sell more. If the market is static then one firm
can only sell more at the expense of another; this can
lead to aggressive, competitive behaviour.
be easy to compare this with other firms’ sales accurately;
market share data is therefore most likely to be accurate
when looking backwards.
We now calculate 1 per cent of the market. If $20 000 =
40 per cent of the market, we can divide by 40 to get
1 per cent.
1 per cent market share =
$20 000
= $500
40
Total sales in the whole market (which is 100 per cent)
will equal $500 × 100 = $50 000.
Market growth measures the rate at which the market as a
whole is growing over a given time period. If, for example,
the growth rate is 2 per cent this year, it means that the
market is 2 per cent bigger than one year before. The
growth may be measured in terms of the growth in sales
volume or value. Its equation is:
this year’s market sales – last
year’s market sales
market growth =
× 100
last year’s market sales
For example, if the market sales last year were $200 000 and
are now $220 000, then:
market growth =
$220 000 – $200 000
× 100 = 10%
$200 000
If the growth rate is positive, it means the market is getting
bigger. If the growth rate is negative, it means the market
has become smaller.
Similarly, data on market growth is difficult to estimate at
any given moment because of the problems in gathering
data from all outlets and all producers. Again, it is most
likely to be accurate when looking backwards.
A further problem with calculating market share and market
growth is actually defining the market in which a business
operates. What is the market for your local bus company? Is
it bus transport in your area? But how large do you define
the area being considered? Or is it bus transport in the
whole country? Or is it all forms of transport in your area?
It is not always easy to clearly define the market a business
operates within.
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3.1
CASE STUDY
Ford
The data below was produced by Ford, the automobile manufacturer, in its 2019 annual report.
AS LEVEL 3.1 The nature of marketing
▼ Table 3.4 Ford retail sales, industry volume and market share, 2018
Retail sales
Industry volume
Market share
(in millions of units)
(in millions of units)
(%)
United States
2.5
17.7
14.1
Canada
0.3
2.0
14.7
Mexico
0.1
1.5
4.8
North America
2.9
21.5
13.4
Brazil
0.2
2.6
9.2
Argentina
0.1
0.8
12.1
South America
0.4
4.5
8.3
United Kingdom
0.4
2.8
13.7
Germany
0.3
3.8
7.9
EU21
1.4
19.6
7.2
Russia
0.1
1.8
2.9
Turkey
0.1
0.6
10.9
Europe
1.5
20.9
7.2
Middle East and Africa
0.1
3.8
3.0
China
0.8
26.2
2.9
Australia
0.1
1.2
6.0
India
0.1
4.4
2.2
ASEAN
0.1
1.7
6.6
Asia Pacific
1.1
43.5
2.5
Global
N/A
94.2
6.3
Total company
6.0
N/A
N/A
Source: https://annualreport.ford.com/Y2019/default.aspx
Questions
1
2
Calculate the proportion of Ford’s sales in 2018 that were made in North America compared to the total
company sales.
Calculate the total size of the market for vehicles in North America in 2018.
[2]
[3]
STUDY TIP
In some cases you may be asked to calculate growth. In
other cases you may be asked to calculate the sales given
a certain growth rate. For example:
A market had sales of $500 000. This grows by 20 per cent.
What are the sales now?
20
× $500 000 = $100 000
100
This means the new sales are $500 000 + $100 000 =
$600 000.
To calculate this you must work out 20 per cent of
$500 000 and add it to the original sales. To calculate 20
per cent you use:
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Implications of changes in market share
and growth
When considering market share, it is important to bear in
mind the total market size. A small percentage of the global
confectionery market is still a lot of sales!
The growth of a market shows the rate at which sales are
increasing. In general, businesses might prefer faster
growth to slower growth because it creates more sales
opportunities. However, it is again important to bear in
mind the size of the sales involved. A 1 per cent growth
in the market for laptops is still a large number of sales
because the market is so big, whereas a 10 per cent growth
of a very small local market might only mean additional
sales of a few thousand. In well-established, bigger markets
growth may be slow but the numbers involved can still
be huge.
HANDLING DATA
1
2
3
4
A business sells $20 000 in a market worth $800 000.
Calculate its market share.
A business has a market share of 8 per cent in a
market worth $400 000. Calculate its sales.
A market was worth $300 000 and increases in size
to $360 000. Calculate the market growth rate.
If a market was worth $500 000 but grows by 2 per
cent, calculate the size of the market now.
3.1.4 Consumer and industrial
marketing
STUDY TIP
It is very important when answering marketing questions to
think about the specific market the business operates in. It
is important to adapt your understanding for the particular
market. Selling bars of chocolate may require heavy
advertising, while selling aeroplanes may require a very
experienced sales team. Attractive packaging may help sell
perfume, but it is less significant for selling tractors!
GLOSSARY TERM
A unique selling point (USP) is something about your
product which is perceived by your customers as unique.
There are many different types of products and these can be
classified as:
» Consumer products, which are items bought by the final
user. These can be subdivided into:
– Convenience items These are usually relatively
cheap items and distribution is the key to marketing
here; for example, newspapers and milk. Customers
will not spend much time searching for them in
different stores; they pick up what is convenient
in the nearest shop. This means producers have to
get them distributed in many different places and
displayed in a way that attracts attention. This
is important because some convenience items are
bought on impulse (for example, chewing gum) when
they are seen in the store.
– Shopping items These are products such as clothes
or electrical goods which are more expensive than
convenience items. When customers go to buy them,
they shop around, comparing prices and features;
they may go and look several times before actually
buying. Customers may go to a retail area where
they can quickly move from one store to another to
compare. The producer has to clearly demonstrate
value for money; for example, by stressing a unique
selling point (USP) to show why its product is
better than the competition’s.
– Specialist products are products that customers
have probably thought about for a long time and
for which they are willing to travel to find the right
item; for example, Rolex watches or Ferrari cars.
Specialist products may be distributed to relatively
few locations, but the nature of the outlet is very
important to the overall brand image. These products
are probably not very price-sensitive because people
want them for their status and their uniqueness.
» Industrial products These are products which are
bought by businesses to use in their production process
to produce the consumer goods. They include:
– Installations These are big items of expenditure,
such as production lines and new office space.
Buyers will take a lot of care over the precise
features of the item, especially any technical
features, because it is a major item of spending.
– Materials These are materials used in the production
process. There may be several possible suppliers, so
buyers will shop around. The quality, reliability and
flexibility of supply will be very important when
buying these products.
– Supplies These are basic items such as paper and
light bulbs; there will be many suppliers and the
buyer will look for good prices.
3.1
3.1.4 Consumer and industrial marketing
A change in market share means that a business’ sales
account for a greater proportion of the total sales in the
market in the given period. If the market remains the
same size or is growing then an increasing market share
means higher sales. However, if the market is declining,
the market share could be increasing even if sales are
falling.
Classification of products and how
marketing might differ for different
types of goods and services
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3.1
Consumer
AS LEVEL 3.1 The nature of marketing
fewer mistakes? At a lower cost? To win sales, it will be
important to convince the customer of the business case
for it. The person buying it will need to justify it to their
managers and investors.
Types of
products
Industrial
Convenience
Installations
Shopping
Materials
Specialist
Supplies
▲ Figure 3.6 Types of product
Business-to-business marketing versus
business-to-consumer marketing
When one business is targeting other businesses, it
will tend to be dealing with relatively small numbers
of customers. These customers will want to understand
how buying this product will help them in what they
do – will it enable them to do their work faster? With
Industrial buyers are usually professionals, and therefore
will be very interested in the technical specifications of
what is being offered and a whole range of issues such as
the payment terms, delivery times and your reliability as a
supplier.
Often business-to-business marketing will involve a sales
force approaching the business customers to explain
the benefits of what they have to offer. The sales team
will usually require specialist technical knowledge and
an understanding of how their product helps the other
business.
Business-to-consumer businesses are dealing with larger
numbers of potential buyers. These buyers will not be
professional buyers (it’s not their full-time job!) and they
may be more interested in the brand, the image of the
product and the emotional benefits they get from buying
it. In B2C marketing, more use is likely to be made of
advertising and other promotional techniques to reach a
wider audience.
▼ Table 3.5 Classification of products
Industrial products
Consumer products
Buyers
Professionals
Amateurs!
Number of buyers
• Relatively few
• Selling to businesses
May be millions if a mass-market product
May focus on
• Technical specifications and how it helps their business
• Benefits in terms of consumption
do better
• May be more influenced, for example, by
• When the product can be supplied and in what quantities
look or design or packaging
• What the payment terms are
Promotion
Often uses sales force to approach customers
3.1.5 Mass marketing and niche
marketing
Niche marketing occurs when a firm targets a specific
market segment – that is, a particular group of similar
customer needs and wants. For example, Aston Martin
targets the luxury sports car market and Umbro targets
the football market. By focusing on a niche, a firm can
understand the specific requirements of its customers and
ensure its offering meets these needs precisely. A business
can tailor its marketing approach and avoid wasting time
and money on activities that are not relevant.
Niche marketing is quite common for small businesses. This
is because:
» It focuses on just one segment of the market and therefore
the resources required may be relatively small. This makes
it affordable and feasible for a start-up business.
May be advertising for mass-market product
» By focusing on a small segment of the market, this may
not be perceived as a threat by larger, established firms.
If a start-up is perceived as a real threat, the established
firms may cut prices or try to influence stores to get
them to stop distributing the product.
However, there are dangers associated with niche
marketing:
» The total number of customers is likely to be quite
low and therefore, if anyone changes their mind
and switches to a different product, this can have a
significant effect on the total demand.
» If the product does prove to be successful then larger
businesses may be attracted by this success and enter
the market. Small businesses may struggle to match the
power and resources of larger firms and so may lose their
share of the market.
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By comparison, a mass marketing approach targets the
majority of the market. This usually involves high volumes
of production and much higher capacity levels than niche
marketing. This may make it unrealistic for a start-up
business, especially given the high levels of promotion
needed to generate the necessary demand to make mass
production viable. However, over time, a niche product may
become more mainstream and therefore niche products may
be moved into the mass market.
3.1
▼ Table 3.6 Advantages and disadvantages of niche and mass marketing
Niche marketing
Mass marketing
Disadvantages
Advantages
Disadvantages
• Small market segment so marketing
activities can be very targeted
• Small segment of market so larger
firms may not be interested
• Can often charge high price for a
specialised, targeted product which
helps cover cost of provision
Small market so
overall returns
not that high in
absolute terms
• Large-scale production enables lower
unit costs; this enables lower prices,
making the product accessible for
customers but at the same time still
profitable for the business
• Large target market means the total
sales and profit in absolute terms
may be high
Products not adjusted
for differences in
customer needs; specific
groups may be targeted
more effectively by niche
producers
GLOSSARY TERMS
Niche marketing occurs when a business focuses on a
particular (usually small) segment of the market.
A market segment exists when there is a group of clearly
identifiable customer needs and wants.
Mass marketing occurs when a business targets the
majority of the market.
STUDY TIP
When studying this topic, you should be aware of the
benefits and problems of a niche-marketing approach.
You should also appreciate the importance of
understanding and monitoring customers’ needs.
To make your business more effective, you have to
understand exactly what your customers want and
provide them with excellent value for money.
3.1.6 Market segmentation
Within any market, different segments may exist. For example,
within the market for newspapers there are some readers who
are most interested in sport, others who want financial news,
and others who want celebrity gossip. Different newspapers
have been developed to target these different groups.
Within the chocolate market, the demand can be segmented
into groups such as:
» snacking – you buy the chocolate and eat it there and
then (for example, a Mars bar)
» sharing – you buy the chocolate and take it home to
share with others (for example, Cadbury’s Heroes)
» gift – you buy the chocolate to give to others (for
example, Thornton’s chocolates).
There are various ways in which a market may be
segmented, including:
» Geographic segmentation This type of segmentation
focuses on aspects of consumers such as the location of
customers or the climate in different regions. Cars sold
to Africa, for example, will have to withstand high levels
of heat; cars sold to Scandinavia will need to cope with
the cold. Cars targeted at people living in cities may
be relatively small so it is easy to get around and park;
people living in the countryside may want more rugged
vehicles to cope with the terrain.
» Demographic segmentation This type of segmentation
focuses on aspects of consumers such as age, gender,
income, occupation, marital status and stage in the
family life cycle. In the toys market, for example, the
type of toys 3 year-olds will play with is very different
from those wanted by 13 year-olds. When you are single,
you may be looking for a city centre, 1-bedroom flat;
when you are married with children you may want a
3-bedroomed house with a garden, near a good school
and out of the city.
» Psychographic segmentation This type of segmentation
focuses on aspects of consumers such as personality,
lifestyle, values, social class and attitudes. Are you
someone who likes belonging to a group? Are you
someone who is very ambitious? Do you want material
things? Do you care how products have been made and
their impact on the environment? These factors might all
influence the way a product is promoted and the actual
design of the product. Some holidays may be designed
for adventurous, outgoing types. Others might target
customers wanting a package holiday in Spain. Your
job and earnings are likely to influence a whole host
of lifestyle factors: the newspaper you read, where you
shop, where you go on holiday, the interests you have
and what you wear.
3.1.6 Market segmentation
Advantages
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STUDY TIP
AS LEVEL 3.1 The nature of marketing
3.1
Although targeting specific segments may seem
appealing from a marketing perspective, it may make
production more complex as it requires different models
to be produced. Managers must balance the desire to
meet the specific needs of customers with the costs and
challenges this may generate.
Geographic
Types of
market
segmentation
Demographic
Psychographic
3.1.7 Customer-relationship
marketing
Aims of CRM
▲ Figure 3.7 Types of market segmentation
For a market segment to appeal to a business, it must be:
» measurable, so you can identify it exists and measure
its size to decide on the likely earnings
» accessible, so you have the resources to offer what
would be required and be able to get your products to
the customers
» profitable, so you can meet customer needs and your
own needs at the same time.
Advantages and disadvantages of
market segmentation
By segmenting a market effectively, managers can identify
which segments they want to target. By understanding the
requirements of a particular segment, they can develop
the marketing activities to meet these needs more closely.
Hopefully, this should increase sales and boost brand loyalty.
Effective segmentation should lead to effective marketing,
with businesses providing exactly the right product in the
right place at the right time and price. However, the more
a market is segmented, the more variations there are to the
product and its marketing – imagine producing a different
cleaner for the sink, oven, shower, toilet, floor, door handles,
carpets, work surfaces, windows, walls, and so on. Each
one may meet a very specific need, but co-ordinating and
providing such a range of products may be expensive. If
possible, it would be easier and cheaper to produce an allin-one cleaner to cover at least some of these functions. The
firm may well get cheaper inputs if it buys in bulk and can
spread one set of marketing costs over more units.
Businesses may therefore have to trade off the appeal
of segmenting and meeting specific groups of needs
more precisely with the benefits and cost advantages of
producing a limited range of products on a larger scale.
Customer-relationship marketing (CRM) involves gathering
and analysing data about customers. The aim of CRM is
to understand customers’ behaviour and take appropriate
actions to move them towards a purchase and repeat
purchases. A business will interrogate its data on customers
to understand where in the buying process they are and to
identify actions to make them buy and to retain them.
Customer retention is very important to businesses. It
is a measure of customer loyalty and can be measured by
the proportion of customers who continue to buy from the
business over a period of time. If a business sells a product
to a customer who does not return to buy again then, to keep
sales going, it has to keep finding new customers. This can
be expensive and time-consuming. Ideally, a business will
develop a relationship with a customer and generate ongoing
sales. For example, an online retailer might want to develop
a relationship so that it becomes the ‘go-to’ place for a
customer to buy from; they become loyal to the business. This
loyalty and repeat purchases of a range of products provided
by a business can be built up in various ways, such as:
» by analysing customers’ buying patterns and making
recommendations of what else they may want to buy
» analysing customer behaviour to understand what
incentives to offer customers to gain their loyalty and
repeat purchases.
Costs and benefits of CRM
By holding on to customers and generating repeat
purchases, the business hopes to generate more revenue
from its customers while keeping its marketing costs low.
The benefits of CRM are that it can lead to more sales from
the existing customer base at relatively low cost. The costs
of CRM are the investment required in data systems to
gather tools and staff skills in order to analyse information
on customer enquiries and buying patterns.
GLOSSARY TERMS
Customer-relationship marketing (CRM) involves gathering
and analysing data about customers to understand their
behaviours and take appropriate actions to move them
towards a purchase.
Customer retention measures the proportion of customers
who continue to buy from the business over a period of time.
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TEST YOUR LEARNING
Short answer questions
1
2
3
5
6
7
8
9
b
Define the term ‘customer-relationship
marketing (CRM)’.
Explain one possible benefit to a business of
customer-relationship marketing.
3.1
[2]
[3]
Data response question
The fluctuating price of oil
In 2020, US oil prices became negative for the first time in
history. This was due to the greatest fall in demand in
25 years. The result was a surplus of oil and a fall in the
price of oil to almost –$40. This meant producers were
paying buyers to take the oil off them, so they didn’t have
to pay for storage costs and because they had no more
storage capacity.
The fall in demand was due to the negative growth of most
economies during the ‘lockdown’ that was necessary amid
the Coronavirus (COVID-19) pandemic. Supply continued
to increase even as demand collapsed, and this is likely to
cause a fall in petrol prices.
Questions
1
2
3
3.1.7 Customer-relationship marketing
4
Define the term ‘marketing objectives’.
[2]
a Define the term ‘market segmentation’.
[2]
[3]
b Explain one benefit of segmenting a market.
a Explain one factor that influences the supply of
[3]
goods or services in a market.
b Explain one factor that might increase demand
[3]
for a product.
a Define the term ‘niche market’.
[2]
b Explain one possible benefit of operating in a
niche rather than a mass market.
[3]
a Define the term ‘market share’.
[2]
b Explain one possible benefit to a business of
having a high market share.
[3]
a Define the term ‘market growth’.
[2]
b Explain one possible benefit to a business of
selling in a fast-growing market.
[3]
Explain one difference between a consumer
market and an industrial market.
[3]
a Define the term ‘business-to-consumer
product’.
[2]
b Explain one possible difference between
marketing a business-to-consumer product
and a business-to-business product.
[3]
a Define the term ‘customer orientation’.
[2]
b Explain one possible benefit of being customeroriented rather than product-oriented.
[3]
10 a
Define the terms:
a ‘market’
[2]
b ‘surplus’.
[2]
Analyse one way in which a fall in the price of oil
might affect businesses.
[4]
Evaluate the factors that might affect the price of oil. [12]
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3 Marketing
AS LEVEL
AS LEVEL 3.2 Market research
3.2
Market research
Chapter overview
In this chapter we examine:
★ the purposes of market research
★ the main features of a market: size, growth, competitors
★ aspects of customer and consumer characteristics, profiles, wants and needs
★ the difference between primary and secondary research
★ the reliability of data
★ the meaning and value of sampling
★ analysis of quantitative and qualitative data.
3.2.1 Purposes of market research
Market research involves the gathering and analysis of data
that is relevant to your marketing. The purpose of market
research is to understand more about the customers of a
business and the main features of the market as a whole to help
the business make better marketing decisions. For example, a
business might want to use marketing research to identify the
main features of a market, such as:
» the size of the market. This can be measured in terms
of the number of dollars spent in it (the value of the
market) or the number of items purchased (the volume of
the market)
» the growth of a market. This measures the rate at which
the market has increased (or potentially decreased) in
size. The growth in a market is measured by:
market growth =
change in market size
original market size
× 100
For example, if the market size is $200 000 and it
changes to $220 000, the growth is:
market growth =
($220 000 − $200 000)
$200 000
× 100 = 10%
Usually the growth of a market will be measured over
a year; for example, 10 per cent growth this year. If a
market is growing fast, this means that demand is there
and may create more opportunities for sales to increase
» competitors. Research will give the business an insight
into how many competitors there are in a market and
what their sales are. A business can identify its own
market share and the market share of its competitors.
The market share of a business is measured by its sales
as a percentage of total sales.
market share of a business =
sales by the business
total market sales
× 100
For example, if the sales of a competitor are $40 000 and
the total market sales are $160 000, its market share is:
market share of a business =
$40 000
$160 000
× 100 = 25%
A business will be interested in the relative size of these
competitors because this might reflect their strength
and the threat they might create. In some markets there
may be relatively few competitors – usually this is true in
the banking and telecommunications industry. In other
industries there may be many competitors; for example, this
is usually the case with hairdressers and cafés.
Market research will also allow a business to identify how it
is positioned relative to its competitors; for example, is it
regarded as better value for money? Is it seen as a premium
product or more basic than its rivals? This might affect
some of the marketing actions the business then takes.
As well as understanding the market as a whole, managers
can also use market research to identify different aspects
of customers and consumers, such as their characteristics,
profiles, wants and needs. A customer is someone who
purchases and pays for a product or service. A consumer
is the person who ultimately uses the product or service.
If you buy and drink a cup of coffee, you are the customer
and consumer. If your parents buy you a present for your
birthday, they are the customer and you are the consumer.
Businesses need to consider both their customers and
consumers when deciding on how best to market their
products.
Characteristics of consumers and customers might include
aspects such as their age, gender, income, where they are
located and their lifestyle. This might allow the business
to identify patterns within its customers and adjust its
marketing accordingly. A customer profile is an outline
of the customer base of the business – it outlines the
characteristics of the customers.
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Customer and consumer needs refer to what people must
have to survive, such as water and food. Customer wants
refer to what people desire but are not essential, such as a
particular type or brand of food. Market research can identify
the fundamental need to buy the product (for example,
because customers are thirsty or hungry) and customer wants
(which shows which product they would like to buy). Having
identified customers’ need, a business will aim to make them
want its products as opposed to those of a competitor.
By undertaking market research, managers should have
a better idea of what people want and how they behave.
This should mean that the firm can meet their needs more
effectively and avoid wasteful marketing activities. Imagine
that you are considering launching a new product. If you
can find out who your target market is, what they like,
what they read, where they shop, what they watch and
listen to, then your marketing can be much more effective.
For example, there is no point in spending money on a
big Saturday afternoon television campaign if your target
audience is out watching a sports match.
Market research may be undertaken before the business is
set up in order to decide whether or not it is viable. It can
also be undertaken once the business is up and running to
decide what to do next; for example, whether to change the
price of a product or launch a new brand.
Identifies
market
opportunities
Market
research
Assesses the
effectiveness
of different
marketing
actions
Assesses the
alternative
options open to
the business to
meet customer
needs
▲ Figure 3.8 Uses of market research
Typically, market research is used to:
» identify features of a market such as its size,
the segments that exist, its growth and what
competitors exist
the market. This means identifying customer needs
and wants, and the profiles of different customer
segments.
3.2
Having undertaken this analysis, businesses can use their
market research findings to:
» assess the alternative options open to the business to
meet customer needs
» assess the effectiveness of different marketing actions.
GLOSSARY TERMS
Market research is the process of gathering, analysing
and producing data relevant to the marketing process.
Primary market research gathers data for the first time
for a specific purpose.
STUDY TIP
Simply gathering data for the sake of it does not make
much sense, so managers need to be clear about why it
is being gathered, how accurate it has to be, what time
there is to gather it in, what the best way of gathering it is
and what costs are involved.
3.2.2 Primary research and secondary research
Market research provides a manager with information which
is important for effective decision-making. Imagine you
are wandering around a house at midnight and none of the
lights are working. You stumble, move slowly and make
mistakes getting around. Market research can provide the
lighting in the room that enables you to move quickly,
efficiently and effectively, to get to where you want. Market
research can provide the light you need in order to view the
whole situation.
» identify features of the customers and consumers in
3.2.2 Primary research and
secondary research
Primary market research
In some cases, you may have to gather new data for a
specific purpose. This is called primary market research.
For example, you may want to discover what people in your
local area think of your specific idea, whether they are
likely to use your particular service or what they think of
your business name. This sort of information will not exist
already, so you will need to undertake new research.
Primary research can be tailored precisely to your own
needs, but it can be quite expensive and time-consuming
compared with using information already collected. The
danger is that because of cost constraints, or because you
are inexperienced, you only ask a relatively small number of
people or a specific group that does not really represent the
population as a whole. This means that your results may be
biased and misleading. If you ask your friends, for example,
they may tell you it is a great idea even if it isn’t, because
they do not want to upset you!
If you are going to undertake primary research, you need to
make sure that you:
» don’t lead people into giving you the answer you want
(for example, ‘Why do you think my idea is so good?’ is a
leading question)
» ask a representative group of people (that is, that you
hope will represent your target group)
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» ask enough people for the findings to be significant (one
3.2
person’s opinion may not necessarily reflect the views of
the population as a whole).
Primary data can be gathered:
AS LEVEL 3.2 Market research
» by observation. For example, you may watch what is
happening in the stores of your possible competitors
or count how many people walk by a potential location
for your shop on a typical day to calculate the
‘footfall’. In high-street retailing, the footfall is an
important indicator of the likely number of customers.
The more people that walk past, the more customers
you may get
» through surveys. You may have been stopped in the
street and asked your opinion about something. This is
a face-to-face survey and is one way of finding out what
people think. Firms also use telephone, mail or online
surveys to find out the views of potential customers.
Surveys may give you an idea of what people think of your
idea and help you decide whether or not to go ahead
» by asking a small group of people what they think
(a focus group)
» by test marketing. Sometimes a business may try a
product in a test market, such as a particular region, for
a while to see how it sells. If this goes well it might be
rolled out to other areas; if sales are poor, changes could
be made to the product or the way it is promoted to see
what happens then.
GLOSSARY TERMS
A focus group is a small number of people gathered
together to talk about a particular issue in open
discussion.
Secondary market research uses data that already exists.
CASE STUDY
Africa
Africa is one of the biggest emerging markets in the
world. This rapidly expanding, competitive environment
creates a growing need for market research. Consumers
are the lifeblood of companies, but do companies actually
possess sufficient knowledge about their consumers? Are
their customers (perfectly) satisfied with their products/
services? What are their opinions and wishes? How could
their loyalty be improved? These are important questions
for organisations and investors operating in Africa. Africa
represents a major market opportunity with a growing
population, a growing middle class and relatively fast
economic growth.
The potential
Africa will be the fastest-growing economy in the world in
the next five years. For example, Uganda has an economic
growth of 6.41 per cent per year, yet only 1 per cent of the
total global market research budget is invested in Africa.
The basic survivors (people living on or below one dollar
a day) is a huge group in African countries (in Uganda,
for example, this group is 65 per cent of the population).
Given the fact that Africa is the fastest-growing economy
in the world, the basic survivors move towards a regular
middle class, with comparable incomes and Western
consumer behaviour. This means there is a huge potential
for doing business, but there is still an unused investment
opportunity in African countries.
Companies that find new ways to overcome constraints
and tap opportunities can gain insights, market share
and customer or supplier loyalty, and will secure a strong
position in this growing market.
Effective market research methods in
developing countries
More than 500 million Africans use a mobile phone
and the market is growing fast each year. Mobiles
have penetrated to even those villages that have no
electricity and no landlines. The rapid and accelerating
penetration of mobile phones through all levels of
society in developing countries means that it is possible
to communicate with the basic survivors and emerging
middle classes. This underlines the massive potential
to use mobile phones in order to reach and interact with
huge groups of people across the continent. The explosive
growth of Africa’s mobile communications industry offers
a vast potential to interact with people on a personal level.
Market research is conducted by inviting people to
participate in surveys and rewarding them with incentives
such as mobile phone credits. The mobile phone is
particularly well-suited to market research as it is costeffective, reliable and enables clients to obtain results
virtually in real time. Furthermore, it allows consumers
to participate in surveys when and where it suits them.
These advantages have a positive impact on response
rates, data quality and validity of results.
Source: www.mckinsey.com
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3.2
2
Working Families
3
Rising Strivers
4
Cosmopolitan
Professionals
5
The Affluent
Basic Survivors are the
largest consumer
group in Africa and are
characteristically low
income consumers.
They tend to live in
urban slum areas or
rural areas and make
day-to-day decisions
based on basic needs.
Working Families are
the second largest
consumer group. They
focus their spending
on their children’s
needs and they value
stability and routine
in their lives.
Rising Strivers are
emerging from the
first two segments,
having built their
purchasing power
through access to
credit or other
resources. They value
upward mobility and
buy based on
convenience, quality,
or even more
‘expressive’ factors.
Cosmopolitan
Professionals are
typically located in
urban areas. They are
busy with work but
often have active
social lives. As a result,
these consumers
value pragmatic
products but are also
brand conscious and
influenced by the
media.
The Affluent of Africa
have a disproportionately
high purchasing power,
and are considered
wealthy regardless of
where they travel
across the globe. This
group is extremely
small and very fickle.
▲ Figure 3.9 Five key sub-Saharan African consumer segments
Questions
1
Analyse one benefit of using the mobile phone to
undertake market research.
2
[4]
Secondary market research
Given that the amount of money you have available to
spend when starting up a business is likely to be limited,
you will probably have to carry out most of your market
research yourself rather than using specialist companies
to do it for you. The cheapest and quickest way of doing
this is to see what information about the market already
exists. What data has been collected and published? A
tremendous amount of information is available on the
internet, in libraries and in newspapers, as well as from
other sources. Using data that already exists is called
secondary market research. It is particularly useful for
Evaluate the potential benefits of using market
research for businesses targeting Africa.
[12]
general information on the economy, the market and on
competitors.
While secondary data is usually quite quick to get hold of,
it is not always in the right format for your needs, or up to
date. The research may have been done in the previous year,
when what you want is this year’s figure. It may organise
sales data according to the sales per country, when what
you need is data focusing on a particular city. Nevertheless,
secondary research is usually a good starting point. Once
you have looked at secondary sources, you can identify what
else you need to know and what information needs to be
gathered for the first time.
3.2.2 Primary research and secondary research
1
Basic Survivors
CASE STUDY
Coca-Cola
Sparkling soft drinks
Hot beverages
Packaged food
$1.6
trillion
Juice, dairy
and plant
Hydration
RTD tea/coffee
NRTD cold
Energy
4.3%
NARTD
Household products
4.0%
3.5%
3%
4%
0
1%
2%
5%
Note: NARTD = non-alcoholic ready to drink. Industry growth
for NARTD excludes white milk and bulk water
▲ Figure 3.11 Industry retail-value growth
Note: RTD = ready to drink; NRTD = not ready to drink
▲ Figure 3.10 Hot and cold beverages industry retail value
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AS LEVEL 3.2 Market research
3.2
According to Coca-Cola, there are significant long-term
growth opportunities both for the soft-drinks industry
and for Coca-Cola. Coca-Cola has a 20 per cent market
share of cold non-alcoholic beverages, with a very small
market share in hot non-alcoholic beverages.
In the developing and emerging world, only about 30 per
cent of beverage consumption is commercialised, and
Coca-Cola’s market share within these regions is about
half of what it is in the developed world. The developing
and emerging world represents 80 per cent of the
world’s population; over 6 billion people.
Therefore, Coca-Cola believes there is compelling
long-term growth potential across the world through
growing the overall industry and continuing to gain
share.
▼ Table 3.7 Hot and cold beverages: developed and
developing/emerging markets
Developed
markets
(% sales
volume)
Non-commercial
Developing and
emerging
markets (% sales
volume)
30
69
Alcohol
11
3
Hot beverages
12
11
Cold beverages
47
17
1.5 billion
6.1 billion
Population
Source: https://coca-cola.com
3.2.3 Sampling
The need for and limitations of
sampling
If you decide to undertake a survey, the total number
of people you are interested in is known as your ‘target
population’. For example, if you have an idea for a website
dedicated to your favourite football team, your target
population would be all the fans of the club around the
world. In most cases it will not be possible to interview all of
the people in your target group. It may be too expensive or
would simply take too long to talk to everyone. Imagine your
website was aimed at the fans of a big club like Manchester
United FC or FC Barcelona. There are hundreds of thousands
of fans all over the world. Even if you managed to identify
them somehow, the cost and time involved in trying to talk
to them would make it unrealistic, especially if you are a new
business and therefore likely to have limited funds.
Instead of interviewing everyone in the target population,
the business might decide to take a sample. A sample is a
group of people that is intended to represent the overall
population. By interviewing, say, 500 fans you would hope
to get an impression of what all the others think.
Obviously, the results will not be 100 per cent reliable,
because you have not asked everyone in the population –
you have only asked some of them. This means that you
cannot be totally confident of the results. So it is important
to choose a sample that is big enough to be representative
of the whole market. The findings from a sample that is too
small may not be very reliable.
Question
1
Evaluate the significance of the data in the case
study, in Figures 3.10 and 3.11, and in Table 3.7, for
Coca-Cola’s marketing.
[12]
HANDLING DATA
1
2
STUDY TIP
When deciding on the size and type of sample, you need
to think about issues such as the time available, the costs
and how accurate the data needs to be.
Sampling methods
Following market research, Nick estimates the
market as a whole is worth $1 500 000. He believes
his company can achieve a market share of 50 per
cent. What would his sales value be?
Nick also thinks the market will grow by 5 per cent
next year, but he can retain the same market share.
What would his sales value be then?
▼ Table 3.8 Primary and secondary research
Primary
Secondary
• New data
• Specific to your needs
• May take longer to gather
• May be expensive
• Existing data
• Gathered for another
purpose
• May be relatively quick
• May be relatively cheap
There are three main ways of selecting a sample:
» Random sample With a random sample, all the
members of the target population have an equal chance
of selection. If you wanted a random sample of 30
students at your school, you could take a list of names
of all the students and then pick 30 names at random.
You would then have to find them to interview. This
approach has the advantage that anyone could be
asked. However, it can be quite time-consuming,
because once the names have been selected you then
have to go and find those people. If they were not in
school on that day, you would have to wait until they
were, slowing up the whole process.
» Stratified sample A stratified sample is based on
particular proportions (such as 60 per cent males, 40
per cent females; or 20 per cent aged 16–35 and 80 per
cent aged over 35). This type of sample is used when
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Types of sample
Random
Stratified
Quota
Qualitative research is based on the opinions, values and
beliefs of people. It is usually undertaken using a small
focus group or in-depth one-to-one interviews. This type
of market research aims to understand why customers
behave in certain ways, or to find out what people think of
a product or what they would do in a particular situation.
Qualitative research examines why customers do what they
do. For example, a focus group might be used to discuss
consumers’ views of a brand to understand their shopping
habits. This often helps marketing managers understand
what customers think of their product compared to another,
and can be a starting point in the research process. Focus
groups may highlight particular issues or give a reaction
to a business idea that can be examined in more detail.
Given that qualitative research involves small groups, it
means that the findings are not statistically reliable; this
is why more extensive research is often used as a follow
up. Qualitative research can be quite expensive and slow to
organise because it is so important to get the right group of
people to talk to.
3.2
3.2.4 Market research data
the target population has particular characteristics that
you want reflected in your sample. You reproduce the
characteristics of the target population and randomly
sample within each category.
» Quota sample With a quota sample, the research sets
proportions (for example, male/female or different
age groups) which may or may not reflect the target
population. People who meet these characteristics are
found as quickly and easily as possible, which means
that a quota is not a random sample. For example,
if you want to interview 12 students (5 male and 7
female) you simply approach people and see if they
match these criteria and work with the first five male
students and first seven female students who agree to
take part.
A quota sample is easier and quicker to complete than
a random sample (as you do not need to know all the
members of the population), but it is not random
because members of the population do not have an equal
chance of selection. To find 30 students, for example,
you might simply find one class and ask them. This could
lead to very biased results because they would all be a
similar age and/or may all study the same subject. With
a random sample you would expect a range of ages and
interests, which might provide a better insight into the
school as a whole.
Quantitative market research is based on relatively large
samples and is therefore more statistically valid. This sort
of research is often used to show what has happened in
a market, and its findings can be expressed in numerical
terms (for example, sales of brand X have increased by 45
per cent; 12 million people watched a particular television
programme last week; the market for soft drinks is worth
more than $4 billion). Quantitative market research is used
to answer questions such as: how many units might be
sold? When are items most likely to sell? Where? What has
happened? Quantitative research is usually gathered via
surveys such as telephone, face-to-face or email.
▲ Figure 3.12 Types of sample
Analysing market research results
Choosing a sampling method
When analysing the market research results a business needs
to consider:
» Can the results be trusted to be relatively accurate? In
other words, is the research valid?
» Would the research give the same results if it were
repeated? In other words, is the research reliable?
The choice of sampling method will depend on factors such as:
» the time available. If time is limited, a quota is likely to
be used because it is relatively quick to do
» your knowledge of the target population. To select
people randomly you must have details of the target
population. If you were selecting from a list of
cardholders or club members this would be feasible.
However, if you were interested in potential buyers of
your product, you would not necessarily know who they
were and so could not select from this group randomly
» the extent to which the target population has clearly
differentiated groups of buyers. If the buyers can be
differentiated clearly (for example, 70 per cent male,
30 per cent female) then you would want to use a
stratified sample.
3.2.4 Market research data
Quantitative and qualitative market
research
Quantitative and qualitative market research are two
different approaches to market research.
GLOSSARY TERMS
A sample is a group of people selected to represent the
population as a whole.
The validity of market research refers to how accurate
the findings of market research are.
The reliability of market research refers to the extent to
which the same results would be received if the research
was conducted again.
The accuracy may depend on factors such as how the
information was gathered, what the sample size was and
how accurate you want the findings to be. Researchers often
express their findings in terms of confidence levels based
on a statistical analysis of the data. For example, they
might say they were 95 per cent confident that sales would
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3.2
be between $20 million and $26 million in two years’ time
but only 68 per cent confident they would be between $23
and $25 million. The more precise you want the estimate to
be, the less confident the researchers are likely to be. The
confidence level of market research findings relates to how
reliable the data is.
AS LEVEL 3.2 Market research
Interpreting marketing data
Marketing data may be presented in many forms, often
tables, charts and graphs. For example, a pie chart may be
used to illustrate market share:
Sales (%)
When examining line graphs, you may want to consider the
trend and how much sales fluctuate around this trend, as this
will affect how much capacity is required and is being used.
Do check the axes when looking at data. Figure 3.15 and
Figure 3.16 show the same sales figures but, by changing the
y-axis, the sales look as if they are rising more sharply in the
second figure.
Sales ($)
120
100
80
Product E: 1, 4%
60
Product D: 2, 8%
40
20
0
Product C: 4,
16%
Product B: 5,
20%
Product A:
13, 52%
2017
2018
2019
2020
2021
2022
2023
2024
2023
2024
▲ Figure 3.15 Line graph – shallow y-axis
Sales ($m)
110
100
90
Product A
Product B
Product C
Product D
Product E
▲ Figure 3.13 Example of a pie chart
In this pie chart we can see the sales of each product and
what proportion of the total market sales this represents
(that is, its market share).
80
70
60
50
Sales data over time is often shown using a line graph:
Sales ($m)
2017
2018
2020
2021
2022
▲ Figure 3.16 Line graph – steep y-axis
Data may also be presented using a bar chart; for example,
the sales of a business in different regions or the sales of
competitors.
60
50
40
Sales ($’000s)
45
40
30
20
10
0
2019
2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024
▲ Figure 3.14 Example of a line graph
In Figure 3.14, we can see there is an upward trend in sales.
Sometimes marketing managers want to plot the underlying
trend to ‘smooth out’ the data. They do this using moving
averages (this is explained in Chapter 8.1). We have assumed
this data was produced in 2022. The sales from 2023
onwards are, therefore, forecasts; this is often shown with a
dotted line.
35
30
25
20
15
10
5
0
Competitor A
Competitor B
Competitor C
Competitor D
▲ Figure 3.17 Example of a bar chart
Some data may also be in the form of tables. For example,
Table 3.9 shows forecasted sales volume and sales value
data for a product.
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» The sales value in 2022 is 5 per cent more than 2021.
» The sales value in 2023 is 10 per cent more than 2021.
» The sales value in 2025 is 15 per cent less than 2021.
» The sales value in 2026 is 10 per cent more than 2021.
▼ Table 3.9 Example of a table showing index values
Index of sales
volume (units)
Year
Index of sales
value ($)
2021
100
100
2022
102
105
2023
105
110
2024
110
120
2025
95
115
Using marketing data
2026
90
110
When examining any marketing research data, in whatever
form it is produced:
» check the source. Has this been produced internally or
by a specialist market research agency, for example? You
will want to take a view on the reliability of the data
» check the dates. How recent is the data? Markets can
change quickly so be wary of old data. At the same time,
if you are considering forecasts, you need to find out
how it is gathered and how reliable it is likely to be
» check the units. Be sure to check whether you are
measuring in thousands or millions of dollars, for
example. Also check the labelling of the axes – are you
measuring sales or profits, for example?
3.2
Notice that in this example the sales volume by 2026 is 10
per cent less than in 2021 and yet the sales value is 10 per
cent more; this must be because the price of the product
has increased.
Notice we can easily see the change in the sales volume;
we do not know what the actual level of sales is, only the
percentage change. Similarly with sales value:
3.2.4 Market research data
Tables often show data as index numbers. An index number
shows percentage changes relative to a starting or base point.
In the table above, the base is 2021 and changes in sales
volumes and values are shown compared to that. For example:
» The sales volume in 2022 is 2 per cent more than 2021.
» The sales volume in 2023 is 5 per cent more than 2021.
» The sales volume in 2025 is 5 per cent less than 2021.
» The sales volume in 2026 is 10 per cent less than 2021.
CASE STUDY
Esports
2000
1790
Revenue in US$ millions
1750
1500
1250
1096
1000
865
750
655
493
500
250
0
325
130
2012
194
2014
2015
2016
2017
2018
2019
2022
▲ Figure 3.18 Esports market revenue worldwide, 2012–2022
Esports, or competitive video gaming, has existed for
over 20 years. Sponsors like Intel and Red Bull have been
hosting events for more than 10 years. However, in the
last couple of years there has been a significant increase
in interest in esports by major brands. Companies such as
Coca-Cola and Mercedes have brought spending on their
esports sponsorship into their main marketing budget.
One of the appeals of esports is the reach it has with
young men and the high levels of engagement. In the USA,
in 2020, it is estimated that there were 21 million esports
fans; 83 per cent were male and 84 per cent under the
age of 35. It is now the third most-popular spectator sport
for young men.
Source: www.mckinsey.com/industries/technologymedia-and-telecommunications/our-insights/the-keysto-esports-marketing-dont-get-ganked
Questions
1
2
3
Calculate the percentage growth in esports market
revenue between 2012 and 2018.
[3]
Explain one factor that might determine the demand
for esports.
[3]
Evaluate the appeal of sponsoring an esports event
to a business.
[12]
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3.2
TEST YOUR LEARNING
Short answer questions
AS LEVEL 3.2 Market research
1
a
b
Define the term ‘market research’.
[2]
Explain one reason for undertaking market
research.
[3]
2 a Define the term ‘secondary market research’. [2]
b Explain one advantage of secondary research
compared to primary research.
[3]
[2]
3 a Define the term ‘primary market research’.
b Explain one advantage of primary research
compared to secondary research.
[3]
4 Define the term ‘sample’.
[2]
5 Explain one reason why a business may use
sampling when undertaking market research.
[3]
6 Explain one feature of effective market research. [3]
7 Explain one source of information for secondary
[3]
market research.
8 Explain one limitation of sampling.
[3]
9 Explain one factor that might influence how much is
spent on market research.
[3]
10 Explain one reason why spending more on market
research may not lead to higher sales.
[3]
Data response question
Burberry and luxury brands
Consumers around the globe have high expectations of
luxury brands. They widely research products before
purchasing and expect exceptional service in-store. The
strong interest in forward-looking fashions and innovative
products is partly driven by the younger customers now
entering the luxury market.
Consumers are increasingly using luxury products
to say something about themselves, to express their
individuality, their own style or point of view. This means
luxury products increasingly have to be fashionable and
are often sold in limited-edition ranges. The fastestgrowing segments of the luxury market are young
consumers and Chinese consumers, and they expect to
buy an increasing number of products they would describe
as ‘fashionable’.
The market for clothing and accessories is increasingly
polarising between the mass market and luxury products.
Consumers are increasingly preferring products that are
positioned either at the highest or the lowest end of the
market rather than mid-market. A huge amount of the
growth in the luxury market is driven by generation Z and
millennial consumers*. Generation Z consumers are more
willing to shop in a physical store – although they also
expect an online presence. They prefer heavily logoed
products and are not especially brand loyal. Younger
consumers are highly socially and environmentally aware.
Concern about sustainability and a brand’s social or
political stance is a key factor in their purchasing decision
process.
Findings from market research about the luxury market
include:
● market growth has varied by region. China has
continued to have very fast growth and is attractive
to businesses due to its market size. There are more
buyers in China due to fewer restrictions on importing
products, more restrictions on buying abroad and
more tax-free shops. Spending across the rest of Asia
has been strong in recent years, with Hong Kong,
Macau and Japan benefiting from travelling Chinese
consumers due to the relative strengthening of the
Chinese yuan and strong local consumption in Korea.
Sales in the Middle East have remained relatively flat
due to low oil prices and lower government spending
in the economy
● online sales of luxury brands have been rising fast,
especially in Asia
● in luxury accessories, the handbag category has done
especially well recently
● growth in shoes has been highest in the trainers
segment
● growth estimates for the luxury market over the next
five years remain in line with 2019 estimates, ranging
from 3 per cent to 5 per cent per year.
* Generation Z refers to people born between 1997 and
the early 2010s. Millennials are people born between
1981 and 1996.
Questions
1
2
3
Define the terms:
a ‘market size’
[2]
b ‘market growth’.
[2]
Analyse one way in which Burberry might research
the market for its new products.
[4]
Evaluate how market research can help the
success of Burberry’s new products.
[12]
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3 Marketing
AS LEVEL
3.3
The marketing mix
In this chapter we examine:
★ the elements of the marketing mix (the four Ps)
★ the importance of the product in the marketing mix
★ product portfolio analysis
★ pricing methods
★ promotion methods
★ place (channels of distribution).
A customer is influenced by many factors when deciding
whether or not to purchase a product. The combination of
these factors is known as the marketing mix. By developing
an effective marketing mix, a business can meet the needs
of its customers successfully. In this chapter we examine
the different elements of the marketing mix.
GLOSSARY TERM
or enhancing the combination of elements that affect the
customer’s buying decision.
Place
(distribution)
The marketing mix is the combination of elements that
influence a customer’s decision on whether or not to buy
a product.
3.3.1 Elements of the marketing
mix
The marketing mix comprises all the elements associated
with a product that affect whether or not the customer
decides to buy it. A broad range of factors may affect
customers’ purchasing decisions.
Consider why a customer might choose to shop in one
supermarket rather than another. The list below contains a
number of factors affecting this decision.
» How far away is it?
» How easy is it to park?
» What is the range of products like?
» Are the prices competitive?
» What facilities are there (for example, a coffee shop)?
» Are the staff friendly and helpful?
» What services are provided (such as carrying shopping to
customers’ cars)?
» Does the supermarket offer a loyalty card?
There are clearly many factors that influence a consumer’s
decision to choose one business rather than another,
and these are all part of the marketing mix. An effective
marketing mix offers the customer the right mix of benefits
at the right price. Improving the mix will involve changing
3.3.1 Elements of the marketing mix
Chapter overview
Price
The marketing
mix
Product
Promotion
▲ Figure 3.19 The marketing mix is commonly described as
the four Ps
The marketing mix is often simplified and is commonly
described as ‘the four Ps’. This approach identifies four
elements in the mix (all beginning with the letter ‘P’):
» Price How much are customers charged for the product
and what are the terms of payment? For example, can
you put a deposit down and pay in instalments? How
does this price compare with that of rivals?
» Product This includes the many different aspects of a
product such as its design, quality, reliability, features
and functions. For example, you may buy something
principally because of its style (for example, Bang &
Olufsen, Apple), its features, its reliability and durability
(for example, JCB, Caterpillar) or the brand (for example,
DKNY, Gucci).
» Place This refers to the way the product is distributed.
Is the product sold direct to the customer or through
retail outlets? Can you buy online, or do you have to
travel some distance to get to a shop where it is sold?
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» Promotion This is the way the firm communicates
AS LEVEL 3.3 The marketing mix
3.3
information about the product to the customer. For
example, it may use advertising or a sales force to highlight
its strengths. The promotion of a product will affect the
image that customers have of it and their awareness and
understanding of the benefits of the product.
However, the marketing mix can be extended to also feature
other factors, such as a further three Ps:
» People A well-trained, well-informed, polite staff can
influence people to buy from one shop rather than another.
Customer service is an important marketing weapon.
» Physical environment This includes factors such as the
layout, decor and parking, and can be an important influence
on which restaurant, pub or store a person chooses.
» Process The ease of ordering and paying can influence
a purchase. Many supermarkets have introduced selfscanning to reduce queues and attract customers.
Intangible aspects of the product refer to aspects that
cannot be touched but can still be important to customers,
such as the brand and its key values. It also includes
aspects of the product such as a guarantee, after-sales
servicing or additional technical support which come with
the purchase. Some people stick with their phone service
or energy company because they trust them to fix things
quickly if ever there is a problem. Some businesses buy
their photocopiers or computers from companies that can
maintain them effectively.
GLOSSARY TERMS
The products of a business refer to what it offers to sell
to its customers. These may be goods, which are tangible
items, or services, which are intangible.
The tangible attributes of a product refer to its physical
aspects, such as how it looks and feels.
3.3.2 Products
The intangible aspects of a product refer to aspects that
cannot be touched but can still be important to customers,
such as the brand and its key values.
The difference between goods and
services
Product differentiation occurs when the benefits of
your product are perceived as clearly different from
competitors’ products.
Products refer to goods which are tangible products;
services are intangible. Businesses will keep reviewing
their products to ensure they are relevant and continue
to meet customer needs. When reviewing their products,
businesses will consider the core benefit that the product
provides. For example, a soft drink satisfies thirst, a washing
machine provides clean clothes and an aircraft moves people
and cargo from A to B. Businesses have to be aware of new
substitutes coming along – with more social communication
systems such as Zoom, Skype and FaceTime, people may not
need to travel as much. With more emailing there may be
reduced need for letter-writing paper. The ways of providing a
core benefit can change and businesses must be aware of this
and prepare accordingly.
Tangible and intangible attributes of
products
The tangible attributes of products refer to the physical
aspects of a product. In the case of a washing machine, for
example, the business would consider what size, features,
capacity and types of wash were needed and what energy
usage it had. The features customers require would vary – in
the case of a washing machine, some people live in tower
blocks and use industrial-size washing machines in the
basement areas. In other cities people have apartments
with smaller washing machines inside. In some countries
people have a utility room with lots of space, and the
washing machine is a ‘top loader’ where people put the
washing in from the top. In other regions the workspace
on the top is needed and so washing machines are ‘front
loaders’. Products must be developed according to how
people are likely to use them. These attributes of a product
include the specifications, features and design of the
product.
The importance of product development
Developing new products is essential to most businesses.
This is because:
» customers’ tastes change and so a business must change
what it offers as well; for example, customers generally
want less sugar in their food products than in the past
» competitors will constantly be developing their
offerings, so a business needs to innovate to keep up
and remain competitive
» developments in technology will create new
opportunities for products (and indeed can create whole
new markets) which businesses will want to make use of
» new laws and regulations change what can be produced;
for example, diesel cars may be banned in the future.
Of course, some products seem to have been around for
many years – such as Kellogg’s Cornflakes – but even
here there will be some developments relating to the
ingredients, recipe, packaging, size of the boxes and
communications about the benefits of the product. At the
same time Kellogg’s will be developing other products to
meet emerging customer needs.
Product differentiation and unique
selling point
One possible approach of marketing is to differentiate the
products that the business sells relative to its competitors.
Product differentiation occurs when the benefits of your
product are perceived as clearly different from competitors’
products. Your product may be perceived as easier, safer,
better designed or trendier, for example. This differentiation
can be achieved by having a unique selling point (USP); this
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is something about your product which is perceived by your
customers as unique. For example, you might be selling the
only water from Lake X or the best performing car according
to a recent survey. By promoting its USP, a business can
differentiate its offering and may be able to charge more or
offer better value for money.
3.3.3 Product portfolio analysis
Sales
The product life cycle traces the stages of a product over
its life. The typical path for a product can be divided into
five stages, as in Figure 3.20.
2 The introduction (launch) stage
This is the stage at which the product or service is launched
and put on sale. Many product ideas will never actually
reach this stage. They are abandoned after prototypes have
been produced and tested. In the launch phase, promotion
costs will be relatively high to make potential customers
aware of the product, therefore a loss is still likely to be
made. Producers may also struggle to get firms to stock
their products or customers to try their service at this
stage if the business is new, with no proven track record.
Buyers may be reluctant to risk switching to or trialling a
new product, particularly if there are heavy costs involved
in doing so. For example, if there is a penalty payment
for switching from one credit card, mortgage company,
electricity company or gas company to another, customers
are more likely to remain with their existing providers.
3 The growth stage
Launch
Time
Research
Introduction
and
development
Growth
Maturity
Decline
▲ Figure 3.20 The product life cycle
GLOSSARY TERMS
Product portfolio analysis occurs when a business
examines the position of all of its products in terms of
their relative market share and market growth.
If the product becomes known and accepted by customers,
sales should grow. At this stage, it should be slightly easier
to get distributors to stock the products, as they will be
more confident of sales and therefore willing to stock
them. The firm should begin to make profits at this stage,
as revenues begin to outweigh costs. For example, sales
of teeth-whitening formulas, smoothies, men’s cosmetics
and laser eye-surgery are at their growth stage in several
countries. At this stage, you need to make sure you can meet
the demand and manage the growth process. You may be
taking on more staff, buying more equipment and expanding
your premises; if this is happening rapidly it can be difficult
to keep control. Making sure you can meet deadlines and
maintaining quality can be major problems at this time.
The product life cycle shows the stages of a product over
its lifetime.
Of course, some products never reach the growth stage:
they are launched but are never successful and sales fail to
take off.
1 The research and development stage
4 The maturity and saturation stage
During this stage, the basic idea for the product is
developed and tested. Mock-ups of a design may be made,
models of a product may be produced or a new recipe may
be taste-tested. This stage can be expensive for a firm
and no revenue is being generated during this period. This
is a time of high risk because the product may never be
developed successfully and the investment at this stage
may not be recovered. For example, it took James Dyson 15
years and more than 5000 prototypes of the Dyson vacuum
cleaner before he got it right, highlighting the time and
money that can be used up in the development phase.
At this point in a product’s life, the growth of sales slows
down. The product may have been in the market for some
time and competitors may have launched similar products.
Products such as washing machines and televisions are
currently in their maturity stage. The maturity stage can
last for years in some cases. There is no rapid expansion and
managers must consider what to do next with the product;
for example, should funds be invested to try to boost sales
or should the product be scrapped?
The length of the research and development process
will vary from product to product. In the case of new
pharmaceuticals, it can take 12–15 years to develop and test
products before they can be launched, whereas developing
a new design for a greetings card is likely to take months
rather than years. Some products, such as newspapers, are
modified on a daily basis (although significant changes,
Eventually, the sales of any product are likely to fall. The
business may find it more difficult to get the product
distributed at this stage and may be forced to cut the price
to maintain sales. For example, you will have seen reducedprice CDs or books in the bargain areas of shops: the price has
been reduced to try to increase sales. Products such as board
games, road atlases and bow ties are in their decline stages.
3.3
3.3.3 Product portfolio analysis
Product life cycle
such as the size of the paper or whether to switch to colour,
are far less frequent).
5 Decline
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AS LEVEL 3.3 The marketing mix
3.3
then adjust the marketing mix accordingly. For example,
promotion may be used to announce the launch of a product
in the introduction phase but to stress the differences
with competitors in the maturity phase. The price may
be high initially if the product has some unique features
but may have to be reduced in later stages as competitors
enter the market. Distribution may be difficult to get at
first when a product is new, but it may be easier over time
when it has begun to prove itself. The business should
be able to improve the firm’s performance by recognising
or anticipating where the product is in its life cycle and
adapting the marketing mix accordingly.
STUDY TIP
Remember that the shape of the product life cycle will
vary from one product to the next. In some cases, a
product may sell well for relatively few weeks or months
and then fade; for example, a successful film. Other
products may sell well for years, such as a popular book.
Products may be at different stages in different regions.
Using the product life cycle
Managers may use the product life cycle model to identify
which stage a product is in at any given moment and
CASE STUDY
Dyson
Dyson is a technology company that is well-known for
its product innovations, such as its vacuum cleaners and
hairdryers. In 2016, it started to develop prototypes of
electric cars but, in 2019, Dyson announced it was going
to end this project. The company said it had developed
a fantastic car but it was not commercially viable to
produce it.
Dyson had intended to invest more than £2 billion
in developing a radical and different type of electric
vehicle. It was never intended for the mass market but,
even given the premium price Dyson expected to charge,
the company did not think it could sell enough to be
profitable.
The intention had been to produce the car in Singapore,
although £200 million was invested in research and
development and test-track facilities within the UK.
The project employed 523 people, 500 of whom were in
UK, and Sir James Dyson said they had achieved a great
deal, even if the car was not going to go into production.
The company said that work on developing the
battery technology could be transferred to its other
projects.
Source: Charlie Box/Dyson
▲ Figure 3.21 Dyson patent diagram from 2019
Questions
1
Analyse one factor that influences the design of a
vacuum cleaner.
2
[4]
Evaluate whether Dyson was right to invest in
developing an electric car.
[12]
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Extending sales in the product
life cycle
Sales
Effect of
extension strategy
▲ Figure 3.22 Extension strategies
A firm may try to prevent the sales of a product going into
decline by using extension strategies. Methods to do this
might include:
» increasing the usage of the product on any given
occasion. For example, shampoo products often advise
you to wash once, then rinse your hair and wash again,
thereby doubling the usage rate
» encouraging the use of the product on more occasions.
For example, Head & Shoulders shampoo was seen
GLOSSARY TERM
An extension strategy occurs when marketing activities
are changed to prevent sales from falling.
3.3
3.3.3 Product portfolio analysis
Time
by consumers as a product to use when dandruff was
already present. The company tried to change this
perception to get people to use it all year round to
prevent dandruff, as well as cure it
» reducing the price. As products approach the maturity
stage, firms often cut the price to maintain sales. The
success of this depends on how sensitive demand is to
changes in price
» adapting the product. Look around a supermarket
and you will see endless examples of ‘new, improved’
products or products with added X, extra Y or less Z!
These are all ways of trying to keep the consumer
interested in the product
» introducing promotional offers. Another technique often
used by firms to try to prevent sales from falling is to
have competitions or offers to boost their sales
» changing the image of the product. Products may be
repackaged to make them appear more modern and
attractive to consumers.
CASE STUDY
Command and conquer
Command and conquer is a computer game in which there
is a war between the Global Defence Initiative and a
terrorist group called the Brotherhood of Nod. Command
and conquer was originally a video game in 1995, when
it was first released on compact discs. Players could
compete against others using what was then an emerging
technology – the internet. It sold around 3 million copies.
More than 30 updated computer games were launched in
2020. Final Fantasy vii Remake is a remake of a PlayStation
game from 1997. It sold 3.5 million copies in three
days when it was released in April 2020. Re-releasing
games appeals to those who remember them from their
childhood. It is also cheaper than developing a new game
from scratch, which can cost $100 million.
In 2020, a new, improved version came out. This was
similar to the original in many ways but had better graphics.
Revamping products is common in the music industry where
music will be remixed, remastered or brought out as a
special edition or part of a compilation. Film studies produce
the director’s cut or an edition with ‘extras’ or ‘outtakes’.
Questions
1
2
Analyse one factor that affects the promotional mix of
a new computer game.
[4]
Evaluate whether computer games companies are
[12]
right to relaunch past games.
▼ Table 3.10 Examples of how marketing decisions may change at different stages of the product life cycle
Introduction
Growth
Maturity
Decline
Price
May be low to introduce May be able to increase
with demand
May hold
May cut to boost sales
Distribution
May be limited as stores May increase to gain
unsure whether to stock access to the market
May hold
May focus on bestperforming outlets
Promotion
May focus on awareness May try to increase
awareness
May highlight differences
with competitors who may
have entered
May try to reinforce
existence and benefits
of the product
Product
May be limited number
of models/varieties
May stop developing new
models/varieties
May focus on best
performers
May widen range with
demand
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Segway
AS LEVEL 3.3 The marketing mix
3.3
CASE STUDY
▲ Figure 3.23 Segway products
The Segway Personal Transporter (PT) was a selfbalancing electric scooter that was launched in 2001
by Dean Kamen, its American inventor. ‘Our inspiration
for the name “Segway” came from the word segue,
which is defined as “to transition smoothly from one
state to another”. Segway transforms a person into an
empowered pedestrian, allowing him/her to go farther,
move more quickly and carry more.’ The Segway had a
self-righting technology. If you leant forward, a collection
of microprocessors and a set of sophisticated tilt sensors
and gyroscopic sensors adjusted so you maintained your
balance. The Segway could travel up to 12 miles an hour
(19 km/h).
In 2015, Segway joined with Ninebot, a privately held
Chinese company. The combined company focuses on
the research and development, design, manufacturing,
distribution and sales of short-distance transportation
products. According to Segway, more and more people
are using Segway-Ninebot products as an eco-friendly
alternative for many of the short journeys that are
typically made by car.’
Unfortunately, the transportation revolution that inventor
Dean Kamen had envisioned when he launched the
Segway PT never really took off. The Segway’s original
price tag of around $5000 was too high for many
customers. The initial difficulties customers often had
balancing also caused problems. The number of highprofile accidents – including the death of the company’s
owner in 2010 when he drove a Segway off a cliff by
mistake – did not help the Segway’s image. Furthermore,
some governments declared that the Segway could not be
used in any public place. It was too fast to be used on the
pavement but not safe enough to be used on the road.
In June 2020, the company announced that it would stop
production of the Segway PT. The company continues to
produce other products and the Segway only accounted
for about 1.5 per cent of the company’s revenue by this
stage.
Source: https://uk-en.segway.com/about-the-brand
Questions
1
2
Analyse one reason why the company may have
stopped production of the Segway PT.
[4]
Evaluate the ways in which the marketing of a
Segway product might change as it moves from
the introduction to the growth phase of the product
life cycle.
[12]
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HANDLING DATA
Over five years the sales of a product are as shown in
Table 3.11.
of portfolio analysis was developed by the management
consultancy Boston Consulting Group and is known as the
Boston Matrix. This model analyses the position of a firm’s
products in terms of their market share and the growth of
the markets they operate in.
3.3
▼ Table 3.11 Sales of a product over five years
1
$100 000
2
$150 000
3
$200 000
4
$220 000
5
$225 000
What stage of the product life cycle do you think the
sales are in? Explain your answer.
The value of the product life cycle model
The product life cycle model is valuable because it highlights
the fact that marketing activities have to be adjusted at
different stages in the development of a product.
However, it is important to remember that the product life
cycle is just a model and its shape will vary considerably
between products. In the case of a new single release by
a band, for example, the life span may be just a matter of
weeks, whereas Marmite was launched in the early twentieth
century and is still in its maturity phase. Toys often have
short life cycles but some of them, such as Barbie dolls,
have been around for many years. So marketing decisions
in relation to the product life cycle are not clear-cut; some
products in decline have had to be taken off the market
because they cannot be made viable while others, such as
the drink Tango, have been rebranded and brought back to
great success.
Often, it will only be clear in retrospect what stage a
product was in; what appears to be a slight dip may turn
out to be the decline of a product, or what appears to be a
decline may only be a slight dip: it only becomes clear later
on. Unfortunately, businesses have to make decisions as
they go. They do not have the luxury of waiting to see what
would have happened if they had not acted.
Another limitation of the product life cycle model is that it
traces the sales of one product over time. Most businesses
have several products and therefore it is important to look
at their overall position.
Product portfolio analysis
Most firms have more than one product; some have
hundreds. For example, at the time of writing, Unilever
owns a huge number of brands, including Ben & Jerry’s, Cif,
Domestos, Lipton, Magnum, Marmite, Omo, Surf, Timotei
and Walls, to name but a few. The range of products and
services a firm has is known as its product portfolio. As part
of its planning process, a business will examine the position
of these products in their markets. This is known as product
portfolio analysis (PPA). One of the most famous models
GLOSSARY TERMS
Product portfolio analysis (PPA) examines the market
position of a firm’s products.
The Boston Matrix is a method of product portfolio
analysis that examines the products of a business in terms
of their market share and the market growth.
Types of product in the Boston Matrix
Each circle in the Boston Matrix represents one particular
product or service. The size of the circle illustrates the
turnover of the product; the bigger the circle, the higher
the turnover. The firm’s products can be classified according
to their market share and the growth of the market in which
they operate.
Stars
Question marks
Cash cows
Dogs
High
Market growth (%)
Sales
3.3.3 Product portfolio analysis
1
Year
Low
High
Market share
Low
▲ Figure 3.24 The Boston Matrix
» Cash cows are products that have a high market share
but are selling in a slow-growing market. In some cases,
this type of product will be the market leader in a mature
market. Although the market may not be growing very
fast, this may be because it has grown in the past,
leaving little room for further expansion. For example,
the market for washing machines in the UK is quite big
but is not actually growing very fast; given the size of the
market, a brand with a high market share will have sales
worth millions of pounds. By comparison, the market for
electric cars and organic food is still relatively small but
has potential for fast growth. A cash cow already has a
large market share, so much of the promotional work will
have been done already. The product is likely to have a
good distribution system and people will be aware that
the product exists. The firm is used to producing the
product in relatively large volumes and so the cost per
unit should be fairly low. As a result, this type of product
is likely to bring in high levels of cash for the firm. This
can be used to finance other products.
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AS LEVEL 3.3 The marketing mix
3.3
products that have a small market share of a fast-growing
market. These products may go on to be very successful
but, equally, they may fail. They are quite vulnerable
and their future is uncertain (hence the name). There
is a high degree of risk associated with these products,
because you cannot be sure they will succeed. They
need protecting by the firm and they require extensive
marketing. Most new products are question marks
because their future is so uncertain, although there are
exceptions when a product takes off quickly.
» Stars These products enjoy a large share of a market that
is growing rapidly. They are highly successful products
for the business; however, they are usually expensive in
terms of marketing. Money must be spent to ensure they
retain their position in a growing market. For example,
they may need to be promoted heavily to maintain
customer awareness and to increase distribution in the
market.
» Dogs These products have a low market share and are
selling in a slow-growing market. A firm may want to
get rid of these products unless it thinks it can improve
its sales. However, dogs can sometimes be revived.
Lucozade used to be seen as a drink to help sick people
get better, until it was very successfully repositioned as
a sports and energy drink.
The impact of product portfolio analysis on
marketing decisions
The Boston Matrix provides a snapshot of the position of
all of a firm’s products at a particular moment in time,
whereas the product life cycle focuses on just one product.
This enables managers to see whether or not they have a
balanced portfolio – that is, an appropriate mix of products.
It can help a business to be more effective by providing an
overview so that the manager can take appropriate actions.
For example:
» If a business has too many dogs, it may have insufficient
new products to keep it going in the future. As a result,
it may want to invest in new products.
» If a business has lots of cash cows, it is generating
relatively high levels of cash but, again, needs to
think about the future: cash cows tend to be dominant
products in markets that have already grown. A business
may want and need to be involved in newer markets as
well, and it should therefore look to develop some star
products.
» If a firm has too many question marks, it may be quite
vulnerable, as question marks need protective marketing
to maintain and grow their position in the market, and
this may drain a firm’s resources.
With an appropriate mix of products, the cash cows can be
used to finance the development of question marks and
turn them into stars. This way the firm uses money from
established markets to enter new markets and so protects
its future. Portfolio analysis, therefore, provides a good
basis for effective marketing planning:
» Dog products may be sold off or production and sales
halted.
» Star products may be invested in to maintain their
position.
» Cash cows may be ‘milked’ to provide funds.
» Question marks may be protected.
Market growth
Low
High
» Question marks (or ‘problem children’). These are
Stars
Question marks
Cash cows
Dogs
High
Low
Relative market share
▲ Figure 3.25 The Boston Matrix (2)
CASE STUDY
Coca-Cola
The Coca-Cola Company is a beverage company. It
has over 500 brands which are sold in more than 200
countries and territories. Its portfolio of products come
in the following categories: soft drinks; water, enhanced
water, and sports drinks; juice, dairy, and plant-based
beverages; tea and coffee; and energy drinks. In addition,
the company owns four of the world’s top five nonalcoholic sparkling soft drink brands: Coca-Cola, Diet
Coke, Fanta and Sprite.
underperforming (which it calls ‘zombies’), it eliminates
them to make room for newer products.
The company believes its success arises from its ability
to connect with consumers by providing them with a
wide variety of beverage choices to meet their desires,
needs and lifestyle choices. The company constantly
reviews its portfolio and when it has products that are
Questions
Just over half of Coca-Cola’s revenue is now from sparkling
soft drinks, with tea and coffee and juice, dairy and plant
drinks making up about another 20 per cent each, and the
remaining sales being from hydration drinks.
Source: https://investors.coca-colacompany.com/strategy/
growth-strategy
1
2
Analyse one reason why Coca-Cola sells products in
different product categories.
[4]
Evaluate how product portfolio analysis is useful to
Coca-Cola.
[12]
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CASE STUDY
3.3
Crocs
Since the business started in 2002, over 600 million
pairs of Croc shoes have been sold in over 90 countries.
The company has over 4000 employees worldwide. Croc
says that it designs everything for the people who wear
STUDY TIP
You need to be able to discuss the value of the product
life cycle model and product portfolio analysis. How
can these models be used in marketing? What are their
limitations? You also need to make sure you can apply
them. Can you tell from sales which stage of the life
cycle a product is in? Can you identify a cash cow or dog
product?
To make their businesses more effective, business
managers need to monitor and develop suitable product
portfolios. They must also adapt their marketing at
different stages of the product life cycle. You need to be
able to make recommendations, such as how to extend
the life cycle of a product or how to improve the portfolio
of a business’ products.
its footwear. It aims to keep its designs simple and
light.
The original Crocs products sold very well, but then
entered the maturity stage of the product life cycle. At this
stage the managers used the original Crocs as cash cows
to finance the development of new styles for different
types of occasion.
Source: https://careers.crocs.com/about-us
Questions
1
2
Analyse one feature of Crocs’ products that you
would use when promoting the product.
Evaluate whether the Crocs brand can last for
another 30 years.
How price affects purchasing decisions
The price of a product plays an important part in our
decision about whether or not to buy it. If the price is too
high, we simply cannot afford the product even if we want
it! Even if we can afford it, we may decide it is not value for
money if the price seems too high compared to the benefits
the product offers.
[12]
The price will, therefore, often play a significant role in
the purchasing decision. However, the relative importance
of price is likely to vary according to the product and
the particular circumstances. For example, if two petrol
garages opposite each other are charging different prices
for petrol, we are likely to choose the cheaper one. We are
unlikely to be loyal to a particular brand of petrol. When
buying a wedding ring, however, we do not always go for
the cheapest! Similarly, when buying clothes and shoes we
may be willing to pay more for an item if we think the brand
justifies this.
Even if you wanted to choose the cheapest price, it can
be difficult to compare prices directly – look at how
complicated the price structure is for mobile phones or
electricity. The structure of special rates, different tariffs
and different options can make it difficult for customers to
know which is actually the best deal.
3.3.4 Pricing methods
The price of a product can have a major influence on its
appeal and whether or not customers think it is good
value for money. In this section, we examine the factors
influencing the price of a product and different pricing
strategies. Getting the price right is an important element
of effective marketing, because it will determine whether
customers believe they are receiving value for money.
[4]
3.3.4 Pricing methods
Crocs, Inc. is a world-famous shoes manufacturer. The
company was established in Colorado, USA, producing
simple, comfortable boat shoes. Nowadays, Crocs
footwear can be found all over the world and there are
over 120 different styles. Crocs are distinctive for their
bright colours and their comfort. The company describes
its products as the ‘most delightfully comfortable shoes in
the world’. It claims that comfort leads to happiness and
this makes the world a better place! The footwear is made
of very soft, light and flexible material which makes them
easy to wear. The shoes are made using the company’s
own resin, called Croslite.
Cost of
producing a
unit
Type of product
Factors
influencing
price
Competitors
Demand for
a product
▲ Figure 3.26 Factors influencing price
Factors determining the price of a product
The price of a product will depend on the following range of
factors.
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» The type of product Demand for some products is more
AS LEVEL 3.3 The marketing mix
3.3
sensitive to price than others. When you are looking
to buy a new microwave, for example, you are likely to
look online or go to a shop that stocks several models.
You may even go to a couple of different outlets to
compare what they offer. This type of product is called
a ‘shopping good’ because you shop around to find a
good deal. These products are very sensitive to price
differences so prices need to be competitive.
Other products are known as speciality items. These
include high-performance cars and luxury watches.
Customers are likely to be willing to travel some distance
to find these items and are heavily influenced by their
design and branding factors. These products are less
sensitive to price changes because they are unique. This
may lead to higher prices.
» The cost of producing a unit Although in the short term
a firm may sell an item at a loss to get it established in
a market, in the long term a product will nearly always
have to generate a profit. This means the price has to be
greater than the cost per unit. Some organisations (such
as museums and hospitals) are non-profit making and so
do not necessarily have to cover their costs. However,
most firms in the private sector have to make a longterm profit to survive. The price therefore cannot fall
below the unit cost for too long.
» The ability of customers to pay If the economy is doing
well and customers have high income levels, a firm may
be able to increase prices. If, however, incomes are
falling, customers may be more sensitive to the price
and look for a better deal (or wait before purchasing);
this may delay any price increases by firms.
» The demand for a product The level of interest in and
demand for a product will also affect the price that
firms can charge. Holiday companies will often increase
their prices in the school holidays, when they know lots
of families will want to go away. The holiday companies
lower prices when demand is lower during term time.
» The sensitivity of demand to price changes The
sensitivity of demand to price is measured by the
price elasticity of demand (which we will examine in
Chapter 8.1). Demand for some products is very sensitive
to the price, as people shop around for the best deal.
Other items may not be so sensitive; for example,
if it is an exclusive item.
» Competitors The price that a business sets for its
product must take account of competitors’ prices. If
competitors are offering a similar product or service
and it is easy to switch from one to the other, firms
are likely to set similar prices to each other. This is why
businesses will often stress the particular benefits of
what they are offering, so they can justify a higher
price. If customers believe a product provides better
value for money, they may still buy it even if it is more
expensive. Stella Artois beer, for example, ran a very
successful ‘reassuringly expensive’ campaign in the UK,
stressing that you pay more for high-quality lager. The
price was said to reflect the quality. There are now many
websites offering price comparisons; this makes demand
more sensitive to price as customers are looking around
more.
» Pricing points Some businesses aim to have a given
range of products at particular pricing points in the
market (for example, the top or bottom end of the
market) depending on the brand image and other
elements of the marketing mix. Some businesses produce
several different brands, priced at different levels.
For example, a business may produce several different
watches (often under different brand names); some in
an exclusive range, some for the mass market and some
discounted items.
» The objectives of the business The price charged by a
firm will be influenced by its objectives. If a firm has a
particular profit target, this will influence the price that
is set per unit. If it wants to achieve $10 000 profit and
expects to sell 20 000 units, it must make $0.50 profit
per unit, if this is possible. If, however, it is aiming for a
high market share (at least in the short term) it may be
willing to sell at a lower price if this will help to boost
sales.
» The stage in the product life cycle The price of a
product is likely to be changed at different stages in the
product life cycle. For example, when the product is in
the maturity stage, the price may need to be reduced to
avoid losing sales to competitors.
» The rest of the marketing mix The price a firm charges
also depends on the other elements of the marketing
mix. A heavily branded consumer product (such as Nike
trainers or Coca-Cola) will be expensive compared to a
product which does not have a well-known brand, for
example. An exclusive four-star restaurant will charge
more than a fast-food store. A designer boutique will
charge more than Primark. Typically, the price will be
higher if the product:
– has a unique selling point
– is perceived as being exclusive
– is in high demand
– is sold through exclusive outlets.
There are therefore many factors that can influence the
price of a product, and setting the price is a complex
decision. If managers understand these influences, they can
market their products more effectively by setting the right
price for the market conditions. Managers can judge, for
example, whether a price cut makes sense, given the market
conditions.
Of course, a price is not fixed forever and there are a
number of times when a firm might reconsider the price
it is charging for a product. In the following sections, we
consider different pricing strategies and approaches.
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CASE STUDY
3.3
Vertu
Every Vertu phone was handmade by a single craftsman
at the company’s small factory at Church Crookham,
England. This is not like any other phone – Vertu used
materials such as ruby, sapphire and titanium. Each
material used was selected not just for the fact that
it looks good, but also for its exceptional strength.
Customers could have phones made to order so that the
design reflects their personal choices.
GLOSSARY TERMS
Competitive pricing is when companies set their prices at
the same level as, or slightly below, their rivals.
Penetration pricing is a pricing strategy aimed at gaining
market share via a low entry price.
Price skimming occurs when a high initial price is set for a
product and this is reduced over time.
Price discrimination occurs when different prices are
charged for the same product.
Pricing methods for new products
When a product is first launched into a market, a firm has
to decide what price to charge. It has a number of options:
» Competitive pricing Some firms set their price at the
same level as their competitors or deliberately undercut
their rivals. Richer Sounds, a hi-fi, home cinema and TV
specialist, guarantees to charge lower prices than rivals.
Esso operates a ‘pricewatch’ to monitor competitors’
prices. Several retailers offer to refund the difference if
you can find the same product cheaper in another local
store. Competitive pricing is common when consumers
can easily make a direct comparison between different
products. The rise in internet usage has made it easier
for customers to compare prices between firms; this puts
more pressure on firms to be competitive.
» Penetration pricing This strategy uses a low price to
enter the market and gain market share. This makes
sense if there are cost advantages from producing on a
large scale. For example, in some markets a high level of
investment is required to set up, such as when investing
in premises and equipment. Once this investment has
When you owned a Vertu you could also get access
to a concierge service. This means you had your own
private butler online. This service was available for
customers 24 hours a day, every day of the year,
and helped customers organise their lives and gain
access to the most exclusive events and places. For
example, the concierge service could help customers
get tickets to watch large-scale sports events around
the world, meet globally famous chefs at Michelin-star
restaurants or travel to private islands.
Questions
1
2
State one group that would be a target market for
[3]
Vertu. Explain your answer.
Evaluate the factors that would have influenced the
[12]
price set for the Vertu phone.
3.3.4 Pricing methods
Vertu‘s aim was simple: to create something
extraordinary. Its main products were luxury mobile
phones. These began at a price of around $10 000. The
company said that its products brought together great
craftsmanship, outstanding performance and exceptional
customer services.
been carried out, a firm may want to generate high
levels of demand to spread the costs over many units.
A low entry price might help do this. Price penetration
is also beneficial if the market is price sensitive (price
elastic), in that a lower price will generate significantly
higher sales and increase revenue.
» Price skimming This strategy uses a high price to enter
a market. Even though the price is high, some people
may still be eager to try a new product. Once sales from
this group of people have been exhausted, the price can
be dropped to attract a new group of customers. When
this group is exhausted, the price can be cut again. A
price skimming strategy is appropriate if the firm can
protect its idea or invention so that competitors cannot
enter with a cheaper version in the early stages. Price
skimming makes sense if the market is not particularly
price sensitive (that is, it is price inelastic), so that a
price cut would generate a relatively smaller increase in
sales. This strategy is often used with new technology;
for example, the latest computer or computer accessory
enters the market with a high price, which then falls
quite rapidly a year or so later.
» Price discrimination This occurs when different prices
are charged for the same product. You will sometimes
find that demand conditions for the same product can
vary and the price changes as a result. For example,
demand for public transport around 8 a.m. is very heavy,
as people want to get to work for 9 a.m. Similarly,
demand is busy between 5 p.m. and 6 p.m., as people
want to get home. Demand is less heavy at other times
of day. If a business can identify different demand
conditions, it may want to change the price in the
different markets. The demand for transport before
9 a.m. and between 5 p.m and 6 p.m. is likely to be price
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AS LEVEL 3.3 The marketing mix
3.3
inelastic: it is not sensitive to price because people have
to get to and from work. At these times, a transport
business may increase price to increase revenue. At
other times of day, demand may be more price elastic
(that is, sensitive to price) because there is not the
same pressure on people to travel; they can always delay
their journey or not go at all. To raise revenue at these
times, the business may decrease price. The result is
that customers pay different prices for the same journey
at different times of day.
Price discrimination may occur when firms charge
different prices:
– at different times of day; for example, taxi fares may
be higher after midnight
– to different age groups; for example, lower fares on
the bus for children and pensioners
– to different customer groups; for example, discounts
for members.
» Dynamic pricing occurs when prices are changed at
different times to reflect demand conditions. Airlines
may change prices according to when you book, utility
companies may change rates according to demand
for their services during a day, theatres, cinemas and
sports stadia may change the ticket prices depending on
when you are looking. Dynamic pricing is much easier
with online ordering, where the business can track
in real time the availability of places or products and
measure levels of demand by the number of searches and
enquiries, and then adjust the price accordingly. For the
business, it means it does not have to estimate demand
in advance and set what it hopes is the right price – it
can adjust continually, increasing it if demand looks
high and reducing it if demand is low. This should allow
the business to control demand more effectively and
ensure, for example, that its planes, hotels and sports
arenas are full. The business should be able to maximise
revenue (increasing prices if demand is high to ration
the products available rather than turning people away)
and make full use of the capacity available. From a
customer’s perspective, it means be prepared to discover
you paid a very different price from the person in the
seat next to you!
» Cost-based pricing occurs when a business considers
the costs of an item and adds on an amount or a
percentage to ensure it makes a profit. A shop may
buy in a product at $10 and add on $2 to sell at $12.
The advantage of this approach is its simplicity and
it means the business is certain it makes a profit,
assuming the item sells. However, the disadvantage is
that it is ignoring demand. It may be that there is such
demand that this product could sell for $20 at that
moment.
» Psychological pricing takes account of the
psychological effect of a price on customers. For
example, a high price for consultancy work might
suggest that the person is an expert; if the price is
too low customers may worry about the consultant’s
competency. Other examples of psychological
pricing are:
– charging, say, $49.99 rather than $50. In the
customer’s mind, this makes the price ‘$40
something’ rather than ‘$50 something’ and therefore
more attractive.
– putting ‘was’ and ‘now’ or ‘sale’ to suggest this is
a bargain. For example, ‘was $20, now $15’ may be
more appealing than just stating ‘$15’.
Penetration
pricing
Psychological
pricing
Cost-based
pricing
Price
skimming
Pricing
strategies
Dynamic
pricing
Price
discrimination
Competitive
pricing
▲ Figure 3.27 Pricing strategies
GLOSSARY TERMS
Dynamic pricing occurs when different prices are changed
at different times to reflect demand conditions.
Cost-based pricing occurs when a business considers the
costs of an item and adds on an amount or a percentage to
ensure it makes a profit.
Psychological pricing takes account of the psychological
effect of a price on customers.
The promotional mix refers to the combination of
ways in which the business communicates about its
products.
STUDY TIP
You need to understand the many different factors that
can influence the price of a product and the different
pricing strategies and tactics used by businesses. You
need to be able to discuss the factors that determine the
right price in any situation.
By understanding these pricing methods, managers can
decide on the best price to set when launching a new
product. To make a business more effective, it needs
to select a price that makes customers feel they are
receiving excellent value for money. The price must be
reviewed and changed as market conditions and external
factors change.
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CASE STUDY
3.3
IKEA
space. It also avoids the assembly costs as consumers
do this for themselves
● stocks many of its products in a warehouse space.
Customers find their products and take them to the
tills themselves; this saves on staff costs.
IKEA is, therefore, committed to high-quality design at
low prices. To achieve this it:
● designs and manufactures the products itself
● manages its supply chain to be as efficient as possible
● locates its stores away from town centres to benefit
from low rents
● stores many of the products ‘flat-packed’ (that is, not
assembled) which enables it to store more in any given
Source: www.ikea.com/ms/en_JP/about_ikea/the_ikea_way/
our_business_idea/index.html
Questions
1
2
Analyse one reason why IKEA is able to keep its
prices low.
[4]
Evaluate the importance of price as a factor in the
success of IKEA.
[12]
3.3.5 Promotion methods
IKEA is a furniture and home-furnishings business. It
seeks ‘to create a better everyday life for people ... by
offering a wide range of well-designed, functional homefurnishing products at prices so low that as many people
as possible will be able to afford them.’
3.3.5 Promotion methods
In marketing, promotion refers to the ways in which
businesses communicate about their products.
A business will want to communicate the benefits of its
products to its customers. It has to let them know the
product exists, what it does and why they should buy it. In
this section, we examine the importance of the promotional
mix in marketing. This is the combination of activities used
to communicate about and promote the business and its
products. Managing the way that a business communicates
with its customers about its products is vital to its success.
Advertising
Sales promotion
Personal selling
Public relations
Merchandising
What is promotion and what are its
objectives?
The promotion of a product involves communicating about
it to existing or potential customers. The purposes of
promotion include:
» informing customers (for example, telling them about
modifications to the product, promotional offers or new
releases)
» persuading them (for example, highlighting your
product’s benefits compared with competitors’ products)
» reassuring buyers they did the right thing by buying the
product in the first place.
The objectives of promotion are likely to be:
» to increase sales of a business
» to increase the market share of a product
» to position the product relative to competitors in the
minds of customers.
The promotional mix
The promotional mix refers to the combination of ways in
which a business can communicate with its customers. The
choice of promotional mix influences the effectiveness of
the way in which the business is communicating; this, in
turn, influences the effectiveness of the firm’s marketing.
Direct mail
Branding
▲ Figure 3.28 The promotional mix
The elements of the promotional mix include the
following.
Advertising promotion
Advertising is a paid-for means of communication which
is part of the promotional mix. Advertising is often used
as a long-term strategy to build brand loyalty. There
are, of course, many different media available in terms
of advertising, such as newspapers, radio, television and
billboards. Increasingly, nowadays, there are also online
advertising media available.
Managers must determine the most appropriate media
to use. This depends on the resources available, the
target group and their lifestyles, the likely sales (which
influences how much can be spent) and the nature of the
product. Mass-market products such as cars may be able
to justify television advertising, for example, whereas a
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AS LEVEL 3.3 The marketing mix
3.3
local decorator may advertise in shop windows or a local
magazine. The difficulty with advertising is that many
consumers are bombarded by different adverts, and so
getting a message through to your target group that they
actually pay attention to can be difficult. With the growth
of digital television and radio, as well as the internet, the
volume of messages aimed at consumers is increasing all
the time and this can reduce the effectiveness of some
advertising. Advertisers therefore have to think carefully
about what messages to deliver, what media to use and
when to advertise.
Effective advertising will be measured by considering the
outcomes achieved (for example, more sales or greater
awareness of the product) in relation to the costs of the
campaign.
Sales promotions
Sales promotions are attempts to boost sales using
techniques such as promotional offers, competitions and
price cuts. Offers can include 10 per cent extra free and
‘buy one, get one free’ (called ‘BOGOF’). Sales promotions
may be used as a means of boosting sales in the short
term. When undertaking a promotional campaign, a firm
must consider:
» What will it cost?
» What will it do to the brand image?
» To what extent will the offer be effective? For example,
the type of offer you would give as a sportswear
company is different from a wine or perfume business
» What is the likely impact on sales?
Personal selling
often takes place through a sales force. If a product is
sold in low volumes, is technical and complex and needs
to be explained to customers, then a sales force is likely
to be an effective promotional method. The sales team
can be absolutely essential in some markets. For example,
manufacturers must work to achieve sales through the
retailers; the manufacturing companies’ sales teams compete
very aggressively to get their products displayed in the best
way to get their promotions highlighted in the stores.
Direct promotion
This promotion involves communications delivered directly
to the consumer without any intervening media. Examples
of direct promotion are house-to-house selling, such as
Avon or Tupperware sales, direct mailings and emailings,
and telemarketing (which is where a sales team telephone
customers). With increasingly sophisticated database
information, these can be carefully targeted – although this
is not always the case. Some direct promotion is associated
with ‘junk mail’, which means it is not very well targeted.
Businesses do need to be careful where they get their
mailing lists from and ensure they are not breaking any data
protection laws by accessing a list. Databases have to meet
data protection requirements (for example, customers must
have access to the information held on them) and be kept
up to date to be useful.
Direct promotion can be relatively cost-effective and
the response rate can be measured relatively easily. For
example, what proportion of visits or telephone calls lead
to action by the customer? What proportion of people who
receive an email respond to it?
Personal selling is based on face-to-face contact with
customers. This may be used by manufacturers to get
distributors to take their products, or in industrial markets
and the service sector, where the producer often deals
directly with the customer. Financial services such as
pensions, insurance and mortgages are often sold in this
way. Similarly, the sale of products such as photocopiers
STUDY TIP
Don’t confuse the promotional mix with the marketing
mix. Read the question carefully and make sure you are
focused on the right ‘mix’!
CASE STUDY
South Africa
According to the market research company Nielsen, South
African shoppers are obsessed with sales promotions.
According to a report by Nielsen, called The Price of
Promoting, 75 per cent of South African shoppers know
the prices of their regular grocery items and notice when
those prices change. This makes South Africa one of the
most price-sensitive countries in the world.
In South Africa, consumers face significant financial
constraints, especially with the rising price of petrol,
taxes and energy bills. This means that customers are
searching for special offers. The use of promotions
can attract customers in the short term but it can also
damage the value of a brand. In 2018, around 30 per cent
of the total sales of consumer goods that are bought
frequently were sold at a discounted price. There were
also more sales promotions. The danger for producers
is that consumers are becoming used to looking for
deals. This will reduce the profit margins of producers
and retailers, as 22 per cent of shoppers say that they
regularly switch stores according to where the best
promotions are (an increase from 16 per cent in 2017).
Question
1
Evaluate the importance of sales promotions as
part of the promotional mix in South Africa.
[12]
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CASE STUDY
Swatch
Questions
1
2
Define the term ‘segmentation’.
[2]
Evaluate the possible reasons why a firm such as
Swatch operates with different brand names.
[12]
The role of branding
In some markets, branding is very important. By building
a brand, businesses hope to make customers more loyal.
This may allow them to charge more for items, by making
the demand price inelastic. It may also make it easier to
introduce new products under the same brand name, as
customers may feel reassured and be more willing to try
them. If customers recognise a brand, they can associate
with all of its values and this in itself can provide a
benefit – people may feel more secure driving a Volvo than
other brands of car, more fashionable using an Apple Mac
than other computers, and smarter wearing Prada than other
fashion labels. Increasingly, some people want to identify
with a brand and the lifestyle that is associated with it.
Brand loyalty is very important because it is easier and
cheaper for a business to sell more to an existing customer
than it is to generate a new customer. However, a brand has
to be protected and managers have to be careful that it does
not become associated with the wrong things. For example,
in 2010, Toyota had to recall millions of cars due to a brake
problem which damaged the company’s reputation for quality.
At the same time, promotional campaigns will help build the
brand. The promotions will convey key messages about the
personality of the brand – is it fun? Quirky? Global? Young?
The design and messaging of advertisements, of digital
campaigns and all other forms of promotion can shape the
brand and customers’ attitudes towards it. Imagine you are
about to buy a laptop or tablet – will you look at Apple?
Microsoft? Lenovo? HP? Google Chrome? Without even
thinking about price or technical specifications, you will
have a reaction to each of those brand names; this reaction
could be due to past experience, but it will also be shaped
by the promotional campaigns of the business. At times,
promotional campaigns will specifically aim to change your
perception of a brand. Burberry, for example, was originally
positioned as quite an exclusive brand, but it then became
one very wide range of products, which some say damaged
its appeal; in recent years it has been trying to re-establish
this link with premium fashion design. Amazon has been
criticised for the terms and conditions of employees in its
warehouses, and it has responded to this by promoting
the work of those people working in the warehouses and
inviting people to visit. Promotion may, therefore, be used
to build, reposition or protect a brand.
3.3
3.3.5 Promotion methods
Swatch Group is an international group active in the
design, manufacture and sale of finished watches,
jewellery, watch movements and components. The
Swatch Group owns a number of watch brands. These
brands target different groups and have different price
points.
Brands may form an important part of a promotional
campaign. Businesses may promote the brand because it
brings with it all the associated values. When a new Apple
iPhone is promoted, we expect a super design, a fantastic
look to the product and some new technology, because
that’s what we associate with Apple. A well-established
brand brings with it immediately a collection of messages
that feed into any communication. A Tesla product will
be innovative, a Gucci product will be luxurious, and a
Volvo product will be safe. Promotional campaigns can use
the brand as a selling point in itself (think about strong
brands such as the University of Cambridge or Harvard
University) that immediately conveys something about the
product.
CASE STUDY
Sir Richard Branson and the Virgin brand
▲ Figure 3.29 Sir Richard Branson
Sir Richard Branson was born in 1950 and educated at
Stowe School, in the UK. He went into business aged 16,
publishing Student magazine. As a young entrepreneur,
it was clear he had a real flair for publicity. He originally
set up the Virgin brand as a mail-order record company,
then subsequently opened a physical store in Oxford
Street, London. In 1972, he founded the Virgin Records
music label and recorded what came to be a best-selling
record, Tubular Bells by Mike Oldfield, in 1973. In the
punk rock era, Virgin Records signed the Sex Pistols,
even though other record labels wouldn’t go near them.
This proved to be a marketing success. Over the years,
Virgin accumulated many other stars, including Genesis,
Peter Gabriel, Simple Minds and The Rolling Stones. This
gave Virgin a major international presence in the music
industry. Virgin has also diversified into air and rail travel,
mobile phones, finance, weddings, wines, retail, drinks,
hotels and gymnasiums. It now has around 200 companies
in over 30 countries, employing more than 25 000 people.
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AS LEVEL 3.3 The marketing mix
3.3
One of Sir Richard’s strengths has been his ability to get
free publicity for the business. He has had his picture
taken in a wedding dress, as well as with Pamela
Anderson, Diana, Princess of Wales, and Nelson Mandela.
In 1985, Sir Richard attempted to beat the record for the
fastest crossing of the Atlantic by boat, but his vessel hit
driftwood and sank only 100 miles (160 km) from home.
In 2004, he achieved the fastest crossing of the English
Channel by amphibious vehicle, marking the twentieth
anniversary of the Virgin Atlantic brand.
vehicles that are designed to give private individuals the
opportunity to see the Earth from space. It will operate
a regular schedule of space flights from the company’s
base at New Mexico’s Spaceport America, the world’s first
purpose-built commercial spaceport.
Questions
1
2
Explain one key feature of the Virgin brand.
Evaluate other products that you think the Virgin
brand could extend to.
[3]
[12]
Sir Richard’s latest venture is space travel. Virgin Galactic
is a commercial spaceline. It operates modern space
CASE STUDY
Biggest global brands
▼ Table 3.12 Biggest ten global brands
Ranking
Company
Change in brand value (%)
Brand value ($m) 2019
1
Apple
+9
234 241
2
Google
+8
167 713
3
Amazon
+242
125 263
4
Microsoft
+17
108 847
5
Coca-Cola
–4
63 365
6
Samsung
+2
61 098
7
Toyota
+5
56 246
8
Mercedes
+5
50 832
9
McDonald’s
+4
45 362
10
Disney
+11
44 352
Source: www.interbrand.com/best-brands/best-global-brands/2019/ranking/
Questions
1
2
Choose one of the brands in Table 3.12 and explain one element of its brand values (that is, what does
the brand stand for?).
Evaluate the benefits to a business of having a strong brand.
The role of packaging
Packaging may be needed to:
» protect the product; for example, while being
transported (think of an egg box!)
» preserve the product; for example, tinned food
» keep the product secure; for example, razor blades
are high-value items and are vulnerable to being
stolen from stores. The packaging of these products
is sometimes bigger than it needs to be to make them
visible in-store
» provide information to customers; for example,
information on the ingredients.
[3]
[12]
However, packaging can also play a role in the promotion
of the product. Packaging helps communicate about the
product. The packaging can:
» reinforce the positioning and branding. Think about
perfumes; the bottle itself and the box it is in often reflect
a premium product. The shape, the design and the colours
of the packaging will send messages about the product
» reinforce a promotional campaign; for example, if a
promotional offer is on where there is 10 per cent extra
free, this can be shown on the packaging.
At the same time, the promotional campaign can focus
on features such as new sizes, resealable containers, new
shapes of containers or new recyclable materials.
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CASE STUDY
L’Oréal
According to L’Oréal, the cosmetic business, packaging
is a ‘make or break’ factor in the beauty experience. It
has a huge influence on the commercial success of a
product, affecting the reviews of beauty bloggers and the
responses of their millions of followers.
A recent packaging development at L’Oréal is Lip Magnet.
L’Oréal’s packaging innovation team designed an
applicator capable of applying the right amount of product
on the lips with comfort, precision and creating the
sensation of a weightless film. The transparent bottle with
thick walls highlights the product shade.
1
2
Analyse one factor that might influence the packaging
[4]
of a cosmetic product.
Evaluate the importance of packaging in the marketing
mix of cosmetic products.
[12]
3.3.5 Promotion methods
Questions
3.3
Source: L’Oréal (UK) Limited
▲ Figure 3.30 L’Oréal packaging
Digital promotion
on what they are searching for or what they have been
looking at. Adverts can adjust depending on whether this
is a person’s first visit to a website or whether they have
been there before. If a business understands its customer
profile well and targets them effectively, and if it monitors
the actions taken by customers and adapts what it does
accordingly, then digital promotion can be very effective
and low-cost.
Businesses use social media such as Facebook, Twitter and
Instagram to develop their brand image and to communicate
with their target market. They also use paid-for online
advertising such as Google AdWords to target potential
customers, or they might pay social influencers such as
Kim Kardashian West to endorse their products – this will
enable a business to bring its product to the attention of all
the followers of the influencer. Businesses also encourage
customers to leave reviews online, as this can help to gain
customers’ confidence in the product.
However, businesses do need to monitor their spending
and make sure it is targeted. Paying for millions of clickthroughs by customers who like the online advert but have
no intention of buying the product can waste money. The
effectiveness of digital promotion is also limited to those
who are online; it will not reach those who are offline.
The fastest growing element of the promotional mix
in recent years has been digital promotion. Digital
promotion involves promoting a brand, product or
service on digital channels such as search engines, social
media, email and mobile apps. Many businesses in recent
years have reduced their spend on printed materials and
increased their digital spend.
Digital promotion can be very cost-effective. You can
target customers very carefully based on factors such as
their location, age and interests. A business can also track
exactly what actions customers take – for example, they can
measure the click-through rate (CTR) from an advert to a
website; they can also track exactly the movements of the
consumer coming to the firm’s website to measure whether
it leads to a sale. Adverts can be shown to users depending
GLOSSARY TERMS
Digital promotion involves promoting a brand, product or
service on digital channels such as search engines, social
media, email and mobile apps.
The click-through rate (CTR) measures the number
of visits to a website as a percentage of the number
of impressions of a digital advert. For example, a
CTR of 20 per cent means 20 per cent of the times an
advert is viewed, someone clicks on it to find out more
information.
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AS LEVEL 3.3 The marketing mix
3.3
CASE STUDY
Dwayne ‘The Rock’ Johnson
In 2020, Dwayne ‘The Rock’ Johnson was listed as the
highest-paid sponsor for an Instagram post. It was
claimed that Johnson charged over $1 million per post
last year. Previously, Kylie Jenner was listed as the
highest-paid. She has 182 million Instagram followers;
Johnson has 187 million. It was estimated that footballer
Cristiano Ronaldo was worth $889 000 per post, and Kim
Kardashian West could charge $858 000. The rankings of
social-media sponsors were produced by Hopper HQ and
were estimates, as the precise amounts paid are highly
protected.
According to Forbes, Johnson was the highest-paid
actor in the world, earning nearly $90 million in 2019
before tax. His films include Fast and Furious and
Jumanji. Johnson also has a partnership with the US
sports brand Under Armour and holds a stake in the
Norwegian bottled-water brand Voss.
Source: www.bbc.co.uk/news/business-53261043
Questions
1
2
Analyse one factor that influences the amount
someone can charge to sponsor a social-media post.
[4]
Evaluate the importance of social media in affecting
consumers’ buying decisions.
[12]
CASE STUDY
Facebook versus Twitter
▼ Table 3.13 Facebook versus Twitter – selected metrics
Facebook
Twitter
Market capitalisation ($bn)
3 June 2020
655.7
27.4
Revenues ($bn)
2019
70.7
3.5
Net profit ($bn)
2019
18.5
1.5
Employees (’000)
Q1 2020
48.3
4.9*
Daily active users (bn)
Q1 2020
1.7
0.2
* Q4 2019
Source: The Economist
Questions
1
2
Analyse one factor that might determine how much a social-media business can charge other businesses to
advertise on it.
Evaluate the importance of social media in the marketing mix of businesses.
[4]
[12]
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CASE STUDY
3.3
Digital marketing
● 54 per cent of consumers say fashion is the top category
where social media has influenced their purchases, while
45 per cent of consumers say the same for technology.
Questions
1
2
Analyse one possible objective of a social-media
campaign.
Evaluate the importance of social media for
businesses wanting to promote their products.
[4]
[12]
Each of the different methods of promotion has its own
advantages and disadvantages, as shown in Table 3.14.
For example, personal selling is obviously quite
labour-intensive, and therefore expensive, but the firm gets
immediate feedback from its customers.
3.3.5 Promotion methods
Recent market research shows:
● Only 17 per cent of consumers have been influenced
to buy a product or service following an endorsement
from an influencer or celebrity.
● On the other hand, 32 per cent of consumers are
influenced to buy a product or service following a
positive review on social media.
● 8 in 10 consumers have undertaken at least one or
more financial activities via a digital channel in the
past year.
▼ Table 3.14 A comparison of promotional methods
Method of promotion
Advantages
Disadvantages
Advertising
• Wide coverage
• Control of the message
• Can be used to build brand loyalty
• Can be expensive; for example, TV advertising
Direct promotion
• Relatively cheap
• May not get read
Sales promotions
• Can entertain and interest the consumer
• Often short-term effects
• Can encourage brand switching
Personal selling
• Two-way communication
• Can answer customer enquiries
• Can be expensive
• Can only reach a limited number of customers
Digital promotion
• Can be very targeted
• Can track actions taken online
• Can use influencers to attract new customers
• Need to target effectively
• Will not reach those who are not online
CASE STUDY
Red Bull
Red Bull is an ‘energy drink’ that originated in Thailand
and is sold to combat mental and physical fatigue. The
marketing of the product has been highly successful and
includes a number of unusual promotional methods.
For example:
● Selected students (students are a key market) are
given free cases of Red Bull if they throw a party;
others are given a car with a model Red Bull on the
top to drive around and be noticed by others. This
is known as ‘viral marketing’. It relies on a few key
trendsetters spreading the word about a product
and leading to others wanting to be associated
with it.
● Sales teams identify key bars and clubs and promote
heavily via merchandise, such as branded coolers
and point-of-purchase (or POP) displays.
● The company heavily invests in brand-building, including
promoting the slogan ‘Red Bull gives you wings’.
● Red Bull sponsors many extreme sports events
including cliff diving, BMX and skiing. Red Bull also
sponsors the Red Bull Flugtag (‘flight day’ in German),
a competition where entrants launch themselves off a
30-foot (9-metre) ramp in homemade ‘flying machines’
into a body of water.
● In recent years, mainstream advertising such as
television has also been used.
Questions
1
2
Analyse one reason why a business might choose
to sponsor an event.
[4]
Evaluate other types of events you think it would
make sense for Red Bull to sponsor. Explain your
[12]
selection.
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Choosing the right promotional mix
AS LEVEL 3.3 The marketing mix
3.3
Businesses use a combination of promotional methods to
communicate to potential customers about their products.
The composition of the promotional mix depends on
numerous factors:
» Nature of the product Consumer-durable products,
such as televisions and washing machines, are likely to
be advertised to the final customer. Firms usually use a
sales team to deal with wholesalers and retailers but use
advertising to get customers to demand the product in
the stores. By raising awareness of the brand, customers
will recognise it when they go to buy a product.
Similarly, companies producing shampoos and household
cleaners often advertise on television. By comparison,
sales of heavy construction equipment are usually made
direct to the customer and rely on the sales force. There
are relatively few customers in this case, the product is
expensive and sold in low volumes, and there are many
technical details that need to be explained. A sales force
is likely to be much more effective than, say, an advert
in a brochure.
» Marketing expenditure budget Inevitably, the budget
acts as a constraint on all firms’ promotional activities
because it limits the amount of money available to
spend in this area. Faced with a small marketing budget,
for example, a firm cannot even consider television
advertising and may have to rely on local newspaper
advertising instead.
» Available options Technological developments are
creating new possibilities, such as internet advertising
and text advertising. Legal changes also influence
what is possible; for instance, what products can be
advertised and how they can promote themselves. For
example, there are strong restrictions on the promotion
of alcohol and tobacco.
Improvements in the promotional mix may:
» reduce costs, as cheaper ways of communicating are
adopted
» boost sales, as better ways of communicating are used
to communicate more effectively and to more people.
STUDY TIP
You need to be able to understand the different
messages a business might be trying to communicate
to different groups, such as investors and consumers.
You also need to understand the different elements of
the promotional mix and how these will be changed for
different products and different situations. Think about
whether some methods are more appropriate than
others for specific products. Do not assume advertising
is always the answer – there are many other ways of
communicating that may be more effective for some
products.
GLOSSARY TERMS
The marketing expenditure budget is the amount of
money a business allocates to spend on marketing
activities such as promotion.
The distribution channel describes how the ownership of
a product moves from the producer to the customer.
To make its promotion more effective, a business might
alter the total amount spent on it or review the promotional
mix. As customers’ habits change, the mix might need to
be altered as well (for example, switching to more internet
advertising).
3.3.6 Place (channels of
distribution)
The distribution of a good or service refers to the way
in which the ownership of it passes from the producer to
the consumer. In some cases, the product goes directly
to the end customer from the producer (business-toconsumer marketing, see page 102). For example, Dell
Computers supplies some of its customers direct, without
intermediaries, as does Avon Products. Services such as
insurance, health care and education tend to be provided
directly to the end customers.
In other cases, producers use intermediaries. Most producers
of electrical goods, such as Sony and Phillips, have
intermediaries between the producer and the final seller.
These intermediaries include:
» retailers (such as Walmart), which are the final stage
in the distribution chain. Many goods are sold through
retailers rather than direct to the customer
» wholesalers. These buy products in bulk from producers
and sell them on to retailers, who then sell direct to
the final consumer. Retailers use wholesalers because
they offer a range of products and it is easier dealing
directly with them than with many different individual
manufacturers.
The different distribution channels can be described in
terms of the number of levels involved in the process (see
Figure 3.31).
Zero-level channel: no intermediaries
Producer
Consumer
One-level channel: one intermediary
Manufacturer
Retailer
Consumer
Two-level channel: two intermediaries
Manufacturer
Wholesaler
Retailer
Consumer
▲ Figure 3.31 Distribution channels
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» In a zero-level channel, the good or service passes
The distribution strategy will vary considerably from
product to product. In the case of milk, newspapers and
chewing gum, for example, the aim is usually to generate
as wide a distribution as possible. These types of goods are
called convenience items because consumers are not willing
to travel far to buy them – they need them to be easily
accessible. In order to get to as broad a market as possible,
several intermediaries may be used.
With products such as personal computers, vacuum cleaners,
microwaves, and so on, consumers usually want to compare
the features and prices of different brands. Manufacturers
of these products need to get them distributed to certain
stores where customers expect to go to find them. These
shopping goods do not need to be distributed to as many
outlets as convenience items, but the firm may have to
fight hard to get intermediaries to stock them. Although
with the growth of online shopping manufacturers do sell
directly to customers, many sales are still through retailers,
including online retailers such as Amazon.
More exclusive (or speciality) products such as Rolex,
Porsche, Bang & Olufsen and Bose have even fewer outlets,
but the nature of these outlets is very important. They
must reinforce the nature of the brand, and so a great deal
of time is spent ensuring they are well maintained and
suitably exclusive. In some cases, the manufacturer owns
the outlet to ensure it presents its products in a way that is
appropriate to the brand.
Products that are sold to other businesses (business-tobusiness marketing, see page 102) rather than the final
consumer are called industrial goods (rather than consumer
goods). These tend to be distributed directly. This might
include machinery, office equipment and specialised
computer software.
One growing trend in business is for products to be bought
directly from the producer. Distribution is increasingly
zero-level. Customers can access their products online and
buy direct from retailers or even direct from the producer.
Distribution at this point is then either direct to the
customer or via a pick-up point; if customers are using ‘click
and collect’, for example, they order the product online and
collect it later in-store.
The objectives of distribution
3.3
The management of distribution will focus on ensuring the
right products reach the right customers at the right time
and at the right cost. It will aim to ensure the distribution
process:
» gets the products where customers need them; for
example, in the right shops and outlets
» makes sure the products reach where they need to be in
good time and are undamaged
» provides good value for money.
3.3.6 Place (channels of distribution)
directly from producer to consumer without any
intermediaries. For example, dentists, accountants and
plumbers have zero-level channels.
» A one-level channel has one intermediary. For example,
a retailer buys the product from the manufacturer and
sells it to the consumer.
» A two-level channel has two intermediaries. For
example, a wholesaler buys the product from the
manufacturer and sells it on to retailers, who sell to the
final customers.
Choosing a distribution channel
The choice of distribution channel will depend on factors
such as:
» Access to markets If the target number of customers
is relatively small (for example, you are targeting
a few large companies), then it may be possible to
distribute directly. If, however, you have a mass-market
consumer product, it is not realistic to try to distribute
individually to all your customers – you will want to
use intermediaries to help get your products to the
market. Heinz could not distribute its baked beans to
every individual household in the UK; it has to sell via
wholesalers and retailers.
» The desired degree of control If a producer sells its
products to other intermediaries then it hands over
control of the way they are marketed. The new owner
can change the price, the way it is described relative to
its competitors and where it is displayed in the market.
Concern over the impact of such decisions on the brand
may mean that a producer decides to sell directly or only
via its own outlets.
» Costs It may be cheaper to sell a product direct to
the customer. If the product goes through various
intermediaries, all of whom add on their own profit
margin, the final price will probably be higher than if
the business sold direct to a customer.
Companies such as Amazon.com, Direct Line and
lastminute.com have turned the distribution of their
services into a major competitive weapon. By distributing
directly to the customer, they have cut their own costs
(enabling them to offer better value) and provide a more
convenient service for customers. You can now order your
weekly shopping, buy your books, check your bank account
and book your holiday from home. The internet allows many
firms (even very small firms) to deal directly with their
customers on a global basis.
Choosing the right distribution channel is an important (and
often under-estimated) part of the marketing mix. It can
have a big impact on the success of the business in terms of
factors such as:
» market coverage
» costs
» control over the way the product is promoted and
marketed in-store.
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Digital distribution
AS LEVEL 3.3 The marketing mix
3.3
One of the growth areas of business is digital distribution,
when customers access products directly online. When Netflix
began, it physically distributed films on CD to customers’
homes. The films were posted out and posted back. It now
produces content which is digitally distributed online. This
has transformed the entertainment industry.
Music is another example of an industry which has been
revolutionised by digital distribution. Many years ago, music
companies produced physical records and distributed these
physically to stores. Now, via providers such as Spotify,
customers can consume music digitally.
Other examples of digital distribution are e-books and
computer games. The Coronavirus (COVID-19) pandemic
in 2020 forced many businesses to increase their online
provision; this is speeding up digital distribution in sectors
such as education and health care.
Digital distribution is cheap and enables products to be
available to customers whenever they wish, wherever
they wish, through a variety of devices. However, digital
distribution will not be appropriate for markets where
customers want a physical product such as clothing.
CASE STUDY
E-commerce sales in Asia
In billion USD
90%
1462
83%
77%
1286
1188
74%
74%
North-east
South
1077
957
832
707
2017
2018
2019f
2020f
2021f
2022f
2023f
Note: f = forecast data
Bangkok
North
▲ Figure 3.33 Percentage of adults owning mobile
phones in Thailand
17%
35%
16%
11%
Central
21%
By segment (2018)
Fashion
Food and beverage, and
Home and personal care
Electronic and media
Furniture and appliances
E-commerce is a very fast-growing industry in Thailand.
According to the Ministry of Digital Economy and Society,
Thai e-commerce has grown the fastest of all economies
that are part of the Association of Southeast Asian Nations
(which is a group of countries that trade together) at 14–18
per cent a year.
With a national income of $602 billion, Thailand is
the second-largest economy and the second-largest
business-to-consumer e-commerce market in Southeast
Asia (Indonesia is the largest).
The e-commerce market in Thailand is worth $3.5
billion. This is expected to reach $13 billion by 2025,
given the higher level of demand for Thai products.
Demand is especially high for electronics, but behind
this there are high levels of interest in fashion, jewellery,
watches, health and beauty products, and car parts.
Toys, hobbies and DIY
▲ Figure 3.32 E-commerce sales in Asia
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One reason for the growth of e-commerce is the
high number of internet users. Nearly 60 per cent of
households have the internet in Thailand; this is one of the
highest rates in Southeast Asia.
In 2008 there were 16.1 million internet users; by 2018
this had increased to approximately 45 million. There are
also currently 124.8 million mobile subscribers, 44 million
LINE messenger users and 52 million Facebook users.
Getting the right distribution outlet
Of course, the nature of the distribution outlet itself can
have an impact on the buying experience. The layout of
the stores, the decor, the availability of staff and changing
rooms, and the in-store displays all leave an impression
and influence the customer’s view of a product. This is
particularly important for speciality items such as luxury
cars, jewellery or sophisticated technology. Visit a Mercedes
dealership, a Gucci outlet or an Apple store and you
immediately get a sense of the brand values.
If producers of such products are selling through stores
(theirs or anyone else’s), the store design and the way their
products are displayed is very important. IKEA, the Swedish
furniture retailer, is renowned for its highly effective store
design. Its stores are very large and are placed out of town.
This makes it cheaper for the company to offer a large
number of parking spaces. The stores are relatively easy
to get to for car drivers, which is important because the
items bought are often big and bulky. Once customers get
there, the stores are designed in such a way that customers
have to walk through all the displays to get to the tills –
you cannot ‘nip in’ and buy one thing. This may mean that
customers buy more than they had planned.
In supermarkets, all kinds of techniques are used to make
you buy more:
» The width of the aisles and the music being played
affects the speed that you walk around the store.
» You will usually be greeted by the fresh-fruit displays
when you walk in; this creates an impression in your
mind that all their products are fresh.
Unsurprisingly, Thailand is an appealing target for
foreign investment, due to its market size and growing
e-commerce potential. Already Chinese internet giants
like Alibaba and JD.com have invested there.
3.3
Source: www.thailand-business-news.com/tech/ecommerce/75276thailand-ecommerce-market-shooting-for-success.html
Questions
1
2
Analyse one reason why e-commerce is growing
fast in Thailand.
Evaluate the benefits of e-commerce to
producers.
[4]
[12]
» The aroma in the store is likely to be fresh bread (many
now have bakeries on-site, but even if they do not, they
can create the smell of fresh bread); this tends to create
positive, warm feelings within us.
» You will usually enter on the left-hand side of a store
because we tend to like walking in and turning right.
» The basic items such as bread and milk will usually be
at the back of the store, so that you have to pass many
other items to find them and hopefully buy other things
along the way.
» Key items on promotion will be placed in display bins at
the end of aisles so you see them when you turn, or by
the tills; these are to prompt impulse-buying.
» Complementary items such as soft drinks and crisps will
usually be placed near each other, as buying one may
prompt buying the other.
3.3.6 Place (channels of distribution)
In Thailand, 52 per cent of online transactions are made
on mobile devices, making the country a regional leader
in mobile commerce. (Thailand is second only to South
Korea, at 58 per cent.) The Thailand Marketing Research
Society reported that 71 per cent of smartphone users
engage in online shopping twice a month, and 90 per cent
plan to shop online in the future.
Store designers have become very aware of the effects that
the decor and layout can have on customers, and they have
therefore become much more sophisticated in their designs.
The physical environment is an element of the marketing
mix, because it can have an important effect on where we
choose to shop and how we behave as shoppers while we are
there.
GLOSSARY TERM
The distribution outlet is where the product is actually
sold; for example, the shop.
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AS LEVEL 3.3 The marketing mix
3.3
CASE STUDY
Hotel Chocolat
When Angus Thirlwell and Peter Harris opened the very
first Hotel Chocolat shop in north London in 2004, ‘it
was the start of a revolution in British chocolate’. The
two entrepreneurs were determined ‘to make chocolate
exciting again’. Hotel Chocolat now has 103 shops
along with cafés and restaurants, three boutiques in
Copenhagen and a hotel on its cocoa plantation in the
Caribbean.
Thirlwell and Harris started an online chocolate business,
investing £5000 each, but found greater success with
a conventional high-street presence. The stores were
carefully designed to reflect the premium chocolate sold
there. The company chose dark-walnut wood interiors and
porcelain tiles. It used long counters like a hotel reception
desk, and made the stores spacious so that people could
wander around, like in a hotel lobby. Whereas fast delivery
was the sales pitch of the internet website, quality was the
selling point of the stores.
The company prides itself on doing things differently.
It says that right from the beginning it ignored what it
was told. When it began and was told to make the shells of
its Easter eggs as thin as possible, it did the opposite and
made them incredibly thick! When it was told it must make
chocolate bars with bite-sized pieces, it decided on giant
slabs!
The company is unusual in that it grows its own cocoa.
This is grown on its Rabot Estate plantation in Saint
Lucia. Unlike most chocolate, Hotel Chocolat focuses on
more cocoa and less sugar. Often, 40–50 per cent of its
ingredients are cocoa; much more than is typical in the
industry.
▲ Figure 3.34
Questions
1
2
Source: https://us.hotelchocolat.com/our-story
Analyse one factor that Hotel Chocolat might take
into account when deciding a location for a
new store.
[4]
Evaluate the possible reasons why Hotel Chocolat
was more successful when it opened stores than
when it was just operating online.
[12]
CASE STUDY
L’Oréal and distribution
L’Oréal produces beauty products, hair products and fragrances. It uses seven distribution channels, shown in
Figure 3.35.
7 distribution
channels
Pharmacies and
medispas
Hair salons
Branded retail
Mass retail
Travel retail
Department
stores and
perfumeries
E-commerce
▲ Figure 3.35 L’Oréal distribution channels
Questions
1
2
Analyse one factor L’Oréal will consider when choosing a distribution channel.
Evaluate the advantages and disadvantages of the different channels of distribution used by L’Oréal.
[4]
[12]
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STUDY TIP
You need to think about the factors that influence a
company’s choice of distribution channel and its outlets,
and the effect this has on its costs and the quality of
service it provides.
The internet and marketing
The growth of the internet is an important external change
which has, of course, had a big impact on marketing
activities. For example, businesses can now:
» trade globally 24 hours a day, seven days a week,
relatively easily
» use very targeted marketing; for example, using Google
AdWords so that your advert only shows when some key
words are used
» monitor consumer behaviour very accurately; for
example, tracking how visitors to the website move
around the site
» charge different prices depending on where people are
searching from and when they search. This is known
as dynamic pricing (see page 126) and is used a lot by
airlines and hotels. The price you are offered depends on
when you enquire and what the demand is at that stage;
if there are still lots of vacancies, the prices tend to be
lower
» use direct distribution from the producer to the consumer
without the need for wholesalers and retailers. It also
enables electronic distribution (for example, of music
and books) without a physical product being distributed
(for example, to e-readers and MP3 players).
The impact of the internet on market research and the
marketing mix includes:
» Data The internet allows businesses to gather and
analyse data on consumers far more than was ever
possible in the past. For example, if you go on the
website of a business, it can track what you look
at, for how long and what action you then take. It
can monitor whether this is the first time you have
visited and how you reached the site – for example,
was it through a direct search or via an online advert?
Was it through your laptop or your mobile phone?
This all provides extraordinary amounts of data on
3.3
3.3.6 Place (channels of distribution)
A business may improve its effectiveness by reviewing its
distribution, as this may influence its market coverage, the
level of service provided and its costs. Many people underestimate the importance of distribution, but it is often
vital to the success of a product. You will only sell chewing
gum or newspapers if they are widely distributed and well
displayed, for example.
consumers that, with advances in technology, can be
processed quickly and cheaply, allowing very targeted
marketing actions. When developing a promotional
campaign online, a business can set criteria which
again allow very focused marketing. Google adverts,
for example, can run in a given region for selected
search terms. Facebook ads can target people in a
particular age range with particular interests, hobbies
or lifestyles. Collecting the right data, analysing and
using it effectively can enable very focused marketing.
» Price The internet allows prices to be changed according
to when people order (for example, how far in advance
of an event), what time of day they order, whether they
have visited the site before, whether they have bought
from you before. The ability to adjust the price based
on many factors so that there is no ‘one’ price is known
as dynamic pricing. Businesses such as airlines and
online retailers such as Amazon use dynamic pricing very
effectively.
» Promotion Businesses can promote their products online
and target who their adverts reach depending on, for
example, where you are searching from and which terms
you are using to search. Businesses can get others to
help promote their products through viral marketing,
where their own campaign is forwarded via social media
(such as Twitter and Facebook) by individuals to their
friends. Methods of promotion such as blogs and Twitter
are cheap ways of communicating.
» Distribution Businesses can now sell direct to
the customer online rather than selling through
intermediaries. By selling directly through e-commerce,
a business may need fewer physical stores. This is known
as ‘clicks rather than bricks’.
» Product Some products can now be downloaded rather
than having to be physically produced; for example,
music and e-books.
» People Interestingly, people are not necessarily removed
from marketing due to the internet. In fact, many
businesses now promote in their websites the ability to
talk to a customer service representative at any time.
The internet can interest you in an item and the sales
representative can help you with enquiries or to make
your choice.
» Process The internet can make the buying process more
convenient in that you can search more widely than in a
main shopping street.
» Physical evidence The design of a store may be less
significant with the internet, but the design of the
website becomes the key. The appearance, the ease of
finding information and navigating the site affect the
customer experience.
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3.3
CASE STUDY
E-books
AS LEVEL 3.3 The marketing mix
Book publishers generated almost $26 billion in revenue
in 2019 in the USA. Of this, total print sales were $22.6
billion and e-books took $2.04 billion, according to the
Association of American Publishers’ annual report (2019).
Those figures include fiction, trade and educational books.
Questions
1
2
Despite the disruption of digital media in other industries
(such as news publishing and music distribution), it seems
that people still favour printed books. In part, it is the
physical object. Cover designs, for example, can make a
book appealing and something people want to own and
have in their homes. Physical books act as a reminder of
what you have read, they show others what you have read
and they decorate your home.
Analyse one factor that might affect sales of
e-books.
Evaluate the threat that e-books pose for printed
books.
[4]
[12]
Popular print genres include nature, cookery and
children’s books while crime, romantic and thriller
readers prefer to engage with novels via e-readers, says
Nielsen Book International.
In the UK, 63 per cent of physical book purchases are
made by people aged under 44, while 52 per cent of
e-books are purchased by those over 45, according to
Nielsen.
▲ Figure 3.36
TEST YOUR LEARNING
Short answer questions
1
2
3
4
5
Define the term ‘marketing mix’.
[2]
a Define the term ‘product life cycle’.
[2]
b Explain one way in which the marketing mix
might change at different stages of the product
life cycle.
[3]
a Define the term ‘extension strategy’.
[2]
b Explain one extension strategy with an example.[3]
a Define the term ‘price penetration’.
[2]
b Explain one condition necessary for price
penetration to be effective.
[3]
a Define the term ‘price skimming’.
[2]
b Explain one condition in the market for price
skimming to be effective.
[3]
6
a
b
7
a
b
8
a
b
9
a
b
10 a
b
Define the term ‘price discrimination’.
[2]
Explain one benefit of price discrimination to a
business.
[3]
Define the term ‘brand’.
[2]
Explain one way in which developments in digital
promotion help businesses.
[3]
Explain one possible objective of promotions. [3]
Explain one way sales promotions can benefit a
business.
[3]
Define the term ‘distribution outlet’.
[2]
Explain one benefit to a producer of a short
channel of distribution.
[3]
Define the term ‘USP’.
[2]
Explain one benefit to a business of having
a USP.
[3]
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Data response question
Harry Potter
Harry Potter is a character who features in a series of
seven children’s books by JK Rowling. The story is mostly
set at Hogwarts School of Witchcraft and Wizardry, and
focuses on Harry Potter’s fight against the evil wizard
Lord Voldemort, who killed Harry’s parents as part of his
plan to take over the wizarding world.
Altogether, the books have sold well over 500 million
copies, have been translated into more than 63 languages
and reach readers via a variety of distribution channels.
The success of the novels has made the author the
highest-earning novelist in literary history.
Although the author did not have any age group in mind
when she wrote the books, the publisher initially focused
on the market segment of young children, aged 9–11.
Rowling, whose first name is Joanne, was asked to use
her initials rather than her first name because it was
thought that young boys would not be interested in reading
a book written by a woman.
Word-of-mouth reviews, especially among young males,
have been an important part of the books’ success.
Rowling’s publishers were able to build on this buzz by the
rapid, successive releases of the first four books, which
maintained interest in the brand.
The launch of a new Harry Potter book was a great event, with
long queues forming outside bookshops and some stores
One of the most remarkable aspects of Harry Potter’s
success is its appeal to adults, apparently reminded of
classics of their own childhoods. Bloomsbury quickly
acknowledged the purchasing power of these ‘kidults’ by
issuing the Potter series as ‘adult hardbacks’, with covers
redesigned using photographs rather than drawings.
Following the original seven books and eight film
adaptations, there are now four Wizarding World of Harry
Potter theme parks (two in Florida, one in Hollywood and
one in Osaka in Japan). The Warner Bros Studio Tour, The
Making of Harry Potter, has had more than 8 million visitors
since it opened outside London in March 2012. Rowling,
who began writing the books as a single mother living on
government benefits, has become hugely wealthy. In 2020,
her fortune was valued at £650 million.
Harry Potter even has its own spin-off prequel series, the
five-star film Fantastic Beasts and Where to Find Them.
3.3
3.3.6 Place (channels of distribution)
The first novel, Harry Potter and the Philosopher’s Stone, was
published in 1997. Since its launch, the books have gained
immense popularity and commercial success worldwide,
also leading to films, video games and various merchandise –
from ‘Quidditch’ chess sets to ‘HufflePuff’ wall hangings,
‘Goblet of Fire’ candle holders to ‘Hedwig’ pillowcases.
opening at midnight to sell the first copies. Fan-generated
content, helped by the growth of the internet, has been an
important part of the Harry Potter success story.
Fan sites such as www.the-leaky-cauldron.org and
www.mugglenet.com help promote products and
merchandise.
Questions
1
2
3
Define the meaning of the following terms:
[2]
a ‘market segment’
b ‘distribution channel’.
[2]
Analyse one way in which the marketing mix has been
[4]
used to maintain sales of Harry Potter products.
If no more Harry Potter books are written, evaluate
the extent to which this means that sales of Harry
[12]
Potter must inevitably decline.
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4 Operations management
AS LEVEL
AS LEVEL 4.1 The nature of operations
4.1
The nature of operations
Chapter overview
In this chapter we examine:
★ the factors of production: land, labour, capital and enterprise
★ inputs, outputs and the transformational process
★ how operations adds value
★ the meaning of effectiveness, efficiency, productivity and sustainability
★ capital-intensive and labour-intensive operations
★ the advantages and disadvantages of different operations methods: job, batch, flow and mass customisation.
4.1.1 The transformational
process
The process of transforming inputs into outputs is the
responsibility of operations managers. They are there to
make sure that the process occurs in the way that the
business wants and that particular operations targets are
met. For example, operations managers may be concerned
with achieving a particular level of quality and ensuring
that costs are not too high.
The effectiveness of a business depends a great deal on the
quality and cost of the operations process. If managers can
improve the operations of the business, they can make it
more efficient, increase the volume of output and improve
quality. The marketing function identifies the opportunities
within a market; the operations function then delivers
this as effectively and efficiently as possible. Effective
operations means the business is doing the right thing –
that is, it is meeting its operational targets. The business
produces these products in the right quantities and with
the right specifications. Efficient operations means the
business is doing what it does at a low cost – that is, it is
producing and delivering its products in a cost-efficient
manner. Effective operations should lead to more sales
and profits. Poor operations leads to mistakes being made,
which can result in having to replace items, recall products
or even pay damages.
Operations involves producing physical goods such as cars,
but also providing services, such as schools and hospitals,
which are intangible. These create particular issues: with
physical products, managers will consider how much
inventory (or stock) to hold whereas with services, it is not
possible to hold inventory and so managers have to deal
with queues if demand is high.
The precise nature of operations will, therefore, vary
from business to business. If you are running a hotel,
for example, operations management involves making
sure the rooms are ready, the kitchens meet health and
safety requirements, the televisions, kettles and trouser
presses in the rooms work, the towels are washed and dried
and there is enough food to feed the guests. If you are
running a tyre and exhaust centre, operations management
involves making sure you have enough spare parts (held as
inventory) so that you can fix a customer’s car quickly and
safely, the equipment you have is suitable and working,
and you can generate the bill accurately. If you are running
a clothes shop, it involves making sure you have the right
number and mix of clothes on display, the store layout is
appropriate, the queues are not too long and there is a
security system to prevent theft.
GLOSSARY TERMS
The output of a business is the total amount produced in a
given time period.
Inventory refers to the stocks held in a business, such as
materials and semi-finished goods.
Operations management oversees the planning, coordination and control of the transformation process,
turning resources (inputs) into outputs.
There are many different forms of transformation. These
include:
» changing the characteristics of materials, information or
customers. For example, manufacturers take components
and build something new with them. Beauty salons,
hairdressers and cosmetic surgeons take people and
improve their appearance (we hope!). Doctors, dentists,
physiotherapists, psychiatrists and teachers all help us
to improve some aspect of ourselves. Accountants take
our receipts and turn them into a set of accounts to
show investors or government tax inspectors.
» changing the location of materials and information.
Federal Express and Cathay Pacific simply move items
or people around. Google helps you find something that
is already there – it helps you to access information.
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An estate agent gives you information on houses that
you might be interested in. This service saves time
and money for the seller and helps the buyer sell the
property more quickly.
» changing the ownership of materials. Wholesalers buy
in bulk from a number of producers. Retailers then buy
from wholesalers because it is easier to deal with them
than with every single producer: it reduces the number
of transactions and makes the process simpler.
The transformation process of a business is ongoing and
dynamic. If the output produced is not acceptable or needs
to be improved, the business will have to change the inputs
and/or the way it produces. It will then monitor the results
and, if necessary, change again. Change may also be due to
external factors; for example, increasing concern about the
environment has influenced what is produced and how.
Using factors of production
Operations will involve the management of its factors of
production, such as:
» Land This will include location decisions and finding
the right base for a business, while considering issues
such as the cost and ease of access to supplies. In
some operations processes, such as farming, managing
the land is a key part of the transformation process.
On the other hand, choosing the right site is essential
to a retail operation. Being close to transport links is
essential to exporters.
» Labour This refers to the number and the skills of people
you employ; for example, in sectors such as sport, music
and computer programming, the skills of employees are
absolutely critical.
and machinery. These are vitally important in sectors
such as online businesses, where the technology is at
the centre of the business, or car production, where
production-line technology determines output, quality
and flexibility.
» Enterprise This refers to the ability of employees to
come up with new ideas, to find solutions to problems
and be creative. This determines what other resources
are used and what the business offers. Enterprise is
very important in sectors such as advertising and
consultancy.
Operations managers must decide on the right combination
of resources for the transformation process given the
desired targets and constraints, such as budgets. This will
depend on factors such as the nature of the process, as well
as the cost and availability of different resources.
The stages of the transformation
process
The operations process involves all the different stages,
including:
» producing the initial idea (for example, in a research
laboratory) to developing prototypes and testing these
to check the product works and is safe to launch
» designing the best method of production to be efficient
and to hit volume and quality targets
» deciding on the levels of inventory which should be held
to keep production going and just in case anything goes
wrong
» ensuring production goes according to plan
» delivering to the next stage in the process, such as a
retailer
» if necessary, handling the recall of products if there are
faults.
4.1
4.1.1 The transformational process
When designing its transformation process, a business must
consider questions such as:
» What level of output will be provided? Is the business
aiming to produce hundreds, thousands or millions of
units? How many customers does the business expect
to have?
» What quality of service will be provided? How many
people will be served in the shop? Will the business
deliver its products to people’s homes? What will its
policy be if people want to return items?
» How will the business provide the service? Will it provide
it online or via shops? Will it use high staffing levels or
invest in more equipment?
» What aspects of the process will the business undertake
for itself and what elements will be outsourced to
or bought in from other providers? The business may
decide to manage the shop itself but get cleaners in
to tidy up, employ accountants to do the finances and
use specialists to design the decor. It may produce a
range of clothes but simply do the design work itself
and get someone else to produce them, like Benetton;
alternatively, it may design and manufacture the
products itself, like Zara and IKEA. All these decisions
will have an impact on the costs, flexibility and the
complexity of running the business.
» Capital This refers to capital goods such as equipment
STUDY TIP
Remember that operations management can affect the
volume of production, the costs and the quality of the
product. Operational decisions will be linked to the other
functions; for example, to sales, the overall finances of
the business, and the skills and number of employees
required.
Operations management involves all the stages of the
transformation process and therefore is directly involved
in the process of adding value. The more efficient the
operations process, for example, the fewer resources are
used up for the output produced and so more value can be
added. Similarly, the better quality the product and the
more effectively that it meets customer needs, the more
likely sales are to increase and the more the customer
may be willing to pay for the product, which increases the
value added.
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AS LEVEL 4.1 The nature of operations
4.1
Marketing is responsible for identifying the needs of
customers; this department must work with operations to
find the best way of fulfilling these needs while at the
same time meeting the business objectives. For example,
marketing will identify the key benefits customers want
and the prices they are willing to pay; operations must then
see if it can meet these targets at an appropriate cost. If
operations can deliver the right combination of products at
the right time and quality, and do this efficiently, it will be
adding value to the business. Effective operations provides
something customers want and are able to pay for at a cost
that is profitable for the business.
The operations of a business will, therefore, affect the value
added because it will affect factors such as:
» the amount of resources used and how they are used,
affecting cost of production. The more efficient the
operations are, the less waste there is and the lower the
cost per unit should be.
» the quality of production and factors such as speed of
delivery, which will affect how much customers will pay
and how many sales are made.
CASE STUDY
Mondelēz International
Mondelēz International is a snacks business that sells its
products all over the world. Its product portfolio includes
chocolate, biscuits, gum and candy. These include worldfamous brands worth billions of dollars such as Cadbury,
Oreo, belVita, Milka and Trident.
Part of the success of the business is due to the
effectiveness and efficiency of its operations. According
to the company, the manufacturing process at Mondelēz
International includes:
l safety and environmental measures. These measures
are to ensure that the business meets global, national
and local safety, security and environmental standards
and regulations
l planning and scheduling production, and ensuring that
the correct supplies of raw materials and packaging
materials, labour and finished goods to meet
production and meet customer demands are in place
l developing new production methods and processes
l ensuring the quality of products
l acquiring, installing and maintaining capital
equipment and ensuring this remains functional.
Operations jobs include production operators, who are
in charge of the production lines, and plant managers,
who have overall responsibility for their area and who are
constantly seeking to improve the production process.
Questions
1
2
Explain one way that operations management
can add value for Mondelēz International.
Evaluate the importance of effective operations
management to Mondelēz International.
[3]
[12]
4.1.2 Efficiency, effectiveness,
productivity and sustainability
The importance of productivity in
operations
The importance of efficiency and
effectiveness in operations
One measure of efficiency is productivity. This measures
the output produced given the inputs used up. Productivity
is very important to businesses because managers will want
to get the most from the resources that they have. Greater
productivity increases efficiency because:
» the more output produced from a given input, the lower
the unit cost
» the less input needed for a given level of output, the
lower the unit cost.
The operations manager will want the operations process
to be both effective and efficient. An operations process is
effective if it achieves its set target; for example, it
produces the target of 200 units a day. The process is
efficient if it does not waste resources and if it minimises
costs given the quantity and quality required.
A production process may be effective but inefficient if it
is producing the target but at a high cost. Equally, it may
be efficient at what it does but ineffective if it is producing
the wrong thing or the wrong quantity.
STUDY TIP
Effectiveness focuses on what you do.
Efficiency focuses on how you do it.
That is, greater productivity leads to higher efficiency.
Labour productivity specifically measures the output per
worker. The equation to calculate this is:
labour productivity =
total output
number of employees
Labour productivity measures the output of a business in
relation to the number of employees. For example, if 10
people produce 50 units in total each week, their productivity
is 5 units each. The higher the labour productivity, the more
is produced per person per time period.
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Productivity is a crucial concept in operations management
because it can have a significant effect on the cost of
producing a unit. The higher the productivity, the more
units each worker is making and, if wages are unchanged,
the labour cost per unit will be cheaper. As a result,
managers are constantly seeking ways of improving labour
productivity because this means the firm can either make
more profit per unit, can reduce the price to become
more competitive or can produce more. Improving the
effectiveness of the business may therefore be directly
related to improving the productivity of its resources.
Imagine a juice drinks business where employees are
squeezing the fruit by hand; if they bought a juicer,
productivity would increase so that more customers could
be served or fewer staff might be required.
4.1
GLOSSARY TERM
Productivity measures the output per hour, per person or
per machine.
4.1.2 Efficiency, effectiveness, productivity and sustainability
HANDLING DATA
Copy and complete Table 4.1. Assume that employees are paid $200 each per week.
▼ Table 4.1 Calculating labour productivity
Number of
employees
Weekly wage
bill ($)
Output
(number of units)
Productivity
(output/number
of workers)
100
$20 000
1 000
10
$20
100
?
2 000
?
?
Labour cost per unit
(weekly wage
bill/number of units)
50
?
1 000
?
?
?
?
2 000
40
?
How can productivity be increased?
Investment in
equipment
and
technology
Changing the
way the
work is done
Increasing
the number
of hours
worked
Ways to
increase
productivity
Training
Motivating
employees
▲ Figure 4.1 Ways to increase labour productivity
Labour productivity may be increased by using a variety of
techniques.
» Increasing the number of hours worked If employees
work more hours or more days each week, this could
increase their output. However, this is not necessarily a
long-term means of increasing employees’ productivity
because they are likely to get tired and stressed, and may
therefore become less productive in the long term. Also,
there is a limit to how many extra hours can be worked.
» Training This is a very important way of increasing
productivity. Training can increase employees’ output by
helping them to gain more skills and to learn new and
better ways of doing things.
» Investment in equipment and technology If employees
have modern and more efficient machinery, they should
be able to make more output than colleagues who are
using outdated equipment. As the UK’s Department
of Business and Skills says when commenting on the
low productivity in the UK compared with many other
countries: ‘A worker can be 100 per cent efficient with a
shovel but it won’t count if his international counterpart
is equipped with a JCB!’
» Changing the way that work is done If the way in
which a product is made is changed, this can affect
the speed and the effectiveness of the production
process. Many firms have implemented teamworking
in recent years, resulting in improved productivity
levels. If activities in the process can be combined and
undertaken simultaneously rather than in sequence,
this speeds up production and enables higher
productivity.
» Motivating employees If employees can be motivated
(perhaps by offering more rewards or by giving people
more responsibility – see Chapter 2.2) effort and
productivity may increase.
At any moment, managers will have to consider which of
the above options are available given the firm’s resources,
and which will work best when it comes to boosting
productivity. In one business the issue might be motivation;
in another it might be a lack of modern equipment. If
managers can boost productivity, they will be improving the
performance of the business.
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AS LEVEL 4.1 The nature of operations
4.1
CASE STUDY
Finance Against Warehouse Receipts
so the returns the farmers gain are low. To help improve
the situation, the Standard Chartered Bank has helped
develop various financing schemes to enable farmers to
get the finance they need. One of these is called Finance
Against Warehouse Receipts. Under this scheme, farmers
use their crops as collateral; the corn, soya or wheat act
as the security for the loan.
▲ Figure 4.2 Nyiombo Investments Ltd is now able to
meet more than 60 per cent of Zambia’s fertiliser
demand.
It is often very difficult for farmers in Africa to get loans in
order to buy essential materials such as seeds, fertilisers
and pesticides. This is because they lack assets to act as
collateral and so many banks are not willing to take the
risk. Without these resources, farming is inefficient and
For example, through this scheme, Standard Chartered
has been able to finance farmers’ borrowing to buy
fertilisers. The use of these fertilisers has boosted
average crop yields to over a tonne per hectare – a
significant increase in productivity. The programme has
been so effective that it has helped the country move
from importing maize to producing bumper harvests and
becoming an exporter.
Questions
1
2
Explain one way you could measure the productivity
of a farm.
[3]
Evaluate the ways in which farmers might improve
the productivity of their farms.
[12]
CASE STUDY
Assembly lines
The Model T Ford was produced between 1908 and 1927.
During that time, Henry Ford introduced assembly line
techniques which dramatically increased productivity.
Each car moved along a line with parts being added to it;
individual workers specialised in a particular aspect of
production. As a result, producing a car took 93 minutes
instead of 12 hours and this brought down unit costs so
much that the price could fall from $890 to $240. The
ability to produce a reliable car at a relatively low price
made this a tremendous success; so much so that, at its
peak, the Model T accounted for 50 per cent of all cars in
the USA and 10 per cent of all the cars in the world.
Questions
1
▲ Figure 4.3 One of the first assembly lines was for the
Model T.
2
Analyse one reason why unit costs usually decrease
when productivity increases.
[4]
Evaluate the possible implications of introducing
assembly line techniques.
[12]
Employee resistance to higher
productivity
» they do not want to work longer or harder
» they do not want to learn new skills
» they fear that higher productivity levels may lead to job
While managers might be eager to increase productivity,
employees may resist such efforts, because:
» they feel it is unfair that they are producing more unless
losses
they receive higher rewards.
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STUDY TIP
Remember that employees may not welcome efforts to
increase productivity. Also, increasing productivity may
lead to a fall in quality if production is rushed.
The importance of sustainability in
operations
Sustainable operations are operations that meet the
present needs of the business and, indeed, society without
compromising on the ability to meet future needs – they do
not use up resources that could be used in the future. For
example, if energy is sourced from non-renewable sources, such
as coal-fired generators, this is a non-sustainable source – the
coal is being used up. If, however, the energy a business uses
comes from wind power, the wind cannot be used up (it is
renewable). Sustainability also involves considering the impact
of the operations of a business on the environment – does it
pollute? Does it create emissions? Does it generate waste?
Customers and society as a whole are much more aware
of climate change issues and of the relationship between
businesses and the environment. This awareness is because
we have more information on the damage that has been
done to the environment and there is a greater appreciation
that the need for change is becoming urgent. Becoming
more sustainable therefore involves:
» using more resources that are not used up by consuming
them, such as recycled materials
» using fewer resources generally
» recycling and reusing resources more
» reducing the negative impact of a business’ activities on
the environment.
Being sustainable will:
» involve change. This will need planning and will involve
training and getting employees to understand the need
for change
» involve costs for new equipment.
However, the benefits are:
» These actions are good for the environment and
therefore good for society as a whole.
» These actions may attract customers, employees and
investors who are looking for businesses who behave in
this way.
» These actions may avoid negative comment in the media.
» These actions may be necessary by law or may be in
advance of future mandatory changes so the firm does
not have to be reactive.
4.1
4.1.2 Efficiency, effectiveness, productivity and sustainability
Customers are increasingly interested not only in what a
business produces but also how it produces it. For example,
customers may want to know where supplies come from and
how employees are treated. They may also want to know
how sustainable the operations process is.
The implications for a business of the greater interest in
sustainability are:
» the need to reconsider what is produced. For example, in
the car industry there has been a very significant increase
in the demand for electric vehicles in recent years rather
than diesel or petrol; this is because electric vehicles
are less harmful to the environment. National and local
governments in many countries are introducing legislation
to force the switch to electric vehicles
» the need to reconsider how products are produced. For
example, can renewable sources of energy be used? Can
waste be reduced and can fewer resources be used in the
process?
» the need to reconsider the packaging used. A great
deal of packaging in the past has been non-recyclable.
Plastic packaging has come under particular attack
because of the levels of plastic found in the sea and the
impact of this on sealife.
GLOSSARY TERM
Sustainable activities are those that meet the needs of the
business or of society without compromising on the ability
to meet future needs.
CASE STUDY
Coca-Cola
Coca-Cola, the world-famous drinks company, says that
its purpose is clear: to ‘refresh the world’ and ‘make a
difference’. It says it does this by creating loved brands
and ensuring these are produced sustainably. The
company says it aims to make a difference in people’s
lives, communities and the planet as a whole by doing
business in the right way.
In 2018, Coca-Cola launched its approach to sustainability,
called World Without Waste, with what it said was a
simple, focused purpose: to make the world’s packaging
waste problem a thing of the past. World Without Waste
has three fundamental goals:
l to make 100 per cent of its packaging recyclable,
globally, by 2025
l to use at least 50 per cent recycled material in its
packaging by 2030
l to collect and recycle a bottle or can for each one that
it sells by 2030.
Coca-Cola is aiming to make packaging part of a circular
economy, with a focus on the collection of 100 per cent of
its products and an increase in the recycling it does. Its
goal is to create what is called a ‘closed-loop system’ in
which old bottles and cans can become new bottles and
cans.
Questions
1
2
Define the term ‘sustainable operations’.
Evaluate the importance of sustainability to the
success of Coca-Cola.
[2]
[12]
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4.1
How often do you include sustainable packaging in your
How
often do you include sustainable
purchasing decision? Global top 10 countries in 2019 (%)
packaging in your purchasing decision?
Always
Usually
AS LEVEL 4.1 The nature of operations
In the case of labour-intensive processes, many of the costs
are variable, whereas in capital-intensive processes, costs
are mainly fixed.
CASE STUDY
10
25
10
7
9
20
23
24
45
Sometimes
47
Never
17
Millennials
43
25
27
Gen Xers
Baby
boomers
▼ Table 4.2 Advantages and disadvantages of labour- and
capital-intensive processes
Labourintensive
processes
46
Capitalintensive
processes
21
Average
Source: McKinsey & Company
▲ Figure 4.4 Sustainable packaging – influence on
purchasing decisions (%)
Question
1
Evaluate the significance of the above data for
businesses.
[12]
4.1.3 Capital-intensive and
labour-intensive operations
A capital-intensive process is one that involves a relatively
high proportion of machinery and equipment relative
to other resources. Imagine a bottling process using a
production line and producing millions of bottles a day.
Other examples of capital-intensive processes are car
manufacturing, oil refining and airlines. A capital-intensive
process can produce high quantities of a standardised
product at a relatively low unit cost (as the costs are spread
over so many units). However, a capital intensive process:
» can be expensive to set up with investment in
technology
» can be relatively inflexible in terms of producing
different versions of the product (although technology
means that flexibility is now improving)
» is expensive per unit if only a few items are produced.
A labour-intensive process uses a relatively high proportion
of people (such as full-time, part-time and temporary
staff) compared to other resources; for example, a design
business, hotels, or a fruit-picking business.
Using a high proportion of labour can enable the business
to be very flexible and produce a wide range of personalised
services. However, it may limit the volume of products that
can be produced.
Advantages
Disadvantages
Production may be
flexible to customer
needs
May take time to train
staff with necessary
skills
Less expensive to
set up than buying
equipment
Product may vary in
consistency and quality
Employees can use
skills and initiative
to be creative
Volumes produced may
be low
Can produce high
volumes
Can be expensive to
set up
Output can be
standardised and
consistent
High fixed costs
increasing break-even
output
May be able to
Can be difficult to
produce continuously customise products to
individual customer
needs
▼ Table 4.3 Capital-intensive versus labour-intensive
processes
Capital-intensive processes
Labour-intensive processes
Expensive to set up
Lower set-up costs
Can produce high volumes
May involve lower output
levels
Can achieve lower average
costs if volume is high
May be relatively expensive
for high volumes as high
amounts of labour are needed
May be relatively inflexible
Can be quite flexible
GLOSSARY TERMS
Capital-intensive production means there is a high
proportion of capital (for example, machinery) used
relative to other factors of production.
Labour-intensive production means there is a relatively
high proportion of labour (employees) used relative to
other factors of production.
STUDY TIP
Whether a process should be capital or labour intensive
will depend on factors such as the importance of a
personal service, the finance available for investment and
the volume of output required.
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4.1.4 Operations methods: job,
batch, flow, mass customisation
Job
process
Different
types
of operation
processes
Batch
process
Flow
process
▲ Figure 4.5 Different types of operation processes
There are different types of operation methods. Some of
these are:
» Job production This involves one-off production.
Imagine the work of a portrait artist, wedding
CASE STUDY
4.1
4.1.4 Operations methods: job, batch, flow, mass customisation
Mass
customisation
process
photographer or architect. Each item is unique for each
customer, which means that production is very flexible.
It tends to require a wide range of skills because of the
range of jobs that may be done. It also requires good
project management skills because each order is unique
and will have different planning requirements. As a
result, job production tends to be quite expensive.
» Batch production This occurs when items move together
from one stage of a process to another. For example,
when producing bread you bake one batch at a time.
This approach is cheaper per unit than job production
because you are producing products in groups. At the
same time, you have some flexibility to change the
recipe or approach from one batch to another.
» Flow production This involves large-scale production
using production-line technology. It is capable of huge
volumes (for example, of cans of beans or bottles of
water) but produces relatively standardised products.
Products ‘flow’ from one stage to another. It is relatively
expensive to set up to buy the production equipment
and is not especially flexible in terms of producing
a variety of products. However, if the volume of
production is high, the set-up costs can be spread over
many units, meaning the unit costs will be relatively
low. Mass production suits mass markets where demand
is stable and high.
» Mass customisation This is a relatively new
development made possible by technological advances.
This type of process is on a large scale but, whereas
mass production usually lacks flexibility, this
technology enables a variety of models to be produced
Coca-Cola and COVID-19
In 2020, Coca-Cola opened the world’s fastest bottling
production line in Chengdu, Sichuan province. This was
part of the United States-based Coca-Cola’s efforts to
increase its manufacturing capacity and investment in
China.
The new plant is able to produce 120 000 cans every hour,
while the current industry average ranges between 66 000
cans and 90 000 cans every hour. This equates to 260 000
metric tons of products every year, worth around 1.3
billion yuan ($183 million). This is also Coca-Cola’s only
automatic production line that is able to produce a variety
of different packaging specifications simultaneously.
Coca-Cola’s first production plant in China was built
in 1999 in Chengdu. This more recent investment was
part of the company’s attempts to increase work and
resume production after the 2020 Coronavirus (COVID-19)
pandemic. This involved investing in equipment renewal
and technical transformation, and upgrading facilities.
Globally, Coca-Cola experienced significant changes in
consumer buying patterns in 2020, with significant falls in
the buying of drinks through distribution channels known
as ‘away-from-home channels’, such as shops.
To expand its range of products, Coca-Cola has recently
combined forces with the Chinese dairy business China
Mengniu Dairy Co. This joint venture will produce
and sell chilled milk, which is expected to have a real
potential for growth in China. Coca-Cola is also offering
a new range of ready-to-drink coffee products in China
under the Costa brand, to further benefit from the
country’s rising ready-to-drink market. Costa Coffee
entered the Chinese market in 2006 and now has over
500 stores there.
Questions
1
2
Explain one way in which the Coronavirus
(COVID-19) pandemic affected Coca-Cola’s sales. [3]
Evaluate the benefits of this new production line
for Coca-Cola.
[12]
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on the same production line. VW, for example, uses
the same basic car platform for many of its cars. Mass
customisation generally involves heavy investment in
technology.
4.1
AS LEVEL 4.1 The nature of operations
▼ Table 4.4 Operations processes
Type of production
Features
Job
One-off, unique, tailor-made items
Batch
Items move as a group from one
stage of the process to another
Flow
Items move continuously from one
stage of the production process to
another
Mass customisation
Large-scale production with the
flexibility to produce a number of
different models
Problems of changing from one method
of production to another
Changing from job to batch to mass production will depend
on the nature of demand. Mass production requires high
volumes and therefore is not appropriate for job production,
where each item is unique. Batch production enables
relatively high outputs and some flexibility (for example,
printing batches of different magazine titles) but is not
appropriate if a customer wants something unique.
Moving from job to batch to mass production will require
investment in capital equipment. It will enable higher
volumes (assuming the demand is there) but there will be
less flexibility in terms of tailoring the product to customer
needs.
TEST YOUR LEARNING
Short answer questions
1
a
b
Define the term ‘operations management’.
Explain one way in which effective operations
management can increase the profits of a
business.
2 Define the terms ‘effectiveness’ and ‘efficiency’.
3 a Define the term ‘labour productivity’.
b Explain one way of increasing productivity.
4 a If output is 300 units and the number of
employees is 20, calculate the labour
productivity.
b Explain one reason why a business might
want higher productivity.
5 Explain one reason why employees may resist
attempts to increase labour productivity.
6 a Define the term ‘sustainable operations
process’.
b Explain one reason why sustainability is
important to a business.
7 a Define the term ‘labour-intensive’.
b Explain one benefit of a labour-intensive
production process compared to a
capital-intensive production process.
8 Explain one reason why a business may adopt a
capital-intensive production process rather than
a labour-intensive production process.
9 a Define the term ‘job production’.
b Explain one benefit of batch production
compared with job production.
10 a Define the term ‘flow production’.
b Explain one benefit of mass customisation to a
business.
Data response question
[2]
The Singaporean economy
[3]
[4]
[2]
[3]
Singapore has a highly developed and successful freemarket economy. The economy depends heavily on exports,
particularly of electronics, petroleum products, chemicals,
medical and optical devices, pharmaceuticals, and on
Singapore’s vibrant transportation, business, and financial
services sectors.
[2]
[3]
[3]
[2]
[3]
[2]
[3]
In the last ten years, the economy of Singapore has grown
by an average of 5 per cent a year. The country’s productivity
has also grown over the same period by about 1 per cent a
year, which matches that of other developed economies. The
majority of the population in Singapore has benefited from
a growth in earnings and a rise in their standard of living.
Even so, productivity gains have been slower than in
the past due to more reliance on people for growth;
for example, in the service sector. The government of
Singapore is eager to improve productivity and sees
this as a key driver of economic growth. It is focusing
on ways of improving productivity through a number of
programmes and schemes. Singapore has attracted
major investments in advanced manufacturing,
pharmaceuticals, and medical technology production.
Source: www.forbes.com/places/singapore/?sh=5268e7dcc959
[3]
[2]
[3]
[2]
[3]
Questions
1
2
3
Define the terms:
a ‘productivity’
[2]
b ‘economic growth’.
[2]
Analyse one reason why an increase in productivity
can help businesses and the economy to grow.
[4]
Evaluate the ways in which the Singaporean
government could help businesses to improve
their productivity.
[12]
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4 Operations management
AS LEVEL
4.2
Inventory management
4.2.1 Managing inventory
Chapter overview
In this chapter we examine:
★ how to manage inventory
★ how to interpret inventory charts
★ the importance of supply chain management
★ just in time (JIT) versus just in case (JIC) inventory management.
4.2.1 Managing inventory
The costs and benefits of holding
inventory
Purpose of inventory
The term ‘inventory’ refers to products that the business
owns but will use up during the operations process.
Inventory was previously also called stock.
Types of
inventory
Raw materials
Work in
progress
Finished
goods
General
supplies
▲ Figure 4.6 Different types of inventory
Types of inventory include:
» raw materials – these are items used in the production
process
» work in progress (semi-finished goods) – these are items
where some work has been done on them but they are
not complete
» finished products – these are goods that are ready to be
sent to the customer
» general supplies – these are items that are used to keep
the business going, such as supplies of cleaning materials.
These inventories are held:
» to enable production to take place and so that orders
can be met
» just in case anything goes wrong. For example, you
may want to hold excess materials in case there is a
problem with deliveries from the supplier; you may want
to hold inventories of semi-finished items in case there
is a breakdown in part of the system; you may want to
hold finished goods in case there is a rush order from a
customer.
The benefits of holding inventory are that you have
products ready if you need them, and if there are any delays
or breakdowns in the process you can continue to operate.
This means sales can continue and the business generates
revenue. However, holding inventory can lead to:
» costs of storage – for example, the costs of a warehouse
facility
» opportunity cost – because the money invested in
inventories could be used elsewhere to earn money.
Money in inventory is therefore ‘tied up’ and not
generating more returns
» security costs – to protect the materials from damage
or theft
» the risk of the inventory depreciating, that is, becoming
out of date – this may be because the inventory goes off
(in the case of food) or becomes unpopular (in the case
of fashion items) and so is wasted.
Buffer inventory, reorder level and
lead time
» Buffer inventory is the minimum amount of inventory a
business wants to hold just in case of problems.
» The lead time is how long it takes from ordering the
supplies from a supplier to them arriving at the business.
» The reorder level is the amount of inventory left at
which a business needs to place an order so that the
new inventories arrive before the business goes below
its buffer level.
» The reorder quantity is the amount ordered each time.
Inventory (stock) control charts
Inventory control charts can highlight how much inventory
is being used up, how much to reorder and when.
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AS LEVEL 4.2 Inventory management
4.2
In Figure 4.7, the business uses up 200 units a week at a
constant rate. It wants to always hold 100 units as a buffer
inventory just in case. The lead time is one week. This
means the business needs to reorder at 300 units. As the
supplies are being made and delivered (which takes one
week) another 200 units will be used up, which means that
when the order arrives, the business is down to its buffer of
100. The reorder quantity in this case is 800 units a month
(given that the business expects to use up 200 units for
each of the four weeks). Figure 4.7 assumes that the usage
rate of the inventory is constant each week.
Inventory 900
(units)
800
400
Reorder level
300
Buffer inventory
1 2 3 4 5 6 7 8 9 10 11 12 Time
(weeks)
Run out of inventory
400
Reorder level
300
200
Buffer inventory
100
1 2 3 4 5 6 7 8 9 10111213141516
Time
(weeks)
▲ Figure 4.7 Inventory control chart
In Figure 4.8, we see a situation where the inventory starts
to be used up at a faster rate after week 8 and the business
therefore runs out of inventory before new supplies arrive.
This is known as an ‘inventory out’.
Inventory 900
(units)
800
700
600
500
400
Reorder level
200
0
500
0
500
100
600
100
600
300
700
200
700
0
Inventory 900
(units)
800
Buffer inventory
1 2 3 4 5 6 7 8 9 10111213141516
Time
(weeks)
Run out of inventory
▲ Figure 4.8 Example of a business running out of
inventory
In Figure 4.9, the supplies do not arrive – perhaps due
to a problem at the supplier because inventory was not
re-ordered – leading again to an inventory out.
▲ Figure 4.9 Effects of failing to reorder
Inventory (stock) control
The decision on how much inventory to hold is a tradeoff between the costs of holding the inventory and the
problems that might occur if inventory is not held.
The minimum amount of inventory that a firm wants to hold
at any time is known as the buffer inventory (or the safety
inventory). If the level of inventory falls below the buffer
level, there may be a risk of running out; this could either
halt production or mean that customers have to be turned
away because no finished goods are available. Several factors
influence the level of buffer inventory a business holds:
» the rate at which inventory is generally used up. The
faster inventory is used up, the more the firm will have
to hold at any moment
» the warehousing space available. The smaller the space
the firm has for storage, the lower the level of inventory
» the nature of the product. If the product is fragile or
likely to depreciate, the firm will not want too much
inventory in case it breaks or loses value rapidly
» the reliability of suppliers. The more reliable suppliers
are, the fewer buffer inventories the firm needs to hold,
because it knows it can get more as and when required
» the suppliers’ lead time. The lead time is the time it
takes for products to arrive from when they are ordered.
If the lead time is two days, for example, this means
that it takes two days for supplies to arrive once you
have ordered them. The shorter the lead time, the
smaller the amount of inventories a firm needs to hold.
If, however, the lead time is long, the firm will need to
hold more inventory to last while it waits for a delivery.
Effective inventory management involves making sure that
the business does not have too much or too little inventory.
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Supply chain management
HANDLING DATA
Businesses will have suppliers. These suppliers will often
have suppliers, and these businesses may also have their
own suppliers. There is therefore a chain of suppliers from
the raw materials through to the finished product. The
supply chain refers to all the different stages involved
in making, distributing and selling a good or service,
beginning with the material through to the production of
parts, through to the distribution and sale of the product.
800
600
500
400
Reorder level
300
200
100
0
1
2
3
4
5
6
7
8
9
Time (weeks)
▲ Figure 4.10 Inventory control chart
1
2
3
What is the reorder quantity in the inventory chart
above?
What is the lead time?
How many units are used up each week?
CASE STUDY
COVID-19 and retailers
The Coronavirus (COVID-19) pandemic of 2020 created
major problems for retailers. In many countries,
retailers of non-essential products were forced to shut
down for extended periods. For clothes retailers, this
meant that they had inventory that would be seen as out
of fashion. Inditex, the world’s biggest fashion retailer,
announced that it was writing off over $300 million
worth of inventory. This means the company reduced its
valuation of what the inventory was worth.
Some retailers responded to the virus by cutting prices
to try and sell their existing inventory. H&M of Sweden
cut prices by up to 70 per cent. Other retailers cancelled
orders of inventory as they did not think the customer
demand would be there.
Once lockdown was over and people came out to start
shopping, retailers then faced the problem of not having
enough inventory that customers wanted to buy.
Questions
1
2
Explain one reason why clothes retailers hold
inventory.
Evaluate the factors that influence how much
inventory clothes retailers should hold.
[3]
[12]
Think of the food in a McDonald’s restaurant. Farmers will
have raised animals that are sent to abbatoirs, and the
meat is then sent to processing facilities before being
distributed to the restaurants. Farmers will also grow
other foodstuffs, such as lettuce, which will be sent to the
McDonald’s outlets. Wheat will have been grown and this
will be sent to grain mills and then to a factory to produce
buns. The range of ingredients used in McDonald’s foods
will be created through a complex set of relationships with
suppliers. Supply chain management involves managing
the flow of goods and services, and includes all the
different processes that transform raw materials into final
products. Effective supply chain management means that
these interrelationships between suppliers are managed
well. This can lead to:
» lower costs, because the process is more efficient
» fewer mistakes being made
» greater co-ordination of what is delivered, when and in
what order
» better-quality supplies
» less time between orders and delivery.
4.2.1 Managing inventory
Inventory (units)
700
4.2
Effective supply chain management can therefore help
provide a business with a competitive advantage. Equally,
poor supply chain management can cause delays, increase
costs and lead to poor quality.
Businesses will want to consider their responsibilities in
relation to their suppliers. For example, to what extent do
they want to know how their suppliers produce? Businesses
are increasingly being questioned about all aspects of their
supply chain, such as the ingredients in their products,
the source of their supplies, the working conditions and
treatment of their employees. Businesses must consider
the processes they want to have in place to manage these
aspects of their supply chain. Many businesses now have
a code of conduct of their suppliers to ensure that these
organisations meet the standards of the business selling the
final product. Greater media coverage has made businesses
think more, not just about how they behave but also about
how their suppliers behave.
GLOSSARY TERMS
The supply chain refers to all the different stages involved
in making, distributing and selling a good or service,
beginning with the material through to the production of
parts, through to the distribution and sale of the product.
Supply chain management involves managing the flow of
goods and services, and includes the different processes
that transform raw materials into final products.
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AS LEVEL 4.2 Inventory management
4.2
CASE STUDY
COVID-19 and supply chains
In recent years, there have been major worldwide shocks
which have threatened the global supply chains of many
businesses. For example, there have been the September
11 terrorist attacks in 2001; the SARS virus of 2002; the
financial crisis of 2008 and the trade wars between the
USA and China in 2019 and 2020. All of these changes have
damaged global trade, and the use of global supply chains
after the global financial crisis has grown more slowly
relative to world income than in the decade before.
It is possible that the consequences of the Coronavirus
(COVID-19) pandemic in 2020 will deal an even bigger
blow to supply chains than these other events. The
World Trade Organization estimated that global trade
would fall by up to 32 per cent in 2020. China’s Hubei
province, where the Coronavirus outbreak began, is
a manufacturing hub which produces components
for many industries such as cars, electronics and
pharmaceuticals. The closure of factories, ports and
airports affected companies across the world and has
also contributed to contracting trade.
One reason that many businesses were affected so badly
is because they had no plan if their supply chain was
seriously disrupted. They had built a chain of efficient,
low-cost suppliers but their plans did not allow for
unexpected interruptions. Since the pandemic began,
many businesses have started to look at bringing supply
closer to home. However, this often involves higher costs
and does not make use of the specialisms which certain
regions around the world have developed.
Questions
1
2
Explain two factors that influence whether a
business chooses local suppliers.
Evaluate how supply chain management can
affect the competitiveness of a business.
[6]
[12]
CASE STUDY
The clothing supply chain
A recent UK parliamentary report, Fixing fashion: clothing
consumption and sustainability, stated the following:
Garment production is one of the world’s biggest and most
labour-intensive manufacturing industries, with estimates
of those directly employed ranging from 25 million to 60
million people. Since the 1980s, many leading Western fashion
retailers have been sourcing their clothes from countries
with low labour costs and poor environmental governance.
This shift in production has been facilitated by a 90 per cent
fall in shipping costs between the late 1950s and 2015, as
shipping containers revolutionised trade in goods. Most of the
garments sold in the UK are produced in Asian countries. This
fashion model means that consumers in the UK ‘are getting
pleasure and enjoyment from fashion, and that is coming
at a cost to workers and the environment in exterritorial,
overseas production routes, as well as agriculture.’ Poor pay
and conditions are standard in global garment supply chains
according to evidence submitted by the global trade union,
IndustriALL. It stated that:
‘Workers work long hours, often far beyond legal limits, for
poverty wages and in conditions that breach Occupational
Health and Safety (OHS) standards. The wages of most
garment workers are no higher than the level of the minimum
wage in their country, which in many cases is well below
the level of subsistence. Excessive working hours are a
continuing and entrenched problem. Production peaks
are managed by relying on excessive overtime. Workers
are compelled to work extremely long hours in order to
supplement their basic earnings towards a level where
they can support themselves and their families. Precarious
employment conditions are rife, with temporary contracts,
agency work and subcontracting the norm. Violations of
the right to freedom of association are commonplace,
unionisation rates are extremely low and collective
bargaining is rare.’
A 2016 report into Corporate Leadership on Modern Slavery
found that of 71 leading retailers in the UK, 77 per cent
believed there was a likelihood of modern slavery occurring
at some stage in their supply chains.
Poor working conditions in fashion supply chains hit the
headlines on 24 April 2013, when the Rana Plaza building
in Bangladesh collapsed. The building housed five garment
factories where 1138 people died and another 2500 were
injured, making it one the largest industrial disasters in
history. The victims were mostly young women.
Source: https://publications.parliament.uk/pa/cm201719/
cmselect/cmenvaud/1952/report-files/195205.htm ©
Parliamentary Copyright
Questions
1
2
Analyse one reason why most garments sold in the
West are produced by suppliers in Asia.
[4]
Evaluate the ethics involved in the management of
the clothing supply chain.
[12]
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4.2.2 Just in time
A different approach to inventory control is known as ‘just
in time’ (JIT). Just-in-time production occurs when firms
produce products to order. Instead of producing as much
as they can and building up inventories, firms only produce
when they know they can actually sell the items. Similarly,
components and supplies are only bought in by a firm as
and when they are needed.
The aim of just-in-time production is to reduce a firm’s
inventory levels by as much as possible. In an ideal world
there would be no inventories at all; supplies would arrive
and be used to produce items that are sold immediately to
the final customer. The advantages of this system are:
» A just-in-time approach should provide a firm with
tremendous flexibility; firms produce what is required,
when it is required. In the past, firms have tended to
try to estimate what demand would be and produce this
amount in advance of actual sales. This system works as
long as demand has been estimated correctly.
» JIT production should reduce costs. With no inventories,
the firm does not have to pay for warehousing or
security. The firm also avoids the opportunity cost of
having money tied up in inventories.
» JIT production should help minimise wastage. If goods
are produced and left to accumulate as inventories,
they are likely to get damaged, to depreciate, to go out
of fashion or to be stolen. JIT avoids these issues. This
means that JIT is part of a lean approach to business.
Lean production seeks to minimise the waste of
any resource, such as time and materials, to make a
business more efficient.
Although the just-in-time process has many advantages,
there are several potential problems or disadvantages:
» The system relies on suppliers providing parts and
components at exactly the time they are needed. If this
type of flexible and reliable supplier cannot be found,
the system breaks down.
» JIT can cause problems if the suppliers fail to deliver on
time. The manufacturer has no buffer inventory and so
cannot produce. For example, the earthquake in Japan in
2011 was a disaster for those directly affected by it. It
also caused enormous problems for businesses operating
a JIT process and reliant on supplies from Japan. With a
delay in supplies, they struggled to produce. The closure
of suppliers due to the Coronavirus (COVID-19) pandemic
in 2020 had similar disastrous effects for those reliant on
their products.
» The JIT system also means that the firm is vulnerable
to action taken by employees. Any stoppage can be
4.2
GLOSSARY TERM
Lean production is an approach that continually
seeks to reduce any form of wastage in the production
process.
4.2.2 Just in time
One approach to inventory control is known as ‘just in
case’ (JIC). This is the traditional approach in which
businesses hold inventory just in case there are problems
with suppliers or just in case there is an increase in
demand. By holding excess inventory, businesses can
keep producing and selling even if suppliers cannot
deliver and even if demand suddenly spikes. However, the
disadvantage of JIC is that inventory has to be stored,
maintained and protected, and this costs money.
extremely expensive because production is halted
completely.
» Switching to JIT can lead to an increase in costs because
of the extra reordering. Because parts are ordered much
more frequently, the firm may lose bulk discounts and
will also have more administration costs.
STUDY TIP
The right level of inventory to hold will depend on factors
such as how well it can be stored, the costs to store it,
the reorder time, the expected level of demand and the
business’ operations strategy.
Using just in time
Running a just-in-time system is complex and places many
demands on a business. It requires:
» Excellent relationships with suppliers Businesses
need to be able to rely on suppliers to deliver goods
at precisely the right time. They cannot afford delays
as this halts production. Also, the goods must be of
perfect quality as the manufacturer has no inventories
to replace faulty supplies. A firm must be able to trust
its suppliers completely.
» Reliable employees Because the business does not have
many (if any) inventories at any stage of the process,
the firm cannot cope with stoppages. If strikes occur, for
example, the whole production process stops. A business
cannot supply customers using inventories as none exist.
JIT relies upon maintaining a good relationship between
employers and employees.
» A flexible workforce To ensure that production can
respond to demand, a firm needs a flexible labour
force. This means that if someone is ill, another
employee must be able to cover for them, or that if
demand is high in one area of the business, people
can be moved to that area to help out. Firms using
JIT expect employees to be ready to work anywhere,
anytime. People must change to meet the demand for
different products because JIT is focused entirely on
matching supply to customer orders.
Introducing just-in-time production involves:
» investment in machinery which is flexible and can be
changed from producing one type of item to another
without much delay
» training employees so that they have several skills and
can do a variety of jobs (multi-skilling)
» negotiation with employees so that their contracts are
flexible and allow them to move from one job to another
» building relationships with suppliers who can produce
just in time as well.
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4.2
CASE STUDY
Toyota
AS LEVEL 4.2 Inventory management
of the Centre for Automotive Industry Research at Cardiff
Business School, Cardiff University, explained that the
problem arose because they relied on parts coming in
from Japan.
Toyota uses a just-in-time supply system, which allows
very little slack in the system. Once supply is interrupted,
it does not take long for other factories to be affected.
▲ Figure 4.11 The earthquake and tsunami in Japan
(2011) caused problems for companies using JIT
systems.
In April 2011, the Japanese car maker, Toyota, had
to temporarily halt production at its UK enginemanufacturing plant on Deeside, Flintshire, and five other
of its factories across Europe. The stoppage came after
Japan was hit by an earthquake and tsunami. A director
Experts have been recommending for years that
manufacturers diversify their supply base. After
all, recent history is full of examples of widespread
supply chain disruptions and their consequences for
manufacturers who were reliant on too few sources
– from the terrorist attacks on 11 September 2001 to
Hurricane Katrina in 2005 and the cloud of volcanic ash
from Iceland that shut down Europe’s skies in 2010.
Questions
1
2
Analyse one way in which lean-production techniques
might benefit Toyota.
[4]
Evaluate whether Toyota should stop using leanproduction techniques given the risks of disruption
to supply.
[12]
TEST YOUR LEARNING
Short answer questions
Data response question
1
2
Zara
Define the term ‘opportunity cost’.
[2]
Explain one reason why a business might hold
inventory.
[3]
3 Explain one cost of holding inventory.
[3]
4 Explain one factor that influences the amount of
buffer inventory held by a business.
[3]
5 a Define the term ‘lead time’.
[2]
b Explain one factor that might influence the lead
time of a supplier.
[3]
6 Explain one reason why supply chain management
is important to a business.
[3]
7 Define the term ‘just-in-time production’.
[2]
8 Explain one reason why a business might use
just-in-time production rather than just-in-case
production.
[3]
9 Explain one possible problem of adopting just-intime production.
[3]
10 Explain one factor that influences the right level of
inventory for a business to hold.
[3]
The international retailer, Zara, is famous for its ‘fast
fashion’. It produces relatively small quantities of any one
design and quickly changes the designs to ensure it stays
up to date with fashion. Store managers monitor designs
in other stores and sales patterns, and send orders each
week directly to the company’s own factories. Unlike many
other retailers, Zara has not subcontracted production,
and produces in Europe rather than Asia to ensure it
keeps control of quality and can respond quickly. It has its
own team of 200 designers able to imitate any new bestselling designs that hit the fashion world. It designs more
than 12 000 items a year. It can design and get an item in
its stores in weeks, whereas its competitors take months.
Its approach is very much just in time; it produces in
response to demand rather than ahead of it.
Questions
1
2
3
Define the term ‘inventory’.
[2]
Analyse one possible advantage to Zara of holding
relatively little inventory.
[4]
Evaluate the issues involved if a retailer wishes to
adopt a fast-fashion approach.
[12]
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4 Operations management
AS LEVEL
4.3
Capacity utilisation and
outsourcing
In this chapter we examine:
★ the meaning and measurement of capacity
★ the significance and measurement of capacity utilisation
★ the impact on a business of operating under or over maximum capacity
★ the impact on a business of outsourcing.
In this chapter, we examine issues relating to the maximum
output a firm can a produce, which is known as capacity.
A business will not want to have capacity sitting idle but
at the same time won’t want to have too little capacity,
so getting the capacity right is an important aspect of
operations planning.
For example:
a Existing output is 300 units a week, maximum output is
500 units a week.
Capacity utilisation = (300 ÷ 500) × 100 = 60 per cent
b Existing output is 400 units a week, maximum output is
500 units a week.
Capacity utilisation = (400 ÷ 500) × 100 = 80 per cent
4.3.1 Significance and
measurement of capacity
utilisation
Imagine a concert where the stadium is completely
sold out, with 30 000 in the audience; this means that
capacity utilisation is 100 per cent, which is good for the
promoter of the event. But what if you have a theatre that
is half-full? This means that its capacity utilisation is only
50 per cent.
The capacity of a business is the maximum amount it can
produce given its existing resources, and it depends on the
number and quality of its factors of production. What is the
amount and what is the standard of equipment available?
How many staff does the business have and how well trained
are they? How efficient is its transformation process?
Over time, the capacity can be increased with more
investment, but at any one moment there will be a
maximum number of orders that a business can cope with.
The capacity of a bus company can be measured by how
many passengers it can carry. The capacity of a restaurant
is how many meals it can serve. The capacity of a school is
how many students it can accept. The capacity of a plane is
how many passengers it can take.
Capacity utilisation measures the existing output relative
to the maximum. It can be calculated using the following
equation:
per cent capacity =
existing output over a
given time period
× 100
maximum possible output
over a given time period
4.3.1 Significance and measurement of capacity utilisation
Chapter overview
GLOSSARY TERMS
Capacity measures the maximum amount of output a
firm can produce at a given moment with its existing
resources.
Factors of production are inputs into the transformational
process of business, such as land, labour, capital and
enterprise.
Capacity utilisation measures the existing output relative
to the maximum possible output.
HANDLING DATA
1
2
3
If capacity is 800 units and present output is 200
units, calculate the level of capacity utilisation.
If capacity utilisation is 20 per cent and capacity is
3000 units, calculate the present level of output.
If capacity utilisation is 20 per cent and present
output is 4000 units, calculate the capacity.
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AS LEVEL 4.3 Capacity utilisation and outsourcing
4.3
CASE STUDY
Suzuki
In 2020, Suzuki, the motor vehicle producer, announced that
it intended to increase its capacity in Myanmar. The company
invested in a new production line for four-wheeled vehicles
at its plant in south-eastern Yangon to handle tasks such
as the painting of car bodies. Suzuki has two factories in
the country.
The investment is estimated to be roughly 12 billion yen
($108.91 million) and it will increase the factory’s floor
space tenfold to 42 000 square metres, from the current
4000.
The factory had previously been importing painted
car bodies from other countries, including India, and
assembling the vehicles in Myanmar. With growth
expected in Myanmar’s new car market, Suzuki has
decided to set up a production system that could supply
demand quickly. As a result, the factory’s production
capacity should increase to 40 000 vehicles per year from
a previous 10 000.
STUDY TIP
Remember that the capacity of a business will affect the
sales it is trying to achieve and, therefore, its human
resource planning and financial position. There is little
point generating more demand if there is not the capacity,
unless the business is willing to let others produce for it
and/or have queues and waiting lists.
The impact of operating under capacity
If capacity utilisation is low, it means that the existing
output is relatively low compared to what could be
produced. This is inefficient because resources are not being
fully utilised. The business could be producing more and,
assuming the demand was there, earning more revenue and
profit. The train could have more passengers, the health
club could have more members, the sandwich business could
be making more sandwiches. A business will, therefore,
usually want a high level of capacity utilisation.
Higher levels of capacity utilisation are desirable because
they spread the fixed costs of a business over more units.
The fixed costs of a business are those costs that do not
change with output; for example, the rent on a building or
the interest payments on a loan. As output expands, these
fixed costs can be divided by more units. For example, if
fixed costs are $10 million and 1 unit is produced, the fixed
cost per unit is $10 million; if 10 million units are produced,
the fixed cost per unit is $1. Higher capacity utilisation
therefore helps reduce unit costs and, therefore, increase
profit margins. Imagine you were renting a market stall for
$500 and you sold 250 items. Each item would have to earn
$2 simply to cover the rental costs. If you sold 1000 items,
each one would only have to earn 50 cents to cover the fixed
costs – this is because as your output increases, the fixed
cost per unit falls. This is very significant because it means
According to the Automotive Association of Myanmar,
sales of new cars in 2019 were 21 916, an increase
of 25 per cent from 2018. Suzuki holds 60 per cent of
Myanmar’s market.
Toyota plans to begin operating its first factory in the
country in the near future. Chinese manufacturers are
also due to enter Myanmar to benefit from growing
demand. The opportunity for Chinese manufacturers has
increased with improved quality and less concern from
younger buyers about the brand.
Questions
1
2
Explain one factor that determines the capacity of
[3]
Suzuki.
Evaluate the reasons why Suzuki expanded capacity
[12]
at its Myanmar factory.
there are major cost advantages of having higher capacity
utilisation. A business with low capacity utilisation not only
wastes resources but has high unit costs. This will reduce
profit margins if the price stays the same. If the firm tries to
increase the price to cover the higher unit costs, it may find
that sales fall and the situation becomes even worse.
Improving the position of the business may therefore
involve increasing the capacity utilisation, either by
boosting demand (which may be through marketing
activities) or reducing the capacity of the business if some
of it is no longer needed.
Methods of improving capacity
utilisation
Your capacity is under-utilised (that is, capacity utilisation
is low) if demand is not matching the level of output you
are able to provide. For example, you have a cinema that
can take 400 people but there are only 80 watching the
film (this is 20 per cent capacity utilisation); you have a
café with 40 tables but only 4 are occupied at the moment
(this is 10 per cent capacity utilisation). Capacity underutilisation therefore occurs when demand is too low. In this
situation the business may:
» do nothing If this is seen as a temporary issue, the
business may accept under-utilisation for a short time
(for example, when a World Cup football match is on
television, the number of high-street shoppers falls;
capacity utilisation in restaurants is usually lower during
the week compared to the weekend)
» renew its marketing activities to boost demand For
example, changes in the promotional strategy may be
made: new offers, increased efforts by the sales team or
more advertising may help increase sales
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» reduce the level of capacity If, over time, demand
GLOSSARY TERMS
Capacity under-utilisation occurs when a business is
producing less than the maximum amount it can produce,
given its existing resources.
Rationalisation occurs when a business reduces the scale
of its operations and reduces its capacity level.
Subcontracting occurs when one business employs
another business to undertake some of the work.
High levels of demand relative to
capacity
If demand is high, a business may be operating close to
100 per cent capacity utilisation. This may be possible in
the short run, but it may put pressure on resources if the
business is operating at full capacity for a sustained period
of time. Employees may feel under pressure and become
tired. There may not be time for day-to-day maintenance
and repair of equipment, increasing the risk of breakdown
or failure. A business may, therefore, wish to operate below
100 per cent capacity utilisation over a period.
If demand is above the normal capacity of a business,
managers may respond in various ways. In the short term,
they may try to increase the capacity by opening longer
and asking employees to work more hours than usual.
Another response might be to subcontract output to other
producers. This brings risks because the original business
is no longer directly responsible for the quality. It is also
expensive because the subcontractor will want to make a
profit. However, using a subcontractor can allow a business
to continue to meet its customers’ orders and may maintain
goodwill. Other responses to high demand include:
» starting a waiting list This can increase the sense
of exclusivity, which may suit premium brands, but
customers may switch to another business where they
can buy the products they want.
» increasing prices Higher prices can be used to reduce
demand. This can increase profit margins, but the
business will need to set the price at the right level to
avoid ending up with demand becoming too low.
If demand looks as if it is going to remain high, a business
may look to invest to increase its capacity over time. For
example, a business may build new production facilities if it
thinks the demand will justify this investment financially.
Capacity shortage
If demand is too high for the firm’s capacity, there is a
capacity shortage; for example, there are more people
wanting tickets for a gig than there are places, there are
queues outside the nightclub, or there is a waiting list for a
product. In this situation a business may:
» do nothing You may think that the fact that the
product is in short supply relative to demand adds to its
appeal. Some clubs might want to build on the image
that they are difficult to get into. Morgan sports cars
used a waiting list of several years but simply saw this
as evidence of the appeal of their cars – they did not
want to increase their output. You may also think that
the excess demand is temporary and so not want to
make any major changes, given that it may not last (for
example, it may be the latest fashion trend to wear a
certain brand of sunglasses or t-shirt, or it may just be a
particularly busy day or night). In this situation people
will simply have to wait. A business may start a waiting
list or limit the number any one person can buy
» expand capacity If you believe demand is likely to
remain high then you may increase capacity. This will
require investment (for example, you may need more
people, more equipment and bigger premises) but
may well be worthwhile due to the extra sales you
can generate
» outsource If you cannot meet all the demand yourself,
you may use other producers to produce for you. This
increases the amount you can supply but you need to
be careful that quality does not suffer and, because
the outsourcing suppliers will want to make a profit,
your own profits may be less on the units they make
compared to you making them yourself. Alternatively, a
business may outsource some of its non-core activities
so that it can focus on the essential elements of the
business. For example, in a school the governors may
decide to outsource activities such as the catering, the
maintenance and the security so that they can focus
on teaching and learning. This may enable managers
to concentrate on what they do best and make use of
the skills and experience of specialists in other areas.
Caterers that supply to many schools, for example, may
have economies of scale that make it cheaper to use
them than to try to do it yourself
» increase the price If demand is too high relative to
supply, a business may increase the price to bring
demand down to the ‘right’ level. This is what happens
in many markets. If demand for a particular company’s
shares increases, there is only a certain number available
4.3
4.3.1 Significance and measurement of capacity utilisation
is lower than capacity, the business may rationalise.
Rationalisation means the business may reduce its
capacity levels. For example, you may reduce the
number of staff you have, you may sell off some of your
production equipment if it is not needed, or you may sell
off some land if this is not required. Of course, changing
capacity levels may be easier in some businesses than
others. If you run a taxi or delivery business, you could
reduce the number of vehicles you operate fairly easily.
However, if you run a cinema, it is not easy to split the
cinema in half to reduce the capacity. If you have a café,
you cannot easily sell off a quarter of it. In general, it
is easier to reduce the labour input by making people
redundant or asking them to go part-time. Reducing the
land and capital inputs can be more difficult
» subcontract for other firms If you do have excess
capacity, you may offer your resources to other firms
and produce on their behalf. This is subcontracting.
Some shops may rent out part of their space to other
businesses, for example. A food business may offer to
produce for someone else and put the other firm’s brand
name on the products.
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and so the holders of these can increase the price. If you
have a house in an area that becomes very desirable then,
given the higher levels of demand compared to supply,
you can increase the price. The price can therefore act as
a rationing mechanism to reduce the demand, and at the
same time it can increase the profit margin per item.
4.3
AS LEVEL 4.3 Capacity utilisation and outsourcing
4.3.2 Outsourcing
Outsourcing occurs when the business uses other producers
to undertake some of its operations. A business may
outsource some aspects of its operations which it does
not regard as critical to what it does and/or where it may
benefit from the expertise and scale of others. A business
might outsource its catering and security, for example.
Similarly, it may outsource its customer enquiry helplines to
specialist call centres. There may be times when a business
does outsource key parts of its process to help expand its
capacity and ability to deal with customer orders.
Outsourcing may enable a business:
» to use the specialist services of another business An
outsourcing supplier may be using specialist equipment
which it is not cost-effective for the business to invest in
for itself, given the scale of this particular operation. A
school is likely to outsource the printing of its prospectus,
because it prints relatively low volumes and it would not
be cost-effective to have its own printing presses
» to benefit from lower costs by using a business that
specialises in an activity (such as customer credit
checks) rather than trying to learn how to do it itself
» to increase its capacity.
However, when outsourcing, a business should consider:
» the impact on costs The provider will want to take a
profit and therefore the business needs to make sure
that outsourcing is better value than doing it itself.
Sometimes a business may outsource initially but, as the
scale of the activity grows, it may be worth taking the
activity back in-house
» the impact on quality The quality of work from a
specialist provider may be better than the business
could produce itself, but the business needs to be
sure. The business is not directly in control of what is
happening and therefore must ensure that specifications
and expectations are clear and that there are systems in
place to monitor quality
» reliability of delivery The outsourcing supplier must be
able to deliver reliably, on time, so that the rest of the
business’ operations are not held up
» the response of the existing workforce By
outsourcing, a business is moving production away
from the business itself. This may lead to a loss of
jobs. For example, if a business decided to outsource
its design and marketing activities, this would reduce
the need for these jobs internally. This may meet with
resistance.
GLOSSARY TERM
Outsourcing occurs when the business uses other
producers to undertake some of its operations.
TEST YOUR LEARNING
Short answer questions
1
2
3
4
Explain one factor that might influence the capacity
of a business.
[3]
Define the term ‘capacity utilisation’.
[2]
a If present output of a business is 400 units and
capacity is 1200 units, calculate its capacity
utilisation.
[2]
b If capacity utilisation is 80 per cent and output is
400 units, calculate the capacity of the business. [2]
a Define the term ‘undercapacity’.
[2]
b Explain one problem for a business of operating
under capacity.
[3]
5
Explain one way in which a business might improve
its capacity utilisation.
[3]
6 Explain one way in which a business might respond
to a capacity shortage.
[3]
7 Define the term ‘outsourcing’.
[2]
8 a Explain one benefit to a business of outsourcing. [3]
b Explain one disadvantage to a business of
outsourcing.
[3]
9 If a business produces 200 units and its capacity
utilisation is 70 per cent, calculate its capacity.
[3]
10 Explain one reason why higher capacity utilisation
is likely to lead to lower unit costs.
[3]
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Data response question
Air travel in Indonesia
Given the rise in air travel in recent years, many domestic
and international airports have been operating over
capacity. The government has highlighted the need for
more infrastructure as a priority. Major improvement
works are planned for existing airports with further plans
for new ones to be built. Soekarno-Hatta International
Questions
1
2
3
Define the term ‘capacity’.
[2]
Analyse one reason why the Indonesian government
wants to increase airport capacity.
[4]
Evaluate the factors the Indonesian government
should consider before deciding whether to
expand airport capacity.
[12]
4.3
4.3.2 Outsourcing
Indonesia has seen a rapid rise in its number of air
passengers, from 30 million in 2009 to over 115 million
in 2018. This growth has been due to the growth of the
middle classes and the appeal of low-price airlines.
Indonesia has also increased in popularity as a holiday
destination for international tourists; there were over 10
million international arrivals in 2018. As a result of this
expansion, there are a number of plans to expand the
capacity of the airports. Although airports and airlines
were massively under capacity in early 2020, demand
grew fast once travel started up again.
Airport, near Jakarta, received 112 million passengers
in 2018 – far above its intended capacity of 70 million.
In December 2019, a third runway was opened to ease
congestion; there are plans to build a new airport to
serve Jakarta in the near future. Other improvements
are planned around the country, including Kualanamu
International Airport which serves Medan. A new airport
is planned in Bali to help reduce congestion in the existing
Ngurah Rai Airport in Denpasar. Although a site has been
proposed on the island, Bali’s popularity as a tourist
destination has put it under significant environmental
pressure, with issues around water availability and safe
sewage disposal.
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5 Finance and accounting
AS LEVEL
AS LEVEL 5.1 Business finance
5.1
Business finance
Chapter overview
In this chapter we examine:
★ the reasons why businesses need capital – for example, for survival or growth
★ why businesses need short-term and long-term finance
★ the distinction between cash and profits
★ shortages of finance and business failure
★ working capital, trade receivables and trade payables, capital and revenue expenditure.
5.1.1 The need for business
finance
Any start-up business is likely to require finance to fund
its market research and also for promotion to establish
its brand and identity among potential customers. It
can prove difficult for some start-up businesses to raise
sufficient finance and this is an important reason why
some business ideas never become reality.
Businesses need finance for a variety of reasons;
for example, to purchase assets such as supplies of
raw materials and machinery. There are three major
circumstances in which a business needs to raise finance.
Businesses also need cash to allow them to start
trading. Cash is required to pay the bills that arrive
regularly, such as for supplies of raw materials or
for services such as telephone and water. A newlyestablished business may not receive any payment from
its customers for a period of time and it is important
that the new business has sufficient funds to settle its
debts. We will cover cash in more detail in Chapter 5.3.
1 When it is first started
This is referred to as ‘start up’ finance or capital, for
obvious reasons. The amount of finance raised by a
business that is starting up is likely to be relatively
small. An entrepreneur establishing a new business is
unlikely to have access to large amounts of finance, and
banks and investors may be unwilling to invest in an
untried enterprise.
GLOSSARY TERMS
Start-up finance or capital may be used to purchase the
assets that a business needs to begin trading. In the case
of a manufacturing business, this may be to buy a lease,
allowing the business to use a factory for an agreed
period of time. Start-up finance may also be required
to buy machinery and vehicles. Start-up businesses
supplying services may purchase slightly different
non-current assets such as leases on shops or offices.
An asset is any item owned by a business that can
generate an income for the enterprise.
Capital is the money invested into a business either by its
owners or by organisations such as banks.
Non-current assets are assets that a business expects to
hold for one year or more. Examples include property and
vehicles.
CASE STUDY
Creating a STORM of interest
The STORM Creative Events Agency was established
by Keyis Ng. It is a fashion, lifestyle, events and public
relations firm. Keyis Ng has had a huge impact on the
Singaporean and regional fashion scene.
The 24-year-old entrepreneur founded his company with
a start-up capital of just $15 000. The company organises
product launches, private parties, fashion shows and
awards ceremonies to promote brands and business
ideas. It is good at gaining press coverage for its events
and uses its contacts in the media throughout Asia to
gain extensive coverage of its innovative events.
Questions
1
2
Explain two reasons why an entrepreneur starting
a new business would need to raise finance.
[6]
Evaluate the reasons why Keyis Ng was able to start
the STORM Creative Events Agency with so little
start-up finance.
[12]
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Short- and long-term sources
of finance
A business may need short-term finance to pay its bills
and to keep its suppliers happy. This is an important part
of the management of cash flow. Managing cash flow
can be difficult if a firm’s customers are late in making
payments for goods and services they have purchased or if
sales are unexpectedly low. In either case the firm is likely
to be short of funds needed to purchase raw materials,
pay wages and salaries, and it will need short-term finance
to continue trading. Sudden increases in the costs of raw
materials can also create a need for short-term finance.
Short-term finance of this kind is usually repayable within
a one-year period.
Sometimes businesses need to purchase major non-current
assets, such as land and buildings, or they may decide to
expand or to take over other businesses. To do this they
will require long-term finance which will be repaid over
a period of time longer than one year and, often, much
longer.
Table 5.1 classifies a range of sources of finance according to
whether they are short- or long-term.
GLOSSARY TERMS
Short-term sources of finance are needed for a limited
period of time, normally less than one year.
Long-term sources of finance are those that are needed
over a longer period of time, usually over a year.
▼ Table 5.1 Classifying sources of finance
Internal sources of
finance
External sources of
finance
Short-term
sources of
finance
• Working capital
• Retained profits
• Overdrafts
Long-term
sources of
finance
• Retained profits
• Sale of assets
• Sale and
leaseback
• Bank loans
• Venture capital
• Mortgages
• Debentures
• Share capital
• New partners
• Government grants
and loans
• Crowdfunding
• Microfinance
5.1
5.1.1 The need for business finance
2 When it grows
Many businesses seek to grow, and for some it is an
important objective, as we saw in Chapter 1.4. When it
is growing, a business will need finance for a number of
reasons:
– To buy additional non-current assets For example,
in 2019, Amazon (an online retailer) announced that
it was expanding its online grocery service, Amazon
Fresh, in India and promised delivery within a few
hours of an order being placed. This new service will
be available to customers in some parts of Bengaluru
and it will be extended to other cities later. In order
to provide this service, the company would have
needed to finance the purchase of a range of noncurrent assets, such as additional chilled cabinets
to store perishable food and vehicles to deliver the
groceries.
– To hire and pay for new staff In Amazon’s case,
this means hiring and training delivery drivers for its
grocery service. As Amazon Fresh is to be extended
throughout India, this could require a large amount
of finance.
– To buy additional supplies of groceries Amazon
hopes to sell its groceries to a large number of
customers and to provide rapid delivery. This will
require it to hold at least some inventories (stocks) of
groceries. Finance will be required to purchase these.
3 To survive
Sometimes businesses need finance to survive. The
ability of businesses to survive is often under threat in
two situations:
– When first established One-third of new businesses
in the USA did not survive their first two years of
trading. A new business may not survive for a variety
of reasons, including a lack of customers or higher
costs than forecast. If the new business can raise
finance during this critical early period, it is much
more likely to survive.
– When facing a crisis Crises can take many forms,
but they normally involve a loss of income from sales
or higher than expected costs, or both. If a business
can raise finance during a crisis, it is more likely
to be able to pay its debts on time and to survive.
It was for this reason that governments across the
world took steps to increase the finance available to
businesses during the Coronavirus (COVID-19) crisis
in 2020.
The difference between cash
and profits
Profit is the surplus of sales revenue over total costs, if
any exists, over a trading period. Just because a business
is profitable, it does not mean that it will hold large sums
of cash or even have enough cash. There are a number of
reasons why this situation might arise:
» Firstly, the business might sell large amounts of goods
or services at profitable prices by offering customers
60 or 90 days to pay for their purchases. This will mean
that the business has to find cash to buy supplies
and pay employees several months before the cash
from the sale of the product flows into the business.
This problem can be worsened if the business pays its
suppliers promptly.
» Alternatively, a business such as a jeweller might hold
large amounts of (expensive) inventory for customers
to view before making a choice. This will result in large
amounts of cash being tied up in the form of inventories
and not available to the business for other purposes.
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» A business may have paid for non-current assets and
5.1
used large sums of cash to do so. These assets may
support the business over many years, and they will lead
to future inflows of cash. However, the outflow of cash
would be at the start and may place pressure on a firm’s
finances.
Thus, a profitable business may find itself short of cash
and possibly unable to settle its bills as they fall due. This
could lead to the firm becoming insolvent and having to
cease trading. A cash crisis is a major reason why many
businesses fail.
AS LEVEL 5.1 Business finance
Periods of cash shortage
Cash
flows
Cash inflows
Cash outflows
0
Income
and costs
Income
At end of the
trading period
income exceeds
costs = profit
Time
Income
Costs
Costs
Costs
Income
0
Time
End of trading
periods
▲ Figure 5.1 Profit and cash
STUDY TIP
Business failure
Do spend time mastering the distinction between cash
and profits, as it is very important for the managers of
businesses. If you are asked about cash flow, try to avoid
drifting into arguments about profit and vice versa.
A lack of finance is a common cause of business failure.
A business fails when it is unable to pay its debts and
is unable to continue trading. This is called insolvency.
A business is judged to be insolvent when its debts (or
liabilities) exceed its ability to pay them. In the UK, and
many other countries, it is illegal for an insolvent business
to continue trading. The process followed by businesses
declared insolvent differs between companies and other
types of business as illustrated in Figure 5.2.
In the long term, however, a business has to make a profit
to satisfy its owners. They have invested funds into the
business, quite possibly by purchasing shares, and expect to
see a return on their investment. This is only possible if the
business makes a profit in the longer term. A business may
survive for some time without making profits if its owners
are prepared to be patient, but cash has to be managed
carefully in the short term to ensure that bills can be paid
on time and that the business survives.
GLOSSARY TERMS
Insolvency exists when a business’ debts (or liabilities)
exceed the assets available to pay them.
Liabilities refers to the money owed by a business to
individuals, suppliers, banks and others.
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Unincorporated
businesses (e.g. sole
traders, partnerships)
Bankruptcy
Creditors
receive
some
payments
A
business is
judged
insolvent
Working capital
Essential, to pay for day-to-day expenses and
keep the business operating
Liquidation
Unsuccessful
Administration
Successful
Continues
trading
▲ Figure 5.2 Insolvency, bankruptcy, administration
and liquidation
1 Bankruptcy
A business whose owners are not legally separate from
the business itself is known as an unincorporated
business. The owners of these businesses do not have
the protection of limited liability as discussed in
Chapter 1.2. If an unincorporated business in the UK is
unable to settle its debts, it will be declared bankrupt
by a court of law. The assets owned by the bankrupt
business will be sold; this can include the private
possessions of the business’ owners, such as property
and savings. The money raised from this sale will be
shared between the individuals and organisations who
are owed money (known as the creditors). It is unlikely
that the creditors will receive all the money that
they are owed as the business will not have assets of
sufficient value to cover all its liabilities.
2 Administration and liquidation
A company (that is, an incorporated business) that is
judged to be insolvent will often have its assets sold to
settle its liabilities. These assets will not include the
private possessions of the business’ owners (normally
shareholders). The process of selling assets for cash is
called liquidation. The process of liquidation takes two
forms:
– Compulsory liquidation. This occurs when a
creditor seeks an order from a court of law to have
the business’ assets sold as it has not received
payment of a debt. In such circumstances the court
will appoint a receiver. A receiver is a business that
specialises in taking control of an insolvent company
and making arrangements for creditors to be paid.
A receiver may be able to keep the business going
if its finances are not too weak. However, it is very
common for receivers to close the business down and
to sell all its assets.
– Voluntary liquidation. This is when the owners of
the company decide to enter liquidation. This might
be because they recognise the weakness of the
business’ financial position. It can also occur when
the owners of a company want to retire and are
unable to sell the business as a growing concern.
Some companies may decide to enter administration.
By entering administration, a company receives legal
protection from the threat of immediate liquidation.
=
Current assets
• Cash in the bank
• Trade and other receivables due to settle
their accounts soon
• Inventories – raw materials and components
less
5.1
5.1.1 The need for business finance
Incorporated
businesses
(e.g. companies)
It is usual for an administrator to be appointed with
the responsibility of protecting shareholders’ interests.
Administrators attempt to keep the business trading,
though they may have to sell some assets to do so.
If the administrator is not able to keep the business
trading by renegotiating and settling its debts, the
company will face liquidation.
Current liabilities
(Debts payable in the short term)
• Debts repayable to the bank, e.g. overdraft
• Trade and other payables who expect to be
paid in the near future
• Tax due to authorities
▲ Figure 5.3 Working capital
GLOSSARY TERMS
Bankruptcy occurs when an individual, a sole trader or a
partnership is judged unable to pay its debts by a court of
law.
Liquidation is the dissolution of a company by selling its
assets to settle its liabilities.
Administration is a process available to a company to
protect itself while it attempts to pay its debts and to
escape insolvency.
STUDY TIP
In some circumstances, current liabilities might be
greater than current assets. In this case, working capital
will be negative (and may be called net current liabilities).
As a negative figure it is often shown in brackets.
HANDLING DATA
Last year Darwin Hotels Limited had current assets
amounting to the value of $25.0 million and current
liabilities totalling $19.9 million.
1 Calculate its working capital for last year.
2 This year its current assets fell by 5 per cent while
its current liabilities rose by $1.1 million. Calculate
its working capital for this year.
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AS LEVEL 5.1 Business finance
5.1
5.1.2 Working capital
Working capital measures the amount of money available
to a business to pay its day-to-day expenses, such as bills
for fuel and raw materials, wages and business rates. Much
attention is given to the capital firms choose to invest in
non-current assets, but of equal importance to the success
of a business is the capital set aside to finance regular
transactions.
Working capital is what remains of a business’ liquid assets
once it has settled all its immediate debts (see Figure 5.3).
It is possible to calculate the working capital of a business
from its statement of financial position by using the
following formula:
working capital = current assets – current liabilities
A statement of financial position records a business’
assets and liabilities. We look at statements of financial
position (also known as balance sheets) in detail in
Chapter 10.1.
Working capital is important to all businesses. It has been
described as the ‘lifeblood’ of a successful enterprise.
If any business is unable to pay its bills promptly, then
it may be forced to close down as a consequence of
insolvency.
However, working capital can also be a source of finance
for a business. If a business manages its working capital
effectively it may have a strong working capital position. To
do this, it may need to:
» make sure that its trade receivables (the money that it is
owed from customers and any other groups) are received
on time
» ensure that it does not hold too high inventory (or
stock) levels as this can tie up large amounts of cash for
a business
» pay its own debts (trade payables) as late as possible
so that as much cash as possible is held in the business
at any given time.
If a business’ current assets exceed its current liabilities
on a regular basis, this provides the business with a
potential source of finance. However, this source of finance
is only available on a short-term basis.
GLOSSARY TERMS
Working capital is the cash a business has for its
day-to-day spending.
Current assets are items owned by a business that can be
readily turned into cash. Examples include cash, money
owed by customers (trade receivables) and inventories
(stocks).
Trade payables is the amount of money owed by a
business to its suppliers for goods and services that have
been received but which have not been paid for.
Trade receivables is the amount owed by a business’
customers for products that have been supplied but for
which payment has not yet been made.
CASE STUDY
Melaka Limited raises $9.3 million
for working capital
Melaka Limited has sold $9.3 million of its shares to
raise finance to ensure that it has sufficient working
capital to fund its future plans. It sold 46.5 million
new shares to raise the finance it required and the
company’s directors said they were ‘delighted’ with the
support of the shareholders in buying the shares.
Melaka Limited operates in the oil and gas industry
and is seeking to expand quickly and provide energy to
the rapidly growing Asian economies. This involves the
discovery and extraction of oil and gas from different
locations including the Timor Sea and the Gulf of
Thailand.
In June 2020, the company announced losses of $5.7
million for the financial year compared to profits of
$14.2 million for the previous financial year.
Question
1
Explain two reasons why Melaka Limited might
have needed large amounts of working capital.
[6]
Managing trade receivables and
trade payables
By managing trade payables and trade receivables carefully,
businesses can reduce the chances of running out of cash and
improve their working capital position. As we saw earlier, a
shortage of cash is a major cause of insolvency.
Most businesses are granted time to pay for products by
their suppliers. For example, an airline might buy a large
quantity of aviation fuel for $5 million from an oil company.
This fuel might be delivered in March, but payment may not
be expected until June. This means that the oil company is
giving the airline credit (called trade credit) for three months.
The $5 million will be a trade payable for the airline as it is
money that it owes for goods it already has but for which
payment is outstanding. This is a financial advantage for the
airline as it is, in effect, a $5 million loan for three months
on which no interest is charged. It is also an example of a
trade payable – a short-term debt which has yet to be paid.
In contrast, many businesses also give their customers
time to pay for the goods and services that they buy.
A coffee producer may sell large quantities of coffee to
customers such as shops and cafés. The coffee producer
may, for example, allow a large supermarket trade credit for
two months when it places an order for coffee worth $2.5
million. This is a valuable order and the coffee producer will
want to keep the supermarket as a customer. This means
that the supermarket does not have to pay the $2.5 million
for the coffee it has bought until two months after it
arrives in its warehouses. From the coffee producer’s point
of view this is a trade receivable, as it is a debt for goods
supplied which has not yet been received.
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We will look at trade payables and trade receivables in more
detail in Chapter 10.2.
Revenue expenditure and capital
expenditure
We have seen that businesses need to raise capital to start
up and to expand. Once a business has raised funds to
finance its start-up costs, the business can start trading.
If it takes a decision to expand, the business will require
additional finance, in excess of that received from sales, to
finance the purchase of additional non-current assets and
other items.
If the start-up or the expansion is successful, the new or
newly expanded business will earn revenue from its sales.
This will be used to buy more labour services and raw
materials to enable it to continue trading.
The expenditure carried out by a business can be divided
into two categories: revenue expenditure and capital
expenditure. Capital expenditure is on items that may
be used many times, mainly non-current assets. A new
computer system is an example of capital expenditure.
Expenditure on items required to start up or to expand a
business can be classified as capital expenditure. These will
be shown on a business’ statement of financial position as
they include the purchase of non-current assets.
Revenue expenditure is on the goods and services needed by
a business that will be used up in the short term as a normal
part of its trading activities. Spending on employees’ wages
is an example of revenue expenditure. Revenue expenditure
is shown on a business’ income statement as it is part of a
business’ trading costs or expenses. The differences between
revenue expenditure and capital expenditure are summarised
in Table 5.2.
5.1
▼ Table 5.2 Revenue and capital expenditure
Revenue expenditure Capital expenditure
Explanation This is spending on
assets that are used
up in a relatively
short period of time.
This is spending on
non-current assets
that will be used by
the business for a long
period of time.
Examples
Spending on fuel,
components and raw
materials.
Expenditure to purchase
property, vehicles and
production equipment.
Possible
effects on
profits
Revenue expenditure This type of spending
is essential to
has no immediate
production but, if not effect on profits.
controlled, can have However, capital
an immediate and
expenditure is essential
damaging effect on a if a firm is to generate
business’ profits.
long-term profits.
5.1.2 Working capital
Businesses can improve their working capital position by
managing trade receivables and trade payables carefully.
There are several actions a business can take:
» It can delay its trade payables (or negotiate more trade
payables) if possible. This will mean that it will hold
cash within the business for longer, giving it a higher
sum of cash within the business.
» It can require that its trade receivables are paid by its
customers within a shorter time period. This will bring
quicker inflows of cash, again helping its trade balance.
» Many businesses will seek to carry out both of the
actions above, as each has a positive effect on their
holdings of cash.
GLOSSARY TERMS
Revenue expenditure refers to the purchase of items such
as fuel and raw materials that will be used up within a
short space of time.
Capital expenditure is the spending by a business on noncurrent assets such as premises, production equipment
and vehicles.
A statement of financial position is a financial statement
that records the assets (possessions) and liabilities
(debts) of a business on a particular day at the end of an
accounting period. It was previously called a balance sheet.
An income statement is a financial statement showing a
business’ sales revenue over a trading period and all the
relevant costs incurred to generate that revenue.
CASE STUDY
Vardhman Textiles
Vardhman Textiles, one of India’s largest textile
manufacturers, plans to increase its capital expenditure by
142 per cent in 2021–22 to finance the purchase of the new
property and machinery needed for its planned expansion.
The company expects to spend Rs. 7.5 billion compared to
Rs. 3.5 billion in 2018–19.
The company manufactures fibre, yarn, sewing thread and
fabrics, and forecasts significant rises in its revenue from
sales and consequently rises in its profits.
▲ Figure 5.4 A selection of textiles
Vardhman’s recently released Annual Report judged
that yarn exports would be affected due to a slowdown
in demand owing to the Coronavirus (COVID-19) crisis
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AS LEVEL 5.1 Business finance
5.1
in 2020. However, it expects a revival in global demand
and significant growth in yarn sales in 2021. The Report
expects cotton prices to be relatively unchanged in 2021–
22 following a 6.1 per cent fall in cotton prices in 2019–20.
At the same time, the prices paid by buyers of yarn have
risen by 32 per cent to Rs. 210 per kilogram.
Questions
1Define the terms:
a ‘revenue expenditure’
[2]
b ‘capital expenditure’.
[2]
2 Evaluate the view that this capital expenditure will
increase the profits earned by Vardhman Textiles. [12]
TEST YOUR LEARNING
Short answer questions
1
Explain one circumstance in which a business may
need to raise finance.
[3]
2 Explain one difference between short-term and
[3]
long-term sources of finance.
3 Explain one difference between cash and profits. [3]
4 a Define the term ‘bankruptcy’.
[2]
b Explain one circumstance in which a business
[3]
would be judged to be insolvent.
5 Explain one difference between compulsory
liquidation and voluntary liquidation.
[3]
6 Analyse one circumstance in which administration
[4]
might enable a company to avoid liquidation.
[2]
7 a Define the term ‘working capital’.
b Explain one reason why working capital
[3]
is important to all businesses.
8 Explain one difference between trade payables
and trade receivables.
[3]
9 Explain two ways in which a business might manage
its trade receivables and trade payables effectively. [6]
10 Explain one difference between revenue expenditure
and capital expenditure.
[3]
Data response question
HW Limited is growing very quickly
HW is a private company that manufactures machinery for
export to businesses across the world. The company has
grown quickly recently and has been keen to attract new
customers. It expects to continue its fast growth in sales
and needs to place a very large order with its suppliers for
parts and components.
HW has:
l ordered increasing amounts of supplies needed to
manufacture its machinery and has some overdue
bills
l offered trade credit to its customers allowing them 90
days to pay for deliveries
l not been able to persuade its own suppliers to offer it
more than 30 days’ trade credit for its purchases.
HW has recently supplied a major customer with
machinery valued at $14.6 million – easily its largest-ever
order. The company is waiting for payment, which is due in
45 days.
The company’s financial position is mixed: it is profitable
but short of cash. Its products are well-designed, reliable
and it is able to charge high prices. The company’s
managers are very successful at keeping costs low.
However, it has an urgent need for short-term finance and
this is worsening.
Last month HW faced a financial crisis and was unable to pay
its suppliers. It feared that it might be forced into liquidation.
However, it was advised to go into administration. The
administrator was able to renegotiate the later repayment of
some of its debts and the company survived.
Questions
1
2
3
a
b
Define the term ‘liquidation’.
[2]
Explain one reason why HW had ‘an urgent need
for short-term finance’.
[3]
Analyse one reason why HW is profitable but suffers
[4]
from cash-flow problems.
Evaluate whether or not it was a good decision for
HW to enter administration.
[12]
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5 Finance and accounting
AS LEVEL
5.2
Sources of finance
In this chapter we examine:
★ business ownership and sources of finance
★ internal and external sources of finance
★ the factors that affect the choice of sources of finance
★ how businesses select their sources of finance.
5.2.1 Business ownership and
sources of finance
The form of ownership (or legal structure) is a major
influence on the sources of finance that are available to
a business. We looked at the different types of business
ownership in Chapter 1.2.
Start-up businesses, many of which may be sole traders or
partnerships, normally have a relatively limited range of
sources of finance to draw upon as they represent a greater
risk to potential investors and have few, if any, internal
sources of finance for use. In contrast, a limited company
has a greater range of sources of finance that it can use,
including the sale of shares. In the UK, only public limited
companies can benefit from being able to raise capital
by selling shares on the London Stock Exchange, but all
companies can sell their shares to individuals, with certain
limitations.
Table 5.3 sets out the major sources of finance available
to each of the major legal structures and offers some
consideration of factors that decision-makers in each case
may take into account. We shall consider these sources of
finance in more detail in the following section.
5.2.1 Business ownership and sources of finance
Chapter overview
▼ Table 5.3 The legal structure of a business, possible sources of finance and key issues
Legal form of business
Possible sources of finance
Key issues for consideration
Sole trader or proprietor
Owner’s savings, banks, suppliers,
government grants and loans
• Difficulty in providing security for those
lending funds to ensure repayment (known as
collateral)
• Loss of control by owner
• Businesses must provide evidence that they
have potential to develop
• Financial history of business/owner
Partnership
Partners’ savings, banks, suppliers,
government grants and loans
• Problems of introducing new partner
• Lack of collateral
• Potential expense of raising large sums of
money
• Should it form a limited company?
Private limited company (ltd)
Dependent upon the size of the private
limited company: suppliers, banks,
government grants and loans, venture
capital institutions, private share issues
• Disagreement among existing shareholders
• Difficulty finding suitable shareholders
• Loss of control by existing shareholders
• Lack of collateral for those lending funds
• Element of risk in a loan
Public limited company (plc)
Suppliers, banks, government grants and
loans, venture capital institutions, public
share issues via the stock exchange
• State of economy and stock market
• Ability to move to an area receiving
government aid
• Recent financial performance
• Reputation of company and senior managers
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AS LEVEL 5.2 Sources of finance
5.2
5.2.2 Internal and external
sources of finance
We saw in the previous chapter that businesses need finance
for a range of reasons. There are a number of sources from
which they can raise finance. These can be split into two
categories:
» internal sources of finance from within the business
» external sources of finance from outside the business.
GLOSSARY TERMS
An internal source of finance is one that exists within the
business.
An external source of finance is an injection of funds
into the business from individuals, other businesses or
financial institutions.
and are not paid to owners. It is common for businesses to
use these retained earnings as sources of finance. By using
retained earnings for reinvesting, a business avoids paying
interest on a loan and this can avoid heavy interest charges
if a large loan is required. Furthermore, using this source of
finance may avoid the need for a company to sell further
shares, enabling existing shareholders to retain control if
they continue to hold a majority of the shares.
But using retained earnings can have substantial
opportunity costs – that is, the business may lose out from
not using these funds in another way. Reinvesting retained
earnings may not be popular with shareholders who could
receive higher dividends if retained earnings were reduced.
Alternatively, the business may lose out on interest it may
have received if it had held the money in an interest-paying
bank account.
Trade credit is a period of time offered by suppliers of
goods and services before payment is to be made.
This method of finance is only available to firms making a
profit over a period of time. Even then, the profits may not
be sufficient to purchase expensive non-current assets.
Internal sources of finance
Sale of unwanted assets
The major internal sources of finance are owners’
investments, retained earnings, sale of unwanted assets, sale
and leaseback of non-current assets and working capital.
Firms can raise cash by selling assets that they no longer
require – normally these are non-current assets. The sale
of some assets can raise large amounts of finance for
businesses. Thus, a business might have land, buildings
or other assets that are not required and they may decide
to sell to raise capital. In 2019, Murphy Oil Company, an
American multinational, sold some assets it owned in
Malaysia, including oilfields, for $2.13 billion. Murphy Oil
Company was raising money to invest in shale oilfields in
America which were expected to be highly profitable.
Owners’ investments
One source of finance is for the owners of the business to
provide the funds from their own resources. This may involve
the use of savings. Alternatively, the owners of a business
may take out a personal loan using their house (or other
assets) as security and invest this money into their business.
They may also persuade friends and family to invest in their
business, perhaps in return for part-ownership.
Owners investing in their own business can be helpful in
persuading others to invest. Banks and other financial
institutions will often want to see evidence that business
owners are willing to risk some of their personal capital
in the enterprise before agreeing to make a loan or other
investment. If the owners are not willing to risk investment
in their own business, it will be more difficult to raise
finance from other sources.
Retained earnings
Earnings from previous years are a major source of finance,
particularly for smaller businesses. A company’s retained
earnings are those profits from previous years that have not
been paid to shareholders as dividends. For other types of
business, they are the profits that remain in the business
Raising finance in this way offers a key benefit in that the
business is not committed to a stream of future interest
payments, nor might its shareholders suffer dilution of
control. However, the business would normally lose access
to the assets it has sold.
Sale and leaseback of non-current assets
But what if the non-current assets will continue to be
required by the business? A popular technique of raising
funds in recent years has been sale and leaseback. Under
this arrangement firms sell valuable assets and lease them
back again. This means that they have the capital from the
sale of the assets as well as the continuing use of these
assets, so that their business is not disrupted. The major
drawback is that the business now has to pay for the use of
assets which previously were freely available. This may have
a negative impact on long-term profits.
CASE STUDY
Ted Baker Plc in a sale and leaseback deal
The British fashion clothing retailer, Ted Baker Plc, has
sold its headquarters in King’s Cross, London, in a sale and
leaseback deal. The company, which sells clothing in stores
in ten countries, has received a reported £78.75 million for
the property known as the ‘ugly brown’ building. This will
allow the company to reduce the amount of debt that it has
and the interest payments due on it.
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many of its shops due to the 2020 Coronavirus (COVID-19)
pandemic. Although it continues to sell its products
online, its managers estimate that sales have fallen by 68
per cent as a result of the store closures.
Ted Baker’s financial performance has been poor in
recent months. Ted Baker recorded a loss from trading of
£23 million over the six months to August 2019, compared
to a profit of £24.5 million in the same period in 2018. The
company’s share price has fallen from around 500 pence
in October 2019 to just over 100 pence in April 2020.
Questions
1
2
Along with many other retailers, the company has
suffered a heavy fall in sales when it was forced to close
levels, chasing customers for payment (other organisations
that owe the business money) more urgently and delaying
payment to suppliers can raise cash generated from a firm’s
working capital.
STUDY TIP
Do take care to distinguish between the sale of unwanted
assets and sale and leaseback arrangements. The latter
may be appropriate as a source of the finance if the
assets are important to a business’ continued trading.
If the assets are surplus to requirements, a simple sale
may be the best option.
Working capital
As we saw in the previous chapter, working capital is
the cash required by a business to pay for its day-to-day
operations. Working capital is needed to pay for items
such as fuel, raw materials and wages. Reducing inventory
Owners’
investment
Retained
earnings
Explain two reasons why Ted Baker might have
[6]
wanted to reduce its amount of debt.
Evaluate whether or not a sale and leaseback deal
was a good method for Ted Baker to raise finance
at this time.
[12]
Firms might seek to improve terms they are offered for
trade credit. Many suppliers grant their customers an
interest-free period of grace in which to pay for goods
and services they have received. From the customers’
point of view, this is a useful form of finance that helps
fund working capital at the expense of the seller’s cash
flow. The typical credit period offered to customers is 30
days. If a business can extend this period to, say, 60 days,
it is equivalent to an interest-free loan lasting for two
months. It may be, however, that suppliers are less willing
Sale of
unwanted
assets
Sale and
leaseback
5.2
5.2.2 Internal and external sources of finance
In 2020, Ted Baker Plc also announced that it was cutting 102
jobs and removing 58 vacant posts as part of a strategy to
cut its costs. The retailer expects to save £12 million over the
next two financial years as a result of these staff reductions.
Working
capital
Internal
Government
grants
Sources
of
finance
Share capital
Crowdfunding
Microfinance
Debentures
External
New partners
Trade credit
Debt factoring
Venture capital
Mortgages
Bank overdrafts
Bank loans
Leasing and
hire purchase
▲ Figure 5.5 Internal and external sources of finance
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5.2
to offer discounts on selling prices if they grant generous
trade credit terms. Although the receipt of trade credit is
a means of improving a company’s working capital, it is
technically an external source of finance.
AS LEVEL 5.2 Sources of finance
External sources of finance
When individuals, other businesses or organisations such
as banks or governments provide capital to a business, this
is termed external sources of finance. Businesses are more
likely to use external sources of finance when:
» a large sum of finance is required (as they will find it
more difficult to raise such sums internally)
» the level of risk associated with the business is low,
making it easier to persuade outsiders to invest or lend
money
» the company’s profit levels are relatively low, reducing
the possibility of the use of retained profits.
The following are some of the main external sources of
finance.
Share capital
This is a very common form of finance for both start-up
capital and also for additional capital in a later stage of the
business’ life. Firms raise capital by selling, quite literally,
a share in their business to investors. A share is simply a
certificate giving the holder ownership of part (or a share)
of a company. Owning shares is sometimes called having
equity in a company. By selling large numbers of shares,
companies can raise significant sums of capital. Issuing
shares can be very expensive as it normally involves hiring
the services of specialist financial experts, which means it
is only appropriate for raising very large sums of capital.
Share capital is available to both private limited companies and
public limited companies. However, in the UK, it is much easier
for public limited companies to sell shares for two reasons:
» They can sell shares on the stock exchange. This is an
efficient international market which brings together
buyers and sellers of shares and sets share prices.
» Unlike private limited companies, public companies do not
need the permission of other shareholders to sell shares.
Equally, existing shareholders can sell their shares freely.
Both these factors make it easier to buy and sell shares in
public limited companies and encourage shareholders to buy
shares in the first place.
There are a number of benefits from selling of shares or
equity as a source of finance. Although a company will
be expected to pay an annual return to shareholders
(dividends), the level of this payment is not fixed and in
an unprofitable year it may be possible for the company to
avoid making any payment.
Bank overdrafts
A bank overdraft is perhaps the best-known method of
short-term finance. It is a service offered by banks allowing
a business to borrow up to an agreed limit for as long as it
wishes. Overdrafts are a very flexible form of finance as the
amounts borrowed can vary as long as they are within an
agreed figure. They are also simple to arrange – established
business customers can often arrange or increase the limit
of an overdraft without completing any forms.
However, overdrafts can be quite expensive, with interest
being charged at between 4 and 6 per cent over the bank’s
normal lending rate on a daily basis. This is not a problem
unless a business seeks to borrow on overdraft over a long
period of time. In these circumstances, it might be better
for a business to convert its overdraft to a longer-term
method of finance. A further drawback of using overdrafts
as a source of finance is that banks can demand immediate
repayment, although this is rare.
Trade credit
This is another form of short-term finance which is
normally available for periods of 1–3 months. Trade credit
is the period of time given by suppliers before payment
for goods and services is due. Trade credit is really an
interest-free loan offered by suppliers, usually for periods
of 30–90 days. This can be invaluable for any business that
is short of cash, and the absence of interest charges makes
it more attractive than an overdraft.
Leasing and hire purchase
These are similar forms of finance in many ways, but they
have one important distinction. Hire purchase is a means
of buying goods whereby a buyer pays through a series of
instalments, often paid monthly. In most cases, the goods do
not belong to the purchasing business until the final payment
is made. This operates similarly to a loan in that the business
effectively has the finance to buy the goods and pays the
cost back over time. Goods purchased on hire purchase may
be more expensive than if the business was able to pay cash.
Leasing also involves paying for non-current assets, such
as vehicles and machinery, over a period of time. However,
in this case the business never owns the assets; it is really
renting them for a specific time period. It does, however,
avoid the need for businesses to find large sums of capital
to finance the purchase of expensive non-current assets.
Bank loans
Bank loans are relatively straightforward to arrange if the
business that is seeking the credit has a satisfactory financial
history. The bank gives the business an agreed amount of
money and the business makes repayments over an agreed
period of time. The amount repaid includes the amount
of capital borrowed, plus interest. If the bank lending the
capital considers the loan in any way risky then it is likely
to charge a higher rate of interest. Small businesses, in
particular, suffer from this effect. Normally banks charge
about 2 per cent over their base rate of interest for bank
loans. Interest rates can be fixed or variable. A fixed rate
means that the interest rate charged will not change over the
period of the loan; however, a variable rate may change.
Banks will often require security for their loans and this will
usually be in the form of property. Such security is often
termed ‘collateral’. If the business defaults on the loan by
not making repayments, the bank can sell the property or
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other assets held as collateral in order to recoup the money
that was lent. In this way, the bank lowers the degree of
risk it incurs in making loans to businesses.
collateral for the loan. These loans can be for long periods
of time – often up to 50 years. Mortgages can have fixed or
variable rates of interest and are particularly suitable when
a business wishes to raise large sums of money.
GLOSSARY TERMS
Some businesses may choose to remortgage their premises
to raise capital. A remortgage either increases the existing
mortgage or establishes a mortgage where one did not exist
before. This source of finance is particularly popular with
small businesses.
A bank loan is an amount of money provided to a business
for a stated purpose in return for a payment in the form of
interest charges.
Debt factoring takes place when banks provide up to 80
per cent of the value of a business’ debts immediately to
provide an instant inflow of cash.
Mortgages
Mortgages are long-term loans granted by financial
institutions solely for the purchase of land and buildings.
The land or building in question is used as security or
5.2.2 Internal and external sources of finance
Venture capital is funds (in the form of a mix of share and
loan capital) that is advanced to businesses which are
thought to be relatively high-risk.
5.2
Debentures
Debentures are a special type of long-term loan to be repaid
at some future date, normally within 15 years of the loan
being agreed. The rate of interest paid on debentures is
fixed. In some circumstances, debentures may not have
a repayment date, representing a permanent loan to the
business; this is an irredeemable debenture. Debentures are
normally secured by using the business’ non-current assets
as collateral. They are another form of loan capital. Holders
of debentures do not have voting rights in the business.
CASE STUDY
Even banks need to raise capital
India’s third-largest private-sector bank raised Rs 125 000
million ($1.76 billion) by selling shares in September 2019.
Axis Bank said that its share issue was oversubscribed
(meaning that the demand for shares was greater than the
number for sale). The share price was Rs 629 each.
Shares of Axis Bank were trading 1.3 per cent higher at
Rs 703.70 on the Indian Stock Exchange following the share
sale. The shares were sold to several large-scale foreign
investors as well as to insurance companies.
Amitabh Chaudhry, Axis Bank’s chief executive officer
said ‘We will strive to ensure that we continue our
growth journey and keep delivering the best value to our
Venture capital
Venture capital is an important source of finance for
small to medium-sized businesses which are considered to
be risky and therefore in some danger of failing. Venture
capital is normally a mix of loan and share capital. Financial
institutions (for example, merchant banks) provide venture
capital, and wealthy individuals (who are known as ‘business
angels’) are another source.
Organisations and individuals providing venture capital
frequently wish to have some control over the organisation
to which they are providing finance. The business’ owners
may need to sell some shares in their company (generally
a minority stake) to the person or organisation providing
the venture capital. Providers of venture capital may seek
a non-executive director role in the business in which they
are investing. Venture capital investors not only provide
capital but also experience, contacts and advice when
required, which distinguishes venture capital from other
customers, shareholders and investors consistently and
on a sustainable basis’.
Raising this capital from an external source of finance will
help Axis Bank to achieve its growth strategy.
Source: www.vccircle.com/axis-bank-raises-1-76-bn-viashare-sale-to-gic-others-bain-capital-sits-out
Questions
1
2
Explain one difference between external and
internal sources of finance.
Evaluate the case for and against Axis Bank
raising finance by selling shares.
[3]
[12]
sources of finance. However, a significant drawback is that
providers of venture capital will not advance huge amounts
to businesses. It is unusual for venture capitalists to lend in
excess of $850 000 in a single deal.
Debt factoring
Debt factoring is a service offered by banks and other
financial institutions. If businesses have sent out bills (also
termed invoices) that have not yet been paid, they can ‘sell’
these bills to gain cash immediately. Selling or factoring
debts in this way provides up to 80 per cent of the value of
an invoice as an immediate cash advance. A further payment
is made once the financial institution receives the payment
of the invoice. It is usual for the financial institution to
retain approximately 5 per cent of the value of the invoice
to cover its costs of collecting the debts. However, in some
circumstances, no payment may be required and, in others
cases, a flat fee may be charged rather than a percentage
payment. The process is summarised in Figure 5.6.
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Business
5.2
AS LEVEL 5.2 Sources of finance
1. Business
supplies customer
with goods
and services.
5. Factor pays
business remainder
of debt when
collected from
customer; charges
fees of
approximately 5%.
3. Factor initially
pays business
approximately
80% of value
of debts.
Organisation providing
factoring services
4. Customer pays
factor full value of
debts when due.
2. Business ‘sells’
debts to factor.
Financial
organisations
such as banks
provide debt
factoring
services
Customer
▲ Figure 5.6 The process of debt factoring
Many small firms believe that to lose up to 5 per cent of
their earnings makes factoring uneconomic – this can
eliminate much of their profit on the sale of their products.
Their customers are also likely to be aware that the debts
have been factored, which may cause them to worry about
the business’ ability to manage its short-term finance. They
may seek other suppliers if they believe the business is
financially unstable. However, debt factoring does offer a
number of benefits:
» The immediate cash provided by the factor means that
the firm is likely to have lower overdraft requirements
and will pay less interest.
» Factoring means businesses receive the cash from their
sales more quickly.
Debt factoring has become more popular for businesses
in some countries. This is particularly true for small and
medium-sized businesses, as overdrafts have become more
difficult to arrange.
Microfinance
Microfinance is a term that describes the provision of
financial services for poor and low-income clients. Although
much publicity has been given to the granting of small
loans, microfinance includes other basic financial services
such as savings, the transfer of money and insurance for
those on low and very low incomes. An important element
of microfinance is that it supports the transfer of money
from people earning reasonable incomes to poorer relatives
and friends in different countries. Without the services
provided through microfinance, this might not be possible.
Improving access to such services allows those on low
incomes to fund activities which will create incomes, build
assets and protect against risks. Microfinance is regarded
by many as a way of reducing poverty among low-income
citizens across the globe. Microfinance can entail a transfer
of money from high-income to lower-income countries. The
case study below illustrates its workings and benefits.
CASE STUDY
Lendwithcare
Lendwithcare ‘fights poverty and injustice in 87 countries
around the world to help the world’s poorest people find
routes out of poverty’. As part of its poverty-fighting
work, Lendwithcare provides microfinance services.
Large numbers of relatively wealthy individuals in
high-income countries provide small amounts of
funds to Lendwithcare. These are subsequently lent to
entrepreneurs in low-income countries and repaid over a
period of time. The loans normally help the entrepreneurs
to establish or expand their businesses.
Lendwithcare is seeking to organise microfinance for
María del Carmen Jimenez’s business plan. María
is 28 and a single mother with one child, and lives in
Cariamanga in Ecuador. María is a primary school
teacher. She has had the position for the last six years.
Additionally, she runs a beauty parlour with her sister. Her
sister works at the parlour full-time while María joins her
each day after finishing teaching at school.
María requested a loan in order to purchase new furniture
and accessories for the parlour. Hopefully, this will make their
business more attractive and bring in more customers. María
would also like to purchase extra inventories, specifically
creams, soaps and lotions, as many of their customers are
women who ask for facials and make-up. María is seeking a
loan of about $2000 and plans to repay it over one year.
Source: https://platform.buildily.com/lend-with-care;
www.lendwithcare.org
Questions
1
2
Explain two reasons why banks in Ecuador might
be unwilling to lend María $2000.
Evaluate the arguments for and against lending
María a small sum of money.
[6]
[12]
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Crowdfunding
Crowdfunding is attractive for businesses as it avoids the
need to deal with local banks, which can be bureaucratic
and slow to make decisions. Furthermore, even if the banks
agree to grant a loan to a business, they may charge higher
interest rates than crowdfunders.
GLOSSARY TERMS
Crowdfunding has become popular in recent years, especially
with small and medium-sized businesses, because banks in
many countries have been unwilling to lend following the
financial crisis of 2009–10. Equally, savers with spare cash
have received very low interest rates and these have often
been lower than the rate of inflation, meaning that savings
are losing value over time. Consequently, savers have sought
other ways to generate income from their savings.
Microfinance is the provision of financial services for poor
and low-income clients.
Crowdfunding is a source of finance that entails collecting
relatively small amounts of money from a large number of
supporters (the ‘crowd’).
CASE STUDY
Crowdfunding: a different source of finance
George Christakos owns and manages a restaurant
in Nova Scotia, Canada. Facing the normal difficulties
in raising capital, he decided to use his business’
customers as a source of finance. He wanted to enlarge
the restaurant that he co-owned with his father, Leo, in
the town of Halifax. George’s first choice as a source of
finance, the bank, decided not to lend him any money.
Not dismayed, George and his father decided to use
crowdfunding to raise the finance they needed.
Mr Christakos’ crowdfunding effort was unique, but
entirely suitable for his business, and comprised three
options for his customers. For investing $50, a customer
was rewarded with lunch for two and two t-shirts. The
option of a four-course dinner for two for investing $100
proved to be the most popular. For customers with larger
sums to invest, George offered two dinners a year for the
rest of the restaurant’s life.
Government grants
There are various grants and subsidised loans available to
businesses from the UK government and other agencies
within the UK. The government offers grants and loans
to support business expansion, to provide funding for
researching and developing new products, and to assist
5.2
5.2.2 Internal and external sources of finance
Crowdfunding is a source of finance that entails collecting
relatively small amounts of money from a large number of
supporters (the ‘crowd’). Crowdfunding in a business context
usually involves members of the ‘crowd’ each lending a small
sum of money to the business. Occasionally, these small
sums may be given as donations or represent early payment
for the business’ goods or services. Online businesses (such
as Kickstarter) exist to bring together entrepreneurs and
large numbers of investors offering small sums of capital.
The activities of businesses such as Kickstarter have helped
to make crowdfunding a viable and popular source of
finance for businesses, especially small ones.
A number of entrepreneurs have set up internet-based
businesses to meet the needs of savers and small and mediumsized businesses. They have acted as a link between the two
groups, providing information on businesses seeking finance
and administering loans provided by the ‘crowds’ of savers.
Each saver may lend a relatively small amount to any business;
this limits the effect if the business fails to repay the loan.
Using crowdfunding as a source of revenue, the
restaurant raised $23 000 from 115 contributors, 80 per
cent of whom lived close to the restaurant. Crowdfunding
campaigns can take many different forms. Some involve
donations while others, such as Mr Christakos’ effort,
involve the pre-purchase of goods or services. In any
event, the goal is to raise capital.
Questions
1
2
Analyse two reasons why a loan from the bank
might have been George Christakos’ first choice
of a source of finance.
[8]
Evaluate the major advantages and disadvantages
to a small business of using crowdfunding as a
source of finance.
[12]
businesses in buying new premises or improving existing
properties. An estimated 4500 grants and financial
programmes are available to UK organisations, amounting to
a potential total value of £50 billion. Many other countries
offer similar schemes.
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AS LEVEL 5.2 Sources of finance
5.2
Government grants will usually only cover a proportion
of the total costs of a start-up or an expansion. There is
also likely to be a great deal of competition from other
businesses for government grants and there is usually a
fixed amount of money available under most grant schemes.
However, the major advantage of government grants is that
entrepreneurs and businesses do not have to repay them as
long as they meet any conditions under which the grant was
given.
The rate of interest
The rate of interest charged by organisations granting loans
can be a significant influence, especially if the loan is a
large one. The interest rate charged will depend on the level
of risk that the loan represents to the lender and the time
period of the loan. A short-term loan to a high-risk business
might be charged at a high rate of interest.
CASE STUDY
GLOSSARY TERM
A government grant is a sum of money given to
entrepreneurs or businesses for a specific purpose.
HANDLING DATA
A government provided a grant of 15 per cent of the
start-up cost of a new business under one of its
schemes. The amount of the grant was $375 000. How
much was the start-up cost of the new business?
New partners
Pakistan’s cement industry faces high
borrowing costs
Paying interest on loans has become a major cost for
Pakistan’s cement industry, given that interest rates
have steadily risen to around 13 per cent at the start
of 2020. Companies in the cement industry are paying
high interest rates on long-term borrowing. This has
led to calls for a reduction in interest rates amid fears
that the high costs of financing loans might hit the level
of profits made by firms in Pakistan’s cement industry.
Some of the firms are considering issuing shares as an
alternative means of raising the finance that they need.
This is an option for small and medium-sized enterprises.
A partnership (whether it has limited liability or not) can
take on a new partner who will invest into the enterprise
in return for becoming a partner and owning a share of the
business. Similarly, a private limited company can decide
to sell more shares, as long as the existing shareholders
support the decision. In return for the ownership of a share
of the business, the new partner(s) or shareholder(s) will
provide an injection of capital.
The industry’s financial position has been weakened
further by poor levels of demand in Pakistan for
concrete products and by a sharp decline in the level of
exports to India. Sales of cement products have been
flat in most countries, with the exception of China.
Table 5.1 on page 163 classifies the sources of finance we
have discussed according to whether they are short- or
long-term, internal or external sources. You will note that
retained profits can be classified as short- or long-term
finance, as a business can opt to use this type of finance
over any timescale.
2
5.2.3 Factors affecting sources of
finance
The managers of a business that is deciding on a source
(or sources) of finance will be influenced by a number of
factors, including the following.
Cost of the source of finance
For most businesses that are raising capital, the cost of
alternative sources might be an important factor in making
a decision as to the best source of finance. The costs
incurred by firms raising capital can take a number of forms.
Questions
1
Explain one benefit that Pakistani cement
producers might receive from selling shares to
raise finance.
Evaluate the reasons why high interest rates
have been such a burden for businesses in the
cement industry in Pakistan.
[3]
[12]
The costs of selling shares
For a public limited company, a share issue can be an
attractive option. However, this can be an expensive
method of raising capital, as it entails considerable
administration and promotion and, on occasions, a form of
insurance to provide the funds if the sale is not successful.
When shares are first sold by a company, it has to use the
services of other expert organisations to organise the sale.
It is common for companies to use merchant banks for this
purpose.
Public limited companies sometimes use rights issues to
sell new shares. A rights issue involves selling additional
shares to existing shareholders in proportion to the number
of shares already owned. For example, existing shareholders
may be offered the opportunity to buy one new share for
each eight already held. Because of the relatively low cost
of issuing shares in this way, it is usual for them to be sold
at a slight discount to encourage sales.
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STUDY TIP
Opportunity cost
A decision to use a particular source of finance may have a
cost in terms of what has to be given up as a consequence
of the decision. For example, a decision to use sale and
leaseback as a source of finance may appear to be a lowcost option. However, this source of finance will commit
the company to paying each month or year for the asset
that has been sold. Similarly, using retained profits for
reinvestment into the company involves an opportunity
cost which can be measured in terms of the reduction
in the amount of profits available to pay dividends to
shareholders. Finally, receiving trade credit from a supplier
may be an attractive short-term source of finance, but it
carries a possible opportunity cost in that the supplier
may charge a higher selling price because it is, in effect,
providing an interest-free, short-term loan.
For many businesses, accessing sources of finance at the
lowest possible cost is the most important factor.
Flexibility
Some sources of finance are highly flexible and can be
adapted to meet a business’ precise needs. The most
obvious example is an overdraft. This source of finance
allows a business to overspend its current account or not
according to its needs (but subject to an overall limit).
Thus, a business can use its overdraft only when necessary
and can avoid any interest charges at times when its
finances are stronger. This flexibility has a cost, however:
overdrafts are an expensive source of finance.
Although government grants are appealing to many
businesses because they do not normally have to be repaid,
they can be an inflexible form of finance. Many grants are
only available with strict conditions attached. Many UK
government grants are only made if the business creates
new jobs or at least maintains employment levels. Because
of this, grants may not be a suitable source of finance in
circumstances where labour is relatively expensive and the
newly acquired finance could be used to introduce laboursaving technology.
The need to retain control
Some sources of finance may result in the original owners
of the business losing some, or even complete control of it.
5.2
Smaller businesses that do not trade as companies can
also lose some degree of control if they opt to use certain
sources of finance. For example, venture capitalists may only
agree to provide finance to what may be a risky business if
a part of their investment is in the form of shares and they
have a say in the management of the business.
The uses to which finance is put
Some sources of finance are particularly suitable in certain
situations. For example, a business that is seeking to raise
finance to purchase property and has to rely on loan finance
will probably consider taking out a mortgage. As we saw
earlier, a mortgage is a long-term loan (and can be available
at relatively low rates of interest) and the combination of
these two factors makes it an ideal source of finance to
purchase property, which can be very expensive.
5.2.3 Factors affecting sources of finance
Do not confuse the sale of new shares and second-hand
ones. Firms sell newly issued shares directly to the
shareholders. In contrast, second-hand shares are sold
mainly through the stock exchange. When second-hand
shares are sold on the stock exchange, it is not a source
of finance for the company whose shares are sold – it
is merely a means of the shareholder recovering the
investment by selling the shares to another person or
organisation.
Certain forms of finance are only available if the person or
organisation investing gains a say in how the business is
managed. This is perhaps most obvious in the sale of shares.
If a private or public company makes a succession of share
issues, it may be that the number of new shares issued is
greater than the number of ‘original’ shares. In this case,
the new shareholders may gain control of the company.
However, it may be possible for the company to issue shares
that do not carry full voting rights. This can allow the
original shareholders to retain control though, of course,
it makes the issue of new shares much less attractive to
potential shareholders.
If the finance is being raised to fund a risky start-up, then
an entrepreneur may experience difficulties in finding
investors willing to put capital into the business. In this
situation, a venture capitalist may be the best choice as this
source of finance specialises in investing in relatively highrisk enterprises and may also provide support and guidance
to novice entrepreneurs.
Finally, if the finance is needed to fund additional working
capital, perhaps because a business is expanding, then an
overdraft or perhaps trade credit may be selected as the
funding will only be required for a short period of time
until the business achieves a higher level of sales and an
increased inflow of revenue. This additional revenue can
repay the overdraft or settle the outstanding trade credit.
The level of existing debt
If a business has substantial amounts of existing loans,
banks may be unwilling to agree to increasing the amount
of debt. Banks may judge that further loans will represent a
risk to them as the interest payments may be considerable,
especially if interest rates rise. In such circumstances,
a business may be forced to seek alternative sources of
finance, such as selling an asset (and possibly leasing it
back) or selling shares if the business is a company. As a
rule of thumb, if a business has borrowed more than half
the total capital that it has raised, banks may judge further
loans to be too risky.
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The preceding section has highlighted that a business will
choose its sources of finance based on a number of factors,
including cost, flexibility and the need to retain control.
When making judgements on the most appropriate source of
finance, managers must take into account a range of factors
relating to the business’ internal position and the business
environment in which it is trading.
» The business’ financial situation Is it profitable? If
so, it may be able to use retained profits as a source of
finance or at least be able to provide evidence to banks
and other trade payables (creditors) that it can repay
loans. Alternatively, it may have assets that it can sell
and lease back, or simply sell.
» The business’ reputation A reputation as a reliable
and popular business may also enable its managers to
persuade suppliers to offer increased trade credit, which
can fund short-term needs for finance. Equally, such a
reputation will assist a business in negotiating loans,
possibly at favourable rates of interest, or in persuading
shareholders to purchase the company’s shares.
» The business’ legal structure This will play a role in
making the decision on the appropriateness of sources of
finance. Thus, only companies will be able to elect to use
share capital as a source to fund start-ups or expansions.
» The business environment The environment in which
the business is trading will also shape the decision.
If sales in a market are growing, the business may be
better able to finance the repayments on a loan as its
revenues should increase in the future. On the other
hand, if interest rates are high (making loan capital a
relatively expensive source of finance), businesses may
seek alternative sources.
CASE STUDY
Venture capital in China very scarce in 2020
50
At the time of writing, China is facing a lack of venture
capital for its start-up businesses. The situation is not
simply affecting start-ups, as established businesses that
are seeking to grow are also starved of venture capital.
There was a fall of over 65 per cent in investment in startups by venture capitalists in China and Hong Kong (called
Greater China) in the first three months of 2020 compared
to the same period in 2019. This increased the difficulties
in raising capital experienced by many businesses through
Greater China in a period which has become known as the
‘capital winter’. Figure 5.8 shows the dramatic decline in
venture capital as a source of finance in 2020 as compared
to previous years.
Questions
1
2
Analyse two circumstances in which a business
might choose to use venture capital as its primary
source of finance.
[8]
Evaluate the other sources of finance that an
entrepreneur starting a business in China in 2020
might choose to use.
[12]
STUDY TIP
If a question asks you to suggest and justify a source
of finance for a given situation, do not always select a
single source. It is very common for businesses to use
several sources of finance to fund a project, especially
if a large sum of capital has to be raised. It may also be
easier to justify the use of a mix of sources, as it reduces
the impact of the disadvantages of any single source of
finance.
45
40
35
US$ billion
AS LEVEL 5.2 Sources of finance
5.2
5.2.4 Selecting the source of
finance
30
25
20
15
10
5
0
2018 2018 2018 2018 2019 2019 2019 2019 2020
(1)
(2)
(3)
(4)
(1)
(2)
(3)
(4)
(1)
Year (quarter)
▲ Figure 5.7 Venture capital provided in Greater China,
quarterly 2018–20
Source: https://edition.cnn.com/2020/03/26/tech/china-startupfunding-coronavirus/index.html
As you can see, a business will take a range of factors into
account when selecting the best source (or sources) of
finance to use. There is no single best source – it always
depends on the circumstances.
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TEST YOUR LEARNING
Short answer questions
Data response question
1
Sunshine Tours looks to expand
a
Sunshine Tours Plc is a London-based company that sells
its shares on the London Stock Exchange. It sells holidays
to European and American tourists. All of its holidays
are based on the island of Mauritius. The company
has suffered a decline in sales due to falling incomes
in Europe and America, and its profits have steadily
declined, reaching just £48 million in 2019. However,
sales are forecast to rise over the next three years at an
accelerating rate.
The company’s directors wish to expand the business. The
company already has large long-term debts, although it
has repaid 30 per cent of these since 2017. Its business
plan for 2021–24 sets out details of capital expenditure
totalling £150 million, although the sources of finance to
be used have yet to be decided.
The company’s shares have been performing well, despite
its recent dip in profits, and it has maintained impressive
dividend payments to its shareholders. One of the
directors believes that the company should raise all the
capital it needs by selling shares. Another argues for the
use of debentures as interest rates are low in the UK.
5.2.4 Selecting the source of finance
Explain one source of finance that is available
to a sole trader.
[3]
b Define the terms ‘leasing’ and ‘hire purchase’. [4]
2 a Define the terms ‘loan capital’ and ‘share capital’. [4]
[2]
b Define the term ‘sale and leaseback’.
3 Explain one advantage and one disadvantage of
[6]
using debt factoring as a source of finance.
4 Define the term ‘microfinance’.
[2]
5 Using an example, explain one difference between
short-term and long-term sources of finance.
[3]
6 a Define the term ‘venture capital’.
[2]
b Explain one advantage to a business of using
venture capital as a source of finance.
[3]
[2]
7 a Define the term ‘government grant’.
b Explain one reason why it is easier for a public
limited company to raise finance by selling
shares than it is for a private limited company. [3]
8 Explain one reason why a partnership may
experience difficulties in raising large sums of
[3]
finance.
9 a Define the terms ‘overdraft’ and ‘bank loan’.
[4]
b Explain one disadvantage to a business of using
an overdraft as a source of finance.
[3]
10 Explain one advantage and one disadvantage to
companies of raising capital by selling shares.
[6]
5.2
Questions
1
2
3
Define the terms:
[2]
a ‘capital expenditure’
b ‘debenture’.
[2]
Analyse two factors that the directors of Sunshine
Tours Plc may take into account when deciding which
sources of finance to use to raise the £150 million it
[8]
needs.
Evaluate whether or not Sunshine Tours Plc
should sell shares as the only means of raising
the capital it needs.
[12]
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5 Finance and accounting
AS LEVEL
AS LEVEL 5.3 Forecasting and managing cash flows
5.3
Forecasting and managing
cash flows
Chapter overview
In this chapter we examine:
★ the meaning and purpose of cash-flow forecasts
★ the interpretation and amendment of simple cash-flow forecasts
★ the methods that businesses can use to improve their cash flow.
5.3.1 Cash-flow forecasts
The meaning and purpose of cash-flow
forecasts
should be included in the plan at the time they take
place. A simplified cash-flow forecast is illustrated in
Figure 5.8, which introduces opening and closing cash
balances. These are the sums of cash held by a business
at the start and end of a trading period.
Businesses need to manage their cash carefully to ensure
they have sufficient to pay their bills as they become due
for payment. This means that businesses need to manage
cash flows to ensure that cash can flow into the business in
time to be available to make payments – that is, in time to
meet cash outflows.
Cash flow is the movement of cash into and out of a
business over a period of time. A potentially profitable
enterprise can fail because of poor management of cash
flow. Businesses are especially vulnerable to cash-flow
difficulties in their first months and years of trading
and during periods of major expansion. It is for this
reason that many financial institutions demand evidence
that entrepreneurs and managers have planned the
management of cash for a new or expanding enterprise
before granting a loan.
NOVEMBER
Closing cash
balance:
+ $35 000
DECEMBER
Opening cash
balance:
+ $35 000
DECEMBER
Add total cash
inflow of:
$120 000
DECEMBER
Net cash flow
of ($20 000)
DECEMBER
Take away
total cash
outflow of:
$140 000
GLOSSARY TERMS
Cash is a business’ most liquid asset – it is notes and coins
as well as funds held in the business’ bank accounts.
A cash-flow forecast is a document that records a
business’ anticipated inflows and outflows of cash over
some future period, frequently one year.
The structure of a cash-flow forecast
Most businesses construct cash-flow forecasts. These
are predictions of a business’ inflows and outflows of
cash. Although cash-flow forecasts differ from one
another, they usually have three sections and are
normally calculated monthly. An essential part of cashflow forecasting is that inflows and outflows of cash
DECEMBER
Closing cash
balance:
+ $15 000
JANUARY
Opening cash
balance:
+ $15 000
▲ Figure 5.8 Opening and closing cash balances
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January
1 Cash in
2 Cash out
March
Net monthly
cash flow
4 Opening Opening balance
and closing
Closing balance
balances
▲ Figure 5.9 A typical layout for a cash-flow forecast
Figure 5.9 shows a typical layout for a cash-flow forecast.
Although the exact structure can vary, all cash-flow
forecasts should contain the following elements.
1 Cash in The first section forecasts the cash inflows
into the business, usually on a monthly basis. This
section includes receipts from cash sales and credit
sales. Credit sales occur when the customer is given
time to pay (normally 30, 60 or 90 days) and are
recorded in the forecast in the month in which the
income is received.
2 Cash out The cash out (or expenditure) section will
state the expected expenditure on the goods and
services. Thus, a typical section might include forecasts
of expenditure on rent, rates, insurance, wages and
salaries, fuel, and so on. These are shown for the
month in which the payment is made. At the end of this
section, the total expected outflow of cash over the
time period in question would be stated.
3 Net monthly cash flow The net monthly cash flow is
calculated by subtracting the total outflow of cash from
the total inflow.
4 Opening and closing balances The final section of
the forecast has the opening balance and the closing
balance. The opening balance is the business’ cash
position at the start of each month. This will, of course,
be the same figure as at the end of the previous month.
The net monthly cash flow is added to the opening
balance figure. The resulting figure is the closing cash
balance for the month. It is also the opening balance for
the following month.
Cash-flow forecasts – a case study
Steve Marshall is buying a bookshop. He knows that he needs
to forecast his cash flow to help him to identify times when
he might experience cash-flow problems. Knowing when he is
likely to be short of cash gives him the chance to arrange an
overdraft or short-term loan. His bank is unlikely to advance
him a loan unless he constructs a cash-flow forecast.
Steve has made the following forecasts about his business for
the first four months of trading from June until September:
» Steve has raised $75 000 from a bank loan and his
savings to buy the lease on a property and to purchase
books. He also intends that this money will be used to
pay his start-up marketing costs.
» Steve expects his business to have an opening cash
balance of $2000 at the start of June.
» Steve anticipates his cash sales to rise steadily for
each of the four months (from $5750 to $9215) as his
business becomes better known. However, he has already
received an order to supply books to a local college. The
order was for $10 000. He expects payment in September,
but will buy the books in June, at the same time as he
purchases his initial inventories.
» Each month, Steve orders books from his suppliers to
replace those he has sold.
» He has to pay his own wages and those of a part-time
assistant. These normally amount to $1500 each month.
» Other costs including his rent, rates, heating and
lighting amount to $1500 each month in June and July,
but are higher in August and September.
Steve’s cash-flow forecast (shown in Table 5.4 on page 182)
illustrates many of the key principles. An important figure
for each month is shown in the row entitled ‘Net monthly
cash flow’. This simply records the balance between the
inflow and outflow for the month. June is a good example
of how this operates: in June, Steve had cash inflows from
savings and borrowings of $75 000 and he expected to
receive $5750 from book sales. At the same time, he planned
to spend $94 500 on his initial purchase of books, as well
as supplying the college’s order, and also on marketing,
wages and rent. Thus, in June he expected his net cash flow
(cash inflows less cash outflows) to be –$13 750 ($80 750 –
$94 500). In cash-flow forecasts, negative figures can be
shown in brackets or with a minus figure in front. Hence, the
figure entered for net monthly cash flow in June is ($13 750).
5.3
5.3.1 Cash-flow forecasts
3 Net
monthly
cash flow
February
Cash sales
Credit sales
Total inflow
Raw materials
Wages
Other costs
Total outflow
There are two main reasons why businesses might forecast
their cash flows:
1 To support applications for loans Almost all new
enterprises require loans to enable them to become
established, and established businesses may need them
during periods of expansion. Banks and other financial
institutions are far more likely to lend money to a
business that has evidence of financial planning. It is
reassuring for the bank that the business’ managers
understand the importance of cash and have planned
carefully to avoid cash-flow crises. Cash-flow planning
gives the bank more confidence that the entrepreneur
or managers will be able to make the repayments of the
loan as and when they are due.
2 To help avoid unexpected cash-flow crises Onefifth of newly established businesses fail within two
years of starting trading. A high proportion of these
fail because of cash-flow difficulties. Similarly, many
large and established businesses encounter cashflow problems which can result in the closure of the
business, as in the case of De La Rue, the British
printer discussed in the case study on the following
page. Planning can help avoid such difficulties. Cashflow planning can help to ensure that businesses do
not suffer from periods when they are short of cash
and unable to pay their debts. By forecasting cash
flows, a business can identify times at which it may
not have enough cash available. This allows it to make
the necessary arrangements to overcome this problem.
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▼ Table 5.4 Steve Marshall’s cash-flow forecast
AS LEVEL 5.3 Forecasting and managing cash flows
5.3
June
July
August
September
Savings and borrowings
75 000
0
0
Cash sales
5 750
7 500
8 475
9 215
Credit sales
0
0
0
10 000
80 750
7 500
8 475
19 215
Purchase of lease on shop
30 000
0
0
0
Purchase of books
59 000
4 500
5 000
6 100
Wages
1 500
1 500
1 500
1 500
Marketing costs
2 500
1 500
975
400
Other costs, e.g. rent
1 500
1 500
1 605
1 630
Total cash outflow
94 500
9 000
9 080
9 630
Net monthly cash flow
–13 750
–1500
–605
9 585
Opening balance
2 000
–11 750
–13 250
–13 855
Closing balance
–11 750
–13 250
–13 855
–4270
Cash in
Total cash inflow
Cash out
CASE STUDY
Banknote printer runs short of cash
In the United States of America, printing money and
minting coins is the job of the Bureau of Engraving and
Printing, part of a government department. But in the
United Kingdom, banknotes and passports are printed by
a private company, De La Rue. It is an irony that De La Rue
is running low on cash.
cash inflows. In 2018, the UK government decided to use
another supplier for its new blue passports following the
country’s decision to leave the European Union. In the
following year, the Venezuelan central bank defaulted on
a payment, resulting in De La Rue losing £18 million in
income.
De La Rue is one of the world’s major suppliers of
passports and banknotes. It is thought to be the largest
commercial printer in the world. The company’s cashflow problems have occurred despite the company earing
£564.8 million in revenues and recording an annual profit
of £31.5 million in 2019.
Questions
De La Rue’s survival has been put in doubt by two pieces
of bad news in two years which will reduce its expected
1
2
Analyse two reasons why cash-flow forecasting is
an important activity for De La Rue.
[8]
Evaluate the reasons why a company that earns
profits of £31.5 million in a year might run out
[12]
of cash.
HANDLING DATA
Use the information in the De La Rue case study to
calculate the percentage of De La Rue’s revenue that
was profit in 2019.
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2 Outflows differ from the forecast It is common for a
business to experience higher outflows than forecast or
for outflows to take place earlier than expected.
Interpreting cash flows
For example, Steve Marshall’s cash-flow forecast (Table 5.4)
may have under-estimated the bookshop’s cash sales in June.
The actual figure may have been $6750. This would result in a
number of changes to Steve’s cash-flow forecast for June:
» the business’ total cash inflow being $81 750 in June
» the business’ net monthly cash flow becoming –$12 750
» the business’ closing balance becoming –$10 750.
Interpreting a cash-flow forecast simply means reading
the forecast and taking note of what it reveals. Managers
will look at cash-flow forecasts in detail and will look
for periods when the business is expected to be short
of cash. This will be shown when closing balance figures
are negative. A negative figure for a closing balance tells
managers that, in that period, the business’ cash outflows
have been sufficiently high to use up more than the cash
that is available. It also tells managers that cash outflows
are taking place before sufficient inflows have occurred.
If managers can identify cash-flow problems before they
occur, through the use of cash-flow forecasts, they are able to
take remedial actions to prevent the problem occurring. They
might, for example, arrange an overdraft with the bank to
ensure they have enough cash available to pay bills on time.
The case study of Steve’s bookshop also illustrates how the
construction and interpretation of a cash-flow forecast can
be of value to managers. Steve’s business will be short of cash
during June, July, August and, to a lesser extent, September.
The closing balances for these months indicate that he will
require a maximum of $13 855 of additional cash in a month
to enable him to pay his rent, wages, and so on. Knowing this
in advance means that Steve can take steps to avoid a cash
crisis, possibly by agreeing an overdraft with his bank.
Although the use of cash-flow forecasts can help businesses
to plan and manage their finances, the process does involve
a degree of uncertainty. Managers cannot be certain about
the accuracy of their forecasts of inflows, especially if they
are engaging in a new venture, such as launching a new
product or entering a new market. Most businesses will
base their forecasts of cash inflows on the results of market
research. However, this may not be accurate if the managers
carry out insufficient primary research or rely on out-ofdate or inappropriate secondary research data. This is more
of a risk for companies entering markets where less current
data is available.
Forecasting cash outflows accurately can also be difficult.
Unexpected changes in the price of resources can result in
forecasts proving to be very inaccurate. For example, between
the start of January and the middle of March 2020, the price
of a barrel of West Texas oil fell from over $63 to around
$27, a decrease of 57.1 per cent. Forecasting cash outflows
accurately can be challenging for businesses that use large
quantities of products which have volatile prices, such as oil.
Amending cash-flow forecasts
Changes in a business’ circumstances can have a substantial
effect on a business’ cash-flow forecast and it may have to
be amended as a consequence. A cash-flow forecast may
need amending for two broad reasons:
1 Inflows differ from the forecast This will be a concern
if they are lower than forecast, perhaps because sales
are lower than was expected or because payments are
received later than anticipated.
9781398308114.indb 183
5.3
5.3.1 Cash-flow forecasts
Interpreting and amending cash-flow
forecasts
The key figure here for Steve Marshall is the closing balance
figure. This is still a negative figure, but a small one. As a
result, Steve may need a smaller overdraft from his bank to
ensure that he has sufficient cash to pay the bookshop’s
costs in July.
Cash outflow figures may also be different from the
forecast, requiring amendments to be made. The handling
data feature below gives an example of this.
HANDLING DATA
Use the information from Table 5.4 to answer the
following questions.
1 What would the closing balance have been in
September if marketing costs in September were
$2150?
2 What would have been the opening balance for
October?
Methods of improving cash flow
Trying to prepare accurate cash-flow forecasts is only part
of the solution. Businesses have to decide how they are
going to improve their cash position – if they identify
a future problem with their cash position. A number of
techniques can be used to improve a cash flow:
» Reducing costs If a business is able to reduce its
costs of production, this will lead to a reduction in the
amount of cash flowing out of the enterprise and will
strengthen its cash-flow position. This reduction in costs
can be achieved in a number of ways. A manufacturing
business may seek lower-cost resources to reduce its cash
outflows. For example, a furniture manufacturer may opt
to use timber from non-sustainable sources because it is
cheaper. A business supplying services may seek to reduce
wages by cutting hourly rates or reducing the number of
employees. Such actions may result in undesirable side
effects even if the business’ cash-flow position improves.
Using lower quality resources may reduce the quality of a
product and lead to a business having to reduce its prices,
which may damage cash inflows. Moving away from the
use of environmentally friendly (and more expensive)
resources or cutting wages and/or employment levels
may attract adverse publicity. The outcome may be a
fall in sales, which could reduce cash inflows. However,
it is possible that a business may opt to use techniques
such as recycling to reduce the costs of acquiring raw
materials. This can have a positive effect on the business’
image if it is perceived to be environmentally friendly and
may result in rising sales.
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» Improving the management of trade receivables and
AS LEVEL 5.3 Forecasting and managing cash flows
5.3
trade payables Most firms receive some trade credit
from their suppliers; this is known as trade payables. This
means they may be given 30, 60 or 90 days to pay for
supplies. If a business can persuade suppliers who have
previously been reluctant to offer trade credit to do so,
it will increase its trade payables figure and improve its
cash-flow position. Remember that cash-flow management
is a matter of timing; delaying payments always helps.
Another important move might be to extend existing
trade credit agreements from, say, 30 to 60 days. It may
not, however, be possible for a small or newly established
business to negotiate favourable credit terms if it does
not have a suitable financial history. A business may also
offer customers less favourable terms for trade credit.
This means it reduces its trade receivables. This may
require all customers to pay for products within 30 days,
whereas in the past trade credit was for 60 days. Good
control of trade receivables and trade payables can mean
earlier inflows of cash and fewer bad debts. If a business
is not actively chasing up customers to ensure that they
pay, and pay on time, cash-flow problems may be the
result. Firms can improve their cash-flow position by
managing these inflows and outflows more effectively.
Using sources of finance to strengthen
a cash position
We saw in the previous chapter that a business may raise
finance through a number of sources of finance. Some
of these sources can be particularly useful in helping to
overcome a period of cash shortage.
Debt factoring
We saw in the previous chapter that a business can receive
cash earlier by ‘selling’ its debts to a debt factor. Figure
5.6 on page 174 illustrates the stages involved in debt
factoring. This technique offers the advantage of providing
a significant and immediate inflow of cash, but it can
damage the business’ profitability. It is likely that a debt
factor will charge a fee equivalent to approximately 5 per
cent of the total value of the debts and this will reduce the
business’ profits on the transaction by the same percentage.
HANDLING DATA
Inara Industries has invoices to the value of $770 000
which it wishes to use for debt factoring. The factoring
company has offered 80 per cent of the value of the
invoices immediately and a further 15 per cent when
they are paid by the customer in three months’ time.
1 How much will Inara Industries receive from the
factoring company immediately?
2 How much will Inara Industries receive from the
factoring company in total?
Arranged short-term borrowing
The majority of businesses have agreed an overdraft
with their bankers. Overdrafts can be expensive but
reasonably economical because a business only borrows
when necessary. A short-term bank loan will also provide
an inflow of cash, but it may be more costly in terms of
interest charges.
Sale and leaseback
This method of improving cash flow entails a business
selling a major asset – for example, a building – and then
leasing it from the new owner. This provides a significant
inflow of cash into the business, improving the immediate
cash position, but commits the firm to regular payments to
lease the asset, which may weaken its future cash position
and its profitability.
CASE STUDY
Otago Communications suffers cash problems
Otago Communications (OC) is one of New Zealand’s
leading manufacturers of telecommunications equipment.
It supplies large quantities of equipment to multinational
companies throughout the world, offering generous trade
credit terms. Its profits have been steady in recent years,
though disappointingly low. Last month it announced its
intention to sell one of its best-known factories to raise
NZ$75 million of urgently needed cash. The company’s
factory is located in a stylish glass and steel building in
Dunedin, on New Zealand’s southern island. OC moved into
the building in 2001 and enlarged it in 2007; it is currently
the workplace for 1880 of the company’s employees.
The company intends to sell and lease back the building
as it is vital to its operations. Analysts estimate that it will
raise NZ$200–300 million, which would provide a crucial
cash inflow for the business.
OC has suffered from well-publicised cash-flow
problems, particularly in recent months – its cash
position weakened by NZ$680 million over three
consecutive months alone. A spokesperson for OC said:
‘We have enough cash resources to do what we need. But
to cut costs and save cash we are looking at all possible
options with no stones being left unturned. One of those is
the possibility of selling one of our factories.’
Questions
1
2
Analyse two other ways in which OC could have
improved its cash-flow position.
Evaluate whether the advantages of OC’s
planned sale and leaseback deal outweigh its
disadvantages.
[8]
[12]
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Leasing
Using leasing, a business simply leases (or rents) noncurrent assets (such as vehicles and computers) rather than
buying them. This conserves precious reserves of cash and
can have quite a significant impact on a business’ shortterm cash position, as non-current assets can be very costly.
However, as with several of these techniques, it does require
businesses to make a steady outflow of cash over time.
We saw in the previous chapter that hire purchase is a
means of obtaining credit for the purchase of a non-current
asset. The business purchasing the asset pays a percentage
of the purchase price as a deposit and the remainder in
instalments over a lengthy period of time. This slows the
Choosing a method of improving
cash flow
There is no single best method of improving a business’
cash flow. All the methods we discussed have their
advantages and disadvantages, as summarised in Table 5.5.
▼ Table 5.5 The advantages and disadvantages of selected methods of improving a business’ cash flow
Method
Advantages
Disadvantages
Improved management
of trade receivables and
payables
• Can be a ‘free’ method of improvement
• Can be implemented relatively quickly
• Available to most businesses
• Reducing trade credit offered may result in a
loss of customers
• May not be available to new businesses or
those without a reputation as reliable payers
Debt factoring
• Can generate large and immediate inflows of
cash
• Available to businesses with little power to
negotiate favourable trade credit terms
• Can reduce the amount of profit on each sale
(by up to 5 per cent)
• May not be viable for businesses making very
small profits (such as start-ups)
Short-term borrowing
• Can be available to the business immediately
• May be highly flexible (as in the case of an
overdraft)
• Businesses with weak cash positions may be
unable to negotiate short-term loans
• Can be a relatively expensive option as
interest rates may be high
Sale and leaseback
• Avoids the need for any interest payments
• Retains the use of the asset for the business
and can raise large sums of finance
• Only a business with saleable assets can
engage in this method
• This may reduce the business’ long-term
profits by increasing expenditure
Leasing
• Avoids the need for large cash purchases on
assets that may decline in value
• Can allow businesses to use the most up-todate assets
• The business is committed to regular, smaller
outflows
• The company does not own the assets that
are used
Reduction in costs
• Can boost the business’ profitability as well
as strengthening its cash-flow position
• May improve the business’ image if it involves
techniques such as recycling
• May compromise quality of products if
cheaper resources are used
• Businesses may have to lower prices if quality
is reduced
Hire purchase
• Can delay cash outflows by a considerable
time period
• May be used to finance the purchase of
relatively expensive non-current assets,
having a significant impact on a business’
cash-flow position
• This is an expensive method of buying noncurrent assets and may reduce profitability
• The business does not own the asset until the
final payment is made
5.3
5.3.1 Cash-flow forecasts
Hire purchase
outflow of cash from the business and helps it to retain
a larger holding of cash. As with leasing, this technique
can strengthen a business’ short-term cash position
substantially due to the high cost of non-current assets.
The purchaser only becomes the owner of the asset once
the final payment is made. Hire purchase may be used to
finance the acquisition of relatively expensive assets such
as vehicles and can therefore have a considerable impact on
the business’ cash-flow position.
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5.3
TEST YOUR LEARNING
1
2
AS LEVEL 5.3 Forecasting and managing cash flows
8
Short answer questions
3
4
5
6
7
a
b
Define the term ‘cash flow’.
[2]
Explain one reason why a business might
forecast its cash flow.
[3]
Explain one reason why a profitable business may
be short of cash.
[3]
Explain one reason why newly established
businesses are vulnerable to cash-flow problems. [3]
a Explain one difference between net monthly
[3]
cash flow and an opening balance.
b A business has a closing balance of $10 000 at
the end of October and has experienced a net
monthly cash flow of $44 500. Calculate its
opening balance in November.
[2]
a Define the term ‘cash-flow forecast’.
[2]
b Explain one benefit to managers of preparing a
cash-flow forecast.
[3]
A business has the following cash-flow data for July:
– an opening balance of $130 250
– cash inflows of $675 750
– cash outflows of $754 500.
a Calculate its net cash flow for July.
[2]
[2]
b Calculate its opening balance for August.
A business has forecast the following cash-flow
data for February:
– cash inflows of $115 000
– cash outflows of $140 115.
a Calculate the business’ net cash flow for the month. [2]
b Its actual cash inflows were 10 per cent higher
than expected. Recalculate its net cash flow.
[3]
a
b
Define the term ‘trade payables’.
[2]
Explain one method a business might employ to
[3]
improve its cash-flow position.
9 Explain one advantage and one disadvantage of the
use of debt factoring as a method of improving a
business’ cash-flow position.
[6]
10 Explain two reasons why a small business suffering
from cash-flow problems might prefer to arrange a
short-term loan rather than rely on an overdraft. [6]
Data response question
Mugunga Mines Ltd
The rising price of copper in world markets has resulted
in the opening of new copper mines in Uganda. In the past,
these might not have been considered profitable, however,
the price of copper might continue to fluctuate in the future.
Mugunga Mines Ltd (MM) is one company that reopened
a small mine last year. It is a well-established company
with valuable non-current assets and a good record for
being profitable. Opening the new mine necessitated a
large investment ($3.5 million) in mining equipment and
preparatory work before mining could commence.
The company’s customers have been given at least 60
days’ trade credit before paying for the copper they
purchase and the size of their orders has risen quickly.
The company had some cash-flow difficulties in the first
year of operating the new copper mine. It has prepared
a quarterly cash-flow forecast for the second year of
trading for the copper mine, as shown in Table 5.6 below.
One manager commented that the cash-flow forecast
showed an improving cash position.
▼ Table 5.6 A cash-flow forecast for MM’s copper mine for Year 2
Quarter 1
$000s
Quarter 2
$000s
Quarter 3
$000s
Quarter 4
$000s
875.5
875.5
923.0
923.0
998.7
998.7
1,075.4
1,075.4
313.6
500.5
100.8
914.9
(39.4)
(125.5)
(164.9)
322.6
501.2
102.1
925.9
(2.9)
(164.9)
(167.8)
366.3
502.5
107.8
976.6
22.1
(167.8)
(145.7)
387.7
503.1
108.7
999.5
75.9
(145.7)
Cash in
Credit sales
Total cash inflow
Cash out
Transport and distribution costs
Wages and salaries
Other costs
Total cash outflow
Net monthly cash flow
Opening balance
Closing balance
2
Questions
1
a
b
Define the term ‘trade credit’.
Calculate the company’s closing balance for
quarter 4.
[2]
[3]
3
Analyse one reason why Mugunga Mines Ltd’s cash
position is described by one manager as ‘improving’
over the year.
[4]
Evaluate whether debt factoring is the best way for
the company to deal with any future cash-flow
difficulties.
[12]
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5 Finance and accounting
AS LEVEL
5.4
Costs
5.4.1 Cost information
Chapter overview
In this chapter we examine:
★ why businesses need accurate information on costs
★ the types of costs businesses have to pay
★ the full and contribution approaches to costing, including their uses and limitations
★ how cost information can be used for decision-making, including setting prices, to monitor and improve business
performance, to calculate profits and for special order decisions
★ the calculation and interpretation of break-even output
★ the uses and limitations of break-even analysis.
5.4.1 Cost information
GLOSSARY TERMS
What is a cost? It is simply an expense paid by a business
as part of its trading. Some of the expenses or costs firms
have to pay include payments for raw materials, fuel and
components, as well as wages and salaries.
Costs are expenses that a business has to pay to engage in
its trading activities.
In contrast, revenues are a business’ income or earnings
over a period of time. Total revenues are the sum of a
business’ earnings from the sale of all its products. Total
revenue is calculated by multiplying the selling price of a
product by the number of products sold.
revenue = quantity sold × average selling price
Costs and revenues are vital data for most businesses.
By comparing the total costs for a business over a period
of time with the revenue that it earns, it is possible to
calculate whether the business has made a profit or a loss.
An important formula for almost every business is:
profit (or loss) = total revenue − total costs
Average
selling ×
price per
unit
gives
Number
of units
sold
Variable
costs
+
Fixed
costs
gives
TOTAL REVENUE minus TOTAL COSTS
gives
1 Profit if TR > TC
2 Loss if TR < TC
3 Break-even if TR = TC
▲ Figure 5.10 Costs, revenues and profits/losses
Revenue is the income a business receives from selling its
goods or services.
The need for accurate cost information
Calculating costs accurately can help managers to make
a number of important decisions. By combining cost
information with expected revenues, managers can calculate
whether or not a business (or an element within it) is likely
to make a profit or a loss. From this information, a range of
other decisions may follow, including:
» whether or not to start up a new business
» whether to go ahead with a planned expansion
» whether to take on a particular order from a customer,
which may be unusual in some way
» whether there is a need to reduce waste
» whether to engage in some activity, such as increasing
security to prevent loss or wastage.
Without precise information on costs, managers cannot
make decisions that are likely to prove beneficial to a
business. For example, a business may be considering a
decision to enter a new market and its market research
may indicate the likely returns from this expansion.
A critical element of the decision, though, will be to
calculate the costs of doing so, enabling the business’
managers to forecast the likely profitability of this
decision. Calculating the costs of this decision with a
high degree of accuracy is not always easy, as we shall
see later in this section.
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Variable costs
Fixed costs
In contrast to fixed costs, variable costs alter directly
with the level of a firm’s output. This means that a firm
increasing its output is likely to have to pay higher variable
costs, whereas one reducing its output could expect
variable costs to fall. Expenditure on fuel, raw materials
and components are all examples of variable costs.
Figure 5.11 relates to XYZ Computers Ltd, a business that
produces computers. You can see that whether the factory
produces 10 000 or 60 000 computers each year, the fixed
costs faced by the business will remain the same at
$5 million.
7
6
Fixed
costs
5
XYZ Computers Ltd in Figure 5.12 faces variable costs of
$500 for each computer it manufactures; this is necessary
to pay for various items including the electronics, case
and monitor. Thus, to produce 20 000 computers means the
company faces variable costs of $10 million (20 000 × $500);
to manufacture 50 000 results in variable costs of $25
million (50 000 × $500).
Variable costs ($m)
Fixed costs do not change when a business alters its level of
output. For example, a business’ rent will not vary if there
is an increase or decrease in the level of production. Other
examples of fixed costs include management salaries and
interest payments made by the business.
Fixed costs ($m)
AS LEVEL 5.4 Costs
5.4
Types of costs
50
40
Variable
costs
4
30
3
25
2
20
1
10
0
10 20 30 40 50 60 70
Output of computers per annum (000s)
▲ Figure 5.11 Fixed costs
The reason that these costs do not alter is that the business
simply uses its existing facilities fully at times when it
is receiving more orders. For example, in the run-up to
warm summer weather, a manufacturer of sunglasses might
increase its output, thereby using its existing production
facilities more fully. The firm’s rent, rates and other fixed
costs will be unchanged. Similarly, as winter approaches,
sales and production of sunglasses are likely to fall,
meaning some production facilities might be unused, but
fixed costs will remain the same.
0
10 20 30 40 50 60 70
Output of computers per annum (000s)
▲ Figure 5.12 Variable costs
It is usual to illustrate variable costs as a straight line,
as in Figure 5.12. This suggests that expenditure on items
such as fuel, labour, raw materials and components rises
steadily along with output. Variable costs are drawn this
way for simplicity. In the real world, the line may gradually
flatten out as businesses frequently negotiate lower prices
per unit when placing large orders. This means that XYZ
Computers Ltd may be able to purchase components more
cheaply, meaning that the variable costs associated with a
production level of 50 000 computers might be $22.5 million.
This means that the variable cost of each computer has
fallen from $500 to $450.
CASE STUDY
High fixed costs in Mauritius
Manufacturers of cement in Mauritius sold around 700 000
metric tonnes of the product in 2019. The island has a
large number of construction projects, including the
sports centre in Côte d’Or and the Metro Express, all of
which lead to a large demand for cement.
Until 2011, the government of Mauritius controlled the
price of cement as it was concerned that prices might be
too high and prevent development. A major cause of this
was a lack of competitiveness in the industry. High fixed
costs of production meant that it was difficult for new
businesses to raise enough capital to enter the industry
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and compete effectively with established producers.
As a consequence, the industry comprised two major
suppliers.
The degree of competition in the Mauritian cement
industry has been reduced rather than increased. The two
firms that existed in 2011 – Lafarge and Holcim – merged
in 2015 to form a single company: LafargeHolcim Ltd.
The calculation of total costs assumes that all the costs faced
by a business are either fixed or variable. This means total
costs can be calculated simply using the following formula:
total costs = total fixed costs + total variable costs
Total costs of production are an important piece of
information for a business. Managers can use this
information in taking decisions on levels of output and
prices to be charged. For example, firms that have very high
levels of fixed costs, perhaps due to needing expensive
equipment, will seek to produce large quantities of output.
This reduces the effect of fixed costs on the selling price by
spreading them over a large quantity of sales.
One point to note is that a business’ total costs when
output is zero are only fixed costs, as without any
production there cannot be any variable costs.
Direct and indirect costs
An alternative way of classifying the costs encountered by
a business is to divide them into direct and indirect costs.
Direct costs can be related to the production of a particular
product and vary directly with the level of output. Examples
include the costs of raw materials and fuel.
Indirect costs are overheads that cannot be allocated easily
to the production of a particular product and relate to the
business as a whole. Indirect costs include the costs of
marketing and administration. Indirect costs are generally
recognised as difficult to control. Unless managers are
vigilant, these costs can increase rapidly and reduce a
business’ profits.
Indirect costs are also called ‘overheads’ and are
always fixed costs. Direct costs tend to vary with the
level of production and are normally (but not always)
variable costs.
GLOSSARY TERMS
Direct costs can be related to the production of a
particular product and vary directly with the level of
output.
Indirect costs are overheads that cannot be allocated to
the production of a particular product and relate to the
business as a whole.
Full costing allocates all the costs of production for the
whole business. Therefore, these costs are absorbed
into each output unit. This is also known as absorption
costing.
1
2
5.4
Analyse two reaons why a business entering an
industry may want to keep its variable costs as low
as possible.
[8]
Evaluate the reasons why high fixed costs may have
led to the cement industry in Mauritius having just
one supplier after 2015.
[12]
The Honshu Motor Company
This manufacturer of motor cars may incur direct and indirect
costs as set out below.
Direct costs
• direct materials such as sheet
steel and engine parts
• direct labour, for example
wages paid to employees on
production line
5.4.2 Approaches to costing
Total costs
Questions
Indirect costs
• indirect labour costs, for
example management salaries
and wages paid to security staff
• other indirect costs such as
administration and distribution
direct costs + indirect costs = total costs of production
▲ Figure 5.13 Direct and indirect costs of production
5.4.2 Approaches to costing
The differences between full and
contribution costing
A problem faced by businesses when attempting to calculate
costs accurately is allocating or dividing up indirect costs
between different elements of the business. This can be a
particular problem for large businesses that produce a range
of products.
One reason why it is difficult to calculate the total costs
of producing a single unit of output is that indirect costs
can be allocated in different ways and this can result in
different cost figures. As a consequence, managers may take
decisions that are incorrect.
When a business produces a number of products using
a single office or factory, it is difficult to calculate the
total cost of producing a single unit of output of any of its
products accurately. The problem it faces is how to allocate
indirect costs such as marketing and administration. There
are two approaches that can be taken.
Full costing
One method of deciding upon costs is full costing, which is
used by many businesses. This is also known as ‘absorption
costing’ and normally categorises costs as direct and
indirect. This approach to costing involves charging all the
costs of a particular enterprise to a unit of output. Thus,
all the costs associated with the production of a particular
product are ‘absorbed’ by it. This approach may require
managers to allocate indirect costs to all the business’
different products.
Full costing can allocate (or divide up) indirect costs
between different products produced by a business using
a range of criteria, such as the percentage of total indirect
costs used in the production of each product.
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5.4
Total cost of
producing a
particular
product
=
Total direct
costs
AS LEVEL 5.4 Costs
Divided by
number of units =
of output
+
Allocated share
of indirect costs
Total cost of
a single unit
of output
▲ Figure 5.14 Key relationships for full (absorption)
costing
Contribution costing
The concept of contribution is an important one and is
used in calculating break-even output, as we shall see later
in this section. The use of contribution is based on clearly
classifying costs as fixed or variable. Contribution can be
calculated by use of the formula below:
contribution = sales revenue – variable costs
Contribution has two potential uses. Firstly, it is used to
pay the fixed costs incurred by a business. Any contribution
remaining after this transaction is profit for the business.
profit = contribution – fixed costs
It is possible to consider contribution in two broad ways:
either in relation to a single unit of output or in relation to
the entire output of a particular product or business.
When contribution is calculated for the sale of a single
product, we refer to it as contribution per unit. It is
calculated by using the formula:
variable costs of
contribution selling price of one –
producing that
=
unit of output
per unit
unit
GLOSSARY TERMS
Contribution can be defined as the difference between
sales revenue and variable costs of production.
Break-even is the level of production or output at which a
business’ sales or total revenue is exactly equal to its total
costs of production.
Profits are the amount by which revenue exceeds total
costs, although there are several different measures of
profit.
The full-costing method
The full-costing approach normally divides costs into
direct costs and indirect costs. To calculate the total cost
of producing a single unit it is necessary to include all
costs, both direct and indirect. This can be a tricky process
if it is to provide accurate costing figures. The problem
centres on allocating indirect costs or overheads in a way
that represents the true costs of producing a product or
operating a division within a business. We explore this in
the case study on Palm Foods.
The allocation of indirect costs in this way is unlikely to be
entirely accurate. This has significant implications because,
by changing the way that these costs are allocated, the
profitability of different areas of a business can be affected.
For example, in the Palm Foods case study, if the company’s
accountants had decided to allocate indirect costs on the
basis of the number of employees in each division, then the
indirect costs allocated to the division producing meat
30
meals would have been:
× $6 000 000 = $2 250 000. This
80
is $150 000 below the method actually used and would have
boosted the profits of this division by a similar amount,
assuming nothing else changes.
HANDLING DATA
The accountants in the Palm Foods case study might
have decided to use the number of employees working
in each of the company’s divisions as the basis for
allocating its indirect costs.
Calculate how the total indirect costs would have
been allocated between the fish and vegetarian meals
divisions if this method had been used.
So, as we have seen, if a business makes two or more
products, or operates multiple divisions or brands, full
costing entails allocating (or absorbing) indirect costs as
accurately as possible to the different parts of the business’
operations. If, for example, a business just produced two
products, it could allocate its indirect costs taking into
account the type of overhead:
» Indirect costs such as rent or property taxes could be
allocated or apportioned according to relative floor
space taken up by the production of the two products.
So, if product A takes up 60 per cent of the floor
space, then 60 per cent of these fixed costs should be
apportioned to product A.
» Indirect costs such as wage costs associated with
management and administrative staff could be allocated
according to the number of people employed in the
production of each product.
As many businesses produce more than a single product,
especially large-scale businesses, this approach to costing
is widely used. It is also recognised by many governments
as the accepted method to use in preparing financial
statements. This trend is also increasing as markets become
more global in nature and businesses have to extend their
product ranges to meet the diverse needs of customers
across the world. Nevertheless, when a business produces
a range of products (as we can see in the Rajasthan
Electronics Ltd case study) it requires managers to make
difficult decisions to allocate indirect costs.
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CASE STUDY
5.4
Palm Foods allocates its indirect costs
The company’s managers want to know the cost of
production for its three divisions to help with their
decision-making. They use the full-costing approach to do
this. The company’s total indirect costs for 2019–20 were
$6 million.
The company’s accounts department has calculated some
key statistics relating to the three divisions within the
company.
▼ Table 5.7 Palm Foods’ key statistics
Accounting item
Meat meals
Fish meals
Vegetarian meals
Sales revenue (%)
50
20
30
Number of employees on each production line
30
25
25
2 000
1 300
1 700
40
30
30
Area of the factory floor used by each division (square metres)
Total direct costs incurred in production (%)
Palm Foods’ accountants have decided to allocate the
company’s indirect costs for 2019–20 according to the
area of the factory’s floor space used by each of its three
divisions. As a consequence, the indirect costs were
allocated as shown below:
l Meat meals: 2 000 × $6 000 000 = $2 400 000
5 000
1
l Fish meals: 300 × $6 000 000 = $1 560 000
5 000
5.4.2 Approaches to costing
Palm Foods manufactures a range of ready-to-eat
meals aimed at high-income consumers. The company’s
products can be divided into three divisions:
l Meat meals: these contain a range of foods based
mainly on chicken and lamb.
l Fish meals: this is a smaller part of the company’s
production and is becoming less popular.
l Vegetarian meals: these are increasingly popular as
meals on their own or as accompaniments to some of
the company’s other products.
l Vegetarian meals: 1 700 × $6 000 000 = $2 040 000
5 000
Questions
1
2
Calculate the allocation of indirect costs that would
have resulted if the company’s accountants had used
sales revenue as a guide.
[6]
Evaluate the ways in which the company should have
allocated its indirect costs.
[12]
CASE STUDY
Full costing at Rajasthan Electronics
Rajasthan Electronics Ltd manufactures consumer
electronics which are sold in Pakistan and other
countries in Asia. The company’s production is divided
into three product groups: televisions, microwave
cookers and digital radios. The costs associated with the
company’s production over the last financial year are
shown in Table 5.8.
The company’s managers use a policy of full costing
to calculate its costs and profits on its three products,
which are made in the same factory in Faisalabad. The
company’s indirect costs were $120 million for the year.
Rajasthan Electronics’ managers decided to allocate the
company’s indirect costs on the basis of the percentage
▼ Table 5.8 Production costs at Rajasthan Electronics Ltd
Televisions ($m)
Microwave cookers ($m)
Digital radios ($m)
Revenue from sales
286
145
225
Total ($m)
656
Direct materials costs
107
77
78
262
Direct labour costs
97
45
87
229
Total direct costs
204
122
165
491
Allocated indirect costs
52
27
41
120
Total costs
256
149
206
611
Profit
30
(4)
19
45
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AS LEVEL 5.4 Costs
5.4
of revenue earned by each division. The calculations (with
some rounding) carried out by the finance department are
shown below:
l Allocated indirect costs to televisions:
286
$120 million ×
= $52 million
656
l Allocated indirect costs to microwaves:
145
$120 million ×
= $27 million
656
l Allocated indirect costs to digital radios:
225
$120 million ×
= $41 million
656
l Total indirect costs = $120 million
In the case of Rajasthan Electronics Ltd, the use of full
costing makes it very difficult to judge with any certainty
the precise financial position of the company’s three
product ranges. There is a danger that the company’s
senior managers may judge that the microwave division is
The managers’ decision to allocate indirect costs in this
way resulted in two of its divisions earning profits while
the third, the microwave division, recorded a small loss.
Not all of the company’s managers agreed with this
approach to allocating indirect costs, and the managers
of the microwave division were angry at suggestions that
production of microwaves should be stopped as they were
apparently making a loss rather than a profit.
Questions
1
2
Analyse two other possible ways that Rajasthan
Electronics Ltd might have allocated its indirect
costs.
[8]
Evaluate whether or not Rajasthan Electronics Ltd
should stop producing microwave cookers.
[12]
unprofitable and decide to discontinue production of this
product. This could prove to be a poor decision for two
reasons, as we shall see in the following continuation of the
case study.
CASE STUDY
Further events at Rajasthan Electronics
The managers of the microwave division are concerned
about proposals to end production of their cookers. In
response, they have recalculated the company’s profits
for the past financial year using full costing but using a
different basis for allocating indirect costs.
l Allocated indirect costs to televisions:
The company’s operations managers have recently
reported that the production of televisions uses 46 per
cent of the factory’s floor space, that digital radios uses
39 per cent and microwave cooker production takes place
in 15 per cent of the available factory space. This was
used as a basis to recalculate the profits from the three
product ranges. Their revised calculations (again with
some rounding) are shown on the right:
l Allocated indirect costs to digital radios:
$120 million × 0.46 = $55 million
l Allocated indirect costs to microwaves:
$120 million × 0.15 = $18 million
$120 million × 0.39 = $47 million
● Total indirect costs = $120 million
This allowed the managers to present a revised set of
profit figures, as shown in Table 5.9.
▼ Table 5.9
Televisions ($m) Microwave cookers ($m)
Digital radios ($m)
Total ($m)
Revenue from sales
286
145
225
656
Direct materials costs
107
77
78
262
Direct labour costs
97
45
87
229
Total direct costs
204
122
165
491
Allocated indirect costs
55
18
47
120
Total costs
259
140
212
611
Profit
27
5
13
45
This data shows that:
1 The microwave division may be profitable.
2 If production of microwaves is discontinued,
the business’ fixed costs are unlikely to change
and will have to be paid by the remaining two
divisions, which will damage the profitability of the
company.
Questions
1
2
Analyse two reasons why a large business might use
[8]
full costing.
Evaluate whether this is a more accurate way of
calculating the company’s profits for its three
product ranges than the approach based on the
percentages of revenues earned by the divisions. [12]
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HANDLING DATA
Use the data in the Rajasthan Electronics case studies to
answer the following questions.
1 Calculate the percentage of total costs that are
represented by direct labour costs.
2
5.4
Calculate the change in the company’s profits if it
managed to reduce its direct materials costs by
10 per cent.
Uses and limitations of the full-costing method
5.4.2 Approaches to costing
Full costing has a number of uses as well as limitations.
Some of these are summarised in Table 5.10 below.
▼ Table 5.10 The uses and limitations of full costing
Uses
Limitations
• This approach to costing allows a business to take all of
its costs into account before making pricing decisions.
• Using the full costing is very common as this approach is
recommended by the International Financial Reporting
Standards (IFRS).
• Managers have to give thought as to the most effective
method of allocating indirect costs, which may result in
an accurate approach.
• It is difficult to allocate indirect costs accurately – the
allocation is often based on proportions of direct costs.
• It can result in bad decisions. Businesses may discontinue
production of apparently unprofitable divisions,
departments or brands.
• If sales are below what is expected, allocated indirect costs
per unit of production could be higher than forecast, meaning
that a price that was expected to be profitable may not be.
GLOSSARY TERM
▼ Table 5.11 Sales revenue, variable costs and contribution
for a business producing three products
Contribution costing calculates the cost of a product
solely on the basis of variable costs, thus avoiding the
need to allocate fixed costs.
The contribution-costing method
Contribution costing is sometimes referred to as ‘marginal
costing’. Contribution costing excludes fixed costs as a
central part of the calculation and only allocates variable
costs. This is valuable in a business that has a number of
products, or several factories or divisions. A product or
division that earns sufficient revenue to cover its fixed
costs is likely to be viewed favourably by the managers
of the business. If this is the case then the product will
generate a positive contribution and assist in paying fixed
costs or providing profit.
The contribution-costing approach can be applied to the
production and sale of a single unit of output or to the
entire output of a product or products over a given time
period. If a business would incur an additional cost of
$100 in producing a single extra unit of output (this is its
marginal cost) but would expect to sell that product for
$125, then it would make a positive contribution of $25 on
that unit of output.
Alternatively, we can consider contribution costing for the
entire production of a particular product or products as
shown in Table 5.11.
Product A ($) Product B ($) Product C ($)
Revenue from
sales
175 000
342 750
55 250
Variable
labour costs
87 150
169 700
14 525
Variable
materials costs
32 000
88 560
12 770
Other variable
costs
25 450
67 425
13 050
Total variable
costs
144 600
325 685
40 345
Contribution
30 400
17 065
14 905
The example in Table 5.11 shows that product A contributes
$30 400 towards paying fixed costs, product B $17 065 and
product C $14 905. In total this is $62 370. If we assume that
the fixed costs of the company for this period of time are
$39 500, we can calculate the profits that the company has
made.
Total contribution:
$62 370
Fixed costs:
$39 500
Profit:
$22 870
If a product makes a positive contribution, as is the case in
Table 5.11, then it is worth the business continuing to produce
it. There may even be an argument for continuing to produce
it if it makes a negative contribution, as we shall see later.
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The difference between contribution and profit
5.4
It is essential to understand that contribution and profit
are not the same thing. Contribution is the surplus left over
from sales revenue (or total revenue) once variable costs
have been paid. Profit is any surplus from sales revenue over
a trading period once all costs have been paid.
AS LEVEL 5.4 Costs
The limitations of contribution costing and when
it might be used
As with full costing, contribution costing has a number of
limitations. The main limitations include the following.
» It can be difficult to distinguish between fixed and
variable costs accurately. For example, some costs
have elements of both and are known as semi-variable
costs. One example of a semi-variable cost is landline
telephone costs. The monthly line rental would be a
fixed cost, because it remains the same irrespective of
the level of business activity. However, the call charges
are variable as they are likely to alter directly with a
business’ level of activity.
» Fixed costs do not always remain constant when the
level of output alters. Some fixed costs tend to be
higher as a result of a business increasing its level
of output. For example, promotional costs or website
maintenance costs may increase in line with production
levels. This makes the division of costs into fixed and
variable elements less accurate.
» The tax authorities in some countries do not accept the
use of contribution costing. For this reason, its use is
less common than that of full costing.
Contribution costing is likely to be used in a number of
circumstances. It can help managers to decide whether to
accept an order as it shows the variable costs of producing
products. If a business receives a number of non-standard
orders, it may use contribution costing to determine
whether or not to accept such orders. We will explore this
more fully in the next section.
Businesses that produce many different products may be more
likely to use contribution costing because the difficulties
involved in allocating fixed (or indirect) costs between
many different products can be too great. Any resulting cost
figures may be judged inaccurate and any decisions taken on
the basis of these figures may be incorrect.
5.4.3 Uses of cost information
Calculating average, marginal and
total costs
Managers can calculate a number of costs to assist with
decision-making. Three vital ones are:
» average costs
» marginal costs
» total costs.
GLOSSARY TERMS
Average costs are the total cost of production divided by
the number of units produced.
Marginal cost is the extra cost resulting from producing
one additional unit of output. In most situations the
marginal cost of an additional unit of a product is the
variable cost of its production.
▼ Table 5.12 Fixed, variable and total costs of producing
televisions
Level of production Fixed
(million televisions) costs
per year
($m)
Variable
costs
($m)
Total
costs
($m)
0
200
0
200
1
200
180
380
2
200
360
560
3
200
481
681
4
200
624
824
5
200
760
960
6
200
880
1 080
7
200
990
1 190
8
200
1 240
1 440
Average costs
Average costs are simply total costs at any level of output
divided by that level of output. They are also called unit
costs. In Table 5.12, it is possible to calculate average costs
at each level of output. For example:
» At an output of 3 million televisions, the average cost is
$681 million ÷ 3 million = $227 per television.
» At an output of 5 million televisions, the average cost is
$960 million ÷ 5 million = $192 per television.
» At an output of 7 million televisions, the average is
$1190 million ÷ 7 million = $170 per television.
Average costs tend to fall as a business increases its
production levels because its fixed costs are spread over a
larger output, and so the amount allocated to each product
is smaller as the level of production rises.
HANDLING DATA
Use the information in Table 5.12 to answer the
following question.
At what levels of output would the average cost of
televisions be:
a highest
b lowest?
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Marginal costs
Costs and pricing decisions
The costs of production can have a significant influence on
a firm’s pricing decisions.
Average costs and prices (cost-plus pricing)
Cost-plus pricing is the most commonly used method of
setting prices. It involves deciding the price of a product
based on the average cost of a single unit of the product.
The average cost is calculated by dividing total production
costs by the number of units that are produced. To this
value is added an amount which is called a mark-up. The
mark-up is, in effect, profit. Average cost plus mark-up is
the price charged.
For example, if a furniture manufacturer is aware that a
single table costs $125 to produce and decides to price the
table at $150, the pricing method is cost-plus. In these
circumstances the manufacturer can be certain the product
will sell at a profit, but may be less sure about the level of
sales. Cost-plus pricing does not take into account the state
of the market or actions of competitors.
Scenario A
The company produces 1000
bicycles during the year. Total
production costs are $100 000 +
($50 × 1000) = $150 000
Average cost of producing one
bicycle = $150
Scenario B
The company produces 5000
bicycles during the year. Total
production costs are $100 000 +
($50 × 5000) = $350 000
Average cost of producing one
bicycle = $70
▲ Figure 5.15 Average costs and production levels
A firm can help to keep costs of production for each
individual unit to a minimum by producing on the largest
possible scale. Consider the two scenarios shown in
Figure 5.15 for the London Bicycle Company. This company
has fixed costs of $100 000 and each bicycle has variable
costs of $50 for materials and labour.
5.4
GLOSSARY TERMS
Cost-plus pricing is the process of establishing the price
of a product by calculating its cost of production and then
adding an amount which is profit.
Contribution pricing is based on the notion that any price
set that is higher than the variable cost of producing a
product is making a payment towards fixed costs.
Marginal costs and prices (contribution pricing)
By knowing how much it costs to produce an additional
unit of output, a business can be guided in setting
prices or deciding whether to accept orders at specific
prices. Marginal costs are based on the variable costs of
production. Fixed costs will not be affected by the decision
to supply additional units and so it is the contribution from
any sale that is critical. Contribution can be calculated
using the formula below:
5.4.3 Uses of cost information
Marginal costs are the extra costs resulting from producing
one additional unit of output. Marginal costs do not
really take into account fixed costs, as they have to be
paid whatever the level of production of the business.
Thus, marginal costs are concerned with variable costs
(the direct costs of materials and labour, for example). In
most situations, the marginal cost of an additional unit
of a product is the variable cost of its production. In the
example of our television manufacturer in Table 5.12, we
know that to produce 4 million televisions would result in
a total cost of production of $824 million. If we assume
that fixed costs are unchanged and that the variable cost
of producing one more television is $200, the total cost will
rise to $824 000 200 for 4 000 001 televisions. This means
that the marginal cost of producing this one additional
television is $200.
Manufacturing in the circumstances of scenario B would
allow the company to set lower prices for its bicycles or to
enjoy higher profits – or both. For example, in scenario B it
could reduce its price from more than $150 per bicycle to,
say, $100. This would allow it to make a profit of $30 per
bicycle and it is likely that sales would rise significantly due
to the price fall, possibly boosting profits further.
contribution = revenue – variable costs of production
The concept of contribution is useful when taking pricing
decisions. If the manager or owner of a business sets a price
in excess of the variable cost of producing the product,
then each sale will make a positive contribution to fixed
costs. If sufficient sales are made, the enterprise will earn a
profit. This approach to pricing is also called contribution
pricing.
For example, the manager of a restaurant may calculate that
the typical variable cost of serving a meal to a customer is
$12. If the restaurant charges customers an average price
of $25 for each meal, then it will make a profit as long as
it attracts enough diners. It is certain that the revenue
received from each customer will contribute $13 ($25 − $12)
towards fixed costs.
Contribution pricing offers firms flexibility when deciding
upon the amount to charge for their products. Businesses
that have well-established products in high demand may
be able to price significantly in excess of the variable cost
of production. In these circumstances, each sale makes
a major contribution to fixed costs and profits. Fashion
clothing is an example of a product where prices are set
considerably above variable costs. Thus, a business might
charge the equivalent of $75 for a t-shirt that costs $10
to manufacture. The contribution of $65 from each sale
is necessary because the business faces high fixed costs,
spending heavily, for example, on marketing. Furthermore,
products in the fashion industry have very short lives.
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AS LEVEL 5.4 Costs
5.4
However, contribution pricing has its weaknesses. While
setting a price that generates a positive contribution
may result in the firm earning a profit, this depends upon
the business in question achieving sufficient sales. This
is far from certain as this approach to pricing places
relatively little emphasis on the state of the market. Using
contribution as a guide for pricing may result in low levels
of sales because competitors’ prices are lower or their
responses may be unpredictable.
STUDY TIP
Many students confuse contribution and profit, yet this
distinction is vital and understanding it is important to
gain top-level grades. Profit is revenue less all costs,
while contribution is revenue less only variable costs.
Using costs to monitor and improve
business performance
» the costs incurred by separate areas of the business
(divisions or branches, for example) do not differ
significantly without good reason
» costs are not increasing unexpectedly and are similar to
the forecasts set out in the company’s budgets
» the business continues to hit its profits targets.
We look at budgets in much more detail in Chapter 5.5.
A business that operates many similar branches or outlets
may compare the costs of its branches and seek to reduce
costs to those achieved by the most efficient performer.
In this way, the company uses cost data as indicators of
best practice and seeks to duplicate this approach in other
areas of its business to improve performance and profits.
It may be possible for senior managers to set cost targets
for areas of the business controlled by junior managers and
to reward achievement of these targets. In this way, large
organisations are more able to control costs and improve
profits.
Managers of all businesses constantly monitor costs to
ensure that:
CASE STUDY
Starbucks expands in the Indian market
The American coffee retail chain, Starbucks, opened its
first coffee shop in India in 2012. Understandably, the
market of 1200 million people was very attractive to the
company, as incomes and a taste for coffee among Indians
increased. However, selling in India required the company
to change its approach in some ways. Starbucks, famous
for its caramel macchiato and espresso, offered smaller
and cheaper beverages to attract coffee drinkers in India.
now has 157 outlets in ten Indian cities including Mumbai,
Hyderabad, Chennai and Bengaluru.
In 2019, Starbucks opened more than 30 outlets in India, the
largest number of new store openings since 2012. However,
Café Coffee Day is still India’s largest coffee shop chain.
Questions
In 2018, Starbucks also announced its plan to open outlets
in the western state of Gujarat, where it opened five
stores in the cities of Surat and Ahmedabad. Starbucks
However, for a large-scale global business, such as
Starbucks in the case study, it may be difficult to compare
performance in different countries in this way because of
huge differences in costs. Thus, monitoring and comparison
of costs in this way is likely to be more effective if it takes
place in a single country or within countries with similar
costs for resources such as labour.
Equally a trend of falling costs may provide an indication
that profitable opportunities exist. For example, in 2019,
the rental costs of retail properties in Hong Kong fell by
over 10 per cent compared with the previous year. This
cost information might assist a retail business to make a
profitable decision on expansion.
Thus, budgets can be used to monitor how well costs are
controlled, but also to assist the business’ managers in
improving the business’ performance. By using the cost
Starbucks will continue to need to set its prices lower
than in the United States if it is to increase its sales
further in India. Starbucks’ expansion plan in India
includes offering customers more vegetarian food options
and adding new food items.
1
2
Analyse one reason why selling its products at
lower prices in India might not necessarily reduce
Starbucks’ revenue.
[4]
Evaluate the reasons why the costs of operating a
coffee shop in Gujarat might be different from those
in a state in the USA.
[12]
information, managers can take decisions to improve the
business’ performance and, especially, its profitability. For
example:
» It may be able to reduce its costs following such an
analysis. If it is placing increasingly large orders with its
suppliers, it may be able to negotiate larger discounts
for bulk orders. Alternatively, if it is not using all of
its supplies, it may reduce the size of its orders and its
costs. This is vital if the supplies are perishable.
» Labour is a major cost for many businesses and
especially those operating in the service sector.
Monitoring labour costs is important to maximise
profits. For example, if a business hires too much labour
and that labour is not fully employed then the business
is incurring costs that are not matched by revenue.
Profitability will be damaged as a consequence.
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Using cost information to calculate
profits
Profits are the amount by which revenue exceeds total
costs, although there are several different measures of
profit. Figure 5.10 on page 187 illustrated that comparing
the total costs for a business with the revenue that it earns
over a period of time shows whether a business has made a
profit or a loss. The key formula for profit is:
profit (or loss) = total revenue − total costs
At the end of a trading period, the managers of a business
can calculate the business’ profits using its cost and
revenue information. So, if a business generated sales
revenue totalling $256.4 million during the financial year
and incurred total costs amounting to $208.9 million, it
could calculate its profits as follows:
profit = $256.4 million – $208.9 million = $47.5 million
In Table 5.12 on page 194 we considered the fixed, variable
and total costs of producing televisions. Table 5.13 shows
how this cost data can be used to calculate whether or
not the business producing televisions makes a profit.
Furthermore, it can be used to calculate the expected profit
at different levels of output and to decide which might be
most profitable. However, this is only possible when the
company has the relevant revenue information as well. In this
case, we assume that to sell higher quantities of televisions,
the company has to sell its products at lower prices. This is
why its revenue does not rise steadily with output. This cost
information, when added to information about sales revenue
(or total revenue), allows managers to calculate profits.
The information in Table 5.13 suggests that the television
manufacturer would make the highest profits if it produced
(and sold) 5 million televisions per year. Of course, it
is important to understand that this is forecast data
and might not be completely accurate. However, it is an
important aid to a business’ decision-making.
▼ Table 5.13 Sales revenue, total costs and profits from
producing televisions
Level of production Sales
(million televisions) revenue
per year
($m)
Total
costs
($m)
Profits
or losses
($m)
0
0
200
(200)
1
300
380
(80)
2
600
560
40
3
900
681
219
4
1 080
824
256
5
1 250
960
290
6
1 320
1 080
240
7
1 420
1 190
230
8
1 600
1 440
160
HANDLING DATA
5.4
5.4.3 Uses of cost information
A business’ managers may look at cost data over a period of
time. Changes in the figures may reveal underlying problems
that can be corrected to improve the business’ profits. We
can consider a few examples of using cost data in this way.
» Rising labour costs within a business when output is not
increasing could show that employees are working less
efficiently. This could be caused by a range of factors,
including a lack of training or poorly motivated employees.
Once the cause of the rising labour costs has been
identified, managers can take appropriate remedial action.
» Rising costs of raw materials over time could indicate
that there are high levels of waste or that suppliers have
increased costs significantly. In either case, the cost
information could alert managers to a problem which
needs attention to improve profits. In 2020, Hasbro, the
American toy manufacturer, said it would be seeking to
manufacture more of its toys outside China due to the
rising costs of producing in China.
» A business’ fixed costs may increase more rapidly than
might be expected over time. Managers responsible for
controlling these costs may take action in response.
Use the information in Table 5.13 to answer the
following questions.
1 Assume the television manufacturer could always
sell its televisions at $300 per television, no matter
what its level of output. At what level of output would
it make the highest profit?
2 Why is profit highest at this level of output?
Contribution costing and special-order
decisions
One of the key advantages of using contribution costing is
that it can help managers to make what are called specialorder decisions.
GLOSSARY TERM
Special-order decisions occur when a business’
managers have to decide whether or not to accept unusual
customer orders.
Special-order decisions
Businesses sometimes have to make decisions on whether
to accept orders that are not on their normal terms. For
example, a firm might receive a large order for its products
at a price significantly lower than it usually receives.
Alternatively, a business might receive an order which offers
a price above the usual but which requires special features
or a very early delivery date, meaning the supplier is likely
to incur additional costs in fulfilling the order.
Firms faced with the dilemma of whether to accept this
type of order are facing special-order decisions. In these
circumstances, the concept of contribution can be applied
to assist the business in reaching a decision on whether or
not to accept the order.
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Margaret Roberts Woollens
are very popular with tourists and sell for high prices,
particularly during the summer season. The cost of wool
and the wages paid to knitters means that the average
variable cost of producing a single woollen garment is
$30. To the surprise of the managing director of the firm,
a large order is received from a national clothes retailer.
The retailer requires 5000 sweaters and other garments,
but is only willing to pay Margaret Roberts Ltd $32 per
item. Should Margaret Roberts Ltd accept the order?
AS LEVEL 5.4 Costs
5.4
CASE STUDY
Contribution is the key to making this decision. The firm
would earn a positive contribution on each sale. Each
woollen item sold would incur variables costs of $30, but
would earn revenue of $32. Thus each sale would create
$2 of contribution. Therefore, meeting the order would
earn the business an additional $10 000 in contribution.
This might mean profits would rise (or losses would fall)
by $10 000.
Questions
1
▲ Figure 5.16 One unit on which contribution costing
could be applied
Margaret Roberts Ltd manufactures woollen sweaters
for local shops at a standard price of $40. The sweaters
Prices lower than normal
It is not unusual for a firm to receive an order for a large
quantity of its products at a price below that normally
charged. Consider the case study above.
A number of factors need to be taken into account when
taking special-order decisions such as this.
» Will additional fixed costs result from accepting the
order? In the circumstances above, Margaret Roberts Ltd
may have to hire additional factory space, increasing
its overheads, meaning that additional contribution is
required to meet these costs before extra profits are
earned. Thus, if the firm has to pay an extra $10 000
in rent, then profits will be unchanged as a result of
accepting the order. Therefore, having sufficient spare
capacity is an important prerequisite of accepting such
an order.
» Might the order lead to higher variable costs? Accepting
a large order might mean that workers are paid overtime,
pushing up variable costs. Workers at Margaret Roberts
Ltd might be paid higher hourly rates, meaning that the
variable cost of producing a single item rises to $35.
In these circumstances the order would not be worth
accepting.
» Before making a special-order decision (at a price below
the norm), a business needs to ensure that the customer
2
Analyse two reasons why accepting this order may
not increase the level of profits earned by Margaret
Roberts Ltd.
[8]
Evaluate the non-financial factors the managers at
Margaret Roberts Ltd might consider before deciding
whether or not to accept this order.
[12]
will not simply resell the product to other firms at the
usual selling price, thereby making a quick profit at the
expense of the manufacturer.
» A business may accept a lower price than normal, even if
it doesn’t produce a positive contribution, if it believes
that it will result in more sales at higher prices in the
future.
STUDY TIP
When responding to questions on special-order decisions
(or costing decisions generally) it is important to consider
non-financial factors as well as financial ones. Read the
case study or stimulus material carefully to ensure you
pick up on any non-financial factors that may have been
included as clues.
Prices higher than normal
It may appear a stroke of good fortune for a business
to receive an order at a price above that usually levied.
However, if the order requires products to have a
specification higher than normal or to be delivered at short
notice, it is likely that the supplier will face higher costs.
This may make the order unprofitable.
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Qualitative factors
Qualitative factors are often important in such decisions.
Accepting an order such as that received by Margaret
Roberts Ltd may offer long-term benefits. The customer
may return with further orders and it may help to increase
brand awareness in new markets. It may help the business
concerned to achieve its corporate aims, especially if these
are growth or increasing market share.
On the other hand, the consideration of qualitative factors
may result in a decision not to supply a special order.
It may be regarded as too risky. For example, managers
may believe that allowing their products to be sold in
large quantities at lower prices could damage its brand
image. It may, for example, make the product appear less
exclusive and make it difficult to charge higher prices
in other markets. Sales and profit margins may fall as a
consequence.
5.4.4 Break-even analysis
What is break-even analysis and why is
it important?
Break-even output is that level of output or production at
which a business’ sales generate just enough revenue to
cover all its costs of production. At the break-even level
of output, a business makes neither a loss nor a profit.
A business’ managers may use break-even analysis for a
number of reasons:
» to help decide whether a business idea will be profitable
and whether it is viable
» to help decide the level of output and sales necessary to
generate a profit
» to support an application by a business for a loan from a
bank or other financial institution
» to assess the impact of changes in the level of
production on the profitability of the business
» to assess the effects of different prices and levels
of costs on the potential profitability of the business
» to judge whether launching a new product or entering
a new market will be profitable given expected sales
forecasts.
Contribution and break-even
Contribution is an important part of break-even analysis. We
saw earlier that contribution can be defined as the difference
between sales revenue and variable costs of production.
Contribution is calculated using the following formula:
5.4
contribution = revenue − variable costs
Contribution can be used to pay the fixed costs incurred
by a firm. Once these have been met fully, contribution
provides a business with its profits.
5.4.4 Break-even analysis
Once again, contribution is the key to the decision. If the
selling price exceeds the variable costs and no additional
fixed costs are incurred, the order would be worthwhile
and would result in increased profits. Therefore, if
Margaret Roberts Ltd had an order for a new style of
sweater which needed more expensive wool than normal
and had to be completed within six weeks, the firm would
need to:
» calculate the extra variable costs associated with the
order – overtime pay for workers and more expensive
materials, for example
» consider whether it had sufficient spare capacity to
meet the order – avoiding additional fixed costs
» decide whether accepting the order would generate
extra contribution and profits.
Revenue from sales
less
Variable costs
gives
Contribution
contribution is
used to pay
Fixed costs
once fixed costs are
paid, contribution
provides
Profits
▲ Figure 5.17 Contribution is the difference between sales
revenue and variable costs of production. Profit is the
surplus of sales revenue over all costs
Calculating break-even output
The manager of a business wishing to calculate the breakeven point or level of output will require the following
information:
» the selling price of the product
» the variable cost of producing a single unit of the product
» the fixed costs associated with the product (remember,
fixed costs do not change as the level of production
alters).
This information is used within the following formula:
break-even
=
output
fixed costs
selling price per unit − variable
cost per unit
This formula can be rewritten given that contribution is the
result of taking away variable cost per unit from the selling
price of a product:
break-even
=
output
fixed costs
contribution per unit
We will use the scenario set out in the following case study
to illustrate the construction and interpretation of breakeven charts.
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AS LEVEL 5.4 Costs
5.4
CASE STUDY
Using break-even analysis
Sarah Feng is planning to expand her restaurant chain
and to open a new restaurant in New York, specialising
in Cantonese food. She has a lot of experience in the
industry, as she already operates 12 restaurants in Sydney
and Kuala Lumpur. Her new restaurant will maintain her
reputation for serving high-quality food in beautifully
furnished buildings. Sarah plans to call her restaurant
‘The River Palace’.
Sarah needs a loan to open The River Palace. She has
already looked at a building which would accommodate
up to 30 diners. She produced the figures set out in
Table 5.14.
▼ Table 5.14 Sarah’s analysis for The River Palace
Type of cost or revenue
Amount
Average selling price per meal at The River Palace
$60
Variable costs per meal – ingredients, fuel, wages
$35
Monthly fixed costs of the new restaurant – lease for the property, rent and rates
Using this information, Sarah was able to calculate how
many meals she will need to sell (or how many diners she
has to attract) in her restaurant if the project is to break
even.
break-even
=
output
fixed costs
contribution per unit
Sarah knows her fixed costs will be $10 000 each month
and this figure is entered into the top of the formula. To fill
in the bottom, Sarah has to take away the variable cost of
producing a meal from the price the customer pays for a
meal. The contribution earned from each meal in Sarah’s
new restaurant is $25 ($60 − $35). Thus:
monthly break-even output =
$10 000
$25
$10 000
So, Sarah knows that, if her plan for The River Palace
is to break even, she will need to attract at least 400
customers each month. If she attracts more than 400
customers, the project will make a profit. Sarah plans to
open The River Palace on 25 evenings each month and
would, therefore, break even if she had an average of 16
customers each night in the new restaurant.
Questions
1
2
If Sarah increases her prices to an average of $70
per meal, calculate the level of her new break-even
output.
[6]
Evaluate whether or not Sarah’s planned price
increase would be a good idea.
[12]
= 400 diners
While this calculation gives Sarah a quick guide to the
number of customers her restaurant will need to break even,
it tells her little more about the level of profit or loss The
River Palace might make. A break-even chart is one way to
work out the level of profits the business will generate if
her forecast is proved to be correct.
Break-even charts
Sarah knows that The River Palace can seat a maximum of
30 customers per night and that she normally opens for 25
evenings each month. This means that her maximum number
of customers each month is 750 (30 customers × 25 nights).
When Sarah constructs her break-even chart, her horizontal
axis will run from zero to 750 customers.
The vertical scale on a break-even chart records costs and
revenues. Normally revenues are the highest figure. At most,
Sarah could attract 750 customers paying an average of $60
each. So, the highest revenue she could possibly receive
is $45 000 ($60 × 750). Her vertical scale should have a
maximum value of $45 000.
Sarah’s break-even chart shows the monthly fixed costs she
will have to pay: $10 000. This is illustrated in Figure 5.19.
Variable costs are also illustrated. As variable costs
are expenditure on items such as components and raw
materials, these costs will rise along with output. If Sarah
has an increasing number of people dining at The River
Palace, she will need to buy more food and her wage bill
will also rise.
Variable costs always start at zero. The highest variable
cost Sarah could encounter is to provide 750 meals, each
having a variable cost of $35. The highest variable cost
would therefore be $26 250 ($35 × 750). This maximum
figure is connected by a straight line to the origin as
shown in Figure 5.18.
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The maximum value on this axis is worked out
by multiplying the maximum output by the
average selling price (i.e. $60 x 750 = $45 000).
35
Variable
costs
30
25
20
15
Fixed costs = $10 000
10
5
0
The
origin
The maximum figure on this axis is simply
the maximum level of output. The new
restaurant can seat 750 diners each month
Total costs are simply the sum of fixed and variable costs.
» If The River Palace has no customers in a month, it will
not incur any variable costs. At zero output, total costs
are the same as fixed costs. In Sarah’s case, this will
mean a total costs figure of $10 000 per month.
» At the other extreme, The River Palace might be full,
with 750 customers each month. Sarah will add together
fixed costs (still $10 000, of course) and variable costs at
full capacity (750 customers’ meals each having variable
costs of $35), equal to $26 250. Thus, total costs for
the restaurant in these circumstances will be $36 250
($10 000 + $26 250).
The line connecting these two points represents total costs.
This line should be parallel to the variable costs line and is
shown in Figure 5.19.
45
Costs and revenues ($000)
35
30
This total costs line will be
parallel to variable costs –
the difference between the
two lines is fixed costs
Total costs = fixed
costs + variable costs
Variable
costs
25
20
15
Fixed costs
= $10 000
10
5
0
Revenue
45
100 200 300 400 500 600 700 750
Monthly output (customers)
▲ Figure 5.18 Fixed and variable costs on a break-even chart
40
Figure 5.20 shows the break-even chart with the revenue
line included. To make the chart easier to read, the variable
costs line has been left out in this case.
The origin – all variable
cost curves begin here
40
35
30
Total costs =
fixed costs +
variable costs
Break-even occurs
where total costs and
revenue are equal
5.4
5.4.4 Break-even analysis
Costs and revenues ($000)
40
Finally, the break-even chart shows the revenue The River
Palace will earn. Sarah has already calculated that an
average customer spends $60 on a meal in her restaurant.
Once again, there are two extreme situations.
» If The River Palace does not have any customers, it will
not have any revenue. Thus the revenue line begins at
the origin.
» If the restaurant is full, Sarah expects each of the
750 customers to pay $60 on average. If The River
Palace attracts this level of custom, it will earn
$45 000 ($60 × 750).
Costs and revenues ($000)
45
25
20
15
10
5
0
Fixed costs
= $10 000
Break-even output
confirming the earlier
calculation
100 200 300 400 500 600 700 750
Monthly output (customers)
▲ Figure 5.20 The complete break-even chart
The break-even chart tells Sarah that she needs 400
customers each month if The River Palace is to break
even. This confirms the calculation we carried out
earlier. However, a break-even chart provides much more
information. Sarah can use it to read off the level of profit
or loss her new restaurant will make according to the
number of customers it attracts.
If the River Palace attracts fewer than 400 customers
each month, it will record a loss. The amount of the loss is
shown on the graph by the vertical distance between the
total cost line and the revenue line at the relevant level of
output. Similarly, if the restaurant attracts more than 400
customers in a month, it will generate a profit that month.
Here the profit is shown by the vertical distance between
the revenue line and the total cost line.
Figure 5.21 shows the level of loss and profit made by The
River Palace if it attracts 200 customers and 600 customers
per month.
100 200 300 400 500 600 700 750
Monthly output (customers)
▲ Figure 5.19 Including total costs on a break-even chart
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Revenue
45
5.4
Revenue earned from
600 customers = $36 000
40
Total costs
Profit = $5 000
Total cost of supplying
600 customers = $31 000
30
Costs and reveunes ($000)
AS LEVEL 5.4 Costs
35
25
Total cost of supplying
200 customers = $17 000
Break-even
point
20
Loss = $5 000
The margin
of safety
15
10
Revenue earned
from 200 customers
= $12 000
5
Break-even
output
0
100
200
300
400
500
600
Loss-making
range of output
Profit-making
range of output
700 750
Monthly output
(Number of customers)
▲ Figure 5.21 Showing profits and losses on a break-even chart
CASE STUDY
Nigerian films fail to break even
The film industry in Nigeria is experiencing some good
times. Much of this is due to the efforts of Kunle Afolayan,
a 46-year-old director. Kunle has produced a series of
films since 2005 which have impressed knowledgeable
film critics and have received highly favourable reviews in
the New York Times.
make a lot of one-off noise, but people don’t remember them
in six months’ time,’ he says. ‘That isn’t the kind of legacy I
want to leave.’ Most of his films have been financed through
a combination of his own earnings, bank loans and individual
investors, though he has now attracted funding from further
afield, receiving a Ford Foundation grant to make Citation.
Despite this international acclaim, it remains difficult to
generate profits from making films in Nigeria. His new
film, Citation, about a scandal at Nigerian and Ghanian
universities which came to light in 2018, began filming in
2020. Kunle predicts that it will ‘beat records’. The film
is still showing and earning revenues, but some analysts
believe it is unlikely to break even.
The Ford Foundation was established by the Ford motor car
manufacturing company.
Yet box-office receipts are not Kunle’s main concern.
‘Nigerian films that are driven by commercial interests alone
Source: https://econ.st/32pt6A6
Questions
1
2
Explain two actions that Kunle Afolayan might take
to help make his latest film profitable.
[6]
Evaluate why investors might choose to invest in a
film which is not expected to make a profit.
[12]
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HANDLING DATA
The margin of safety
A break-even chart can be used to show the margin of
safety, although this can also be calculated. The margin
of safety measures the quantity by which a firm’s current
level of sales exceeds the level of output necessary to
break even.
The following formula expresses the margin of safety as a
number of units of output.
margin of safety = current level of sales − break-even output
In our previous example of The River Palace restaurant, if
it is successful and attracts 600 customers each month, the
margin of safety will be 200 customers (600 customers –
400 customers). This means that, in these circumstances,
the restaurant could lose 200 customers each month before
it reached break-even output and began to make a loss.
This is shown in Figure 5.21 (page 202) for an output of 600
customers per month.
There is an alternative method of calculation which
expresses the margin of safety as a percentage of current
sales. The formula to use for this is:
margin of current level of sales − break-even output
× 100
safety =
current level of sales
Using this formula for our example we would get:
margin of safety =
600 − 400
600
× 100 = 33.3%
This tells us that the restaurant could lose just over 33
per cent of its sales before it found itself in a break-even
position.
Most financial techniques have uses and limitations, and
break-even analysis is no exception. The uses of break-even
analysis include the following:
» It is a simple technique, allowing most entrepreneurs to
use it without the need for expensive training. Because
of this, it is particularly suitable for newly established
and small businesses.
» It is a technique that can be completed quickly,
providing immediate results.
» It can be of value in supporting a business’ application
to a bank for a loan.
» By using break-even charts, a business can forecast the
effect of varying numbers of customers on its costs,
revenues and profits.
» Break-even analysis can be used to analyse the
implications of changing prices and costs on the
enterprise’s likely profitability.
5.4
5.4.4 Break-even analysis
Mike plans to open a business providing people with
help to learn how to use computers and the internet.
Mike thinks his fixed costs will be $21 000 per year
and the variable costs of serving each customer will
be $100. His average price per customer will be $240.
He expects to have 200 customers in his first year of
trading.
1 If his figures are correct, will he break even in his
first year of trading?
2 Calculate his expected profit or loss during his first
year of trading.
The uses and limitations of break-even
analysis
However, break-even analysis has a number of limitations:
» It assumes that all products are sold. For example,
Sarah might assume that she will attract 600 customers
each month. She will order the necessary food and hire
sufficient staff. However, if only 500 turn up, she will
not make the profit indicated for 600 customers on the
break-even chart.
» It is a simplification of the real world. Businesses do not
sell all their products at a single price and calculating
an average is unlikely to provide accurate data. The
technique is also difficult to use when a business sells a
number of different products.
» Costs do not rise steadily as the technique suggests. As
we have seen, variable costs can rise less quickly than
output because of the benefits of buying in bulk.
» Any break-even analysis will only be as accurate as the
data on which it is based. If costs or selling prices are
incorrect, then the forecasts will be wrong.
Break-even analysis offers some support to businesses,
and especially to start-up enterprises or those seeking to
expand by launching new products and/or entering new
markets. However, it is only a guideline and its value should
not be overstated. Perhaps, most importantly, entrepreneurs
and managers should bear in mind that the value of the
technique depends on the use of reliable data for costs,
prices and expected sales.
GLOSSARY TERM
The margin of safety measures the quantity by which a
firm’s current level of sales exceeds the level of output
necessary to break even.
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5.4
TEST YOUR LEARNING
Short answer questions
1
AS LEVEL 5.4 Costs
2
3
4
5
6
7
8
9
Define the terms:
a ‘costs’
[2]
[2]
b ‘revenues’.
a Explain one difference between average costs
[3]
and marginal costs.
b Explain one reason why average costs might
fall as a business increases its level of output. [3]
a Define the term ‘full costing’.
[2]
b Explain one way in which a large manufacturing
business might allocate its overheads between the
different products that it supplies.
[3]
Explain one reason why it might be difficult for the
manufacturer in question 3b to allocate its overheads
accurately.
[3]
Explain one reason why a business might refuse an
order for its products at a price that is higher than
[3]
normal.
Explain one reason why a business might decide to
accept an order for its products at a price of $300 per
unit when its normal selling price is $400 per unit. [3]
Explain one way in which a business might calculate
the marginal cost of a single unit of output.
[3]
Explain one reason why contribution costing avoids
the need to allocate overheads.
[3]
a Define the term ‘break-even output’.
[2]
b A business sells its products for an average price
of $40, has fixed costs of $100 000 and contribution
per unit of $15. Calculate the level of output
required to break even.
[2]
10 a
b
Define the term ‘margin of safety’.
[2]
Calculate the margin of safety if a business has
sales of 10 000 units per year and its break-even
[2]
output is 6500 units.
Data response question
The new hotel
Santa Rosa Hotels has just opened its latest hotel in
Huaraz, close to the Parque Nacional Huascarán in Peru.
The area is a popular tourist destination and the numbers
visiting are rising quickly. There are many other hotels in
the area and the new hotel is not expected to be full at any
time during its first year of operation.
The hotel’s manager is keen to make the new business
profitable and plans that every guest at the hotel will
make a contribution to fixed costs. They are concerned
about their pricing decisions, as labour and other costs
are expected to rise significantly over the next year or two.
Santa Rosa Hotels has not been a very profitable company
since 2019 and its shareholders are keen to see an
improvement in this area over the next year or two.
Questions
1
2
3
Define the terms:
a ‘contribution’
[2]
b ‘fixed costs’.
[2]
Analyse one reason why it is important for the
company to calculate its costs accurately.
[4]
Evaluate the case for and against the decision to use
cost-plus pricing.
[12]
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5 Finance and accounting
AS LEVEL
5.5
Budgets
In this chapter we examine:
★ the meaning and purpose of budgets and the benefits and drawbacks of their use
★ the meaning, calculation and interpretation of variances.
5.5.1 The meaning and purpose of
budgets
What are budgets?
Budgets are financial plans. Firms plan their earnings and
expenditures using budgets. Budgets are usually drawn
up on a monthly basis, over the period of a financial year.
There are a number of types of budgets:
» Sales revenue or income budgets These set out
the business’ expected sales revenue from selling its
products. Important information here includes the
expected level of sales and the likely selling price of
the product. A start-up business may have relatively low
revenue budgets during its first few months of trading. It
is likely that the sales revenue budgets will be increased
as the business becomes better known. In contrast, an
established business may have a large and loyal customer
base and substantial inflows of revenue from a range of
different products or brands, for different regions, or
from a number of subsidiary companies.
» Production or expenditure budgets Businesses need
to plan their expenditure on labour, raw materials, fuel
and other items which are essential for the process of
production. Research is necessary to prepare accurate
expenditure budgets. For example, an independent
forecast in 2019 revealed that wages in countries in
Asia are expected to rise by between 2.3 per cent and
12 per cent during the next financial year – this would
be important data for Asian firms with large workforces.
The production budget will also contain forecasts for
expenditure on overheads and a cash budget as well.
» Profit budgets This type of budget forecasts a
business’ total revenue and total costs and shows
whether it is expected to make a profit or loss over
a future trading period. The Coronavirus (COVID-19)
pandemic of 2020 led to numerous businesses revising
their profit budgets following forecasts of substantial
falls in revenue from sales.
5.5.1 The meaning and purpose of budgets
Chapter overview
STUDY TIP
Remember that budgets are forecast data and may
be incorrect. You should read any case study material
carefully to see if there is any evidence about its likely
accuracy and use this to help to develop your answers.
CASE STUDY
Hotels in Singapore
Hotels in Singapore enjoy one of the highest rates of
occupancy in the world. Data from the Singapore Tourism
Board shows that 93.8 per cent of its hotel rooms were
occupied in July 2019. This represents a small increase
from the summer of 2018, when the rate was 92.5 per cent.
Forecasters are expecting Singapore’s hotel occupancy
rate to decline in the future. They have identified three
reasons for this forecast:
● Hotels in Singapore are projected to lose customers to
competitors located in Hong Kong, which is expected
to become a more popular location for business
conferences, boosting demand for hotels.
● A number of new hotels are due to open in Singapore
during 2020, including the Singapore New Edition. This
will increase the number of hotel rooms available.
● Many businesses have decided to reduce their
travel and accommodation budgets. Fewer business
travellers are forecast to stay in hotels in Singapore.
These changes have already affected the financial
performance of hotels in Singapore. In the autumn of 2019,
Singapore Hotels Ltd reported that the average earnings
from its rooms was $240. Since the summer of 2019, the
average earning figure had fallen from just over $249.
Questions
1
2
Analyse two reaons why the changes forecast in the case
study might have a significant impact on the sales revenue
budgets of the hotel division of Singapore Hotels Ltd. [8]
Evaluate why it might be difficult for hotel companies
in Singapore to forecast future sales revenues
accurately at this time.
[12]
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5.5
There is the risk, of course, that the information in budgets
may not prove to be accurate. For example, sales revenue
budgets may be incorrect if there is an unexpected slump in
sales due to, say, a change in consumers’ tastes and fashions,
or the entry of a new competitor into a specific market.
The benefits and drawbacks of budgets
AS LEVEL 5.5 Budgets
As with most techniques of financial control, there are
benefits and drawbacks to the use of budgets.
The benefits of budgets
» Production or expenditure budgets allow managers
to ensure that a business does not overspend. Senior
managers receive their own budgets and can allocate
these between the various parts of the department
or area for which they are responsible. Figure 5.22
illustrates this process. As long as each individual
budget holder makes sure that they do not spend
more than the agreed figure, the business’ overall
expenditure should remain under control. Modern
technology makes the control and monitoring of such
budgets easier.
» Budgets allow senior managers to direct extra funds into
important areas of the business. Thus, if a business is
concerned that its product range is not selling well, it
may increase its budgets in the areas of market research,
research and development or advertising.
» Budgets can be used to motivate employees. Employees
can gain satisfaction from being given responsibility
for a budget. Often large businesses use what is known
as ‘delegated budgets’ whereby control of budgets
is given to individuals and teams at all levels within
the organisation. They may also gain satisfaction
from keeping within a budget. As a result, their level
of motivation and their performance may improve,
benefiting the firm as a whole. In Chapter 2.2 we
considered motivation in more detail.
» Sales revenue budgets can also be used as targets
for employees, possibly as part of the appraisal
process. Employees may be motivated to improve their
performance by the existence of targets in the forms of
sales revenue budgets.
» Information on expenditure budgets allows senior
managers to examine those areas of a business that
manage costs effectively. The most successful areas
or divisions can become models for other parts of the
business.
Board of Directors
(advised by Director
of Finance) plans
revenue and spending
for financial year
Production
Human Resources
Decides budget of $3m
for marketing – Director
of Marketing controls
budget
Public relations –
$¾m for
sponsorship and
events
Staff salaries and
expenses – $1¾m for sales
and marketing salaries,
commission and expenses
Advertising –
$½m to pay for a
series of advertising
campaigns
These budgets will be controlled by relevant managers. They may be
further divided into, for example, a budget for expenses for the sales force.
▲ Figure 5.22 An example of using budgets within a company
The drawbacks of budgets
» If a business intends that a significant proportion of its
employees should manage budgets (known as delegating
budgets) then training will be required. Some people will
not welcome the extra responsibility or feel confident
in their ability to control finances. The cost of the
training could be substantial, depending on the skills
of the workforce. Furthermore, there could be teething
problems as employees adjust to the new roles and
responsibilities.
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» Allocating budgets fairly and in the best interests of the
business is difficult. Some managers may be skilled at
negotiating large budgets for the areas for which they
are responsible. This might be at the expense of more
worthy areas. Thus, for example, a manager responsible
for the sales force in existing markets may receive a
large budget allocation, while insufficient funds are
given to developing new markets.
» Budgets normally relate to the current financial year
only and are short-term in nature. Therefore, managers
might take decisions in order to keep within the current
budget which is not in the longer-term interest of the
business. For example, a decision to reduce the size
of a workforce for budgetary reasons might result in
competitors gaining more of the market over the next
few years.
Alibaba
The Alibaba Group was founded in 1999 by 18 people led
by Jack Ma, a former English teacher from Hangzhou,
China. Its founders started the company to support small
businesses, to help small enterprises to compete more
effectively in China and globally. Initially the company
created online marketplaces enabling buyers and sellers
to meet and buy and sell products. By 2019, the company
had grown very rapidly and employed 102 000 people,
earned revenues totalling $56.15 billion and profits
amounting to just under $12 billion.
By 2020, Alibaba provided a wide range of services. Its
websites provide:
● sales services for businesses and consumers
l services for electronic payments
l search engines for shopping
l cloud computing services.
Alibaba owns and operates a wide variety of different
businesses throughout the world. For example, in 2018,
Daraz, a Pakistani online store, was bought by the Alibaba
Group, making the South Asian e-commerce platform an
important part of Alibaba’s global operations.
The Alibaba Group aims to grow quickly. It has set itself
some important targets to ensure its continued growth.
Three important targets are:
l to have 2 billion global customers by 2036
l to create a further 100 million jobs
l to support over 100 million profitable businesses on
its websites.
Questions
1
2
Different approaches to budgeting
Incremental budgets
Incremental budgets are a very simple approach to
budgeting. In an incremental budget, figures from the
previous budget are used as a basis for the new budget.
According to circumstances, a small percentage change may
be made to the previous figures to allow for alterations in
costs or expected revenues.
Incremental budgets work well in a stable business
environment, where changes are relatively small and
normally predictable. This approach to budgets is more
common in less competitive or less changeable markets
where profits are relatively stable. However, the use of
incremental budgets can have a number of shortcomings.
» It can encourage overspending by managers Managers
may be encouraged to add a percentage to costs each
year rather then looking at ways to reduce costs when
using incremental budgeting.
» Managers may ‘massage’ the data Some managers may
forecast little growth in sales revenue but substantial
increases in costs when drawing up incremental budgets.
This would lead to them having favourable variances
which could suggest the area has been managed
efficiently.
» It does not encourage risk-taking One of the main
criticisms of incremental budgeting is that it tends to
5.5.1 The meaning and purpose of budgets
CASE STUDY
5.5
Analyse two reasons why budgeting would be
important to Alibaba while it is growing quickly.
‘It is impossible for Alibaba to draw up accurate
budgets.’ Evaluate this view.
[8]
[12]
allocate funds to the same use each year. Managers may
find it difficult to acquire large sums for new and more
risky activities. This may result in lower profits in the
long term.
GLOSSARY TERMS
Incremental budgeting is a process where budget figures
are minor changes from the preceding period’s budgeted
or actual data.
A flexible budget is a budget that is designed to change
along with the sales volume or production levels.
Flexible budgeting
Flexible budgets (or flex budgets) avoid some of the
problems that are associated with the use of variances
within normal budgets. A common problem with the use
of variances is that some of the variances may be due to
external factors, such as a significant fall in sales due to
an economy moving unexpectedly into a period of falling
incomes. In such circumstances, it can be difficult to
identify how much of a difference between a forecast
and an actual budget is due to external factors and how
much to poor management within the business. The use
of flexible budgeting removes at least some of the effects
of the external factors, allowing managers to analyse
underlying issues.
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5.5
In the example in Table 5.15, the managers would be
able to see that sales were much lower than expected, at
$600 000 rather than $750 000. The flexed budget adjusts
other budget figures in the light of this change. This
means that, in this case, direct costs will be divided by
750 000 and multiplied by 600 000 to reflect the change in
sales revenue.
▼ Table 5.15 An example of a flexible budget
AS LEVEL 5.5 Budgets
Normal budgets ($000s)
Flexible budgets ($000s)
Budget
Actual
Budget
Flexed budget
Actual
Sales revenue
750
600
750
600
600
Overheads
200
204
200
200
204
Labour
180
162
180
144
162
Materials
220
201
220
176
201
Other costs
60
53
60
48
53
Total costs
660
620
660
568
620
PROFIT
90
(20)
90
32
(20)
Therefore, although costs fell as a result of the large drop in
sales, they didn’t fall as much as may have been expected
given the substantial reduction in output. Once the budget
has been flexed, it is simple to see that all categories of
costs recorded adverse variances and that they overspent
in the context of the falling level of production. Contrast
this with the original budget – the favourable variances
for direct costs such as labour and materials may have
suggested that the budget holders managed these costs
effectively.
HANDLING DATA
1
Look at the information in Table 5.15. If the flexed
budget for sales revenue was $700 000, calculate the
flexed budgets for labour and materials.
Zero budgeting
Gathering information can be time-consuming even if
budgets are based heavily on the previous year’s figures.
An alternative approach used by a number of firms is zero
budgeting. Using this system, each expenditure budget
is set at zero at the start of the budget setting process.
Managers responsible for the areas covered by the budget
(HR managers, for example) have to bid for budget and to
justify the money they request.
Using zero budgets can help firms in a number of ways:
» It avoids budgets creeping up each year as one year’s
budget is based on the figures from the previous year,
plus a little to allow for inflation. In this way, it can
assist a firm to control costs.
» It helps firms adjust their spending as the relative
importance of areas within the firm changes. For example,
the purchase of an automated switchboard might mean
that the budget for this area can be reduced. This money
can be used effectively elsewhere in the business.
However, the process has a number of drawbacks too:
» Zero budgeting is effective for setting production (or
expenditure) budgets, but it has little relevance to sales
budgets. To set a zero budget for sales revenue would be
ridiculous.
» Budgets might be allocated according to the negotiating
skills of managers rather than the genuine needs of their
areas or departments.
GLOSSARY TERMS
A budget holder is responsible for the use and
management of a particular budget.
Zero budgets exist when budgets are automatically set
at zero and budget holders have to argue their case to
receive any funds.
The uses of budgets
Measuring performance
For many businesses, the figures in the profit budget will
have an important influence on decision-making within
the business. Comparing the actual profit figure with the
budgeted figure for the trading period can be a useful
measure of a business’ performance.
A business’ managers will also use budgeted and actual
data to assess the performance of elements of the business
as well as its performance overall. We saw earlier (in
Table 5.15) that the use of flexible budgets can strip out
the effects of changes in the market and overall sales.
The resulting budgetary data can be used to judge the
effectiveness of, for example, the control of costs in
different areas of the business. Those managers who return
favourable variances on expenditure budgets may be judged
more effective.
A business’ budgets may also highlight the relative
performance of a business’ divisions or sectors. Many
multinational businesses operate in different regions of
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the world. Coca-Cola, the American multinational soft
drinks company, produces and sells its products throughout
the world. It separates its activities into five geographic
divisions: North America, Africa, Asia, Latin America,
Europe and other. The performance of these areas against
the budgets that have been drawn up will assist the
company’s managers in judging the performance of these
five divisions.
Allocating resources
The provision of detailed budgets on expected sales can
reveal much about the forecast performance of individual
areas or divisions within a large business. This information
can help managers to make decisions on which areas of the
business are likely to perform well and those that may not.
Using this information, managers can make decisions on
how to allocate financial, human and other resources most
effectively. We saw in the previous section that Coca-Cola
operates five divisions in different regions of the world.
The company’s managers may allocate more resources to
those divisions that perform most successfully when actual
performance is judged against budgeted data.
It is not unusual for businesses to have budgets of many
millions, or even billions, of dollars – this would certainly
be the case for Coca-Cola. In such circumstances, it is
impossible for a single person, or even a group of people,
to effectively monitor these budgets to ensure costs are
controlled and planned revenues are earned. A system
of budgets allows a large number of people within the
organisation to take a share of responsibility for managing
finances. This process was illustrated in Figure 5.22
(page 206). In this way, budgets provide an effective means
of allocating resources.
Controlling and monitoring a business
Budgets are an effective way of ensuring that a business
does not spend more than it should. As long as every
employee ensures that they do not spend in excess of their
budget, costs should not get out of control. Equally, if
those involved in sales meet their targets then the business
should earn its planned level of profit. This should help the
business to achieve its objectives.
Managers may also take decisions based on the actual data
in budgets through the calculation of variances. If, for
example, sales budgets show substantial adverse variances,
managers may question the quality of their products or their
approach to pricing, as well as the accuracy of the market
5.5
Businesses use budgets to assess the viability of new
projects, such as launching a new product or relocating to
a new region or country. In this case, the research process
involved in preparing the necessary budgets is helpful and
the final budget figures are likely to have a major influence
on a final decision by senior managers.
5.5.2 Variances
Once a business has planned its sales revenue and
expenditure, it is essential to monitor the accuracy of
these financial plans by comparing the budget figures
with the actual figures resulting from the business’
trading. Budgets can also provide a wealth of information
to help managers take decisions on how to improve the
performance of the business.
» Analysing budgeted and actual expenditure This
provides information on how successful the business
is at controlling its costs. As a business grows, it is
possible to judge the ability of different parts to manage
its expenditure against given targets. If one area of a
business is regularly overspending its budgets, managers
may take action to reduce expenditure and, by so doing,
increase profitability. Relevant actions might include
addressing issues such as poor motivation, quality
problems or not using capacity fully. Of course, if a
business or part of a business fails to meet expenditure
budgets regularly, it may be because the budgets are too
low to be achievable.
» Analysing sales revenue A business that fails to
meet its sales revenue budgets for one or more of its
products may need to consider why this is occurring.
Prices may be too high when compared with those
of competitors, the business may not be advertising
sufficiently or not targeting the correct market
segments, or the quality and/or design of the product
may be inadequate. Good managers will use the
information from analysing budgets to make decisions
to improve the business’ sales performance.
» Analysing profits budgets Profits below budget are
likely to be a cause of concern for most businesses.
These can be caused by excess expenditure or by revenue
falling short of expectations or a combination of these
factors. This scenario may prompt managers to examine
means of cutting expenditure as well as boosting sales
revenue.
5.5.2 Variances
Budgeted data alone can be used as a measure of
performance. It may be that a business’ budgeted profits
are low or declining when compared to previous financial
years. This may lead the business’ managers to take
decisions to improve the financial performance of the
business in advance of the year’s trading. This may entail
changing prices and reducing costs in the short term. In
the longer term, management teams may consider entering
new markets and developing new products as a means of
improving financial performance.
research they undertook. Similarly, managers will respond
to expenditure budgets that show significant variances –
adverse or favourable.
Adverse and favourable variances
A variance occurs when an actual figure for sales revenue,
expenditure or profits differs from the budgeted figure.
Actual sales revenue or expenditure figures may be higher
or lower than budgets. Variances are categorised as adverse
or favourable. These two categories of variance are shown in
Table 5.16 on page 210.
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▼ Table 5.16 The two categories of variance
AS LEVEL 5.5 Budgets
5.5
Favourable variances
Adverse variances
A favourable variance
exists when the difference
between the actual and
budgeted figures will result
in the business enjoying
higher profits than shown in
the budget.
An adverse variance occurs
when the difference between
the figures in the budget and
the actual figures will lead to
the firm’s profits being lower
than planned.
Examples of favourable
variances include:
• actual wages less than
budgeted wages
• budgeted sales revenue
lower than actual sales
revenue
• expenditure on fuel is less
than the budgeted figure.
Examples of adverse
variances include:
• sales revenue below the
budgeted figure
• actual raw material costs
exceed the figure planned
in the budget
• overheads turn out to be
higher than in the budget.
Possible causes of favourable
variances:
• wage rises lower than
expected
• economic boom leads to
higher than expected sales
• rising value of currency
makes imported raw
materials cheaper.
Possible causes of adverse
variances:
• competitors introduce new
products, winning extra
sales
• government increases
business taxes by
unexpected amount
• fuel prices increase as
price of oil rises.
$840 000. However, the actual figure was $790 000. In this
case the variance (or difference) is $50 000. It is an adverse
variance because it will result in the business’ profits being
lower than forecast or its loss larger than forecast. In
contrast, the business’ fuel costs are only $70 000, which is
$5000 less than the budgeted figure. In this case, this is a
favourable variance because this will result in the business’
profits being larger than forecast (or a smaller loss than
budgeted).
▼ Table 5.17 Calculating variances
The process of calculating a variance is simple, as shown
by Table 5.17. It simply involves a comparison between
the budgeted figure and the actual figure. In Table 5.17,
the business had forecast that its sales revenue would be
Cut prices
if consumer demand
is sensitive to price
changes (price elastic)
Revenue/ Budget
cost
figure ($)
Actual
figure ($)
Variance
Sales
revenue
840 000
790 000
$50 000 (adverse)
Fuel costs
75 000
70 000
$5000 (favourable)
Raw
material
costs
245 000
265 000
$20 000 (adverse)
Labour
costs
115 000
112 000
$3000 (favourable)
HANDLING DATA
1
Look at the information in Table 5.15 (page 208).
Calculate the actual sales revenue required under
the ‘normal budget’ to result in a favourable
variance of $79 000.
Calculating variances can give a business advance notice
that its financial plans are inaccurate. This can be carried
out each month and will show before the end of the financial
Seek new markets
at home or overseas
Product range
update or extend as
appropriate
Improve company
image
PR donations to
charities
Adverse sales
revenue
sales revenue less than
planned
Increase advertising
and/or promotions
Cut wages or increase
labour productivity
increase amount
produced per worker
per hour
Adverse production
(cost) variances
expenditure higher
than planned
Reduce waste
use fewer raw materials
and produce fewer
faulty goods
Seek cheaper raw
materials
purchase from
overseas or in bulk
▲ Figure 5.23 Responding to adverse variances
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year that the firm’s finances are not as planned. This
allows the business to take action to reduce expenditure or
increase revenue at an early stage. Figure 5.23 summarises
the range of actions that businesses may take in response
to adverse variances.
There are internal connections in budgets which are
important to understand. For example, if a business
experiences a rise in output and sales revenue above
expectations, it will affect expenditure. If a product
becomes unexpectedly popular and sales rise, the
business may have to purchase more raw materials and
hire additional labour. This is likely to result in adverse
expenditure variances. Similarly, sales below those set out
in the budget may lead to favourable variances for costs, as
expenditure falls since less is produced. We considered this
in the section on flexible budgets on page 207.
It may be that variances are not the result of unexpected
developments and changes in the markets in which
businesses operate. Poor forecasting techniques can also
result in unexpected revenues and expenditures, and
therefore variances.
Managers may make insufficient use of market research to
forecast sales revenue. This can lead to adverse or favourable
revenue variances. It may also result in inaccurate budgets
for expenditure, as the managers will not have forecast
correctly the amount of labour and other resources that
the business needs to satisfy customers’ needs. Inaccurate
budgets are also the result of inexperience on the part
of managers, and variances will be more common when a
business is new to a market and has no financial records on
which to base forecasts.
5.5
5.5.2 Variances
Firms may also need to respond to favourable variances.
Production costs which are lower than planned may be
regarded as beneficial. But sales revenue that is greater
than anticipated might be caused by the firm selling
more products than planned. In these circumstances, the
business might not have sufficient supplies to meet future
customer requirements. This could result in the loss of longestablished customers and should be avoided.
Other factors leading to adverse and
favourable variances
STUDY TIP
Questions asking you to analyse variances are common in
Business exams. It is important for you to identify those
areas in which major differences between planned and
actual expenditure or revenue have occurred. This will
help to give a focus to your answer. It is also very likely
that you will be asked to suggest possible causes (or
cures) for the variances.
CASE STUDY
BMW’s new factory in Mexico
In 2019, the German car manufacturer, BMW, opened a
new car factory in Mexico, approximately 400 km north
of the capital city, at San Luis Potosí. The new factory
uses ports on both the west and east coasts of Mexico for
transporting components and to export finished vehicles.
The company has invested more than US$1 billion in
the new production location. The plant, which already
employs 2500 people, has a high proportion of Mexican
employees who have been trained in BMW’s approach to
production.
The factory at San Luis Potosí will build BMW’s most
successful model series: the BMW 3 Series Sedan.
This popular car has set the standard for performance,
efficiency and design, and the company expects high sales
of the new model. The new model does, however, face
intense competition from the Audi 4 and Mercedes C class
and others.
In its new factory, robots and employees work directly
alongside one another, making effective use of the
strengths of each. Production began in April 2019, with the
plant producing 240 cars per day by October. In 2020, the
factory‘s production had risen to 580 cars per day, moving
towards its annual production capacity of 175 000 units.
▲ Figure 5.24 Use of robots on BMW’s production line
means that fewer workers are used.
Questions
1
2
Analyse one possible factor that might result in the
new factory recording adverse variances.
[4]
‘The “intense competition” that the BMW 3 series
will face is the most important reason for BMW
drawing up budgets for the new factory.’ Evaluate
this view.
[12]
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AS LEVEL 5.5 Budgets
5.5
CASE STUDY
ADL acts on budgets
ADL is a television company in Argentina which produces
and broadcasts a range of programmes and operates
three satellite channels. It is particularly noted for
producing documentaries and popular drama series.
The market for making and broadcasting television
programmes is growing rapidly in Argentina and other
Spanish-speaking countries, although rates of growth
vary widely over time. Last year’s growth in sales was 11.5
per cent, while the year before it was just 2.9 per cent.
The company’s managers have just been reviewing
its financial performance, including analysing its
performance against budgets. Some of the data they
considered is shown in Table 5.18 below.
One of ADL’s managers said she believed that this
budgetary data provided the best possible measure of
ADL’s performance.
▼ Table 5.18 ADL’s budget data
Budget ($m)
Actual ($m)
Variance
Sales revenue
3 347.8
3 999.4
Labour costs
1 552.2
1 840.3
288.1 A
Materials costs
205.7
201.6
4.1 F
Other costs
630.1
916.6
286.5 A
Overheads
597.0
602.4
5.4 A
Total costs
2 985.0
3 560.9
Profit/(loss)
362.8
438.5
Questions
1
Calculate the variances for the company’s total sales
revenue, total costs and profits, stating whether each
is adverse or favourable.
[6]
2
One manager believed that ‘this budgetary data
provided the best possible measure of ADL’s
performance’. Evaluate this view.
[12]
TEST YOUR LEARNING
Short answer questions
1
2
3
4
5
Define the terms:
a ‘sales revenue budget’
[2]
b ‘expenditure budget’.
[2]
a Explain one reason why setting budgets may
lead to an improvement in the motivation of
employees.
[3]
b Budgets are short-term in nature. Explain one
reason why this might be a problem for a
business.
[3]
a Explain one reason why it might be difficult for
a business to forecast its sales accurately.
[3]
b Explain one way in which a change in the economy
may make a business’ budgets inaccurate.
[3]
a Define the term ‘flexible budget’.
[2]
b Explain one reason why a business might decide
to use a flexible-budgeting system.
[3]
a Define the term ‘zero budgets’.
[2]
b Explain one reason why a business might decide
to use a zero-budgeting system.
[3]
6
7
a
b
Define the term ‘variance analysis’.
Explain one reason why it is important for
managers to monitor budgets once they have
been set.
A business has the following budgetary data:
[2]
[3]
▼ Table 5.19
Budget ($m)
Actual ($m)
Sales revenue
254.75
295.10
Total costs
222.86
256.84
Calculate its profit variance and identify whether it is
adverse or favourable.
[4]
8 Explain one difference between adverse and
favourable variances.
[3]
9 a Explain one factor that may lead to a business
having adverse variances on its profits.
[3]
[2]
b Define the term ‘incremental budgeting’.
10 Explain one way in which budgets might help a
large multinational company to manage its finances
efficiently.
[3]
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Data response question
Nadal Ltd
Last year, Nadal Ltd opened its 59th café in Ronda,
southern Spain. This is its first café in this part of Spain
and the company has only conducted secondary market
research. The new manager in Ronda has no experience
of cafés or financial planning, but they are experienced
in retail and in managing people. Despite this, sales have
risen steadily, if slowly, and customer feedback is positive.
Budget ($)
Actual ($)
Sales revenue
11 500
10 990
Indirect costs
4 250
4 300
Direct costs
6 890
6 900
Profits
360
(210)
Questions
1
2
3
Analyse two problems that Nadal Ltd faced in
[8]
setting its budgets for the new café.
a Calculate the profit variance for the first three
[3]
months of trading for the Ronda café.
b Evaluate whether the benefits of drawing
up budgets outweigh the drawbacks to
[12]
Nadal Ltd.
‘The managers at Nadal Ltd should be pleased with
the performance of its café in Ronda.’ Evaluate this
view.
[12]
5.5
5.5.2 Variances
Nadal Ltd’s cafés sell budget-priced drinks such as coffee
and tea, as well as tapas and light meals. The company
has succeeded despite, or maybe because of, the weak
economic position in Spain. The company’s brand name
is associated with low prices and value for money. The
company plans to expand using finance raised mainly
through loans.
▼ Table 5.20 Nadal Ltd, Ronda Café – budget figures for
first three months of trading
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6 Business and its environment
A LEVEL
Chapter overview
In this chapter we examine:
★ the cases for and against nationalisation and privatisation
★ how the government might use the law to control a range of business behaviour
★ the effects of changes in political and legal factors on businesses and their decisions.
The business environment
Businesses do not operate in isolation and are subject to
a range of external influences. This external environment
is subject to constant change and these changes can mean
different things to different businesses. For example, a
change in the economic environment might lead to a fall
in consumers’ incomes. This could cause a large reduction
in sales for a business selling luxury products such as
jewellery but have little impact on a retailer selling
basic foods.
Politi
cal
and
leg
al
ntal
me
n
o
vir
En
omic
Econ
Internati
ona
l
FORCES
Responses to forces for
change by entrepreneurs,
directors, managers and
other stakeholders
pe
ra p
h ic
Co m
rs
su
FOR CHANGE
pp
lie
de
an
d
m
og
ti t o
A LEVEL 6.1.1 External influences on business activity: Political and legal
6.1.1
External influences on business
activity: Political and legal
So
rs
l
ci a
an
d
Technological
Businesses cannot ignore changes in their environment and
any single business is not sufficiently large or powerful to
have any significant influence on this external environment.
This means that all businesses have to make appropriate
responses to changes in their external environment
to ensure that they remain competitive and, for many
enterprises, as profitable as possible.
The factors which make up the external environment for
businesses differ. A small business that grows vegetables
and fruit for sale in a local market is likely to be subject
to different external forces compared to a multinational
company that sells consumer electronics globally. Despite
this, the elements making up the external environment for
businesses can be classified as shown in Figure 6.1.
We shall consider each of these elements of the business
environment over the next three chapters. In particular,
we will consider the impact of changes in these elements
and how such changes might affect decisions taken by
businesses.
The political environment
A range of political decisions can help to determine
the business environment. For example, governments
throughout the world take decisions on the extent to
which they will become involved directly in the production
of goods and services. In some European countries,
government-owned businesses supply a range of products
including water and electricity. The government in the USA
tends to rely on privately owned organisations to supply
most products to consumers.
▲ Figure 6.1 The external environment within which
businesses operate
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6.1.1.1 The advantages and
disadvantages of privatisation
In some countries, privatisation has been accompanied
by the reduction in government subsidies and grants to
industry and by legislation limiting the state’s role in
business matters. This approach to managing the business
environment is described as laissez-faire (where the
government intervenes as little as possible) and puts faith
in a greater degree of self-regulation by businesses.
Nationalisation is a policy which has the opposite effect
to that of privatisation, as shown in Figure 6.2. There are
recent signs that some governments are pursuing policies,
including nationalisation, which involve a greater degree
of state control over business. This has been driven
by a number of factors, including the perceived weak
performances of privatised businesses in some economic
sectors. The Coronavirus (COVID-19) crisis of 2020 has also
resulted in some governments being forced to take a greater
degree of control over economic activity. At the time of
writing, it remains to be seen to what extent this will be a
permanent state of affairs.
» Increased efficiency This is a key argument for
6.1.1
governments implementing a policy of privatisation and
was used to justify its use in the UK from 1980 onwards.
Managers in government-owned businesses do not
normally share in profits and may be set targets other
than making profits. In a privatised business, managers
are responsible to shareholders who expect to receive a
share of profits. Managers also often receive a share of
profits. These factors encourage managers to cut costs
and increase efficiency. There is some evidence that
businesses do operate more efficiently once privatised.
» Operational independence Managers in stateowned businesses often have to meet targets set by
governments. Such targets might include maintaining
employment levels, rather than producing as efficiently
as possible with whatever size workforce is optimal.
Being free of any government targets, privatised
businesses can become more competitive and may, in
the longer term, be more profitable.
» Higher levels of investment and innovation
Governments are often unable to afford to invest
enough to ensure a business remains competitive.
They may have other priorities, such as investing in
health care services, which are important if they want
to be re-elected. Privatising a business may mean that
its new owners are more willing and able to invest in
establishing production methods and in developing new
products which make the business more competitive.
This can secure its long-term future.
6.1.1.1 The advantages and disadvantages of privatisation
The issue of privatisation is a central part of the debate
about the extent to which the government should intervene
in the economy. Over time, governments in diverse
economies such as Argentina, Malaysia, New Zealand and
the UK have implemented policies to reduce the state’s role
in the economy, to allow markets and businesses to operate
with the maximum degree of freedom. In part, this has been
achieved through the policy of privatisation whereby stateowned enterprises are sold to the private sector.
The advantages of privatisation
The disadvantages of privatisation
» Some industries are not suited to competition The
Can be achieved through
a policy of privatisation
Can be achieved through
a policy of nationalisation
A more laissez-faire
approach to managing the
business environment
Lesser
Extent of the state’s role in the economy
Greater
▲ Figure 6.2 Nationalisation and privatisation
We shall consider privatisation first. There are, not
surprisingly, advantages and disadvantages to privatising
businesses. The main advantages and disadvantages of
privatisation are set out below.
GLOSSARY TERMS
Privatisation is the process of transferring organisations
from state ownership to being owned and controlled by
individuals and other businesses in the private sector.
Nationalisation is the transfer of a privately owned
organisation to the control of the state.
Innovation is the development of new ideas into new
products or new methods of producing products.
nature of some industries means that it can be most
efficient to have just a single producer – this is termed
a ‘natural monopoly’. For example, it makes sense to
have a single firm supplying tap-water to households
in a particular area. If this single business is privately
owned, it would lack competition and may charge high
prices and offer poor services, as customers would have
no choice. Privatising such businesses would be unlikely
to offer benefits to consumers or to promote efficiency.
» The need to protect consumers Some industries, such
as health care and education, are not well-suited to
private ownership. The risk in privatising businesses
in these types of industries is that private businesses
might prioritise profits over, for example, patient care
in a hospital. Many countries in the world operate public
health services for these reasons.
» Short-termism There is a risk that the managers of some
privatised businesses may focus on short-term profits to
satisfy shareholders through rising share prices and high
dividend payments. However, this might be achieved at
the expense of investing in projects which would provide
long-term profits, ensuring the viability of the business
over many years and its ability to provide employment
and pay taxes to the government.
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A LEVEL 6.1.1 External influences on business activity: Political and legal
6.1.1
An assessment of privatisation
Privatisation will not always be successful. Firstly, it depends
on the industry. Some industries such as airlines and
telecommunications have enjoyed much increased levels of
efficiency and profits following privatisation. It has proved
less effective in industries such as public transport and
health care, where the profit motive is not so important.
Privatisation has generally been more successful in creating
efficient and fair industries when regulators have been
established. Regulators can ensure that competition is fair
and that dominant firms do not exploit their market power
at the expense of competitors and customers. In particular,
it is important that governments avoid privatisation where
it would create a private monopoly (a single supplier of a
particular product) as the lack of competition may result in
high prices and poor products.
6.1.1.2 The advantages and
disadvantages of nationalisation
Nationalisation occurs when the state takes control of
privately owned enterprises. It is not surprising that there
are also advantages and disadvantages associated with a
policy of nationalisation.
The advantages of nationalisation
» Businesses can operate in the public interest Privately
owned businesses normally operate with a profit
motive – though there are exceptions. Nationalising
a business means that the government can set its
objectives. These objectives can be in the interests of
society as a whole and not just based on making the
maximum possible profits for the owners of the private
business. The East Coast Main Line is a major railway
route between London and Edinburgh in the UK. This
route was privatised in 1997 but returned to state
control in 2008, when the private company operating
it suffered financial difficulties. It was managed
successfully by the state until 2015, when it was once
again privatised before being taken into state control
once more, as the second private company operating
it faced financial problems. This shows that there are
circumstances in which it is challenging for a private
company to make sufficient profits while operating a
business in the public interest.
» The treatment of employees There is some evidence
to suggest that employees are more likely to be
exploited within a privatised business. Governments
often privatise businesses to cut the costs of
operating them. So, for example, many government
buildings in the UK are cleaned by employees
belonging to private companies. Private cleaning
companies win contracts for cleaning by offering
to provide such services at very low costs. The pay,
conditions and job security for cleaners and other
employees in state-run businesses tend to be better
than in their privatised equivalents.
» Levels of long-term investment There is some
controversy over whether state or private ownership
results in higher long-term levels of investment.
However, there is a school of thought that governments
are more likely to provide the long-term investment
needed to create important services for the public, such
as railways and electricity supply networks. Governments
across the world have provided the investment necessary
to create high-speed railways.
The disadvantages of nationalisation
» Political interference Opponents of nationalisation
argue that governments are subject to political pressures
and take decisions that please voters rather than making
sound business sense. Some governments have pursued
policies which have led to nationalised businesses hiring
too many workers. This has boosted employment (often
in poor regions) but has resulted in high costs and
uncompetitive enterprises. Subsequently, governments
are often unwilling to make redundancies for fear of the
bad publicity that will result.
» Inefficiency This is perhaps the major criticism
of nationalised businesses. The managers of some
nationalised businesses are not expected to meet
targets that would be common in privately owned
enterprises. Nationalised businesses are also sometimes
shielded from the full force of competition from overseas
businesses. These factors can remove the incentive
for managers to produce up-to-date and desirable
products at the lowest possible cost, thereby offering
the greatest value to consumers. It is this perceived
weakness that has prompted many calls for privatisation.
» Reduced competition Nationalisation can discourage
competition. Governments that privatise industries
frequently reduce the regulations governing that
industry at the same time. This encourages more
businesses to enter that industry. The outcome is often
more choice and lower prices than would be the case
with a nationalised business.
GLOSSARY TERM
Regulation is the enforcement of principles or rules that
result from the passing of a law or series of laws.
An assessment of nationalisation
As with privatisation, it is not possible to say that
nationalised businesses will perform better (or worse) than
their privately owned equivalents. Inevitably, it depends
on the circumstances. However, it is possible to say that
the advantages of a nationalised business are more likely to
outweigh its disadvantages in the following circumstances:
» where high-quality managers are appointed and clear
targets are set
» where the central government does not try to manage
the business
» where sufficient investment is available for short- and
long-term investment needs
» where the interests of all stakeholders are considered
and not simply the need to generate profits.
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▼ Table 6.1 A comparison of privatisation and nationalisation
Nationalisation
Management
Transferred by the state to be managed by
the private sector
Owned and managed by the state instead of
the private sector
Examples
In 2015, the Australian government sold NSW Ferguson Marine Engineering, a shipbuilding
Electricity to the private sector for more
company, was nationalised by the Scottish
than $16 billion.
Government in 2019.
Key benefits
• Increased efficiency
• Operational independence
• Higher levels of investment and
innovation
• Better treatment of employees
• Operate in public interest
• The state can provide a reliable source of
long-term investment
Key drawbacks
• Some industries not suited to competition
• The need to protect consumers
• Short-termism
• Political interference
• Inefficiency
• Reduced competition
Circumstances in which more
likely to be successful
• Industries open to global competition,
such as airlines or telecommunications
• Industries requiring a high degree of
innovation
• Natural monopolies such as water supply
• Non-profit services such as health care
STUDY TIP
Do think about the cases for nationalisation and
privatisation in different situations. You should appreciate
that there is not a simple answer to the question of which
is best. Thinking about the circumstances in which each
is best will deepen your understanding and improve your
ability to develop arguments and make judgements on
this issue.
6.1.1.3 How a government might
use the law to control business
activity
The law is a framework of rules governing the way in which
societies operate. Laws are sometimes called legislation.
These rules apply to businesses as well as individuals. The
legal framework influences businesses in a number of ways,
affecting almost all areas of business activity. Marketing,
production, employment, relationships with customers and
competitors, and even decisions on location are examples of
areas of business activity that can be influenced by laws.
STUDY TIP
You do not need to know about specific laws, but you
would benefit from some knowledge of the major laws
in your country relating to the aspects of business
behaviour covered below. You should also consider the
effects they have on local businesses. This chapter will
use examples of laws in operation in the UK to illustrate
the explanations.
6.1.1
6.1.1.3 How a government might use the law to control business activity
Privatisation
Laws relating to employment practices,
working conditions and pay
These laws govern the relations between workers, employers
and trade unions. The UK government has a range of laws
which it uses to control the ways in which people are
employed in the UK. Governments can use laws to control a
range of issues related to employment, including:
» employment practices
» conditions of work
» wage levels.
Some examples of the employment laws in the UK are shown
in Figure 6.3.
Working
time
regulations
Working
conditions
Health and
Safety at
Work Act
Collective
labour law
The Minimum
Wage Act
Pay
Laws relating to
employment practices,
working conditions
and pay
Employment
practices
Employment
Relations
Act
The National
Living Wage
Individual
labour law
The Equality
Act
▲ Figure 6.3 Employment legislation
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Employment practices
A LEVEL 6.1.1 External influences on business activity: Political and legal
6.1.1
Employment practices refers to the way in which businesses
treat their employees from hiring until the end of their
relationship with the business. Most countries have a range
of laws covering issues relating to individual employees and
groups of employees within the workplace.
Laws relating to individual employees are frequently
designed to ensure that all employees are treated fairly and
equally. In recent years, there has been a focus in many
countries on avoiding discrimination against particular
groups of employees. The UK passed a key piece of antidiscrimination legislation in 2010, as outlined below.
» The Equalities Act 2010 This Act replaced a number
of earlier anti-discrimination laws in the UK (such
as the Disability Discrimination Act) to simplify
legislation in this area. The Act relates to nine protected
characteristics which cannot be used as a reason to treat
people differently or unlawfully. Each person in the UK is
protected by this Act, as everybody has one or more of
these characteristics. The protected characteristics are:
– age
– disability
– gender reassignment
– marriage and civil partnership
– pregnancy and maternity
– race
– religion or belief
– sex
– sexual orientation.
This Act makes unfair treatment unlawful in the
workplace, in education and when supplying goods and
services.
Employees in many countries are protected against unfair
dismissal. Unfair dismissal is the termination of a worker’s
employment contract without a legal reason. In the UK,
legislation relating to unfair dismissal only relates to
workers once they have been in a particular job for one
year or more. There are a limited number of reasons why an
employee might be dismissed:
» where a job no longer exists – this is redundancy
» gross misconduct – examples of this include theft from
the employer or behaving violently at work
» failing to carry out duties in a ‘satisfactory manner’
» another substantial reason – for example, the ending of
a temporary contract.
All other reasons for dismissal are considered unfair.
Employees who think they have been unfairly dismissed can
claim compensation by taking their case to an industrial
tribunal.
There are also laws that govern relationships between
employers and groups of employees. This is often referred
to as collective labour law. This group of laws applies
to the operation of industrial relations and collective
bargaining as well as the activities of trade unions.
Employers and employees are likely to negotiate on a
variety of matters. These negotiations may include items
such as working conditions and other workplace rules, pay,
hours of work, holidays, sick leave, retirement benefits
and health care benefits. Some examples of these laws
in the UK, as well as a later one granting more powers to
trade unions, are described below.
» Employment Act 1980 Under this Act employers were
no longer obliged to negotiate with unions – many
unions were derecognised as a consequence.
» Trade Union Act 1984 This legislation made a secret
ballot of employees a legal requirement before unions
could take any industrial action against employers, such
as strikes.
» Trade Union Reform and Employment Rights Act 1993
Unions were required to give employers a minimum
of seven days’ notice before taking official industrial
action. It also abolished minimum pay rates, although
laws establishing minimum wage rates were introduced
by a different government in 1999.
» Employment Relations Act 1999 Under this Act, a
trade union with a membership exceeding 50 per cent
of the employees in any particular business can demand
union recognition and the right to introduce collective
bargaining.
Laws relating to employment practices can quickly become
outdated, as business practices and operations change.
Governments in countries throughout the world are under
pressure to ensure that laws relating to all aspects of
employment are up-to-date and fit for purpose.
One matter which is receiving a lot of attention in
many countries across the globe is that of the insecure
employment of workers in the so-called gig economy. A
‘gig’ is a term used to describe a single piece of work, such
as delivering a meal or transporting a passenger in a taxi.
At the core of the gig economy are app-based platforms
that allocate work in small quantities – making deliveries,
driving passengers or cleaning homes. People working
in the gig economy are not classified as employees,
but contractors. As a consequence, they do not receive
guaranteed hours of work or amounts of pay. However,
from the point of view of companies operating in the gig
economy, using workers in this way can be an effective
means of controlling labour costs. The case study below
looks at the response of law-makers in the American state
of California to the gig economy.
GLOSSARY TERM
The gig economy is a labour market in which short-term
contracts or freelance work are common, as opposed to
permanent jobs.
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CASE STUDY
6.1.1
New laws affect the USA’s gig economy
The legislation came into effect at the start of 2020 and
states that, if a company directs a worker in the way they
perform their tasks or includes their work as part of
their regular business, they must class that worker as an
employee instead of a contractor.
The new law may have an effect on other states. Trade
unions and other employee groups are calling for similar
legislation in New York, Washington State and Oregon.
Many people working in the gig economy have been
classified as contractors without access to benefits
including minimum wage rates, sick pay and holiday pay.
Examples of occupations in the gig economy include taxi
drivers, food-delivery workers, construction workers
and those employed in nail salons. It was predicted that
the new law would affect at least 1 million workers in
California.
But the new law threatens the business models (and
possibly the futures) of gig economy companies like
Uber and Lyft, which employ large numbers of people as
contractors to reduce costs and increase profitability. The
law has received a lot of criticism from some businesses
for potentially reducing employment levels and the growth
of businesses.
Questions
1
2
Analyse one possible way in which the managers
of a Californian business in the gig economy might
respond to this new law.
[4]
Evaluate the case for and against the passing of
this new law in California.
[12]
We will explore the gig economy and other new employment
practices further in Chapter 7.4.
▼ Table 6.2 The legal requirements for paid holidays in a
selection of countries
Working conditions
Country
The term ‘working conditions’ refers to a range of factors
affecting an employee’s experiences at work, including
hours of work and paid holidays, as well as their safety and
security in the workplace.
Legal entitlement Notes
to paid holiday
per year
China
16–26 days
Precise figure depends
on length of employment
with the enterprise
USA
–
No federal or state laws
on paid holidays
Singapore
18–25 days
Precise figure depends
on length of employment
with the enterprise
Iran
53 days
This includes 27 days of
paid public holidays
Many countries have laws relating to working hours. The
European Union (EU) operates its Working Time Regulations,
which were introduced in 1998. This European Union
legislation set a limit of 48 hours on the number of hours
that employees could be required to work each week.
Employees can opt to work longer hours if they wish, but
employers cannot insist that they do so without inserting
an appropriate clause in their employment contract. The
regulations also gave employees an entitlement to four
weeks’ paid annual leave. Although the UK has left the
European Union, these laws will remain in place until and
unless new ones are passed.
It is increasingly common for employees to have an
entitlement to a period of paid holiday each year. These
legal rights are also part of the Working Time Regulations
mentioned above. This law applies to most employees who
are paid at their normal rate. The amount of paid holiday set
out in employment legislation varies considerably between
non-EU countries. Table 6.2 offers some examples.
6.1.1.3 How a government might use the law to control business activity
The government in California (one of the USA’s most
prosperous states) has passed a new law that makes it
mandatory for contract (or gig) workers to be treated by
companies as employees. The intention is to improve job
security and working conditions of employees in the state’s
gig economy. Uber’s use of contractors has enabled the
company to operate taxi services in cities across the world.
Laws relating to health and safety in the workplace
are an important element of the conditions of work for
all employees, especially those working in potentially
dangerous industries, such as mining. The International
Labour Organisation (ILO) reports that there are more than
2.78 million deaths per year in workplaces throughout the
world. Additionally, there are some 374 million non-fatal
work-related injuries each year resulting in more than 4 days
of absences from work. The human cost of this is vast and
the economic burden of poor health and safety practices is
estimated at 3.94 per cent of global gross domestic product
(GDP) each year. In this case, GDP measures the total value
of output produced by the world’s economy over a year.
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A LEVEL 6.1.1 External influences on business activity: Political and legal
6.1.1
» providing protection against dangerous substances.
Health and safety legislation has been enacted to
discourage dangerous practices by businesses and to
protect the workforce. The legislation in the UK is designed
to prevent accidents in the workplace and has developed
steadily over the last 30 years. The main Act in the UK
is the Health and Safety Act of 1974. This is an example
of delegated legislation, whereby parliament gives
responsibility to government departments to update the
scope of the legislation as necessary. This process avoids
any particular aspect of legislation taking up too much of
parliament’s time.
Businesses are required to protect the health and safety of
their employees ‘as far as it is reasonably practicable’. This
means that the business concerned must have provided
protection appropriate to the risks. Thus, a chemical
manufacturer would be expected to provide considerable
protection for its employees. The Act also requires employees
to follow all health and safety procedures and to take care of
their own and others’ safety. In the UK, the Health and Safety
Executive (HSE) oversees the operation of the Act and carries
out inspections of businesses’ premises. The HSE also carries
out investigations following any serious workplace accident.
The Health and Safety at Work Act gives employers a
legal obligation ‘to ensure that they safeguard all their
employees’ health, safety and welfare at work’. The Act
covers a range of business activities, including:
» the installation and maintenance of safety equipment
and clothing
» the maintenance of workplace temperatures
» giving employees sufficient breaks during the
working day
Wage levels
Pay rates are another area relating to employment in which
a high proportion of countries have passed laws. Many
countries have minimum wage laws, which set out wage
rates below which businesses must not pay. The use of
minimum wage laws is illustrated in Figure 6.4 below.
100%
91%
73%
97%
89%
Note: The ILO has 187 members, meaning few countries are not members.
Source: International Labour Organisation; Minimum wage setting in Europe and beyond –
the ILO perspective, 18 September 2019, David Mosler
▲ Figure 6.4 The proportion of ILO members in different regions of the world that operate minimum wage legislation
Minimum wage rates can vary within countries. Some are
not the same throughout the different regions of a country.
In the USA, some states (for example, Alabama and South
Carolina) do not have any minimum wage laws and the rates
can vary significantly in other states. In 2020, the minimum
hourly wage rate in Wyoming was $5.15 compared to $13 per
hour in California. Other countries have passed minimum
wage laws which impose different minimum rates for different
occupations. For example, India has a large number of
different minimum wage rates for some selected occupations.
The UK’s National Minimum Wage Act came into force on
1 April 1999. The key features of this legislation are:
» a general hourly minimum wage rate for workers aged
over 24
» separate minimum wage rates for those aged 16–17,
18–20 and 21–24
» all part-time and temporary workers must be paid the
minimum wage.
In April 2016, this legislation was supplemented by
the introduction of the national living wage in the UK.
This applies to employees aged 25 and over and pays a
significantly higher rate than the minimum wage. In 2020,
the rate was set at £8.72 per hour. UK minimum and national
living wage rates are raised each year to ensure that these
wages at least keep up with the current rate of inflation.
In November 2020, the University of Massachusetts
Amherst, the National Bureau of Economic Research and
the IZA Institute of Labor Economics carried out research
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into the effects of minimum wages. Their conclusions were
that even the UK’s relatively high minimum wage rates
had little negative impact on employment rates, while
substantially increasing the pay and living standards of
low-paid employees.
Laws relating to marketing
behaviour
Since 2014, the Competition and Markets Authority (CMA)
has overseen legislation relating to marketing activities
in the UK. It seeks to improve the position of consumers
by giving them information to allow them to make better
choices when purchasing goods and services. It also
protects consumers by prosecuting businesses that offend
against marketing legislation and by negotiating voluntary
codes of practice with producers of goods and services.
6.1.1
It is also necessary to protect the public from improper use
of the power of advertising. It involves a combination of
legal controls and self-regulation.
» The Trade Descriptions Act 1968 This Act makes
misleading descriptions of goods and services an offence.
» The Advertising Standards Authority This body
supervises the operation of this code of practice. It
is an independent body; its members are not in the
advertising industry. The ASA protects the public and
deals with their complaints.
CASE STUDY
6.1.1.3 How a government might use the law to control business activity
The law covers the marketing activities of businesses in
most countries. Approximately 80 per cent of countries
have passed laws to protect consumers from the marketing
activities of businesses. The scope of these laws varies
and there is a general criticism that they are not updated
sufficiently to reflect changes in marketing behaviour,
such as the use of the internet. The UK has a series of laws
designed to safeguard consumers against:
» businesses charging excessively high prices or rates of
interest
» unfair trading practices; for example, selling quantities
less than those advertised
» unsafe products, such as children’s toys with sharp
objects or toxic paint
» having insufficient information on which to take
purchasing decisions.
There is a considerable quantity of marketing legislation in
the UK. The Acts listed below represent a few highlights.
» The Consumer Rights Act 2015 replaced three major
pieces of marketing legislation in the UK. This Act was
introduced to modernise the law in this area, making it
simpler and stronger. The Consumer Rights Act states
that all products (including, for the first time, digital
products as well as physical products) must be of
satisfactory quality, fit for purpose and as described.
All products must meet the following standards:
– Products must be of satisfactory quality. Goods
shouldn’t be faulty or damaged when purchased.
– Products should be fit for the purpose they are
supplied for and offer the consumer the benefits
promised.
– The goods supplied must match any description
given to consumers, or any models or samples shown
to consumers.
» The Consumer Credit Act 1974 This Act lays down
that consumer credit can only be given by licensed
organisations. It also sets out the terms under which
credit may be given.
Queensland to ban ‘junk food’ adverts
The government of the Australian state of Queensland
has banned junk food advertising at government-owned
locations in a bid to eliminate poor diets and obesity
among children. The state’s Health Minister, Steven Miles,
said the unhealthy marketing activities would be stopped
throughout the state. The advertising sites affected will
include bus stops and train stations.
‘Junk food advertisers target kids, we know that, and
obesity in childhood is a leading indicator of obesity in
adulthood,’ Mr Miles said. ‘This is about doing what we can
to protect our kids from the kind of marketing that leads
them to make unhealthy choices.’
‘Obesity is a real challenge for our community, for our
hospitals and the health services, but also for the
individuals who are suffering – this is really just a decision
about the government leading by example and saying that
we will use our spaces to advertise healthier options,’
he said.
Jane Martin is the executive manager of the Obesity Policy
Coalition, a group pressing the Australian government
to take action against obesity. Ms Martin approved this
decision by the government of Queensland, noting that
young people are particularly susceptible to junk food
advertising.
The governments of other Australian states are
considering passing similar laws to control marketing
activities.
Source: www.abc.net.au/news/2019-04-21/junk-food-adsbinned-queensland-government-crackdown/11034284
Questions
1
2
Analyse two ways in which laws can constrain the
activities of fast-food businesses.
[8]
Evaluate the extent to which laws of this type
benefit the stakeholders of fast-food restaurants
in Queensland.
[12]
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Laws relating to competition
A LEVEL 6.1.1 External influences on business activity: Political and legal
6.1.1
Competition law is intended to protect businesses and
consumers from the effects of anti-competitive practices.
Most governments believe that free and fair competition in
markets brings many benefits. The UK government set out
the importance of competition to its economy in 2001:
Vigorous competition between firms is the lifeblood of strong
and effective markets. Competition helps consumers get a
good deal. It encourages firms to innovate by reducing slack,
putting downward pressure on costs and providing incentives
for the efficient organisation of production. As such,
competition is a central driver for productivity growth in the
economy, and hence the UK’s international competitiveness.
Source: UK Department of Trade and Industry
The scope of
UK and EU
competition law
Cartel activity
Abuse of a
dominant
market position
Other
anti-competitive
practices
▲ Figure 6.5 The extent of competition law
GLOSSARY TERMS
A cartel exists when two or more businesses collude to
control prices and/or output, thereby limiting competition
and increasing profits.
Businesses operating in the UK are subject to UK and, at the
time of writing, to EU competition law, although this may
change after 31 December 2020. The major competition laws
in the UK are:
» the Competition Act 1998
» the Enterprise Act 2002
» the Enterprise and Regulatory Reform Act 2013.
A merger is the combining of two or more firms into a
single business, following an agreement by the firms’
management teams and shareholders.
Competition law in the UK operates in three main areas:
1 Cartel activity Cartels involve two or more businesses
working together to limit the extent of competition
that exists in a market; they are considered to be a
serious form of anti-competitive practice. Cartels are
agreements between businesses not to compete with
each other, for example, on price, discount levels,
credit terms or in respect of particular customers or in
particular areas. The outcome is that consumers will
be disadvantaged, primarily because they will have to
pay a higher price (agreed by the cartel) than would
otherwise be the case. In addition, the economy will
be damaged by a lack of competitiveness among its
businesses.
2 Abuse of a dominant market position The law defines
a dominant market position as ‘a position of economic
strength enjoyed by an undertaking which enables it to
prevent effective competition being maintained in the
relevant market by affording it the power to behave to
an appreciable extent independently of its competitors,
customers and ultimately of its consumers.’ Such markets
can be national or local, as well as the whole of the EU.
Abuse of such a position can take a number of forms,
including:
– imposing unfair purchase or selling prices or other
unfair trading conditions
– limiting production, markets or technical
development to the prejudice of consumers
– imposing unfair and inconsistent terms on different
trading partners.
3 Other anti-competitive practices These could include
agreements with suppliers not to sell below certain
prices, limiting production to drive up prices, agreeing
not to sell to a competitor’s customers, etc. This also
includes mergers and takeovers which may be harmful
to the competitive process in markets.
Mergers and takeovers
A takeover occurs when one company acquires complete
control of another by purchasing more than 50 per cent of
its share capital.
Takeovers and mergers have the potential to provide
businesses with a high degree of market power, as they
create larger enterprises. They can also lead to a reduction
in the degree of competition within a market. The
competition authorities in the UK are required to assess
whether a merger or takeover should be prohibited on the
basis of whether it can be expected to lead to ‘a substantial
lessening of competition’. In the UK, the primary
responsibility for the regulation of mergers and takeovers
lies with the Competition and Markets Authority (CMA).
Mergers will be assessed by the CMA if:
» the business being taken over exceeds a given size (a
sales revenue exceeding £70 million), or
» the newly merged business would control 25 per cent or
more of its market.
Key UK competition laws
The legal framework for the UK’s competition policy
is provided by the Competition Act 1998, the Enterprise Act
2002 and the Enterprise and Regulatory Reform Act 2013.
» The Competition Act 1998 prohibits cartels and
abuses of dominant market position. It also outlaws
concerted practice; for example, when businesses
agree to divide up a market and not to compete in each
other’s ‘part’ of the market. The penalties for breaching
this Act can be severe. Businesses may be fined up to
10 per cent of their worldwide sales revenue if they
enter into an anti-competitive agreement or abuse a
dominant market position.
» The Enterprise Act 2002 amended earlier laws and
strengthened the power of the UK authorities to deal
with anti-competitive practices and market dominance.
This Act has a number of important provisions:
– It places a clear focus on the impact of the business’
activities on the degree of competition. Practices
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means that businesses may be sued for damages by
third parties that have been harmed by their anticompetitive actions.
– The assessment of mergers is influenced less by
politicians and is more independent.
» The Enterprise and Regulatory Reform Act 2013 The
main provisions of this Act, relating to competition, are
as follows:
– It created the CMA, bringing together the
Competition Commission and the competition work of
the Office of Fair Trading. Thus, a single organisation
is responsible for competition policy.
– It makes it quicker and simpler for businesses,
especially small and medium-sized enterprises,
to make legal challenges to anti-competitive
behaviour.
– It also makes it easier for consumers and small
businesses who have suffered loss due to anticompetitive behaviour to obtain redress.
CASE STUDY
US authorities approve T-Mobile and Sprint merger
The competition authorities in the United States have
approved a merger between two of the country’s biggest
mobile telephone service providers: T-Mobile and Sprint.
The new business will be valued at $26.5 billion. On
the face of it, this deal reduces the number of mobile
telephone providers in the USA from four to three.
The deal was finally approved after the two companies
agreed to sell some of their assets to another company. The
deal includes agreement that Dish, a satellite dish supplier,
will buy Boost Mobile, Virgin Mobile, Sprint’s prepaid
business, and ‘certain’ other assets currently owned by the
two companies. This will position Dish as the fourth major
US mobile telephone provider, replacing the one that will be
lost once T-Mobile and Sprint merge. The two companies
will be required to provide at least 20 000 cell sites and
hundreds of retail locations to Dish, and it will also get
unrestricted access to T-Mobile’s network for seven years
as it works to build a mobile network of its own.
The law and business location decisions
Many countries have legal systems which control where
businesses can locate. It is not unusual for businesses
to be located in particular areas – often alongside other
businesses. So, many towns and cities create industrial
estates where business can locate. Retailers may be limited
to certain streets – often where other shops already
operate. Many countries, including the United States, make
it illegal to locate businesses outside designated zones.
Businesses that want to build new premises may need to
apply for permission from the authorities. Applications for
new premises are decided in line with national and local
policies. Points for consideration include:
When T-Mobile and Sprint announced their merger plan,
they claimed that their combined assets would make them
a stronger competitor to the other two companies in the
market: AT&T and Verizon. T-Mobile and Sprint said they
would be able to reduce prices for consumers and more
quickly offer the new 5G service across America. These
claims have faced harsh criticism from consumer groups
and some experts.
Questions
1
2
Analyse one reason why reducing the number of
companies selling products in a particular market
might be harmful to consumers.
[4]
The American competition authorities ruled in favour
of the merger. Evaluate whether or not this is a good
outcome.
[12]
6.1.1
6.1.1.3 How a government might use the law to control business activity
are judged as to whether they create a ‘substantial
lessening of competition’ rather than whether they
are ‘in the public interest’.
– It imposes tougher penalties on those involved in
cartels by criminalising their activities. Directors or
other people involved may be fined or sent to prison
for up to five years if involved in cartel activity.
Company directors may also be disqualified from
being a director for up to 15 years.
– It empowers consumer organisations to make
complaints (known as ‘supercomplaints’) to the
CMA about markets that are not working well for
consumers. For example, in 2018, this legislation was
used to make a complaint about businesses charging
loyal customers higher prices than new customers for
the same products.
– There are greater opportunities for victims of
anti-competitive behaviour to gain compensation.
Consumer bodies will be able to make claims on
behalf of individuals who have suffered. This
» the size, layout and external appearance of buildings
» proposed means of access and impact on the
neighbourhood
» availability of infrastructure, such as roads and
electricity supply
» how the proposed use of the development relates to the
rest of the neighbourhood.
Another factor influencing business location which
has a legal dimension is the use of special economic
zones. These are areas within individual countries where
business and trade laws are different from the rest of
the country. They are designed to attract businesses to
locate there. Governments pass laws to allow businesses
locating in these areas a range of benefits such as tax
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A LEVEL 6.1.1 External influences on business activity: Political and legal
6.1.1
holidays, financial support, and fewer laws and regulations
relating to employment and international trade. Often
these special economic zones are sited in poor regions
of the country. By 2018, 147 economies operated special
economic zones including China, India, Bangladesh, Saudi
Arabia, the Philippines, South Korea and the UAE.
6.1.1.4 The impact of changes
in political and legal factors
on businesses and business
decisions
Laws and particular goods and services
Changes in political and legal factors frequently lead to
more intervention in business matters. For many businesses,
this can be a disadvantage as such interventions can result
in increased costs of production, as businesses in most
nations are legally obliged to employ a number of nonproductive employees. For example, health and safety laws
may require the appointment of safety officers. In addition,
other costs of production may increase as businesses
have to pay minimum wage rates and locate in what may
be costly places. Similarly, the requirement (under the
Equalities Act in the UK) to make ‘reasonable’ alterations
to the working environment to enable the employment of
people with disabilities adds to production costs.
Governments use laws to control the production, sale
and consumption of a range of goods and services. Legal
controls may be applied to particular products for a number
of reasons:
» The production and consumption of these products may
result in damage to the natural environment.
» The goods and services may be harmful to consumers
and they may also be addictive.
» Their consumption may have adverse effects on others or
on society generally.
Globally there are many products that are subject to legal
constraints; we shall consider a small selection. Some of the
more common ones include:
» tobacco
» alcohol
» medicines
» gambling
» vehicles with diesel and petrol engines.
Governments tend to take a range of steps to control
businesses that produce and sell these products, as well as
consumers who use them.
» Taxation Governments may impose heavy taxes on the
sale of products, such as tobacco and alcohol. This is
intended to discourage consumption, though it also acts
as an important source of revenue for many governments.
Tobacco taxes in many countries form more than 50 per
cent of the selling price of the products.
» Limiting sales Governments may control the sale of
products directly to a lesser or greater degree. The use
of vehicles with petrol and diesel engines is restricted
in many cities including Singapore, London, Milan and
Stockholm. Equally, there are commonly age limits
on those who can buy and consume certain products,
such as gambling and tobacco. It is thought that such
products can be particularly harmful to younger people.
In some countries (for example, Canada), strong alcohol
can only be purchased from a relatively small number of
licensed shops.
» Outright bans on production and consumption
The sale of alcohol is banned in a number of Muslim
countries and some states in India. All forms of
gambling are illegal in Cambodia and Qatar.
» Restricting sale to ensure safe consumption
Many countries control the sale of products, such as
medicines, to ensure that consumers use them safely.
The intention is for consumers to receive the health
benefits with minimal risks. In most countries, only
specified shops and other outlets with suitably qualified
staff are allowed to sell certain medicines.
Changes in laws relating to employment practices,
marketing behaviour or competition, or decisions to raise
minimum wage rates, may all have negative effects on
businesses. Such changes can be critical if they increase
costs of production and the business concerned operates in
a globalised market with very price-conscious customers.
If rival businesses operating in other countries do not face
similar increases in costs of production, they will operate
with a competitive advantage. Such changes may result in
some businesses losing sales, market share and profits.
However, there can be positive consequences for businesses
from political and legal changes. Changes in employment and
other laws can help to motivate the workforce and improve
the performance of the workforce. For example, employees
who work in a safe and secure physical environment will be
more contented and probably more productive. Employers
will also avoid the costs, delays and bad publicity caused
by accidents at work or employee complaints about poor
conditions. Furthermore, freedom from arbitrary dismissal
may encourage a more co-operative and productive
workforce, enhancing the performance of the business.
The effects of legal and political changes may be greater
for small firms that have fewer resources and are less able
to keep up with changes in employment and other laws,
and may not be able to afford to respond in the appropriate
manner. Larger firms are more likely to employ specialists
and are more likely to be prepared for, and able to finance,
change. They may also be able to afford employment
lawyers to advise them on avoiding some of the effects of a
new piece of legislation.
STUDY TIP
Do think about political and legal changes in a balanced
way. The effects on businesses do not always have to be
negative, as we have seen. Also think in a structured way
about how businesses might respond to such changes.
Considering the likely effects on, and responses of, each
functional area of a business may be helpful.
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CASE STUDY
6.1.1
Vietnam increases its minimum wage rates
The country has different minimum wage rates in four
regions, determined by the level of economic development
in each region. Zone 1 covers urban Hanoi and Ho Chi
Minh City. Zone 2 covers rural Hanoi and Ho Chi Minh
City, as well as Can Tho, Da Nang and Hai Phong. Zone
3 includes provincial cities and the districts of Bac Ninh,
Bac Giang, Hai Duong and Vinh Phuc. Zone 4 comprises
the rest of the country.
Business responses to the effects
of changes in the political and legal
environment
Most businesses will take decisions necessary to offset the
effects of the change in their political or legal environment
as far as possible. If the changes are judged favourable,
businesses will consider how to take advantage of the new
circumstances. Business decisions could take a number of
forms, which include the following.
» Changes in production methods Legal and political
changes may lead to decisions whereby businesses
use fewer employees in the production process and
replace them with capital equipment. Some businesses,
particularly footloose multinationals that can move
location easily, may decide to close production facilities
and produce elsewhere.
» Selling or buying assets Businesses may take the
decision to sell part of their operations if they need to
meet the requirements of competition authorities when
According to a survey released by an employment
website, salaries in Vietnam are rising faster than other
Asian countries but still remain low – and lower than
in countries such as China. Vietnam’s minimum wage
increase of 5.7 per cent is higher than last year’s figure of
5.3 per cent, but lower than that in 2018 and 2017.
Vietnam has been considered a low-cost location for
multinational businesses and is a popular location for many
well-known multinationals. Samsung, Bosch, Panasonic
and General Electric all have operations in the country.
Questions
1
2
Analyse two possible effects of this change in minimum
wage rates on businesses located in Vietnam.
[8]
Evaluate the best way for businesses in Vietnam to
respond to this change in minimum wage rates. [12]
contemplating a merger or takeover. Conversely, changes
in laws relating to conditions of work, including health
and safety, might result in the purchase of new assets to
meet changed legal requirements.
» Changes in prices and target markets Rising costs
may force some businesses to pass these onto
consumers in the form of higher prices, if market
conditions allow. Other businesses may decide to
target other market segments which may be willing to
pay higher prices.
» Decisions to cut production and/or develop new
products Political and legal changes can lead to
businesses deciding to stop producing certain
products and to supply other products. Legal changes
in many countries have led to tobacco sales falling
significantly. Some tobacco manufacturers have
responded by closing factories, while others have
switched production to vaping products.
TEST YOUR LEARNING
b
Short answer questions
1
2
3
4
Define the terms:
a ‘privatisation’
[2]
b ‘nationalisation’.
[2]
a Explain one advantage of privatisation.
[3]
b Explain one reason why some industries may not
be suited to privatisation.
[3]
a Explain one advantage of nationalisation.
[3]
b Explain one reason why nationalised industries
may be less efficient than those in the private
sector.
[3]
a Define the term ‘trade union’.
[2]
5
6
7
Explain one reason why laws relating to
employment practice need to be updated
regularly.
Explain one way in which minimum wage rates
might vary within a single country.
a Explain one way in which laws relating to
marketing behaviour might affect businesses.
b Explain one type of business activity that
competition law is designed to prevent.
Explain one action that a government might take
to control the production, sale and consumption of
particular goods and services.
6.1.1.4 The impact of changes in political and legal factors on businesses and business decisions
The Vietnamese government increases its minimum
wage rates each January in line with the cost of living. A
new minimum wage rate for workers, which will result in
an increase in monthly pay of up to 300 000 Vietnamese
dong, equivalent to approximately US$14, was introduced
in January 2020. This represented an increase of
approximately 5.7 per cent in the country’s minimum
wage rates.
[3]
[3]
[3]
[3]
[3]
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A LEVEL 6.1.1 External influences on business activity: Political and legal
6.1.1
8
Explain one reason why political and legal changes
might reduce the competitiveness of a business.
[3]
9 Explain one reason why the existence of laws to
control employment practices may be beneficial to
businesses.
[3]
10 Explain one way in which a business might respond
to a change in the law which increases its costs of
production significantly.
[3]
One director of MD said that the effects of the changes to
laws on working conditions would damage the company’s
future performance.
Data response question
Questions
MD vehicles
1
MD is a multinational company that manufactures vehicles
and has factories in several countries. The company’s
workforce is becoming less productive over time and
profit margins are falling as a result. The market for cars
is increasingly price competitive, although MD is a brand
that is highly valued by customers and demand for its cars
is not strongly sensitive to price.
A new government has been elected in one of the
countries where MD produces over 30 per cent of its cars
in a very large factory. This government has announced
changes to laws governing working conditions which will
come into force in one year’s time. These include:
● an increase in the number of days of paid holiday from
15 to 20
● an extension of health and safety laws.
The new government has also taken a decision to
nationalise one of MD’s most important suppliers of
components which is sited close to its factory. This was
an unexpected change and MD’s directors are concerned
about the impact it may have on its operations.
2
3
Analyse one possible effect on MD of the government’s
decision to nationalise one of its major local suppliers. [4]
Evaluate the decisions that the company might take
in response to the changes in the laws relating to
working conditions.
[12]
One director said that ‘the effects of the changes to
laws on working conditions would damage the
company’s future performance.’ Evaluate this view.[12]
Essay question
1
Evaluate whether or not new laws designed to
promote competition are in the interest of all the
stakeholders of a business.
[20]
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6 Business and its environment
A LEVEL
6.1.2
External influences on business
activity: Economic
In this chapter we examine:
★ how governments assist businesses and promote enterprise
★ the ways in which governments constrain business activity
★ government macroeconomic objectives
★ the effects of macroeconomic objectives and economic performance on business activity
★ the government’s economic policies – fiscal, monetary and supply side policies – and their impact on businesses.
Every business is affected to some degree by the national
(or global) economy in which it operates. An economy is an
immensely complex thing. It comprises millions of buyers
(or consumers) and hundreds of thousands of businesses
all making decisions to spend, hire labour, use certain
machinery, produce more or less, lend money or borrow it to
produce goods and services.
This is then complicated further by the actions of
governments that intervene in the working of the
economy in order to achieve their social and economic
objectives. Most governments aim to manage economies
so as to maximise the standard of living of the country’s
inhabitants, while pursuing other goals such as protecting
the environment. The UK government aims to achieve
economic stability in its management of the economy by
avoiding, whenever possible, sudden and dramatic changes
in the performance of the economy.
A country’s economic environment is made up of two main
elements:
» The factors which reflect the performance of that
economy as well as other economies; for example, how
fast prices are rising (inflation) and the number of
people who do not have a job (unemployment).
» The actions taken by governments to achieve the desired
economic performance.
6.1.2 External influences on business activity: Economic
Chapter overview
The factors which make up the economic environment are
summarised in Figure 6.6.
Government policies affecting
the economy
Policies to support
businesses and
promote enterprise
Fiscal
policies
Monetary
policies
Supply-side
policies
Exchangerate
policies
Policies to
avoid market
failure
Businesses
in the
economy
Inflation
The exchange
rate
Unemployment
Economic
growth
Elements of economic
performance affecting
the economy
▲ Figure 6.6 Influences on the economic environment
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How governments help businesses
There are a number of ways in which governments may
provide help to businesses throughout the economy.
Developing an effective infrastructure
Governments benefit from having a strong economy. It
provides employment for the country’s inhabitants and a
source of taxation for the government. The government
is able to use the tax revenues it receives to pursue
its objectives, such as providing education and health
services. For these reasons, all governments intervene
in the economy to help businesses and to encourage
enterprise.
An economy’s infrastructure is essential for its businesses
to be able to operate. Without effective systems of
transport, communications and energy supply, businesses
would not be able to engage in production and supply goods
and services. Infrastructure can also help to determine
the competitiveness of a country’s businesses. If energy,
transport and communications are provided efficiently and
relatively cheaply, it can help to reduce the operating costs
of businesses and sharpen their price competitiveness.
GLOSSARY TERMS
Some governments recognise the importance of up-to-date
infrastructure to economic success and invest relatively
heavily. Figure 6.7 shows the relative amounts invested in
infrastructure in a selection of countries between 2008 and
2017. Governments may invest directly or use a mixture of
state and private investment to develop their infrastructures.
In recent years, there have been more projects, of greater
scale and complexity than ever before, being proposed and
progressed. High-profile examples include a new bridge
linking Hong Kong to Macau and Zhuhai, Thailand’s Eastern
Economic Corridor, Australia’s Inland Rail project and the
Dubai Solar Park (this is the world’s largest single-site solar
installation, to which more than US$4.3 billion of private
investment has been committed).
Enterprise is the skill needed to make new ideas work.
Infrastructure refers to the physical and organisational
factors necessary to allow both society and an economy
to operate effectively; for example, transport and
communication networks.
A joint venture occurs when businesses collaborate on a
project (or projects) but do not formally join together all of
their activities.
2.0
1.8
Infrastructure investment (% GDP)
A LEVEL 6.1.2 External influences on business activity: Economic
6.1.2
6.1.2.1 How governments might
help businesses and encourage
enterprise
1.6
Australia
1.4
1.2
1.0
Japan
Turkey
UK
India
0.8
Germany
0.6
USA
0.4
0.2
0
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Year
Note: This data relates to transport infrastructure investment only. GDP is a measure of the value of a nation’s output.
Source: OECD; https://data.oecd.org/transport/infrastructure-investment.htm
▲ Figure 6.7 Infrastructure investment in a selection of countries, 2008–17, as a percentage of GDP
HANDLING DATA
Look at the data presented in Figure 6.7 and answer the
following questions.
1 The graph shows infrastructure investment as a
percentage of GDP. Why might the USA’s investment in
transport infrastructure have been higher in 2017 than
that of Turkey?
2
In 2016, Germany’s investment in its infrastructure,
measured in billions of euros, was higher than in 2015.
Explain how this happened, given that the graph in
Figure 6.7 shows a decline between 2015 and 2016.
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The UK has taken some important decisions on its
infrastructure. It has not invested as heavily as some
other countries in its infrastructure over the past 30 years,
although investment has risen since 2009. Partly as a
response to this, the government prepared its infrastructure
spending plan for the period to 2033.
How businesses benefit from investment in
infrastructure
Infrastructure projects create significant opportunities for
businesses as well as providing better facilities (such as
road and rail transport for them to use). There are obvious
opportunities for firms in the construction industry to
benefit from expenditure on building new roads, bridges
and power stations. These can result in strategic decisions
to expand production or to engage in joint ventures with
competitors to deliver on large infrastructure projects such
as the Crossrail Project in London.
Other businesses in a wide range of industries are also likely
to benefit from orders associated with improving the UK’s
infrastructure. For example, the Crossrail Project has resulted
in Bombardier (a Canadian multinational engineering company)
supplying an order for 65 new trains for the Crossrail railway.
This order created 760 new jobs to build the trains and 80 jobs
to maintain them once they are operational. Bombardier has
a contract to build 60 per cent of the new trains that will be
needed in the UK as it improves its infrastructure.
Providing advice to businesses
The provision of advice to companies can be a relatively
inexpensive means of supporting businesses and helping
them to become more competitive. Governments can offer
advice in a number of areas, including:
» raising capital and managing finance
» managing employees effectively; for example, offering
guidance on recruiting, training and keeping employees
» trading overseas – governments may offer advice on how
to sell products in specific overseas markets
» developing new products and processes of production.
Many governments operate websites which offer a range
of advice and contacts for those starting new businesses
and managing existing ones. For example, the USA federal
government operates a small business hub which provides a
wide range of advice for the country’s small businesses.
Providing services for businesses
Governments can support business activities in other ways
apart from offering advice.
to operate systems designed to match unemployed
workers to potential jobs. In this way, they can help
to reduce the costs to businesses of finding suitable
new employees. In the UK, the government operates
Job Centre Plus to bring employers with vacancies
and unemployed workers together. A new government
website named Universal Jobmatch has been introduced,
allowing unemployed workers to search for employment;
employers can upload and manage their own vacancies
while searching for prospective employees. Similarly,
governments can support businesses by providing training
or helping businesses to provide their own training. The
Indian government funds programmes providing training
and has also established the National Skill Development
Corporation (NSDC) as a public–private sector partnership
to stimulate investment in training.
» Helping businesses to raise finance Governments may
provide loans and grants directly to businesses, usually
to invest in new equipment, buildings or other facilities.
They may also guarantee loans provided by banks. This
makes banks more willing to lend to what might be
high-risk businesses, as the government guarantees
the repayment of the loan should the business default
on payment. We look at how the UK government helps
businesses financially in more detail below.
» Supporting businesses trading overseas It is common
for governments to support businesses that are
exporting goods and services overseas. In the UK, the
government supports businesses that are exporting, or
planning to do so, through the work of the Department
for International Trade. This department helps
businesses to acquire the skills and contacts necessary
for exporting and provides advice about exporting
to particular countries. It also offers help in winning
contracts overseas, on using technology to facilitate
exporting and by organising trade shows and exhibitions
to showcase UK businesses and exports.
6.1.2
6.1.2.1 How governments might help businesses and encourage enterprise
The National Infrastructure Plan details about £375 billion of
investment in energy, transport, communications and water
projects by 2033. The insurance industry also plans to spend
£25 billion by 2020 using customers’ payments in pension
and other funds to finance this investment. Examples of the
UK’s programme of investment in infrastructure include the
Crossrail Project in London, the development of a new nuclear
power station at Wylfa, North Wales, and, controversially, the
building of a high-speed rail line, known as HS2, to connect
London to Birmingham and, later, Manchester and Leeds.
» Recruitment and training It is common for governments
Government policies to encourage
enterprise
Governments generally seek to establish an enterprisefriendly business environment, which will encourage people
and organisations to develop their ideas as well as to
establish and expand their businesses. Governments pursue
policies to promote enterprise for many reasons: enterprise
creates jobs, increases the taxes paid to the government
and, of course, today’s new enterprises can become
tomorrow’s multinational businesses.
Establishing or expanding a business can be a risky process
for those involved: entrepreneurs may give up safe, wellpaid jobs and owner-managers may mortgage homes to
borrow money to expand businesses. It can go wrong,
but the aim of much government support is to promote
enterprise and to reduce the degree of risk.
Decisions and actions by governments and their agencies
encourage and promote the development of enterprise and
innovation. The UK encourages enterprise in a number of
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6.1.2
ways, both financial and non-financial. These have changed
significantly in recent years as the importance of enterprise
to the government has increased.
A LEVEL 6.1.2 External influences on business activity: Economic
Financial support for enterprise
The British Business Bank is a government-owned
business development bank. It manages all UK government
programmes that help smaller businesses to gain access
to finance. It was established in 2012 to help make sure
finance markets for small and medium-sized businesses work
effectively. It does not lend directly to businesses, but it
will work alongside private-sector partners. It will pull in
more private-sector funding to maximise its impact. At the
end of the 2018–19 financial year, the bank had lent £6.6
billion to 89 000 businesses. Its lending activities increased
by 27 per cent in that year.
Some of the national schemes of financial support for
enterprise (specifically smaller businesses) overseen by
the British Business Bank are shown below, but these are
supplemented by a variety of regional and local policies.
» The New Enterprise Allowance This is available to the
long-term unemployed who want to start their own
business. It is in two parts: a weekly allowance totalling
£1274 over 26 weeks and access to a loan of up to £2500.
» Start-up loans This scheme provides loans to businesses
of up to £25 000, with the average being £7200. There is
a fixed interest rate of 6 per cent and repayment can be
made over any period between 1 and 5 years.
» Enterprise Finance Guarantee (EFG) EFG is a loan
guarantee scheme. It allows banks and other lenders to
offer small businesses which lack security or a proven
track record a normal commercial loan. Lenders can use
EFG to help businesses arrange loans and overdrafts.
Loans can be guaranteed from £1000 to £1.2 million.
Small and medium-sized businesses with annual sales
revenue below £41 million can get EFG-backed loans.
Between its launch in 2009 and 2018, EFG has supported
the provision of over 29 000 business loans to a value of
over £3.2 billion.
CASE STUDY
Malaysia urged to make social enterprise scheme simpler
Social enterprises are businesses which have clear social
objectives, such as helping those on very low incomes
or protecting the environment. A scheme in Malaysia
designed to help this type of business will increase growth
rates in this sector. However, Malaysian entrepreneurs
have argued that the government must offer greater
incentives and fewer regulations.
Twenty-two diverse social enterprises have received
accreditation recently for this scheme. The scheme
gives social enterprises tax deductions as well as the
opportunity to apply for grants.
However, some entrepreneurs state that registration
is not easy to manage. ‘The documentation process is
very data-intensive. Aspiring or new social enterprises
will find it difficult so there must be an easier process,’
said Kuhan Pathy, co-founder of Masala Wheels, a
social enterprise that supports disadvantaged young
people.
Non-financial support for enterprise
The UK government provides a range of support, advice
and inspiration for entrepreneurs establishing and growing
their businesses. A focal point of government support for
enterprise is its website ‘Business is Great’.
The Department for Business, Innovation and Skills (BIS)
is the key UK government department concerned with
developing and providing enterprise support. It works with
businesses, financial institutions and other government
departments to help UK businesses start up, grow and
succeed.
In many Asian countries, such as Malaysia, incomes
have risen but governments have continued to struggle
with poverty in towns and cities, unequal educational
opportunities and environmental issues. This has led a
number of countries (Thailand and Vietnam, for example)
to pass laws intended to encourage and support social
enterprises. Some critics of these laws think that too
many regulations will limit the growth in numbers of
social enterprises.
Source: www.reuters.com/article/us-malaysia-socialenterprisescheme/cut-the-paperwork-malaysia-urged-to-makesocial-enterprise-scheme-simpler-idUSKBN1ZT19A
Questions
1
2
Analyse two ways in which the Malaysian government
might encourage the creation of more social
enterprises.
[8]
Evaluate the view that any government intervention
into a market will lead to significant long-term
[12]
constraints on some businesses.
One element of the BIS’ work has been to develop ‘growth
hubs’ across the UK. Since May 2016, the UK has 39
growth hubs across the country. They are communication
networks bringing together local and national, public- and
private-sector partners – such as Chambers of Commerce,
universities and banks – co-ordinating local business
support and connecting businesses to the right help for
their needs. Businesses that have been in contact with a
growth hub are growing faster than other businesses in
terms of sales revenue (9 per cent compared to 2.5 per
cent on average) and employment (8 per cent compared to
0.1 per cent).
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necessary to develop new products and processes. The
government established UK Research and Innovation
in 2018. This new organisation operates across the
whole of the UK with a combined budget of more than
£6 billion.
» The government offers a range of schemes to help
entrepreneurs and businesses to develop new products
and processes. These include help to develop the ideas
(in terms of expertise, advice and funding) as well as
support on how to protect ideas (known as intellectual
property or IP).
CASE STUDY
The Four Anjels bakery
In 2010, four entrepreneurs established Four Anjels
bakery in Gloucestershire, England. It operates with
the vision of employing ‘passionate bakers to make
hand-made products’. Initially the bakery had just five
employees but has since grown to have 40 staff and major
customers including Caffè Nero.
It is possible to judge that the support the Four Anjels
received was effective: by 2020 the bakery was operating
24 hours a day, five days each week.
After six years of successful operation, the business’
owners realised that changes would be required in order
to continue their planned development and growth. Project
manager Phil Stevens said: ‘We knew that we needed
to relocate to new premises, but we also saw that we
were entering a period of significant change. We needed
guidance to manage the change efficiently and further
business support around the issues that would naturally
come from a period of change and rapid growth.’
The team consulted a range of different business advisors
and consultancy services, but could not find the kind of
support they needed. Phil was sceptical of the advice they
received, feeling it was not considering fully the needs of
their specific business.
‘When we made contact with the growth hub and were
introduced to our business guide, Sarah Gregg, we knew
from the very first meeting that we had found the right
partner. She took the time to really get to grips with our
business and requirements, and then showed us how the
growth hub could provide us with effective support.’
The four entrepreneurs attended a number of growth hub
events. Meeting a financial advice panel ‘provided a valuable
focus and delivered real results’ according to Sarah Gregg.
The UK government also seeks to encourage enterprise and
to develop the relevant skills in young people. It:
» recruits young business owners to volunteer as
enterprise champions to talk to young people about
establishing and running their own enterprises
» works directly with schools and colleges to encourage
the use of schemes. For example, it promotes
the ‘Enterprise Village’ to help schools to set up
businesses.
▲ Figure 6.8
Source: www.thegrowthhub.biz/the-buzz/
news/case-study-four-anjels
6.1.2
6.1.2.1 How governments might help businesses and encourage enterprise
Other aspects of BIS’ work to provide a more ‘enterprisefriendly’ environment in the UK include:
» Reducing the number of regulations which constrain
business activity. The government operates a policy of
removing two regulations for each new one created.
» BIS works with the tax authorities in the UK (HM
Revenue and Customs) to offer support to new and small
businesses by reducing the tax they pay on any profits
and also the cost of employing people.
» Supporting innovation through helping researchers,
developers, innovators and businesses, together with
universities, to bring together the skills and technology
Questions
1
2
Analyse two reasons why the support provided by
Gloucestershire growth hub was an important
element in expanding Four Anjels.
[8]
‘Non-financial help is more important than financial
support to establish an enterprise-friendly business
[12]
environment.’ Evaluate this view.
The effects of enterprise policies
The impact of these policies to encourage enterprise and
innovation is greatest among smaller organisations. It has
a substantial impact on strategic decisions made by the
owners of such businesses by influencing decisions on
whether to start an enterprise or to expand it. However,
these policies also stimulate innovation in organisations
of all sizes. In many ways, this could affect functional
decision-making significantly as managers seek to expand
operations, hire additional employees to produce innovative
products and plan marketing campaigns to promote them.
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A LEVEL 6.1.2 External influences on business activity: Economic
6.1.2
6.1.2.2 How governments might
constrain business activity
In the previous chapter, we considered a range of laws
which might constrain the activities of businesses. For
example, many governments have passed laws constraining
the production, sale and consumption of certain products
such as alcohol, tobacco and gambling. Laws that affect
businesses are supplemented by regulations in many
countries. Regulations are used to set out how businesses
should respond to laws.
The most common forms of regulation are government
regulation and self-regulation. Government regulation is
a natural extension of legislation, in that it defines and
controls some of the ways that a business or individual can
operate in order to follow the law. A very straightforward
example is food packaging in Canada, which must, at the
very least, be packaged with both English and French
wording.
The use of regulation
Regulation can relate to a variety of business activities,
including pricing and their impact on the environment.
There are a number of aspects of regulation that affect
business activity in the UK and shape the economic
environment in which all firms operate. These include:
» Regulation with the aim of creating free and fair
competition between businesses Regulation can
relate to any industry or business in the UK that is
not operating in the best interests of consumers. The
focus of most regulation is to protect the consumer
by ensuring that there is sufficient competition
within specific industries and to eliminate any trading
activities that are not in the interests of consumers.
Such activities may include businesses limiting the
range and variety of products available to consumers.
Regulators can take a number of actions to protect the
interest of consumers, such as controlling prices, taxing
profits that are judged to be ‘excessive’, and allowing
new entrants to an industry to have access to the
facilities of existing producers.
Regulations constraining business activity operate in
every country. In 2020, Chinese regulators investigated
Luckin Coffee Inc for uncompetitive activities; at the
same time, regulators in America were investigating
whether Apple’s credit card infringed some of the
country’s rules.
» Regulation of certain high-profile industries such as
banking Some industries in the UK and elsewhere are
regulated particularly closely because of their potential
to act against the interests of consumers or their ability
to damage the economy. Banking and financial services
are examples of such industries.
Governments in a number of countries have passed
new laws constraining the activities of banks and
other businesses supplying financial services such as
insurance. These new laws have led to regulations which
are imposed and monitored by relevant authorities,
often central banks. In 2020, the banking regulator in
the United Arab Emirates investigated the behaviour
of a Pakistani bank to determine whether or not it had
breached the country’s financial laws.
» Regulation of privatised monopolies to protect
consumers and other businesses We saw in
Chapter 6.1.1 that privatisation brings advantages
and disadvantages. Regulations are used to protect
consumers, especially when state-owned monopolies
have been privatised. In the late-twentieth century,
the UK privatised many state-owned monopolies that
supplied products including water, electricity and
gas during the 1980s and 1990s. This meant that
these monopolies became private companies and the
government established regulators (Ofwat, Ofgem and
Ofcom, for example) to ensure that the companies did
not abuse their market positions. The role of these
regulators is to act to ensure that consumers’ interests
and those of other businesses are protected and that
these natural monopolies do not charge excessive prices
and make excessive profits.
» Self-regulation In some industries, governments have
permitted self-regulation to operate, usually through
a code of conduct which all businesses within the
industry agree to abide by. The government reserves
the right to impose legal controls if a code of conduct
is judged to be ineffective. Such self-regulation can
be overseen to ensure that firms in industries subject
to legal controls operate properly and as intended. For
example, the Indian government has proposed using
self-regulation to control the content that is available
on the internet throughout the country. India already
uses self-regulation to limit the activities of the print
and broadcast media.
Other ways in which governments
might constrain business activity
Governments can intervene in markets to constrain the
activities of businesses in other ways apart from imposing
regulations.
» By subsidising production of good and services When
a government offers a business or an industry a subsidy,
it effectively pays a part of the costs of production. This
encourages a greater increase in output of that product
as it becomes more profitable to produce it. However,
this can have negative effects on those businesses
that supply goods and services which compete with
the subsidised products. In a number of countries,
governments offer subsidies to kerosene producers.
These affect the competitiveness of businesses
supplying gas or solar power and may result in some
failing or not growing as they might have done without
the subsidies to their competitors.
» Providing information on products Many consumers
are unable to make informed and good-quality
buying decisions on health and education products.
Governments intervene in a range of markets through
the use of advertising to give consumers relevant
information to help them make better buying decisions.
Such advertising may impact negatively on industries
such as those supplying alcohol, tobacco and gambling.
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» Implementing a range of economic policies We shall
see later in this chapter that governments can intervene
in markets by implementing a range of policies, such
as altering interest rates or changing the level of
expenditure on goods and services supplied by privately
owned businesses.
One reason for governments to intervene in the operation of
a market is market failure.
When a market operates correctly, it responds to the signals
given by prices and increases or reduces the resources
used by businesses in the market to supply more or less of
the product. Over time, global oil prices have risen from
$30 per barrel in 2016 to more than $60 per barrel at the
start of 2020. The price has risen because consumers of
oil (individuals and businesses) have demanded more of
the product. In response to the signal of rising prices,
oil companies have sourced new supplies of oil and have
increased production.
The failure of markets to work properly can come about for
a number of reasons. Most governments have taken steps to
attempt to limit the extent of each type of market failure.
1 Monopolies and cartels The existence of monopolies
and cartels might mean producers have too much power,
resulting in insufficient output and high prices. As a
consequence, consumers may receive too little of certain
products, resulting in a lower standard of living.
Governments frequently pass laws to encourage
competition and to restrict a wide range of anticompetitive activities. Such laws prohibit the abuse
of monopoly power (for example, by raising prices
excessively to boost profit margins) and the operation of
cartels. Such laws protect consumers from the adverse
effects of monopoly power. Offending firms are normally
fined, sometimes very heavily.
2 Damage to the environment Producers that pollute the
environment are not paying the full costs of production.
For example, they might discharge toxic waste into a
river rather than paying for it to be taken away and
treated. These costs are imposed on someone else. It is
often governments (and therefore taxpayers) that have
to pay to clean up the pollution. This means that part of
the costs of production are paid by a third party. Costs
passed on in this way are called external costs, and they
can result in severe environmental damage and problems
for future generations. This type of market failure
creates oversupply of certain products as producers
(and ultimately consumers) do not pay the full cost
of production. Some industries (for example, palm oil
producers) have received criticism for the environmental
damage arising from the deforestation that has
accompanied huge increases in the supply of this type
of oil.
6.1.2
6.1.2.3 How governments deal with market failure
6.1.2.3 How governments deal
with market failure
Governments tend to control external costs in three
main ways. They can impose indirect taxes (that is, a
tax that adds to the selling price of a product) with the
aim of raising the costs of production to account for
the external costs paid by other groups in society. This
should lead to higher prices and lower profit margins,
discouraging production and consumption of the
products. Alternatively, governments can levy fines on
businesses that damage the environment and thereby
impose costs on others. Finally, a government may pass
laws to ban processes and products that cause external
costs.
3 Consumers and producers possess insufficient
information about products Some consumers may have
too little information about the benefits of buying
products, such as health and education services. As a
result, they may buy too little of them and there will be
an inadequate supply of these products – this is a form
of market failure. Governments frequently intervene
in these markets to encourage consumers to buy these
types of products, either by subsidising them or by
supplying the products themselves and providing them
without charges. This form of market failure is likely to
result in undersupply, as too few resources are allocated
to producing goods and services in these markets.
However, it can also result in the over-consumption of
some products (drugs, for example) if consumers are
unaware of the dangers they pose.
To overcome this type of market failure, governments
frequently provide information about the benefits or
drawbacks of products. For example, in many countries
there have been health information programmes to
advise smokers of the danger to health of consuming
tobacco. Many such programmes have been successful
and there has been a sharp decline in tobacco
consumption in many countries.
4 Poaching of skilled labour If a business invests
heavily in training its workforce to provide jobrelated skills, it can expect a consequent increase
in productivity as a reward for devoting resources
to training. However, one possible outcome is that
highly skilled employees become attractive to rival
businesses, who are able to offer them higher wages as
they have not paid the training costs. Such poaching of
labour can result in too few resources being allocated
to training for fear of poaching. Thus, the market fails.
Overcoming the poaching of labour is difficult for
any government. If it has sufficient funds available,
it may provide some training itself and can offer tax
benefits to businesses that engage in staff training.
However, such approaches can be very costly to have any
significant effect.
GLOSSARY TERM
Market failure occurs when a market does not work
properly and resources are not allocated correctly.
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A LEVEL 6.1.2 External influences on business activity: Economic
6.1.2
STUDY TIP
Market failure is a strong argument for government
intervention in the economy and can provide a powerful
line of analysis when responding to questions on the
merits (or otherwise) of state involvement in the business
environment.
6.1.2.4 Macroeconomic objectives
of governments and their impact
on business activity
Every government in the world operates with a number
of macroeconomic objectives. The key macroeconomic
objectives for the UK are as follows.
» Sustainable economic growth This means that the
value of the economy’s entire production of goods and
services should increase over time. However, this should
be at a rate which is sustainable – this means that it can
be maintained over time while minimising the damage to
the environment.
» A steady and low rate of inflation The UK
government’s inflation target at the time of writing
is 2.0 per cent, meaning that it aims to have prices
rising in the UK at this rate annually. This is a major
economic objective which the Bank of England pursues
on behalf of the government.
» Low levels of unemployment It is not possible to
eliminate all unemployment in an economy. The UK
government (along with many others) wants to achieve
a level of employment whereby those who are able and
willing to work have a job.
These macroeconomic objectives have implications for
businesses, as they influence the economic environment
in which all businesses operate. In the following sections,
we will look at each of the government’s main economic
objectives in more detail, along with the impact they can
have on business activity.
Economic growth
the rate of economic growth result in the business cycle,
which we consider later in this section. If the rate of
economic growth is negative (that is, if the economy is
getting smaller) for six consecutive months, then it is said
to be in recession.
Economic growth is normally judged through the changes in
the level of gross domestic product (GDP), which measures
the value of a nation’s output of goods and services. In
February 2020, the GDP of the UK was £2 264 855 million.
The population of the UK is approximately 66 million,
giving a GDP per head (or per capita) equal to £34 316.
Governments seek to increase this figure over time, as it
represents a rise in the country’s standard of living.
Most countries’ economies experience economic growth over
a period of time, though, in the short term, economies may
stagnate or even decline in size. Figure 6.9 illustrates the
quarterly economic growth rates for the UK from 2010
until 2020.
Governments usually aim to maintain steady and sustained
economic growth over a period of time. However, this is a
difficult target to achieve, as the operation of the business
cycle tends to create the fluctuations apparent in Figure
6.9. Governments use counter-cyclical policies (including
control via interest rates and taxation levels) to attempt
to eliminate the more extreme fluctuations. High rates of
economic growth are not desirable, as they tend to result in
slumps whereby economic growth may become negative.
Governments can stimulate growth as a consequence
of their economic policies. Short-term growth can be
encouraged by cuts in interest rates and taxation which
fuel borrowing and spending, leading to greater output
and, hence, economic growth. The danger is, however,
that firms and individuals purchase products from
overseas, promoting growth in foreign economies. Supplyside policies may be put in place to achieve sustained
economic growth. This type of policy involves increasing
the productive capability of the economy by improving
the skills of the workforce, encouraging more people into
employment and promoting competition within markets to
increase output and GDP.
Economic growth is an increase in the value of goods and
services produced by a nation’s economy. Fluctuations in
GLOSSARY TERMS
Macroeconomics is the study of the behaviour of a whole
economy and the factors that can influence it.
Unemployment is the number of people who are seeking a
job but are unable to secure one.
Microeconomics is the study of smaller parts of an
economy, such as the behaviour and decision-making of
businesses and individual consumers.
A recession is characterised by falling levels of demand and
declining levels of output and employment over at least a
six-month period.
Economic growth is an increase in the value of goods and
services produced by a nation’s economy over a period of
time.
A slump takes place when production is at its lowest,
unemployment is high and there are many business
failures.
Inflation is a sustained rise in the general price level and a
corresponding fall in the value of money.
Supply-side policies are a range of measures designed to
improve the free operation of markets and, therefore, the
total amount that is produced (or supplied) by an economy.
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3
6.1.2
GDP
2.5
2
1
2010
2012
2014
2016
2018
2020
Year
Source: Trading Economics (Office for National Statistics)
▲ Figure 6.9 Economic growth rates in the UK, 2010–20
CASE STUDY
UK’s economic growth slows
The UK’s Office for National Statistics (ONS) has stated
that growth in gross domestic product (GDP) was flat
overall in the last quarter of 2019, as consumer spending
was low over the Christmas shopping period and
manufacturing output fell sharply.
The growth rate slowed in the third quarter of 2019,
although annual growth did increase slightly to 1.4 per
cent in 2019, just above the 2018 economic growth rate of
1.3 per cent.
However, the ONS reported that the economy grew by
0.3 per cent in December from the previous month,
faster than expected, and suggesting that the decline in
economic growth might be short-lived. Surveys show
that the service sector – which accounts for about 80
per cent of the economy and includes hotels, shops and
restaurants – also recovered to show the strongest
growth since mid-2018.
However, economists said the underlying momentum
of the economy slowed over the year as a whole.
Manufacturing output fell sharply in the fourth quarter,
owing to weaker levels of production in the car industry,
effectively finishing 2019 in recession after three
consecutive quarters in contraction.
The ONS said quarterly GDP growth had been declining
during 2019, continuing the slowing that has been
experienced over the previous five years.
Questions
1
2
Analyse one reason why economic growth is an
important macroeconomic objective for most
governments.
[4]
‘The economic data provided in the case study
represents bad news for all UK businesses.’ Evaluate
[12]
this view.
The case for economic growth is not clear-cut. Growth brings disadvantages as well as advantages for businesses. These
arguments are summarised in Table 6.3.
6.1.2.4 Macroeconomic objectives of governments and their impact on business activity
1.5
▼ Table 6.3 The benefits and drawbacks of economic growth for businesses
The benefits
The drawbacks
• High rates of economic growth provide the government
• Not all regions within an economy benefit equally during
with increased tax revenues permitting greater
periods of economic growth. For example, firms selling in
expenditure on health, education and transport,
prosperous regions of a country are likely to enjoy increased
benefiting all businesses and encouraging further growth.
sales, while those in less prosperous regions may only see a
• Growth provides opportunities for all in society.
marginal increase in revenues.
Individuals benefit from greater chances of promotion;
• Growth may result in shortages of labour and other materials.
high levels of consumer spending encourage enterprise.
This may result in higher wages and prices, fuelling inflation
Businesses small and large may thrive in a growing
and creating uncertainty among the business community.
environment.
• Growth places individuals and businesses under pressure.
• Businesses generally enjoy higher sales and increased
Workloads increase and decisions may be rushed. In these
profits. Expansion is likely for firms selling income
circumstances, it may prove impossible to maintain the quality
elastic products such as cars and foreign holidays.
of management and businesses may lose co-ordination and a
Growth creates new markets for products.
clear sense of direction.
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Economic growth and the business cycle
All countries suffer fluctuations in the level of GDP and
business activity within their economies. At times spending,
output and employment all rise; during other periods, the
opposite is true. The value of a country’s output over a
period of time is measured by a nation’s gross domestic
product – this figure is dependent upon the level of
economic activity. A rising level of economic activity will
be reflected in a higher level of GDP.
GLOSSARY TERM
The level of economic activity refers to the amount of
spending and production in an economy. Governments
generally aim to have smooth increases in the level of
economic activity over time.
The business cycle describes the regular fluctuations
in economic activity (and GDP) occurring over time in
economies. Figure 6.10 illustrates a typical business cycle.
Trade cycles generally have four stages:
» Recovery or upswing as the economy recovers from
a slump; production and employment both begin to
increase. Consumers will generally spend more in these
circumstances as they are more confident in the security
of their employment. Initially, businesses may respond
cautiously to signs of increasing consumer confidence.
No major decisions are required to meet rising demand
while spare capacity exists – firms simply begin to utilise
idle factories, offices and other assets. As business
confidence increases, firms may take the decision to
invest in further non-current assets (factories, machinery
and vehicles, for example). Employees experience less
difficulty in finding jobs and wages may begin to rise.
» A boom follows with high levels of production and
expenditure by firms, consumers and the government.
Booms are normally characterised by prosperity and
confidence in the business community. Investment in
non-current assets is likely to increase at such times.
However, many sectors of the economy will experience
Gross domestic product
A LEVEL 6.1.2 External influences on business activity: Economic
6.1.2
Boom
pressure during booms. Skilled workers may become
scarce and firms competing for workers may offer higher
wages. Simultaneously, as the economy approaches
maximum production, shortages and bottlenecks will
occur as insufficient raw materials and components
exist to meet demand. Inevitably this will result in their
prices rising. The combination of rising wages and rising
prices of raw materials and components will create
inflation. It is the existence of inflation that usually
leads to the end of a boom.
» A recession occurs when incomes and output start to
fall. Technically a recession exists once GDP has fallen
for two successive three-month periods – that is, for six
months. Falling sales will begin to eat into businesses’
profits. In circumstances such as this, governments in
the UK and elsewhere have tended to lower interest rates
in an attempt to stimulate demand and sales. Despite
the falling interest rates, falling profits are likely to
result in plans to invest in new factories and offices
being delayed or abandoned. The level of production in
the economy as a whole may stagnate or even fall. The
amount of spare capacity within the economy will rise.
Some businesses will fail and the level of bankruptcies is
likely to rise.
» A slump often, but not always, follows a recession.
In some circumstances, an economy may enter the
upswing stage of the business cycle without moving
through a slump period. Governments may take action
to encourage this by, for example, increasing their
own spending or lowering interest rates. A slump sees
production at its lowest, with high unemployment, and
increasing numbers of firms will fail.
Figure 6.10 illustrates a smooth and regular trade cycle in
operation. In reality, the change in gross domestic product
is likely to be irregular, as economic cycles of different
duration and intensity operate simultaneously. The business
cycle is a major influence on the performance of businesses.
As the economy moves from one stage of the cycle to
another, businesses can expect to see substantial changes
in their trading conditions.
Trend of
r time
GDP ove
Recovery or
upswing
Recession
or downswing
Slump
0
Time
▲ Figure 6.10 The stages of the business cycle
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The impact of economic growth and the
business cycle
6.1.2
Table 6.4 identifies some actions that different businesses
might take in response to the business cycle. However, not
all businesses are equally affected by the changing trading
conditions, as summarised in Table 6.5.
▼ Table 6.4 The trade cycle and business actions
Key features
Likely reactions by business
• Increasing consumer expenditure
• Existing spare capacity used
• Production rises
• Business confidence strengthens
• Investment increases
• Opportunity to charge higher prices
• Rising numbers of business start-ups
• Businesses take decisions to invest in non-current
assets
• Businesses operate nearer to (or at) full capacity
Boom
• Rate of inflation increases
• Bottlenecks in supply of materials and
components
• Some firms unable to satisfy demand
• Profits probably high – but hit by rising
costs
• Firms face increasing pressure to increase prices
• Businesses seek alternative methods to increase
output
• Wage rises offered to retain or attract skilled
labour
• Managers plan for falling levels of demand
Recession
• Government reduces interest rates
• Firms reduce production as demand falls
• Spare capacity rises
• Business confidence declines and
investment is cut
• Profits fall
• Firms seek new markets for products – possibly
overseas
• Some products may be stockpiled
• Workers laid off – or asked to work short-time
• Financially insecure firms may become bankrupt
or insolvent
Slump
• Increasing number of bankruptcies and
insolvencies
• Government lowers interest rates further
• High levels of unemployment
• Low levels of business confidence and
consumer spending
• Firms offer basic products at low prices
• Businesses may close factories to reduce capacity
• Large-scale redundancies may occur
• Marketing concentrates on low prices and easy
payment deals
▼ Table 6.5 Products affected and unaffected by the business cycle
Firms supplying these products may be significantly
affected by the business cycle
Firms supplying these products are unlikely to be affected
to a great extent by the business cycle – in fact demand
may rise for some of these products in a recession/slump
• Leisure air travel
• Sports and leisure goods
• Jewellery
• Household furniture
• Cars
• Fuel, including petrol, gas and electricity
• Cigarettes and tobacco
• Water and sewage services
• Unbranded basic foods
A number of businesses may find that demand for their
products is relatively unaffected as the business cycle
moves through its stages and the rate of economic growth
alters. Producers and retailers of basic foodstuffs, public
transport and water services may notice little change
in demand for their products. This is because these are
essential items consumers continue to purchase even when
their incomes are falling – demand for them is not sensitive
to changes in income.
products such as televisions and laptops, and construction
materials such as bricks and windows.
Demand for other categories of products is more sensitive
to changes in income levels and therefore the stages of the
business cycle. Examples include foreign holidays, electrical
6.1.2.4 Macroeconomic objectives of governments and their impact on business activity
Stage of business cycle
Recovery or upswing
Businesses selling basic foodstuffs might have to take little
or no action to survive a recession; in fact, demand for their
products might increase as consumers switch from more
expensive alternatives. At the other extreme, businesses
supplying materials to the construction industry could
be hard hit, as firms delay or abandon plans to extend
factories and build new offices. Their position might be
made worse by a fall in demand for new houses, as hard-up
consumers abandon schemes to move home.
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A LEVEL 6.1.2 External influences on business activity: Economic
6.1.2
CASE STUDY
Pakistan misses economic growth target
government should take action to support the country’s
economy to achieve sustained economic growth. In its
report, the SBP pointed out that the output of Pakistan’s
larger manufacturing businesses fell by nearly 6 per
cent in comparison with the previous year. The industries
affected by this decline included construction and vehicle
manufacturing. In view of this, the report suggested that
Pakistan could not be expected to achieve its GDP growth
target of 4 per cent. The central bank has previously
predicted a growth rate of around 3.5 per cent for
Pakistan’s economy; other economists fear it might be as
low as 2.4 per cent. The country’s growth rate would need
to be around 7 per cent to maintain living standards for its
rapidly-growing population.
▲ Figure 6.11 The State Bank of Pakistan
Questions
Pakistan’s central bank has estimated that the rate of
economic growth in the country for the financial year
2019–20 will not reach the 4 per cent target that was set.
1
The State Bank of Pakistan (SBP) has analysed Pakistan’s
economic performance and recommended that the
HANDLING DATA
Assume that Pakistan’s average annual population
growth is 1.75 per cent. Given that the country had 219
million inhabitants in 2019, what will be the revised
forecast for 2025?
Economic growth and the business cycle are permanent
features of the economic environment for firms. The effects
of changes in the business cycle vary from industry to
industry. Firms selling goods whose demand is sensitive to
changes in income (known as income elastic goods), such
as designer clothes and foreign holidays, may find that
sales rise in a boom and fall during recession. Conversely,
businesses selling staple products, such as foodstuffs,
where demand is not income elastic may be relatively
unaffected by the business cycle.
It is possible to argue that the business cycle will only
provoke short-term responses in many firms, because its
effects are relatively short-lived. Booms and slumps do not
last forever and businesses can take actions to see them
through difficult trading periods. During boom periods,
managers may increase prices to restrict demand and
increase profitability; they may subcontract work to other
firms or seek supplies from overseas. Equally, in conditions
of recession or slump, lay-offs may occur or short-time
working may take place while overseas markets are targeted
to increase sales. Well-managed firms will predict the onset
of a boom or slump and take appropriate action in advance.
2
Analyse two effects on businesses in Pakistan of the
country’s rapid growth in population.
[8]
‘The expected fall in the economic growth rate will
have differing impacts on the country’s businesses.’
Evaluate this view.
[12]
Short-term responses may be all that are required if
governments are successful in eradicating the more extreme
effects of the business cycle.
Inflation
Inflation can be defined as a persistent rise in the price
level and the associated fall in the value of money. For
many businesses, a low rate of inflation is not a problem.
As long as wages are rising at about the same rate or
higher, a low constant rate of price increase simply serves
to help maintain demand. Inflation only becomes a major
problem for businesses when it is high, rising rapidly or
(worst of all) is doing both together.
Inflation in the UK, and in many industrialised nations
throughout the world, has been at historically low rates
over the last 15 years or so. The UK’s rate of inflation
was 0.7 per cent (as measured by the CPI – see below) in
September 2020, and is forecast to remain around 2 per cent
until 2023.
How is inflation measured?
The UK government measures the rate of inflation by use of
the Consumer Price Index (CPI). The CPI was introduced in
December 2003 and measures the average monthly change
in the prices of goods and services purchased by households
in the UK. The government will use this to set targets for
inflation in the future. The CPI is calculated using more
than 700 separate goods and services for which price
changes are measured throughout the country.
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» Wage rises If trade unions and employees are successful
The causes of inflation
There are a number of factors that may cause inflation.
Economists tend to classify the causes of inflation as
demand-pull or cost-push factors. The cause of inflation
can be an important factor for businesses as it provides
some indication of likely future government policies to
control inflation.
Demand-pull inflation
Cost-push inflation
Cost-push inflation occurs when firms face increasing costs
due to factors such as rising wages or increasing costs of
raw materials and components. This type of inflation can
arise from a number of sources.
6.1.2
6.1.2.4 Macroeconomic objectives of governments and their impact on business activity
Demand-pull inflation occurs when the demand for the
country’s goods and services exceeds its ability to supply
these products. As a consequence, prices rise generally as
a means of restricting demand to the available supply. The
underlying cause of this might be the government allowing
firms and businesses to have too much money to spend,
perhaps as a consequence of cutting taxes or lowering
interest rates.
in negotiating pay increases significantly above the
rate of inflation, then further price rises might be the
result. This becomes more likely if productivity is not
increasing, allowing businesses to offset some of the
increased wage costs against additional production.
However, labour market conditions can influence the
rate of wage increases and, therefore, inflation. For
example, wages in Spain fell by about 20 per cent
between July 2011 and January 2014 as jobs were scarce
and the rate of unemployment rose above 20 per cent.
This contributed to the country’s very low inflation rate.
» Imported inflation One of the hidden causes of
inflation is rises in import prices. The UK and Belgium
are susceptible to this type of inflation as they are
‘open’ economies, importing large quantities of raw
materials, components and finished goods. Import
prices rise when the exchange rate is falling and more
of the domestic currency is required to purchase a given
amount of a foreign currency. Although exporters might
complain about rising exchange rates, they do help to
control inflation.
GLOSSARY TERMS
The Consumer Price Index (CPI) measures the rate of
inflation based on the changes in prices of a basket of goods
and services.
Cost-push inflation happens when firms face increasing
costs due to rising wages or increasing costs of raw
materials and components.
Demand-pull inflation occurs when the demand for the
country’s goods and services exceeds its ability to supply
these products.
6
CPI
4
2
0
–2
2010
2012
2014
2016
2018
2020
Year
Source: https://tradingeconomics.com/united-kingdom/inflation-cpi
▲ Figure 6.12 Inflation in the UK 2010–20
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Comparing the rates of inflation in Uruguay and Indonesia
The annual inflation rate in Uruguay increased to 10.86 per
cent in April 2020 from 8.32 per cent in the previous
month. It was the highest inflation rate since June 2016, as
prices rose further for food and non-alcoholic products,
and housing. Uruguay’s exports declined by 40 per cent
between April 2019 and March 2020.
Indonesia’s annual inflation rate declined to 2.67 per cent
in April 2020, the lowest since March 2019 and below
market expectations of 2.77 per cent. Prices rose more
slowly for housing and utilities, food, drinks, and food and
restaurant services. On a monthly basis, consumer prices
rose 0.08 per cent in April, the least since October 2019.
10
CPI
8
6
4
2
2010
2012
2014
2016
2018
2020
Year
Source: https://tradingeconomics.com/uruguay/inflation-cpi
▲ Figure 6.13 Inflation in Uruguay 2010–20
10
8
CPI
A LEVEL 6.1.2 External influences on business activity: Economic
6.1.2
CASE STUDY
6
4
2
2010
2012
2014
2016
2018
2020
Year
Source: https://tradingeconomics.com/indonesia/inflation-cpi
▲ Figure 6.14 Inflation in Indonesia 2010–20
Questions
1
Analyse one likely effect of Uruguay’s high rate of
inflation on its businesses.
2
[4]
‘Indonesian businesses have operated in a better
macroeconomic environment than those in
Uruguay.’ Evaluate this view.
[12]
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The impact of inflation on business
Types of unemployment
Inflation can have a number of effects on businesses.
» Many businesses may suffer falling sales in a period
of inflation. Consumers might be expected to spend
more during inflationary periods, as they would not
wish to hold an asset that is falling in value. However,
research shows that people save more (perhaps due to
uncertainty) and sales for many businesses fall.
» It can be difficult to maintain competitiveness (and
especially international competitiveness) during bouts
of inflation. Rising wages and raw material costs may
force firms to raise prices or accept lower profit margins.
Firms operating in countries with lower rates of inflation
may gain the edge in terms of price competitiveness
under such circumstances.
People can be unemployed for a number of reasons.
Governments find it useful to distinguish between the
various types of unemployment, as each type requires
a different remedy. Although many different types of
unemployment exist, we shall focus on three main types.
Unemployment
Unemployment remains an important issue in most
countries. It is important because it represents a waste of
resources if labour is unused: if all available workers were
used, the country concerned would be able to produce more
and its citizens would enjoy a higher standard of living. The
social effects of high and prolonged rates of unemployment
can be devastating – poor health and crime are just two
factors associated with unemployment and poverty.
1 Structural unemployment
Economies continually change: some industries die and
others emerge to replace them. Structural unemployment
occurs due to fundamental changes in the economy whereby
some industries reach the end of their lives. Structural
unemployment occurs for a number of reasons:
– the adoption of new methods of production
– significant and permanent changes in demand
– increasing competition from overseas
– rising income levels, meaning demand for some
products declines.
6.1.2.4 Macroeconomic objectives of governments and their impact on business activity
Inflation can offer some benefits to businesses, however.
Some analysts suggest that low and stable rates of
inflation may be beneficial. A steady rise in profits can
create favourable expectations and encourage investment
by businesses. Inflation can also encourage long-term
borrowing and investment by businesses, as the value of
their repayments (in real terms) declines over time.
6.1.2
But structural change in the economy also offers
opportunities to businesses. Rising incomes and
technological developments have led to the development
of the mobile phone industry. This industry employs a large
number of people in manufacturing the product, supplying
networks and in retail outlets.
Structural unemployment is a difficult problem for
governments to solve. Because large numbers of employees
may no longer have the skills that employers require,
training is an important part of any solution. Other
approaches include encouraging foreign producers to
establish themselves in the country to provide employment
for those with skills not needed by domestic businesses.
The UK has been particularly successful in attracting motorvehicle producers from across the world.
GLOSSARY TERM
Structural unemployment occurs due to fundamental
changes in the economy whereby some industries reach
the end of their lives.
9
Unemployment rate
8
7
6
5
4
3
2010
2012
2014
2016
2018
2020
Year
Note: The unemployment rate is the percentage of the workforce who do not have a job but are looking for one.
▲ Figure 6.15 UK unemployment
Source: https://tradingeconomics.com/united-kingdom/unemployment-rate
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6.1.2
Competition
from overseas
New methods
of production
Causes
A LEVEL 6.1.2 External influences on business activity: Economic
Effects
Changing patterns
of demand
Structural
unemployment
Certain skills no
longer needed
New opportunities
Localised
unemployment
▲ Figure 6.16 Causes and effects of structural
unemployment
2 Cyclical unemployment
Cyclical unemployment arises from the operation of the
business cycle – a topic we considered in detail earlier in
this chapter. The boom stage of a business cycle will see
this type of unemployment minimised as firms increase
their production levels. At this stage of the business cycle,
those who have been unemployed for some time (and with
relatively few skills) may find work.
At the other extreme, much of the unemployment
experienced during a slump will be cyclical. The effects
of cyclical unemployment can be considerable as
unemployment increases substantially in the move into
recession. Some businesses seek to protect themselves
against cyclical unemployment by the introduction of
profit-related pay. Such schemes allow pay to fall during
a recession along with profits, reducing the need to make
workers redundant.
3 Frictional unemployment
People moving between jobs cause frictional
unemployment. If a person leaves one job, they may not
be able to move into a new position immediately. While
they are searching for new employment, they are classified
as frictionally unemployed. The government providing
improved information on job vacancies available may reduce
the level of frictional unemployment. A healthy economy
will have some amount of frictional unemployment as
people move between jobs.
GLOSSARY TERMS
Cyclical unemployment is caused by the operation of the
business cycle, rising in slumps and falling in booms.
Frictional unemployment exists because people may
be temporarily out of work between leaving one job and
starting another.
Inventories are the raw materials and other items
necessary for production to take place. They also include
finished products that have not yet been sold.
STUDY TIP
It is important to relate the impact of unemployment (or
changes in other economic factors) to the precise type
of business under consideration. Some businesses rely
heavily on labour as a key element of production – this is
more likely to be true of businesses that supply services.
Hence, a change in the level of unemployment will have a
greater impact on this type of business.
The impact on businesses of changing
unemployment levels
Rises in unemployment can have serious implications for
businesses, though the precise impact and likely responses
of firms will depend upon their circumstances and the type
of unemployment.
Cyclical unemployment might result in businesses suffering
from falling sales. In the short term, firms may be able to
add any surplus production to inventories. Alternatively,
businesses may seek new markets, perhaps by selling
overseas. Not all businesses will be equally affected
by changes in unemployment levels. Businesses selling
essential products may be relatively unaffected by cyclical
unemployment, while suppliers of luxury products could
suffer substantial reductions in sales.
Structural unemployment can have a significant effect
on businesses because it is frequently highly localised
and often very persistent. For example, high levels of
unemployment suffered by former coal-mining communities
would have considerable implications for most businesses
in the locality. Unemployment brought about by the
decline of an industry also has an impact upon associated
industries. For example, falling production in the UK’s
shipbuilding industry contributed to the decline in the
country’s steel industry.
If there is a need to reduce output then rationalisation
and redundancy might follow and factories and offices
may be closed. Research and development plans may be
abandoned or postponed as firms seek to reduce their
costs to match their (reduced) revenues. A predicted fall in
the level of demand may encourage the firm to diversify,
possibly into foreign markets. Businesses may consider
mergers with other firms to help reduce costs or to
broaden product ranges.
Periods of low unemployment cause different problems
for businesses and provoke different responses. Falling
unemployment and accompanying skill shortages create
problems that take time to solve. Businesses look to the
government to assist through the provision of state training
schemes and the development of relevant vocational courses
in schools and colleges. In the UK, governments have
attempted to support industry in these ways.
Migration is the movement of people between countries or
regions with the intention of settling in the new location.
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» Businesses may invest in training schemes to develop
the required skills in their employees. This may entail
giving relatively junior or unskilled employees additional
skills to enable them to carry out a wider range of
activities. This can be a risky approach, however, as
unscrupulous competitors may poach skilled employees
once training is completed.
The skills shortage creates difficulties for many businesses
and opportunities for others. Recruitment agencies and
firms providing training for other businesses may enjoy
increasing demands for their services during a period of
skill shortages.
CASE STUDY
Global migration
20% and over
10–19%
5–9%
1–4%
<1%
No data
Source: United Nations Report on International Migration, 2019 (page 13)
▲ Figure 6.17 International migrants as a percentage of the total population, 2019
Migration is the movement of people between different
countries. Over the last 20 years, many European and
North American countries have experienced significant
inflows of migrants from parts of the Middle East, Africa
and Asia. According to the UN, ‘in 2019, more than half
of all international migrants worldwide lived in Europe
and Northern America, with roughly 82 million residing
in Europe and nearly 59 million in Northern America’.
Although some people have left countries in Europe and
America, the inflows have generally been much larger,
creating a positive net inflow of migrants. Figure 6.17
shows the percentage of the population that are migrants
in most countries.
The impact of migration depends upon a number of
factors and not just the size of the net migration flow.
If migrants possess suitable skills and are primarily of
working age, they offer substantial benefits to businesses
in countries such as the UK and Australia. They can
assist in overcoming skill shortages and reduce the
expenditure that firms must make on training. In addition,
the increased supply of people into the labour market may
help to prevent wages from rising. This is especially likely
if migrants are willing to work for lower wage rates.
6.1.2
6.1.2.4 Macroeconomic objectives of governments and their impact on business activity
However, businesses can take action.
» Skill shortages encourage the development of capitalintensive methods of production in manufacturing and
service industries. Using technology to replace labour
can boost productivity, thereby enhancing international
competitiveness.
» Businesses may relocate to take advantage of more
plentiful and cheaper sources of skilled labour. However,
in the case of the UK, this may require location outside
Europe as most of the EU is experiencing similar skill
shortages.
Source: United Nations Report on International Migration 2019
(page 6), www.un.org/en/development/desa/
population/migration/publications/migrationreport/
docs/InternationalMigration2019_Report.pdf
Questions
1
2
Analyse two benefits that Australian businesses
might receive from a net inflow of migrants.
[8]
Evaluate whether a net inflow of migrants affects
the competitiveness of businesses in the receiving
nation.
[12]
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A LEVEL 6.1.2 External influences on business activity: Economic
6.1.2
The economic environment and
business strategy
growth. These plans may include increasing innovation as
part of the development of new products, entering new
markets or pursuing a policy of takeovers and mergers.
Figure 6.18 summarises some of the major economic
variables that might impact upon businesses’ strategic
planning and decision-making. The diagram also emphasises
the interrelationships that exist between the elements that
make up the economic environment for businesses.
A business’ strategy is simply the long-term plans through
which it seeks to attain its corporate objectives – that
is, the objectives of the whole business. For example, a
business may have growth as a major corporate objective
and will develop plans to achieve the desired rate of
Business cycle
• Boom
• Slump
Unemployment
varies according
to stage of the
business cycle
Unemployment
State of labour market
• Type (e.g. frictional)
• Skill surpluses
• Location
• Skill shortages
• Migration flows
• Skills in surplus
Business strategy
e.g.
• Growth
• Rationalisation
Inflationary pressures
more likely in a boom
• Market dominance
• Diversification
• Technological
leadership
Inflation
• Rate of price increase
• Trend in price change
• Rate relative to that
in other countries
Inflation and
interest rates
tend to rise and
fall together
Interest rates
• Levels, relative to
other nations
• Trend: rising/falling
Close links
between
interest and
exchange rates
Exchange rates
• Level and trend
• Affect all firms
but especially those
trading overseas
▲ Figure 6.18 Business strategy and the economic environment
6.1.2.5–7 Government
macroeconomic policies and their
impact on businesses
Governments operate a number of different policies with the
aim of providing the best possible economic environment
for businesses. This entails adjusting the level of activity
in the economy to avoid the excesses of booms and slumps.
The government’s economic policies can be divided into the
following categories:
1 Monetary policy Using this policy, the government (or
the central bank, such as the Bank of England, acting
on its behalf) manipulates the amount of money and/
or interest rates within the economy in order to achieve
the desired level of economic activity.
2 Exchange rate policy This is often regarded as a part
of monetary policy and involves the manipulation of
the value of a country’s currency. This can affect the
economy by changing the prices of exports and imports
and, thereby, the price competitiveness of the country’s
businesses.
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GLOSSARY TERMS
Monetary policy is controlling the amount of money and/
or interest rates within the economy in order to achieve
the desired level of economic activity.
Exchange rate policy is the deliberate adjustment of the
value of a country’s currency to achieve desired changes in
the prices of imports and exports.
Fiscal policy is the use of taxation and public expenditure
to manage the level of activity in an economy.
Monetary policy
This type of economic policy involves adjusting the amount
of money in circulation and, hence, the level of spending
and economic activity. Monetary policy can make use of one
or more of the following:
» adjusting interest rates
» controlling the money supply
» manipulating the exchange rate (which we will consider
separately).
Although at times all three techniques have been used, more
recently governments have tended to rely upon altering
interest rates to manage the economy. Since 1997, in the
UK, the Monetary Policy Committee of the Bank of England
has had responsibility for setting interest rates. Giving this
power to central banks is common in other countries, too.
For example, the Reserve Bank of India performs a similar
role. In the UK, the Monetary Policy Committee sets interest
rates monthly with the aim of achieving the government’s
target for inflation while attaining long-term growth in the
economy. Table 6.6 highlights the aims that may lie behind
authorities altering interest rates and, importantly, the
implications for individuals and businesses.
▼ Table 6.6 Changes in interest rates – objectives, impact and business decisions
Rising interest rates
Falling interest rates
The likely objectives of increasing interest rates include:
• reducing the level of consumer spending
• limiting inflationary pressure in the economy
• slowing the level of economic growth (as measured by GDP)
• avoiding increasing imports creating a deficit on the
balance of payments.
Reductions in interest rates may be introduced with the
following objectives in mind:
• reducing levels of unemployment
• stimulating the level of production in the economy
• promoting exports sales by reducing the exchange value of
the currency
• increasing rates of economic growth in the economy.
(In general, higher interest rates will assist in dampening
down an economic boom.)
(Reducing interest rates can assist an economy in recovering
from a slump.)
The likely impact on businesses of increasing interest rates
include:
• Many businesses may experience falling sales as consumers
increase savings.
• Demand for products purchased on credit may decline
significantly.
• The cost of borrowing, whether short- or long-term, is likely
to increase for businesses, possibly cutting profit margins.
• Increased value of the currency increases the prices of
exports while reducing import prices.
The impact on businesses of falling interest rates include:
• Demand and sales are likely to increase, especially for
products bought on credit.
• Production is likely to be stimulated, increasing
employment.
• Export sales of price-sensitive products may increase while
imports become less competitive.
• Businesses may undertake increased investment, promoting
growth in industries such as construction.
Examples of how businesses’ decisions may be affected by
increasing interest rates include:
• Businesses may cancel or defer investment plans as they
may be too costly with higher interest rates.
• Firms reduce levels of inventories as they seek to cut
borrowing costs.
• New marketing campaigns might be introduced, possibly
based on low prices, to attract consumers.
• Some businesses may seek to borrow money from overseas if
interest rates are significantly lower in foreign countries.
Examples of how businesses’ decisions may be affected by
falling interest rates include:
• Businesses may decide to increase investment in new
factories and new products as borrowing is cheap and
consumer spending may be forecast to rise.
• Firms may invest in advertising campaigns to attract new
customers at a time of cheap borrowing.
• Businesses may offer attractive ‘buy now, pay later’ deals to
attract customers as they can afford to increase borrowing
to finance this.
• Some businesses may seek to use cheap finance to finance
takeovers of rivals or suppliers.
6.1.2
6.1.2.5–7 Government macroeconomic policies and their impact on businesses
3 Fiscal policy This refers to the government’s use
of taxation and public expenditure to manage the
economy. By adjusting the levels of taxation and
government expenditure, the government can alter the
level of activity within the economy.
4 Supply-side policies These are designed to improve
the free operation of markets and, therefore, the total
amount that is produced (or supplied) by the economy.
Privatisation is one type of supply-side policy, along
with limiting trade union power and providing training
for unemployed workers.
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A LEVEL 6.1.2 External influences on business activity: Economic
6.1.2
Broadly speaking, rises in interest rates depress the level of
economic activity and reductions promote an expansion of
economic activity.
Interest rates are the price of borrowed money. Although
the Bank of England sets the base rate, many other interest
rates operate in the UK. The precise rate of interest charged
on a loan depends on several factors, including the time
period of the loan and the degree of risk attached to it.
In the UK, expenditure is particularly sensitive to changes
in interest rates. One prime reason for this is mortgage
interest payments. Millions of UK consumers have mortgages,
which are large loans taken out to purchase houses. A rise in
interest rates increases the payments made on mortgages,
leaving less money available for other types of expenditure.
Similarly, a cut in rates reduces mortgage payments, freeing
money for other forms of expenditure.
The impact on businesses and their
decisions of changes in interest rates
The impact of rising interest rates will depend upon the
size of the change as well as the initial rate. A small
increase at a relatively high level of rates will have little
impact, while a larger increase from a low base rate will
have a significant impact, prompting businesses to take
significant decisions.
Not all businesses are affected equally. We can identify
several categories of businesses that are particularly
susceptible to changes in interest rates:
» Small firms are often affected greatly by changes in
interest rates, as they have smaller financial reserves
and a relatively greater need for borrowing. The Bank of
England estimates that every 1 per cent rise in interest
rates costs the UK’s 1.5 million small firms an extra
£200 million in interest rate payments. Significant rises
in interest rates can lead to substantial increases in
bankruptcies or insolvencies among small firms.
» Even larger firms with high levels of borrowing can be
affected by alterations in interest rates. For example,
a rise in rates can lead to a hefty increase in interest
payments, forcing firms to reduce costs elsewhere or to
pass on the extra expenses in the form of higher prices
– if this is possible. Alternatively, a cut in interest rates
offers a substantial reduction in expenses to such firms,
improving their competitiveness.
» Firms trading overseas are affected by alterations in
interest rates. Rising interest rates tend to lead to an
increase in the country’s exchange rate. This occurs
because individuals and businesses overseas purchase,
say, rupees to invest in Indian financial institutions to
benefit from higher interest rates. Rising demand for a
currency tends to increase its price – or its exchange
rate. A fall in interest rates would have the opposite
effect.
CASE STUDY
Consumer debt worries in Russia
The monetary authorities in Russia have been concerned
by a sharp increase in unsecured borrowing by the
country’s consumers. Any borrowing that is unsecured
is not guaranteed by collateral such as property or other
saleable assets. Credit cards and some bank loans
are examples of unsecured borrowing. In 2019, around
5 million Russians were using more than 50 per cent of
their incomes to repay unsecured loans. Any financial
institution offering new loans of more than 10 000 roubles
($154) will be subject to the new rules.
Before being able to offer unsecured loans, banks
in Russia will be required to assess the extent of a
consumer’s previous borrowing and the proportion of
However, it is not only the direct effects of altering interest
rates that affect businesses. The use of interest rate
policy by the authorities can have a profound impact upon
the general economic environment in which businesses
operate. The Reserve Bank of India changes interest rates
to assist the Indian government in achieving its economic
objectives. This means that altering rates affects the level
income already used to repay existing debts. If banks do
make any ‘risky’ unsecured loans, they will be required to
hold increased reserves to cope with any consumers who
do not repay their debts.
Forecasts by the Russian Central Bank suggest that growth
rate of consumer borrowing will decline in the last three
months of 2019 to about 10 per cent, from 22 per cent in 2018.
Questions
1
Evaluate whether or not the effects of a continued
rise in unsecured borrowing will be entirely bad for
[12]
businesses in Russia.
of unemployment, inflation and growth existing in the
economy. Changes in interest rates also change business
managers’ expectations of these key economic variables,
affecting their day-to-day and strategic decisions.
Table 6.7 illustrates the relationship that exists between
the level of interest rates and key economic variables such
as economic growth and unemployment.
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▼ Table 6.7 Interest rates and other economic variables
Rising interest rates
Falling interest rates
Unemployment
Unemployment increases as levels of
production decline
Unemployment decreases as the level of
economic activity rises
Inflation
Falling demand and output reduces
inflationary pressure
Increasing output and spending causes
prices to rise, fuelling inflation
Economic growth
Will slow as businesses cut output and
investment
Is stimulated by cheaper loans and rising
business investment
Exchange rates
Exchange value of currency is likely to rise
Exchange value of currency generally falls
Quantitative easing (QE)
Since March 2009, interest rates in the UK have been held at
very low levels by the Bank of England. In March 2020, the
rate was cut to 0.1 per cent, the lowest figure ever, as part
of the government’s response to the Coronavirus (COVID-19)
crisis. Many other countries have very low rates of interest
at the time of writing. Rates in Hungary, Hong Kong, South
Korea, the USA and New Zealand are all below 1 per cent.
Such low interest rates limit the flexibility of authorities
responsible for monetary policy. There is no real possibility
to lower rates further to expand production and to help
the economy achieve higher rates of economic growth.
When interest rates can go no lower, a central bank’s only
monetary policy option is to pump money into the economy
directly. That is quantitative easing (QE).
The way the central bank does this is by buying assets –
usually financial assets, such as government and corporate
bonds – using money it has simply created. The institutions
selling those assets (either commercial banks or other
financial businesses such as insurance companies) will then
have ‘new’ money in their accounts, which then boosts the
money supply. The hope is that this money is subsequently
used to purchase goods and services and to boost output
and growth. In 2020, the UK government announced a new
programme of quantitative easing with a total value of
£200 billion to help to stimulate the economy as part of its
response to the Coronavirus crisis. Quantitative easing has
also been used by central banks in Japan, Sweden, the USA
and Brazil.
Business decisions and changes in
monetary policy
Businesses can be affected significantly by changes in
monetary policy, both the use of quantitative easing and
changes in interest rates. Such changes may prompt a range
of decisions by businesses, depending on the scale and
expected duration of any changes in monetary policy. We
consider a small sample below.
» Borrowing Changes in interest rates directly affect the
cost of borrowing; quantitative easing can affect them
indirectly. Businesses will be likely to adjust the amount
they borrow and invest in the light of changes in
6.1.2
interest rates. For example, a period of very low interest
rates (as is the case in North America and much of
Europe at the time of writing) may encourage decisions
on investment as any funds needed will be relatively
cheap, making it likely the profits on a project will
be higher.
» Prices Reductions in interest rates may give a business
more flexibility to raise prices as consumers will be more
able to afford loans to buy products. A rise in rates
might put pressure on businesses to reduce prices for
some products – especially those (such as cars) normally
bought using loans.
» Product development Falling interest rates might
encourage businesses to invest in developing new
products as the cost of doing so may be reduced.
Alternatively, rising rates may persuade businesses to
adapt existing products to reduce production costs and
boost price competitiveness.
» Cutting costs Rising rates may provoke bouts of costcutting as businesses seek to reduce the debts on which
they have to pay interest. This can lead to decisions
affecting many parts of a business including the sale
of assets, reductions in the size of the workforce and
ceasing production of less successful products.
GLOSSARY TERMS
6.1.2.5–7 Government macroeconomic policies and their impact on businesses
Other economic variables
Debt is an amount of money that has been borrowed by a
business but not yet repaid.
An exchange rate is the price of one currency expressed
in terms of another. For example, the US dollar might be
worth 0.78 euros.
Exchange rates
An exchange rate is simply the price of one currency
expressed in terms of another. Thus, at a particular time,
the Chinese yuan may be worth 3500 Vietnamese dong or
4.9 Thai baht.
London is one of the premier international centres
for buying and selling foreign currencies – each day
transactions total billions of pounds. Exchange rates
between most currencies vary regularly according to the
balance of supply and demand for each individual currency.
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The effects of exchange rate changes
A LEVEL 6.1.2 External influences on business activity: Economic
6.1.2
Exchange rates can change significantly over time. A rise in
the value of a currency is an appreciation; a decline in its
value is termed a depreciation.
In October 2018, the American dollar exchanged for 32.49
Uruguayan pesos ($U). By May 2020, the exchange rate was
$1 = $U44.21. This meant that the value of the Uruguayan
peso had depreciated by just over 36 per cent over the
period. Alternatively, the value of the American dollar had
increased (or appreciated) by the same amount.
HANDLING DATA
In May 2020, an American company exported cars
to Uruguay at an average price of $32 000 per car.
Assuming no other changes, how much would an
average car sell for in Uruguay?
Changes in the value of currencies affect the prices of
exports and imports, as shown in Table 6.8.
▼ Table 6.8 The effects of changes in the value of the Uruguayan peso
The exchange rate of Uruguayan
pesos
Prices of Uruguayan exports overseas
(in foreign currencies)
Prices of imported goods in Uruguay
(in pesos)
Appreciates (rises)
Increase
Fall
Depreciates (falls)
Fall
Increase
Using the information in Table 6.8, we can see that the fall
in the value of the Uruguayan peso against the American
dollar between October 2018 and May 2020 would have had
the following effects (assuming no other changes):
» Prices of Uruguayan exports to the United States of
America (for example, wool from its Corriedale sheep)
would have fallen by approximately 36 per cent. Sales
would be likely to rise as a consequence, and Uruguayan
exporters would receive the same amount in pesos per
kilogram of wool.
» American products (for example, software for computers)
imported by Uruguay would have been up to 36 per cent
more expensive. However, the price the Americans received
in dollars would not have changed. It is likely, however,
that because prices were higher in Uruguay, American
companies would sell smaller quantities of their products.
Small changes in the exchange rates of most countries occur
all the time as demand for the currency and supplies of it
alter. A series of slight rises and falls over a period of time
is not necessarily a major problem for industry. Of more
concern is a sustained rise or fall in the exchange rate,
or a sudden and substantial change in the exchange rate.
Governments often seek to control fluctuations in exchange
rates (as we shall see later this chapter), as exchange rate
changes can create uncertainty for a number of reasons.
» If firms agree deals priced in foreign currencies, they
may receive more or less revenue from a particular
transaction than expected if the exchange rate alters in
the intervening period. Thus, a deal to sell clothes to
France may give Bangladeshi manufacturers less revenue
than anticipated if the contract is agreed in terms of
euros and the Bangladeshi taka then rises in value
against the euro. In these circumstances, the quantity of
euros stated in the contract will convert into a smaller
number of taka, causing a shortfall for the exporter.
» Changing exchange rates can affect prices and sales
in overseas markets, even if the exporter avoids direct
exchange risk by insisting on payment in domestic
currency. For example, a London-based clothes
designer may sell clothes overseas but stipulate that
they are paid in pounds sterling. A rise in the value of
the pound may mean that foreign retailers are forced
to increase the prices of the clothes to maintain profit
margins. As a consequence, sales may be lower than
expected, giving the London-based design company
less revenue than forecast.
» Competitors may respond in unexpected ways to exchange
rate changes. Foreign firms may reduce prices to offset
the effects of an exchange rate change, putting rivals
under pressure to do the same or lose market share.
▼ Table 6.9 Changes in exchange rates
Exporters
How might Zimbabwean firms respond to a
rising value of the Zimbabwean dollar?
How might Zimbabwean firms respond to a
falling value of the Zimbabwean dollar?
• Allow prices to rise in foreign markets reducing
probable sales. Remember, exporters receive
the same price in dollars for each overseas sale
but will sell less in this situation.
• Leave prices unchanged in overseas markets.
Sales should be unchanged but the exporter
will receive fewer dollars from each sale.
• Exporters could allow prices to fall in overseas
markets as a result of the exchange rate change.
They will receive the same amount in dollars from
each sale but should achieve higher sales.
• Increase their prices to maintain price levels
in terms of the foreign currency. Sales should
remain constant (depending on competitors’
actions) and revenue should rise in dollars as
a result.
Neither of these options is attractive to
exporters – a rising exchange rate is bad news.
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Domestic producers
How might Zimbabwean firms respond to a
rising value of the Zimbabwean dollar?
How might Zimbabwean firms respond to a
falling value of the Zimbabwean dollar?
• Reduce prices to compete with cheaper
imports.
• Enjoy the benefits of cheaper imports of
materials and components.
• Emphasise other elements in the marketing
mix; for example, the quality of the product.
• Enjoy increased sales as a result of rising prices
of competitors’ imported products, assuming
foreign businesses do not hold prices down.
• Increase prices (to some extent) to enjoy
increased revenues from each sale.
• Beware the increased cost of imported raw
materials and components.
Remember that products are not sold on the basis of
price alone. When considering the likely consequences
of a change in exchange rates, it is important to note that
factors such as quality, reputation, after-sales service
and meeting delivery dates are important influences on
buyers’ decisions.
GLOSSARY TERMS
A currency appreciates when its value rises against
another currency or currencies.
A currency depreciates when its value declines against
another currency or currencies.
The impact of changes in exchange rates on
businesses
Fluc