MANAGEMENT OF BUSINESS FOR CAPE® EXAMINATIONS JEROME PITTERSON CAPE is a registered trade mark of the Caribbean Examinations Council (CXC®). MANAGEMENT OF BUSINESS for CAPE® EXAMINATIONS is an independent publication and has not been authorised, sponsored, or otherwise approved by CXC. Macmillan Education 4 Crinan Street, London, N1 9XW A division of Macmillan Publishers Limited Companies and representatives throughout the world. www.macmillan-caribbean.com ISBN 978-0-230-40043-6 Text © Jerome Pitterson, 2014 Design and illustration © Macmillan Publishers Limited, 2014 The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2014 All rights reserved; no part of this publication may be reproduced, stored in a retrieval system, transmitted in any form, or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publishers. 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Printed and bound in Malaysia. 2018 2017 2016 2015 2014 10 9 8 7 6 5 4 3 2 1 3 Contents List of figures and tables Introduction 7 10 UNIT 1 MANAGEMENT PRINCIPLES AND PROCESSES 11 MODULE 1 BUSINESS AND ITS ENVIRONMENT 12 1 Economic and Legal Structures Types of economic activity Economic sectors and legal structures The private sector The public sector Privatisation Multiple Choice Questions Extended Essay Questions 12 12 14 15 23 26 27 28 2 Business Objectives Nature, role and importance of objectives Business ethics and social responsibility Obligations of the firm to stakeholders Good corporate governance Importance of business ethics and integrity Code of ethics Government’s response to social irresponsibility Multiple Choice Questions Extended Essay Questions 29 29 32 34 34 34 34 35 35 36 3 Decision Making Essential features of information Significance of qualitative versus quantitative decision making The stages of decision making Factors affecting decision making Multiple Choice Questions Extended Essay Questions 37 37 4 Caribbean Business Environment and Globalisation The nature and structure of Caribbean business organisations Caribbean business culture The growth of multinational corporations in the Caribbean The impact of trade liberalisation and globalisation 37 38 39 45 46 47 47 48 49 50 Protectionism Other barriers to trade Multiple Choice Questions Extended Essay Questions 54 55 56 57 MODULE 2 THE MANAGEMENT OF PEOPLE 58 5 The Functions and Theories of Management The need for and nature of organisations The major management theories The functions of management The roles of management Multiple Choice Questions Extended Essay Questions 58 58 58 64 65 67 67 6 The Organisation and its Structure Classification of organisations Factors influencing the classification of organisations Characteristics of the formal organisational structure Centralisation and decentralisation Multiple Choice Questions Extended Essay Questions 68 68 72 73 75 76 76 7 The Theory and Application of Motivation Factors that stimulate and influence motivation Theories of motivation Financial and non-financial motivational strategies Implications for managers Multiple Choice Questions Extended Essay Questions 77 77 78 80 85 87 87 8 Leadership Leadership theories Theory X and Theory Y The Trait Theory Leadership skills Leadership styles Factors influencing the choice of leadership style Leadership roles Informal leadership Multiple Choice Questions Extended Essay Questions 88 88 88 89 90 92 94 95 95 96 97 9 Team Management and Conflict The nature of teams 98 98 4 CONTENTS Stages of team development Types of formal group Characteristics of effective teams Team or group cohesiveness Evaluation of team work Benefits of team management to the organisation Conflict management Multiple Choice Questions Extended Essay Questions 99 99 99 100 101 101 101 106 106 10 Management of Change Factors that may cause change in the organisation Differences between leading and managing change Resistance to change Strategies for managing change The importance of communication in the management process Multiple Choice Questions Extended Essay Questions 107 107 108 108 110 11 Communication in Business Types of communication The communication process Channels of communication Factors influencing the choice of channel used Lines of communication Barriers to effective communication Reducing barriers to communication Multiple Choice Questions Extended Essay Questions 113 113 113 114 116 117 119 120 122 123 12 Human Resource Management The role and importance of human resource management The functions of human resource management Labour–management relations Laws affecting health and safety in the workplace Multiple Choice Questions Extended Essay Questions 124 MODULE 3 BUSINESS FINANCE AND ACCOUNTING 13 The Need for Capital and Sources of Finance The need for capital Sources of finance Criteria for seeking finance How to choose from these sources of funds? Money and capital markets and international financial institutions The money and capital markets Multiple Choice Questions Extended Essay Questions 111 112 112 124 124 131 134 135 136 137 137 137 140 140 143 143 145 147 147 14 Accounting Information and Financial Statements Why do we need accounting records? Internal users of accounting information External users of accounting information Getting started with accounting Components of financial statements Multiple Choice Questions 148 148 148 149 149 152 158 15 Financial Statements Analysis Financial analysis Importance of financial analysis Ratio analysis Types of ratio Multiple Choice Questions Extended Essay Questions 159 159 159 159 160 166 166 16 Budgetary Accounting Projections The budgeting process Categorisations of budgets Operational budgets Types of budget Budgetary control Multiple Choice Questions 167 167 167 168 168 168 170 172 17 Investment Appraisal Investment Investment appraisal Analytical methods of appraisal Limitations of investment appraisal Comparison of methods of appraisal Multiple Choice Questions 173 173 173 173 178 178 179 END OF UNIT ASSESSMENT 180 UNIT 2 APPLICATIONS IN MANAGEMENT 184 MODULE 1 PRODUCTION AND OPERATIONS MANAGEMENT 185 18 The Nature of Production The production process Factors of production What to produce? Production methods Factors that influence the method of production used When to produce? Location of production Multiple Choice Questions Extended Essay Questions 185 185 185 186 186 190 191 191 195 195 19 Forecasting Techniques Forecasting techniques 196 196 CONTENTS Qualitative forecasting techniques Quantitative forecasting techniques Multiple Choice Questions Extended Essay Question 196 199 202 203 20 Production Design Strategies and Capacity Planning Product design planning Product design strategies Capacity planning Capacity utilisation Options available to increase capacity Economies and diseconomies of scale Diseconomies of scale Business layout Multiple Choice Questions Extended Essay Questions 204 204 204 206 207 208 208 210 210 215 215 21 Costing Direct costs Indirect costs Fixed costs Variable costs Fixed costs per unit Semi-variable cost Approaches to costing Including stock Application of marginal costing ’Make or buy’ decisions Multiple Choice Questions Extended Essay Question 216 216 216 216 216 217 217 217 219 220 221 223 223 22 Inventory Management Importance of inventory Importance of inventory control Inventory control management Multiple Choice Questions Extended Essay Question 224 224 224 225 228 229 23 Lean Production and Quality Management Importance of quality Dimensions of quality Techniques for improving quality Multiple Choice Questions Extended Essay Questions 230 230 230 231 239 240 24 Productivity Factors that affect productivity Methods of measuring productivity Methods of improving productivity Multiple Choice Questions Extended Essay Questions 241 241 243 243 246 246 25 Project Management Critical Path Analysis (CPA) Decision trees Multiple Choice Questions 247 247 250 253 MODULE 2 FUNDAMENTALS OF MARKETING 254 26 The Concept of Marketing The core marketing concepts Multiple Choice Questions Extended Essay Question 254 254 260 260 27 The Marketing Environment The micro-environment The macro-environment Multiple Choice Questions Extended Essay Questions 261 261 262 265 265 28 Marketing Research Importance of conducting marketing research Importance of developing a research plan Stages of marketing research Limitations of market research Multiple Choice Questions Extended Essay Questions 266 266 266 266 272 274 275 29 Principles of Segmentation Market segmentation Criteria for effective segmentation Bases of segmentation Consumer buying behaviour The consumer decision-making process (the buying process) Factors influencing buying behaviour Multiple Choice Questions Extended Essay Questions 276 276 278 278 281 30 Product Management The concept of product Dimensions of the product mix Product line and extension The Boston Matrix New product development process The product lifecycle Branding and packaging Characteristics of services Multiple Choice Questions Extended Essay Questions 285 285 286 286 286 289 290 292 293 296 297 31 Pricing Decision Introduction to pricing Factors influencing pricing decisions Pricing strategies 298 298 299 302 281 283 284 284 5 6 CONTENTS Multiple Choice Questions Extended Essay Questions 305 306 32 Distribution Management The role of distribution in the organisation Factors influencing distribution decisions Types of distribution channel Introduction to logistics strategy Types of distribution strategy Multiple Choice Questions Extended Essay Questions 307 307 307 308 309 310 311 311 33 Promotion Strategy The concept and objectives of promotion Tools of promotion Multiple Choice Questions Extended Essay Questions 312 312 312 318 319 34 Internet Marketing Development of internet marketing Opportunities created by internet marketing Challenges associated with internet marketing The importance of e-commerce to business organisations Challenges created by e-commerce Multiple Choice Questions Extended Essay Question 320 320 321 322 322 323 325 325 MODULE 3 SMALL BUSINESS MANAGEMENT 326 35 The Nature and Characteristics of Entrepreneurship Corporate entrepreneurship (‘intrapreneurship’) Social entrepreneurship Characteristics of successful entrepreneurs Benefits of entrepreneurship Drawbacks of entrepreneurship Multiple Choice Questions Extended Essay Question 326 326 326 327 328 329 330 330 36 Economic Systems and Business Growth The economy problem Types of economic system Criteria for measuring size and growth of businesses A comparison of small firms and large firms Strategies for growth Multiple Choice Questions Extended Essay Questions 331 331 331 334 335 338 343 343 37 Major Challenges and Opportunities Faced by Small Businesses Identifying successful business opportunities Sourcing capital (finance) 344 344 344 Selection of business types Determining a location Globalisation and trade liberalisation E-commerce Intellectual property Multiple Choice Questions Extended Essay Question 345 345 345 345 346 347 348 38 Types and Nature of Assistance Available to Small Firms Government agencies Non-government agencies Financial institutions Types of assistance offered to small businesses Extended Essay Question 349 349 350 350 351 352 39 Preparation of a Business Plan for a Small Business Feasibility study The business plan Elements of a business plan Multiple Choice Questions Extended Essay Question 353 353 353 354 359 359 END OF UNIT ASSESSMENT 360 40 Internal Assessment Choosing an appropriate topic or title for your research Introduction Literature review Writing your methodology Presentation of data Analysis of data Interpretation of results Conclusion and recommendation References and citations Appendices Note to teachers 364 364 365 366 367 368 369 370 370 370 370 370 Glossary 372 Answers to Multiple Choice Questions 384 Index 386 7 List of figures and tables Figures Figure 17.1 NPV graph 178 Figure 18.1 Figure 18.2 Figure 18.3 Figure 18.4 185 186 187 189 Figure 1.1 An example of industry in the primary sector Figure 1.2 An example of industry in the secondary sector Figure 1.3 An example of industry in the tertiary sector Figure 1.4 Private-sector organisations Figure 1.5 A sole-trader business Figure 1.6 A public limited company Figure 1.7 A cooperative business Figure 1.8 A franchise Figure 1.9 Public-sector organisations 14 15 16 19 20 21 24 Figure 19.1 Examples of common trends Figure 19.2 A scatter diagram 199 201 Figure 20.1 Figure 20.2 Figure 20.3 Figure 20.4 Figure 20.5 Diseconomies of scale Process layout Product layout Fixed-position layout Cellular layout 210 211 212 213 214 Figure 2.1 The hierarchy of objectives Figure 2.2 Scotiabank 31 33 Figure 3.1 The stages of decision making 38 Figure 4.1 Business culture factors Figure 4.2 Digicel headquarters, Kingston 48 51 Figure 21.1 Figure 21.2 Figure 21.3 Figure 21.4 Figure 21.5 Fixed costs Variable costs Fixed costs per unit Semi-variable costs A breakeven chart 217 217 217 217 221 Figure 5.1 A basic system Figure 5.2 The three levels of management 62 64 Figure 6.1 Figure 6.2 Figure 6.3 Figure 6.4 Figure 6.5 Figure 6.6 Figure 6.7 Figure 6.8 Figure 6.9 68 69 69 70 71 71 71 73 74 Functional organisational structure Product organisational structure Geographical organisational structure Matrix organisational structure Team organisational structure Network organisational structure Virtual organisational structure Narrow span of control Wide span of control 12 13 The production process An example of job production An example of batch production An example of flow production Figure 22.1 Stock control levels Figure 22.2 Simpson Lumber Yard stock control graph Figure 22.3 A typical economic order quantity graph Figure 22.4 Economic order quantity graph for Questions 6–8 225 247 247 248 248 249 249 249 250 251 252 253 228 Figure 10.1 Managing change 110 Figure 11.1 The communication process Figure 11.2 The flow of communication 113 118 Figure 25.1 Figure 25.2 Figure 25.3 Figure 25.4 Figure 25.5 Figure 25.6 Figure 25.7 Figure 25.8 Figure 25.9 Figure 25.10 Figure 25.11 Figure 12.1 The recruitment plan 125 Figure 26.1 Core marketing concepts 254 Figure 14.1 The double entry system 150 Figure 28.1 Stages in developing a research plan 267 Figure 16.1 The budgetary process 168 Figure 29.1 Market coverage strategies Figure 29.2 The consumer decision-making process 277 282 Figure 7.1 Maslow’s Hierarchy of Needs 78 The sections of a node Lines representing activity Network diagram New network diagram Three possible situations in CPA New diagram, using dummy activity Network diagram A decision tree The revised decision tree A more complex decision tree Network diagram for Questions 1–3 226 227 8 LIST OF FIGURES AND TABLES Figure 30.1 The Four Ps Figure 30.2 Attributes of the product Figure 30.3 Dimensions of the product mix Figure 30.4 The Boston Matrix Figure 30.5 New product development process Figure 30.6 The four-stage product lifecycle Figure 30.7 The five-stage product lifecycle Figure 30.8 Extending the product lifecycle Figure 30.9 Secondary packaging 285 285 286 287 289 290 291 291 293 Tables Figure 31.1 Price ceiling Figure 31.2 Price flooring Figure 31.3 Penetration pricing and price skimming compared 301 301 Figure 32.1 Types of distribution channel Figure 32.2 One-channel intermediary Figure 32.3 Two-channel intermediary 308 309 309 Table 5.1 Contributions of classical theories to modern organisations Table 5.2 Contributions of modern theories to modern organisations Table 5.3 Mintzberg’s ten roles for top management Figure 36.1 Market share illustrated in a pie chart Figure 36.2 Diseconomies of scale Figure 36.3 An example of conglomerate integration 335 337 339 Figure 40.1 Examples of statistical tools 369 304 Table 1.1 Benefits and problems associated with a change in legal structure 23 Table 2.1 The firm’s social responsibilities to stakeholders 34 Table 3.1 The decision-making process Table 3.2 Possible impact of factors on a firm’s decision making Table 8.1 An evaluation of different leadership styles Table 9.1 An evaluation of conflict management strategies 39 44 61 63 65 93 104 Table 11.1 An evaluation of communication methods 117 Table 11.2 Methods of overcoming barriers to communication 121 Table 13.1 Advantages and disadvantages of sources of capital 141 Table 14.1 Transactions illustrating the double entry system Table 14.2 Cash inflows and outflows 151 156 Table 15.1 Net profit figures for analysis Table 15.2 Data for calculating investment or shareholders’ ratios Table 15.3 Data for calculating efficiency and activity ratios Table 17.1 KEP Industry initial capital outlays and annual cash inflows Table 17.2 initial capital outlays and annual cash inflows for three projects Table 17.3 Initial capital outlays and annual cash inflows for two projects Table 17.4 Forecasted data for Projects A and B Table 17.5 An extract of discount factors for $1 Table 17.6 Investment information for DGF Company Ltd Table 17.7 Information for NPV/DCF analysis Table 17.8 Comparison of methods of appraisal 159 162 163 174 174 175 175 176 177 177 178 LIST OF FIGURES AND TABLES Table 19.1 Data for calculating simple moving averages Table 19.2 Data for Future Sales Ltd sales forecasts Table 19.3 Data for least squares regression calculation Table 19.4 Data for Questions 5 and 6 Table 21.1 Calculating operating profit under marginal costing Table 21.2 Calculating operating profit under absorption costing Table 21.3 Production costs for Great Juices Ltd Table 25.1 Table 25.2 Table 25.3 Table 25.4 Table 25.5 Table 25.6 Table 25.7 Getting ready for school Getting ready for school (revised timings) Information for critical path exercise Information for critical path example Activities by A Fisher Ltd Expected values Data from James Duncan’s market research 200 200 201 203 218 218 222 248 248 249 249 250 251 252 Table 26.1 Overview of business concepts 259 Table 28.1 An evaluation of marketing research techniques 272 Table 30.1 Possible responses from marketers to characteristics of services 295 Table 31.1 Information for calculating price elasticity of demand Table 31.2 Degrees of elasticity 299 300 Table 33.1 Overview of types of advertising media 314 Table 36.1 The impact of economic systems on business decision making 333 Table 40.1 Module content related to SBA topics 365 9 10 Introduction This textbook is geared towards students studying CAPE® Management of Business Units 1 and 2, including private candidates. The text is divided into two units and gives comprehensive coverage of the CAPE® Management of Business syllabus, providing students with a wide knowledge base of business concepts. Students will be furnished with the information needed to do well in their CAPE® examinations and the book forms a basis for higher studies. The text also incorporates some ‘hard to find and explain’ concepts and so it is also an excellent resource for teachers. The text breaks down accounting information so that students without accounting knowledge from CSEC® level will be able to understand the concepts of Module 3, Unit 1. However, it also offers challenging exercises for those with a strong accounting background. The book gives a number of definitions, examples from different territories and practice exercises to assess students’ understanding of the concepts. Each chapter is summarised at the end and also incorporates multiple choice questions, case studies which help students to think critically, and extended essay-type questions. The text also contains photographs, artwork and diagrams to cater for visual learners, as well as worked examples of accounting questions and tables to break down information for ease of understanding, studying and remembering. 11 Unit 1 MANAGEMENT PRINCIPLES AND PROCESSES 12 1 Module 1 Business and its Environment Economic and Legal Structures LEARNING OBJECTIVES: At the end of this chapter students should be able to: Identify the different types of business activity Distinguish among the different types of business activity Distinguish between the private and public sectors Describe the different private- and public-sector businesses Outline how each of the businesses is formed Discuss the benefits and drawbacks of each type of business Identify examples of each type of business Types of economic activity T he Caribbean business environment can be divided into three types of economic or business activity. These are discussed below. Figure 1.1: An example of industry in the primary sector Primary sector The primary sector incorporates all the extractive industries, including mining (for example, bauxite), fishing, forestry and farming. In most cases, the products of the primary sector are the raw materials that are used for secondary production. For example, bauxite is used for manufacturing aluminium and lumber is used in the building of furniture and houses. The primary sector also includes the fishing and agricultural industries. Some Caribbean countries are heavily dependent on the primary level of activity in order to earn foreign exchange. Currently, some countries export large amounts of our raw materials in their natural state instead of exploring the products that could be produced by using those same resources. This means that the secondary level of activity is perhaps not explored as much as it could be. Dependence on the primary sector presents the country with the following advantages and disadvantages: CHAPTER 1 | ECONOMIC AND LEGAL STRUCTURES Advantages of reliance on the primary sector The country is able to supply raw materials to firms for conversion The country can gain a comparative advantage over others in producing certain goods Creation of jobs Generation of export revenues. Disadvantages of reliance on the primary sector Depletion of natural resources, especially because of exploitation Potential to earn more revenue if raw materials were to be converted into finished products A decrease in the demand for finished products will decrease the demand for primary products and so reduce revenue. Secondary sector The secondary sector involves the changing of raw materials into finished goods. It incorporates the manufacturing and construction industries. Examples of secondary business activities include the manufacture of chemicals and of baked products, and the construction of houses, roadways and bridges. The Caribbean has a number of businesses that take the raw materials produced in the region and convert them to finished products – for example, Trinidad Cement Ltd and Grace Kennedy Jamaica. While the trading of primary products is important, secondary sector products are usually in higher demand. A dynamic manufacturing firm can take one primary product and create a number of secondary products which will generate greater revenues for itself. For example, a firm could use bananas to make banana chips, banana milk shakes, banana bread, banana-flavoured soft drinks, banana porridge mix and banana fritters. The struggle for some Caribbean countries is that they are not able to make the best use of their primary products by converting them into secondary products. Involvement in secondary production offers the following benefits and disadvantages: Advantages of involvement in the secondary sector Reduction in the importation of goods that are produced using the same raw materials from the Caribbean Earn foreign exchange from the products that are exported One primary product can be used to create a number of secondary products Creation of jobs in different areas other than the extractive industry Possible increase in investment in the manufacturing sector Improvement in the country’s Gross Domestic Product and so possibly its standard of living. Disadvantages of involvement in the secondary sector The profit motive of manufacturing firms could lead to depletion of some primary products A number of manufacturing companies are often multinationals which repatriate their profits instead of reinvesting in the host country Some of the raw materials used in the secondary sector have to be imported and this uses up the foreign exchange earnings of the country. Tertiary sector Figure 1.2: An example of industry in the secondary sector The tertiary sector does not produce goods, but instead provides services. Over the last decade the Caribbean business environment has become more service oriented. Some of these services include tourism, financial services, transportation and management services. In recent 13 14 MODULE 1 | UNIT 1 | BUSINESS AND ITS ENVIRONMENT Figure 1.3: An example of industry in the tertiary sector times, the tertiary sector has become one of the main contributors to Caribbean countries’ Gross Domestic Product, with tourism being the most popular. We have seen improvements in the banking sector, transportation, insurance, telecommunications, courier services and money services, among others. The tertiary sector offers the following benefits and disadvantages to Caribbean countries: Advantages of involvement in the tertiary sector Generates foreign exchange, especially from tourism Creation of jobs, especially because the sector is mostly labour intensive The sector does not depend heavily on primary products and so would not deplete the countries’ natural resources As mentioned, the sector contributes to the Gross Domestic Product of countries Less pollution generated when compared with the primary and secondary sectors. Disadvantages of involvement in the tertiary sector Services as a whole are very volatile and so may not be sustainable It may require high training costs to ensure that the service being offered is the same regardless of location Services such as tourism can impact on a country’s culture and values and may even lead to a change in people’s social behaviour. Economic sectors and legal structures The big economic problem lies in the fact that the resources of this world, though plentiful, are not sufficient to meet humans’ unlimited wants. This condition is known as scarcity and, as a result, businesses, government and households have to make choices. The three main economic questions that are usually asked in any economy are: What to produce? How to produce? For whom to produce? Governments and firms must make the necessary decision on each question. In order to make these decisions, different business organisations have been created. Each organisation may react in different ways to these questions. The organisations can be classified into private-sector and public-sector organisations. Each of these organisations within the private or public sector carries a particular legal structure. It is the legal structure that determines the following: How profits or losses are shared The firm’s tax obligation CHAPTER 1 | ECONOMIC AND LEGAL STRUCTURES CASE STUDY Switching the economic focus Isle J is a territory in the Caribbean region that has a rich history and cultural background. Once colonised by different developed countries, its main focus was on producing agricultural products. Its rich and fertile lands allowed crops such as bananas and sugar to flourish for a number of years. As the population grew, farmers diversified their cultivation and are now producing a number of agricultural products. As the isle developed, the number of investors also increased and Isle J started to experience a growth in manufacturing industry. A number of different manufacturing companies were established. This included companies that converted agricultural products, such as cocoa beans, coffee, oranges and bananas, into finished goods. With the proliferation of investments both locally and abroad, the mining sector also came to the fore, with the main products being bauxite, gypsum and limestone. Since the latter part of the 20th century there has been an evident change in the country’s economic focus. While the previously mentioned economic activities are still present, greater focus is now being placed on the service industry. Some of the main services being offered in Isle J include tourism, banking, insurance, transportation and telecommunications. This trend in the service industry has dampened the once vibrant manufacturing sector to some extent. However, a number of manufacturers have been pressing on with production. Questions 1. With the use of examples, name the types of economic activities that take place in Isle J. (6 marks) 2. Describe three (3) benefits that Isle J could derive from its dependence on the primary sector. (6 marks) 3. A noted economist in Isle J has stated that ‘The tertiary sector is the way forward in the 21st century for the country’. Discuss your view of this statement, stating whether such a decision would benefit or cost Isle J. (13 marks) Total 25 marks Ease of formation Funding Who bears the legal liabilities Continuity of existence. Choosing the most appropriate legal structure for a business depends heavily on the aim of the business owner. For example, a person who wants to start a business and keep full control will start a sole proprietorship, while another person who wants financial support for start-up from a number of people is likely to start a company or a partnership. At the same time, a sole proprietorship business may not be suitable for a very large multinational firm because of its size and the geographical area it decides to span. The private sector The private sector consists of businesses that are owned by individuals or groups of individuals with the main aim of making profits. These businesses differ in size and structure Private-sector organisations Sole proprietor Figure 1.4: Private-sector organisations Partnership Private Limited companies Public Franchising Cooperative Financial Retail Joint ventures Producer/ worker 15 16 MODULE 1 | UNIT 1 | BUSINESS AND ITS ENVIRONMENT and range from sole proprietorship to large companies. The following are the different types of private-sector organisations. Sole trader or proprietor This is the oldest and probably the most common form of business organisation. It ranges from the street-side vendor to large businesses, for example a doctor’s private practice. A sole trader refers to a business owned and operated by one individual. This person manages the business, makes all the decisions and enjoys all the profits or bears all the losses. While there is only one owner, he/she may employ other people to carry out different functions for which those people would be paid. A sole trader is the simplest business to form as there are few or no legal requirements. The business is generally unregistered. However, in Jamaica and other Caribbean countries the sole trader is required to register the business or trading name. In addition, depending on the product being traded, the sole trader may be required to apply for different licences. For example, a person running a bar or pub is required to obtain a spirit licence; likewise, someone selling food must obtain a food handler’s permit. Figure 1.5: A sole-trader business Main features of a sole-trader business Simplicity of formation The owner is in control of the business Requires little start-up capital The owner and the business are one (they are the same legal entity) Lack of continuity. The sole trader raises finance from different sources, however, these options may be limited. A person wanting to start a sole-trader business may opt to use his/her own personal savings, obtain bank loans or borrow from family and friends. The sole trader may also find that it is difficult to acquire a loan from lending institutions because of the risks involved or the lack of collateral available. In some cases, even when such a loan is granted, it comes with very high interest rates. Advantages of a sole-trader business It is easy to form, as there are few or no legal requirements Decisions can be made quickly The owner enjoys all the profits CHAPTER 1 | ECONOMIC AND LEGAL STRUCTURES With the exception of tax returns, business affairs are private Can be most suitable where capital is scarce. Disadvantages of a sole-trader business The owner has unlimited liability, i.e. he/she stands to lose personal assets if the business fails Difficulty in sourcing finance The business dies with the owner, hence there is a lack of continuity It may be difficult to achieve economies of scale There may be great demand on the owner’s time and attention. Partnership A partnership is defined as a business where two to twenty people work together towards a common goal of making profits. The partners are often the main source of finance even though the business can source funding from financial institutions. Like sole proprietorship, a partnership is not required to be registered. However, it is required to register its trading name. The partnership is governed by the agreement that was drafted at its outset, known as a partnership deed. This is a legal document which amounts to a binding contract among the partners. The document stipulates how profits or losses should be shared; the rights of each partner; rules for taking in new partners or dissolution of the partnership; and the capital to be contributed by each partner, among other things. While preparing a partnership deed is advisable, it is not required by law and so some partnerships do exist without one. In such case, the partnership is governed by the Partnership Acts of 1890 and 1907. The Partnership Act 1890 stipulates that: Profits and losses should be shared equally Each partner may take part in the management of the business No partner should receive a salary for working in the business No partner is entitled to any interest on his/her capital. While the Partnership Act 1907 did not disturb the rules set down in the previous Act, it added the new concept of a limited partnership. This Act stipulated the following: A limited partnership shall not consist of more than twenty people, and must consist of one or more people, called ‘general partners’, who shall be liable for all debts and obligations of the firm, and one or more people to be called ‘limited partners’ A limited partner shall not, during the continuance of the partnership, either directly or indirectly, draw out or receive any part of his contribution A limited partner shall not take part in the management of the partnership business, and shall not have power to bind the firm. Sometimes a partner may invest capital in the business but does not want to take any active part in how it is run. Such a partner is referred to as a ‘sleeping partner’. Main features of partnership Unlimited liability on partners (except for a limited partner) Two or more members Profits/losses are shared Few legal requirements No separation between business and partners. Partnerships are prevalent in, but not limited to, accounting and law firms throughout the Caribbean. These include Price-Waterhouse-Coopers, Deloitte & Touche, George Walton Payne & Co, and Fitzwilliam Stone, FurnessSmith & Morgan. Advantages of partnerships They are easy to form, as there are few or no legal requirements Each partner contributes to the capital of the business Responsibilities may be shared among the partners It allows for division of labour, as partners may have specialised skills There is privacy of affairs, as it is not compulsory to publish the partnership’s accounts. Disadvantages of partnerships Partners have unlimited liability, except for a limited partner Decision making may be tedious and slow There might be conflict among partners There is a lack of continuity – that is, once a partner leaves the partnership it has to be dissolved. The problem of limited liability may have led to the enactment of the Limited Liability Partnership Act 2000. This Act states that a partnership may be formed where all of its partners have limited liability. According to the Act: A limited liability partnership is a body corporate (with legal personality separate from that of its members) which is formed by being incorporated under this Act … The members of a limited liability partnership have such liability to contribute to its assets in the event of its being wound up as is provided for by virtue of this Act. The partnership must submit the required documents to the Registrar of Companies, who will regulate the partnership. 17 18 MODULE 1 | UNIT 1 | BUSINESS AND ITS ENVIRONMENT ACTIVITY 1. Identify five (5) firms within your country that are partnerships. 2. What are three (3) benefits of organising a business as a partnership rather than a sole trader? Limited companies This is a business unit that is regarded by law as an artificial person, distinct and separate from its members, i.e. its owners. There are certain legal requirements that must be met before a company is incorporated and starts trading. These are stipulated in a Companies Act. Two documents must be drawn up: a memorandum of association and articles of association. In Jamaica, under the Companies Act 2004, the articles of incorporation include these two documents. The Act also stipulates that ‘One or more people may form a company by signing and sending articles of incorporation to the Registrar’. In some other countries, however, individuals who want to form a company must submit both documents to the Companies Office. The memorandum of association should outline: The name of the company, including the abbreviation ‘Ltd’ or ‘plc’ The address of the registered office of the company The objects of the company and the scope of its operations Details of the company’s capital, i.e. both authorised and issued share capital. This list is not exhaustive, as other clauses may be included, depending on the type of company. The articles of association outline the internal running of the company and should include: The number of directors, the procedures for their appointment and their powers The rights of the shareholders Procedures for meetings Tenure of the directors before re-election The process for transferring shares. Having submitted the above documents and having satisfied the requirements of the Companies Office, the company will be issued with a certificate of incorporation. This certificate gives the company the right to trade. Finance and management A company’s main source of funding is from the shares that it issues (equity capital). However, the company may also be financed by debt capital (loans). The shares are issued to shareholders who become the owners of the company upon purchase. The number of shares will determine the level of control of each shareholder. Shareholders may not necessarily be the managers of the company, but at an annual general meeting (AGM) may vote for directors to carry out that role. These directors sit on a board which is headed by a chairperson. The board of directors is accountable to the shareholders and may be dismissed or voted out if its performance is below par. The company also has a secretary, who is entrusted with the responsibility of maintaining a register of shareholders, notifying them of AGMs and preparing the company’s annual reports. Types of company There are two main types of company: private limited companies and public limited companies. Private limited companies This is an incorporated business venture which is separate and distinct from its owners. Such a company is usually small in size and family owned. Its membership is limited to 50 individuals and its shares cannot be sold publicly – that is, on the stock exchange. Some well-known private limited companies in CARICOM include Digicel Group Ltd, Sugar Company of Jamaica Ltd, Barbados Shipping & Trading Co Ltd, ADM Import & Export Distributors Ltd, Columbus Communication Ltd and Advantage General Insurance Co Ltd. Main features of private limited companies Usually small and owned by family members or friends The name of the company must be registered Shares cannot be traded on the stock exchange Shareholders cannot sell their shares without the agreement of the other shareholders Limited liability Involve two to fifty people. Advantages of private limited companies Each shareholder has limited liability Continuity of existence There is greater capital potential, as shares can be sold to family members Lower possibility of loss of control to outsiders The company has a legal identity separate from that of its owners. Disadvantages of private limited companies Raising of capital may be hampered since shares cannot be traded publicly Profits have to be shared among a larger group of people CHAPTER 1 | ECONOMIC AND LEGAL STRUCTURES A copy of the audited financial statement must be submitted to the Companies Office (so a lesser degree of privacy than for partnerships and sole traders) Transfer of shares is limited by the approval of existing members Legal requirements may be time consuming and costly to implement. Public limited companies This type of limited company is usually larger than a private limited company. The abbreviation ‘plc’ is usually found at the end of its name. Public companies may be listed on a country’s stock exchange, where they can raise capital. In addition, the company may advertise its shares to prospective investors in a document called a prospectus. Some well-known public limited companies in CARICOM include Grace Kennedy, Cable and Wireless and Trinidad Cement Ltd. Like private companies, public limited companies must be registered with the Companies Office and issued with a certificate of incorporation indicating that trading can begin. Public limited companies differ from private limited companies in the following ways: Shares can be advertised to the general public in order to raise capital Shares can be bought and sold on the stock exchange This type of company usually indicates its status by including ‘plc’ in its name Must disclose their accounts at the end of the financial period. Main features of public limited companies Must be registered with the Companies Office Separate legal identity from that of its owners Can raise capital through the sale of shares to the public Managed by a board of directors elected by shareholders Limited liability for its owners. Some companies are incorporated as private limited companies but later choose to go public as they expand. Private companies may go public for the following reasons: To raise more capital so as to facilitate expansion To offer shareholders greater liquidity, as shares can be transferred on the stock market To gain prestige or status. Advantages of public limited companies Shareholders have limited liability – each shareholder is only liable to the amount he/she has invested in the business Continuity of existence Figure 1.6: A public limited company: the headquarters of telecoms company Cable and Wireless, Barbados 19 20 MODULE 1 | UNIT 1 | BUSINESS AND ITS ENVIRONMENT Easier to raise capital on a large scale Freedom to transfer shares via the stock exchange Better credit rating, therefore it is easier to secure loans Benefits from economies of scale due to size and lower production costs. Disadvantages of public limited companies Many legal requirements which may be costly and time consuming to implement There is a risk of takeover bids, as shares can easily be purchased on the stock exchange Published accounts can be viewed by the public, including competitors Can become large, impersonal and difficult to manage. Some public limited companies also own other companies. This can be in the form of holding companies, conglomerates and associate companies. Is there a difference between a holding company and a conglomerate? Essentially there is very little difference between these. A holding company is not usually involved in the day-to-day operations of the companies it controls (which are called subsidiaries). Each subsidiary also retains legal separation but is controlled by the holding company. It must be pointed out that a holding company can become a conglomerate if it expands and takes over a controlling interest in unrelated firms – that is, businesses with which it has nothing in common. As a result, the company would have a diversified range of business activities, which helps to minimise the risk of failing completely if just one of its markets fails. Associate companies An associate company is one that controls between 20 and 50 per cent of the shares in another company. Holding companies Cooperatives Public limited companies can also act as holding companies. A holding company is one that purchases enough shares of other companies so that it can control the decisions that are made by the board of directors and the policies that are implemented. For the most part, the holding company is formed to take over controlling interest in other companies. Having controlling interest in more than one company can minimise the risk of failure for the holding company. These companies can also benefit from economies of scale brought about by large-scale production and increased size. A cooperative is a form of business that consists of a group of people who have come together to perform a business venture that is more efficient being done collectively rather than individually. This form of business is common throughout the Caribbean and there are several types, four of which will be discussed later in this section. This form of business is expected to be registered with a Registrar of Cooperative Societies. It is owned and controlled by its members, who exercise their control by using their votes at annual general meetings. The business is financed Conglomerates Some companies expand over time and take over or purchase controlling interests in other unrelated companies. By doing so, a conglomerate uses this opportunity to produce different products and cater to different markets. One such company in the Caribbean is Grace Kennedy Group Ltd, which consists of a bank, a foreign exchange business, a hardware business, manufacturing businesses and a supermarket, among others. Figure 1.7: A cooperative business: a credit union, Belize CHAPTER 1 | ECONOMIC AND LEGAL STRUCTURES by the members who purchase shares. The cooperative may also seek funding from banks and other lending institutions. by its members – that is, those people with accounts at the credit union. Main features of cooperatives Advantages of cooperatives Democratic organisations – each member has a say Profits are distributed to their members equitably Each member has one vote Membership of a cooperative is voluntary. Types of cooperatives Consumer cooperative Members have limited liability Profit is shared among members Members have equal say in the operation of the business Economies of scale Opportunity to earn interest on investment. This type of cooperative is owned by its customers, who receive mutual benefits. It is organised to provide each member with items that are needed – at reduced prices. Each member contributes funds to purchase the items in bulk. The items are then sold at a reduced price to the members. Disadvantages of cooperatives Producer cooperative Franchises These are usually found in the agriculture sector. Farmers may be assisted in areas of production, purchasing and marketing. The members come together and share marketing and production facilities for the benefit of all. This move will allow them to benefit from economies of scale through bulk buying of supplies such as fertilisers, which in turn lowers their production costs. A franchise is a system whereby an already established and successful business (the franchisor) enters into a contractual arrangement with semi-independent business owners (the franchisee) to operate under the franchisor’s trade name. The franchisee may also be given permission to sell the franchisor’s products and use its business format and system. This privilege is often granted in exchange for a fee and royalties being paid to the franchisor. There are a number of franchise businesses in CARICOM, including Kentucky Fried Chicken, Burger King, Subway and McDonald’s. The Workers’ cooperative A workers’ cooperative is owned, controlled and operated by its members. The cooperative provides its members with employment and they are able to influence the operation of the business. Each member contributes through the purchasing of shares and also benefits from a share of the profits. Financial cooperative Like any type of cooperative, this is also controlled and operated by its members. The main aim of financial cooperatives is to provide its members with different financial services at competitive rates. These services may include banking, investment and even insurance. The most popular form of financial cooperative is a credit union. A credit union’s resources can be accessed only Profits may be minimal or even non-existent There is a possibility of conflict among members Longer decision-making process Capital deficiency may impede growth. Figure 1.8: A franchise 21 22 MODULE 1 | UNIT 1 | BUSINESS AND ITS ENVIRONMENT franchise arrangement may take different forms, including those outlined below: Pure franchise – this a type of franchise in which the franchisor sells the franchisee the complete business format and system Product distribution franchise (or dealer franchise) – here, the franchisee is given a licence to sell products under the franchisor’s name and trade mark through a selective and limited distribution network Trade name franchise – this is where the franchisee purchases the right to use the franchisor’s trade name. Advantages of franchise The franchisee receives management training and support Brand name appeal, since the brand is already established Advertisement by the franchisor will also benefit the franchisee The quality of the product is maintained in order to protect the reputation of the franchisor The products and business format are tested and proven Availability of financial assistance to the franchisee. Disadvantages of franchise The franchisee must pay a fee and royalties to the franchisor There must be strict adherence to the standards outlined by the franchisor The franchisee may not be able to deviate from the product line of the franchisor Market saturation may lead to failure of the business. Joint ventures A joint venture is a business that is jointly owned by two or more parties or firms in order to undertake an economic activity. Both parties continue their original operations separately but pool their resources to carry out the purpose of the venture. There should be an agreement to contribute capital to the entity, and to share revenues, expenses and the control of the business. While a joint venture is similar to a partnership, it is usually formed for a short time, with a limited or specific purpose. For example, in 2001, PriceSmart Inc announced its joint venture arrangement with Restaurant of Jamaica to establish a store in Jamaica. In 2008, Production Services Network (PSN) formed a joint venture with Kenson Production Services Ltd, based in Trinidad. The reasons for firms entering into a joint venture arrangement may include: Fostering expansion by utilising another company's resources To make use of other firms’ established distribution channels and dealership Diversification of the product line To gain access to advanced technology and expertise To share costs and risk involved with the establishment of the venture. The parties involved in the joint venture should draft a written agreement, including, but not limited to, the following matters: Objectives of the venture Parties involved in the venture Amount of funding each party will contribute Responsibilities of each party Management of the venture. Advantages of joint ventures Parties share assets which leads to fixed costs being spread over production, therefore lowering costs of production Fosters specialisation since labour and management are shared between parties Easily dissolved There is greater access to resources, including technology Firms benefits from expansion. Disadvantages of joint ventures Parties may have disagreements Differences in culture and strategies may lead to poor integration Decision-making process may be long and tedious Loss of independence. Changing the legal structure Even though a firm may have been established with one type of legal structure, over time this may change. From time to time a firm may opt to change its legal structure. This is often motivated by either growth of the firm or a desire to secure more funding, among other things. So, a sole trader may convert to a partnership because the owner is in need of additional funds. Likewise, a partnership may decide to convert to a limited company in order to minimise the risks from continuing with unlimited liability. While there are benefits to be derived from changing the legal structure of a business, it can also bring about certain problems. Table 1.1 evaluates the benefits and problems associated with changing from one legal structure to another. CHAPTER 1 | ECONOMIC AND LEGAL STRUCTURES CASE STUDY Tanya Taylor’s choice of business Having received her law degree and completed her training, Tanya Taylor was recently accepted to the Bar Association. Tanya is now optimistic, with a number of grand ideas to implement when she starts her own firm practising corporate law. She has managed to gather some funds which she thought would be sufficient for start-up. However, as Tanya started doing the necessary paperwork she realised that she would have a shortfall in start-up capital if she needs to pay the rent, buy office furniture and pay utility bills and her secretary. This situation is now causing Tanya to think twice about starting a business and she is beginning to think she will probably just continue working for her current employer. While she is trying to figure out her next move, Kayan, a friend from law school, calls her to see how she is doing after graduation. Tanya relays her situation to her and Kayan decides to pool some funds to lend to Tanya at the end of the month. A week later, Kayan calls to say that another friend is interested in the business and suggests that instead of lending Tanya the money they would want to come on board and start the business together. The idea sounds good to Tanya and so she agrees. Questions 1. What type of business was Tanya going to establish initially? (1 mark) 2. What would have been three (3) advantages and three (3) disadvantages of starting that type of business? 3. Based on the fact that her friends are coming on board, which type of business would be the most suitable, bearing in mind the service that they are offering? Give three (3) reasons for your choice. 4. Outline one (1) benefit and one (1) drawback to Tanya if she had opted to take the loan instead of going into business with her friends. (12 marks) (8 marks) (4 marks) Total 25 marks Table 1.1: Benefits and problems associated with a change in legal structure Change in legal structure Benefits associated with the change Problems associated with the change Sole trader to partnership Possibility of greater financing Less work for each person Greater pool of ideas Profits will now have to be shared More people make the decision-making process longer One bad decision by one partner may affect all More legal documents required, e.g. a partnership deed Partnership to private limited company Limited liability Continuity of existence even if an owner dies or leaves Possibility of greater financing The business and its owners are no longer one, as it is a separate legal entity Greater legal requirements Longer decision-making process The company may be required to submit its accounts to the Companies Office Private limited company to public limited company Greater financing Can sell shares to the public Accounts of the company must be published There is a risk of takeover bids which will result in loss of ownership Can become too large and suffer from diseconomies of scale Loss of privacy The public sector The public sector includes businesses that are owned and controlled by the government or local authorities of a country. The main purpose of these businesses is to provide some form of benefit to society and not to make profits. 23 24 MODULE 1 | UNIT 1 | BUSINESS AND ITS ENVIRONMENT Public-sector organisations Public corporations Nationalised industries Statutory boards Government departments Local authorities Figure 1.9: Public-sector organisations Public corporations Public corporations are owned and controlled by the government. They are usually formed by an Act of Parliament as a separate legal entity. The capital outlay and financing for these corporations come from government funds acquired mainly through taxation. Unlike privatesector organisations, public corporations are not aimed at making profits but rather at providing an efficient public service at the lowest possible price. Main features of public corporations Funding comes mostly from grants Main aim is not to make profits Annual accounting records are sent to the Auditor General Managed by directors appointed by the state. Public corporations are controlled by a Minister of Government who will appoint a board of directors to deal with the day-to-day operations. The business has unlimited liability and the state has to bear its debts. State corporations are often found in areas of transportation, telecommunication, postal services and utilities companies, e.g. electricity and water. Some possible objectives of public corporations are: To create employment for citizens To provide goods or services that are needed in the country To keep prices affordable to all Profits are usually ploughed back into the country through infrastructural developments and other government spending. Nationalised industries Nationalised industries are enterprises that have been taken over by the government from private-sector organisations. In order to nationalise an industry, the government will purchase the majority of the company’s shares. The government will then appoint a board of directors which will deal with the management of the company. A private-sector enterprise may be nationalised for a number of reasons, including the following: To save an essential enterprise that is in danger of closure. The closure of such an enterprise may have lasting implications for the citizens and the economy of the country. For example, the Guyana Sugar Corporation and the sugar companies in Jamaica were nationalised in the 1970s. The government may want to provide certain goods and services that would not otherwise be produced by the private sector or might be limited in their production. This is evident in most Caribbean territories’ transport services and the provision of roadways. Where consumers’ interests are in danger of being violated through the formation of monopolies, the government may nationalise the industry in an attempt to prevent this from happening. There is a common view that public monopolies will be better able to cater for consumers’ interests than private monopolies. Nationalising certain industries may offer social benefits to the citizens of the country. A public transportation sector may be able to offer subsidised fares for the disabled, elderly people, children and public-sector workers. These benefits may not be possible with private-sector ownership. The nationalisation of certain resources and industries ensures that profits remain in the country. Unlike the case of multinationals which repatriate profits, the profits from nationalised firms are revenue for the government and can be ploughed back into the country’s funds. Advantages of state corporations and nationalised industries The products and services offered are usually lower in price than those of other firms They increase employment opportunities Essential services that may be very expensive may be undertaken by the government Products are standardised and uniform Struggling firms can be taken over by government Resources are used in ways to benefit the community. Disadvantages of state corporations and nationalised industries Where state-owned companies are monopolies, there is little choice for consumers Large debts may cause a burden on taxpayers Some state-run enterprises suffer from gross inefficiencies Politics may interfere with the running of these businesses. CHAPTER 1 | ECONOMIC AND LEGAL STRUCTURES Statutory boards These are controlled by the state but operate with a board of directors partially appointed by central government. Each board is answerable to a particular ministry in the government. Each entity is given specific responsibility for some aspect of the country. These are common in CARICOM in areas of housing, water, scientific research, agriculture and transport. Examples of statutory boards are the Jamaica Tourist Board and the Statistical Institute of Jamaica. Most statutory boards are similar to public corporations in terms of formation, structure of management and objectives. Government departments These are divisions or ministries of the government that facilitate interaction with local authorities and nationalised industries. Each department is headed by a Minister who is appointed by the Prime Minister. These departments are created to carry out various services, such as: Implementation of government policies Monitoring operations within the country and ensuring that there is compliance with the law Performing the duties and responsibilities stipulated by the state. These departments are non-profit organisations and are funded from the tax revenue of the country – for example, the Auditor General’s Department. Local authority and municipal undertakings This type of public-sector organisation deals with the affairs of government at the local or community level. The functions, powers and duties of local authorities are determined by an Act of Parliament. Local authorities are controlled and managed by councillors who are elected by the local citizens. These councillors form the council which is headed by a mayor. They make and implement policy decisions on the management of the town or city. Some of their responsibilities include: Construction and maintenance of drains Cleaning of gullies Garbage disposal Water supply Maintenance of parks and markets. Local authorities and municipal undertakings are financed by grants from central government, rents, council taxes, business rates and trading activities. Advantages of local authority and municipal undertakings Relevant issues at the local level can be addressed Citizens can be more involved in decisions that affect them Promote democracy. Disadvantages of local authority and municipal undertakings Some projects may be stalled or shelved when there is a change in government Politics may interfere with the management of certain projects. Not-for-profit organisations Charities There are a number of charity organisations in the Caribbean and around the world. These businesses are formed for the main purpose of helping the less fortunate or disadvantaged in society. While these charities are run based on business principles, they rely heavily on donations from the business community, governments and international organisations. Some of these organisations also raise finance from hosting benefit concerts or plays or may even sell memorabilia. Some examples of such charities in the Caribbean are The Red Cross, Food for the Poor and The Jamaica Cancer Society. The legal requirements for the formation of charities may not be overbearing but these organisations must be established based on the framework outlined by the relevant Companies Office. In Jamaica, for example, the charity must be registered with the Companies Office of Jamaica. It must register its name and also submit articles of incorporation to the office. In Barbados, the charity has to abide by the stipulations as mentioned in the country’s Charities Act. Other Caribbean countries may have their own requirements for formation of charitable organisations. These organisations are often exempt from certain statutory obligations such as paying taxes or duties on imports. The exemptions may vary, depending on the territory in which the charity is located. Non-governmental organisations These organisations are commonly referred to as ‘NGOs’ and are not influenced by government. NGOs are non-profit making, voluntary citizens' groups which are formed at local, national or international level by individuals or institutions with common interests. They are usually formed to: Provide humanitarian functions Lobby governments on behalf of citizens Offer aid and relief, especially in time of disaster Address issues such as education and health care. Different NGOs may also provide a number of other services. However, NGOs are not formed by governments; neither do they answer to the government of a country. Some examples of NGOs are the United Nations, Jamaicans for Justice, Barbados Nursing Association, and Trinidad and 25 26 MODULE 1 | UNIT 1 | BUSINESS AND ITS ENVIRONMENT Tobago Association of Psychologists. Further information on NGOs across the Caribbean can be sourced from the Caribbean NGO Database. ACTIVITY Discuss the potential problems that may arise if a business changes from: Sole trader to partnership Partnership to limited company. Privatisation In recent times, governments in the Caribbean and around the world have been divesting and handing over ownership of a number of public corporations. For example, in 2001 the Jamaica Public Service was sold, which is one of many companies in Jamaica that have been privatised. Privatisation is the change of ownership of a firm from state (government) to private individuals. Privatisation may take different forms, including: Direct sale of nationalised industries or public corporations to individuals in the private sector Removal of barriers that prevent public corporations from competing. This is referred to as ‘deregulation’ and has happened in, for example, the telecommunications industry Contracting out services that would otherwise be rendered by the public sector, such as cleaning services. The government may privatise public corporations for different reasons, such as: To generate much-needed income to fund projects or take off budget shortfall To improve efficiency in these businesses which may benefit consumers It can no longer afford to finance and operate these entities To share ownership of resources and encourage competition. Privatisation offers benefits to the country and the government but it also has some disadvantages. Disadvantages of privatisation May cause private monopolies to develop, which may exploit consumers Income generated from the sale of nationalised industries is a one-off receipt and cannot be repeated if future needs arise If private firms are not regulated then there might be degradation of the environment through overproduction Private individuals’ main aim is to make profits and if this is not realised then the privatised business might be closed down. CASE STUDY Privatisation The Jamaica Public Service Company (JPS) was incorporated in 1923 as a privately owned company. JPS was established at a time when several communities had their own electric companies, however, it quickly took over and bought out these companies. It was eventually given the licence to operate as the sole supplier of electricity in Jamaica in 1966. The ownership of JPS changed in 1970 as the government took over the controlling interest in the company. For the next 31 years, the government would have to make the necessary capital injections and take steps to improve the efficiency of the company. With its equipment becoming old and the firm being a strain on the public purse, coupled with regular power outages, the decision was taken by government to privatise the company in 2001. The government sold 80 per cent of ownership to Mirant while retaining almost 20 per cent. This move was said to benefit not only the company but its customers. Questions 1. Discuss four (4) possible reasons why a company such as JPS was nationalised in 1970. 2. What is meant by the term ‘privatisation’? 3. Outline three (3) benefits and three (3) drawbacks of privatising a publicly owned company such as JPS. (12 marks) (1 mark) (12 marks) Total 25 marks CHAPTER 1 | ECONOMIC AND LEGAL STRUCTURES CHAPTER SUMMARY The three types of business activity are primary, secondary and tertiary Organisations are classified as private or public sector The private sector consists of businesses that are owned by individuals or group of individuals with the main aim of making profits The private sector includes sole traders, partnerships, franchises, limited companies, cooperatives and joint ventures The public sector includes businesses that are owned and controlled by the government or local authorities of a country MULTIPLE CHOICE QUESTIONS 1. A firm offering management services to its customers would be regarded as what level of business activity? a. Primary b. Tertiary c. Temporary d. Secondary 2. Which of the following would NOT be regarded as a privatesector organisation? a. Holding company b. Public company c. Associate company d. Conglomerate 6. Burger King in the Caribbean would best be described as a: a. Sole trader b. Public corporation c. Franchise b. Public limited company d. Cooperative d. Partnership 3. Which business organisation has as a feature separate legal identity? 7. The process of government taking over enterprises that were in the private sector is known as: a. Globalisation b. Privatisation a. Sole trader c. Nationalisation b. Company d. Liberalisation c. Partnership d. Franchise 4. ALL of the following are included in the articles of association, EXCEPT which one? Privatisation is the change of ownership of a firm from state (government) to private individuals. 5. A company that controls other companies but is not involved in their day-to-day operations is known as: a. Franchise c. Public corporation The public sector includes public corporations, government departments and local authorities 8. The following are reasons for nationalisation EXCEPT which one? a. To offer social benefits b. To crowd out investors a. The rights of the shareholders c. To protect consumers b. Procedures for meetings d. To provide certain goods and services c. The process for transferring shares d. Details of the company’s capital 27 28 MODULE 1 | UNIT 1 | BUSINESS AND ITS ENVIRONMENT 9. Which of the following is NOT a type of cooperative? a. Worker cooperative 10. The government may privatise public corporations for the following reasons EXCEPT which one? b. Owner cooperative a. To generate much-needed income c. Producer cooperative b. To improve efficiency d. Consumer cooperative c. To lay off workers d. To encourage competition Extended Essay Questions Question one a. Explain the three (3) levels of business activities. Total 25 marks (6 marks) b. Briefly explain how the Caribbean’s dependence on primary products such as bauxite, oil and agricultural produce could become troublesome in the future. (4 marks) In recent times, a number of Caribbean businesses that were once owned by the state have been sold to private businesses and individuals. (9 marks) c. i. Discuss three (3) possible reasons for this decision by Caribbean governments. ii. Outline three (3) disadvantages of privatising these firms. (6 marks) Question two Total 25 marks a. Identify two (2) features of a sole trader and three (3) features of a partnership. (5 marks) b. Billy Barns has been the sole owner of his dairy farm for the last 25 years. Under his leadership the farm has grown significantly and he has expanded his operations into making dairy products such as cheese, boxed and bottled milk, etc. Now that his children have grown and are old enough to make business decisions, Billy is considering changing his type of business organisation to a private limited company called Barns Dairy Ltd. Before doing so, however, he has come to you, a management consultant, for advice. Citing at least five (5) points, discuss how Billy would be better off setting up as a private limited company when compared with his current legal structure. (20 marks) 29 2 LEARNING OBJECTIVES: At the end of this chapter students should be able to: Explain the nature, role and importance of objectives Differentiate between the types of objectives Write meaningful and relevant objectives Outline the hierarchy of objectives Discuss the ethical and social responsibility of businesses Nature, role and importance of objectives What are objectives? N o matter what we do in life, we ought to have an idea of where we want to reach and how we plan to get there. We all have objectives. For you, it may be to get at Grade One in your Management of Business Unit 1 exam or to achieve all distinctions in your CAPE subjects. With this in mind, objectives can therefore be defined as specific targets of performance. They are an organisation’s performance targets – that is, the results and outcomes it wants to achieve in a particular time frame. An objective should contain the action to be performed, the condition under which it will be performed and a time frame in which it should be performed. However, there are times when all three components might not be present in an objective. In such a case we refer to it as a ‘partial objective’. These partial objectives should contain the action to be performed and a time frame in which the action should be performed. Well-written objectives should have the following characteristics, which form the acronym ‘SMART’: Specific – objectives should be quantifiable and precise: for example, ‘To increase retail sales by 15 per cent’. This objective is precise and states exactly what management wants to accomplish. Compare it with this example: ‘To achieve healthy growth in sales’ (this is not meaningful as ‘healthy growth’ is too wide and can easily be misconstrued). Broad and ambiguous objectives can lead to chaos as their interpretations Business Objectives may vary among employees. The targets of the business must be clearly stated without any ambiguity and must be properly communicated to all employees of the organisation. Measurable – managers should be able to plot the organisation’s progress toward its objectives. This requires a well-defined reference point from which to start and a scale for measuring progress – for example, ‘To increase retail sales by 15 per cent by the end of this financial year’. With this objective, the managers can measure the business progress over the 12-month period until the financial year has ended. They can take the necessary action, if needed, from early on to prevent a shortfall in their sales target for the year. Attainable (or Achievable) – while the objectives should encourage people to work harder, achieving them must be within their reach. This is to say that the objectives should be not so extreme that they are impossible for the firm to attain. When writing objectives, firms must take into consideration their ability to achieve them within the expected time frame. While being achievable, objectives must also be challenging. This will motivate and encourage employees to work hard and propel the business forward. Workers may consider work boring if they are not challenged in their bid to reach the expected targets of the business. The more challenging objectives are, the higher the performance will be. Relevant (or Realistic) – many businesses have failed because they set unrealistic and irrelevant objectives, especially in their earlier years. As a result, a large amount of money is spent irrelevantly, perhaps to take on investments or a large advertising campaign which could have been delayed until the company is established. The objectives must be relevant for the firm given its market share, resource base and employees’ capabilities. Timely – earlier we stated that the business should track the achievement of its objectives over a period of time. With this in mind, objectives must specify not only what is to be achieved but also a time frame for its achievement. 30 MODULE 1 | UNIT 1 | BUSINESS AND ITS ENVIRONMENT ACTIVITY Below is a list of objectives. You are required to state whether or not each objective is written properly, explaining your answers. a. A mobile phone service provider has a target of ‘reducing customers’ complaints from 6 per cent to 3 per cent within the next 12 months’ b. A cricket team wants ‘to improve performance in the future’ c. A wellness centre and spa sets an objective of becoming ‘the best in the market’ d. A hardware firm has the objective of ‘increasing sales revenue by 5 per cent this year’ e. A local tinned food manufacturing business desires to ‘increase market share from 15 per cent to 60 per cent within the next four years’. Importance of objectives It is important that we realise that being successful will never mean that there may not be failures, since success can be judged by our ability to achieve the objectives that were established. For a business to become successful, it needs to outline measurable and achievable objectives. As mentioned above, they must be ‘SMART’. This will give the employers, employees and clients or customers a clear vision of where the business is going and how it plans to get there. The importance of objectives is outlined below: Objectives act as a guide for employees and the employer to follow in order to propel the business forward and thus attain its goal They give employees a sense of direction as to where the business is going Objectives are also used as a tool to analyse the performance of the business and its employees over a period of time They are important in the decision-making process, as they provide a guide and framework for management to make decisions. They are used to help management to explore different courses of action or try different business strategies Objectives function as a yardstick for tracking an organisation’s performance and progress. For example, having an objective to reach a desired profit by year end will mean that the firm can track its monthly profit to ascertain whether it is still in line with the objective Objectives can also be used to set targets for individual departments as the firm aims to achieve its corporate objectives. Types of objective Objectives can be broken down into short-term, mediumterm and long-term objectives, based on the time frame in which they should be achieved. These are outlined below. Short-term objectives These are sometimes referred to as ‘specific objectives’. These are outcomes that a business wants to accomplish within a short period of time – usually a year to 18 months. The period of time set for the accomplishment of these objectives may vary across businesses. These objectives are the most critical for newly established businesses, and can be broken down, in terms of their achievement, on a monthly, quarterly or yearly basis. An example would be ‘To earn at least 5 per cent profit after the first year of trading or to earn revenue of $1m in year one’. Medium-term objectives Medium-term objectives are usually less general than long-term objectives. They form the basis on which shortterm objectives are written and the stepping stone for the achievement of long-term objectives. Medium-term objectives are usually written for a period of one to four years. An example of such an objective would be ‘To increase the firm’s product line in two years’ time’. Long-term objectives These are sometimes referred to as ‘general objectives’. Longterm objectives are often developed from the firm’s mission statement and describe where the organisation wants to be at some point in the future, usually five years or more later. These can be more general, but should give the reader an indication of the overall direction of the business. Some business owners find it advantageous to look to the fiveto ten-year mark as well as to clearly define where they would like to steer their business. Example: ‘To become the dominant firm in the automobile industry within six years’ time.’ This dominant position is the general or overall target which most firms would plan to achieve at some point in their existence. The firm may also want to achieve a growth target – for example, ‘To expand and set up physical business locations in at least three Caribbean countries by year ten’. However, in order to achieve the general objective, the specific and more medium- and short-term targets must first be achieved. CHAPTER 2 | BUSINESS OBJECTIVES Hierarchy of objectives Objectives can be broken down into different categories, as seen in Figure 2.1. As we ascend on the hierarchy, the objectives become broader and more general. At the pinnacle of the hierarchy is the business’s aim. An aim or vision is where the business wants to go in the future. It is a statement of purpose – for example, the business aims to expand its market share across the Caribbean. The vision of the firm is often broad, with very few specifics as to when it will be achieved. The vision gives an idea of the firm’s plans for development and is also used as a tool for marketing, especially for potential investors. The vision statement of a firm must be able to motivate workers by giving them drive to accomplish beyond what is happening at present. While the terms ‘goal’ and ‘vision’ are sometimes used interchangeably, the vision outlines the firm’s goal which is said to be a desired future outcome that the organisation attempts to realise. The overall aim of the organisation should form the firm’s mission statement and objectives. Mission statement This is a statement which outlines the main aim of a business or company. A mission statement gives a clear outline of the business’s aspirations and values. It enables all the stakeholders (employees, managers, customers and suppliers) to understand the underlying reasons for the actions that are taken by the business. While the firm’s vision outlines where it hopes to be in the future, the mission statement usually says what the firm sets out to do during its operation. A good mission statement carries a number of elements which will give a clear indication of the strength and effectiveness of such a mission. A well-written mission statement should: ion Aims / Vis Give a clear indication of the purpose of the organisation Outline the legitimacy of the organisation Clearly describe the organisation’s values, objectives or targets and reason for existence Be customer focused or oriented and at the same time catering to the needs of the employees and other stakeholders Outline the products that are being offered and its desire to maintain these State the firm’s commitment to the fulfilment and satisfaction of customers’ needs Signal how it will maintain a competitive edge over its rival organisations. ACTIVITIES 1. Find a copy of your school’s or a business’s mission statement and analyse it to see whether any of the above elements are present. 2. Write a brief mission statement for a business of your choice. The business should be given a name and mention must be made of the product being sold. From the mission statement the organisation will construct objectives which will clearly outline the plan of action that it will take in order to fulfil its overall mission. These objectives must be stated in a form that is measurable and attainable – that is, that management must be able to ascertain whether the firm is achieving them. Failure to achieve the lower-level objectives usually results in failure to achieve the mission or vision of the firm. Corporate objectives The basic purpose of the organisation especially for the external audience Mission te Corpora es objectiv jectives ic ob Strateg l Tactica es bjectiv o tional Opera es bjectiv o Figure 2.1: The hierarchy of objectives Senior management, the organisation as a whole Middle management, major division, function Lower management (departments and individuals) Having established its vision and mission, it is essential for a business to develop its corporate objectives. These will give an understanding of how the business plans to achieve its vision and mission. Vision and mission statements are broad and general, therefore the corporate objectives help to narrow the focus. Corporate objectives can therefore be defined as specific, realistic and measurable aims which an organisation plans to achieve within a given period of time. These objectives are usually written as longterm objectives with a time frame of five years or more. Both corporate and strategic objectives, which will be discussed below, are often set by top or senior 31 32 MODULE 1 | UNIT 1 | BUSINESS AND ITS ENVIRONMENT management. An example would be ‘To increase profits by 40 per cent in all divisions within the next five years’. Other corporate objectives could focus on maximising sales revenue, growth or expansion; the expected return on investment; or even the firm’s broader corporate social responsibility. CASE STUDY Lack of direction at JK Foods Some firms do not have a separation of their corporate and strategic objectives. However, strategic objectives are usually medium to long term and relate to outcomes that strengthen an organisation’s overall business position and competitive vitality. They refer to an organisation’s articulated aims or responses to address major change, improvement or competitiveness and outline how the firm plans to accomplish its corporate objectives. Some examples of strategic objectives are: To be ranked in the top five of the best hotel accommodation in the country in terms of market share by three years’ time To concentrate on innovation as the way to satisfy our customers in order to gain 20 per cent increase in sales by two years’ time. ‘To become the best processed food company in the whole wide world’ is the objective that is being used JK Foods. This has been its only objective since the firm was established two years ago. The company has suffered huge losses in the past two years. The board of directors has become concerned and has called a special meeting to identify strategies to improve the company’s performance. The decision coming out of the special meeting is formally to set some realistic targets to work with. Even though cash is limited, the directors decided to engage the services of a management consultant to help in the process. Upon his arrival at the company, Tom Greaves was alarmed that it had been established without any proper vision, mission and achievable targets. He explained to the directors that the way forward would involve an overhaul of the business’s vision, mission and objectives. He pointed out that the current objective is not ‘SMART’ and will have to be changed. Everyone is committed to the cause, and the work to turn the company around will begin soon. Tactical objectives Questions Strategic objectives are sometimes called tactical objectives. They are performance targets established by middle management (department heads) for achieving specific organisational outcomes. They are plans designed to help execute the major strategic objectives and to accomplish a specific part of the organisation’s strategy. Tactical objectives are usually short- to medium-term targets which the firm is expected to achieve within a year or close to a year. An example would be ‘To improve productivity by 6 per cent this year or to increase sales revenue by 10 per cent for this financial year’. 1. Outline two (2) things that are wrong with the objective (4 marks) being used by JK Foods. Strategic objectives 2. State three (3) reasons why having a proper mission (3 marks) statement is important to JK Foods. 3. Tom Greaves suggested that objectives should be ‘SMART’. Explain the acronym as it relates to writing (10 marks) objectives. 4. List the four (4) levels of objectives that JK Foods may want to develop and give one (1) example of each that it (8 marks) could use. Total 25 marks Operational objectives Operational objectives are short-term organisational objectives necessary to achieve longer-term tactical and strategic objectives. They are usually managed by lowerlevel management such as supervisory personnel who are concerned with immediate results. They are detailed costed and timed plans of what the organisation will do to meet each tactical or strategic objective. For example: an insurance company may have an objective to introduce at least five more clients to the business each month. Business ethics and social responsibility The Caribbean business environment is changing and more Caribbean governments are becoming aware of the damage that is being done to our environment and society by some of our factories and business organisations. It is more commonplace to hear about protecting our coral reefs and marine life; prevention of land slippage through reforestation exercises; reducing the depletion of the ozone layer through a reduction in emissions from our factories and motor vehicles, among other things. Governments have CHAPTER 2 | BUSINESS OBJECTIVES not only embarked on massive environmental protection campaigns; they have encouraged, and at times forced, organisations to do likewise. This has encouraged many businesses to change their strategies to include objectives of an ethical and/or social nature. This can also be attributed to adverse or bad publicity that is being faced by these businesses which is perceived as damaging to stakeholders and the wider world. ACTIVITY Identify a business within your country that has been taken to task in recent times for doing something that is socially or ethically irresponsible. Changes in legislation at local, national and international levels can also be attributed to this move by businesses. Organisations such as the National Environmental Protection Agency (NEPA) in Jamaica have filed lawsuits against companies against whom it has evidence of damage being done to the environment. At least one hotel was brought before the courts for alleged breach of the environmental laws in Jamaica. A proposal by the bauxite companies in Jamaica to mine in the Cockpit Country in the parish of Trelawny was turned down by the government because of environmental concerns. Consumers and other stakeholders are reacting positively to businesses that act in a socially responsible way. There have been lobby groups encouraging consumers to refuse to purchase products that were tested on animals or products containing CFCs. In addition, some businesses have dedicated a portion of their yearly budget to the minimisation of pollution and the improvement of their social responsibility. This is a practice of firms to act in a manner so that their actions do not negatively affect society or the environment. Some examples of these include: Producers who use recycled materials in the manufacture of their products. Some producers have also encouraged consumers to recycle their packaging, for example the repurchasing of plastic drinks bottles for recycling. CASE STUDY Scotiabank’s commitment to corporate social responsibility The thrust of corporate social responsibility (CSR) has always been the hallmark of Scotiabank’s business strategy. This is evident in the following statement: ‘We have taken pride in creating value for our shareholders, fulfilling our customers’ unique financial needs, providing employees with rewarding careers, and supporting the well-being of our communities.’ To this end, Scotiabank established the Scotiabank Jamaica Foundation (SJF) in 1996, with an injection of $100 million. As part of its mandate, the Scotiabank Jamaica Foundation ‘is guided by the principles to assist in alleviating poverty, deprivation, distress among economically and socially disadvantaged individuals and their dependents: and to undertake research into these problems, along with Figure 2.2: Scotiabank methods of addressing them’. To this end, the bank has spent large sums of money to assist in the areas of education, health and community projects, among other things. Another hallmark of Scotiabank’s commitment to CSR is its ‘Bright Future Program’ which was launched in 2008. As part of this program Scotiabank seeks to create opportunities to touch the lives of children across the Caribbean.The program endeavours to provide hope to youths through supporting education, the arts and culture, the environment and the underprivileged and abused. It has contributed to International Women’s Day, Read Across Jamaica Day and the Bustamante Hospital for Children. Questions 1. What is meant by the term ‘corporate social responsibility’? (2 marks) 2. What are some of the areas where Scotiabank’s CSR was evident? (4 marks) 3. Name two (2) benefits that Scotiabank could receive from its involvement in CSR. (4 marks) Total 10 marks 33 34 MODULE 1 | UNIT 1 | BUSINESS AND ITS ENVIRONMENT Obligations of the firm to stakeholders The firm’s social responsibilities can span four stakeholders of the business in different ways. These are summarised in Table 2.1. Stakeholders The firm’s responsibilities to the stakeholder Consumers Ensure that they get value for their money Fair and truthful advertisements Ensure that products are safe and are of the highest standards Offer after-sales service Employees Foster participation of employees in decision making Provide proper working conditions Fair treatment of all employees Maintain proper communication lines, especially where employees will be affected by a change or decision Provide opportunities for social gatherings, whether through family days, parties, etc. Shareholders Give fair returns on shareholders’ investment Keep them informed of the business’s performance Provide a forum through which they can express views and give suggestions Protect their investment Community Ensure that waste is properly disposed of Reduce pollution, including that from air and noise Lessen displacement caused by the building of factories or roadways Give back to the community in which it operates Table 2.1: The firm’s social responsibilities to stakeholders Good corporate governance Corporate governance is often defined as a set of rules, practices and processes which guide the way a business is operated. The aim of corporate governance is to balance the interest of the stakeholders of the company – that is, the firm must cater for the needs and interest of its stakeholders as much as is possible. For this to be achieved, though, the board of directors should ensure that meaningful and healthy relationships are created with shareholders and other stakeholders. A firm which has good corporate governance will find it easier to achieve its objectives. In many companies we find that the owners (shareholders) are not necessarily the people who are in control on a day-to-day basis. Instead, these shareholders often employ paid managers and professionals to operate the firm. The sad reality is that sometimes board members may not always act in the best interest of the shareholders. Good corporate governance is therefore needed to ensure that the interests of shareholders are catered for – it ensures that the rights of shareholders are not infringed; that they, along with other stakeholders, are treated fairly and equitably; and promotes disclosure and transparency on the part of management. Today, most firms are operating within a competitive global environment and, as such, being a good corporate citizen is of the utmost importance. While aiming to generate a profit, the firm must also prove itself as being aware of the environmental impact of its operations and take steps to lessen that impact. A firm with poor corporate governance may find it difficult to attract potential investors. It could also lead to financial collapse, failure of privatisation attempts and an increase in corruption. Importance of business ethics and integrity Presently, in most territories, there are some laws preventing businesses from damaging the environment. However, some actions cannot be prevented by the enactment of laws. Therefore businesses are also encouraged to act ethically in their operations. Ethics defines what is right or wrong – or what is moral. It refers to the principles or guidelines that help to inform individuals or groups of individuals of how they should behave. This definition is largely dependent on the norms of society and what is accepted over time. Business ethics refers to the morals or set of standards that are used to guide a business on how it should conduct its affairs. This usually includes written and unwritten codes on how businesses should behave. Some common ethical issues within CARICOM include: The testing of products on animals The use of child labour How employees deal with customers Truthful versus deceptive advertisements. Code of ethics This is a document issued by the firm, outlining the set of guidelines that will be used to govern the behaviour of management and employees. This code is often based on a set of pre-established standards or principles and usually includes: The firm’s corporate social responsibility statement The relationship that the firm has with its customers and suppliers Environment requirements and unanswered questions Rules on relating to the maintenance of integrity. CHAPTER 2 | BUSINESS OBJECTIVES Government’s response to social irresponsibility CHAPTER SUMMARY The following steps can be taken by governments to deal with businesses that are being socially irresponsible and unethical: Impose taxes to offset the cost to the environment (social cost) Pass legislation limiting noise and other forms of pollution Refuse to give contracts to companies that are unethical or socially irresponsible Impose stiff penalties. Objectives that are well written should be SMART – that is: Specific, Measurable, Attainable, Realistic and Timely Long-term objectives are general and give the overall direction of the firm in the future Short-term objectives are specific and outline what the firm wants to achieve in a short period of time The hierarchy of objectives outlines the firm’s vision; mission statement; and corporate, strategic, tactical and operational objectives CASE STUDY A ‘toxic nightmare’ Over 100,000 people on Covory Isle woke up to what is now dubbed a ‘toxic nightmare’. This happened after a cash-rich and powerful multinational chemical producing firm (Chemi-Prod Inc) dumped waste along the coast of the small island. The situation infuriated the residents, who called in the relevant authority to look into the situation. Upon investigation it was found that an entire shipment of highly toxic waste was illegally disposed of along the coast. Further inquiry revealed that the company was faced with a transportation cost that had quadrupled since the agreement was made with the company TranSecure. Rather than face this cost, Chemi-Prod Inc instructed its staff to dump the waste in the most secretive and least costly way. Since the revelation, Chemi-Prod Inc has faced numerous criticisms and threats of lawsuit by environmental agencies and other pressure groups. If the lawsuits were to be successful, the firm could be asked to pay out billions of dollars to settle claims. Questions 1. Describe what made Chemi-Prod Inc’s behaviour (5 marks) unethical. 2. Discuss two (2) ways in which this behaviour could affect the performance of Chemi-Prod Inc in the long (6 marks) run. 3. Why is it important for firms to behave ethically? (4 marks) Total 15 marks Ethics define what is right or wrong, or what is moral A number of firms are becoming more aware of their corporate social responsibilities and some have taken steps to become more socially responsible. MULTIPLE CHOICE QUESTIONS 1. ALL of the following EXCEPT one outline the importance of objectives. Which is it? a. They give the employees a sense of direction as to where the business is going b. They function as a yardstick for tracking an organisation’s performance and progress c. They may be limited and take a long time to be achieved d. They are used in the decision-making process 2. It is said that objectives should be SMART. Which one of the following is NOT a part of this acronym? a. Timely b. Separable c. Measurable d. Realistic 35 36 MODULE 1 | UNIT 1 | BUSINESS AND ITS ENVIRONMENT 3. A sixth-form student’s objective reads: ‘To achieve grade 1 in all my CAPE examinations’. Which type of objective is this? Extended Essay Questions Total 25 marks a. Medium-term Question one b. Long-term a. Outline five (5) reasons why objectives are important to (5 marks) businesses. c. Short-term c. Strategic b. Opportunistic Joe has decided to start a small business selling cane juice extracted from sugar cane on his farm. Joe possesses very little knowledge of what is required in setting up his business and the objectives that he should establish before trading starts. With the use of possible examples, discuss four (4) categories (levels) of objectives that Joe should seek to achieve in his cane (20 marks) juice business. d. Operational Question two d. None of the above 4. Middle management deals with which of the following objectives? a. Corporate b. Tactical 5. A/An __________ defines the organisation’s purpose and direction. a. Aim b. Objective c. Goal d. Mission 6. ‘To sign up ten more people for health insurance in each quarter this year’ represents a/an __________ a. Corporate objective b. Tactical objective c. Operational objective d. Strategic objective 7. A firm is responsible to its shareholders in the following ways EXCEPT one. Which is it? a. To give fair returns on shareholders’ investment b. To keep them informed of the business’s performance c. To sell them more shares d. To protect their investment 8. Which of the following would NOT be included in a discussion on ethical issues? a. Testing of products on animals b. Deceptive advertisement c. Evading taxes d. The use of child labour Total 25 marks a. Define the term ‘business ethics’. (2 marks) b. Discuss the importance of social obligations that a firm has to the following stakeholders: i. Customers ii. Shareholders iii. Community (16 marks) iv. Employees. c. M essy M Ltd is a manufacturing company located on a small island with only a few rivers which supply the population with clean water. While the company has created job opportunities, foreign exchange earnings and a myriad of household chemicals, it is very irresponsible in how it disposes of its waste products. Messy Ltd has been disposing of its waste upstream in the Long River. It has also been confirmed that some of its products are being tested on the local animals and employees are often asked to work for long hours without much remuneration. i. Discuss the ethical issues that are mentioned (3 marks) in the scenario above. ii. Explain two (2) steps that government could (4 marks) take to deal with the issues. 37 3 LEARNING OBJECTIVES: At the end of this chapter students should be able to: Understand the nature of decision making Discuss the essential features of the information used to make decisions Discuss the different stages of the decision-making process Identify the factors that affect decision making Differentiate between qualitative and quantitative decision making L iving in a world with limited resources forces businesses and individuals to make choices. We have to make different choices each day. Any decision that is taken will result in some benefits or costs to the decision maker. We decide which clothes to buy, or where to go for a family vacation or which subjects and career path to pursue. These decisions are influenced by a number of factors, including preference and financial standing. Businesses have to make decisions on a daily basis too. Decisions have to be made on which product to invest in, which supplier to buy from, who to employ and how to raise capital, among other things. This chapter will deal with the process of decision making, the stages in the decisionmaking process and the factors that affect decision making. Decision making is the act of choosing between two or more alternatives. Decisions are made at three basic levels in most organisations: Strategic level – long-term decisions that entail high risks and are usually made by top management. Strategic decisions influence the direction, overall policy and performance of the business (for example, building a new plant or entering a new market) Tactical level – short- to medium-term decisions that are usually made at the middle management level. They carry fewer risks and would involve decisions such as what price to charge, which supplier to purchase from and who to employ or make redundant Decision Making Operational level – short-term decisions that deal with the administration of the firm’s strategic and tactical decisions. They involve few risks and can be made quickly. At this level, decisions such as which credit limit can be offered to a customer or on the ordering of stationery are made. Essential features of information In order to make effective decisions it is vital that firms gather sufficient information to aid in the decision-making process. However, any information collected must have four essential features which can be summarised using the acronym ‘CART’, broken down into: Cost effectiveness – the cost of gathering the information should not outweigh its benefits. The information should be gathered in the least costly way while maintaining its accuracy and relevance Accuracy – information collected must be accurate so that it can be relied upon by the manager. Misleading information may impede the decision being made and results in undue cost to the firm Relevance – the information collected must be appropriate for the situation or decision being made. It must be up to date, as outdated information is useless Timeliness – information must be available to managers and other decision makers on time. It should be obtained in a timely manner, since failure to do so may lead to bad decisions. Significance of qualitative versus quantitative decision making Since decisions are made by a firm on a daily basis, it must ensure that the decisions that are made were carefully thought about. Managers making decisions can consult different resources or people to assist in the decision-making process. The sources that are consulted may influence the decisions that are made. There are two forms of decisions that firms make which are based on the resources that are consulted. These are qualitative and quantitative decision making. 38 MODULE 1 | UNIT 1 | BUSINESS AND ITS ENVIRONMENT A qualitative decision is one that is made based on non-quantifiable information. These decisions often entail people’s value judgements and opinions. Firms embarking on qualitative decision making may make use of the ‘SWOT’ analysis (Strengths, Weaknesses, Opportunities and Threats) and ‘PEST’ analysis (Political, Economic, Social and Technological factors). These decisions tend to be very subjective since they are not based on statistical data. In contrast, a quantitative decision is one based on statistical data. Unlike qualitative decisions, quantitative decisions rely on historical data that can be quantified and analysed to make generalisations and draw conclusions. Quantitative decisions could be based on information gathered from sources such as market research, historical sales figures and accounting information. Even though the two forms of decision making are essentially different, a number of firms may employ both of them. In so doing, decisions that are made may be based on a mixture of qualitative and quantitative decision making. time and possibly cost. For example, a firm may want to ascertain why its sales revenue has fallen over the past two years. The firm could also outline the objective(s) it wants to achieve at the end of this process. A dynamic firm is one that is able to turn its problems or the problems of others into an opportunity to provide goods or a service. Therefore this stage could also include the identification of opportunities that are available. Data collection The decision-making process can be broken down into various stages shown in Figure 3.1. Having identified the problem, the firm must now decide how and from what sources the data will be collected. The data needed may be collected from primary and/ or secondary sources. ‘Primary data’ refers to original information collected specifically in response to the problem. This may be collected through observation, interviews and questionnaires. Primary data must be collated and analysed in order to have some value based on the problem defined in the first stage. ‘Secondary data’ represents information collected from other sources, such as newspapers, textbooks, internet sources or other work of a similar nature that was compiled for previous research. This form of data will be reprocessed and reused in an attempt to solve the problem identified or to clarify the opportunities identified. Definition of problem or opportunity Developing alternatives The first step of the decision-making process is to identify the problem to be solved or the objective to be achieved. The problem may be identified by thoroughly searching through the firm’s annual reports or financial statements or from customers’ feedback, among other sources. When the problem is identified, it is imperative that it is clearly defined so as to prevent the business from going in the wrong direction. Problems that are unambiguous will save After collecting sufficient data, the next step is to develop a list of possible actions that can be taken. These options may be developed individually, by teams or through analysis of similar situations in comparable organisations. These alternatives should be geared toward solving the problem or achieving the objective outlined above. Having formulated the possible alternatives, the manager can then move to the other stages. The stages of decision making of Definitionor problem ity opportun ction Data colle g Developin s e v ti a rn e lt a Analysing es alternativ and Selecting ng ti n e m le imp ative the altern n Evaluatio Figure 3.1: The stages of decision making CHAPTER 3 | DECISION MAKING Analysing the alternatives Using the list of alternatives, management should analyse the practicality and appropriateness of each alternative. An alternative may be deemed impractical because of: Lack of financial resources Lack of expertise to implement the alternative Legal restrictions Ethical and social responsibility implications Technological constraints Insufficient information. To assess the appropriateness of an alternative, the decision maker should consider its adequacy to address the problem. The decision maker should also consider the costs or benefits of choosing each alternative. This should include the possible impact that each option will have on the defined problem and the entire organisation. options instead of one. Once selected, the option(s) should be implemented in the least costly way feasible. It is also possible that management may encounter unforeseen problems and face resistance to change from employees. Evaluation The final stage is the evaluation of the option(s) that were implemented above. Here, the decision maker needs to evaluate the outcome of the decision taken. These results are then compared with the original objectives or problem to ascertain whether they were achieved or solved. The results are often presented in a report. Having assessed the report, it may be necessary to modify the course of action or to start the process of decision making over again. Examine the example given in Table 3.1. Selecting and implementing the alternative Factors affecting decision making Here, the decision maker selects the best course of action to solve the problem. As we examine this stage, you will realise that many situations do not lend themselves to mathematical or quantitative analysis but instead are subjective. However, there are some situations where sufficient quantitative data is present to aid in the selection of a particular alternative. The manager may also select and use a combination of A number of factors affect decisions that we make on a daily basis. Like us, a business faces constraints on its decision making. The downturn in the world economy during the period 2007–09 has had a negative impact on many businesses worldwide. In addition to this, government decisions, technological advancements, socio-cultural factors and human constraints also influence decision making in business. Stages of decision making Solutions Definition of the problem Assessing the decline in sales of Company X for the period 2009–10 Data collection Primary data may be collected through market research, e.g. consumer survey or suggestion slips Secondary data may be garnered from economic surveys carried out by government agencies on macroeconomic variables, market analysis or reports from other businesses Developing alternatives The firm can list the different steps that can be taken to improve sales, e.g. sales promotion, advertisement, product modification and rebranding Analysing alternatives Assess the options in the previous stage in terms of effectiveness and appropriateness. The cost of implementing each option should also be ascertained Selecting and implementing The company would select the most effective and cost-efficient option from the list and implement the decision Evaluation The company needs to assess whether the option chosen has improved its sales figures. If not, then it may need to modify the option or choose another Table 3.1: The decision-making process Government, political and legal The government is responsible for passing various laws and requirements and establishing frameworks that will affect decision making. Since political parties have different philosophies and goals, a change in administration may also pose a problem for some businesses. The macroeconomic policies that will be pursued might differ and this will have some influence on businesses. The legal environment of the Caribbean is becoming even more pressing, with the signing of a regional treaty to form the Caribbean Single Market and Economy (CSME). One clause of the agreement seeks to harmonise laws relating to commerce. Once this clause becomes fully enforced, all firms within the CSME will be subjected to the same laws. Based on what those laws are – or will be – some Caribbean firms may have to change the way they do business. In the Caribbean there are currently a number of laws governing the behaviour and operation of businesses. These include: Employment laws which govern contracts, recruitment, termination of employment, redundancy, health and safety in the workplace, unionisation, dispute resolution and minimum wage payments. Businesses must be 39 40 MODULE 1 | UNIT 1 | BUSINESS AND ITS ENVIRONMENT CASE STUDY Decision crisis in J & K Fast Food J & K Fast Food is a partnership between two close friends. The business was established some nine years ago and has performed fairly well financially. For its tenth anniversary, the two partners are thinking of making a number of changes, including converting to a private limited company, offering more products and either expanding or changing its location. The two partners are unsure of how things will work out and both have some reservations. In a discussion about the change, the following issues were raised: How will changing the business from a partnership to a company benefit each partner? What are the new products that will be offered? Should the firm expand at its current location or relocate? What profit margin is expected after the conversion? The issues raised in the meeting are now having an adverse effect on the two partners who are indecisive in all the areas mentioned above. They have agreed to compromise on all of the decisions except the one on expanding or relocating. If not dealt with quickly and effectively, this deadlock could see the death of the firm instead of a tenth anniversary celebration. A close friend of both partners heard of the pending crisis and suggested that before they make any decisions they should search for the necessary information that would make the decision easier. He suggested that they should also use the steps of the decision-making process to iron out the question of expansion or relocation. Questions 1. Define the term ‘quantitative decisions’. 2. What are the three (3) levels of decisions that are often made in firms? 3. J&K’s friend mentioned seeking information to assist with the decision. Give the four (4) characteristics that this information should have. 4. Using the decision-making process, discuss how the two partners could come to a consensus on whether to expand at their current location or to relocate. aware of these laws when making decisions since they have serious implications for them. Laws to promote competition in business. Governments have enacted laws revoking previous monopoly licences and liberating some of these markets in order to foster competition. These laws may also prevent mergers and limit uncompetitive practices among firms. For example, the Jamaican telecommunications market was liberalised in 2001 to allow other firms to enter the industry. A number of other Caribbean territories have also liberated their telecommunication markets. Consumer rights which protect consumers from exploitation and unfair practice in business. In Jamaica, consumers may obtain redress from the Consumer Affairs Commission, the Bureau of Standards and the Fair Trading Commission, while landlords and tenants are protected and governed by the Rent Board. The Sale of Goods Act is also important, as it stipulates the conditions under which goods are sold. (1 mark) (3 marks) (8 marks) (18 marks) Total 30 marks Environmental laws. With the emphasis that is being placed on global warming in recent times, firms now have to be more careful about their impact on the environment. Governments are also becoming more vigilant in the enforcement of environmental protection laws. For example, firms in the food services industry have to be mindful of offseason fishing and other firms have to limit their pollution of the air, water or land. ACTIVITY Conduct research in your country to find other organisations that protect you as a consumer. Social and cultural As was discussed in Chapter 2, a number of firms are becoming more socially responsible. With some governments passing environmental and animal protection laws and the impact CHAPTER 3 | DECISION MAKING of global warming being felt around the world, businesses must now be more aware of these factors in their decision making. They must also be aware of the culture of the market in which they are entering or operating. ‘Culture’ is defined as a combination of beliefs, values, rituals and practices that shape one’s behaviour over time. Culture plays a critical role in some markets in terms of food, dress and music. In business, the decision maker must be aware of this and guide his/her decision likewise. Social and cultural factors may also be extended to include the structure of the population. Decision makers need to be conscious of the following factors in society: Changing family structure – there are a number of single-parent households in many Caribbean territories and the number keeps growing. Management must be mindful of this trend, in addition to the existence of nuclear and extended families, and try to ascertain how any decision made will affect each structure. The decision maker must be aware of families’ range of income, and the products that they demand. He/she must be mindful that the family structure can affect the level of poverty or give an indication of how the firm should price its product. Improvement in education – Caribbean territories are now open to a number of tertiary institutions and the number of people achieving higher education has grown remarkably. These people will question a firm’s decision and action before purchasing their products. Population age and working habits – the age of the population is influenced by the life expectancy rate, which has increased over the years as a result of healthier lifestyle and developments in medicine. With investment opportunities increasing, some people are retiring earlier and this is compounded by the fact that they are generally living longer. Decision makers have to bear these factors in mind as they make decisions that will affect this group of people. Technological We would all agree that technology has evolved rapidly in the past two decades. Computers have been reduced in size significantly; the internet has opened up a myriad of opportunities; there is new and improved technology in manufacture that has reduced wastage and improved yield; and there are a number of social networks that bring together people from all over the world. Decision makers need to be aware of the pros and cons of technology and capitalise on the opportunities it brings while being mindful of its threats. The world has become a global marketplace and firms are faced with competition from all over the world. E-commerce has grown considerably and firms in the Caribbean may have to compete with others in Europe or Asia. The banking sector is one such industry that has made strides in incorporating and utilising improvement in technology in the delivery of its services. E-banking has given customers freedom to pay bills, transfer funds and check account balances, among other things. Likewise, technology has improved significantly in the area of communication in the Caribbean region. With the liberalisation of most Caribbean territories’ telecommunication industries, communication has improved significantly. Decision makers must assess how the changes in technology will affect decisions made. The proliferation of social networks in recent times has provided firms with a new medium to promote their products and gain customer feedback. This also changes the way in which firms do business. Today, more people are looking for comfort and high-quality service. With the increase in the number of customers using credit cards when compared with, say, five years ago, there are more online shoppers for whom firms must be able to provide. At present, many people are moving away from spending actual cash by paying their bills online and buying some products online where they are available. At the rate at which technology is improving, Caribbean firms may have to change their way of doing business so as to be able to cater for the needs of their customers. Economic Economics is a social science which deals with study of human behaviour and how scarce resources are allocated to satisfy human beings’ unlimited wants. We all make economic decisions on a daily basis and these decisions may be influenced by different forces in the economy. The government has to make macroeconomic decisions which will impact on the business community. These macroeconomic policies may aid or discourage business and decision makers must be aware of this. Macroeconomics deals with economic aggregates – in other words, it is the study of the economy as a whole. Macroeconomics policies include such things as inflation, the unemployment rate, interest rates, exchange rates, economic growth and the balance of payments. Now let’s examine each of these policies in more detail. Inflation rate Inflation is a continuous or sustained increase in the general price level in an economy. High inflation rates may cause an increase in production cost for firms. It will also mean that 41 42 MODULE 1 | UNIT 1 | BUSINESS AND ITS ENVIRONMENT revenue will lose its value as inflation rates get higher. In addition, the purchasing power of consumers will decrease as they will not be able to purchase the same amount of goods and services with the same income as before. Inflation is calculated as: CPI t – CPI t-1 × 100 CPI t – 1 Where t = present year and t–1 = previous year. There are two main causes of inflation: Demand pull inflation – this is commonly referred to as ‘too much money chasing too few goods’. It occurs where aggregate (total) demand is increasing while the available output of goods or services is limited. The excess demand will cause the general price level to increase Cost push inflation – occurs when the price of inputs into production increases and causes producers to increase the price to consumers. This type of inflation is influenced by three main factors, including wage push factor, import price push and profit push. Unemployment rate The unemployment rate measures the percentage of the population between the ages of 18 and 65 that are currently not working but actively seeking employment. This is calculated as: Unemployed × 100 Labour force Labour force consists of Employed + Unemployed people. There are four main types of unemployment, namely: Frictional – this type of unemployment is as a result of the search process when people are between jobs. For the period of time that they are out of a job or waiting to find another job, they are referred to as being ‘frictional unemployed’ Cyclical – this is caused by the recessional phase of the business cycle. When total demand falls, firms tend to employ fewer people and the unemployment rate will increase Structural – this is caused by changes in technology or the structure of the organisation. As a result, some skills are no longer needed or people lack sufficient skills to secure employment Seasonal – unemployment that is as a result of the off-season period of production. This is evident in the agricultural industry in the Caribbean, as some workers are laid off when the crop season ends and then reemployed when it starts again. Interest rate Interest rate is the amount that borrowers pay to lenders per dollar of the money borrowed. In other words, interest is the price paid for the use of money or for the use of capital. The level of interest rates is very important to management. Very high interest rates will impede growth, as the cost of borrowing money will be too high. Firms will not be able to borrow to invest and, without additional investment, businesses will not grow. The government’s macroeconomic policy on interest rate may hinder or enhance the business environment and decision makers must be aware of this. Interest rates may vary for a number of reasons, such as the length of the loan, the risk involved and administrative charges. Exchange rate The main trading currency for most Caribbean countries is the US dollar. However, most countries, with the exception of the Eastern Caribbean states, have their own currency. This means that, in order to get the US dollar to trade, their currency must be converted. The rate at which one country’s currency trades for another is known as the exchange rate. The exchange rate for these countries ranges from low to high, depending on the territory in question. High exchange rates may hurt businesses which import most of their inputs into production. Low exchange rates hurt exporters who will receive lower return on their products when revenue is converted in their local currency. Countries in the Caribbean use one of the two main types of exchange rate systems. For example, Barbados has a fixed exchange rate system, while Jamaica has a managed floating exchange rate system. A fixed exchange rate system is one where the government fixes the external value of its currency in relation to other currencies – for example, at $2 Barbados to $1 United States (BD$2:US$1). The rate is maintained by the Central Bank which intervenes in the foreign exchange market by supplying US dollars when there is a shortage and purchasing excess currency when there is a surplus. The opposite of this is a floating exchange rate system where the value of the currency is determined freely by the interaction of demand and supply of the dollar. Where a floating exchange rate system is being used by the government, the currency may depreciate or appreciate in value. A depreciation of the dollar occurs when there is fall in the demand for a country’s currency, which leads to a reduction in the value of the dollar in terms of other currencies. Conversely, an appreciation of the dollar occurs where there is a decrease in the supply of the dollar, which leads to a reduction in the value of the dollar in terms of other currencies. CHAPTER 3 | DECISION MAKING Ecological factors Ecology is the study of living organisms and their environment. Ecological or environmental factors deal with how businesses treat the environment in which they operate. Businesses are being urged to be more socially responsible and laws have been enacted to monitor their behaviour. For example, there are laws prohibiting firms from dumping their wastes inappropriately, cutting down large numbers of trees and damaging coastlines. Decision makers must be aware of the implications of making decisions that are bad for our environment. As was discussed earlier, firms must become more socially responsible. As many countries grapple with the effects of global warming, they must implement environmental laws to protect themselves from further degradation. What was once a concept on paper has quickly become a reality and is evident in the growing number of natural disasters being faced within the Caribbean region. The degradation of the environment has serious implications for the region’s agricultural industry and has the potential to create food shortages whenever a major disaster hits. We have seen where many firms and individuals have bought into the ‘Go Green’ campaign by using eco-friendly packaging or recycled materials in production. Human and natural constraints The human element in business may pose different challenges. The fact is that we are all different in thought, ability and attitude. The decision maker should be aware of the following factors: The skill level of employees, which may foster or hinder the implementation of certain decisions The years of experience of both management and staff People have different attitudes to risk and change. Some employees may not like change, while some might be more cautious than others in terms of risk taking Size and composition of the labour force is also vital The level of motivation of the workforce. We will examine this further in Module 2. ‘Natural factors’ refers to the natural resources that are used as inputs into production. These include land, labour, capital and entrepreneurship. A firm experiencing a shortage of these resources will find it difficult to produce its product in large quantities. CASE STUDY Turbulent times for Yummy Fast Food Ltd Yummy Fast Food Ltd has recently converted from a partnership to a private limited company. The changeover for the most part was smooth and things have started to return to normal. However, within the last year things within the country and the CARICOM region have started to change rapidly. The present struggles started with a downturn in the global economy which is now being dubbed ‘the recession of the new millennium’. Since the recession started, the company has been losing money and profits have been falling. Unemployment rates and inflation rates have skyrocketed and the government has implemented a high interest rate policy in an attempt to curtail inflation. The government has also increased taxes in a bid to finance the Budget. To exacerbate the issue further, citizens are becoming uneasy and frustrated to the point where demonstrations and riots have started as the Opposition put pressure on the ruling party. If this situation continues for a prolonged period, the company may have to leave not just the country but possibly the Caribbean region. The directors are therefore keeping a close watch on the situation. Questions 1. Identify two (2) factors from the case that may affect the decision making of Yummy Fast Food Ltd. 2. Discuss how the economic factors mentioned in the case could affect decisions at Yummy Fast Food Ltd. 3. How could the political instability of the country affect the company’s decision to expand its operations? (2 marks) (12 marks) (6 marks) Total 20 marks 43 44 MODULE 1 | UNIT 1 | BUSINESS AND ITS ENVIRONMENT Table 3.2 summarises the possible impact of these factors on a firm’s decisions. Factors affecting decision making Positive impact on businesses Negative impact on businesses Governmental, legal and political Governments can provide the legal framework within which businesses operate, which could work in the business’s favour Businesses can be protected from unfair competition Government policies can create business opportunities in some areas, e.g. through liberalisation of the market or industry Infant industries can receive protection from external competition Laws such as those on minimum wage could have an adverse effect on firms’ revenues Political instability may result in the loss of productive time Government taxing policies could also deter firms from operating in the region and could lead to reduced revenue Government monetary policy framework could make it difficult to do business in the region, e.g. high interest rate Social and cultural Social networking can be used as a good marketing tool to reach a larger group and wider cross-section of people The age differences in the population can be used as an opportunity for segmentation, i.e. creating different products to meet the needs of each age group Once the firm learns the culture of the country, it can produce products that are in tune with people’s belief system If an age gap exists then firms could experience a slowdown in production as more experienced employees retire A shift in the family structure could result in more absenteeism, especially when children become sick If the product being sold by the firm is viewed as offensive because of some belief in the market country’s culture then it may not be supported there Technological This has paved the way for doing business online (e-commerce) Each firm can market and sell its product globally, thus having access to the global market New and improved technology can increase productivity and hence the output of the firm Technological advancement in and of itself creates business opportunities Decisions made in the firm can easily be transmitted using e-mail or video conferencing, etc. Technology comes with a cost to the firm and this may be very expensive The use of internet technology has brought new competition to regional firms Technology may cause information to become available to unscrupulous users Employees can feel alienated by technology. This could lead to low levels of motivation and productivity Economic Low interest rates can be good for firms wanting to borrow for investment The business needs to know information on inflation and exchange rate in order to forecast or plan for the future better The firm can decide to locate in a country whose economy is growing in order to maximise profits A firm may decide to market its products where it can gain high returns on investment Economic instability can reduce business confidence, thus affecting investment decisions High inflation rate can result in increasing input cost for the firm If the economy moves into a recession, the firm could see significant falls in sales and profits. This may lead to it closing down Ecological Decisions that are made with the environment in mind show the firm’s corporate social responsibility The firm must be aware of the legal implications of polluting the environment Table 3.2: Possible impact of factors on a firm’s decision making CHAPTER 3 | DECISION MAKING CHAPTER SUMMARY Decisions are generally made at the strategic, tactical and operational levels in a business The four essential features of good information are: accuracy, timeliness, relevance and cost-effectiveness The stages in the decision-making process are: definition of problem, data collection, development of alternatives, analysis of alternatives, selection and implementation, and evaluation Decisions made within a firm may be affected by factors such as: technological, governmental, social and cultural, economic, ecological, and human and natural constraints. MULTIPLE CHOICE QUESTIONS 1. Information should have four main features. Which of the following is NOT one of them? a. Realistic b. Accurate c. Cost effective d. Relevant 2. A continuous or sustained increase in the general price level in an economy is referred to as: a. Inflation b. Deflation c. Stagflation d. Consumerism 3. Cost push inflation is influenced by ALL of the following EXCEPT which one? a. Profit motive b. Increased demand c. Increased wages d. Import prices 4 The type of unemployment which is associated with recession in an economy is known as: 5. Decisions are often made at all the following levels EXCEPT which one? a. Shop floor b. Tactical c. Operational d. Strategic 6. Which stage of the decision-making process involves an assessment of the decisions taken and the level of success by matching objectives to outcome? a. Definition of the problem b. Developing alternatives c. Evaluation d. Analysing alternatives 7. Which of the following would NOT be a legal factor affecting decision making? a. Sale of Goods Act b. Unemployment rates c. Consumer protection agencies d. Bureau of Standards policies 8. An increase in the number of single-parent families across the region is an example of which of the following factors affecting decision making? a. Frictional a. Technological b. Seasonal b. Economical c. Cyclical c. Social d. Structural d. Human constraint 45 46 MODULE 1 | UNIT 1 | BUSINESS AND ITS ENVIRONMENT Extended Essay Questions Question one Total 25 marks Mrs Doubtful has decided to expand her business and is about to purchase two delivery trucks. Since there are a number of trucks available for sale, she has approached you to assist with the decision. Advise Mrs Doubtful on the following five (5) steps involved in the decision-making process and how they would apply to the decision she has to make. a. Definition of the problem b. Data collection sources c. Analysis and evaluation d. Formulation of alternative strategies e. Implementation (25 marks) Question two Total 25 marks Good Food Ltd is a fairly new restaurant in your country. The management of the restaurant makes a number of decisions daily that will impact on the firm and its main stakeholders. Discuss how the following factors may affect a firm in its decision making. a. Economic b. Government, legal and political c. Technological d. Ecological e. Socio-cultural (25 marks) 47 4 Caribbean Business Environment and Globalisation LEARNING OBJECTIVES: At the end of this chapter students should be able to: Understand the nature and structure of Caribbean business organisations Discuss the role of culture in organisations’ behaviour Assess the growth of multinational corporations in Caribbean countries Discuss the impact of globalisation and trade liberalisation Discuss the pros and cons of protectionism and barriers to trade The nature and structure of Caribbean business organisations T he Caribbean territories are characterised by mostly small developing economies. These economies tend to be open, with little protection against more developed countries dumping unwanted goods on them. The economies are mostly mixed and businesses range from local firms to multinationals. In recent times some of these economies have been making strides to foster economic growth and increase foreign direct investments. If this move is successful it may bring about improvements in standards of living and the economic outlook for these countries. However, some of the Caribbean countries’ efforts have been hampered by the downturn in the world’s economy in the latter part of the first decade of the 21st century. Bearing in mind the above factors, businesses in these Caribbean territories are faced with many challenges. Some have been hit so badly that they have thrown in the towel; others have downsized; and others have merged with other firms in an attempt to survive. When we discuss organisational charts in Module 2 we will look at the structures of most of these businesses. The environment in which these businesses operate also poses many challenges: Most territories are still struggling with high rates of unemployment. Where a significant percentage of a country’s citizens is unemployed, businesses cannot make sufficient revenue as people do not have money to spend. Some sociologists believe that there is a correlation between high unemployment rates and social problems such as crime and violence. Where crime escalates, investors are deterred from the country and so fewer jobs will be provided and economic growth will be suppressed While some countries, such as Barbados, are doing well, others are struggling with below-average literacy rates. Some of these countries have poor education facilities and also suffer from overcrowding. This will impact on the future workforce who will not be employable or marketable. Poor literacy impedes development, as citizens might be underproductive A large percentage of these countries depend on the agricultural sector to earn foreign exchange. However, some of their farmers are undercapitalised and are still using old techniques which are not bringing about sufficient yields to compete on the international scene. Produce is at times expensive and limited. To compound the issue, imported produce has found its way into the market, stifling some of the small farmers who cannot compete with the lower prices. The agricultural sector is also susceptible to natural disasters which damage a number of farms regularly. This has been highlighted as one of the factors that caused Jamaica Producers Group Ltd to abandon banana exports, resulting in the loss of jobs Some businesses face the challenge of operating with outdated technology. As a result, productivity is low and the cost of production is very high. Since at times it is difficult to secure funding, these technologies cannot be replaced as soon as there is an improvement. Some of these businesses have a poor capital structure and depend largely on human effort, therefore limiting the size of their operations As mentioned earlier, most Caribbean economies are characterised as small and open. As a result, businesses face competition from international companies. With the popularity of the internet which provides easy access to these markets, Caribbean businesses are faced with competition from both home and abroad. 48 MODULE 1 | UNIT 1 | BUSINESS AND ITS ENVIRONMENT Caribbean business culture Communication networks We are all influenced in some way by our culture and the business place is no different. Business culture is defined as the beliefs, attitudes and values of the employees in an organisation. Managers must be aware of the culture that exists in their organisations. This is very important since culture will influence the pattern of behaviour, attitudes to change, motivation, morale and performance of the staff. Good corporate culture may also promote or demote the business and its ability to attract qualified and experienced employees. The culture of any organisation is formed over time and is usually influenced by a number of factors shown in Figure 4.1. Now we will examine each factor in more detail: These have grown extensively over the past decade and this has influenced the culture of many organisations. Networking is seen in staff magazines, social gatherings, staff involvement in decision making and informal groups. Networking employees are more likely to be influenced by their colleagues and hence influence the culture of the organisation. Environment The environment in which the organisation operates will affect its culture. Caribbean businesses operate in an environment that has a rich history embedded in the colonisation of the region. This past could affect the way business managers and employees react to different situations. Some managers still practise a very autocratic style of leadership, from the time of the plantation system, instead of the more accepted democratic style. Our economic environment is generally mixed and businesses have adopted a culture of ascertaining the needs and wants of their customers while aiming to maximise their profits. This profit motive may overshadow matters such as environment preservation, ethical practices and the rights of consumers. Leaders s Employee ent Environm ss Busine re u lt u c nication Commu orks netw Figure 4.1: Business culture factors Daily s re procedu Leadership style The style of leadership and the personalities of the leaders themselves may influence the organisation’s culture. A leader who encourages participation among employees and management will have a warm and hospitable culture compared with one who does the opposite. The leader’s personality may help to motivate the workers and influence their norms, attitudes and beliefs. Employees’ attitudes Employees’ norms, beliefs and attitudes will transcend into the culture of the organisation itself. Most of the time, the employees are the ones who are in direct contact with the customers and, if disillusioned, may send the wrong signal. The culture of management may be infused into the employees and the way they behave in the organisation. Daily procedures The procedures that have to be followed on a daily basis may influence the culture of the organisation. Some businesses are very bureaucratic, with a lot of checks and balances. This contributes to an office which is paper dominated. With such strict guidelines, workers in these organisations tend to be less spontaneous and are not allowed to be autonomous in the decisions they make. From the above, it is clear that a positive and strong business culture is very important. The reasons for this are outlined below: A strong and positive business culture helps to improve the loyalty of employees and customers The firm’s culture can motivate the workers and improve their productivity When each employee understands the culture of the organisation, they are able to communicate and understand instructions clearly, minimising conflicts. Business culture is good but does have a number of criticisms. Some of these are outlined below: There may be conflicts of culture, especially for multinational corporations (MNCs). These CHAPTER 4 | CARIBBEAN BUSINESS ENVIRONMENT AND GLOBALISATION MNCs enter the overseas market with their own culture, which may conflict with the local culture Some businesses are very large and so it is difficult for a unique culture to be communicated. In a single business, there may be a variety of beliefs, norms and attitudes. The growth of multinational corporations in the Caribbean As we discussed earlier, the Caribbean economies are mostly open and more susceptible to the impact of globalisation than developed countries. These economies provide large international companies with a good opportunity to expand into different markets. These companies are referred as multinationals. A multinational or transnational corporation is one that owns and controls other business operations outside of the country in which it is situated. The parent company usually operates out of one country but operates other branches (subsidiaries) or factories in other countries. The branches are subjected to the laws governing each particular country. Examples of multinationals in the Caribbean would include C&W Ltd. Multinationals in the Caribbean have increased steadily over the years and, in some cases, have captured a significant portion of the total market share. But what are the causes of this increase? To be close to their markets. Multinationals can cut cost and gather more accurate data if they are operating near to their markets. Such a company would be able to understand the culture of the market and its consumers’ buying behaviour. A company operating out of Europe might find it easier and cheaper to open a branch in the Caribbean rather than trying to export its products there Lower production cost in those countries. Locating in the Caribbean may present multinationals with lower production costs. Some territories offer cheap labour since the supply of labour is greater compared with its demand. In other words, the number of people seeking jobs is greater than the number of vacancies available. In such cases wages tend to be lower than in places where the opposite exists. In addition, the minimum wage in most Caribbean territories is relatively lower than in developed countries. Multinationals may also come to the Caribbean to make use of the natural resources found there. If they can manage to get raw materials at source, it is likely that they will be cheaper – for example, bauxite companies trading in Jamaica and oil companies in Trinidad and Tobago To be shielded by tariff-protected markets. Since the inception of CARICOM, the Caribbean region has benefited from a common external tariff (CET). This means that countries within the free trade area trade without tariffs but all products coming into the region are subjected to a common tariff. Multinationals can take advantage of this by setting up operations in any of the member countries of CARICOM and enjoy free trade within the region while being protected from competition outside the region Government policy. In order to foster economic growth and investments, governments may pursue fiscal and monetary policies that encourage the growth of multinationals. This move may also help to increase industrialisation, as some technology will spill over into existing local firms. In order to encourage investment in the local markets, the government may offer tax holidays and provide the necessary land space or infrastructure needed by these firms To avoid local laws. Some MNCs move some of their operations out of their home country in order to avoid laws affecting them – for example, countries with antitrust laws which encourage competition by preventing monopolies and mergers Most Caribbean countries have some form of restriction on imported goods. MNCs enter the local market so as to avoid these import restrictions. Locating within the region would give them open access to the market without having to pay to export their products to these territories. For more information on import restrictions, see the section on protectionism. The growth of multinationals in the region has provided the host countries with a number of benefits. However, there are also drawbacks. In this section, we will examine and discuss some of the benefits and drawbacks of MNCs on the country in which they are located. Advantages of MNCs to the host country Gain foreign exchange as a result of the initial investment and exportation of products from these companies. The Caribbean countries’ main trade currency is the US dollar. Once these companies export their products the country will gain foreign exchange which will help to improve the balance of payment position Improvement in the country’s Gross Domestic Product (GDP). GDP is the value of all final goods and services produced within a country over a one-year period. With more output being produced by these MNCs, the GDP of the country will increase, all other things being equal 49 50 MODULE 1 | UNIT 1 | BUSINESS AND ITS ENVIRONMENT The country will experience a reduction in unemployment. Most MNCs will employ some citizens of the country in which they are located. When this occurs, some people who are unemployed will be able to find jobs. As more people find employment, their standard of living should also improve Local firms that provide auxiliary services to large companies will also benefit from increased business – for example, cleaning services. The construction sector may benefit from the construction of buildings or plants. If the investment is in the hotel and tourism sector, the local agricultural sector may also benefit by supplying its produce to it The country will receive increased revenue from taxation. This will include taxes on the company’s profit (corporation tax); increased value added (consumption) tax from increased sales; and personal income tax from employees There may be an improvement in technology as the multinationals will introduce new and improved technology which may spill over in the economy. With the introduction of new technologies, local firms may be forced to improve their own in order to remain competitive. As a result, there could be a general increase in output and quality of products Consumers benefit from increased variety as they can now choose from a wider range of products. Disadvantages of MNCs to the host country Multinational corporations are known to repatriate most, if not all, of their profits. If this is done the host country will not benefit from profits being reinvested in it. Therefore these firms would be using their resources to generate revenue but the country will not enjoy great benefits as a result If stringent laws are not in place to protect employees, the local workforce can sometimes be exploited. They may be asked to work long hours but receive less than equitable remuneration Motivated by profit, multinationals may deplete local non-renewable resources. In an attempt to maintain production and profits, MNCs may overproduce. Countries such as Jamaica and Guyana have seen tonnes of bauxite being mined each year. This mineral can take thousands of years to form but over time the supplies have dwindled considerably. Trinidad has seen a reduction in its oil reserve as more and more barrels are extracted year after year Multinationals may cause increased pollution and little might be done to curtail it. Large plants may emit waste in the atmosphere, depleting our ozone layer. Some MNCs may also contribute to land and water pollution if waste is not disposed of properly Some local competing firms may be forced out of business as they try to compete with these multinationals. Local firms are at times undercapitalised and have inferior technology and equipment to these multinationals. As a result, they are not able to compete effectively. The impact of trade liberalisation and globalisation Have you ever heard the statement that ‘the world is a single global marketplace’? Well, that is exactly what it is now. Our markets are no longer dominated by local products, but have been infiltrated by products from all over the globe. Today, if you walk into a supermarket or a department store or even the corner shop in your community, you will realise that the products available are made in a number of countries. We can be in the Caribbean and do business with a company in Europe and have a product couriered to the customer very quickly. All of this is made possible through trade liberalisation and globalisation. Trade liberalisation Trade liberalisation is the removal of barriers to trade and giving free access to the market. This access may be limited to certain products or it may be a total lifting of the barriers to trade. These barriers are explained in the next section. The emphasis on trade liberalisation started in the Caribbean with the formation of the Caribbean Free Trade Association (CARIFTA) in 1965. The association’s main aims were to increase, liberalise and diversify trade among the member states. In 1973 CARICOM was established, with the aim of improving on CARIFTA. One of its objectives was to include economic integration in the region, along with each member implementing a common external tariff (CET). Trade among the member states would be free while the region was protected by the CET. Today, CARICOM has grown into the Caribbean Single Market and Economy (CSME). The CSME finally came into being in 2006, having been proposed and agreed upon from 1989. The CSME is designed to represent a single economic space where people, goods, services and capital can move freely within the member states. Article Six of the revised Treaty of Chaguaramas which established the CSME has outlined the following objectives: CHAPTER 4 | CARIBBEAN BUSINESS ENVIRONMENT AND GLOBALISATION CASE STUDY Changing the mobile service landscape When the Jamaican Government decided to liberalise the telecommunication industry in 2001, investor Denis O’Brien seized the opportunity to make what is now seen as a very successful investment. In April 2001, Digicel Jamaica was launched with less than five per cent mobile phone penetration. With its three-pillar business strategy of ‘best network, best service and best value’, the company quickly gained a foothold in the Jamaican market. To this end, its success in its first year was above target and it has continued to grow since then. This same strategy would see Digicel becoming one of the larger multinational corporations in the Caribbean. From just its Jamaican establishment, Digicel is to date operating in 31 markets worldwide, including 26 in the Caribbean and Central Figure 4.2: Digicel headquarters, Kingston America and five in the Pacific. The company is said to employ over 5,000 people, with over 1,000 retail stores, and boasts a customer base of approximately 13 million. Digicel has made huge contributions to the mobile landscape, as the monopoly of Cable and Wireless, its main rival, was not sufficient to cover all the demand in the region. This gave the company a good platform to work from and very soon many individuals had access to mobile services. The contribution of this multinational corporation is also seen in its corporate social responsibility work which it does through the Digicel Foundation. The foundation is guided by its mission statement which says: Digicel Foundation is a non-profit organisation that distributes and utilises funds on a charitable basis for the sole purpose of building communities and community spirit in Jamaica. Questions 1. What is a multinational corporation? (2 marks) 2. What evidence is there in the case to prove that Digicel is a MNC? (5 marks) 3. Discuss three (3) possible benefits and costs to the host country from Digicel’s operations in the Caribbean. (18 marks) Total 25 marks improved standards of living and work full employment of labour and other factors of production accelerated, coordinated and sustained economic development and convergence expansion of trade and economic relations with third states enhanced levels of international competitiveness organisation for increased production and productivity. The CSME Agreement had the following key elements: Movement of capital – which will be achieved by eliminating foreign exchange controls and establishing a common currency. This also includes the integration of the regional capital market (for example, establishing a regional stock market) Movement of labour – this will allow skilled labour to travel and work in any of the member states. It will facilitate the harmonisation of social services (education and health services) and transfer of social security benefits (pension benefits) Movement of goods and services – which is achieved through the removal of all trade barriers among member states and setting regional standards for the goods being traded Right of establishment – this element allows business people from any member state to establish and own businesses in another member state without restrictions A common external tariff gives each member state the right to apply the same rate of tariff on all imports that are not coming from a member state 51 52 MODULE 1 | UNIT 1 | BUSINESS AND ITS ENVIRONMENT A common trade policy allows for joint negotiation on matters relating to internal and international trade and a coordinated external trade policy Free circulation – goods that are imported from nonmember states are allowed to be circulated within the region duty free since the relevant taxes would have been collected at the first point of entry Harmonisation of laws – laws in the region are to be carefully coordinated to reflect ‘oneness’. These laws include intellectual property rights and company laws Monetary policy measures – there should be a coordination of exchange rate and interest rate policies. Fiscal policy measures include the coordination of indirect taxes and budget deficits. The concept of trade liberalisation has also taken the spotlight in the world economy. This was evident with the establishment of the General Agreement on Tariffs and Trade (GATT) in 1947. Its main objective includes the regulation of trade among about 150 countries. It sought to ‘significantly reduce tariffs and other trade barriers and eliminate preferences, on a reciprocal and mutually advantageous basis’. GATT was later replaced by the World Trade Organization (WTO) in 1995. The essential functions of the WTO are: Administering and implementing the multilateral trade agreements that collectively make up the WTO Acting as a forum for multilateral trade negotiations Seeking to resolve trade disputes Reviewing national trade policies Cooperating with other international institutions involved in global economic policy making. The WTO embraces the two main operational principles of the original GATT: Reciprocity – arranging for countries to receive foreign tariff reductions in return for tariff cuts of their own The ‘Most Favoured Nation’ Rule – requiring that a country should apply its lowest tariff for any particular product to all its suppliers. Globalisation Globalisation entails the increased connectivity and interdependence of the world economy. The growth of globalisation is seen in the growing integration of the world’s market. This has been amplified in the past two decades by advancements in technology. Globalisation has opened access to markets all around the world so that it truly has become ‘a single marketplace’. The growth of globalisation is being driven by the following factors: Reduction of transportation costs – this has led to easier access to markets as the available modes of transportation have increased. Businesses can make and receive shipments within a day by using courier services. Local consumers can purchase products from abroad and easily ship them to their country of origin Technological advancement – improvements in internet technology and communication networks have also contributed to the growth in globalisation. It is much easier to communicate with the world and this fosters the growth of businesses and business opportunities. Communication in the Caribbean has evolved rapidly over the last decade or so. Most people now have access to cellular internet technology. Companies have laid underwater fibre-optic cables to improve efficiency and speed. All this has contributed to the growth of globalisation Trade liberalisation – as discussed earlier, the liberalisation of trade has opened a number of markets that were once heavily protected. This is evident in CSME where business people can locate in any member state without restrictions Deregulation of business and financial markets – in recent years, governments have removed restrictions and regulations in certain industries, giving them more leverage. A number of public-sector businesses have been privatised, increasing competition and the need to expand abroad. Deregulation has led to the abolition of capital controls in many countries, making it easier to acquire capital overseas. Developing countries will also benefit from increased foreign direct investment as money flows more freely across national boundaries Change in the tastes and preferences of consumers – consumers’ interest in foreign products has increased significantly over the years. More people are now demanding international products and new market opportunities are opening up. The impact of globalisation The impact on the economy Increased unemployment – unfortunately, the impact of globalisation is not always good. Increased competition may cause some small vulnerable businesses to shut down. When this occurs, workers will be made redundant and the country’s unemployment rate will increase. This can cause a reduction in standards of living and suppress economic growth Depletion of local resources – if international demand increases significantly, local resources may be over utilised to meet such demand, increasing their depletion. Most of these resources are non-renewable CHAPTER 4 | CARIBBEAN BUSINESS ENVIRONMENT AND GLOBALISATION and so a rapid depletion may be disastrous for the nation in the future Opportunity for economic growth – with trade liberalisation and the opening up of the world market, local companies can increase trade. The increase in trade will earn more foreign exchange for the country and profits for the businesses. This money can be ploughed back into the local industry, causing growth. In addition, the local industry can benefit from foreign direct investments as international businesses seek to enter our local markets Opening up the markets of countries will also open up an opportunity for the underground economy. This may include the drugs trade and money laundering. Unless local authorities are able to curtail this problem, it can spiral into an increase in criminal offences of all natures Earlier in the chapter we discussed that the Caribbean economies are usually small and open. This makes them vulnerable to global or external shocks and globalisation increases their vulnerability. The possible impact of global or external shocks was made evident with the contraction of the global economy in 2008–09. The recession, which started in the United States, affected all Caribbean countries, sending their economies into turmoil. The role of government International policies may impede central governments’ ability to control the economy. Caribbean governments may have to adhere to the policies outlined by institutions such as the World Bank, the World Trade Organization and the International Monetary Fund (IMF), and therefore lose their power to pursue their own macroeconomic policies With the negative impact of globalisation on some Caribbean countries, governments now need to develop policies and find the necessary resources to combat these negative impacts. This may put strain on the already cash-strapped local economy Some governments may find that multinationals have grown so large that they are no longer able to control them. These businesses may avoid taxes and contravene labour laws. In order to reap the full benefits of globalisation or to ensure that multinationals operate in accordance with the country’s laws, the government has to play the following roles: Facilitating or creating the right environment. Amid the negative impact of globalisation, it can be beneficial to the country and as such the government has a key role to play. The country’s business environment can either impede or foster the establishment of multinationals or the transaction of trade by global organisations. The country’s business environment must be one that is inviting, with proper infrastructure such as road networks and communication technology. The government should also work on lowering crime and violence which can be a deterrent for potential investors. The government could also improve the ease with which business can be conducted within the country – that is, removing or reducing ‘red tape’ Developing the necessary legal framework. The government also has the responsibility for developing laws and regulations to monitor these overseas-based companies. It has to ensure that its consumers are protected from unfair trading practices and that they are not exploited. The legal requirements for formation must also be clearly outlined, as these can be different from those in other countries. Consumer behaviour Consumers within the domestic economy will also benefit from globalisation. Some of these benefits are outlined below: Variety of choices – consumers benefit from a greater variety of goods and services to choose from. Since the growth of globalisation, consumers can acquire products that were not previously available to them. These can now be accessed via e-commerce. Some of these goods may help to improve customers’ standard of living Most of the time, consumers are on the receiving end of increased competition. They benefit from increases in product quality and after-sales service as companies try to outdo each other. They also benefit from lower prices if companies are involved in price wars. Increased competition also forces businesses to become more efficient as they seek to create brand loyalty Employment – some consumers also benefit from employment in multinational corporations and other firms that were established through Foreign Direct Investment (FDI) Changes in taste and preference – as the market opens to international influences, local consumers might gravitate towards foreign products. This could influence what they eat and how they dress, among other things Quality – some MNCs have the tendency to provide a higher-quality product to their consumers in their homeland. However, in the absence of stringent laws or quality standards in the regional countries, they may produce sub-standard products. To this end, consumers 53 54 MODULE 1 | UNIT 1 | BUSINESS AND ITS ENVIRONMENT must ensure that they do not settle for mediocrity but remain adamant that quality be maintained by these MNCs. Without valiant efforts by consumers, the firm may produce and sell sub-standard products Responsibility – consumers have a responsibility to ensure that their rights are not infringed by MNCs. Consumers must be aware of the fact that some MNCs may run away from more stringent laws in their home countries and as such may not provide the best service to their host countries. With this in mind, consumers should hold them responsible for providing quality service. Domestic businesses The impact of globalisation is felt by businesses worldwide. The impact might be different among these businesses, though. Below are some of the possible ways in which businesses might be affected by globalisation: Competition – businesses are likely to face increased competition from foreign firms. As barriers are reduced and businesses are deregulated, they can enter markets that were once difficult to get into. Globalisation also paved the way for new and innovative firms to enter markets and compete with existing firms. This may be detrimental for some small domestic firms which are not able to compete with large multinationals. The Caribbean is characterised by small entities that are sometimes undercapitalised and therefore they may not be competitive Economies of scale – domestic firms can also expand into the global market. As they do so, large-scale production brings about economies of scale. Their fixed costs can be spread over a larger amount of output which leads to a reduction in unit cost and a lower price. These firms may also benefit from purchasing economies as they conduct bulk buying Technology advancement – businesses gain access to improved technology which can be used to increase output and productivity. Advanced technology will also allow the firm to reduce its costs of production as older technology is often inefficient and causes wastage Choice of location – globalisation opens a number of markets that were previously inaccessible and as a result firms can now choose to locate in different countries. Doing so may provide businesses with other opportunities such as labour cost saving and increased sales The internet is a main driver of globalisation and this provides businesses with numerous opportunities. With the internet through e-commerce, the business can advertise, sell or purchase online Pricing policy – globalisation can also affect the prices charged by domestic businesses. Where international firms are able to sell their products at a lower price than domestic firms the latter may be forced to lower their prices. This could mean serious losses or reduced profits for local firms Quality assurance – this is a guarantee to maintain an agreed or established set of quality standards. Regional businesses that desire to sell their products in foreign countries may have to seek certification to prove that these products meet international standards. Two international standards by which the firm may be certified include the British Standards Institution (BSI) and the International Organization for Standardization (ISO). Having certification from these bodies gives a business a stamp of quality that will make it easier for it to trade on the international market. This topic is dealt with further in Unit 2. Protectionism As explained above, the impact of trade liberalisation and globalisation is evident in different spheres of the business environment. In order to protect the interests of Caribbean businesses, some governments have embarked on protectionism. This refers to attempts by the government of a country to restrict the importation of goods and services. Protections may be placed on the importation of goods and services in order to: Prevent the dumping of the surplus of foreign goods into the local market. These are usually low priced and will compete against local firms Since some firms would have to shut down if they cannot compete with foreign firms, some workers would have lost their jobs. However, with protectionism unemployment may be reduced Protect infant industries by giving them a space to grow and settle in the market with little or no competition Rectify balance of payment disequilibria – that is, where the value of imports exceeds the value of exports. Protectionism will reduce the amount of imported goods and reduce or rectify the disequilibria. The following are the types of protection that are commonly used by Caribbean governments: Tariff is a tax on imported goods. The tax can be a fixed amount per unit or can be calculated as a percentage of the value of the imports. Since the tax will cause imported goods to be more expensive, the amount of CHAPTER 4 | CARIBBEAN BUSINESS ENVIRONMENT AND GLOBALISATION CASE STUDY Globalisation and Caribbean sugar The reality of a changing global environment is becoming more evident in the Caribbean as a number of firms struggle to stay afloat. This is no different for many businesses in the agricultural sector, including sugar companies. Sugar companies in the Caribbean have long benefited from preferential arrangements with Europe which to some extent secure a market for their produce. However, with higher production costs, poor technology and undercapitalisation, coupled with competition from countries such as Brazil, some of these sugar companies have been adversely affected. The Jamaican sugar industry has gone through privatisation then had to be repurchased by the government in the 1990s when it accumulated huge losses because of high inflation rates and a revaluation of the Jamaican dollar. The industry had to depend on capital injection from the government and the preferential agreement from Europe. After losing that preferential treatment with the signing of the European Partnership Agreement in 2008, it became evident that the government could not continue to carry this entity on the Budget. It was decided to privatise the industry once again. The sugar companies in Barbados are facing similar challenges. The 1990s also saw a threat of closure of at least one of the factories and poor economies of scale. Globalisation has further worsened the woes of the sugar companies in the Caribbean as many have suffered from high labour costs, falling world prices and the introduction of tariffs in the European market. Questions 1. Define the term ‘globalisation’. (1 mark) 2. Outline three (3) factors that are driving globalisation. (6 marks) 3. Amid the challenges being faced by the sugar companies in the Caribbean, discuss three (3) benefits to the following: a. Consumers b. Businesses c. The economy. (18 marks) Total 25 marks goods that are imported should fall. Local firms will be able to sell more products. This method is often used successfully in the agricultural sector in most Caribbean countries Quota is a restriction that is placed on the quantity of a product that can be imported at a given time Embargo is a complete ban on trade between two countries Export subsidies – the government may grant subsidies to local firms so that their products can be sold at a lower price than imports Exchange controls – this is a deliberate restriction of the foreign currency available to citizens. Since most Caribbean countries trade using the US dollar, if it is unavailable or in short supply, people will tend to consume fewer imported products. Other barriers to trade The government may also use other barriers to trade, such as: Rules and regulations Import licences Voluntary export restraints (VER) which limit the amount of goods that can be exported from a country. 55 56 MODULE 1 | UNIT 1 | BUSINESS AND ITS ENVIRONMENT CHAPTER SUMMARY The Caribbean business environment is characterised by low literacy rates, outdated technology, small and open nature and high rates of unemployment ‘Business culture’ is defined as the beliefs, attitudes and values of the employees in an organisation The culture of any organisation is formed over time and is usually influenced by leaders, the environment, employees, communication and procedures A multinational or transnational corporation is one that owns and controls other business operations outside the country in which it is situated Globalisation entails the increased connectivity and interdependence of the world economy ‘Protectionism’ refers to attempts by the government of a country to restrict the importation of goods and services. Trade liberalisation is the removal of barriers to trade and giving free access to the market MULTIPLE CHOICE QUESTIONS 1. Caribbean economies are characterised by: a. High employment rate b. Many trade barriers c. High illiteracy rates d. Advanced technology 2. Business culture is influenced by ALL of the following EXCEPT: a. Consumers b. The environment c. Procedures 4. Which of the following have led to the growth of MNCs in the Caribbean? i. Lower production cost ii. Government policy iii. High profits iv. Repatriation of profits a. i and iv b. ii, iii and iv c. i and ii d. i, ii, iii and iv 5. Which of the following are drawbacks to having MNCs in the Caribbean? a. Vision i. Exploitation of workforce ii. Reduction in unemployment iii. Depletion of resources iv. Closure of local firms a. i and iii b. Culture b. i, iii and iv c. Mission c. ii and iv d. Aim d. i, ii, iii, and iv d. Management 3. The beliefs, attitudes and values of the employees form an organisation’s ____ 6. Trade liberalisation in the Caribbean started with which organisation? a. CARICOM b. CSME c. CARIFTA d. GATT CHAPTER 4 | CARIBBEAN BUSINESS ENVIRONMENT AND GLOBALISATION 7. Which of the following is NOT a key element of CSME? 9. A tax placed on imported goods and services is called a/an: a. Right of establishment a. Exchange control b. Movement of labour b. Tariff c. Free circulation c. Quota d. Barriers to trade d. Embargo 8. Globalisation is being driven by ALL of the following factors EXCEPT which one? 10. Protectionism is used for ALL of the following reasons EXCEPT which one? a. Reduced transport cost a. To prevent dumping b. Trade liberalisation b. To protect infant industries c. Available raw materials c. To promote inefficiency d. Deregulation of markets d. To fix balance of payment problems Extended Essay Questions Question one Total 25 marks There are a number of multinational corporations (MNCs) within the Caribbean region. These firms have presented the region with both benefits and drawbacks. a. State what is meant by a ‘multinational corporation’ and give one (1) example of such a business within the Caribbean. (5 marks) b. Discuss three (3) benefits and two (2) drawbacks of MNCs to the Caribbean region. Question two (20 marks) Total 25 marks Globalisation has opened many doors for the main stakeholders of the Caribbean. Its impacts are felt on a day-to-day basis. In fact, the concept of globalisation should be of interest to all. a. Define the term ‘globalisation’. (1 mark) b. Discuss three (3) factors that give rise to globalisation. (9 marks) c. Discuss three (3) impacts that globalisation may have on businesses within the Caribbean region. (9 marks) d. Discuss two (2) impacts that globalisation may have on consumers within the Caribbean region. (6 marks) 57 58 5 Module 2 The Management of People The Functions and Theories of Management LEARNING OBJECTIVES: At the end of this chapter students should be able to: Discuss the need for and nature of organisations Evaluate the major management theories Outline the contribution of each theory on present-day organisations Explain the functions of management Discuss the effect that each function has on the organisation Assess the main roles of management in an organisation The need for and nature of organisations S imply put, an organisation is a group of people working together to achieve a common or collective goal. Organisations work to transform inputs (people, raw materials, money, etc.) into outputs which are of greater value than the inputs used. In Module 1, we discussed the different types of organisations that exist in both the private and public sectors. It was pointed out that, because of scarcity and out of choice, humans must make decisions regarding what to produce, how to produce and for whom to produce. Therefore there is a need for organisations that will convert inputs into outputs. Each organisation may be different in many ways. This difference is sometimes caused by the management theory that is being utilised. The next section will outline the main tenets of these theories while discussing their impact on modern-day organisations. The major management theories The classical theories This form of management theory dates from as far back as the Industrial Revolution when it was adopted to deal with the new problems that had emerged. Managers found it difficult at the time to train employees and decrease dissatisfaction. This led to the development of classical theories as they tried to find a proper solution. The work of three main classical theorists will be discussed in this section, namely Frederick Taylor, Henri Fayol and Max Weber. Scientific Management: Frederick W Taylor (1856–1915) Frederick Taylor is usually regarded as the father of Scientific Management. During the time of the development of this theory most managers had little contact with the activities of the factory. Instead, foremen were given full control to produce the goods that were in demand. Workers would generally use the available tools and developed methods that fitted their style of work. This had become counterproductive and inefficient, and workers were often dissatisfied. The existing situation sparked the interest of Taylor, who wanted to improve productivity and reduce inefficiencies in the US manufacturing sector. He started his study at Midvale Steel Company and found out that there was confusion between management and workers on what constituted ‘a day’s work’. He carried out numerous experiments, called work studies, in order to determine the best way to perform a job. Taylor viewed man as an ‘economic animal’, meaning that he was rational and made economic choices based on the monetary or material reward to be gained. This view of the economic man led him to develop payment systems which linked efforts with the rewards received. This was done using a piece rate system. Taylor’s study outlined ways in which managers could use the principles of his theory to improve productivity. His theory suggested that work should be broken down into smaller components or tasks to enable workers to specialise and become competent at those tasks. Taylor outlined four principles of Scientific Management: Develop a scientific study of management, with stated rules, laws and principles to replace the outdated ‘rule of thumb’ methods Workers should be selected scientifically, trained and developed as opposed to past practices where they were selected randomly and usually untrained Cooperate with workers in order to ensure that work is done in accordance with the prescribed scientific principles CHAPTER 5 | THE FUNCTIONS AND THEORIES OF MANAGEMENT There should be an equal division of tasks and responsibilities between managers and workers. This will allow managers to apply Scientific Management principles in planning the work that will be performed by the workers. For the most part, these principles had some level of success. According to research done, they were implemented in many factories and would often increase overall productivity. In addition to his four principles of management, Taylor used the following elements of Scientific Management to manage his staff effectively: The separation of planning from the actual performance of the task Carefully selecting workers to carry out a task on a scientific basis Closely observing workers doing the task, and documenting findings Carrying out job analysis to ascertain the best way of completing a task Standardisation of the process involved in carrying out the task based on the job analysis Assigning foremen to supervise workers, based on specialisation of functions Fostering a suitable environment to encourage cooperation between management and workers Providing financial incentives to motivate workers and pay them based on performance. This theory enjoyed the following successes: Factories that implemented his approach benefited from increased productivity Some organisations benefited from increased profits His theory led to the development of fields such as industrial engineering, personnel and quality control. Some drawbacks of Taylor’s theory are: Identifying the ‘best way’ to do a job often made the task monotonous, dampening autonomy and skill variety Some people were opposed to the use of stopwatches to assess the work done in a day His view of the economic man was heavily criticised because humans were likened to machines and would only be satisfied by money. Administrative Management: Henri Fayol (1841–1925) Henri Fayol is also a classical theorist and is regarded as the ‘father of modern management’. His theory of Administrative Management was developed around the same time as Taylor’s but he did not focus on the workers. Instead, he focused on management from the upper level of administration. He concluded that business activities are divided into six interdependent groups which managers should coordinate so as to achieve the organisation’s goals: Technical – including manufacturing, production and adaptation Commercial – including buying and selling Financial – sourcing and utilising capital Security – extending to both property and individuals Accounting – inventory, final accounts and statistics Managerial – including his five functions of management, which are discussed below. Fayol’s five functions of management are outlined as follows: Planning – involves the establishment of objectives and development of strategies to achieve them. Managers should also be able to anticipate future events and plan accordingly Organising – this deals with the delegation of responsibilities to subordinates in order to get the job done Commanding – giving clear instructions to workers and ensuring that the business is operated effectively Coordinating – the manager should ensure that all groups within the organisation are working toward a common goal Controlling – ensuring that activities are being done according to plan. The manager monitors the performance of the staff against the prescribed rules and procedures. Incidentally, some of the functions Fayol proposed became well known and accepted as the main functions of management. These will be discussed in more detail later in the chapter. In addition to the five functions of management, Fayol outlined 14 principles of management which should help the manager to run a business smoothly. These are: Division of labour – work should be divided into smaller tasks to promote specialisation. This should increase efficiency, productivity and output Authority and responsibility – managers should be given the authority and autonomy to carry out their responsibilities Discipline – all levels of managers should be disciplined in order to accomplish their tasks. Discipline will help them to develop obedience, diligence, energy and respect for all Unity of command – in order to prevent confusion, subordinates should take command from and report to only one supervisor 59 60 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE Unity of direction – activities of the same nature should be supervised by one manager who will guide subordinates to achieve the same objective Subordination of individual interest to general interest – the interest of an individual or group should not override the interest of the enterprise as a whole Remuneration – workers should receive fair payment for work done Centralisation – this deals with the way in which decisions are made. The degree of centralisation in decision making should be based on the circumstances being faced by the organisation Scalar chain – there should be a clear line of authority from the highest to the lowest level in the organisation. In other words, there should be an organisational hierarchy with a manageable span of control Order – all resources (people, raw material, tools, equipment, etc.) in the organisation should be carefully and properly ordered to ensure efficiency Equity – employees should be treated fairly and justly. Managers should not discriminate but be kind, honest and impartial to every employee Stability of tenure of personnel – labour turnover rate is an indication of the effectiveness of management. This rate should be minimised so that each employee can grow and propel the organisation towards achieving its goals Initiative – workers should be encouraged to generate ideas and develop plans that will benefit the organisation. This will also help the employees to develop their personal skills and abilities Esprit de corps – this means a ‘spirit of cooperation’. Employees and managers should develop good team spirit and morale. Unity and harmony should be promoted in order to strengthen the organisation. Fayol’s 14 principles of management are still being used in some organisations today. They guide managers on how to supervise subordinates and organise their departments or firms. Bureaucratic Management: Max Weber (1864–1920) Bureaucratic Management was developed by Max Weber, a German sociologist. His work focused mainly on how the organisation was structured rather than the practical problems of management proposed by Taylor and Fayol. Having viewed and analysed the growth of large-scale organisations, Weber developed a set of principles for what he dubbed ‘an ideal bureaucracy’. To Weber, ideal bureaucracy was based on legal authority rather than tradition or charisma. This legal authority encompasses rules and controls that govern the organisation. He believed that managers were given the mandate to enforce these rules and controls based upon the authority given to them by the office in which they serve. In his study, Weber pointed out that bureaucracy had become inevitable because of the growth of businesses, advancement in technology and modern legal demand. This concept of bureaucracy is evident in governments, businesses, trade unions, churches and even voluntary associations. Weber developed six characteristics of bureaucracy: Division of labour – this will lead to an increase in efficiency due to specialisation. By dividing labour, authority and responsibility will be clearly defined Authority hierarchy – the chain of command should be clearly outlined from the top to bottom in the organisation. Each employee must be aware of the person to whom he reports. Likewise, a manager must be aware of the people for whom he is responsible Formal selection – employees should be hired based on their qualifications, education and training Career orientation – managers were seen as professionals instead of just owners of units they managed. As a result, they were expected to pursue ‘careers’ in their respective fields Formal rules and controls – the organisation has formal rules and controls which must be adhered to by employees in the performance of their duties Impersonality – rules and controls were applied impersonally and uniformly across the organisation. Weber’s theory of bureaucracy faced criticisms, some of which are outlined below: The constant dependence on rules and controls may impede the organisation’s ability to change to meet the changing environment The delegation of authority may lead to subdivisions within the business, with people focusing on the objectives of the unit rather than the business as a whole Rules and controls may become tedious over time and lead to inefficiencies rather than the efficient running of the business. Table 5.1 sets out the various contributions of classical management theories to the running of modern organisations. CHAPTER 5 | THE FUNCTIONS AND THEORIES OF MANAGEMENT Classical theories Contributions Scientific Management (FW Taylor) Some firms still hold money as the only motivator, instead of utilising other incentives such as recognition, etc. ‘Best practices’ are promoted in different spheres to achieve objectives The selection of workers in a number of organisations is done with stringent procedures to ensure that the best person is employed Staff appraisal is practised today which is very similar to Taylor’s observation and documentation of workers Workers, especially in the manufacturing and construction sector, are still being closely supervised by foremen Firms still place great emphasis on efficiency and profit maximisation Administrative Management (Henri Fayol) Fayol’s five functions of management provide a basis for managers in carrying out their roles and responsibilities. These are still being practised by today’s managers Specialisation is widely practised in a lot of organisations Fayol’s principle of scalar chain is seen in many firms’ organisational charts. The chain of command is still practised today The principle of initiative is pursued by many of today’s firms as workers are given the autonomy to develop projects and work in teams to improve business activities and performance Bureaucratic Management (Max Weber) The theory of bureaucracy is being used in a number of large organisations The hierarchical structure proposed by Weber is widely used today as managers and subordinates are clear on who is in control and to whom they should report Organisations and institutions outline rules and regulations to monitor the activities that go on in the business Managers are still required to acquire the necessary qualifications in order to be considered for the job The concept of specialisation is evident in many organisations Table 5.1: Contributions of classical theories to modern organisations CASE STUDY ‘Old school’ management at OSM Ltd When Mr Grumpy took over the reins at OSM Ltd the staff were optimistic that a big change would be coming and a new style of management would emerge. However, reality set in as soon as Mr Grumpy became settled. Employees quickly realised that while his was a new face, his management style was old. Being a steward of a deeply entrenched classical leader, Mr Grumpy has approached this job with the same traits. Since his arrival he has implemented hectic training programmes, workers are given guidelines on how work is expected to be done and payment is now being made based on performance. In addition to those changes, workers feel as though they are being closely monitored and that there are too many supervisors. The workers are becoming restive and the other managers are now looking at ways in which they can improve the management of the firm. Some of them are thinking of using either Henri Fayol’s or Max Weber’s approach to management in a bid to change the way things are done. Questions 1. Which of the classical theories is being used at OSM Ltd? Give at least two (2) pieces of evidence from the case. (5 marks) 2. Looking at the circumstances, is this the best approach to be implemented? Explain your answer. (4 marks) 3. Briefly describe the principles of the two (2) other theories that were mentioned in the case. (8 marks) 4. Discuss whether or not these approaches are the best move for the firm at this time. (8 marks) Total 25 marks Human Relations School of behavioural theories By the 1920s, while the classical theories were successful, other scientists started to look for other solutions to management problems. Together they formed the Human Relations School (Behaviour Management Theory) which focused specifically on the human side of management. Their view was that management needs to focus on people more than science or techniques, as purported by the classical theorists. These theorists, led by Elton Mayo, studied the reaction of employees to performance incentive schemes, job satisfaction and working conditions. They concluded that if managers attempt to understand their 61 62 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE Job enlargement – workers are given more than one task to perform at the same level of skill and responsibility Job enrichment – the workers’ tasks are improved upon to make them more interesting and satisfying. Workers are also given more responsibility and recognition Job rotation – workers get the chance to work in different positions throughout the business, doing different tasks before being moved to another task Group working – this involves placing workers in groups to complete a given task. Some criticisms of this theory are: Humans are complex and so predicting behaviour may be more difficult than presented There are other factors outside of motivation that affect workers’ performance The Human Relations School was criticised for playing down the conflict of interest between management and employees. employees’ behaviour better, they can improve productivity. This school got its ‘kick start’ from a major study carried out at the Western Electric Company’s (WEC) Hawthorne plant in Chicago between 1924 and 1932. The Hawthorne Study: Elton Mayo This study was spearheaded by Elton Mayo, a Harvard University professor. The main purpose of the research was to determine the effect of working conditions on productivity. The study started out by trying to determine the relationship between lighting in the work area and employee productivity. The initial experiment heeded no positive result and so Mayo and a colleague (Fitz J Roethlisberger) were hired to find other variables. The new experiment focused on a Relay Assembly Test Room where they studied a group of female employees. The women were allowed to supervise themselves, enjoy less control and form groups. The theorists soon found out that these privileges boosted the workers’ morale. They were no longer thinking that they were a small part of the organisation and that they were not needed as much as others. This led to an improvement in output as the women had become more motivated to do the work. This study changed the views of many stakeholders of the day and improved their knowledge and understanding. The study’s findings outlined the following views: Workers are not motivated only by money but also by social and personal factors Management should analyse employees’ attitudes when trying to ascertain their behaviour Effective supervision helps to maintain employees’ morale and productivity More emphasis should be placed on informal groups and they may have a significant impact on employees’ performance. The Human Relations School consisted of other theorists who brought forward ideas such as: Maslow (Hierarchy of Needs) McGregor (Theory X and Theory Y) Herzberg (Two Factor Theory). These theories will be People, material, further examined and discussed money and under ‘Motivation’ later in the information module. The following methods of motivation were proposed by the Human Relations School: Figure 5.1: A basic system The system management approach The system approach is a modern form of management. It focuses on the organisation as a system that transforms inputs into outputs. A system is a set of interdependent parts (subsystems) that relate to each other in the accomplishment of a purpose or task. The system theory sees the organisation as having four components or elements: Inputs – people, materials, money or information Transformation – includes managerial or technological processes Output – the goods and services that are produced Feedback – includes the possible reactions from the environment in which the firm operates, for example from consumers or clients. External environment Inputs Transformation process Feedback Output Goods and services CHAPTER 5 | THE FUNCTIONS AND THEORIES OF MANAGEMENT A model of a basic system is shown in Figure 5.1. Based on this, it is clear that the process of inputs, transformation and outputs is continuous. The organisation has to ensure that it produces products that can be exchanged for the resources (profits) needed to obtain new inputs and to maintain its survival in the market. System theorists believe that businesses should be analysed in terms of the interaction of their basic components. These components could lead to an improvement in the business’s performance. However, in order to realise this, managers are required to manage the interaction of each component rather than their independent actions. As a result, the system approach suggested that management integrates its major functions of planning, organising, staffing, leading, human resource management and controlling. The system approach stated that most organisations (systems) depend on other systems for their inputs and sell their outputs to other systems (consumers). These organisations are affected by market forces within their environment, along with societal values, legislation, shareholders’ demands and so on. The system approach is concerned with some key concepts which give a clear picture of how a system works. First, a system is divided into two categories: Closed system – which is one that has very little or no interaction with its external environment Open system – which is one that has interaction with its external environment. Another set of concepts important to the system theory are: Synergy – this occurs where the total output of the system is greater than the sum of all of its inputs. However, for synergy to occur, each subsystem may have to sacrifice its optimisation for the success of the whole system. In terms of the business, each department should not aim solely at achieving its own objectives but instead work together to achieve the overall objectives of the firm. Therefore the production department cannot work without the input of, say, marketing or finance if the business is to be successful. Synergy is therefore associated with an open system Entropy – this refers to the tendency of systems, especially where they are not properly maintained, to run down and die. The concept of entropy is closely associated with closed systems because of the lack of interaction with the external environment. This lack of interaction results in no possibility for new inputs and energy and so the system will eventually die Subsystems – as was alluded to earlier, these are the individual parts of the entire system and are interdependent. Management must realise that a change to any of these subsystems will result in a change in the entire system. As a result, the firm must not be managed as having separate parts but as one unit. Contingency theory After analysing the existing management theories, in the late 1950s Joan Woodward and other theorists developed the contingency theory. These theorists believed that there was no ‘one best way’ to carry out a task. Instead, its main approach is one of ‘it all depends’. The theory stipulates that each situation is affected by different factors and must be treated on its own merit. With this in mind, the contingency approach is flexible and draws on the concepts of all previous theories in solving a problem. It integrates the findings of all theories in an attempt to deal with each situation. The effectiveness of such action depends on the size of the organisation, history, the environment and the techniques used, among other factors. The main ideas of the contingency approach are summarised as follows: A universal or ‘one best way’ to manage does not exist The organisation should ensure that there is coordination between its design and subsystems and the environment in which it operates For the organisation to be effective, its subsystems must be in sync Modern theories Contributions Human Relations School It gave insights to businesses on motivation and group dynamics which are still practised today The recognition of employees as valuable resources has changed the view that they are economic animals and tools System theory The concepts of this theory are being widely used in a number of organisations that practise teamwork. Departments are no longer isolated but are making their contributions to the development of certain projects Organisations have placed more emphasis on all stakeholders. As a result, firms are signing quality assurance deals with their suppliers, are becoming more aware of the needs of their customers and are becoming increasingly socially responsible Contingency theory In reality there is no one way of doing things, therefore this theory is synonymous with the approach that many organisations have taken in employing aspects of the different theories in management Table 5.2: Contributions of modern theories to modern organisations 63 64 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE The appropriateness of the design and management style of the organisation is very important to success of its tasks and the nature of its work group. Table 5.2 (p 63) sets out the various contributions of modern management theories to the running of modern organisations. The functions of management The term ‘management’ may be defined as the process of organising the available resources of the business to achieve desired results. Since employees do not normally organise themselves and resources to achieve business objectives, managers are very important. A manager is an individual who makes decisions about the use of limited resources and the planning, organising, directing and controlling of these resources to achieve the organisation’s goal. There are three levels of management, especially in larger organisations (see Figure 5.2): Top level – has overall responsibility for the business. This includes positions such as Chief Executive Officer, President, Chief Operations Officer, Principal, etc. Middle level – these managers report to top managers. They are usually responsible for departments or divisions and make tactical plans for how to achieve the business’s overall objectives. This level includes heads of department, Vice Principals, heads of division, etc. Low-level or first-line managers – these managers supervise the workers and the daily operations of the business. They have direct responsibility for implementing the plans outlined by middle managers. This level includes supervisors, foremen and office managers. A manager has a number of functions that he/she carries out on a daily basis. Each function is as important as the others and may affect the efficiency of the business. These functions assist with the management of the organisation. The main functions carried out by management are discussed below: Planning This function of management relates to setting business objectives and establishing the necessary plans to achieve such objectives. This function is vital as it will outline the direction that the business will be taking in the future. For example, if a business’s objective is to increase its annual sales by 20 per cent, the manager has to outline the plan to achieve this goal. This plan could include increasing advertising or the sales force. With this plan in place the manager can work towards achieving the stated objective. Organising In this function the manager organises the human and other resources necessary to execute the plan and objectives in the preceding function. It involves the grouping of activities and resources in order to achieve objectives and the distributing of authority to employees. The work may be organised in groups or departments or assigned to specific individuals. Lines of authority may also be established which should help to improve communication, improve decision making and prevent the duplication of resources. Directing Directing involves the motivation and leading of employees in order to attain business objectives. This function is mostly carried out by lower-level managers who interact and work with employees on a daily basis while they carry out their assigned tasks. Managers are also expected to motivate employees so that they can achieve the business’s objectives. They use different strategies to motivate employees, which may include giving incentives, recognition etc. Motivation will be discussed further in Chapter 8. Controlling Top level Middle level Low level In carrying out this function, managers are expected to evaluate and correct activities to ensure that the business is on track to attain its objectives. Controlling usually follows the process of measuring performance, comparing actual performance with the firm’s objectives, highlighting variances and taking the necessary steps to correct any shortfall. Staffing Figure 5.2: The three levels of management This function of management deals with the recruitment, selection, development and compensation of the staff. CHAPTER 5 | THE FUNCTIONS AND THEORIES OF MANAGEMENT Managers use this function to build their organisations through the development of their employees. The function is of utmost importance since the firm needs employees to carry out its day-to-day activities. It involves management filling the organisational positions, improving workers’ professionalism and making full use of their human resources. The roles of management Managers carry out different roles in an organisation. These are organised into three main categories: Decisional role Informational role and Interpersonal role. Using these, Henry Mintzberg proposed ten roles for top management (see Table 5.3). Categories of roles Specific Explanation Decisional role Entrepreneur The manager should use the resources of the organisation to develop new products and projects or identify areas for the business to improve or develop Disturbance handler When unexpected problems arise the manager should deal with them immediately. He should take corrective action to quell conflicts or crises and overcome changes in the external environment Resource allocator To allocate resources to the different departments in an equitable manner. Managers should also draft budgets for the different departments Negotiator Offers representation for the organisation when bargaining with trade unions and suppliers or in any other situation that may arise Monitor The manager must monitor the performance of the departmental managers while taking corrective actions where needed. He should also be aware of any changes that are occurring in the internal and external environments which have the potential to affect the organisation Disseminator The manager should communicate the firm’s vision and goals to the employees, along with the possible changes that may take place as a result of the changing business environment Spokesperson This involves being ‘voice’ of the organisation to the general public. He is responsible for promoting the firm’s products and sharing any pertinent information about the firm Figurehead The manager performs certain ceremonial and symbolic duties including interacting with customers and visitors and offering representation on legal matters Leader This includes directing, hiring, training and motivating subordinates Liaison The manager interacts with the different stakeholders of the firm. He also should coordinate the tasks of managers in different departments Informational role Interpersonal role Table 5.3: Mintzberg’s ten roles for top management 65 66 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE CASE STUDY A manager’s dream Joan Phillips has taken over the position of CEO at a reputable manufacturing company in her country. This happened after the previous manager was relieved of his duties because of a slew of issues affecting the employees, shareholders and the firm’s profitability. Joan has been charged with the task of turning the company around. She knew from the very outset that this would have been a difficult task but decided to take up the challenge. Joan arrived to find a firm where things were done haphazardly, workers had little direction and knew very little about where the firm was going, and the level of motivation was also very low. The lower-level managers were not very clear on their roles and about what was expected of them and as a result the firm has not done very well. As part of the recovery process, Joan decided to meet with all the department managers to improve the situation. She decided that she would outline the functions of each manager and implement strategies from the Human Relations School of Management to improve the morale of employees. She believed that this move would bring about a turnaround for the firm. Questions 1. Outline how the four methods of motivation proposed by the Human Relations School can be used to improve motivation in the firm. 2. State one (1) criticism of the Human Relations School. 3. Describe four (4) functions of management that Joan would want to discuss with the department managers. (8 marks) (1 mark) (16 marks) Total 25 marks CHAPTER SUMMARY The three main classical theorists are FW Taylor (Scientific Management); Henri Fayol (Administrative Management); and Max Weber (Bureaucratic Management) Taylor viewed man as an ‘economic animal’, meaning that he was rational and made economic choices based on the monetary or material reward to be gained A work study is a combination of a time and motion study. It analyses a specific job in an effort to ascertain the most efficient method to use in terms of time and effort The Human Relations School changed the perception of management in that, unlike the classical theorists, they focused on the human side of management. Contributors to this school include Elton Mayo, Frederick Herzberg, Abraham Maslow and Douglas McGregor The system approach stated that most organisations (systems) depend on other systems for their inputs and sell their outputs to other systems (consumers) The contingency theory stipulates that each situation is affected by different factors and must be treated on its own merit The main functions of management include planning, organising, directing and controlling Management carries out three main roles in the organisation. These are decisional, informational and interpersonal. CHAPTER 5 | THE FUNCTIONS AND THEORIES OF MANAGEMENT MULTIPLE CHOICE QUESTIONS 1. Which of the following theorists is NOT associated with the Classical School? a. Max Weber b. Frederick Taylor c. Job satisfaction d. Job rotation 7. The system theory sees the organisation as having four components. Which of the following is NOT one of those components? c. Frederick Herzberg a. Management d. Henri Fayol b. Transformation 2. Which of the following theorists viewed man as an ‘economic animal’? a. Elton Mayo b. Frederick Taylor c. Output d. Feedback 8. Which function of management involves the motivation and leading of employees in order to attain business objectives? c. Frederick Herzberg a. Planning d. Henri Fayol b. Organising 3. Which of Fayol’s 14 principles of management states that ‘Activities of the same nature should be supervised by one manager who will guide subordinates to achieve the same objective’? c. Directing d. Controlling 9. ALL of the following are decisional roles of management EXCEPT which one? a. Unity of command a. Negotiator b. Unity of direction b. Entrepreneur c. Equity c. Disturbance handler d. Centralisation d. Leader 4. Which of the following BEST defines Fayol’s principle of division of labour? 10. The informational role of management includes which of the following? a. Managers should be given the authority and autonomy to carry out their responsibilities a. Figurehead b. Workers should be encouraged to generate ideas and develop plans that will benefit the organisation c. Leader c. Work should be divided into smaller tasks to promote specialisation b. Liaison d. Monitor d. Employees should be treated fairly and justly 5. Max Weber is credited for his work on which of the following theories? a. Hawthorne Study b. Bureaucratic Management c. Contingency theory d. Administrative Management 6. ‘Workers get the chance to work in different positions throughout the business doing different tasks before being moved to another task.’ This statement BEST defines: a. Job enlargement b. Job enrichment Extended Essay Questions Question one Total 15 marks Discuss how any five (5) of Henri Fayol’s principles of management can be used to improve an organisation in modern times. (15 marks) Question two Total 25 marks a. Outline five (5) contributions that Taylor’s theory of Scientific Management has made to modern-day management. (10 marks) b. Explain five (5) of Max Weber’s characteristics of bureaucracy. (15 marks) 67 68 6 The Organisation and its Structure LEARNING OBJECTIVES: At the end of this chapter students should be able to: Discuss the importance of organisational structure Outline the different classifications of organisations Illustrate the different classifications of organisations diagrammatically Discuss the characteristics of the formal organisational structure B efore we delve into the major concepts of this chapter it is important that the term ‘organisation’ be revisited. In Chapter 5 an ‘organisation’ was defined as a ‘group of people working together to achieve a common or collective goal’. Put another way, it is a well-coordinated social unit of two or more people with a desire to achieve a common goal or collective goals. Based on these definitions, we see that the organisation should have some form of structure which will facilitate coordination of the activities carried out by the firm. The structure also helps to guide employees as it relates to their actions and lines of communication. The organisational structure is a framework that outlines the lines of authority and communication in the organisation. work of Frederick W Taylor who is seen as the ‘father’ of the Scientific Management approach. Figure 6.1 shows a typical functional organisational structure. Some of the features of a functional organisational structure are: Well-defined communication channels which are usually downward Clearly outlined chain of command and supervisory roles Utilises job specialisation and departments have welldefined roles The structure is less flexible and so it relies heavily on formal procedures. Advantages of the functional organisational structure Promotes co-ordination and control among employees, which can improve effectiveness Specialisation can improve the performance of departments Operational functions can be delegated to lower-level management. Disadvantages of the functional organisational structure Coordination and control may become too stringent and lead to low morale The decision-making process may be very slow, especially for very centralised structures The structure may become too rigid, so that it cannot adapt to the changing environment Classification of organisations An organisation can be classified in different ways, with each classification being dependent on various factors such as functions, product and location. The different classifications are described below. Figure 6.1: Functional organisational structure CEO Functional organisational structure The functional organisational structure is where the organisational structure is designed in terms of the functional areas of the business – for example, marketing, purchasing, accounting, etc. This is the most widely used classification by far, and is usually inexpensive. This type of organisational structure has been credited to the Purchasing Manager Purchasing Department Production Manager Production Department Finance Manager Finance Department Engineering Manager Engineering Department Human Resource Manager Human Resource Department CHAPTER 6 | THE ORGANISATION AND ITS STRUCTURE In the long run, specialisation can lead to a lack of focus on the organisation as a whole. The success of the product is highly dependent on the people with direct contact with the product There is duplication of the functional areas Competition could become negative, which is not good for the firm as a whole. Product organisational structure In situations where businesses have different products, management may decide to separate the activities for each product. Each product would have its own management structure which is answerable to top management. The management structure of the product may be extended to include the major functional areas of production, sales, finance, etc. An illustration of the product organisational structure is shown in Figure 6.2. The product organisational structure has the following important features: Allows for delegation of responsibility by top management Each product unit is accountable for profit in that division Each product is assigned the main functional departments of the organisation. Geographical organisational structure Where organisations are operating in different countries, the likely organisational structure will be geographical. The geographical organisational structure organises the enterprise in terms of regions or countries. However, each region or country can then be organised in terms of function or product. This type of structure is frequently used by multinational corporations which have different firms in various countries. An illustration of the geographical organisational structure is shown in Figure 6.3. The geographical organisational structure has the following features: Each region is a profit centre Figure 6.3: Geographical organisational structure Advantages of the product organisational structure OwnerPresident Focus is placed on the product’s performance and level of profitability Diversification in the product offerings of the firm is encouraged Promotes positive competition among divisions Each product division is given more autonomy to achieve divisional and organisational objectives. Country 1 Country 2 Disadvantages of the product organisational structure Maintaining the different divisions may prove to be expensive Marketing Operations Finance Marketing Figure 6.2: Product organisational structure General Manager Product (dairy) Production Marketing Product (bun) Finance Production Marketing Product (tinned food) Finance Production Marketing Finance Operations Finance 69 70 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE The different regions are arranged on a functional or product basis Regions are allowed some amount of autonomy in the management of their operations. Advantages of the geographical organisational structure The firm can respond quickly to local environmental change The organisation is presented with local opportunities which may not otherwise be available Promotes delegation of responsibilities Each region has responsibility for profit generation. Disadvantages of the geographical organisational structure There is duplication of resources across regions Poor coordination across regions can hurt the entire organisation Competition for corporate resources may lead to conflict Lower level of control by top management could lead to inefficiency. Matrix organisational structure The matrix organisational structure offers a different tactic in organising business operations. It is usually used where the environment is rapidly changing and there is a need for effective coordination to combat the situation. This structure combines elements of the functional, product and possibly geographical organisational structures. The matrix structure depicts two lines of authority. It shows the lines of vertical authority which concentrate on the major General Manager Production Sales and Marketing Product X Manager Product Z Manager Figure 6.4: Matrix organisational structure Purchasing functional areas of the firm and horizontal lines which show the lines of authority across the different divisions, regions or departments. A typical matrix structure is shown in Figure 6.4. Advantages of the matrix organisational structure Often leads to better use of resources Flexible and adaptable to the changing environment Employees are more involved in the operation of the firm Improves cooperation and problem-solving techniques Improves management skill. Disadvantages of the matrix organisational structure Workers may become confused from answering to so many authority figures Slow decision-making process May lead to a power struggle among managers Teams or divisional goals may override the goals of the organisation May increase the cost to the firm in organising its activities. Team organisational structure Later in this book we will examine the importance of teamwork and its impact on the organisation. More and more organisations are embarking on a team-based approach to their operations. The importance of teams is also evident in the school system through group work. This thrust of teamwork has led to the development of the team organisational structure. The structure seeks to remove departmental boundaries by establishing teams which work to complete an overall business objective. These teams are usually cross-functional and are composed of employees from different functional departments, including production, sales and finance. Team members are answerable to both their functional managers R and D and the team leader. A team organisational structure is illustrated in Figure 6.5 (p 71). Advantages of the team organisational structure Product Team X Product Team Z Improves employees’ motivation Removes departmental barrier while facilitating intradepartmental relationships Speeds up the decision-making process Adaptable to change in the environment and consumers’ taste and preference Allows authority to be delegated as the hierarchy is lessened. CHAPTER 6 | THE ORGANISATION AND ITS STRUCTURE ch and Resear ment p lo e Dev on Producti r e g a n Ma ng Marketi nt a lt u s n Co e Financ r e g a n Ma Disadvantages of the team organisational structure This structure may lead to conflicts among departments as they compete for scarce resources There is always a possibility of the problem of dual loyalties A lot of time is spent in meetings Teams may substitute the firm’s objective for theirs as decentralisation occurs. Network organisational structure This organisational structure links a number of separated organisations with a desire to achieve a common goal through their interactions. The network can be in the form of a joint venture agreement or where some of the major functions of the firm are subcontracted to other firms. These firms are linked by and to a company which serves as the headquarters or hub. For example, a large construction firm may give subcontracts to other firms that will assist with the completion of a project. Figure 6.6 shows an example of this type of organisational structure: cturer Less control over what is done, since most workers are contracted Can be time consuming, especially where there are regular meetings. Virtual organisational structure Figure 6.5: Team organisational structure Training on instituti Minimises administrative costs Faster decision-making process since there is a reduction in hierarchical structure. Disadvantages of the network organisational structure ng Marketi r e Manag Sales er Manag Advantages of the network organisational structure n Huma e c resour y agenc The virtual organisational structure uses networks to create linkages among people, assets and ideas. These linkages enable the company to manufacture and distribute products without the hindrances of organisational boundaries or location. This gives companies the ability to draw on the capabilities of others without having to be there physically. The virtual organisation relies on a centralised database which uses technology such as videoconferencing and e-mail via the computer to communicate. To this end, the stakeholders within a virtual organisation may not meet face to face for a while, if ever at all. Instead, they communicate via the internet to receive their assigned tasks and send their reports once their tasks are completed. Since meeting in a physical location is not a usual occurrence for the stakeholders, the physical company can be small but retrofitted with the capabilities to operate globally. A very successful example of the capability of virtual organisations is seen in Amazon.com. An illustration of the virtual organisational structure is shown in Figure 6.7. The virtual organisation is often characterised by the following features: Minimal physical structure Heavy reliance on communication technologies Manufacturing company Design company Manufa pany The comhub) l a tr n e (c g Auditin firm r uto Distrib er Design Figure 6.6: Network organisational structure ng Marketi c n e ag y Core company Sales and marketing company Logistics company ounsel Legal c ) fi w (la rm Finance company Figure 6.7: Virtual organisational structure 71 72 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE No boundaries to operation Work can be done from home Very few physical assets Heavy reliance on a network of part-time self-employed workers who are connected electronically. Advantages of the virtual organisational structure Access to worldwide expertise in order to provide highquality goods and services The firm can adapt quickly to changes in the external environment because of its flexibility Minimal overhead costs, as products are often outsourced Its smaller and flatter structure gives the firm better control Elimination of the physical boundaries of the firm. Disadvantages of the virtual organisational structure Heavy reliance on external organisations to provide high-quality goods in large quantities Lack of job security as the services of the employees might be subcontracted Close monitoring of external suppliers is required It can be difficult to build a corporate culture, as employees and employers may be from different cultures across the world Communication in the virtual office may be difficult, as people are working within different time zones. CASE STUDY Amazon.com: a virtual difference In hindsight, several years ago, who would have known that Amazon.com would have become one of the largest online companies? The company was established in 1994, with its headquarters in Seattle, Washington, USA. The company specialises in the online sale of a number of items, including books, electronics, toys, tools and clothing. The company has expanded its product offering significantly since its inception. Expansion is also seen in the company’s international retail websites, worldwide network of fulfilment and customer service centres. There are also a number of Amazon teams across the world providing fast and reliable shipping directly from Amazon retail websites to customers. Other services provided by Amazon teams worldwide include customer service centres and technical support. Driven by technological advancements, Amazon.com now employs over 88 000 people worldwide. In addition, over 2 million third-party sellers participate in Amazon by offering new, used and collectible selections to Amazon customers worldwide. To cement its position in the virtual environment further, Amazon.com opened its e-commerce platform to other retail brands and individual sellers in the year 2000. This has given hundreds of thousands of retail brands and individual sellers the opportunity to expand their market reach and increase sales drastically. Questions 1. Explain what a ‘virtual organisation’ is, giving one (1) example other than the one used in the case study. 2. Give two (2) pieces of evidence from the case to show that Amazon.com is a virtual organisation. 3. State one (1) reason for why technology is important for the success of Amazon.com. 4. Discuss three (3) benefits and three (3) drawbacks of Amazon operating solely as a virtual organisation. (2 marks) (4 marks) (4 marks) (18 marks) Total 28 marks Factors influencing the classification of organisations Size of the firm – as firms increase in size it may be necessary to upgrade or change their organisational structure. For example, an entrepreneurial business may move from an entrepreneurial structure to a functional structure. Likewise, larger firms such as multinationals tend to have geographical or product organisational structures The business cycle – firms may downsize or expand in relation to fluctuation in external environment. During periods of boom, firms may expand their CHAPTER 6 | THE ORGANISATION AND ITS STRUCTURE chain of command and functional areas. However, a recession may force them to downsize, possibly closing international branches or cutting management Business strategy and objectives – the strategies employed by the organisation to achieve its objectives may necessitate a specific type of organisational structure. In other words, organisational structure should coincide with business strategy. For example, if the organisation’s objective is to establish entities overseas, then its organisational structure must be flexible enough to be converted into a geographical one The business environment – there are a number of factors in the business environment that might affect the organisation. These include technological, political, socio-cultural and economic factors. These factors will affect the type of structure utilised by the firm. Characteristics of the formal organisational structure Hierarchy This shows the different levels of authority in the organisation. The hierarchy in most organisations usually consists of three levels. At the top of the hierarchy there is top-level management which has responsibility for setting long-term objectives and policies to chart the way of the firm to success. An example of a top-level management position is Chief Executive Officer (CEO). Below this level there is the middle management level, with managers having responsibility for the operational issues of the firm. This would include setting the jobs to be performed and the way in which they should be done. An example of a middle management position is Plant Manager. The lowest level in the hierarchy is the first-line managers. They have a supervisory role and should ensure that the work is done by the staff. An example of a first-line management position is Department Manager. Span of control Span of control refers to the amount of employees that are directly under the control of one manager or supervisor. As you might imagine, the greater the number of people being supervised by one person, the less effective that supervision will be. Therefore most organisations have a limit on the size of the span of control. The span of control is broken down into two categories, based on the number of subordinates involved. These are: Narrow span of control This is usually the case in organisations that have a very tall organisational structure – that is, having a number of managers or supervisors. However, it results in closer supervision of workers and helps managers to maintain quality and reduce risks. See Figure 6.8. Wide span of control This involves the supervision of a larger number of people. Organisations with a wide span of control tend to have a flatter organisational structure, with fewer levels of authority. A wider span of control enables managers to delegate responsibility to subordinates. See Figure 6.9 (p 74). Some of the factors that may affect the span of control are outlined below: The nature of the work being undertaken – that is, more complex tasks warrant greater supervision The ability, competence and skill level of subordinates The leadership style employed by management The structure of the organisation. Line and staff relationship Line relationship – this is one that exists between senior management and subordinates. It depicts an organisation where authority or directives flow from top Chain of command Chain of command shows the lines of authority in the organisation. These lines are used to transmit information and instructions up and down the hierarchy of the organisation. As was outlined above, the higher the level of management, the greater the level of authority. Therefore senior management is at the top of the chain of command which will continue down the organisation so long as there are people (subordinates) receiving directives from someone higher in the chain than themselves. Figure 6.8: Narrow span of control 73 74 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE Figure 6.9: Wide span of control management down through the organisational structure. This relationship gives management the opportunity to delegate authority, direct and control employees Staff relationship – in the organisation, there are people who offer specialist advice to managers. These specialists do not have the authority to ensure that their suggestions are implemented since they are not within the hierarchy of the organisation. An example of a staff relationship would be a legal secretary to a CEO of a large company Line and staff organisation – this is one that combines the line authority with the supporting or specialist roles within the organisation. Both sets of people work together to achieve the organisation’s overall goals and objectives. Responsibility This refers to the fact that all people in the organisation are obliged to perform the given task to the best of their ability. One’s responsibility will then give him/her authority in the organisation to assign tasks to subordinates and make decisions. Authority This is defined as the right or power to give instructions and make decisions in the organisation. Authority allows management to direct subordinates to perform duties. This characteristic of organisation structure is based on three underlying principles: Similar positions have the same level of authority and this authority comes with the position held and not the individual Subordinates accept and comply with the authority of management because of their legitimate power The level of authority flows down the hierarchy of the organisation – that is, top management has more authority than lower-level management. Accountability The concepts of responsibility and authority necessitate the concept of accountability. Managers or people who have been given authority and responsibility should be able to justify their actions and the outcome of their decisions to higher-level management. The concept of accountability also affects the subordinates who must be accountable for any task given to them for completion. Delegation The truth is that no one person can complete all the tasks that are necessary to bring about success of the organisation. To this end, managers pass down some of their powers to subordinates to complete specified tasks. ‘Delegation’ may be defined as the tendency of management to entrust subordinates with responsibility and authority to carry out a task. There are a number of factors that would result in a manager delegating responsibility to subordinates. These include: To facilitate specialisation Time constraints To foster a succession plan for managers To encourage flexibility and adaptability to environmental change – for example, a change in customers’ needs. Benefits of delegation Helps to motivate workers Firm can utilise the specialist skills of employees Sheds some of the workload of managers Increases the time that management has to focus on issues at the corporate and strategic levels. Drawbacks of delegation Some managers may be reluctant to delegate some of their responsibility CHAPTER 6 | THE ORGANISATION AND ITS STRUCTURE There could be some reluctance by subordinates to accept the tasks delegated If the task assigned is unsuitable, it may lead to significant losses and inefficiencies. Centralisation and decentralisation In centralisation senior management of the organisation maintains full control of decision making and there is minimal delegation of responsibility. On the other hand, in decentralisation the organisation is one where decision making involves subordinates and there is delegation of responsibility. A decentralised organisation is often separated into divisions, with some amount of autonomy, however, working towards the fulfilment of the organisation’s goals. Advantages of centralisation Facilitates easy control and coordination of policies Cost minimisation since resources are not duplicated Decision making is less time consuming There are less extensive planning and reporting procedures. Advantages of decentralisation Firms can respond to changes quickly Decisions made can reflect the needs of the market and customers May improve the level of motivation of the employees The workload of the firm is spread across departments and to different individuals. CASE STUDY This lifestyle was never sustainable in the long term. While feeling as though he will be shirking the responsibility that was given to him by his father, Mr Workwell has decided to reorganise the firm. Some of the moves that he is thinking of include appointing a manager for the farm, finance, production at the factory, marketing and human resources. He would continue being the general manager and employees would be formally placed into the different departments. This, he believes, would lessen the burden on himself and give others an opportunity to show their prowess and bring in new ideas. Questions 1. How would you describe the span of control of the business prior to the intended changes? (3 marks) 2. Based on the information given in the case, draw an organisation chart showing what the structure of the business will be after the change. (12 marks) 3. Using the information in the case for reference, explain the concept of delegation. (5 marks) 4. Outline three (3) benefits and two (2) drawbacks to delegation in this firm. (5 marks) Total 25 marks CHAPTER SUMMARY For an organisation structure to be effective the following criteria must be met: flexibility; satisfying the needs of the firm; encouraging growth and development; and incorporating organisational design The overworked manager Mr Workwell is the manager of a medium enterprise with a total of 100 employees manufacturing grapefruit juice. To cut costs, the company is also involved in grapefruit production with a 100-acre farm. The business was passed down to Mr Workwell from his father when he retired. After a few years, Mr Workwell started to realise that he too needed to slow down and delegate some of his responsibilities. He is now giving the idea some thought. Prior to this point Mr Workwell was the sole manager of both the farm and the processing plant. He had to supervise all 100 employees, control the finances of the firm, hire and dismiss workers, promote his grapefruit juice and take orders from large customers. Functional organisational structure is designed in terms of the functional areas of the business – for example, marketing, purchasing, accounting, etc. The geographical organisational structure is predominantly utilised by multinational corporations which operate in different countries Line relationship is one that exists between senior management and subordinates Staff relationship exists where people within organisations offer specialist advice to managers. 75 76 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE MULTIPLE CHOICE QUESTIONS 1. A well-defined communication channel and clearly outlined chain of command are features of which organisational structure? 4. ALL of the following would affect the type of organisational structure chosen by the firm EXCEPT which one? a. The firm’s suppliers b. The business cycle a. Geographical c. Size of the firm b. Product d. Business objective c. Matrix d. Functional 5. The number of employees who are directly under the control of one manager or supervisor is referred to as: a. Span of control 2. Which of the following is a disadvantage of the product organisational structure? b. Chain of command a. There is duplication of the functional areas c. Hierarchy b. Focus is placed on the product’s performance and level of profitability d. Responsibility c. Diversification in the product offerings of the firm is encouraged 6. If the Marketing Manager gives advice to the Production Manager about a possible product development, what type of relationship is being displayed? d. Promotes positive competition among divisions 3. Just for You Ltd is planning on expanding its operation to the countries within the CSME. Which of the following structures would be BEST suited for the business? a. Line and staff b. Line c. Staff d. Horizontal a. Team b. Network c. Geographical d. Matrix Extended Essay Questions Question one Mr Confusion from MJ Coolers is thinking of using a product organisational structure but is seeking your advice. a. Draw a typical product organisational structure. b. Advise Mr Confusion of five (5) benefits and five (5) drawbacks of using this structure. Question two a. Explain four (4) factors that can affect the type of organisational structure used by a firm. b. Differentiate between a line relationship and a staff relationship. c. Define the term ‘span of control’ and, with the use of diagrams, differentiate between a ‘narrow’ and a ‘wide’ span of control. Total 25 marks (5 marks) (20 marks) Total 25 marks (12 marks) (3 marks) (10 marks) 77 7 The Theory and Application of Motivation LEARNING OBJECTIVES: At the end of this chapter students should be able to: Discuss the factors that stimulate and influence motivation Outline the main concepts of Maslow’s Hierarchy of Needs Theory Outline the main concepts of Herzberg’s Hygiene Theory Compare and contrast the two main theories of motivation Analyse the main financial and non-financial incentives that are used in businesses Outline the implications of motivation theories for managers W e all make choices in life and the choices we make may be influenced by a number of factors. As students, there are a number of factors that influence the level of work you do in each subject, including Management of Business. Some of you might be driven by a desire to do well; a good teacher who encourages you all the time; a desire to qualify for the best university; or wanting to ensure that your parents’ money is not wasted. These factors will influence your level of motivation. In this chapter, the concepts of motivation, motivation theories and incentives will be discussed. Factors that stimulate and influence motivation Motivation is generally defined as the ‘will to achieve’. It is the internal and external forces that arouse a person to carry out a task with enthusiasm. Your level of motivation may be influenced or stimulated by the following factors: Individual needs We are driven by our needs and the things we do are, very often, influenced by our desire to satisfy these needs. An employee’s basic need for food, clothing and shelter will influence how he/she works or operates. For example, a desire to own a home may motivate a person to work hard in order to gain the income or level of savings needed to acquire that house. Later in the chapter we will examine the work of theorist Abraham Maslow, who shared this view in his Hierarchy of Needs. Self-motivation While some people are motivated by forces in their environment and what is done by others, others are selfmotivated. Self-motivation speaks to a situation where someone has the drive or ability to perform a task without the influence of anyone else. People who are self-motivated tend to be able to complete a task even in the face of adversities or without encouragement from anyone. Such people are often optimistic, energetic and driven by their desire to succeed in the task at hand. Ability to make choices One of the greatest desires for humans is having the ability to make certain choices. When this is not the case, people may feel confined or unhappy with their current situation or environment. In a business operation some employees desire to have the autonomy to make choices which could influence the work environment or the way the work is done. They want to participate in decision making while knowing that their suggestions will be treated with high regard. These choices may be given to employees by a democratic leader as opposed to an autocratic one. It is often said that employees who have a democratic leader are usually better motivated than those with an autocratic leader. These different leadership styles will be discussed later in this book. The idea of allowing employees to have some level of autonomy is supported by the work of theorists Herzberg and McGregor. Both theories are also discussed later. Environmental opportunities The environment in which people work can be a good source of motivation. If the work environment offers opportunities for personal growth or for promotion, then people may be motivated. Employees may become de-motivated if their work environment offers neither of these two opportunities. Working in an environment where there is no chance of 78 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE promotion or growing will discourage people from giving the extra effort to carry out their tasks. Other influences on motivation include values, attitudes, beliefs and goals. Selfation tu ac alis Esteem Theories of motivation ingness Belong The theories of motivation can be classified into two main categories: content theories and process theories. Safety Content theories These theories focus on the needs of employees and how these needs motivate them. Theorists in this category believe that people are driven by their needs. These needs will be transformed into internal forces that influence their behaviour pattern. Organisations are therefore encouraged to develop reward systems that cater to these needs and employees will be motivated. Content theorists feel that each individual differs in their ability as well as their ‘will to do’ a task. To this end, motivation depends on the level or strength of an individual’s needs. Two of the most prominent content theorists include Abraham Maslow and Frederick Herzberg. needs needs needs s al need gic Physiolo Figure 7.1: Maslow’s Hierarchy of Needs Safety or security needs Individuals desire to be in a safe and secure physical and emotional environment. These needs include job security, stability, freedom from fear or threat, being treated fairly and avoidance of pain. Management should provide security guards, ensure that the environment is not easily accessible to unscrupulous people and protect workers from harmful substances such as toxic fumes. Maslow’s Hierarchy of Needs Belongingness or social needs The work of Abraham Maslow came about in the mid-1950s. He proposed that: An individual’s needs will influence his/her behaviour The greater the need, the greater will be its influence on the individual’s behaviour. Maslow identified a number of needs that will influence human behaviour. He summarised his findings in the Hierarchy of Needs as shown in Figure 7.1. According to Maslow, each level of needs must be acquired or fulfilled before the individual can move on to a higher need. Therefore lower-level needs must be fulfilled in order for the higher-level needs to be accomplished. These needs are expanded below: Employees want to feel accepted by their peers, to be loved, to have lasting friendships and to be a part of groups. They yearn to socialise with their co-workers and have good relationships with both peers and supervisors. Managers should cater for this need by having social events at work, promoting group work and encouraging interaction among employees and between management and employees. Physiological needs These are the basic needs in life, including food, water, clothing and shelter. Employees desire the means to acquire these basic needs by working in an organisation. A sufficient salary should be able to take of these needs. Therefore, if the salary earned cannot sufficiently provide these needs, the individual will not be motivated. With these needs in mind, some organisations provide subsidised lunches, housing solutions and concessions on motor vehicle purchases, among other rewards. Esteem needs These needs include a desire to have a positive self-image, status, recognition and appreciation by others. Workers want to be recognised and credited for any contribution given to the organisation. Organisations can provide for these needs by recognising the contributions of employees through promotions, award ceremonies and bonuses, etc. An example of this is seen where they publish photographs of their outstanding employees in newspapers. In other businesses, a photograph of an ‘employee of the month’ is posted at the reception area to recognise that person’s effort. Self-actualisation needs This is the highest category of need. It is where employees feel a sense of self-fulfilment. The employee desires to reach his/her full potential while increasing the level of CHAPTER 7 | THE THEORY AND APPLICATION OF MOTIVATION competence at the task being completed. Managers can help employees to fulfil this need by providing additional training for employees, whether on the job or off the job. Some organisations provide scholarships for employees who desire to do higher studies. Implications of Maslow’s theory for management Management needs to understand the needs that motivate the employees and use them to their advantage Motivation is sometimes tied to the leadership style of the manager Management should provide a safe working environment Opportunities should be given for people to reach their full potential Managers should pay an appropriate salary to workers. This will allow them to afford the basic needs in life By rewarding employees, managers can build longlasting motivated relationships. These factors will attract people to the job and help them to keep the job. The presence of these factors will not bring about satisfaction, as this is only achieved through motivators. However, their absence will mean that workers are indeed dissatisfied. Herzberg’s theory has the following implications for management: Managers should be aware that workers can be satisfied or dissatisfied with the job or even both. For example, a worker may love the work that he is doing but be dissatisfied whenever he receives his pay cheque The notion is that unless motivators are present at work, employees will not be motivated. Managers must therefore be aware that improving hygiene factors will not lead to motivation but simply prevent dissatisfaction In order to improve motivation, management needs to design the job to provide an opportunity for growth, recognise employees for work done and assign responsibility. Two-factor theory Process theories In the late 1950s, Frederick Herzberg developed what he called a two-factor theory of motivation. After conducting interviews with a number of employees, he concluded that there are some factors that will lead to job satisfaction and others that will cause job dissatisfaction. The factors that lead to job satisfaction were called ‘motivators’ and those that cause job dissatisfaction ‘hygiene factors’. Process theories essentially argue that people’s thought processes will influence their behaviour. They change the focus from people being driven by their needs (content theories) to one where they select behavioural actions to meet their needs. Process theories include Vroom’s Expectancy Theory and Adams’ Equity Theory. Vroom’s Expectancy Theory Motivators These factors include: An attraction to the work itself Recognition from both management and colleagues Being given responsibility for tasks A sense of achievement Opportunities for advancement and personal growth. Herzberg suggests that where there is a presence of motivators on the job, workers will be motivated. However, the lack of motivators will not lead to dissatisfaction but workers will be neutral towards their work. Instead, it is the hygiene factors that will prevent dissatisfaction. Hygiene factors These factors include: Working conditions Interpersonal relationships Pay and job security The policy of the organisation The quality of management and supervision Perceived differences with others. Victor Vroom’s Expectancy Theory suggests that employees will be motivated to carry out tasks in order to reach a goal if it is worthwhile to do so. Therefore a person's motivation can be linked to the anticipated worth that is placed on a goal and the probability of that goal being achieved. The Expectancy Theory proposes three variables: The effort of the individual – this assess the individual’s expectation that if enough effort is placed on a task it will generate the desired level of performance. The level of expectation usually depends on the worker’s ability, experience and the available resources The performance of the individual – the expectation here is that the desired level of performance will bring about the desired outcome. For example, an insurance agent who believes that selling 100 life insurance policies will earn him the ‘agent of the month’ award. Suffice it to say that the level of expectation will determine the level of motivation – that is, a high level of expectation will result in highly motivated workers The attractiveness of the desired outcome (valence) – this represents the value that is placed on the 79 80 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE CASE STUDY ‘Chaos at Fun Lovers’ Paradise’ These are the words of the livid union leader, Mr Folkes. He opined that the union will have to be called in to deal with the unfair treatment and poor working conditions that workers at Fun Lovers’ Paradise amusement park have to contend with. Workers have complained that they are expected to work under less than favourable conditions. There is poor lighting in the factory and when it rains heavily the roof leaks. Management has blamed this on tough times for the firm, indeed, staff have been asked to take a 15 per cent cut in pay and to forgo their Christmas bonus. Some workers also bemoaned the fact that they have been doing the same boring tasks for the last five years and there is no more zest in them to carry on. Mr Folkes stated that management usually just post information on the notice board at the front entrance and there is little or no opportunity to communicate with them. He said that even if workers gave suggestions they were not even considered. Productivity levels have plummeted and profits are dwindling as a result. If management does not make a decisive move to improve the morale of the workers then Fun Lovers’ Paradise may be no more. Now the patrons are watching the situation with bated breath, as the firm is one of the largest local attractions for both children and adults. Questions 1. Give evidence from the case to show that the workers are de-motivated. (3 marks) 2. Discuss how the occurrences at Fun Lovers’ Paradise represent a deviation from Maslow’s Hierarchy of Needs. (10 marks) 3. Briefly explain Herzberg’s theory and discuss how it could be used to improve motivation at Fun Lovers’ Paradise. (12 marks) Total 25 marks outcome by the individual. For the employees’ level of motivation to be high, the outcome must be desirable and highly valued. Adams’ Equity Theory John Adams’ Equity Theory suggests that inequities will exist if people believe that the rewards they receive for a completed task are unequal to those received by other people. If employees perceive that the rewards received for a task are the same as the rewards for other people carrying out a similar task, they will see themselves as being treated fairly and equitably. Where this is not the case, however, then they attempt to reduce the perceived inequity by: Modifying the inputs – for example, the level of effort exerted to carry out the task Changing the outcomes – for example, lobbying for better wages and working conditions Resigning from the post Mentally distorting their perception. Financial and non-financial motivational strategies Financial strategies Earlier in this chapter it was discussed that theorists such as Herzberg believe that money is not source of motivation. However, in a number of organisations today, money is still being used to motivate employees. Financial strategies can be divided into payment schemes and incentive schemes. Each of these is examined below. Payment schemes Time rates This type of payment is used for workers who are paid for the amount of hours they spend at work. At the end of the week, fortnight or month, workers will be given their total wages or salary. The rate paid is usually a fixed amount and is based on a standard working week. For example, most CARICOM states have a standard work week of 40 hours. In some cases workers are paid for working over the specified amount of hours for the week. The excess hours work for the week is termed ‘overtime’. The payment received for overtime work done is usually over and above the ordinary hourly rate. For example, regular hours work may be paid at $50 per hour but overtime is paid at ‘time and a half’ per extra hour worked – that is $75 per hour. If a worker works for 45 hours for the week, his weekly pay would be calculated as: Regular pay: 40 hr × $50 Overtime pay: 5 hr × $75 Total week’s pay = = = $2,000 $ 375 $2,375 CHAPTER 7 | THE THEORY AND APPLICATION OF MOTIVATION This higher rate is an incentive for people who have made the sacrifice and worked more than the specified weekly rate. Compared with time rates, the level of supervision is far lower Encourages efficiency, as, if products are unacceptable, then payment would not be made. Advantages of time rates Simplicity in calculation and administration Gives employees some amount of certainty in the prediction of their income Offers an incentive for workers who put in extra effort to get work done Suitable for jobs where productivity is difficult to measure Workers have some security of payment even in the ‘down times’ of machinery and equipment Workers can focus on quality since they are not being paid based on output Tends to improve punctuality and truancy. Disadvantages of time rates Does little to encourage efficiency and productivity, as output may not increase Requires close supervision of workers who may want to waste valuable production time Paying for idle time may increase cost of production Firms may not be able to estimate the exact payment for employees because of possible overtime work. Piece rates or piecework Piece rates occur where a worker is paid a specific or agreed rate per unit produced. This type of payment scheme is often used in manufacturing such as in the garment industry. It serves as a form of motivation since workers will be rewarded more for more work done. Since payment is based on the amount of goods produced, workers may be disadvantaged during production ‘down times’ – for example if machinery or equipment fails or there are shortages or delays in raw materials. With this in mind, piece rates may be reinforced by a basic pay or a guaranteed amount. Workers would be given a basic pay and then be paid using the piece rate system. Advantages of piece rates Encourages workers to work harder and thus improve productivity Workers will earn more as a result of their putting in more effort The firm can lower labour cost since it would not pay for sick leave and holidays Reduces idle time as workers are paid by result Disadvantages of piece rates May lead to poor quality as workers may hasten production to receive more pay May affect workers’ health negatively, as they may be overworked Firms may incur huge costs in implementing quality control strategies. Commission Commission is a form of payment scheme often used with salespeople. It is a reward given to employees for making a number of sales in a given period of time. Commission pay schemes are highly utilised in the insurance sector and fashion stores. The employees are usually paid a basic salary and are then given a percentage of the total sales value of the items sold. Advantages of commission Workers can earn more salary by doing more work Used by firms to attach pay to performance Workers are motivated to work harder The firm can ascertain the amount of its products that are actually sold rather than just produced as with the piece rate system. Disadvantages of commission Workers may give misleading information in order to make numerous sales May affect workers’ health negatively, as they may be overworked. Fringe benefits Fringe benefits are forms of compensation to employees apart from wages and salaries. They may include, but are not limited to, health insurance, car upkeep, housing allowance, free lunches and pension schemes. The amount of fringe benefits received by a worker may differ according to their position in the firm. For instance, senior managers tend to receive more fringe benefits than floor members. Advantages of fringe benefits Workers’ human and social needs are met These benefits encourage loyalty to the firm Will increase employees’ morale and work ethics 81 82 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE Some fringe benefits are not taxable and so employees benefit from having a tax-free portion of their income. Disadvantage of fringe benefits These benefits are additional costs to the firm. Fees Fees are paid to workers for a specific task that is performed. Unlike salaries or wages, which are paid for a specified time (week or month), a fee is a one-time payment. The amount paid to the worker may depend of the length of time it takes to finish the task and the level of difficulty in doing so. Fees are paid to people such as consultants and lawyers. Incentive schemes Performance-related pay In recent times a number of firms have been taking this approach in paying their workers. You will recall that in Chapter 5 it was pointed out that FW Taylor believed that workers should be paid based on performance. Today, firms and governments are gravitating towards performancerelated pay. Performance-related pay occurs where workers are paid based their performance on the job. They are expected to meet or exceed the required standard in order to receive the full amount of their salary. In order to measure performance, three steps are usually followed: 1. The workers’ performance is assessed against the agreed objectives or standards 2. They are then categorised, based on the results of the assessment 3. Employees are then paid for their performance, which may take the form of bonuses, increments, or increase in salaries. Advantages of performance-related pay Employees receive a reward for their contribution Properly developed performance-related pay systems will reward the best performers Can be used to eliminate poor performance in an organisation It is an incentive to achieve the targets of the business. Disadvantages of performance-related pay The workers may not be able to meet unrealistic targets, which lowers motivation Disputes may arise about the measurement of performance May hamper cooperation and teamwork. Appraisal This is the process of reviewing employees’ performance. The process is usually carried out annually and seeks to rate employees’ skills and expertise in relation to the job requirements. Management uses performance appraisal to: Promote, redeploy or transfer employees Identify strengths and weaknesses of employees and their training needs Review the annual performance of employees Assess the effectiveness of the recruitment, selection and training processes Outline the requirements and responsibilities of employees. Appraisal may be done formally (where employees are assessed at a specified time through one-on-one interviews or using an appraisal document) or informally (which is an ongoing process carried out by supervisors). Advantages of performance appraisal Managers are able to keep a record of performance throughout the year Gives managers and employees an opportunity to discuss their performance When used in conjunction with a good reward system, it can improve workers’ motivation Can be used as a means of providing employees with feedback on their performance Gives employees an opportunity to clarify the organisation’s expectations of them. Disadvantages of performance appraisal Can be time consuming and overwhelming for the parties involved Since it can be opinionated, the result is subject to biases and errors It may create a very negative experience for workers if not conducted properly. Job evaluation This is a process of measuring the worth of a job using prescribed factors such as qualification, knowledge, responsibilities and skills. It gives managers the opportunity to compare jobs that are similar or different and ascertain a fair wage for them. Before firms can evaluate a job, they must first decide on a suitable method of evaluation. Firms have a number of job evaluation methods available to them. These may include: Ranking – this is where jobs are organised from top to bottom, focusing on the level of managerial skills involved and the value that is placed on each position. CHAPTER 7 | THE THEORY AND APPLICATION OF MOTIVATION For example, a Managing Director would be ranked and paid more than a clerk. This is by far the easiest and least expensive method of job evaluation Classification – this involves the categorisation and description of jobs and the assignment of job titles. Workers are then paid based on their classification. Public-sector workers such as nurses and teachers are usually paid based on this type of job evaluation Point evaluation – this is a widely used system of job evaluation. It involves the identification of a set of factors for which workers receive compensation, such as skills, responsibilities, effort and working conditions Market evaluation – compensation for a job in one organisation is compared with the market rate for similar jobs in comparative organisations. Work study This concept was borne out of the work of FW Taylor in his Scientific Management theory. It seeks to determine the level of efficiency achieved through the use of labour when compared with other factor inputs in an organisation. Work study incorporates and uses two techniques: method study and work measurement. The first technique, method study, analyses the way in which a job is performed and identifies ways to improve performance. The process usually involves the following steps: 1. Selecting, observing and recording the current method of work being used 2. Examining, in detail, the method being used, placing emphasis on quality 3. Developing an improved alternative way of performing the job 4. Implementing the new method of performing the task. This method should be constantly monitored and improved to ensure that it is reaping the desired results. The second technique, work measurement or time study, is used to measure and compare the time it takes to complete a particular task or job. Work measurement may involve the following steps: 1. Identification and selection of the work to be measured 2. Definition of the method of measurement to be used 3. Assessing the task and measuring its duration 4. Gathering details about the work 5. Setting a standard time in which the particular task should be done. A major feature of work study is the concept of ergonomics. Ergonomics studies the relationship between workers and machines or equipment. Machines and equipment used in the organisation must be adaptable so as to achieve the best performance. It incorporates factors such as lighting, seating, noise level and temperature, among other things. Work study is known to provide the firm with the following benefits: Avoidance of bottlenecks, as work flows at a good pace Management can maintain closer control Improved performance by employees Can be used to implement performance-based pay Improves the overall performance and efficiency of the firm. Profit sharing and share ownership In order to motivate workers, firms sometimes distribute a proportion of their profits to employees. In this case the employees would be given the same benefits as a shareholder would receive when the company is profitable. This practice encourages employees to improve their level of productivity, since the company’s success will result in their receiving a portion of the profits. An evaluation of this technique is seen below. Advantages of profit sharing Helps to motivate workers Workers have an opportunity to earn more as the company makes more profit Workers are more willing to accept changes that will improve efficiency and performance. Disadvantages of profit sharing There may be disagreements about how the profits should be divided among workers It is sometimes difficult to see the link between workers’ performance and the profit of the firm. Share ownership is where senior managers in the company are given shares. This may be done instead of paying bonuses or using profit-sharing schemes. The manager in receipt of a share in the company will become a part-owner of the company and would have the same rights as any other shareholder. The benefits of this technique would be that managers would work harder to ensure that the company is successful and they are less likely to resign from since they have ownership in it. A drawback of this practice is that it is usually not given to the entire workforce. Non-financial strategies Initially, most firms saw financial rewards as the way to motivate workers. This view was also supported by the early management theorists. However, the workplace is quickly changing and many firms are finding that workers are not motivated just by money but also by other non-financial 83 84 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE factors. In this section we will examine some of these non-financial rewards that are commonly used in the organisation to motive workers. Individual job needs This can be linked to the work of Frederick Herzberg. On the heels of mounting dissatisfaction with financial incentive, Herzberg attempted to ascertain the factors that would reduce dissatisfaction and motivate workers. In essence, he tried to identify the individual job needs of workers by attempting to answer the question of ‘What do people want from their jobs?’. From this research he came up with what he termed ‘motivators’, which were discussed earlier in this chapter. In order to foster motivation, jobs should be designed to meet the individual needs of the workers. These needs could include, but are not limited to: status, friendship, self-fulfilment, responsibility, interaction and cooperation. If workers feel that their individual job needs are being met, then their level of motivation may increase. Participation This relates to the involvement of employees in the decisionmaking process of the firm. It can be used to motivate employees, as they feel that they are valued by the firm. Their involvement in the decision-making process gives a sense of accomplishment and recognition. A manager who desires to improve motivation can involve his subordinates in decisions regarding the planning, design and scheduling of the work. The process of employee participation helps in their empowerment in the organisation. Participation helps to decentralise the organisation as decisions are no longer skewed to top management but may involve any level of workers. Employee participation may include quality circles, consultation and suggestion schemes. Some of the common benefits of employee participation include increased motivation, increased productivity, improvement in product quality and improvement in the performance of employees. However, amid the benefits of employee participation, it may considerably slow down the decision-making process in some organisations. Also, there may be certain sensitive information that cannot be communicated to the wider organisation. Job satisfaction An important way to improve performance on the job is to ensure that workers are satisfied. Job satisfaction occurs where an employee regards his/her work with a positive attitude. It is where the work being done coincides with interests and needs and the remuneration is satisfactory. The extent to which an employee is satisfied with work may depend on the relationship with co-workers and supervisor, the quality of the work environment and the level of fulfilment received from working. Managers who make the link between job satisfaction and performance can use it to their advantage. The notion is that the more satisfied workers are, the greater will be their level of productivity and, hence, performance. To this end, managers should ascertain the factors that influence workers’ satisfaction and implement them in order to improve performance. Managers may also find that job satisfaction can reduce the level of absenteeism and labour turnover while improving productivity. They should also be aware that there are other factors, apart from job satisfaction, that may affect performance. Those factors should also be ascertained. Job enrichment This non-financial strategy is where employees are given more interesting and complex tasks to complete. For job enrichment to be successful, workers should be given greater responsibility in the work process. The workers’ tasks may be extended to include supervisory roles, planning the work process and quality control, among other things. The challenge provided by job enrichment can help workers to achieve a sense of self-fulfilment, especially when they have successfully completed the task. Job enrichment works to expand the responsibility of workers ‘vertically’ and gives them an opportunity to utilise their ‘unused’ skills. Workers who do well with job enrichment may feel a sense of fulfilment as they note their contribution to the success of the organisation. Job enlargement Unlike job enrichment, which deals with a ‘vertical’ expansion, job enlargement involves expanding the number of tasks that workers are expected to complete. For example, a dressmaker would be given an entire dress to sew rather than just sewing on a collar or sleeve. Job enlargement is particularly effective where workers feel that the job that they are completing is oversimplified. Using this strategy gives workers a variety of tasks to complete and more challenge on the job. The increase in tasks can work as a motivator for workers who have successfully completed the tasks given amid the challenges. Job rotation This strategy has helped a number of employees to develop their skills and working ability. Job rotation involves the moving of workers in a systematic way from one job CHAPTER 7 | THE THEORY AND APPLICATION OF MOTIVATION responsibility to another. For example, a cashier may be transferred to complete the task of a receptionist then customer service representative while the others workers are also reshuffled. This can be motivating for workers who would rather learn new tasks than do the same repetitive tasks on a daily basis. discuss quality problems, recommend solutions and take the necessary actions to solve the problem. Quality circles, to a large extent, consist of shop-floor workers who can use the opportunity to become self-motivated. This concept will be discussed further in Unit 2, Module 1. Opportunities for promotion Implications for managers According to Maslow, people strive to reach a state of selfactualisation, which is the highest level in his hierarchy of needs. Workers want to feel that they have an opportunity to move up the hierarchy. The lack of such assurance can lead to a state of boredom on the job, dissatisfaction and low productivity. Employees need to know that if they put in the effort at work for a number of years they have a chance of becoming supervisor or manager. Senior managers should ensure that there is a succession plan in place which includes lower-level managers and employees. People should be trained to succeed senior managers upon retirement. Giving employees an opportunity for advancement and growth can lead to increased satisfaction and motivation. The implications of motivation for managers can be examined in terms of getting the best out of individuals, appreciation of work and appropriate reward systems. Management has to realise that in order to get the maximum output from its subordinates they should be satisfied with their jobs – and satisfied employees means that they will put in more effort in carrying out their jobs. Herzberg outlined the factors that will bring about satisfaction. Think about this: when a teacher is able to motivate you in class, it is more likely that you will try to do your best in that particular subject. It is no different in the work environment: people who are motivated tend to exert more effort in carrying out a job. This can help to improve the quality of work done, appreciation for the job, labour productivity and the overall output of the firm. Choosing an appropriate reward system can be a challenge for some managers. Managers should be aware of the fact that people are motivated in different ways. Some people may be motivated by financial rewards, while others are motivated by non-financial rewards. Management, in particular the Human Resource Manager, needs to assess the workforce to ascertain the best reward system to use. Often, it is advisable to use a combination of financial and non-financial rewards. Group or team work A group or team can be defined as the interaction of two or more people, in an interdependent way, to achieve a common goal or objective. This concept will be explored further in a subsequent chapter. However, working in teams can be beneficial to both employees and management. Some of the common benefits would include an increase in productivity, improvement in motivation and improvement in the morale of employees. Quality control circles Quality control circles are groups of employees who have been given the responsibility for holding regular meetings to 85 86 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE CASE STUDY Bounce back: a success story Just over a year ago, Fun Lovers’ Paradise was on the verge of failure as productivity had fallen because of a myriad of labour relations problems and poor motivation. After the malaise had set in and workers had voiced their opinion openly, management decided to meet, with the intention of quelling the impasse that had emerged between themselves and the workers. With the help of a management consultant, they were able to organise a programme that now seems to be working. The benefits of this programme are being realised through an increase in sales, as more customers patronise the amusement park, the workers are more upbeat and productivity levels have risen. In an interview with Mr Stone from ‘Everything News’ on the local TV station, the Human Resource Manager, Mr Destiny, said that management owes the success now being enjoyed to the new motivational strategies that were implemented. He mentioned that the company had taken steps to offer its sales team commission; employees agreed to performance-based pay; they now receive health insurance; some employees were given more tasks to complete; and they can now participate in the decision making of the firm to some extent. ‘We have become one big happy family’, stated Mr Destiny. With the improvements at Fun Lovers’ Paradise, management is now looking to propel the firm forward so that it can win the hearts of customers and potential customers as the best amusement park in the country. From the look of things, this aim is quite achievable. Questions 1. What evidence is provided in the case to show that an improvement in motivation benefited the firm? 2. Identify three (3) financial motivational strategies that were used by Fun Lovers’ Paradise. 3. Outline three (3) benefits of each of the financial motivational strategies identified in Question 2 above. 4. Describe two (2) non-financial motivational strategies that were implemented by the management of Fun Lovers’ Paradise. (3 marks) (3 marks) (18 marks) (6 marks) Total 30 marks CHAPTER SUMMARY The theory of motivation may be divided into content and process theories must be acquired or fulfilled before the individual can move on to a higher need Content theories focus on the needs of employees and how these needs motivate them People strive to reach the highest level of need, which is selfactualisation Process theories essentially argue that people’s thought processes will influence their behaviour According to Herzberg, in order to improve motivation, management needs to design the job to provide an opportunity for growth, recognise employees for work done and assign responsibility Maslow proposed the Hierarchy of Needs Theory. Essentially, he proposed that each level of needs It is important for firms to know that employees are motivated in different ways. Some are motivated by financial rewards and others by non-financial rewards For best results, firms should use a combination of financial and nonfinancial strategies for motivation. CHAPTER 7 | THE THEORY AND APPLICATION OF MOTIVATION MULTIPLE CHOICE QUESTIONS 1. The term ‘motivation’ is BEST defined as: a. The will to achieve b. Getting rewards c. Absence of dissatisfaction d. Dedication to work 2. The level of motivation may be influenced by ALL of the following factors EXCEPT which one? a. Ability to make choices b. Individual needs c. Attitudes d. Satisfaction 3. Which of the following is NOT a content theory? a. Herzberg’s Two-Factor Theory b. Maslow’s Hierarchy of Needs c. Vroom’s Expectancy Theory d. Adams’ Equity Theory 4. Which of the following is an example of a financial reward? a. Participation b. Job enlargement b. Work study c. Fringe benefits d. Profit sharing 8. Which of the following is NOT one of Herzberg’s motivating factors? a. Recognition for work done b. Rules and regulations c. Promotion prospects d. Sense of achievement 9. Which of the following is defined as ‘the process of giving workers a number of tasks to perform instead of one simple task’? a. Group working b. Job enrichment c. Job rotation d. Job enlargement 10. According to the Equity Theory, inequities will exist if people believe that the rewards they receive for a completed task are unequal to those received by other people. People can reduce the perceived inequity by doing ALL of the following, EXCEPT which one? c. Piece rates a. Changing the outcome d. Job satisfaction b. Modifying the input 5. Using time rates, calculate the weekly pay for an employee using the following information: An employee works a regular 40-hour week at a rate of $100 per hour and overtime at ‘time and a half’. If he works for 50 hours in a particular week, what would be his total pay for the week? a. $5,000 b. $4,000 c. $7,500 d. $5,500 6. Which of the following would NOT be regarded as a fringe benefit? a. Overtime pay b. Health insurance c. Car upkeep d. Pension scheme 7. An example of a non-financial reward is: a. Job enrichment c. Working harder on the job d. Resigning from the post. Extended Essay Questions Question one Total 25 marks a. Differentiate between financial and non-financial motivational strategies. (5 marks) b. Describe two (2) financial and two (2) non-financial motivational strategies and explain how they can be used to improve motivation. Question two (20 marks) Total 25 marks a. Define the term ‘motivation’. b. Describe two (2) factors that may stimulate or influence motivation. c. Discuss how management can use Maslow’s Hierarchy of Needs to improve motivation in the workplace. (1 mark) (4 marks) (20 marks) 87 88 8 LEARNING OBJECTIVES: At the end of this chapter students should be able to: Define the term ‘leadership’ Outline the sources of power Discuss the different leadership theories Evaluate the different leadership skills Explain each leadership style Compare and contrast the different leadership styles Outline the factors influencing the choice of leadership style Outline the influences of informal leadership on organisations M ost, if not all, of us have been a leader at some point in time in our lives. The question then is: who is a leader? A leader is anyone who influences others. If you examine your life at school you will realise that you may have influenced many people in your daily activities. Having established who is a leader, we must now define the term ‘leadership’. While the definition of leadership varies, the term is commonly defined as the process of influencing people towards a specific or common goal. Now let us look more closely at our definition: Leadership is interpersonal – it involves people or a group of people People are influenced – this is the use of power to affect others. We will examine the sources of power below Specific or common goal – this is the desired end result that one hopes to achieve. In order for leadership to be effective, the leader has to have some form of influence or power over the people being led. ‘Power’ is defined as having the potential or capability to influence the actions of others. Leaders get their power from a number of sources including: Reward power – this is associated with the distribution of rewards to employees. As was discussed in Chapter 7, these rewards can be monetary or non-monetary and can be used to alter or influence employees’ behaviour Leadership Coercive power – this is where the leader exercises control over employees and the activities that take place in the organisation. As the leader is in control, he/she has the ability to mete out whatever punishment or sanction is necessary to correct the mishap Legitimate power – power here comes from the belief that the leader has the right, by virtue of his/her position, to give orders and instructions. For example, in the classroom, the students are expected to adhere to the teacher’s instruction by virtue of his/her position Expert power – this stems from the ability and knowledge of the leader. Employees believe that the individual has significant knowledge and skills in the area involved and so power is accorded to him Referent power – this source of power is largely based on the qualities of the leader. These characteristics help the leader to earn the respect of the subordinates who also emulate his/her behaviour. Leadership theories A number of theorists focus on leadership in the organisation. Some of their views are similar, while others are very different. In this section we will focus on McGregor’s Theory X and Theory Y, and the Trait Theory. Theory X and Theory Y In the 1960s, Douglas McGregor made his mark on research into leadership and motivation. He proposed two theories on how employees’ level of motivation may be affected by the leadership style of management. He called these theories ‘Theory X’ and ‘Theory Y’. He suggested that managers will adopt one of the two styles, depending on their beliefs and views of the employees. Managers who still hold the traditional view of management were referred to as Theory X while those who held a more humanistic view were referred to as Theory Y managers Theory X managers McGregor states that the Theory X manager assumes that: CHAPTER 8 | LEADERSHIP There is an inherit dislike for work in the average human and they will seek to avoid work if possible As a result of the first assumption, workers must be coerced, controlled, directed or threatened in order to get them to work People possess little ambition and will avoid responsibility and so they prefer to be directed Being self-centred, the average person will not be concerned about the goals of the organisation. Theory Y managers McGregor states that the Theory Y manager assumes that: People do not inherently dislike work but instead work is as natural as play or rest Employees will exercise self-direction and self-control as they seek to fulfil the firm’s objectives People will seek responsibility under the proper working conditions People possess the skills, imagination, ingenuity and creativity needed to solve the organisation’s problems The intellectual potential of humans is only partially being utilised. The above two sets of assumptions will influence the manager’s behaviour. Managers who hold Theory X assumptions about their employees are likely to have autocratic traits. They usually believe that the organisation’s objectives will be achieved through coercion, discipline and penalties. Theory X managers are of the view that money and security are people’s main motivation to work. As a result, firms under such management will depend largely on money and benefits to satisfy employees’ needs. McGregor proposed that this view is not effective in motivating employees. Conversely, managers who hold Theory Y assumptions about their employees are likely to be democratic. They usually believe that the organisation’s objectives will be achieved through the involvement of employees in decision making. Employees should also be encouraged to seek responsibility and participate in self-management. Organisations holding the assumptions of Theory Y are more likely to have motivated employees than those supporting Theory X. The Trait Theory The trait approach to leadership seeks to identify the characteristics of leaders and how these characteristics affect their effectiveness. Its main assumption is that effective leaders are born and not made. These leaders have outstanding leadership qualities that assist them in becoming great leaders. In its early days after inception this theory was sometimes referred to as the ‘great man’ theory. It suggests that individuals are different in terms of their traits. A ‘trait’ is defined as a distinguishing feature in character, appearance or habit from which an individual’s personality is formed and can be identified. These traits are often used to distinguish leaders from non-leaders. The traits identified may range from different categories, including: Physiological (appearance, height and weight) Demographic (age, education and socio-economic background) Social (sociability and cooperativeness) Personality (self-confidence and aggressiveness) Intellectual (intelligence, decisiveness, judgement and knowledge). Some of the core traits that a good leader should possess were also highlighted: A drive to achieve – there should be a high level of effort, ambition, energy and initiative Motivated leader – possessing an intense desire to influence others to reach common goals Honesty and integrity – the leader should be trustworthy and reliable High level of self-confidence Strong cognitive ability – should be able to exercise good judgement and possess strong analytical abilities and conceptual skills Knowledgeable – must be conversant with the industry and the technicality of the type of business Possess good social skills and flexibility Display emotional maturity. While the above list of core traits is not exhaustive, the more traits a leader possesses, the more effective he/she will be. Trait theorists tend to suggest that: Good leaders are born and not made, since the traits of a leader are innate Some traits are more suited for leadership than others The right combination of traits is necessary in order for a person to be an outstanding leader. Now we will examine some of the more popular trait theorists. Ralph Stogdill Stogdill was among the first people to challenge the findings of the early and traditional views of trait theorists. In his research he found out that some of the traits identified by his forerunners were not in sync with effective leadership – for example, age, weight, height and physique. Instead, he proposed ten traits which give a clearer picture of who an effective leader is. These include: 89 90 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE Honesty Intelligence Having a great sense of humour Using initiative Competence Integrity and conviction Responsibility Insight Self-confidence and Inspirational. Richard D Mann Extraversion–introversion Emotional stability Agreeableness – this is where people tend to be friendly and accommodating Conscientiousness – these people tend to be orderly, get their work done and be punctual Openness – these people tend to be open minded and creative. Though the final two theories speak to one’s personality, we see where the personality trait of the leader can have significant effect on how he/she leads. In his research Mann summarised the traits that were identified by previous theorists and identified the following traits as those that separate leaders from followers: Intelligence Masculinity Dominance and Extraversion. Advantages of the Trait Theory Hans Eysenck Disadvantages of the Trait Theory This theorist was the first to put a statistical twist on the research on traits. His research was characterised by a list of adjectives that were issued to hundreds of thousands of people. He then used statistics to figure out the factors that carry the most weight. Once these were identified, Eysenck developed a test that is referred to as the ‘Eysenck Personality Questionnaire’ (EPQ). His research findings suggested that there are three dimensions of personality: Introversion/extraversion – introversion involves directing attention on one’s own experiences, while extraversion is where attention is placed on other people and the environment Neuroticism/stability – neuroticism refers to the tendency of an individual to become upset or emotional, while stability refers to the tendency of the individual to remain emotionally sound Psychoticism – this dimension was added after further research was carried out on mentally ill people. Individuals with this trait are said to have difficulty dealing with reality and are often anti-social, hostile, non-empathetic and manipulative. They sometimes even suffer from hallucinations. The Five Factor Theory With the development of technology and knowledge, other theorists have built on the work of Eysenck to develop what is called the Five Factor Theory. This identifies five personality traits: It is used as a yardstick to assess an individual’s leadership traits It outlines, in a detailed way, the leader (individual) element in the process of leadership The basis of the theory has been validated by a number of other pieces of research. It lends itself to subjectivity The traits of successful leaders tend to run to a very long list Equating physical traits, such as height and weight, may not be the best tool for measuring effective leadership Based on the theorists’ work, it is evident that there are disagreements in terms of which traits are most important for effective leadership The traits that are needed for one organisation may be very different from those needed for another In a number of cases, the trait needed depends on the situation in which the leader is leading. Therefore there is no uniformity. Leadership skills The desire of any leader is to be successful and to guide his/ her followers in the right direction to achieve the desired goals. However, this may not be possible unless the leader possesses the right skills. The skills needed by a leader may vary, depending on the situation or task requirement. However, some common ones are: Communication It is often said that great leaders are great communicators. For any leader to be effective it is imperative that he/she is able to communicate effectively. The leader must be able to give unambiguous instructions and be able to communicate the objectives and goals of the firm to their subordinates. CHAPTER 8 | LEADERSHIP CASE STUDY Do it my way Everything Styrofoam Ltd is a large manufacturer of Styrofoam. It supplies a number of appliance manufacturers, both for use inside some products and to act as packaging material in other cases. Everything Styrofoam Ltd is led by Dr Exymus, who is a very stern leader who likes to see things done his way. If workers fall out of line he will unilaterally suspend them or dock their pay, depending on the offence. Though he is of this temperament he is highly rated by the employees because of his knowledge and expertise in a number of areas of the business. Dr Exymus believes that workers will not ordinarily carry out the tasks that are given and so must be intimidated into doing so. He is also of the view that his workers will shirk their responsibility and so they have to be closely supervised. The business is enjoying some success but the workers feel that they could be treated more fairly. Questions 1. Describe two (2) sources from which Dr Exymus gets his power. (8 marks) 2. Briefly describe McGregor’s Theory X and Theory Y and, with reasons, state the kind of leader that Dr Exymus is. (12 marks) Total 20 marks Effective communication can help the leader to develop a good business relationship with employees which may bring forth success. Poor communication can lead to low worker morale and confusion regarding the expectations of employees. The ability to listen is also a vital part of communication and to any leader. In order to communicate effectively, the leader must also learn to listen actively. Subordinates will be motivated by a leader who takes the time to listen to their concerns and suggestions. Good listening skills can also generate respect, trust and belief in the leader. Critical thinking An effective leader is one who practises higher-order thinking by making responsible judgements and decisions. A critical thinker is an individual who asks the appropriate questions in order to ascertain relevant information and then uses the information to draw logical conclusions. The leader needs to think critically in order to deal with the day-to-day running of the firm and to make strategic decisions on how to move forward. Problem solving To be an effective problem solver, the leader needs to be a critical thinker, as was discussed above. It is inevitable that the leader will be faced with different problems or decisions within the organisation. Therefore, having the skill of problem solving is vital to the effective running of the firm. Problem-solving skill speaks to the leader’s ability to work through the details or aspects of a problem and to reach an appropriate solution. Planning Planning, as defined earlier, is the setting of business objectives and establishing the necessary plan to achieve such objectives. An effective leader needs to be a very good planner. Having stated goals is not enough unless there is a clearly outlined step-by-step plan to achieve these goals. The leader needs to identify opportunities and develop the courses of action to take while making the best use of the limited available resources. A good planner will be aware of the foreseeable future and develop strategies to deal with the possible problems that he/she may encounter. Consideration A leader who needs to gain the trust and support of subordinates must learn how to be considerate. Employees come to work with a lot of ‘baggage’ and may respond to a situation in a particular way depending on what is happening in their own environment. The leader needs to be sympathetic to employees as they go through their different challenges. The effective leader is one who will be considerate of a decision affecting his/her subordinates. When a leader gives consideration in response to good performance it increases the likelihood of the level of performance being repeated. 91 92 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE Leadership styles Autocratic or directive This is probably the oldest leadership style and was featured in the work of Frederick Taylor in his Scientific Management theory. An autocratic leader makes all the major decisions in the firm, gives orders and closely monitors the activities of the employees. Employees are not involved in decision making and do not act independently of the leader. Communication usually flows from the top down in this form of leadership, as workers’ suggestions are not given much regard. This can cause frustration and low morale as workers’ intuitive abilities are being stifled by management. Amid the challenges that workers may face with this leadership style, it may be the most suitable style to use in certain industries or situations. It is suitable for the army and for large companies. Democratic or participative The democratic leadership style is one where the leader allows employees to share their ideas and suggestions and participate in the decision-making process. This leader delegates authority to subordinates but retains ultimate responsibility. Unlike the autocratic leadership style, the democratic leader facilitates two-way communication and the employees’ input is highly regarded. The leader may seek employees’ views prior to a decision being made or may share the decision and then try to convince workers that it was the correct one. This style of leadership is entrenched in the work of some of the major motivational theorists who were discussed earlier. Among these are Maslow (in his higher level of needs), Herzberg (motivators) and McGregor’s Theory Y leader. Paternalistic The paternalistic leader is a ‘father figure’ who gives attention to the social needs and opinions of the employees. This style of leadership is similar to the autocratic one, in that workers do not participate in the decision-making process. Instead, the leader makes all the decisions, which, in their view, is in the best interests of the workers. While there might be consultation with the workers and noting of their opinions or feedback, the final decision rests with the leader. Constitutional or bureaucratic Bureaucratic leadership is very stringent as the leader leads in accordance with the stated rules of the firm. Therefore, there is little, if any, room for workers to use their intuitive ability and to be flexible. The activities of the firm are undertaken based on the prescribed policies and procedures. This style of leadership is particularly important when the employees must follow certain procedures to maintain a certain level of quality. The leader gains his/her authority based on the office or position as stated by rules governing that position – that is, legitimate power. Employees are expected to act professionally in the workplace and among each other. This leadership style is entrenched in the work of Max Weber and his Bureaucratic Management theory. Laissez-faire This is the most liberal of all the leadership styles. The leader is seen as the representative of the group of people being led and acts on their behalf. The leader is mostly responsible for setting the business objectives, which should be unambiguous. The subordinates are given autonomy to carry out their own activities and make decisions as far as possible in order to achieve the objectives. The success of this style of leadership often depends on the level of competence, skill and reliability of the employees. Since workers are given the chance to carry out their own work, this type of leadership often leads to a high level of motivation. Transformational A leader using the transformational leadership style seeks to inspire his/her subordinates to achieve a shared goal or objective. The transformational leader is well involved in the day-to-day activities of the firm and communicates well with subordinates. This style of leadership involves the delegation of responsibility to subordinates rather than ‘leading from the front’. The transformational leadership style is highlighted by the following: Stimulation of subordinates to be creative and to develop innovative ways to solve problems The transformational leader gives individualised attention to subordinates and allows for one-on-one conversation Transformational leaders are motivators as they are able to influence subordinates to reach their full potential This type of leader is able to garner trust and respect from subordinates Promotes intelligence and rationality. The transformational leadership style often leads to positive changes in the lives and attitudes of subordinates. In addition to being involved in the process, transformational leaders are filled with energy, enthusiasm and passion. These CHAPTER 8 | LEADERSHIP characteristics help the leader to encourage the members of the organisation to succeed in their different endeavours. The transformational leadership style is also particularly suitable for a marketplace where a product’s lifecycle is short. This could be as a result of the current technology Leadership styles Main features becoming obsolete in a short span of time. These turbulent times force firms to be flexible and to forecast and meet new and changing demands. Table 8.1 evaluates the different leadership styles we have just considered. Advantages Disadvantages Autocratic/directive Employees have little or no say Decisions are made solely by the leader The leader stipulates the work process and methods One-way communication Close supervision Quick decisions can be made Suitable for businesses with an unskilled labour force Helps to maintain quality and standards in large businesses Lack of consultation can be de-motivating Stifles intuitiveness Staff do not partake in decision making Democratic/ participative Two-way communication Workers participate in decision making Workers are kept informed about the business Manager delegates responsibility Helps to motivate staff Suitable for complex decisions that require specialist skills Employees are allowed to be intuitive Encourages team building Decision making tends to be slow May not be best for some types of decisions that need a quick response Requires a skilled labour force for informative decisions Paternalistic Managers make decisions based on what they believe is best for workers The final decision rests with the leader even if there have been consultations Caters for employees’ welfare Two-way communication Workers are consulted on decisions The social needs of workers are met Consultations may improve workers’ motivation Slow decision-making process Still dictatorial to some extent Bureaucratic/ constitutional Clearly defined rules and guidelines Authority is attached to the leader’s positions Poor communication Decision making is usually centralised Suitable for some government bodies and hazardous workplaces Helps to maintain quality, especially in large organisations Lack of self-fulfilment Extensive red tape which slows decision making Stifles creativity Laissez-faire Little direction and control Decision making rests with subordinates Workers are allowed to be creative Can improve motivation Lack of direction may lead to waste of resources Possibility of poor work relations If the workforce is not skilled and responsible it may lead to poor performance Transformational Individualised consideration Intellectual stimulation Encourages people to reach full potential Helps to stimulate people to think differently Helps to improve worker motivation Employees often exert extra effort for the transformational leader Leaders may have to invest a lot of time in making this work Only works well when employees have the requisite skills and experience Table 8.1: An evaluation of different leadership styles 93 94 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE CASE STUDY Leadership concern at Digital Innovative Inc Digital Innovative Inc is a manufacturer of cellular phone brands such as Craze and Raspberry. The company is a fairly large one and it has been doing well in the cellular phone market, competing with the big-name and more established brands. Most of the local phone companies on the Isle of Lucia are now carrying the company’s Craze and Raspberry brands of cellular phones. The company’s market share is growing as there continues to be an upsurge in sales. The company owes its success to a good management team and motivated workers who ensure that high quality is maintained at all times. The workers believe that their leader, Mr Walters, takes a keen interest in their wellbeing and is a very good listener. To substantiate their view, they say that he has an ‘open door’ policy and communication often flows in both directions. Mr Walters is willing to stop as he walks through the factory, to listen to the concerns of the staff. Staff members are also recognised for their efforts on a monthly basis. As the years have passed by, Mr Walters has grown in the position and, especially with the success of the firm, he has the employees’ best interests at heart. In his monthly meetings he usually encourages his subordinates to strive to achieve their full potential. The workers are given opportunities to improve their expertise through regular training programmes that are held and are sponsored by the firm. Amazingly, for someone who is so busy and focused, he can remember the entire staff and will greet them by first name more often than not. ‘Digital Innovative Inc is blessed to have a leader such as this’ was the sentiment shared by one employee at a recently held awards dinner. Questions 1. How can an effective leadership style contribute to the success of a business? 2. What are the two (2) possible leadership styles that Mr Walters is practising? Give evidence for your answer. 3. List five (5) factors that may have influenced Mr Walters’ choice of leadership style. Factors influencing the choice of leadership style Different leaders practise different leadership styles. However, the extent to which a particular style of leadership is utilised may depend on a number of factors, among them being: Time pressures – the length of time available for the completion of a project will determine the style of leadership that is employed by the leader. Where there is challenge in terms of the time available, the leader tends to make all the decisions instead of consulting with the employees Organisational culture – over time, the employees of the organisation will develop a certain lifestyle and culture. An organisation with a warm culture tends to have a more participative leadership style where employees and management trust each other and consultation is the norm Staff size (span of control) – leaders in very large firms may find it difficult to consult employees on every decision. In order to maintain underlying standards, (5 marks) (10 marks) (5 marks) Total 20 marks management may have to make decisions itself. For example, fast food giants may have to stipulate how their operations should be carried out in order to maintain the quality of their food and the service offered Attitude of subordinates – some employees prefer to be led rather than sharing in decision making. This could be as a result of low self-esteem, past experiences or their personality types. A leader in such an organisation may find that it is more effective to utilise an autocratic, paternalistic or bureaucratic leadership style as opposed to a democratic or laissez-faire one Skill level of the labour force – the leader should be aware of the ability and skill level of the labour force. A highly skilled labour force can be trusted to share ideas and make suggestions which, if implemented, may lead to success. These employees are more likely to work on their own to accomplish the objectives of the firm. Leaders may find that a democratic or laissez-faire leadership style is viable in such a situation CHAPTER 8 | LEADERSHIP Personality of the leader – this is perhaps one of the most difficult factors to correct. It is based on the innate or learned traits of the leader. Some leaders have autocratic tendencies and hence will not utilise any other leadership style The nature of the task – in practice, not all decisions that are made can go through consultation. The leader may have to make a drastic decision based on its urgency. There are also times when a leader has to make a unilateral decision because of its nature and the impact it is expected to have on the organisation. Leadership roles Guidance A leader is often seen as a guide and subordinates look to the leader to provide guidance on how to complete a task. While employees are not necessarily seeking someone to make their task easier, the leader must be able to guide them to success and the achievement of goals. The leader is often perceived to have a wealth of knowledge regarding an area and so is expected to use this knowledge to guide his subordinates. Do you remember, in your early years, when you were learning to write the letters of the alphabet? You would be given dots to trace out each letter. In the same way, a leader should provide an outline for how the work can be carried out to attain the business’s objectives. Direction A leader should be able to provide his/her subordinates with a sense of direction. There must be a clear view of where the organisation is going and how it plans to get there. The leader has the role of being a visionary and must communicate this vision with subordinates. Directing employees is an important part of leadership and is paramount when the leader has an inexperienced staff. Counselling It is almost inevitable for employees of an organisation to have conflicts and concerns that they need to offload. With this in mind, the leader has to play the role of counsellor. This is especially important for leaders who practise an ‘open door’ policy and have a good relationship with subordinates. To be an effective counsellor, the leader must be a good listener and should be able to help employees through difficult situations. The leader has to be trusted by subordinates and must maintain his/her integrity. This role is especially important and many firms are now employing qualified counsellors in their Human Resource Department. Coaching ‘Coaching’ is defined as the process of training and providing employees with the necessary knowledge and tools to carry out their job responsibilities effectively. In the organisation, the leader has to play the role of coach as he/she is expected to train and equip employees for the task at hand. The leader can use this role as coach to direct employees towards the attainment of the firm’s goals. The role of coaching is particularly important in the coordination of teams in the organisation. Each member has to be aware of the purpose and objective of the team and the leader has to guide them likewise. Inspiration of others It is very interesting how some people influence others to do wrong, knowing the consequences of their actions. However, a leader plays an integral role in the lives of his/her followers – that is, the role of inspiration. The leader should be able to inspire subordinates to work assiduously to complete the given task. In carrying out this role, the leader will transfer his/her passion about the vision and mission of the firm to employees. This will inspire them to go beyond the call of duty to attain the goals of the firm. Informal leadership It is a common phenomenon for the formal leader in the organisation to be credited for the achievements of the organisation, with no mention of some of the ‘unsung heroes’ who are the informal leaders within the business. An informal leader is a person who does not have formal authority in the firm but who has been able to inspire and motivate his/her peers to achieve a desire or set of goals. These leaders are often charismatic and influential and often get others to follow them. Look around in your classroom. Who is that student who attracts followers without exerting much effort? Which student commands respect, motivates and inspires the rest of the class to carry out a task without having a formal leadership position? That person is an informal leader. Such leaders are particularly important to firms even though their contribution is often unrecognised by management. However, in recent times, the formal leadership of the firm has started to realise the integral role that informal leaders play in the organisation. The role of the informal leader may include, but is not limited to, the following: Motivating and inspiring peers and team members to achieve the stated objectives 95 96 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE Being the driver of a business concept ‘on the ground’ to achieve positive results Bridging the communication gap between management and employees Offering mentorship and support for others. The role of the informal leader should be of the utmost importance to formal leadership. Management must realise that there may a divergence between their views and those of the employees. A prudent formal leader is expected to coach, to some extent, the informal leader to ensure that there is uniformity of direction. Evaluation of informal leadership Tends to improve the employees’ social relationships, thus building self-esteem Suggestions from informal leaders could be implemented by management since they are the ones ‘on the ground’ Informal leaders often know how to get the work out and so can be used to communicate directly with employees. Disadvantages of informal leadership The informal leader could use his/her influence to resist changes in the firm Could result in employees being ill informed about matters within the organisation. Advantages of informal leadership Can motivate the workforce, which could eventually improve productivity CHAPTER SUMMARY A leader is anyone who influences others The power or authority of a leader can come from one of five sources. These sources include legitimate power; coercive power; reward power; referent power; and expert power A successful leader will need to have at least three very important skills. These are: communication; critical thinking; and listening Leadership styles can be seen as having two extremes: autocratic and laissez-faire. If we put these styles on a continuum, the others would fall somewhere in between them. For example, bureaucratic style would be near to autocratic and democratic near laissez-faire The style of leadership utilised in an organisation depends on a number of factors, including time pressure; size; organisational culture; and personality of the leader MULTIPLE CHOICE QUESTIONS 1. Leadership may be defined in terms of ALL of the following EXCEPT which one? a. Involves people or a group of people b. Use of power to influence others c. Working towards a specific or common goal d. Using one’s position to belittle others Informal leaders are particularly important to firms even though their contribution is often unrecognised by management. 2. Which leadership power comes from the belief that the leader has the right, by virtue of his/her position, to give orders and instructions? a. Legitimate power b. Referent power c. Coercive power d. Expert power CHAPTER 8 | LEADERSHIP 3. A leader should possess ALL the following skills EXCEPT which one? Extended Essay Questions Total 25 marks a. Communication Question one b. Possessive The type of leadership style used in an organisation may be influenced by a number of factors. a. Discuss how any three (3) of these factors affect leadership style. (9 marks) c. Listening d. Critical thinking 4. Mr Bigstick does not allow anyone to participate in decision making, only gives directives and hardly listens to his staff. What is his leadership style? a. Paternalistic b. Bureaucratic c. Democratic d. Autocratic 5. Which leader is often seen as a ‘father figure’? a. Charismatic b. Democratic c. Paternalistic d. Laissez-faire 6. This leadership role is defined as ‘the process of training and providing employees with the necessary knowledge and tools to carry out their job responsibilities effectively’: a. Counselling b. Coaching c. Inspiration d. Guidance b. Outline three (3) sources of power for a leader in an organisation. (6 marks) c. Discuss the importance of the following leadership skills in an organisation: i. Communication ii. Critical thinking iii. Listening. (10 marks) Question two Total 25 marks A number of leadership styles are practised in organisations today. Two (2) of these leadership styles are: i. Directive (autocratic) ii. Participative (democratic) a. Discuss the differences between the two (2) leadership styles mentioned above. (15 marks) b. Mr K Young is the CEO of a major company. He sees himself as a ‘father figure’. He consults with the workers but he makes the final decisions and caters for their social needs. Identify the type of leadership style that Mr Young is using and state the three (3) advantages and disadvantages of using such a style. (10 marks) 97 98 9 Team Management and Conflict LEARNING OBJECTIVES: At the end of this chapter students should be able to: Discuss the nature of teams in terms of their composition, objectives and interaction Differentiate between formal and informal teams Outline the stages of team or group development Explain the characteristics of effective teams Describe the forces that influence group cohesiveness Outline the advantages and disadvantages of working in teams Outline the benefits of team management to the organisation Discuss the possible causes of conflict in organisations Evaluate the strategies used to manage conflict groups or teams are interest groups, reference groups and friendship groups. The nature of formal teams can be analysed in terms of their composition, objectives and interaction. Composition The composition of the team usually plays an integral part in its ability to achieve the task that was assigned to it. The activities that should be carried out may require a variety of skills and knowledge. Therefore its members must be carefully chosen, based on the objective to be achieved. The team must have members with the desired skills, knowledge and experience in the field in which they will be working. The personalities of team members must be considered since there may be a clash, resulting in conflict. Management should also consider the individual attributes of each member. The nature of teams Objectives he business world is evolving and many firms are now realising that teamwork can result in success. While individualism has its place in the working environment, major projects in some firms are undertaken by teams. For example, some insurance agencies have organised their workforce into units of agents instead of individually. It should be noted, though, that while the use of teamwork is growing rapidly, this concept was endorsed by the Human Relations School as a means of improving workers’ morale. A team or group can be defined as the interaction of two or more people, in an interdependent way, to achieve a common goal or objective. A team can be formal or informal. Formal teams are those that are created by the organisation, with a defined and designated task to accomplish. The discussions and activities of formal teams are directed towards the achievement of business objectives. In contrast, an informal team is one that is self-created in the work environment, without any influence from management. Informal teams tend to be of a social nature and are formed to fulfil a desire of the members, including sports, socialisation, and common interests. Examples of informal A team’s nature is embedded in the objectives that it sets out to achieve. Earlier, it was stated that a team must be geared towards a common goal or objective. The objective of the team must be clearly defined and achievable. In some cases, the members of a team may be chosen based on the task that must be completed. For example, if the goal is to change or improve a situation at the tactical level then the team may include middle managers and supervisors. T Interaction The effectiveness of any team will depend on the level and quality of interaction among team members. This interaction may be in the form of face-to-face meetings, telephone conversations, video conferencing, etc. Regular interaction among team members can help to build synergy within the team. However, in order for this to happen, the team members must share a good working relationship. It must be noted, though, that this level of synergy and working relationship may take some time to develop. This is evident in the stages of team development which are discussed below. CHAPTER 9 | TEAM MANAGEMENT AND CONFLICT Stages of team development Forming – at this stage, members are just getting to know each other. They are often uncertain about the purpose, structure and leadership of the group. Members may be timid as they seek to find out what behaviour is acceptable or not acceptable Storming – as members start to share ideas and become more acquainted with each other, intra-team conflict and disagreements may develop. They express their individuality and resist the pressures and influence of the remaining team members Norming – as the team members get to know even more about each other, the conflicts and disagreements start to subside. In this stage, members start developing good relationships and cohesion. The purpose of the team is now clear and each member knows the accepted behaviour Performing – the focus of the team is now on getting the job done and achieving its objectives. The method of working is established and each member can now make their contribution to the task. This is the final stage for permanent teams Adjourning – at this stage, teams that are temporary wrap up their activities and prepare for disbandment. The task would have been performed and the team members now look towards separation. Types of formal group Groups are formed in organisations to carry out different functions. These functions will determine the type of group. Below are some examples of groups or teams that are formed in the organisation: Command group – this usually consists of department heads and the subordinates who work in the departments. Such groups derive their function as given by the organisational structure of the firm Functional group – this is a group which is formed to carry out a particular goal or function of the firm. The goal of the group is determined by the major functional areas of the business – for example, marketing and customer service Task group – this is created to accomplish a specific task or objective in a given time period. Once the task is completed, such groups are usually disbanded. A task group could be formed to work on a project or to solve a problem being experienced by the firm. In all groups or teams, people play different roles. Some of these roles are specified by management, while others may be left for the group to decide among the members. If you examine the groups that you have been in at school, you may find that some people naturally gravitate towards a particular role. In some cases a natural leader will emerge, perhaps at or after the first group meeting. Some of the common roles in any group would include, but are not limited to, the following: Coordinator or chairman – this person presides over the team and coordinates its activities to meet its targets or goals Initiator – this person generates new ideas, defines the problem or suggests procedures for the group Shaper – this person is usually task oriented; an extrovert who usually gets things done Informer – this person gathers factual information and makes generalisations or gives opinions and suggestions Clarifier – the person in this role will interpret ideas, define important terms and seek clarification on issues for the group Summariser or recorder – this person is responsible for restating information that was discussed, proposing decisions and drawing the necessary conclusions. Characteristics of effective teams Commitment It is almost certain that many people will not feel comfortable or perform properly if they are in a place where they do not want to be. Some students may agree that they really would rather be in university or working and so they are not very committed to school. The same is true for teams. If the members are not committed to the team and the activities that will be undertaken, then not much will be accomplished. In order for a team to be effective, the management of the firm has to ensure that the people being chosen to be a part of the team are committed to the task. A strong level of commitment is very important if the team is expected to achieve the common goal or objective. Participation The level of participation in the team is essential to its success. It is expected that team members will be able to share their ideas, make comments and suggestions. No member of the team should be prevented from participating in its decision making. This therefore means that the team leader has to be democratic in his/her leadership approach. In any team, each person’s idea or view should be as valid as the other person’s. There should be no partiality or disregard. However, the level of participation necessary for effective 99 100 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE decisions may come only after the team has reached or surpassed the ‘norming’ stage. Trust This characteristic is of the utmost importance, as almost nothing can be accomplished if team members keep ‘looking over their shoulder’. Trust is vital, as team members want to know that whatever is said in the team will not be misconstrued because of one’s position. Each member should be genuine in their actions and should not be trying to put down another person. Where these actions are present, the team will not be able to build the type of trust needed to carry out the assigned task. In addition to a high level of trust among team members, the team must be trusted by management. The team should be given the autonomy to carry out its mandate without regular interference from management. Decision by consensus Decisions made by a team should not be one sided. Each member should be given a say in the decision. The issue should be thoroughly discussed and the different views should be taken into consideration before arriving at a final decision. By doing so, team members are more likely to feel motivated and appreciated in the team and, by extension, the firm. Flexibility We are living in a world that is constantly changing and these changes usually affect business organisations. To this end, team members must be aware of the possible changes that might occur and be ready to adapt to the new situation. An effective team is one that is flexible enough to reduce considerably the time it takes to adjust to or overcome unforeseen circumstances and get the task done. Encouragement As the team ‘norms’, its members usually develop a sense of camaraderie. This relationship is important, especially when a member may be losing focus on the task ahead or is just in need of encouragement. The leader of the team should possess the requisite skills to motivate and inspire his/ her fellow team members to achieve the stated objectives. In doing so, he/she should be able to keep the members encouraged even in difficult and trying times. There is a common saying that ‘encouragement sweetens labour’. Support and growth This characteristic is connected to the previous one, in that the level of support needed in the team will come only after a close relationship is developed among the members. Team members will not only encourage each other, but will also lend their support where needed. Over time, the team should be able to mould each member, bringing them to the point where there is personal growth. An effective team is one that supports its members and ensures that they grow from the experience they garnered while working in the team. Synergy This characteristic is based on the notion that when individuals work together, their output will be greater than the sum of the outputs of the individual people. In other words, if we should add the output for each person who worked on a project individually the total would be less than if they had worked together on the project – hence the notion that working in groups produces more results. This is a very important characteristic of effective teams. As individuals in the firm come together to achieve a common goal, the end result should be indicative of the benefits of doing so. The individual achievement and ability has to be transcended into the group effort. Team or group cohesiveness Team cohesiveness refers to the degree to which group members are drawn to each other and are encouraged to remain within the group. The general rule of thumb is that groups that are highly cohesive tend to work more effectively and are more likely to be successful. It is therefore vital that management tries to enhance group cohesiveness in order to get the best results possible. Forces that influence group cohesiveness Size The size of the team or group can influence its cohesiveness, in that very large groups may find it difficult to work together effectively. Smaller groups may find it easier to agree on a common goal and make decisions. To this end, smaller groups are usually more cohesive than larger ones. While this is true, however, a group that is too small may result in members being overworked, which can in turn lead to conflict. It is therefore important that management find the optimum size for each team being used – that is, not too big and not too small. Group goals A hallmark of group cohesiveness is members having a common goal. By definition, a group should include people with a common interest or objective. Cohesiveness will CHAPTER 9 | TEAM MANAGEMENT AND CONFLICT improve once all members of the group agree on a common goal and work towards achieving it. Where the goal of the group is ambiguous or disagreed upon, the level of cohesiveness will be low. Similarities This speaks to the similarities that exist among members of the group. Members who share similar characteristics, such as social background, interest, ethnicity, age, values and beliefs are more likely to develop cohesion. A word of caution, however, is that this could also lead to conflict where there is a clash of personalities. Diversity Group cohesiveness can also be affected by the level of diversity of its members. This can have a negative or positive effect on the group cohesiveness. The group should consist of people with a variety of abilities but who are willing to work to a common goal. Where members are too diverse in personality, ability and experience it can result in competition and conflict. Attraction Personal attraction is also important for group cohesiveness. The more attracted group members are to each other, the greater will be their cohesion. Evaluation of team work Advantages of working in teams The team combines the individual strengths and therefore better decisions can be made. The combination of each individual ability and potential will therefore improve the effectiveness of the team and its impact on the firm Team working enhances flexibility in the organisation. Since the skill and knowledge base of the team is broad, it may be able to adjust fairly quickly to the changing business environment Team working helps to motivate employees, building character and catering for their social needs Employees want to feel that they are an integral part of the organisation in which they work. Working in teams provides this opportunity and, in the long run, will improve the workers’ commitment. The feeling of being a part of the organisation enhances commitment to the stated goals Working in teams can improve productivity, as each member encourages the others to do well. This may also be as a result of an improvement in the team members’ level of motivation. Disadvantages of working in teams Decisions taken by teams tend to be time consuming. Since there are more people involved in the decisionmaking process, it may take some time before a consensus is reached The firm incurs additional cost to set up teams. This includes the cost to train or retrain team members for the task to be completed The firm may lose productive time during the establishment of the team. The time that it will take to organise the team could be used to produce a number of products One danger of working in teams is that it is difficult to ascertain which member of the team is accountable for mishaps that might happen. Benefits of team management to the organisation An effective team can bring a myriad of benefits to the organisation. These include: The firm usually benefits from improved performance as team members pool their ideas and talents to effect growth and achieve the assigned objectives The possibility of workers in the group producing outputs of better quality is greater than that of individuals The use of groups will help senior managers to offload some of their responsibilities while giving them the opportunity to focus more on effecting change at the corporate level The level of flexibility is good, as group members can adapt quickly to changing customer needs since they are aware of the dynamics of the business and its environment. This could result in the firm being able to keep its current customer base Since working in teams improves motivation, there may be an increase in the team’s contribution to the final output of the firm. Conflict management A conflict is defined as a disagreement that exists between two or more individuals. It is almost inevitable that conflict will develop in the workplace, since there are many people with varying personalities and opinions. A conflict usually develops because people may disagree with the goals, 101 102 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE perceptions and principles of the organisation. In the workplace, disagreements may occur between management and subordinates or among subordinates. There are various causes of such conflict, ranging from the style of leadership to a clash of personalities. These are discussed below: Causes of conflict Management style In Chapter 7, we discussed the different types of leadership or management styles in the organisation. The reaction of the employees to the style of leadership being used is a common cause of conflict. Where a manager is very autocratic, employees may retaliate against decisions that are made that will affect them negatively. The employees may not see ‘eye to eye’ with a manager who does not show concern for them or listen to their suggestions. While some people prefer to be led or directed, others want to share in the decision-making process while knowing that their ideas will not just be brushed aside. Competition for scarce resources At any given time most businesses will have a limited amount of resources for which employees are competing. The resources of the business may include cash, supplies and information. These have to be shared among the different departments of the firm. As each department seeks to attain its objectives and surpass targets, it may need to compete for the limited resources and this may cause conflicts to arise. Lack of communication This concept will be discussed in Chapter 9 and is arguably a major problem in many spheres of society. Communication should be clear and managers must ensure that the intended message is what is communicated. However, on many occasions that is not the case and the message is misunderstood. Poor communication will result in conflict. The lack of communication is also a problem for employees who may feel alienated and unimportant. Intentionally withholding information can cause distrust, animosity and eventually conflict among the parties. CASE STUDY Teaming up for a better solution Son Sunny Ltd is a manufacturing company specialising in producing and selling powdered soap. The business has been doing well in this market and, with that success in mind, the management has decided to explore the possibility of entering the bar soap market. The name of the firm is already well established because of the quality powdered soap that it makes. Another key factor in this decision is that most of the production staff have been at the company for over five years and have perfected the art of making that type of soap. Management believes that it should not be very difficult to add a new line to its current product offering. In order to make this change as smoothly as possible, management chose a group of seven people consisting of three employees from Production and the rest from across the other four departments. These people have started having meetings but things are not going exactly as planned. The last meeting held ended abruptly as the representative from the Finance Department felt as though he was not being heard. There was also a clash of personalities between the Production member and the member from Marketing. Amid their setbacks, the group has a mandate to fulfil and time is running out because they must present their findings and suggestions to management at the end of the upcoming month. Questions 1. Would you classify the team in the case as formal or informal? Give reasons for your answer. 2. Which stage of group development would you say that the team has reached? Give reasons for your answer. 3. Which type of group would you describe this as? 4. Discuss four (4) benefits that the firm could derive from allowing the group to suggest ideas rather than management making the decision and passing it down. (3 marks) (4 marks) (2 marks) (16 marks) Total 25 marks CHAPTER 9 | TEAM MANAGEMENT AND CONFLICT Clash of personalities Since we are all different individuals, there will be times when our personalities, values and attitudes vary. As a result, some employees may have a hard time getting along or seeing eye to eye. This will cause conflict in the workplace. The conflict may be so severe that the only solution is to separate the parties. Conflict of duties Conflict may also arise because the responsibilities boundaries are not clearly defined. Where workers are not given clear job descriptions, there might be an overlap of duties which will result in confusion and conflict. Strategies to manage conflict Since it is inevitable for conflicts to arise, managers must be prepared to deal with any eventualities. There are a number of strategies that are available to deal with conflicts. Avoidance There are times when a conflict does not have much bearing on the organisation and so the manager may choose to allow the parties to resolve the issue on their own. Avoidance is appropriate for conflicts that are trivial and not worth intervention from higher authority. The parties may avoid the conflict because there is no chance of any of them winning or coming to a compromise. The process needed to solve the problem may be very costly and cause undue disruptions in work which could have been avoided. Smoothing The smoothing strategy is sometimes referred to as ‘accommodating’. It is where the manager seeks to emphasise the areas of agreement but downplay the areas of disagreement. The use of this method will see one party sacrificing his/her interests or rights in order to appease the other party. Smoothing may not always work, as the sacrificing party is still not appeased. This method is best suited for situations where the stakes are low or it is in the firm’s best interests to do so. For example, an employee may sacrifice his goals so that someone else’s goals and opinions can be undertaken by the firm. Compromise A compromise is where each party agrees to give up something. In this situation there will be no clear winner or loser but a willingness of both parties to accept the solution. This method is best suited in situations where the end result of a conflict might be very costly compared with the sacrifice that each party will make. For example, a worker may agree to accept half the pay increase due to him/her in order to ease the financial strain on the firm or institution. Collaboration Collaboration seeks to meet the needs and satisfy the concerns of each party. This will lead to a ‘win-win’ situation where both parties leave the conflict feeling satisfied. The views of both parties must be heard and discussed extensively to ensure that the agreement that is arrived at is fair and mutual. Extensive discussion may render this method time consuming. This method is particularly important when the issues or concerns are paramount and cannot be compromised or ‘smoothed’. Confrontation Confrontation happens where conflicting parties meet face to face and are coerced into stating their disagreements and stances on the issue. Using this method should lead to open communication which, in the end, should solve the problem. Table 9.1 (p 104) evaluates the various conflict management strategies just discussed. 103 104 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE Strategy Features/meaning Appropriateness Avoidance Conflicting parties are allowed to resolve the conflict themselves The conflict has no bearing on the organisation Used for conflict that management sees as trivial and not having much bearing on the organisation The process to solve the conflict might be very costly There is no chance of any of the parties winning or reaching a compromise Smoothing/accommodating One party’s concern is satisfied at the expense of another Aims to protect relationship by appeasing the hurting party Areas of agreement are emphasised while areas of disagreement are downplayed Point of caution is that the wronged party may not be appeased Often used when the conflict has the potential of hurting important relationships Used where the stakes are low and it is in the best interests to give up one’s rights to appease the other party Often used when the issue is more important to the other party Compromise Each person gives up something of value There is no clear winner or loser in this situation Parties are willing to lose something in order to gain something else Used when it is important to save time by solving the conflict instead of prolonging it Suited for a situation where the end result of a conflict will be more costly that what is being given up by each party Used when both parties are committed to a common goal within the firm Collaboration This is often a win-win strategy where both parties benefit Each party can achieve their goal while maintaining meaningful relationships Often time consuming as parties work to reach the best solution that will benefit all Often used when the issue cannot be smoothed or compromised When a mutual agreement is paramount Used when there is some amount of flexibility on the part of both parties Confrontation Parties meet face to face to resolve the conflict Often leads to open communication about the issue of disagreement Usually, only one party can win The loser could continue the issue if he/ she feels cheated Often used when the issue is pertinent to the firm and must be openly dealt with The firm can benefit from discussion on the issue or problem Table 9.1: An evaluation of conflict management strategies CHAPTER 9 | TEAM MANAGEMENT AND CONFLICT CASE STUDY Trouble brewing at Tropics Beer and Stout Ltd ‘We cannot afford it any more and so as we begin the financial year some things will have to change.’ These were the words of Roger Wall, the General Manager of the private limited company, in a meeting with staff held two weeks before its financial year began. He continued to point out that the company will be revoking some of the benefits that the staff have enjoyed over the last ten years. These changes include cutting back on the amount of time given for vacation leave and protective clothing would no longer be given by the firm so employees must now bear the cost of that. The staff were also told that, come December, what they now know as their annual bonus will only be paid if the company surpasses its target in December by more than 5 per cent. These utterances have angered the employees and the meeting ended abruptly after the union delegate staged a walk-out. The decision to walk out came after management refused to have dialogue on the matter, saying that its decision was final. The employees continue to hold that even though sales are declining, they cannot afford to lose so many benefits at the same time. A closed-door meeting was called, with members of the hierarchy of the workers’ union, and the decision coming out of this meeting is to take the matter to management in the coming week. While not ruling out the possibility of industrial action, the employees would rather that the matter be dealt with amicably. Questions 1. With the use of examples, describe two (2) factors that caused the conflict between management and the employees. (6 marks) 2. For each of the factors identified in Question 1 above, discuss one (1) way in which the situation could have been better handled by management parties. (6 marks) 3. Discuss two (2) strategies that management and the workers’ union can use to resolve the conflict that is brewing in the company. (8 marks) Total 20 marks CHAPTER SUMMARY A team or group can be defined as the interaction of two or more people, in an interdependent way, to achieve a common goal or objective Informal teams tend to be of a social nature and are formed to fulfil a desire of the members, including sports, socialising and other common interests Composition, objective and interaction will shape the nature of teams in an organisation scarce resources and unpopular management styles A group usually goes through different stages of development as it tries to work together effectively to achieve its stated objective A firm usually benefits from improved performance as team members pool their ideas and talents to effect growth and achieve the assigned objectives Conflicts are almost inevitable in the organisation and can be caused by a number of factors such as lack of communication, competition for Conflicts should be dealt with as soon as they arise and management should find the best strategy to resolve the issue. 105 106 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE MULTIPLE CHOICE QUESTIONS 1. Which of the following would be classified as an informal team? 5. Which of the following is an advantage of working in teams? a. Helps to motivate employees b. Decisions can be time consuming a. Quality circle c. Loss of productive time during team development b. Task group d. Additional cost to set up teams c. Lunch group d. Functional group 2. During which stage of group development do members express their individuality and resist the pressures and influence of the remaining team members? a. Adjourning b. Storming Extended Essay Questions Question one Total 25 marks a. State four (4) characteristics of effective teams.(4 marks) b. Explain how each of the characteristics stated in (a) may affect effective teamwork. (12 marks) c. Forming c. Explain three (3) benefits of teamwork to the organisation. d. Norming Question two 3. ALL of the following are causes of conflict EXCEPT which one? a. Clash of personalities b. Lack of communication c. Management styles d. Increased overtime pay 4. The strategy where management allow both parties to solve their conflict themselves is known as: a. Smoothing b. Avoidance c. Compromise d. Collaboration (9 marks) Total 25 marks Conflict is inevitable in most organisations and, unless it is dealt with properly and carefully, it can lead to serious repercussions. a. Outline four (4) possible causes of conflict in the organisation. (12 marks) b. Explain four (4) strategies that a manager can use to resolve conflict. (13 marks) 107 10 Management of Change LEARNING OBJECTIVES: At the end of this chapter students should be able to: Discuss the nature of change in the organisation Outline the differences between leading and managing change Discuss the factors that may lead to resistance to change Discuss the strategies to manage change Outline the importance of communication in the management of change C hange is probably one of the most feared activities in some businesses. This is especially difficult when employees have become accustomed to doing their tasks in a particular way or have served many years in an organisation and have developed a specific culture. In any organisation change is inevitable and so the main concerns should be how change will affect the business and how the main stakeholders (managers, employees and customers) will respond to it. a merger or takeover results in staff cuts and addition to the existing management team. In recent times the Caribbean has seen mergers such as Royal Bank of Trinidad and Tobago and the Royal Bank of Canada and takeovers such as Columbus Communication (Flow Jamaica Ltd) and other cable providers in Jamaica Control systems – this will be discussed further in the Unit 2 section of the book. As firms seek to improve the quality of their product and the service offered, there may have to be some changes in the way things are done Customer service – this is very important, especially in these times when a number of firms are becoming customer focused in order to remain competitive. As the tastes and lifestyles of the consumers change, it may spur changes in the way the firm carries out its activities. External influences These result from factors that are outside of the control of the firm. External factors include: Technological There are a number of factors that may cause change in an organisation. These can be categorised as either internal or external. This is probably the fastest-changing external variable. We have seen vast improvements in technology over the past decade or so. There have been changes in computer technology, communication technology and the use of artificially intelligent robots in factories and offices. This improvement may be used to cut labour costs or employees may have to be retrained to operate the new technology or redeployed. Internal influences Economical Internal influences may arise as a result of management policies or employees’ attitudes. These factors can be controlled by the management of the firm. Internal influences include: The development of a new product – this may require change in the staff composition or general processes that are necessary to introduce the product to the market Mergers and takeovers – inevitably, once there is a takeover or merger of two entities there will be changes in management and staff. On many occasions Some of the major economic variables include inflation rates, exchange rates, interest rates, unemployment, economic growth and development. Changes in one or more of the above variables will bring about changes either in the financial viability of the business or in the lives of the employees. The recent recession and global meltdown have no doubt left many people and businesses financially worse off than before. This may mean that demand for the firm’s product has decreased and soon people will have to be laid off. Some workers may even be asked to take a pay cut in Factors that may cause change in the organisation 108 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE order to preserve their jobs. This can lead to a sense of job insecurity and uncertainty. Demographic This concept relates to the characteristics and structure of a population. Demographical factors include age, size of families, marital status, sex, income and occupation. As the size and structure of the population change there will be changes in individuals’ consumption pattern. Eventually, firms will have to modify their activities to adapt to the changes in the consumption pattern of the population. Modification may include changes in the product or how the firm does business. Social These changes include modification to society, lifestyle of people and the environment. Social factors may also include society’s attitude to work and leisure and the increasing numbers of women at work. Changes in the social structure of society will in turn affect the firm which will have to change also. Legal (political) The legal environment includes legislation and other government policies that will have an impact on the way the firm does business. Some pieces of legislation that should be of concern to the firm include health and safety laws, consumer protection laws, environmental protection laws and taxation policy. A change in any of the aforementioned legal factors will impact on the firm and its employees. Another issue that cannot be overlooked is the political environment in which the firm operates. Where there is political instability the firm may have to go through constant changes. Some firms have to make changes as the government changes its economic policy or if there is a change in the government itself. Differences between leading and managing change You may be asking the question: is there really a difference? The answer can be found in the definitions of both concepts and how each relates to change in the organisation. S Robbins, Organizational Behaviour (6th edn, 1993; Prentice Hall International Editions) defines ‘leading’ as the ‘act of motivating subordinates, directing others, selecting the most effective communication channels and resolving conflicts’. Leading the change involves actions on the part of senior management to create a plan of action to implement the change and delegating responsibility to people who will manage the process. On the other hand, managing is the act of bringing people together to achieve a common goal or objectives. Managing the change involves actions on the part of lower-level management to implement and oversee the change while evaluating the progress and effectiveness of such change. The people leading the change are those who decide on what changes to make in the organisation. In leading the change, there has to be a strategic plan which details the timing of the change and the people who have responsibility for its implementation. As the global environment changes, senior management has to envision the necessary changes that should be made to remain competitive and gain an edge over rivals. It is important to point out, though, that the success of these changes might depend on the effectiveness of the management team which implements and manages them. The way in which these changes are implemented will lead to either acceptance or resistance. Resistance to change Resistance to change is any action of non-conformance taken by employees because of a perception that a change will be a threat to them. The extent to which employees may resist change may depend on whether or not the change will be beneficial to them. There are several factors that may lead to a resistance to change, as seen below: Fear Uncertainty as to the possible impacts of change on the lives of employees creates a sense of fear. The fear of the unknown may prevent employees from accepting change in the organisation. Disrupted habits There is a tendency for us to become ‘creatures of habit’. In any given day there are at least a few things that we do the same way and we have become good at doing them. It is no different in the workplace, as employees develop habits and generic responses to certain situations. For example, a telephone operator who has practised answering the company phone in a specified way may find it difficult to deal with a name change. Loss of control and confidence Trust is probably one of the hardest things to build and usually takes time. Over time, employees may have developed confidence in the management of the firm and such a relationship is essential, especially when a change is to happen. However, if employees feel that their trust has CHAPTER 10 | MANAGEMENT OF CHANGE CASE STUDY A change is coming to HLD Ltd It was a sombre morning for employees of HLD Ltd. This came after news broke the night before that a giant Irish multinational company had purchased 65 per cent of its shares. The employees knew that the company was going through tough financial times but thought that management would have ridden it out as it did once before. A takeover has come as a surprise and has left many of the employees in a daze. It is quite obvious that the downturn in the world’s economy affected the medium-sized Caribbean company. The country had to implement austerity measures as stipulated by the IMF when it secured a deal for balance of payment support. Since the recession, unemployment in the country has risen by more than 10 per cent coupled with rising inflation rates which were triggered by a hike in oil prices. As a result, the domestic market has been shrinking and the export market has not been very good either. The struggles of the company were worsened by the government’s taxing policy which is seeking to take more from all stakeholders within the country. The communiqué via the local news suggests that the takeover and full changeover will be completed in another two months and there will be extensive changes. It is quite evident that management was fully aware of the change but did not prepare employees for what was communicated via the media. Now everyone waits with bated breath as the events unfold. Questions 1. Describe one (1) internal factor and two (2) external factors that caused the change in HLD Ltd. 2. What would be a better way to communicate the change that is about to take place at the company? Substantiate your answer. 3. Differentiate between managing a change and leading the change. 4. Giving one (1) reason, would you say that management is managing the change or leading the change that is coming to HLD Ltd? been betrayed or they have lost confidence in management then there will be resistance to change. Poor training Ignorance can lead to uneasiness and thus resistance to a change that will require a certain level of competence beyond one’s training. Unless people are properly trained to deal with different situations, a change in job requirements and tasks may spur serious resistance. Redistribution of workload Over time, people will have become comfortable with their workload and the tasks they have to complete on a daily basis. Where the firm decides to shuffle staff members or redistribute the workload, it may lead to severe resistance. Some people may feel that they are being unfairly treated as their workload is greater than that of others, even though they are equally qualified. Lack of purpose Employees need to know what the purpose of any change that occurs in the organisation is. Once employees are not (9 marks) (3 marks) (3 marks) (3 marks) Total 18 marks clear on the purpose of a change they will be reluctant to support it. This is perpetuated by poor communication. People who are particularly keen, in terms of having a clear vision of where they are going and how to get there, may resist any change that is not properly communicated or does not have a clear and defined purpose. Loss of power In some situations any change that will result in people losing autonomy or the power to make certain decisions will be met by resistance. The resistance might even be greater if the employee once had a supervisory role and is now being asked to accept a lower position or one with no authority. Lack of communication Ignorance is probably one of the most contributing factors to resistance to change. People are more willing to accept something about which they have sufficient information. Lack of or poor communication on an upcoming change may result in serious resistance. This is magnified especially where management has an autocratic leadership style. 109 110 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE Strategies for managing change Prudent managers can help their subordinates to overcome their resistance to change. It is in the best interests of the firm and management to decrease the level of resistance to change. Prolonged periods of resistance may lead to conflict between management and subordinates. The following are some of the tactics available to management to overcome resistance to change. Educate employees and communicate the change It is often said that ‘knowledge is power’. Some people within the organisation resist change because they are not aware of the benefits to be derived from changing or they lack the necessary skills and training to deal with the change. Educating the employees about the changes that are necessary and how they coincide with the goals and objectives of the firm can nullify the resistance being experienced. Workers should not be kept in the dark since, in most situations, the resistance is as a result of misinformation and poor communication. Therefore, upcoming changes should be communicated in an effective manner depending on the nature of the change – for example, the use of memos, one-on-one discussion, letters or group presentation. Allow employees to participate in the change process If we really think about it, people may find it difficult to resist a decision for change that they were involved in making. With this tactic, employees would be consulted prior to the change and meaningful discussion undertaken. This gives each person a chance to voice their opposition and work to find an amicable solution before the change is implemented. If this is successful, the organisation could benefit from reduced resistance, increased commitment from staff and increased quality in the change decision. The firm must be cautioned, though, that such a move may be time consuming and has the potential to result in a poor solution to the problem that warrants the change in the first place. Negotiate with resisters This tactic involves conferring and bargaining with the employees until an agreement is reached regarding the change. This tactic gives possible resisters an opportunity to influence the change process during the bargaining sessions. Negotiation is particularly effective when a change may cause a trade union to become involved – for example, a decision to downsize the organisation. In addition, this tactic is often used where some individuals stand to lose significantly as a result of the change and have the power to put up resistance. In such situation negotiation may help to lessen the resistance. However, the act of tailoring the change to suit some people may spill over into the rest of the organisation and employees may feel that they too can force management to modify the change. In very serious situations it could even lead to blackmail. Play a supportive role In order to lessen resistance from those employees who are fearful or who lack the requisite skills to deal with change, the organisation may play a supportive role. In doing so, management may provide skills training or counselling sessions to deal with fear and anxiety. However, this tactic tends to be very expensive and time consuming. Coerce employees to comply This tactic is probably the least popular of all. It involves management threatening employees with loss of promotion, transfers or dismissal. Resistance to change Figure 10.1: Managing change Education n Participatio n Negotiatio ess Supportiven Coercion CHAPTER 10 | MANAGEMENT OF CHANGE CASE STUDY Stonewalled Nobody likes change, especially when they have become used to a particular pattern of doing things. This was no different at Hack and Hill firm. In order to improve efficiency and output, the two partners decided to make some wholesale changes to the way things are done in the firm. These changes will be implemented at the beginning of their upcoming financial year. In their regular monthly meeting with staff, held last month, the employees were told to look out for these changes, which will include making the system fully computerised, from order to delivery. Sales personnel are to be given handheld computers which should be uploaded to the main system every evening. Two of the departments will be merged to cut costs and so some of the employees will be transferred to other areas of the business. The company has committed itself to the fact that no employee will lose his or her job in the change process. Notice of the upcoming changes has left some employees feeling jittery as they anticipate what the new-look company will be like. This feeling is further worsened by management’s pronouncement that the total change process has not yet been fine-tuned. When asked for feedback on the pending changes, most employees voiced their resistance, saying that things have been working fine so far and so should be left the way they are. Questions 1. Discuss three (3) possible factors that could have caused resistance to change in Hack and Hill. (12 marks) 2. Discuss three (3) possible strategies that can be used, under the present circumstances, to minimise the resistance to change. (12 marks) 3. In your estimation, was the medium used to communicate information about the pending changes appropriate? Give one (1) reason for your answer. (3 marks) 4. If not done properly, how could the pending changes affect the employees and performance of the firm? (4 marks) Total 31 marks The importance of communication in the management process Effective communication is one of the key components of the management of people. Communication is also important in the change process. There is a tendency for employees to resist change where they are not informed or misinformed. The onus is therefore on management to ensure that the change is communicated properly and effectively, and in a timely manner. The following are some generally accepted ‘rules of thumb’ that should be followed when communicating a change in organisations: The message should be unambiguous – since the impact of the change may be very great, it is imperative that the information being communicated can be understood by everyone. The message about organisational change should be simple and clear to all employees Information should be given in a timely manner – delaying the communication of information will just add to the possibility of resistance to change. Therefore, information should be communicated as soon as possible and in a timely manner Use numerous methods of communication – there is no one best way to communicate information regarding change. Management should then utilise as many methods of communication as possible that will enable an effective way of communicating the necessary information Important information must be communicated – all information of importance must be communicated to employees. Nothing should be withheld, as this may add to speculation and the spread of falsified information which may be damning to the change process Pay attention not just to quantity but to quality of information – in communicating information about a change, management should look not only at the amount of information but at the quality of such information. Give employees opportunities to share feedback – as was pointed out in Chapter 9, communication really is not complete unless there has been feedback. It is therefore paramount that employees be given sufficient opportunities to voice their concerns regarding the changes in the organisation. 111 112 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE CHAPTER SUMMARY Organisation change is inevitable and so the main concerns should be as to how change will affect the business Organisational change may be influenced by internal or external factors Internal factors are those over which management has control, such as customer service and development of new products External factors are those over which management has no control, such as technology and political factors Leading the change involves actions on the part of senior management to create a plan of action to implement the change, while managing the change involves actions on the part of lower-level management to implement and oversee the change MULTIPLE CHOICE QUESTIONS 1. Which of the following is an internal factor that may influence change in the organisation? a. The development of a new product b. Demographical factors c. Mergers and takeovers d. Control systems 2. Which of the following is NOT an external factor that may influence change in the organisation? a. Customer service b. Technology Change may not be readily accepted by the workforce. Some people may resist change because of fear, disrupted habits, poor training and lack of purpose, among other things Management needs to explore the ways in which it can overcome the resistance to change There is a tendency for employees to resist change where they are either not informed or misinformed. Managers have to ensure that the change is communicated clearly. c. Negotiate with resisters d. Give monetary incentive 5. Which of the following involves actions on the part of senior management to create a plan of action to implement the change and delegating responsibility to people who will manage the process? a. Leading the change b. Resisting the change c. Managing the change d. Implementing the change c. Economic Extended Essay Questions d. Legal/political Question one 3. ALL of the following are reasons why people may resist change EXCEPT which one? Total 25 marks a. Explain the difference between leading a change and managing the change. (4 marks) b. Fear b. Discuss three (3) internal factors and four (4) external factors that may cause change in an organisation. (21 marks) c. Poor training Question two d. Disrupted habits a. Define the term ‘resistance to change’. a. Monetary gain 4. Which of the following is LEAST LIKELY to be used to overcome resistance to change? a. Communicate the change b. Allow participation in the change process Total 25 marks (1 mark) b. Explain four (4) reasons why employees might resist change. (12 marks) c. Discuss four (4) strategies that management can use to minimise employees’ resistance to change. (12 marks) 113 LEARNING OBJECTIVES: At the end of this chapter students should be able to: Define the term ‘communication’ Outline the major functions of communication within the organisation Outline the types of communication Explain, with the use of diagrams, the communication process Analyse the different communication channels Outline the factors that influence the choice of communication channel Evaluate the different methods of communicating Explain the lines or flow of communication Discuss the major barriers to effective communication Analyse how the firm can reduce the barriers to effective communication W Types of communication Verbal – this is communication that uses words. Verbal communication may be spoken (oral) or written. This would include telephone or face-to-face conversations, meetings, e-mails and letters Non-verbal – this is communication without words (speech or written). It includes body language, gestures and pictures Formal – the use of the established channels of communication in the organisation Informal – this does not take established channels of the firms into consideration but instead communication is done through the channels of the employees. This type of communication makes good use of the ‘grapevine’. The communication process The communication process illustrates the successive steps that occur between when a sender (source) sends a message and when it is received by the receiver. Figure 11.1 shows a simple communication process and the possible barriers to effective communication. ssage Me age ess Channel Encoding Messa ge Decoding Source Messa g e e communicate every day – or do we? Is our communication effective? Have you ever stopped to think about what communication is? In this chapter we will explore the meaning and process of communication. This concept is by far one of the most important concepts to a number of business organisations. A firm may have remarkable goals and objectives that are achievable but if they are not communicated properly it may defeat the purpose. Think about this: how would you feel if a person only ever gives you instructions without giving you an opportunity to respond or provide feedback? The truth is that there has not been any real communication there. So what, then, is communication? Communication may be defined as a two-way process which enables information to be disseminated between two or more people. It involves the exchange of ideas, facts and emotions by individuals. There are different definitions of communication and it would good for you to refer to these other definitions. It must be pointed out, though, that no matter which definition is used, communication must involve a message which will be transmitted from the sender to the receiver. Communication has four distinct functions within an organisation: Provision of information Control Motivation of staff Facilitation of interaction. M 11 Communication in Business Receiver Feedback Figure 11.1: The communication process 114 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE Source – this is the person sending the message or, in other words, the initiator of the message Encoding – this is the process by which the message is converted into a symbolic form to facilitate transmission. The way a message is encoded may be affected by the level of skills, attitudes, knowledge and the socio-cultural system of the sender. These factors may also affect the effectiveness of the message being communicated Message – this is what is being communicated. This may take the form of spoken or written words. An artist may also communicate through his/her drawings or paintings. It is very important that the sender’s message is clear, as ambiguity may distort effective communication Channel – this is the medium that is used to transfer the message from sender to receiver. The channel used is selected by the sender and must be appropriate for the message being communicated. The improper selection of a channel may lead to poor communication – for example, if an employee is fired by the firm and management simply leaves a voice message to communicate the decision. This channel was not appropriate and may lead to other problems Decoding – before the message can be understood by the receiver it must be decoded. This is done by retranslating the message that was sent by the sender. This stage is critical as it is very important that the message that was communicated will be the same one that is received Receiver – at this stage the decoded message is received by the person to whom it was sent. The receiver must have a clear understanding of the message that is being communicated and must possess good listening skills Feedback – the communication process is not complete without this stage. The receiver should provide feedback to the sender of the message in acknowledgement that the message was received. If the message is not clear enough the feedback would give the receiver the opportunity to seek clarification. Channels of communication There are a number of channels of communication that may be explored in the organisation. These include the following: Oral communication Oral communication is the use of spoken words when communicating. This conversation can take place face to face or over the telephone. Oral communication offers both parties rapid interchange of information and feedback can be given immediately. It is a very good channel to use when information has to be transmitted quickly. Oral communication is by far the most used channel of communication and is favoured for meetings, interviews and presentations. Advantages of oral communication It is usually quick and requires little prior preparation Allows for immediate feedback It is flexible and can be easily adjusted to meet the situation The sender of the message can be more persuasive and convincing It offers direct contact between the sender and receiver of the message. Disadvantages of oral communication It offers little time to think of the feedback that will be given Lacks record unless the conversation was recorded on tape It is more susceptible to distractions (barriers) It is influenced by non-verbal clues which may distort the message being communicated. Written communication Written communication is another widely used channel of communication. It includes the use of letters, memos, bulletins, reports and notices. Written communication is suited for formal long-term records where details of the communication must be kept. One of the problems with oral communication is the lack of record in most cases. However, written communication eliminates this problem. Organisations opt for written communication especially for meetings so that checks can be done in the future and assessment can be made in terms of performance. Advantages of written communication A record can be kept of the information being communicated Information can be sent to people who are in different locations Can be used to clarify, explain and confirm oral communication Suitable for messages that are complex, detailed and with far-reaching effect – for example, the dismissal of a staff member CHAPTER 11 | COMMUNICATION IN BUSINESS Written communication often gets to the point, since the sender has time to organise the message to be communicated. intranet messages which reduce the amount of paper in the office and the time it takes for a written message to be communicated. There has also been an increase in the use of satellite communication systems. Disadvantages of written communication Written communication tends to be time consuming, especially in its preparation Feedback is usually delayed or very slow Can be very impersonal The transmission of messages can be very expensive, especially where communicating parties are far apart Does not offer the opportunity for immediate clarification of messages that are not understood. Visual communication Visual communication is the transmission of information in a form that can be read or seen. Research has shown that people remember more of what they see than what they hear. Therefore, for some communications, a visual message is very important. Imagine a sales manager trying to present information on the business’s performance and predictions based on trends without using some form of visual aid. This presentation would more than likely be on the failing side since people want to see the trend being spoken of. There are a number of options available to the organisation for visual communication, including films, videos, graphs and PowerPoint presentations. Advantages of visual communication Helps to simplify both oral and written communication Suitable for communication over long distances People tend to remember visual images over audio Enables complex information, such as statistical data, to be communicated effectively. Disadvantages of visual communication Visuals may be difficult to understand if they are not accompanied by other methods of communication Tends to be expensive Its preparation may be time consuming. Electronic communication We will all agree that the world has changed drastically when it comes to how we use technology. These changes have affected the way we communicate. The internet has opened up a myriad of opportunities to communicate via electronic means. Electronic communication involves the sending of written, oral or visual messages by electronic means – for example, e-mails. Firms are increasingly developing and expanding their network capability. This facilitates Advantages of electronic communication Usually a very quick way to transmit information Other than the initial set-up cost, it offers a low-cost way to communicate Receiver can give instant feedback Allows employees to work from home Gives the sender a variety of way to communicate – for example fax, e-mail, video conferencing. Disadvantages of electronic communication Can be expensive to maintain equipment There is an increase in security risks, such as hacking and computer viruses There are privacy issues which may prevent the transmission of certain information Unable to retrieve information once it is sent. Non-verbal communication As was stated earlier in the chapter, non-verbal communication is the type that takes place without words (speech or written). It is very difficult for us to transmit a verbal message without non-verbal clues. As a result, it is very important that we consider the non-verbal aspects of communication. The sender of the message must be aware that the way he/she looks, listens and moves sends a signal to other people. This signal can be used to judge whether or not he/she cares, is being truthful or is actively listening. Once the sender’s non-verbal signals match with their verbal communication then it can build trust, transparency and good relationships. The reverse could lead to a series of distrust, anxiety, misunderstandings and creating bad relationships. As we communicate we must be mindful that the non-verbal clues that we are using could be contradicting, repeating, complementing, substituting or accenting our verbal communication. Some of the popular non-verbal clues or signals that are used include: Eye contact – the eyes say a lot of things that are not spoken. Maintaining eye contact during communication is important as it shows interest, confidence and truthfulness Touch – some humans tend to touch during communication. This may include a pat on the back, a handshake, a hug or a rub of the head. Touching can be a distracting non-verbal communication, especially 115 116 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE when the person on the receiving end is uncomfortable with the touch. However, it can also be reassuring or be used as encouragement Body movements – the way you sit, walk or stand up can send signals. We communicate through our posture and subtle movements. Our body movements could be saying ‘I am comfortable communicating with you’ or ‘I cannot wait for this to be over’ Gestures – the way we gesticulate can obstruct or enhance our messages. Over-gesticulation is often distracting. For some people, what is being gesticulated and what is being said are two opposites Facial expressions – our facial expressions say a lot about our interest in the conversation. We can therefore communicate a message that we are not aware of, depending on our reaction to what we hear or what we say Physical distance – some people are very protective of their personal space and will become uncomfortable once they feel that that space is being invaded. However, people are willing to share their space with others with whom they are comfortable or share a good relationship Intonation – this is where emphasis is placed on certain words, thus changing the meaning of the message. Factors influencing the choice of channel used There are pros and cons for each communication channel available to transmit information between the sender and receiver. The type of communication method (see Table 11.1) used is dependent on, but not limited to, the following factors: The nature of the message – this may be influenced by the importance and level of confidentiality. For example, a caution from management to an employee would necessitate a medium that is confidential and leaves a record of the contents The line of communication – where communication is flowing upwards, i.e. from subordinates to CASE STUDY Communication or no communication ‘I went to the staff, called an impromptu meeting and told them what you told me and left.’ These were the words of the Human Resource Manager, Mrs Sassy, as she recounts the task given to her by the General Manager of the firm, Mr Flex. The information was of great importance and feedback would have been welcomed. In the meantime, the members of the Human Resource Department are disgruntled about the manner in which things were done. They have always seen Mrs Sassy as an autocratic leader and one who doesn’t listen to their concerns. They felt that for her to just walk into the office, announce that she had some information to give them, give the information and then just walk out without giving them a chance to respond was unprofessional, if not rude. The workers believe that such information regarding a reshuffling of the department should have been done in a more formal manner. These were her words: ‘I know some of you in here do not like me and the General Manager told me to tell you that the department will be reshuffled and some of you will be reassigned next month.’ The decision to reshuffle the department and reassign some of the members came as a result of the firm’s thrust to implement the strategies of job rotation and enrichment. What could have been a very good gesture and a motivational strategy has now left a bad taste in the workers’ mouths. The General Manager had met with all department heads and told them to approach their departments sensitively about the pending changes. He had expected that they would return with some feedback so that he could properly plan a meeting with the entire staff to discuss the changes and give the reasons for them. Now he may have to do some damage control before proceeding. Questions 1. Describe the type of communication used by Mrs Sassy. (3 marks) 2. With reference to the definition of ‘communication’ and the communication process, did communication take place? (9 marks) 3. State three (3) factors that may influence the channel of communication used by the firm. (3 marks) 4. Explain what would be the proper manner for such information to be communicated. (5 marks) Total 20 marks CHAPTER 11 | COMMUNICATION IN BUSINESS Methods Benefits Drawbacks Internet Cheap and easy to use Can send a large amount of information Can be used to promote the product Can send pictures and videos Customers can interface with the firm Computers are needed and they may not be widespread Possibility of information leakages Threat of viruses E-mail Message reaches receiver relatively quickly Convenient to use Can send information to a group of individuals at the same time There is no limit on the length of the message Allows for the attachment of files May not receive immediate feedback Eliminates social interface Depends on access to computers and internet Personal information might be hacked into Intranet Can share confidential information Easy communication with employees Can lead to improvements in teamwork Increased collaboration between employees and management There are still some security concerns Initial set-up cost can be high Needs computers and internet access Facsimile Allows written information to be sent over a telephone line It is sometimes regarded as being more official than an e-mail Needs telephone lines Lines might be busy Can only send limited information Information sent might not be very secure Uses a lot of printed papers which may lead to storage problems Video conferencing There is no time constraint since it can be done at any time Saves time and money in terms of travelling Offers face-to-face interaction Facilitates meeting with people in different locations Information can be shared and received at the same time from all participants High initial set-up costs Needs technical expertise Risks of the equipment breaking down Table 11.1: An evaluation of communication methods management, only some methods can be used. In addition, management will decide on certain methods when communicating to subordinates Cost – as discussed earlier, some methods of communication tend to be expensive. Organisations will weigh the pros and cons of each medium and decide which is most cost effective The level of urgency – this is based on how soon the sender wants the message to be communicated. In the case of an emergency the sender would want to use a method that will get the information to the receiver as quickly as possible Length of message – lengthy messages tend to require some form of written communication, as it is difficult for the receiver to remember all the information Record requirement – earlier, we discussed that oral communication lacks record unless it was recorded using some form of electronic device. For communication where a record is important (for example, a staff meeting), then the manager would choose a more appropriate method. Lines of communication Lines of communication refers to the flow or direction of communication from the sender to the receiver. The lines of communication can further be broken down into formal channels. A formal communication channel is one that is clearly defined by the organisation and follows the chain of command. The responsibilities and tasks to be carried out by each individual are also clearly outlined. Formal communication channels allow information to flow in a vertical (downward or upward) or horizontal manner. See Figure 11.2 (p 118). Downward channels This type of communication channel allows information to be passed down from top management to subordinates. The effect of such communication may depend on how the information is transmitted. Management can communicate the intended information in a number of ways, including the use of newsletters, speeches, e-mail, memos and bulletin boards. Downward communication is often used to achieve the following: 117 118 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE Upward Horizontal Downward Figure 11.2: The flow of communication Establishing the mission, goals and objectives of the firm Outlining job descriptions and responsibilities Giving instructions about the procedures that should be followed Communicating feedback on employees’ performance Motivating staff. Upward channels This type of channel is particularly utilised under a democratic leadership style where employees can freely share their suggestions and concerns. These channels allow subordinates to communicate with top management. They give employees an avenue through which they can negotiate salaries and pacify conflicts. Upward channels can be used to communicate the following information: Conflicts and disputes Suggestions to improve the business Submit reports about the different aspects of the organisation Present financial data to senior management Draft reports on the current performance level of the firm. Horizontal or lateral channels These channels allow communication to flow among peers and co-workers. Organisations may use this type of channel to deal with interdepartmental issues or projects. For example, departmental managers may meet in order to forecast sales or work on a project to improve the organisation. Therefore these channels are used to communicate information between people or organisational groups having the same level of authority. Lateral communication channels may be used to: Coordinate the activities at the tactical level that will result in the achievement of the organisation’s objectives Disseminate information among departments which can help to improve the operations of the business Resolve conflicts that may arise between departments Solve problems that have the potential to affect all departments – for example, an emerging budget cut. Drawbacks of formal channels of communication Subjected to rigidity, as communication has to be sanctioned by those in authority and is limited to those who are a part of the channel Can be costly, as it requires additional human resource – for example, secretaries; storage space for records; and reproduction of the communication (such as minutes) The fact that formal communication usually carries some form of record may act as a deterrent to some people to be truthful Formal communication tends to be impersonal and as a result may lead to poor motivation of staff It is time consuming and prior preparation is required. This can be compounded especially when planning a meeting or seminar which involves a number of managers. Informal channels of communication Inevitably, in any organisation, communication will occur through not only the formal authorised channel outlined by the firm’s organisational structure. Communication that occurs outside of the formal channel is known as informal communication. This does not follow the established channel but is able to coexist with formal communication. It must be pointed out, though, that this form of communication is not necessarily bad for the organisation. As a matter of fact, some managers support the use of informal channels especially where they are able to influence them implicitly. A commonly used informal channel of communication is the grapevine. The grapevine is an informal network that exists among employees or other people that is not officially sanctioned by management. The grapevine usually thrives when certain conditions exist. These may include, but are not limited to, the following: When there is insufficient information about an issue, employees may attempt to fill in the missing pieces Lack of confidence in the formal channels of communication When employees feel threatened or insecure in their job CHAPTER 11 | COMMUNICATION IN BUSINESS There is a strong need for socialisation which is not facilitated by the formal channel The use of the grapevine may also be used to spread rumours or to gossip. If these rumours or pieces of gossip get out of control it can be damaging to the firm. They can spread throughout the organisation uncontrollably, and therefore should be of concern to management. Informal channels of communication have contributed to the operation of the organisation and carry the following benefits and drawbacks: Advantages of informal channels of communication They tend to be less intimidating and so are good channels to use to share plans and new ideas to benefit the firm May be used to motivate workers since it is personal and can build team spirit and camaraderie Usually verbal and facilitate two-way communication Informal communication may be used to supplement communication when formal channels fail. Disadvantages of informal channels of communication The organisation cannot control what is communicated therefore people might be misinformed Where a rumour is spread it can be very difficult to effect damage control Employees may sacrifice productivity for socialisation and sharing information Classified information may be circulated that may have serious repercussions. Barriers to effective communication The communication process is at times interrupted by various barriers to communication. These barriers may distort the message being sent and how it is perceived by the receiver. Below are some of the main barriers to effective communication: Selective perceptions Since we are all unique individuals, our interpretations of messages will differ. Messages are sometimes misinterpreted because of the receiver’s own perception of what was communicated. The preconceptions of what a person may be saying may impede the message that is being communicated. How employees perceive each other also amounts to barriers being created. One’s perception of another may be influenced by past experiences, distrust, social background, poor relationships with the sender and other personal characteristics. CASE STUDY A flourishing grapevine ‘The local PA system’ – that is what she is called in some spheres. It is amazing how information quickly spreads throughout this organisation once one person gets wind of it. The social structure of the organisation is very close knit and workers often sit in their groups in the lunch room. This creates a grand opportunity for information to circulate within minutes. Ms Outspoken is often the instigator of this grapevine. It is astonishing how she keeps getting access to information but she does and once this is done everyone in the lunch room will be informed before leaving. In recent times management has recognised that the employees are quite informed about information that would have been communicated behind closed doors. Upon investigation, they have come to realise that there is a flourishing grapevine within the organisation. Since it is very difficult to minimise the success of this channel of communication, they are considering using it to their benefit. Questions 1. In relation to communication, what is meant by the term ‘grapevine’? (2 marks) 2. Describe the two (2) potential types of damage that this flourishing grapevine can cause the organisation. (6 marks) 3. Management are exploring the option of using the grapevine in their favour. Discuss two (2) ways in which this could be beneficial to the firm. (8 marks) Total 16 marks 119 120 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE Attitudes The level of camaraderie in an organisation may influence how a message is interpreted. It is more likely to have attitudinal barriers to communication when employees do not have good working relationships. For example, where there is a lack of trust between two people it may be very difficult for them to have confidence in what is communicated between them. Attitudinal barriers may be brought about by factors such as: Poor management Personality clashes Lack of consultation with employees Lack of motivation Resistance to change. Noise distractions such as poor working conditions or background noise can also prevent effective communication from taking place. Filtering This is where the sender manipulates the information being sent so that it appears more favourable to the receiver. This practice is widely done in organisations – and even among you and your peers. Have you ever heard the term ‘telling you what you want to hear’? Well, if you have, it is the same thing as filtering. The sender of the message may ‘tweak’ the information so that it is not read into deeply by the receiver but taken at ‘face value’ and the desired feedback is given. For example, in organisations with a number of hierarchical levels, information may be filtered before it gets to senior management in order to encourage the desired decision. Simply put, ‘noise’ is any interference that occurs between when a message was sent and when it is received. Noise can be internal or external (physical). Internal noise is affected by a person’s background, experiences or perceptions. These influences cause a person to interpret a communicated message in a particular way. In contrast, external noise includes physical sounds that will impede communication. External noise can come from a noisy environment or even a faulty telephone cable. Whatever the source of the noise, the important thing is that noise prevents effective communication from occurring. Non-verbal signal Cultural bias Ensure clear message Culture brings about a different set of barriers to communication. The culture of a country influences the way people see and hear things, think and interpret the world. To this end, the same words could have an entirely different meaning in another culture. For example, ‘pants’ in Britain means ‘underpants’ but in the United States it means ‘trousers’. You can also think of the different examples in your region and even your country. Other factors that may influence one’s culture and create barriers to effective communication include age, social position, economic status, political views, values and rules, ethics or standards and motives. A problem that is faced by some receivers is the lack of understanding of what was communicated by the sender. Messages that are vague often present a serious challenge and may lead to misinterpretation and misunderstanding. In order to reduce this barrier to communication, the sender should ensure that the message is unambiguous and communicates what was intended. The onus is therefore on the sender to keep the message simple and free of jargon of which the receiver may not be aware. Sending a clear message will increase the chance of the receiver understanding the message and giving feedback. Physical barriers The nature of the environment where communication is taking place can become a barrier. Where the staff are located in different buildings, which sometimes are not even close to each other, communication may be distorted. Physical barriers also arise as a result of poor or outdated equipment which should facilitate effective communication. Other Some people gesticulate a lot during communication. While gestures and body language can enhance communication, they sometimes become a barrier to effective communication. This is especially true when a person’s body language is contradicting what is being spoken. For example, imagine sharing what should be exciting information with a straight and sulky face. Reducing barriers to communication Choice of channel Good messages can be distorted at times because of the channel that is used by the sender. In order to reduce the barrier to communication, the sender should analyse the message and use the most appropriate channel to communicate it. While some messages can be communicated orally, other important messages may have to be written. Knowing the audience is also important in choosing the CHAPTER 11 | COMMUNICATION IN BUSINESS right channel to communicate the message. Some people are auditory, while others might be visual. This should be borne in mind when communicating, since using a channel that suits the receiver should bring about better feedback. Managing feedback There is a common notion that communication has not taken place if there is no feedback. Unless there is feedback, there is no guarantee that the receiver of the message has totally understood what was transmitted. For any organisation to grow and remain competitive, all stakeholders must be aware of its goals and objectives. Management needs to ensure that these goals and objectives are clearly communicated and employees given sufficient feedback as evidence that they are clear on what is required of them. To this end, the management of the organisation must implement strategies to manage feedback to get the desired result. The feedback received will give an indication of how well communication has taken place. The management of the organisation can obtain feedback from evaluation of the staff, e-mail or ‘open door’ policies. Barriers to communication If management is not satisfied with the feedback received, it may need to revise the communication process as there might have been barriers which prevented the message from being properly transmitted. A keen manager will use feedback to plan programmes and strategies to improve the ability of subordinates. Improving physical conditions As discussed above, the working environment can pose serious challenges for effective communication. Poor working conditions will create both internal and external ‘noise’ which will impede communication. Management should create the right environment which is conducive to work. It should ensure that the working environment is safe and ergonomically arranged. The environment should be free of health hazards, with proper lighting and space. The right environment will allow employees to feel comfortable, thus reducing the barriers such as noise or physical barriers. Table 11.2 summarises the ways in which barriers to communication might be overcome. Possible ways to overcome barriers to communication Selective perception Communicate the message clearly and free of misleading information Create good employer–employee relationships Very important information should be communicated preferably when people are at their optimum, i.e. rested and alert Attitudes Be empathetic and analyse the possible effect of the message on the receiver’s feelings Build good labour–management relations Interact with staff regularly so as to build trust Noise Minimise or eliminate ‘noise’ in the environment Give information in fragments to prevent information overload Assist people with their problems that may be causing internal ‘noise’ Cultural bias Speak in a clear language free of jargon that may be culture-specific Gather information about the receiver’s culture before formulating the message Physical barriers Use technology to communicate effectively across physical barriers Improve or replace old equipment Provide a good working environment Minimise or eliminate the ‘noise’ in the environment Filtering Be honest in the communication of the message by not withholding vital information from the receiver Put information in writing so as to maintain its quality when it reaches the receiver Non-verbal clues Reduce the number of gestures that are used during communication, i.e. do not over-gesticulate Ensure that the gestures being used coincide with what is being communicated Table 11.2: Methods of overcoming barriers to communication 121 122 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE CHAPTER SUMMARY Regardless of the definition used for ‘communication’, a general rule is that it must involve a message which will be transmitted from a sender to a receiver Communication is not always effective as it can be interrupted by barriers including ‘noise’, selective perception, attitudes and cultural bias Lines or flow of communication refers to the flow or direction of communication from the sender to the receiver and can be either formal or informal Communication can be verbal (communication spoken by individuals) and non-verbal (communication without words) There are various communication channels that may be explored in the organisation. Examples of these are oral, written, visual and electronic The formal communication channel is further divided into downward, upward and horizontal channels The communication process illustrates the successive steps that occur between when a sender (source) sends a message and when it is received by the receiver The choice of channel used by the firm may be affected by cost, length of message, line of communication, nature of message and urgency MULTIPLE CHOICE QUESTIONS 1. Which of the following is NOT a function of communication? a. Provision of information 4. Mrs Feeble has had a bad experience with her previous male boss who was very domineering. She is now employed in a new job but has a male manager. Which of the following is the MOST LIKELY barrier to communication that may exist? b. Telltales a. Filtering c. Motivation b. Selective perception d. Facilitate interaction c. Cultural bias 2. The use of gestures would be classified as: a. Formal communication b. Verbal communication 3. The grapevine is a commonly used informal channel of communication. d. Attitudes 5. Which of the following is an advantage of oral communication? c. Non-verbal communication a. Offers little time to think of the feedback that will be given d. Informal communication b. Lacks record, unless the conversation was recorded on tape In which step of the communication process is the message converted into a symbolic form to facilitate transmission? c. Is more susceptible to distractions a. Encoding b. Decoding c. Channel d. Feedback d. Allows for immediate feedback 6. A disadvantage of written communication is: a. A record can be kept of the information being communicated b. Information can be sent to people who are in different locations c. Can be used to clarify, explain and confirm oral communication d. Feedback is usually delayed or very slow CHAPTER 11 | COMMUNICATION IN BUSINESS 7. Which of the following is NOT an example of visual communication? Extended Essay Questions Total 25 marks a. Videos Question one b. Letters a. Outline, with examples, the differences between verbal and non-verbal communication. (4 marks) c. PowerPoint presentations d. Films 8. Which line of communication is particularly utilised under democratic leadership styles where employees can freely share their suggestions and concerns? a. Upward b. Downward c. Horizontal d. Diagonal 9. The grapevine is an example of which of the following? a. Formal communication b. Verbal communication c. Non-verbal communication d. Informal communication 10. Which of the following would NOT be regarded as a benefit of informal communication? a. Less intimidating b. Can supplement formal communication c. Can motivate workers d. Classified information may be circulated b. Using a diagram, explain the steps involved in the communication process. (21 marks) Question two Total 25 marks The communication process may be halted or disrupted by barriers. a. Discuss four (4) common barriers to communication. (12 marks) b. Briefly explain one (1) way in which each of the barriers discussed in (a) can be overcome by the organisation. (8 marks) c. Outline five (5) factors that may influence the type of communication channel used. (5 marks) 123 124 12 Human Resource Management LEARNING OBJECTIVES: At the end of this chapter students should be able to: Discuss the role and importance of human resource management Outline the factors that may affect human resource management Assess the effectiveness of human resource management Explain the main functions of human resource management Outline the process of labour–management relations Give an overview of the laws affecting health and safety in the workplace The role and importance of human resource management T he view of Adam Smith that ‘man is an economic animal’ has been criticised over the years and many organisations have come to realise the importance of the human capital. We are living in a changing business environment and the way firms once carried out their operations is quickly changing. To this end, many firms are now placing greater emphasis on human relations. Some firms have created a Human Resource Department (HRD) to ensure that staff members are motivated and well trained so that customers will be given the best care possible. Human resource management has its roots embedded in the Human Relations School of the early 1920s, led by Elton Mayo. Human resource management is seen as the policies, practices and systems that influence employees’ behaviour, attitudes and performances. The growth of human resource management has been affected by: A change in the goals and objectives of businesses Increased representation of staff by trade unions The passing and implementation of government legislation Increased business competition for both goods and staff Increased financial resources. The main role of human resource management is to attract, develop and maintain an effective workforce. In carrying out its role the HRD has to be able to attract workers to the organisation. It should be aware of the organisation’s needs in terms of the amount and skill level of employees. This is done through its function of recruitment, which will be discussed in a subsequent section of this chapter. The HRD should also help to develop the workforce over time through training and development programmes aimed at improving their skills, productivity and work ethics. Maintaining its workforce will take a concerted effort by the firm to keep the workforce motivated to work. This could be done through the use of financial or non-financial strategies, as were discussed earlier in the module. A number of businesses have benefited from human resource management. Some of these benefits are outlined below: Effective human relations can help to prevent industrial action Easier for the business to anticipate any changes that may occur in the workforce requirement. It can then make plans for these changes Helps to motivate workers, thus increasing their productivity and reducing potential costs to the business Good human relations can prevent problems such as absenteeism or a high rate of turnover Where consumers are given high regard and have a good relationship with the firm, it can gain a competitive edge over its competitors. The organisation must also be cautious, though, of the possible drawbacks of human resource management: Poor human relations can result in serious industrial disputes Any plan that is implemented must be constantly monitored and adjusted as the forces of the environment change. The functions of human resource management Workforce or manpower planning This is possibly the most important function of the Human Resource Department. Unless this function is carefully CHAPTER 12 | HUMAN RESOURCE MANAGEMENT carried out, the department may encounter serious problems in carrying out the subsequent functions. Workforce planning is the process whereby a firm forecasts its future demand for labour and develops a plan to meet such demand. In economics the demand for resources, including labour, is termed ‘derived demand’. In essence, the concept states that the demand for the factors of production, for example labour, is determined by the demand for the firm’s final product. Therefore, in planning for the workforce the level of demand should be taken into consideration. There are a number of other factors that may influence workforce planning, including: Financial resources and stability of the firm – the firm has to take into consideration its expected labour cost and its ability to cover such cost with the projected revenue. If labour cost is too high, then the firm may need to consider labour cost-saving techniques such as using machines. Poor financial prospects will reduce the amount of workers employed in the organisation The objectives of the firm – if the firm’s longterm objective is to expand, whether locally or internationally, then it means that more workers will be needed. Where the firm’s objective is to reduce costs by becoming capital intensive it means that there will be the possibility of large-scale job cuts Technological advancement and the firm’s ability to implement these changes – as changes in technology occur there will be a reduction in the labour requirement The success of training and development programmes – training and development is a part of many larger firms. It is used to improve the skills of the workers. The firm’s ability to train employees will have an impact on the amount and skill level of the people required Changes in the population and its composition – the population can be affected by a number of factors such as migration, war, increased birth rate, age or gender. As the population changes, the firm has to change its workforce planning. For example, if the majority of the population is ageing, then the firm must put a plan in place to seek replacement of workers elsewhere Labour turnover and absenteeism rate – a firm with a very high turnover rate must constantly make plans to replace workers when they leave. While this may be an indication of poor labour management relations, the firm has to ensure that its operation is not seriously affected by the sudden resignation of a number Job analysis of workers. Recruitment In the previous section we examined how the firm will make plans for its workforce and the factors that will influence such plans. Having outlined a plan, the next function is to find suitable people to fill the positions. According to RL Daft (Management (6th edn, 2003), p.415), recruitment is the activities or practices that define the desired characteristics of applicants for specific jobs. This is a very important function of the Human Resource Department, as recruiting the wrong people for the job can lead to low labour productivity and loss of revenue for the firm. With this in mind, firms often draft a recruitment plan. This plan outlines the steps that will be taken to recruit individuals for a particular job. See Figure 12.1. The recruitment plan contains five stages which are outlined below: 1. Job analysis – this is the examination of what the job entails: that is, the responsibilities, skills, training and tasks that are required for the job. In order to ascertain this information, the Human Resource Department must conduct the necessary research about the job. The job analysis, when completed, is used as the standard against which the applicant will be measured in the interview 2. Job evaluation – here, an assessment of the worth of the job is done. The aim of this process is to assess whether the reward being given for the job is fair when compared with those for other jobs in the organisation. This will enable the firm to determine the appropriate salary and wage levels for the particular job 3. Job description – having completed the job analysis, the firm can describe the position that is available. It would give information about the purpose, duties, tasks and responsibilities of the position. The job description can be used to measure performance of the person employed 4. Person or job specification – in this stage, the profile of the person to fit the job is outlined. It states the years of experience, minimum qualification and character of the person required for the job. Like the job description, this is also used to assist in the recruitment of a suitable person for the job Figure 12.1: The recruitment plan Job evaluation Job description Person or job specification Job advertisement 125 126 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE 5. Job advertisement – the final stage of the recruitment plan is where the particular job is communicated, whether internally or externally. The main aim of job advertisement is to attract a cohort of suitable applicants for the job in question. Recruiting internally versus externally Having drafted the recruitment plan, management now has to decide how applications for the post will be solicited. In many firms, the general rule is that the post must first be advertised internally (for example, over the intranet) and if it is not filled then the post would be advertised to the wider population. Irrespective of this, the firm will have to decide whether to recruit internally or externally. In making this decision, there are certain factors that must be taken into consideration and the firm would have to weigh the advantages and disadvantages of each option and then make a decision. Factors that may influence the recruitment decision The amount of time that is available to fill the post. If the post has suddenly become vacant and it demands a quick replacement, then management may not have enough time to go through external recruitment The level of skills that are available internally is also another deciding factor. If there is no one in the organisation with the requisite skill and experience needed for the post, then attention may have to be turned to the external route The type and nature of the job may also be a deciding factor. The skill required for this particular job may not be available anywhere in the firm and so must be sought from outside The composition of the external labour market. The firm may need to do an assessment of the external labour market to decide whether or not the applicant that it is looking for will be available The firm may also need to consider the impact that an external recruitment may have on the level of motivation of the existing staff. Advantages of internal recruitment Improves employees’ morale as this is seen as a reward for hard work done May be cheaper, since large sums of money would not have to be spent on advertisement Employees benefit from job enlargement and rotation and they can get full use of their potential The entire process is less time consuming. Disadvantages of internal recruitment There may be an absence of new ideas The firm incurs the cost of training if the skill of the internal staff is not sufficient Narrow applicants base, as more people could be recruited from outside Promoting internal staff will create vacancies that will still need to be filled People who are not chosen may create some animosity for others, which can result in conflict. Advantages of external recruitment Offers more choice, as there is a greater variety of applicants ‘New blood’ can be injected into the organisation. This can result in new ideas and different approaches to the job. Disadvantages of external recruitment Advertisement costs may be high May lead to morale issues within the firm. EXERCISE List some of the institutions and agencies in your country from which firms can attract external applicants. Selection Job advertisement usually creates another challenge for employers – which is choosing the most suitable candidate(s) for the job from the myriad of applicants. This process may be different for some businesses but the general stages are outlined below: Applications Once a job is advertised, potential workers are required to submit an application letter accompanied by their curriculum vitae or résumé. Some firms may request that the applications be mailed or dropped off. However, with the development of technology, a number of firms are requesting that applications be sent via e-mail. Some organisations have also created a general structured application form which should be completed by applicants. Once applications are received, the firm can move to the next stage. Short listing This particular step is used when the number of applications far outweighs the available positions in the firm. The Human CHAPTER 12 | HUMAN RESOURCE MANAGEMENT Resource Department has to sift through these applications to select a manageable list of applicants who best fit the requirements for the job. This is not the final process but these people will be brought in for an interview after which further ‘trimming’ of the list will be carried out. To cut costs, some firms will only reply to these people inviting them to an interview. Interview This is where both the employer and the applicant have a chance to interact so that a two-way exchange of information can take place. The employer has the chance to clarify points made in the application letter and résumé. It also presents an opportunity for the employer to assess each applicant’s deportment, articulation and persona. The main purposes of the interview for the employer and applicants are to: Give employers an opportunity to decide the suitability of the applicants for the job Give applicants a chance to garner more information about the job and the firm. Testing In some organisations, before a final decision is made regarding employment, applicants are tested. This is particularly important where the people being employed are expected to come to the job with prior information and knowledge or the firm wants to ascertain what its training needs are. Employment Once the most suitable applicant for the job is chosen, the final part of the selection process is to communicate with them and give them a date for work to begin. Compensation Developing a fair and attractive remuneration package is also an important function of human resource management. Without fair and proper remuneration, the firm is running the risk of industrial action, low productivity and low performance. The preceding functions of the Human Resource Department all lead up to the type of pay structure that best suits the job offering. The compensation package that is chosen will depend on the job analysis and job evaluation that were carried out at an earlier stage. These two very important pieces of information give the firm a very good idea of the worth of the job and the level of compensation in the market. The firm may choose to pay the worker based on the going rate in the market or above the market rate. While paying above the market rate might add to cost, it could be used CASE STUDY The search for a Production Manager SWATER Bottling Company Ltd is a retail business established ten years ago and which bottles products for a number of firms within the local area. This business has been thriving and management is now thinking of expanding its product offering. This will entail making and bottling fruit juice, using fruits from the country and the region if necessary. To this end, it would have to add the juiceprocessing equipment to its bottling factory. In addition, the factory will need to employ a Production Manager. The good thing is that most of the rest of staff members are competent and can easily make the switch from bottling to making and bottling juices. The issue with the change is to secure a Production Manager. Management is planning on advertising the post internally, as there are two possible candidates there. The other option is to advertise in the local newspaper. This, management believes, will bring in fresh ideas and the firm may find someone who is more qualified than those who are internal to the company. Eventually, the decision was taken to send out an internal communiqué about the upcoming changes and the new position that will be created. The intention was that if no suitable candidate was found internally then the company would look externally. Questions 1. Discuss how the use of a recruitment plan could help the firm in the search for a Production Manager. (15 marks) 2. Outline two (2) factors that could have influenced the company’s decision to recruit internally. (4 marks) 3. Outline two (2) advantages and two (2) disadvantages of recruiting internally as opposed to externally. (8 marks) 4. If more than one employee applies for the post, describe one strategy that the company could use to choose only one of them. (3 marks) Total 30 marks to attract and keep highly skilled workers who could in turn contribute significantly to the performance of the organisation. However, whichever of the two options is chosen, the firm should ensure that the pay package is fair. The compensation package may also be influenced by the complexity of the job, working conditions, educational requirements, years of experience and the amount of responsibility that comes with the job. 127 128 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE Types of compensation Compensation to employees may take different forms, including: Wages and salaries – this is possibly the most popular type of compensation. The terms are often used interchangeably, with little, if any, difference at all. A ‘salary’ is defined as a fixed payment to an employee for work done. This payment is often made on a monthly basis and made to white-collar workers. ‘Wages’ are often paid weekly, fortnightly or monthly and can be based on an hourly rate and are usually paid to manual or unskilled workers or labourers Allowances – these are often paid in addition to the regular or basic salary. They are paid as part of the salary package or to settle out-of-pocket expenses incurred in carrying out duties for the firm. This may include travelling allowances, housing allowances or car upkeep and taxi and supper allowance Pension fund – this is a pool of contributions made by either the employer or the employee or both. This fund will be used to pay workers after retirement in the form of pension. Pension funds are usually managed by an external financial institution and the funds collected are invested to earn greater returns Health insurance – this is usually a part of the fringe benefits offered to employees. Health insurance is a coverage of employees which includes the payment of medical expenses. This payment is made by the firm entirely or by both employees and employer in an agreed percentage. Training and development Training is seen as a process of improving the knowledge and skills of employees. Firms that want to remain competitive in a constantly changing environment have to improve the skill level of their employees. Companies such as The Jamaica Public Service spend large sums of money to ensure that their staff are well trained to improve efficiency. The aims of training may vary across organisations but general purposes of training may include: Preparation of employees for their job Helping existing employees to hone their skills and ability Fostering adaptation to new technology and innovation Improving efficiency through increased productivity For promotion. Some of the main types of training carried out by the firm are: Induction – which is used to introduce new employees to the firm and its processes Basic skills training – used to develop the skills of lowerlevel staff Refresher training – gives long-serving employees an opportunity to update their skills and learn how to use new technologies Management trainee programme – used to prepare employees to take up management positions. This is usually part of the succession plan of the firm. There is no one perfect way to train employees of an organisation. As a matter of fact, some firms do not have the capability to train employees with the requisite skills. As educational institutions and businesses themselves expand over the years, firms have more options in terms of training for their staff. Organisations have two methods of training available to them. Both are explored below: On-the-job training This is where employees learn while they are performing the job. On-the-job training may take several forms: Job rotation – as was discussed in earlier chapters, this involves a lateral transfer of employees to enable them to work in and learn about other job responsibilities in the organisation Apprenticeship – this is where new employees understudy more experienced employees in an attempt to learn about the task being performed Coaching – trainees are guided by a coach who will give the necessary instructions to carry out a job or use a machine or equipment Mentoring – a trainee is paired with an experienced worker who acts as an adviser for the trainee while he/ she carries out the job. Advantages of on-the-job training Usually cost effective Employees are working while learning Less productive time is lost than with external training. Disadvantages of on-the-job training The quality of training might be compromised since it is dependent on the person giving the instruction Bad habits might be passed on Production may be disrupted during training. Off-the-job training Off-the-job training is where employees are trained away from their immediate workplace. This training could be done elsewhere within the firm’s premises or in an educational facility, such as a university. Some examples are: CHAPTER 12 | HUMAN RESOURCE MANAGEMENT Lectures – these are verbal presentations on a specified area and are conducted by a person qualified in the field Audio-visual – this can be done using videos or films to conduct training. Workers may watch a presentation on how to perform a particular task or set of tasks Simulation – this is where a real-life situation is created and participants may be asked how they would respond in such a situation. For example, it could be used to assess tellers in a bank. Simulation exercises may incorporate case studies, sensitivity training and role play E-learning and distance learning – both of these can take place over the internet and so are convenient for a number of employees. People are able to upgrade their skills at their own pace. Advantages of off-the-job training A wider variety of skill and qualifications available Trainers may have specialist training Employees can be exposed to the latest information available Usually more systematic and organised. Disadvantages of off-the-job training More costly Loss of productive time while workers are being trained externally Firm may lose workers to other firms after they are trained Firms may still have to do supplementary training. Training versus development The main difference between the two concepts is the time frame. Training focuses on the present situation and the job that the employee is currently doing. The aim of training is usually to enhance specific skills and abilities of employees so that they can improve their performance on the job. Conversely, development focuses on future jobs in the organisation. The organisation may seek to develop its employees based on its succession plans or on the fact that in the future new skills and abilities will be required. Developing employees will help to prepare them for the future when these skills and abilities are needed. Performance management The lack of checks and balances can become detrimental for any business. With this in mind, the Human Resource Department has to measure the performance of the staff in a timely manner. Performance management is seen as a process used by managers to measure how well employees are executing the task given to them. It is the process that is used to identify, measure, manage and develop the performance of the employees within the firm. Employees’ performance is also measured against the goals and objectives of the firm. The firm uses this to measure the extent to which employees’ performances fall below, meet or exceed the targets of the organisation. Performance management can help the firm to: Select people with a possibility of promotion or redeployment Assess the efficiency with which the previous functions are being carried out Determine a pay structure for employees Identify possible training needs. Performance appraisal Performance appraisal is defined as the on-going process of measuring and evaluating employees’ performance. This is sometimes confused and the term even used interchangeably with ‘performance management’. However, the two are not the same, as performance management covers a broader scope of management including performance appraisal. For any performance appraisal to be successful, there are a few important characteristics that the firm should take into consideration: Fairness Performance appraisal plays a critical role in the life of the employee and the firm. Some firms even use the appraisal to make critical decisions in terms of whether to promote or demote employees. It is therefore imperative that any such appraisal be done in a fair and transparent manner. For example, the same instrument should be used to measure performance for the same category of employees. Performance appraisal should not be geared towards ‘weeding out’ some people but to assist the staff in improving their expertise. At the end of the appraisal the employee should not have just reason to believe that he/she was cheated out of a good or satisfactory performance. Performance appraisal can be subjective to some extent, since it is partially dependent on the person conducting the appraisal. This subjectivity becomes greater where the instrument being used is not clear in what is being measured. To minimise this occurrence or feeling by employees, a common practice is for the employee to be given a chance to read through the appraisal and sign it once they are in agreement. Discussions are sometimes held on areas with which they are not comfortable. 129 130 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE Participative Management should ensure that any performance appraisal that is to be done receives the full support of the employees. Employees should be allowed to participate in the appraisal process. This could be done by asking them to help create their performance goals and development plans. Employees could also help to generate the instrument that will be used to appraise them. The notion is that employees are more likely to buy into something the development of which they participated in. Having them setting some of the performance measures will also mean that they will make a concerted effort to meet those targets. In some organisations employees are allowed to participate in the appraisal process by doing peer evaluation. This type of appraisal may be best suited when the supervisor is absent or does not have frequent contact with the employees. Co-workers are knowledgeable of the job requirements and so would be able to assess each other on how well it is being done. A word of caution, however, would be that this could backfire. Again, such appraisal could be very biased and conflict on the job could spill over into the appraisal. nature, the aim of performance appraisal is to improve the firm and as such it should be done periodically and not haphazardly. The time frame for performance appraisal is different for some firms while it is common for appraisals to be conducted quarterly or annually. Another policy for some firms is to do partial appraisal throughout the year and then a full appraisal at the end. These partial appraisals could be focused on a particular aspect of the job requirement. There are a number of strategies available to the firm to measure the performance of its employees. These include: Labour productivity This measures the ratio of output to input. Put another way, it measures the amount of a product or service that is produced by one hour of labour input. This measure indicates the efficiency with which labour is used in production. The formula for calculating labour productivity is: Total output Labour productivity = Per hour input of labour The concept of productivity is dealt with in more detail in Chapter 24. Feedback Labour turnover It is critical that feedback be provided to the employees once the appraisal is completed. If performance appraisal is to fulfil its role of developing the employees effectively then they must be informed of their performance measure. As said earlier, performance appraisal is an ongoing process and as such it requires ongoing feedback. Regular feedback ensures that the employees receive the guidance and encouragement that they desire. Management should be mindful that performance appraisal can only be successful when meaningful and timely feedback is given to the subordinates. Employees should be told what the findings were and be given guidelines on how to improve their performance. Therefore, the feedback given should not just be ‘You need to improve your performance’. Instead, the employee must be given suggestions and guidelines on how to improve any areas of concern. There is a common adage that says that ‘Delay is danger’. Delaying feedback can bring on feelings of anxiety and the employee may feel that the performance appraisal is a waste of time. Delaying feedback to an employee will simply mean that the employee will continue doing his/her job in the same way while not knowing whether things are being done properly. This measures the number of workers who leave an organisation in a given time period compared with the average number employed within that same time period. This is calculated as: Number of workers leaving × 100 Average number employed A firm may experience high labour turnover because of the following factors: Low salary package or fringe benefits Poor management style – for example, autocratic Poor working conditions Workers may be getting more attractive offers elsewhere. A firm having high labour turnover should be concerned with the impact this could possibly have on its operations. This might include: Production time loss during recruiting and shortage of workers High training costs, since this has to be done regularly High turnover rate could affect the morale of the workers who stayed and this could affect their performance It may be disruptive and unsettling, especially where people work in groups. The group would have to keep building synergy and camaraderie. Periodic Performance appraisal is sometimes seen as an isolated occurrence that should happen only once in a while. By CHAPTER 12 | HUMAN RESOURCE MANAGEMENT Absenteeism rate This is the amount of the total workforce that is absent from work during a given time period when they should have been there. Absenteeism rate is calculated as: Number of absent workers × 100 Total number of workers A firm that has a high absenteeism rate is more than likely to experience poor performance. Employees who are frequently absent will not contribute much to production or the service being offered. It is important to note that a high absenteeism rate is also a sign that something is wrong within the firm – for example, low morale or a poor management style. Labour–management relations Those students who keep abreast with what is happening in the business environment will have heard about some form of industrial action being taken by employees from time to time. Once employees have to resort to industrial action it is indicative of a breakdown in labour–management relations. In a number of these situations, industrial action is the end result of poor labour–management relations. The question then that we should ask is: what are some of the factors that can cause a breakdown in these relations? The truth is that there can be many factors, however, some of the common ones are: Unfair dismissal of a worker Poor working conditions Low remuneration Unfair practices Lack of job security. An important thing to note, though, is that it is in the best interest of both parties to attempt to resolve the dispute before it escalates. Below we will examine some of the ways in which employees and management can resolve their disputes and also the options that are available to employees if the dispute cannot be settled. CASE STUDY Getting a hold on performance Green Pot Ltd is a small privately owned company that specialises in the manufacturing of flower pots using both plastic and ceramics. The firm has been doing fairly well but not excellently and management believes that it could be doing better, especially in terms of production. Management is of the view that if production increases then it would be able to tap into other markets and be able to keep a constant supply – but for now that is not the case. With this view in mind, management has embarked on a thrust to improve performance. In order to carry out such a policy, management has implemented a performance management system whereby each employee will now be appraised bi-annually. This is a step up from the existing ‘once in a while’ performance appraisal. The fact is that much emphasis was never placed on performance appraisals and, when they were eventually done, employees would wait months before getting feedback and sometimes they got none at all. In fact, things were so bad that sometimes the appraisals would be done in the form of a peer review and then passed on to management. With this new thrust, management has pumped life into the Human Resource Department by employing a younger HR Manager, asking the previous one to take early retirement. This new manager has created an instrument that will be used to appraise the production staff. She is also thinking of implementing a training programme for the staff to ensure that they are acquainted with the new technology and methods of working. It has not yet been decided how this training will take place but it is high on the agenda. The company is hoping that things will start turning around by the middle of the upcoming financial year. Questions 1. Explain two (2) reasons why it is important that the firm has a very effective Human Resource Department. (4 marks) 2. Discuss two (2) ways in which the previous performance arrangement could have a negative impact on the firm. (6 marks) 3. Using the four principles of performance appraisal (fairness, participative, feedback and periodic), briefly discuss how the firm could improve its performance appraisals going forward. (12 marks) 4. Given the nature of the firm’s product and the current situation there, which of the two methods of training would you recommend that the HR Manager use in her upcoming training programme? Give at least three (3) reasons for your answer. (8 marks) Total 30 marks 131 132 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE Collective bargaining As the name suggests, collective bargaining is a situation where trade unions and employers meet to negotiate better terms and conditions of employment such as salary, wages and working conditions. The important factor in this process is that both parties get a chance to present their arguments and iron out differences in the hope that a mutual agreement will be reached. A trade union is an association of workers who have joined together to accomplish a common goal of improvement in the terms and conditions of employment. Since it is not always possible for the entire workforce to meet with management, they select representatives to speak on their behalf. In collective bargaining, the trade union representative will outline the grievances or positions of the employees and try to come to an amicable solution to the problem. It is usually the responsibility of the Human Resource Department to bargain on behalf of the firm. However, managers can also be involved in the bargaining process, especially in some firms that do not have a Human Resource Department. It must also be noted that any agreement reached in the bargaining process is binding on both parties. If this agreement is breached, the injured party may get redress from the Industrial Dispute Tribunal or the courts. There are a number of benefits to both employees and employer of being involved in collective bargaining: Benefits of collective bargaining for employees Workers have greater bargaining power than if the process is done individually Discourages management from making a unilateral decision that affects employees Trade union representatives are more knowledgeable of issues that are discussed with management and can explain any decision made to the employees in simple terms Can be flexible and provides a fair settlement for grievances While some people may not agree, collective bargaining provides all employees with the same benefits from any agreement that is reached, whether they are a part of the bargaining union or not. Benefits of collective bargaining for the employer It is easier and less time consuming for management to bargain with the union instead of each individual Collective bargaining can help to allay the possibility of industrial action Since the union will explain the agreement reached to its members, employers may not have to deal with misunderstanding of terms. Dispute settlements Sometimes both parties involved in collective bargaining encounter a problem and cannot reach an amicable solution. The employer may be holding out on a clause of the salary claim and the unions decide that their members should benefit from such clauses. This can result in lengthy delays and an unhealthy relationship between employer and employees. Whenever this occurs the parties can turn to the options available under what is termed a ‘grievance procedure’. A grievance procedure is a process through which a dispute can be settled. This can be a short or lengthy process, depending on how soon the dispute is ratified. There are three main stages of grievance procedure. These are: Conciliation Mediation and Arbitration. The idea is that if the first stage fails then the parties would move to the next stage and if no agreement is reached then the third stage will be used. Now let us look at each stage in detail. Conciliation At this stage a third party will be asked to sit in on the discussion between both parties. The conciliator will not offer a solution to the dispute but instead will encourage both parties to come to an agreement. In most Caribbean countries the conciliator could be a representative from the Labour Ministry. In Jamaica, the Ministry of Labour offers conciliation services to both employer and employees, with specific focus on: Negotiations between employer and employees or unions Settlement of dispute regarding perceived unfair dismissal Infringement of labour privileges or rights. As said previously, if the conciliator is not able to assist the parties in reaching an agreement, then the dispute would be referred to the next stage (mediation). Mediation At this stage a third party will be asked to sit in on the discussion but, unlike in conciliation, the mediator will give suggestions on how to resolve the dispute. The parties will then deliberate on the suggestions in an attempt to reach an agreement. CHAPTER 12 | HUMAN RESOURCE MANAGEMENT Arbitration ‘Go slow’ This is the final stage of the grievance procedure. It is where a third party, termed the arbitrator, is called in to come up with a solution to the dispute that has been going on. Unlike the previous two stages, the arbitrator will give a solution to both parties. This solution is legally binding on both parties. In some Caribbean countries, there are specified courts or judicial boards that will deal with these disputes. These are referred to as Industrial Dispute Courts or Labour Courts. They have been established to deal with issues relating to dismissal of staff, legality of strikes, wage disputes, retrenchment and other labour dispute matters. In Jamaica the organisation responsible for these issues is the Industrial Dispute Tribunal. In Trinidad and Tobago, the Industrial Court carries out these functions. Now, check in your country and find the organisation responsible for helping to settle industrial disputes. This is a deliberate effort by employees to slow down the pace at which they work. The aim of this form of industrial action is to frustrate management in an attempt to get a settlement of the dispute. Trends in industrial action Overtime ban There are times when the efforts of collective bargaining fail and workers become militant and resolute in seeking a settlement to their dispute with management. Whenever this is the case, the workers may take industrial action in the hope that management will change its stance and accept their offer. There are a number of industrial actions available to the worker. These include: For this form of industrial action, the workers would refuse to work overtime hours and instead just complete their regular hours of work. This may cause a slowdown of production, especially in peak seasons. The inconvenience caused by this action and/or the loss of revenue may force management to consider the concerns of the staff. Strikes While this practice may not be widespread, employers can also find redress in industrial actions of their own. The employer can stage a lock-out – that is, where employees are prevented from entering the property and hence receiving wages for that period of time. This is usually the last form of action to be taken. It is usually used when most, if not all, of the other methods have failed. In strike action, workers withdraw their services from work. Strikes may be classified as: Official strike – this is called for by the union representing the workers. It is usually called when the union has explored all other avenues and legal requirements Unofficial strike – this takes place without the backing of the union. These strikes are usually done on a local basis and for a specific reason. Work to rule In this form of industrial action, employees work rigidly to every rule in the organisation. Stringently working to every rule can slow down the work process considerably. With a work to rule, employees do not perform any role that is outside of the stipulated job description. For example, if teachers should take this industrial action, it may mean that no extracurricular activities will be supervised or field trips that are not a part of the course may not be attended. ‘Sit in’ This is a popular form of action to take when the firm is threatening employees with a close-down of operations. It is where employees attend work but refuse to leave the work site when work is done. Picketing This is used in conjunction with a strike. It is where workers use placards to show signs that they are disgruntled with management and to win over the support and sympathy of passing members of the public. Lock-out The need for reconciliation Having ‘bad blood’ in an organisation can be detrimental. Unfortunately, some labour–management disputes have been so fierce that, even after the dispute is settled, relationship problems still exist. With this in mind, it is very important that both employers and employees work assiduously to repair the relationships they once shared. A workforce which is continually in disagreement with management will not be able to achieve much, if anything at all. Rebuilding good labour–management relations will take time and effort on the part of management. It is advisable that both parties do not create any long-term hurt in the period of the dispute. It must be pointed out that communication is also going to be an integral part of moving forward. Management and staff can pursue a number of options in trying to rebuild labour–management relations. In doing so, 133 134 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE management could implement an ‘open door’ policy where subordinates could speak with them freely at any time. Management could also have staff functions where both parties can socialise in an attempt to bring back the synergy that once existed. Laws affecting health and safety in the workplace The issue of health and safety in the workplace came to prominence in the mid- to latter part of the 20th century. As leadership styles and management practice changed, more firms have put in place policies and regulations to promote health and safety in the workplace. The central governments of some countries have also moved to enact laws to promote it. To this end, in 1974 the United Kingdom passed the Health and Safety at Work Act. The issue of health and safety has been given even more attention internationally due to the fact that the International Labour Organisation (ILO), an arm of the United Nations, has started celebrating April 28 as World Day of Safety and Health at Work. Since 2003, the ILO has influenced health and safety in the workplace. Suffice it to say that countries such as Trinidad and Tobago, Guyana and the Bahamas have based their health and safety laws on the CARICOM Model Law on Occupational Safety and Health and the Working Environment. In 2008 the Ministry of Labour in Jamaica also communicated its intention to introduce an Occupational Safety and Health Act. Any health and safety policy will seek to promote safety for both the employer and the worker. Below are some of the general responsibilities and rules that would be covered under a Health and Safety Act for the workplace: The use of dangerous machinery Wearing of protective clothing Protection against dust and dangerous fumes Having functional fire and emergency exits, along with conducting emergency drills Cleanliness and sanitary conveniences Proper disposal of waste Minimising noise and vibration Proper ventilation. Find a copy of the Health and Safety Act for your country and discuss with your teacher the provisions that are contained in it to protect employers and employees. In this section, we will examine three main aspects of health and safety in the workplace: Education of employees on safety regulations Having a health and safety policy is not enough unless it is communicated to the staff. The health and safety policy of the firm should be placed where it is evident to everyone. Communicating its contents is especially important in the manufacturing industry, where a mistake could easily cost a life. Training employees on health and safety issues will improve their knowledge, understanding and compliance. One of the requirements of the 1974 Act in the UK was that employees were to be trained on health and safety. Employees must be trained about the dynamics of health and safety and what to do when different situations arise. The HR Manager should organise such training for existing and new employees. All safety requirements should be communicated. Employees and employers must also be trained about what to do when there is an emergency or a natural disaster. A trend in many organisations today is that a safety monitor will be appointed in each group. This person is responsible for training the other people in the department and reacting accordingly when there is a health or safety issue. An organisation where an effective training programme is in place, regular updates are given and regular emergency drills are done is more likely to respond favourably when there is a safety or health problem. Importance of the provision of safety facilities If you look at the possible impact that not having health and safety facilities may have on the firm, then you will be aware of the importance of the provision of safety facilities. However, the following points will give you an idea of the importance of providing safety facilities: The firm can mitigate the possibility of lawsuits and additional costs incurred from accidents Protection of workers and employers from bodily harm or illness Minimises the possibility of high turnover rate since the working environment would be a safe one Good working environment can improve productivity and, by extension, production It is a requirement of law that firms implement a health and safety policy. The above list is not exhaustive but acts as a base on which you can build in your class discussions. Procedures for dealing with safety complaints In addition to a health and safety policy, firms should have a clearly outlined procedure to deal with safety complaints. Without such a procedure in place, breaches of the health CHAPTER 12 | HUMAN RESOURCE MANAGEMENT and safety policy may go unattended and lead to greater problems in the future. For example, if a worker reports an exposed electrical wire and nobody does anything about it, a fire or electrocution of a worker may occur in the future. While this may be different for some organisations, a typical procedure to deal with safety complaints should, however, include: The appointment of a safety monitor or committee that will spearhead the health and safety policy on the ground Any safety complaints would first be lodged with the safety monitor or committee Upon receipt of the complaint, the necessary checks should be done to substantiate the complaint. This may be done by the committee itself or by a trained professional from outside the firm The next step would be to address the complaint in the shortest possible time and take corrective measures to ensure that there is no recurrence. CHAPTER SUMMARY As the working environment changes with time, human resource management is becoming more and more important Workforce planning is the process whereby a firm forecasts its future demand for labour and develops a plan to meet such demand The recruitment process is very important, as recruiting the wrong people for the job can lead to low labour productivity and loss of revenue for the firm The firm should draft a recruitment plan that should include job analysis, job evaluation, job description, person specification and job advertisement The selection process usually incorporates three steps: short listing, interview and employment The compensation package may be influenced by the complexity of the job, working conditions, educational requirements, years of experience and the level of responsibility involved Firms usually explore two methods of training: on-the-job training and off-the-job training Where collective bargaining fails, the firm and employees can go through the grievance procedure, including conciliation, mediation and arbitration Industrial action includes strikes, work to rule, ‘go slow’ and ‘sit in’ The CARICOM Model Law on Occupational Safety and Health and the Working Environment has been developed to be used as a guide for the Caribbean countries. Collective bargaining gives both parties a chance to present their arguments and iron out differences in the hope that a mutual agreement will be reached MULTIPLE CHOICE QUESTIONS 1. The growth of human resource management may be affected by ALL of the following EXCEPT which one? a. Lack of knowledgeable managers c. Marketing d. Selection 3. Which of the following would be included in a typical recruitment plan? b. Increased representation of staff by trade unions a. Job rotation c. The passing and implementation of government legislation b. Job analysis d. Increased business competition for both goods and staff c. Job enlargement 2. Which of the following is NOT a main function of the Human Resource Department? d. Compensation 4. a. Workforce planning ALL of the following are factors influencing whether to recruit internally or externally, EXCEPT which one? b. Recruitment a. The amount of time that is available to fill the post 135 136 MODULE 2 | UNIT 1 | THE MANAGEMENT OF PEOPLE b. The type and nature of the job c. The composition of the external labour market Extended Essay Questions d. The biases of management Question one Total 25 marks c. Lectures Human resource management is a very important function of any business. There are a number of functions that the Human Resource Department has to perform, including: a. Workforce planning b. Recruitment c. Selection d. Compensation e. Training and development f. Performance management Discuss any five (5) of the functions outlined above that the Human Resource Department must perform. (25 marks) d. Audio-visual Question two 5. A disadvantage of recruiting internally is: a. Improves employees’ morale b. May be cheaper c. Absence of new ideas d. Less time consuming 6. An example of on-the-job-training would be: a. Job rotation b. Simulation 7. Which of the following is LEAST LIKELY to cause labour management problems? a. Poor working conditions b. Issuing non-financial rewards c. Unfair dismissal d. Lack of job security 8. The process whereby a third party is called in to give a solution that is binding on both parties to quell a dispute BEST defines: a. Arbitration b. Collective bargaining c. Conciliation d. Mediation 9. Which form of industrial action is usually used as a ‘last resort’ in labour–management relations? a. Work to rule b. ‘Sit in’ c. Overtime ban d. Strike 10. Which of the following would NOT be a good health and safety practice? a. Using liquid near the computer b. Removing cords from across the walkway c. Having proper ventilation d. Proper disposal of waste Total 25 marks Training and development is an integral part of the organisation. Training may be conducted internally or externally. a. Explain the difference between on-the-job and off-the-job training. (4 marks) b. Briefly explain two (2) types of on-the-job techniques and two (2) types of off-the-job techniques. (8 marks) c. Dealing carefully with labour–management issues is vital to the success of any business. i. Define the term ‘grievance procedure’. (2 marks) ii. Explain the three (3) main stages of the grievance procedure. (9 marks) iii. Explain the concept of collective bargaining. (2 marks) 137 13 Module 3 Business, Finance and Accounting The Need for Capital and Sources of Finance LEARNING OBJECTIVES: At the end of this chapter students should be able to: State the main needs for funds Explain how businesses can meet those needs Discuss the main sources of finance available to businesses Explain the difference between equity and debt capital Identify internal and external sources of finance Outline the criteria used by businesses when seeking finance Discuss the roles and functions of regional and international money and capital markets A ll businesses, whether large or small, need funds. Sourcing finance can be a tedious process, especially when there are limited options available to the particular business. Some firms have limited options because of a lack of collateral or finding a financial institution that is willing to take the risk of lending them money. However, there are a number of sources from which capital can be sought. These will be discussed later in this chapter. The need for capital Capital is very important in the establishment and operation of a business. It is defined as the money invested in a business venture which is used to purchase assets to facilitate trade. It also refers to goods (plant, equipment and machinery) that are used in the production of other goods and services. For example, a gardener needs to purchase a weed whacker or lawnmower, among other tools, in order to carry out his work effectively. He will also need additional funds to take care of other day-to-day expenses such as gasoline and lubricating oil. Likewise, a manufacturing company needs to source funds to purchase large machinery and equipment. It also needs fund for its day-to-day expenses such as electricity bills. The need for capital can be classified into three categories: Start-up capital and venture capital Working capital Investment capital. Start-up capital and venture capital Start-up capital is the capital that is needed to establish a business. The amount of funds needed may vary depending on the size, nature or type of business being pursued. A street vendor will need considerably less capital than a wholesaler. Similarly, a capital-intensive business (for example, an aluminium plant) may need more start-up capital than a labour-intensive one (for example, a sugar plantation). A number of prospective businesses have not passed the stage of being an idea because entrepreneurs encounter problems in sourcing the funds for start-up. Starting a business is a high-risk venture and not many banks and other financial institutions will finance such a venture unless it can be proven that the business is feasible and sustainable. Thus, entrepreneurs may have to depend on their personal savings and assets for start-up capital. As a result, if the business fails they may lose their houses, cars or land, among other valuables. In order to minimise the risk of losing everything, entrepreneurs may choose to use venture capital for funding their business. Venture capital refers to funds invested, or that are made available for investment, in a business which offers favourable returns. Using venture capital may provide businesses with more funds for start-up, as wealthy individuals (venture capitalists) normally pool funds which they use for investment in business ventures. Working capital The need for funds does not end with start-up. Money is also needed to finance the day-to-day operations and expenses of the business, including bills and creditors. This is known as working capital. It is calculated as: Current Assets – Current Liabilities Current assets include inventory, accounts receivable, bank and cash, while current liabilities include accounts payable, bank overdraft and short-term loans. A business’s working capital can be either positive or negative. If its current assets exceed its current liabilities then its working capital will be positive, indicating that the business can pay 138 MODULE 3 | UNIT 1 | BUSINESS FINANCE AND ACCOUNTING for its current liabilities or it is fairly liquid. Since working capital deals with the day-to-day expenses and its depletion can lead to liquidity problems, businesses must have a proper system in place to manage working capital. How can businesses manage working capital? The above section outlined the components of working capital. Managing these components will help businesses to manage their working capital. Inventory (stock) A number of businesses have liquidity problems because too many resources (funds) are tied up in stock. While the business will want to meet its demand at all times, knowing how much inventory to keep is also vital. The firm should devise a strategy that will enable it to purchase the optimum level of stock. This means that it has to determine the costeffective level of stock that it should keep. To this end, the firm should ensure that its inventory level is neither too high nor too low. It is also important that the firm minimises the time between when resources are purchased and when income is generated from those resources. This will ensure that the firm’s cash is not tied up in inventory that cannot be sold quickly enough to recover it. Accounts receivable (debtors) Lack of payment by debtors or extended credit periods will decrease the amount of liquid funds available to the business. Firms must find creative ways of monitoring and managing their debtors in order to managed working capital. This can be done by: Offering cash discounts which encourage debtors to pay on time. Cash discount is a reduction in the total amount owed by the buyer for credit purchases if payment is made promptly or within a stipulated time Reducing the credit period – that is, the length of time that debtors have before payment is required Reducing the credit limit. If a business continues to give credit to a debtor who is not able to pay or who has outstanding balances, it might be setting itself up for bad debt. As a result, there has to be a limit on the amount of credit any one debtor will receive from the business. spread in terms of repayment. Having too many short-term loans will drain the coffers of the business when these loans mature. Before borrowing, the ability to repay and the time frame in which money has to be repaid must be taken into consideration. The business must consider whether it will generate enough returns or revenue from this venture to cover the money that was borrowed in the stipulated time. Borrowing on a long-term basis to finance short-term projects or purchases may not be a good idea for businesses. The reason for this is that the purpose for which the money was borrowed would have passed, however, the firm would still be repaying the loan. Cash management This relates to the monitoring of the flows of cash into and out of the business. Cash management should be of importance to every business as it is more susceptible to theft and misplacement. Having a proper and efficient system of cash management can help to prevent the firm from having liquidity problems – that is, not having enough cash to deal with daily expenses. The firm can manage its cash by: Doing cash flow statements. This topic is dealt with further in Chapter 14 Drafting cash budgets which give a breakdown of how it expects or plans to spend and earn its cash Making the best use of its excess cash. This could be done by investing it. Increasing working capital A firm that has liquidity problems has a number of options that can be used to increase working capital. However, each must be carefully analysed before the decision is made. Some of the options are outlined below: Additional funds from owner(s) Businesses that have a cash flow problem can increase their cash base from additional funds being ploughed into the business by the owner. This money can represent either additional capital from the owner or a loan to the business. In the case of a sole trader, funds may be taken from personal savings, relatives or friends. In the case of a company, additional shares may be sold to families and friends or on the stock exchange in the case of a public company. Bank The firm may source financing from a bank in terms of loans or overdrafts. However, being heavily indebted is never a positive sign for a business. While funds may be sourced externally, businesses should ensure that proper debt management strategies are in place. In managing working capital, firms may want to ensure that loans are Dispose of non-productive assets Some businesses are ‘rich on their books but poor in their till’. The reason for this is that there are non-productive fixed assets on their balance sheets that could be disposed of to solve liquidity problems. Fixed assets which are not being used, but still saleable, should be disposed of to increase the CHAPTER 13 | THE NEED FOR CAPITAL AND SOURCES OF FINANCE amount of cash available to the business and thus increase working capital. For example, a business that carries out delivery may have a number of defective vehicles in its parking lot that could be scrapped and sold. loans which are putting pressure on its working capital. While this seems like a ‘Band-Aid’ approach, it can provide extra cash for businesses in the short to medium term. Factoring Increase net profit By increasing its net profit, a business can also increase its working capital. Increasing profit will result in an increase in the current asset cash or bank. This can be accomplished by either reducing the firm’s expenses or increasing the revenue gained from the sale of its products, providing that its gross profit is high enough. This is to say that, even if the firm sells a lot of products but its production and trading costs are high, its gross profit may not be significant. Another option for the firm would be to assess its operations in order to identify areas where resources are being wasted and to tighten these areas. Cutting waste of resources helps the firm to save money that would otherwise be lost. Debt switching Firms may want to explore the option of switching debts from short term to long term. This can be accomplished through debt switching or refinancing. This is the process of raising a new loan to pay off existing loans. The business may want to acquire long-term financing to retire (repay) short-term Factoring is an agreement, between a specialist finance company and a business that is in need of ready cash, to purchase the amount owed by debtors. In essence, the factoring company will wait for the payments from the debtors while the firm will get the cash needed. The amount paid by the factoring company to the firm will usually be less than the amount owed to the firm by the debtors. The disparity between the two figures will provide the factoring company with a profit. This is because the factoring company makes money by paying out to the firm less than what is owed by the debtors. This could be seen as the payment or incentive given to the factoring company for taking on the firm’s debt. Although the firm may be giving up some of the money that is owed to it by its debtors, the arrangement will provide ready cash which will increase its working capital. Increasing stock turnover The amount of times that stock turns over is also of interest to the organisation. A high rate of turnover will provide the business with more cash in hand to cover its day-to-day CASE STUDY Cash strapped Windows & More Ltd has not been riding the turbulent economic waves well. In fact, management is faced with a mammoth task in surviving on a day-to-day basis. The options for the firm are running out, as it has almost frustrated its creditors by asking for extension on credit terms and has defaulted on a couple of payments in the last month. To make matters worse, some of its debtors are also going through financial problems and have been late with payments themselves. The firm is now facing possible closure. The situation the firm finds itself in is an interesting one, as the problem is not a lack of assets. As a matter of fact, the firm has assets that are valuable but the bulk of its cash is tied up in the numerous windows that are in its warehouse. Things were going fine until the construction industry started shrinking and demand became anaemic. Even though there was evidence of falling demand, the company continued to make windows and doors since it had enough raw materials to do so. In recent times the company has halted production and now is waiting for a miracle to happen. Management now has to devise strategies to improve the liquidity position of the firm. Questions 1. What is meant by ‘working capital’ and how is it calculated? 2. List three (3) day-to-day expenses that the firm may incur. 3. Discuss two (2) ways in which firm could have managed its working capital better. 4. Bearing the present situation in mind, discuss three (3) strategies that the firm can use to increase its working capital. (4 marks) (3 marks) (6 marks) (12 marks) Total 25 marks 139 140 MODULE 3 | UNIT 1 | BUSINESS FINANCE AND ACCOUNTING expenses and bills. If the need arises, the business may have to sell some of this stock at below list price to generate additional income. Investment capital As businesses become more and more established, the need for more capital will arise. This money may be used to purchase new and improved equipment and machinery, for expansion of the plant or to take on a new project. Competition may also prompt existing companies to expand their product line, creating the need for additional capital. Increased demand puts pressure on the firm’s production capacity, thus capital may be needed for expansion. Sources of finance In sourcing finance, businesses need to assess the following options before making a final decision: Equity capital versus debt capital Internal versus external. The choice that is made will have different benefits or costs to the business. Let us examine each option until it is repaid. The major sources of debt capital include commercial banks, building societies, trade credit, credit unions, bonds and other financial institutions. Table 13.1 (p 141) shows the advantages and disadvantages of each of the sources of capital we have just discussed. Internal sources of finance Sale of fixed assets – a business has the option of disposing of non-productive assets to generate muchneeded funds. Excess or obsolete assets represent financial resources that could be used otherwise. The cash received from the disposal of these assets can be used to fulfil the business’s demand for funds Retained profit (earnings) – this represents a business’s after-tax profit that is ploughed back into the business. Such profit will not be issued to owners in the form of dividends but is used to purchase fixed or current assets Working capital – the management of working capital was discussed earlier in the chapter. This also serves as a source of funds for the business which can reduce its stock balance by selling more, collecting outstanding funds from debtors or increasing its creditors. Equity capital External sources of finance Equity capital is money or funding that is raised from the issuing of shares. It is also seen as a personal investment in a business by its owner(s). The major risk associated with equity capital is that the owner(s) stand(s) to lose all the money that was invested in the business should it fail. A business wishing to access equity capital must be willing to surrender some of its ownership, as a share represents ownership in the issuing company. However, businesses using equity capital do not have to worry about repayment since it is not a loan but an investment on the part of each shareholder. The company will only pay dividend when it has made profit and it is feasible to do so. The major sources of equity capital include sale on the stock exchange, personal savings, partners, venture capitalist companies and friends and families (that is, where the funds are not in the form of a loan). Some of the major external sources of finance include: Issue of shares Bank loans and overdrafts Debentures Venture capital Government assistance. Debt capital Debt capital represents any money that is borrowed by the business which must be repaid with interest. One of the main advantages of using debt capital is that businesses do not have to surrender any of their ownership in order to source capital. It is important to note, though, that, with debt capital, the funds must be repaid along with interest, whether or not the company is profitable. This loan will have to be carried on the business’s balance sheet as a liability Criteria for seeking finance Short-term financing ‘Short-term’ usually refers to a period of time of one year or less. Funding that is sourced on a short-term basis is not normally used for long-term financing in the organisation. It may be used for financing day-to-day activities. These funds might come from one of three major sources: trade credit, bank overdraft and factoring of debt. Trade credit Trade credit is the deferment of payment for goods or services supplied to the business. The supplier delivers the product but an arrangement is made to collect the payment due at a later agreed date. The amount of time given will depend on the relationship between supplier and business or the credit policy of the supplier. The longer the credit period, the more money the business will have in the short CHAPTER 13 | THE NEED FOR CAPITAL AND SOURCES OF FINANCE Sources of capital Advantages Disadvantages Equity capital There is no need for collateral The firm does not have to pay monthly amounts for principal and interest Since the shareholders are part owners of the company, they do not have to be repaid if the company fails The company has to surrender some of its ownership to shareholders The public limited company has to publish its accounts Debt capital The lender has no equity in the firm and so the owners do not lose any control The lender will only be paid the agreed principal plus interest and so there is no interest in or claim on the profits of the firm The amounts for principal and interest are usually known expenses. This means that they can be planned for The company is not required to publish its accounts on an annual basis for shareholders to see Since this is money borrowed by the firm, it must be repaid The lender often requires the firm to submit its cash flow statements and balance sheet The company’s assets may have to be used as collateral for the loans received The loan has to be repaid regardless of the level of profit or loss Table 13.1: Advantages and disadvantages of sources of capital run. The business will now have the opportunity of making revenues from the sale of these products before payment becomes due. Bank overdrafts Medium-term financing The medium term refers to a period of between one year and five years. Finances that can be sourced in the medium term include loan, hire purchase and leasing. It may be argued that it is not good to spend more money than you have but in the world of business this can provide firms with much-needed funds in the short run. However, running a bank overdraft on an account must be done as a result of an agreement between the bank and the business. The agreement would be one where the business is allowed to draw cheques in excess of its account balance at the bank. The limit of the overdraft would be specified in the agreement. This option provides the business with shortterm funds. It is now able to settle debts (pay suppliers and bills) in the short term, knowing that these cheques will still be honoured by the bank. Loans Factoring of debt Hire purchase As discussed earlier, this can provide businesses with extra funds given by a ‘factor’ company in exchange for a business’s debtor balances. This can be classified as short or medium term, depending on the time frame given by the factoring company. We are now living in a competitive environment and banks are offering more options to business to solve their cash woes, at least in the short term. One such way, which was not mentioned in the three major categories above, is the issuing of credit cards to businesses. Firms can now buy their supplies or pay their debts by simply ‘swiping’, while making payments to the bank at a later date. These cards are issued by some of our major banks, including National Commercial Bank (NCB) and Bank of Nova Scotia (BNS). This means of financing is usually given to customers of most furniture and appliance stores in Jamaica. The hire purchase agreement (contract) is made between the buyer and seller or a provider of credit facility. Under such agreement, an initial amount is paid as a down payment and the balance is paid over time in fixed instalments along with any interest accrued for the period. Businesses wanting to purchase assets can utilise this facility while using those same assets to generate revenue to pay the monthly instalments. For example, an entrepreneur setting up a laundrette may purchase commercial washing machines on hire purchase from a reputable appliance store such as Courts Plc for a five-year period. The income generated on a monthly basis will then be used to cover the monthly instalment, including interest. These are set sums of money that are borrowed by the business from either a bank or other financial institutions such as credit unions. The time for repayment and the interest to be charged are specified upon the agreement of the loan. In addition to the payment of interest, most banks or financial institutions may require security or collateral upon the issuing of the loan. This poses a problem for some firms which may not be able to provide meaningful and substantial collateral to secure such loans. Institutions lending for start-up purposes may also require a welldefined business plan before agreeing to lend. 141 142 MODULE 3 | UNIT 1 | BUSINESS FINANCE AND ACCOUNTING Leasing Firms that do not have sufficient funds, especially for startup, can lease assets rather than buy them. Leasing will help to minimise the finance that is needed to purchase capital equipment. Tom the farmer could therefore lease land and a tractor as opposed to finding millions of dollars to purchase both. Under a lease agreement, the asset will remain the property of the lessor, who grants the lessee the right to use the asset for a specified period of time in return for a specified payment. This can be beneficial for the business since a large amount of capital (funds) is not tied up for a prolonged period. Long-term financing The long term is a period of time over five years. Long-term financing is usually used for capital projects or to purchase fixed assets such as land and buildings. The business can choose from various sources of long-term financing. These include: Sale of shares Venture capital Debentures Mortgage and Assistance from government. The sale of shares The sale of shares is the major source of capital for limited companies. A share can be defined simply as a unit of ownership in a company. Holders of shares are seen as part owners and have the right to participate in the decisionmaking process. The company will issue shares in exchange for money. The shares issued can be categorised as either ordinary or preference shares. Ordinary shares The owners of ordinary shares have greater risk than preference shareholders as they will be the last to receive repayment if the company fails. The ordinary shareholders have the following rights in the company: To vote at meetings – for example, Annual General Meetings (AGMs) To receive dividends when declared To claim undivided assets if the company goes into liquidation To subscribe for additional shares before they are offered to the public. Preference shares Holders of these shares have a lower risk than ordinary shareholders. Preference shares carry a fixed rate of dividend and payment will be made before ordinary shareholders receive their dividend. Preference shareholders also have certain rights in the company: To receive dividend at the specified rate before ordinary shareholders To receive a share of the company’s assets before ordinary shareholders in the case of liquidation. Venture capital This was discussed earlier in this chapter. The period of time for payment would be used to categorise it as long term or medium term. However, such financing is usually seen as being long term. Debentures (loan stock) Debentures are fixed-interest loans that are issued to companies and are secured against its assets. The lender of the funds is issued with a debenture certificate which will specify the rate of interest to be paid by the company. The company must honour such interest payments whether it makes a profit or loss. Debentures are either redeemable or irredeemable. Redeemable debentures will be repaid by the company at or by the date specified on the certificate. This can go up to ten or more years. Conversely, irredeemable debentures are only repaid when the company is being wound up or liquidated. Bonds Bonds are often called ‘fixed income securities’. A bond is a loan from individuals or firms at a fixed income rate and for a defined period of time. Bonds are usually divided into government or corporate bonds. The entity that is indebted issues the bond and the person or entity lending the money takes it up. Put another way, the issuer of the bond owes the holder of the bond until it matures. The indebted firm is usually the one to state the interest rate that will be paid and when the bond will be repaid. The amount of money lent is known as the ‘bond principal’, the interest paid as the ‘coupon’ and the date of repayment is known as the ‘maturity date’. The period of time that a bond takes to mature may vary but could run from 90 days to even 30 years. Mortgage This is a loan that is given to a person or a business and is secured over or guaranteed by the mortgagor’s property. The rate of interest charged can be either fixed or variable. The interest, along with a portion of the principal, is paid in instalments over the life of the mortgage. CHAPTER 13 | THE NEED FOR CAPITAL AND SOURCES OF FINANCE Assistance from government While this is not prevalent in the private sector, some businesses have benefited from government assistance. This can be in the form of grants, subsidies or loan guarantees. This type of assistance is usually given to sectors that are critical within the country but are undergoing financial difficulties. In Jamaica, for example, fertiliser manufacturer Newport Fersan benefited from a subsidy of J$70m at a time when fertiliser prices were sky rocketing as a result of the import of raw materials. Farmers were faced with this high cost and many could not afford to purchase this important resource in the agricultural sector. The government may also stand as guarantor for loans that are given to certain industries. If the firm is unable to pay back the loan, then the government will have to stand the cost. How to choose from these sources of funds? In choosing among the sources of finance, a business needs to consider the following factors. Careful consideration of each factor will assist the business in making a decision: Cost to the firm The costs incurred by a firm sourcing finance will include administrative costs and interest payments on loans and bank overdrafts. The business may want to use sources of finance that charge lower fees and interest. For example, a firm may choose to issue shares rather than undertake debentures. The use of the funds As mentioned earlier, it is not a wise decision to use shortterm funding for long-term projects. Long-term funding is usually more suited to projects that will take large amounts of capital outlay or expenditure. For example, a cash register would be purchased on hire purchase rather than by taking out a mortgage. Size of the firm A larger firm is more likely to secure certain sources of finance than a smaller firm. A number of financial institutions would rather give a loan to a company than to a sole trader. On the other hand, larger firms are more likely to secure collateral for loans than smaller firms. Financial stability Banks and other financial institutions normally ascertain the financial viability of the business and the project being undertaken before they will lend funds. A firm that is financially unstable is less likely to secure certain financing and even if the loan is given the rate of interest may be very high. Gearing of the firm A company’s gearing refers to the relationship of its equity capital (ordinary shares) to loan capital (long-term loans and preference shares). A company is said to be highly geared if its loan capital is significantly higher than its share capital. It is low geared if its loan capital is smaller than its share capital. The gearing ratio will also be used to determine the source of financing undertaken by the company. A highly geared company may refuse to sink itself further into debt by borrowing, therefore it may seek other sources of finance such as issuing additional shares. Money and capital markets and international financial institutions While potential entrepreneurs and businesses can raise their own finance, there are a number of agencies and institutions throughout the Caribbean that can provide meaningful information about business operations. These institutions provide a myriad of services, including technical support, managerial advice, conducting feasibility studies, doing economic appraisals of countries and providing financing in some cases. This section identifies some of these institutions and gives a synopsis of their roles and functions. Caribbean Development Bank (CDB) The CDB was established in 1969, with its main purpose being ‘to contribute to the harmonious economic growth and development of member states and to promote economic cooperation and integration’. As a regional body, members would be exposed to a number of benefits that may have been problematic in sourcing from international bodies. The CDB has the following functions: To assist the borrowing member countries in optimising the use of their resources, developing their economies and expanding production and trade To promote private and public investment, encourage the development of the financial upturn in the region and facilitate business activity and expansion To mobilise financial resources from both within and outside the region for development To provide technical assistance to its regional borrowing members To support regional and local financial institutions and a regional market for credit and savings 143 144 MODULE 3 | UNIT 1 | BUSINESS FINANCE AND ACCOUNTING CASE STUDY A capital dilemma Raspberry Juice Ltd is a small private limited company in Fruitland which specialises in making raspberry juice and wine. The company has been doing fairly well over the years and is now thinking of expansion. Due to an influx of fruits in Fruitland, the company has decided to change its product line to include other juices and wines apart from raspberry. However, this will require heavy investment in new equipment and machinery. The challenge is that while the idea sounds feasible and would encourage the desired success, the firm does not currently have the kind of money required to carry this out. If it should continue with this plan it could very well lead to a capital dilemma. In a meeting with the directors of the company, Mr Trendsetter, the Managing Director, stated that the Finance Department is exploring two broad options of debt versus equity capital. However, checks are still being done to find the best option. One of the directors suggested that they should explore the option of internal or external sources. The firm is anticipating that the expansion will result in the following initial costs: Machinery and equipment Supply of fruits An addition to the building. Questions 1. Distinguish between debt and equity capital. (4 marks) 2. Discuss two (2) benefits and two (2) costs of using debt capital over equity capital to fund the expansion plans of Raspberry Juice Ltd. (12 marks) 3. Outline the best source of finance that Raspberry Juice Ltd should use for each of the initial costs listed in the case. Give reasons for your answer. (9 marks) Total 25 marks To support and stimulate the development of capital markets in the region. Since its establishment the bank has contributed financing to projects in agriculture, livestock, fisheries, forestry, tourism, export services and education, among others. Inter-American Development Bank (IDB) The IDB was established in 1959, with a mission ‘to contribute to the acceleration of the process of individual and collective social and economic development of member countries’. In carrying out its mandate the IDB provides financial and technical support for its Caribbean members. This assistance can be further highlighted as follows: It provides loans, grants and guarantees to assist countries in the areas of education, health and environmental preservation It fosters social equity and policies that are geared towards poverty alleviation It lends support to regional integration and the enhancement of free trade in the region Technical assistance is given in the planning and implementing of development projects and reform policies. In January 2009, the Prime Minister of Jamaica signed an agreement with the IDB for a loan of US$329m to assist with the country’s Competitiveness Enhancement Programme and Reform of Public Sector Management Programme. The Trinidad and Tobago Government also signed an agreement in May 2009 with the IDB for a loan of US$48.75m to support an education programme to improve early childhood care and education centres. World Bank The World Bank was established in 1944 and since then has provided financial and technical assistance to a number of developing countries around the world, including those in the Caribbean. The bank is made up of two major institutions which, though they are different, work in collaboration in carrying out its mission. These institutions are: The International Bank for Reconstruction and Development (IBRD), which focuses on middle-income and creditworthy poor countries The International Development Association (IDA), which focuses on the poorest countries in the world. Both institutions work toward the achievement of the following functions of the bank: It facilitates capital investment for the restoration of economies affected by war and the development of CHAPTER 13 | THE NEED FOR CAPITAL AND SOURCES OF FINANCE productive facilities and resources in less developed countries It provides loans for developing countries to be used in the areas of health, education and water supply To promote international trade and equilibrium in countries’ balance of payments. International Monetary Fund (IMF) The International Monetary Fund was established in 1944, with the main purpose of establishing a framework to prevent a recurrence of the economic policies that led to the Great Depression in the 1930s. This framework would guide the IMF to achieve its purposes of: Promoting international monetary cooperation Facilitating steady growth of international trade Offering its resources to correct balance of payments disequilibrium Promoting stability in the exchange rates of member states. The work of the IMF can be categorised in three main areas: Surveillance – in this area, the IMF monitors economic and financial developments and provides policy advice in an effort to prevent economic and financial crisis Lending – funding is made available to countries that are experiencing balance of payments disequilibrium. Loans are also given to low-income countries in order to reduce poverty Technical assistance – technical advice is given to its members on how to manage their economic policy issues and financial affairs. The money and capital markets The money market This is a market where financial institutions such as banks lend and borrow money from each other on a short-term basis. It is a source of funds for government and institutions that have short-term cash problems. Institutions in the money market will lend money by using a variety of different securities including Treasury bills and certificates of deposit. These securities are very liquid and mature in the short term. While larger money markets are found in places such as London and some states in the USA, financial institutions in the Caribbean have given investors access to such markets. One such institution in the region is the Jamaica Money Market Brokers (JMMB). In 1999, the JMMB entered a joint venture to establish the Caribbean Money Market Brokers (CMMB) in Trinidad and Barbados. The capital market or stock market This market involves the buying and selling of company stocks and shares and government bonds. The stock market provides the link between companies that are in need of financing and people who have money to invest. The stock market is divided into a primary market, where capital is raised through the issue of new securities (stocks, shares and bonds), and the secondary market, where existing securities are traded. The trading in the stock market is done through a marketplace known as the stock exchange. The stock exchange has the following basic functions: To provide a channel through which people can save and invest To foster the expansion and growth of the financial service sector To offer some level of protection to its savers from inflation To help to minimise borrowing by providing companies with equity financing. Now we will look briefly at the existing stock markets in the region: Jamaica Stock Exchange (JSE) The Jamaica Stock Exchange was incorporated in 1968 and started trading in 1969, with its main role of ‘promoting the development of a vibrant capital market and ensuring orderly trading in listed securities’. JSE is regulated by a council which monitors its activities by setting guidelines, rules and standards for its operation. The council also reserves the right to suspend from trading any companies who violate the rules. Shares are traded through agents called stockbrokers. A sale is made when the broker of the buyer and the broker of the seller agree on a price for the share. The price of a share is determined by its demand and supply and the level of confidence that investors have in its value. If more people are offering to buy than sell a share, its value will increase; the opposite is also true. Confidence in a company’s shares may be influenced by the company’s growth prospects and capabilities. It is important to note that government bonds are not traded through the JSE but are sold by the Bank of Jamaica. The Trinidad and Tobago Stock Exchange (TTSE) This was the second stock exchange to be established in the Caribbean. It was formally established in 1981, with 37 listed securities. The TTSE has been opening windows of opportunities for investors and companies as well the benefits that are transcended to the economy. Investors have benefited from the dividends they received from companies. 145 146 MODULE 3 | UNIT 1 | BUSINESS FINANCE AND ACCOUNTING It fosters entrepreneurial activities which can lead to further growth in the economy. The Barbados Stock Exchange (BSE) This was first established in 1987 but was re-incorporated in 2001 in conjunction with the enactment of the Securities Act of Barbados in 2001. Like the other two abovementioned stock exchanges, BSE has been offering a number of benefits to investors and the Barbados economy. Its listed companies cover the areas of manufacturing, distribution, utility and service. After much deliberation and with the desire to unite the Caribbean, in 1989 leaders in CARICOM proposed to have a Regional Stock Exchange which would bring together the three stock exchanges of Jamaica; Trinidad and Tobago; and Barbados. This decision started bearing fruit in 1991 when all three stock exchanges agreed to partake in cross-border trading. This allowed securities to be listed and traded on each of the three stock exchanges. Companies may be listed on any of the stock exchanges using one of the following methods: Prospectus issue – the offering of a security to the public at a fixed price Offer for sale – the offering of a security to the public, by or on behalf of a third party, at a fixed price Offer by tender – the offering of a security to the public by tender by or on behalf of a company or a third party Placing – an offer made to a stockbroker to sell the securities of a company to the public Introduction – where none of the company's securities is being offered to the public. Two other stock markets that are important to us in the Caribbean are the New York Stock Exchange and the London Stock Exchange. The New York Stock Exchange (NYSE) This stock exchange was established in the late 1700s and was seen as the largest stock market in the world. It is said to be the trading hub of the world and has a large number of listed companies which trade on a daily basis. The NYSE received another boost in 2007 when it merged with Euronext of Paris to form NYSE Euronext. The new entity now operates the largest and most liquid stock market in the world. Its offerings are also seen as the most diverse array of financial products and services. The London Stock Exchange (LSE) This stock exchange is possibly the oldest in the world, dating back to over 300 years ago. The LSE consists of four primary markets: Main Market – this is the principal market of the LSE for listed companies Alternative Investment Market – this market offers equity to smaller growing companies Professional Securities Market – for listed debt and depository receipt securities Specialist Fund Market – which is dedicated to specialised investment entities. CHAPTER SUMMARY Firms need capital for start-up, working capital and investment capital Working capital can be increased by selling unproductive assets, debt factoring, additional cash by the owner, increasing net profit, debt switching and increasing stock turnover Firms may source capital from internal or external sources. This can be expanded to include debt capital and equity capital Equity represents money invested by the owners into the business, while debt capital represents money borrowed that must be repaid with interest When sourcing finance it is important to examine the criteria of short-term financing, medium-term financing and long-term financing. The above-mentioned criteria will determine whether or not the firm utilises short-, medium- or long-term sources of finance Caribbean countries have received both financial and technical assistance from a number of institutions, namely the World Bank, the CDB, the IDB, the IMF and other sources The three major stock exchanges in the Caribbean are situated in Jamaica, Trinidad and Barbados. CHAPTER 13 | THE NEED FOR CAPITAL AND SOURCES OF FINANCE MULTIPLE CHOICE QUESTIONS 1. The need for capital can be categorised under three main headings. Which of the following is NOT one of those headings? a. Working capital b. Cost of acquiring the funds c. Gearing of the firm d. The lending institution 8. Which of the following institutions is subdivided into the IBRD and the IDA? b. Loan capital a. World Bank c. Start-up capital b. Caribbean Development Bank d. Investment capital c. International Monetary Fund 2. Working capital is BEST defined as: a. Money needed to start a business b. Money used for investment c. Money used for daily expenses d. Money received from wealthy individuals 3. A firm has been diagnosed with working capital problems. Which of the following is the BEST option for it to take? a. Increase stock turnover b. Extend the payment date for debtors d. Inter-American Development Bank 9. Which of the terms below best suits the following definition: ‘A business or person who acts as an intermediary to bring together buyers and sellers of financial securities’? a. Shareholder b. Stock exchange c. Stockbroker d. Capital market 10. The price of a share is usually determined by: c. Pay creditors promptly a. Demand and supply d. Group the repayment schedules for loans b. The stockbroker 4. Which of the following is an example of equity capital? a. Debentures c. The stock exchange d. The business b. Bonds c. Loans Extended Essay Questions d. Shares Question one 5. Sources of internal capital include ALL of the following EXCEPT which one? a. Disposal of fixed assets b. Preference shares c. Working capital d. Retained profit 6. Which of the following items is MOST LIKELY to be bought using hire purchase? a. Land b. Equipment c. Factory d. Stock 7. When choosing among the sources of funds, the firm usually examines ALL of the following factors EXCEPT which one? a. Size of the firm Total 25 marks a. What is the difference between working capital and venture capital? (4 marks) b. With the use of two (2) examples of each, distinguish between equity capital and debt (9 marks) capital. c. Discuss three (3) benefits to the firm of using equity capital over debt capital as its source of finance. (12 marks) Question two a. Define the term ‘working capital’. Total 25 marks (2 marks) b. Identify three (3) components of working capital. (3 marks) c. A firm having working capital problems is facing the risk of bankruptcy. Discuss five (5) methods that the firm can use to improve its working capital. (20 marks) 147 148 14 Accounting Information and Financial Statements LEARNING OBJECTIVES: At the end of this chapter students should be able to: Identify the main users and uses of accounting information State the types of information that are needed by these users Outline the current accounting standards Explain the different accounting concepts Outline basic accounting procedures as a base for financial statements Draft simple financial statements including income statements, balance sheets and cash flow statements State the importance of these financial statements to the business organisation Assess the relationship between statement of financial position and statement of comprehensive income Why do we need accounting records? A ccounting is defined as the systematic recording, summarising, analysing and reporting of business and financial transactions. It is imperative that individuals and businesses keep proper accounting records. For the most part, we all keep some form of accounting record. In our daily activities we have a mental picture or make jottings of our spending and income. The need for accounting records is even greater for businesses which have to ensure that its activities are above ground and meet the stipulated standards while preventing issues such as bankruptcy. A business cannot run efficiently if it does not keep proper accounting records. Businesses usually keep accounting records to: Measure the performance and evaluate the progress of the business Show details of each transaction between buyers and sellers Provide necessary information for management and owners Provide information for taxation purposes. A business will keep records of sales, purchases, payments, receipts and other day-to-day transactions. The records that are kept by businesses are important to a number of stakeholders and other interested parties. These stakeholders can be divided into internal users and external users. Internal users of accounting information Internal users are those people who are directly affiliated with the company and have access to certain information that would not be available to external users. These internal users include the following people: Managers The manager’s role in the business is important and decisions made are critical to its success. Managers need information for the planning of future activities, controlling of the operations of the business, for decision making and for budgetary reasons. With the information given, a manager can assess the performance of a business in relation to its stated goals, objectives and targets. Employees The accounting information of a company is very important to employees. They need information on the company’s ability to continue providing employment and make remunerations. In tough economic times employees will need to ascertain information on whether or not there will be a restricting or downsizing of the company. Information about job security is also of concern to these employees who may need to start searching for alternative employment. Internal auditors These are employees of the company who are charged with the responsibility of carrying out internal financial monitoring of the business’s performance. They generate an internal audit report which is passed on to management along with any advice and recommendations that would influence decision making at the senior management level. CHAPTER 14 | ACCOUNTING INFORMATION AND FINANCIAL STATEMENTS External users of accounting information Customers and consumer groups External people are those who are indirectly affiliated to the company. The information given to external users will not be as detailed as that for internal users, as it may contain certain sensitive material that cannot be published. These users include the following: Consumers need information about a company in order to assess its sustainability and to decide whether or not to enter into long-term relations with it. They will need to know if the business is able to continue supplying their needs. Agencies that seek to protect consumer rights, for example the Consumers’ Affairs Commission in Jamaica and other such agencies across the region, may need information to ascertain whether consumers are being exploited or treated fairly. Shareholders/investors By law, a public limited company has to publish its accounts for its shareholders. These are often published in its annual report or in newspapers. As stated in Chapter 13, shareholders are investors in the company and they will need information on the performance of the business, whether or not dividends will be paid and in what amounts, if additional shares are being offered, the present value of their investment, the potential for growth or failure and the financial viability of the business. Lenders Banks or other financial institutions giving a loan will want to know whether the firm is able to meet its obligation of repayment along with interest. If the potential risk of non-payment is too high then these institutions may refuse to give the loan or may provide the loan at a higher than normal interest rate. Government and its agencies Accounting information is important to the tax authorities (Inland Revenue) who will calculate the amount of tax owed and is used by them to measure compliance. Information is also needed on the business’s ability to create additional jobs, whether or not financial support should be given and whether the business is complying with any stipulated regulation or legislation. The Office of Utilities Regulations is a regulating body in Jamaica that would need a business’s accounting information. Company creditors These are the individuals or businesses who supply goods to the firm on credit. Before credit is given, information is needed on the financial stability of the company and its ability to pay within the given time frame. The creditors can also use information gathered to determine the length of credit period that should be given to the firm. If possible, the creditors would want to know the creditworthiness of the firm before entering into a long-term business relationship. However, this information may be difficult to ascertain, especially when there are no legal requirements to do so. Competitors A proactive competitor will keep abreast of the operations of its competing firms. The information gathered can be used to make comparisons and as a benchmark for the evaluation of its own performances. While the competitor may not be privileged to see certain information about a firm, it would seek to have information about matters such as price and forms of promotion. It is a tendency of firms in a very competitive industry to be involved in stiff price wars as each seeks to capture the bulk of the market share. Community Accounting information is also important to the community in which a firm operates. The community needs this in order to assess the company’s ability to continue providing employment for its members and funding environmental improvements. Based on the type of business, for example a mining company, community members will be keen to see information about the potential environmental impact of the business operations. Trade unions These organisations will want to gather information about a firm. Since trade unions bargain for the rights of their members, they would want to ensure that members are not being exploited or unfairly treated by firms. Obtaining information on the financial viability of firms can help trade unions to make informed decisions about wage demands. Trade unions may also seek accounting information on a firm when there are looming job cuts. This is to ensure that the firm isn’t simply laying off workers without just financial cause. Getting started with accounting This section is particularly geared towards those students who have never been exposed to accounting before studying Management of Business. While it’s not a comprehensive package, it should provide the necessary information to 149 150 MODULE 3 | UNIT 1 | BUSINESS FINANCE AND ACCOUNTING expose students to the basic principles on which accounting is built. The accounting equation The worth of a business can generally be calculated by subtracting what it owes the business from what it owns. This idea is used by many people who do not keep proper financial records, but have a general idea of their profits. As simple as it may seem, the entire accounting sphere adopts this simple idea. The idea is formally known as the ‘accounting equation’, which states that: Capital = Assets – Liabilities Where there are no liabilities, the equation will now read: Assets = Capital We can also transpose the equation in order to calculate the assets of the business: Assets = Capital + Liabilities ACTIVITY Using a table similar to Table 14.1, record the following transactions: 2009 April 1: Started business with $1 million in the bank 3: Bought van for $250 000, paying by cheque 4: Bought office furniture on credit for $100 000 from Furniture Ltd 10: Bought computers valued at $50 000, paying by cheque 15: T Thomas lent the business $100 000; this was placed in the bank 16: Returned some of the office furniture which was the wrong colour (valued at $20 000) 18: Paid the amount owing to Furniture Ltd 25: Withdrew $10 000 from the bank and placed it into the cash till 30: Repaid half of the loan from T Thomas The double entry system In accounting, every transaction affects two items in the company books. As a result, each transaction has to be entered twice: once on the debit side of one account and once on the credit side of another account. The left-hand side of each account is called the debit side and the right-hand side is called the credit side. The double entry system holds that for every debit there is an equal and corresponding credit. Figure 14.1 will help you to understand how a transaction will affect the different categories of accounts. From the above illustration we can summarise that: to increase capital and liability accounts, a credit entry is made; while a debit entry is made when we want to decrease the accounts to increase an asset account, a debit entry is made; while a credit entry is made to decrease the account. Now let us examine the transactions in Table 14.1 and the effects they have on the company accounts. Capital accounts Liability accounts Decreases Increases Decreases Increases Figure 14.1: The double entry system Asset/expense accounts Increases Decreases Posting entries to journals The journals are also known as the books of prime entry or the day books. There are six books of prime entry, each having a different purpose: Cash Book – used to record receipts and payments, cash and bank transactions Sales Day Book or Journal – used to record sales made on credit Purchases Day Book or Journal – used to record purchases made on credit Returns Inward Day Book – used to record stock previously sold by the company but later returned by customers Returns Outward Day Book – used to record stock previously purchased by the company but later returned to the supplier General Journal – used to record other transactions that are not recorded in the above journals. Now we will look more closely at two of these day books: Sales Day Book As mentioned above, the Sales Day Book is used to record credit sales. ‘Sales’ refers to the selling of a business’s normally traded goods that were purchased with the intention of reselling. Therefore the sale of a fixed asset is not recorded as sales but the sale of stock is. The people to whom we sell goods on credit are known as ‘debtors’. There are three steps to remember when posting transactions in the Sales Journal: 1. Post each entry in the Sales Journal CHAPTER 14 | ACCOUNTING INFORMATION AND FINANCIAL STATEMENTS Date Transaction Action to take Effect on the accounts June 1 Mr Jones opened a hardware store with Debit Bank A/c $1 500 000 Credit Capital A/c Increases the asset Bank Increases Capital 6 Bought two cash registers on credit from Office Supplies Co ($20 000) Debit Cash register Increases the asset Cash register Increases its liability to Office Supplies Co 16 Bought motor vehicle, paying by cheque Debit Motor vehicle ($500 000) Credit Bank Increases the asset Motor vehicle Decreases the asset Bank 17 Withdrew $20 000 from the bank and placed it in the cash till Debit Cash A/c Credit Bank A/c Increases the asset Cash Decreases the asset Bank 20 Paid by cheque the amount owing to Office Supplies Co Debit Office Supplies Co Credit Bank A/c Decreases its liability to Office Supplies Co Decreases the asset Bank 21 Receive loan of $200 000 from J Pang Debit Bank A/c Credit J Pang Increases the asset Bank Increases its liability to J Pang 24 Paid electricity bill amounting to $5 000 Debit Electricity Credit Bank A/c Increases the expense Electricity Decreases the asset Bank 31 Paid by cheque ($100 000) to J Pang as part-payment for loan Debit J Pang Credit Bank A/c Decreases its liability to J Pang Decreases the asset Bank Debit Cash register Credit Office Supplies Co Table 14.1: Transactions illustrating the double entry system 2. Post each sale separately to the individual customer account in the Sales Ledger 3 Transfer the total of all the credit sales to the Sales a/c in the General Ledger. Now let us examine the example below: K Francis p. 24 2009 June 14 Sales Folio SJ 44 $ 14 600 J Harris Credit sales transactions for June 2009 June 6 E Carthy $6 200 14 S Edwards $14 600 27 K Francis $22 000 30 J Harris $11 900 2009 June 27 Sales 2009 June 30 Sales Date Details Invoice no Folio June E Carthy 5432 SL 10 6 200 6 S Edwards 5433 SL 13 14 600 14 K Francis 5434 SL 24 22 000 27 J Harris 5435 SL 31 11 900 30 Total transferred to Sales account GL 11 54 700 E Carthy S Edwards Amount ($) p. 10 p. 13 Folio SJ 44 $ 6 200 Folio SJ 44 $ 22 000 Folio SJ 44 $ 11 900 General Ledger Sales Day Book p. 44 Sales Ledger 2009 June 6 Sales p. 31 Sales A/c p. 11 2009 June 30 Credit sales for the month Folio SJ 44 $ 54 700 Purchases Day Book The Purchases Journal is used to record goods bought on credit. ‘Purchases’ refers to those goods that are bought with the intention of reselling. Therefore, the purchase of computers to be used in the Accounts Department will not be recorded as purchases. The people or businesses from which goods are purchased on credit are known as ‘creditors’. There are three steps to remember when posting transactions in the Purchases Journal: 151 152 MODULE 3 | UNIT 1 | BUSINESS FINANCE AND ACCOUNTING 1. Post each entry in the Purchases Journal 2. Post each sale separately to the individual customer account in the Purchases Ledger 3. Transfer the total of all the credit sales to the Purchases a/c in the General Ledger. Now let us examine the example below: The following credit purchases were made in the month: May 2 D Reece $12 000 6 O Smith $14 670 15 K Perkins $25 000 18 S Wilson $ 8 000 27 S Haynes $18 650 Purchases Day Book p. 19 Date Details Invoice no Folio Amount ($) May 2 D Reece 2345 PL 10 12 000 6 O Smith 2346 PL 13 14 670 15 K Perkins 2347 PL 24 25 000 18 S Wilson 2348 PL 31 8 000 27 S Haynes 2349 PL 40 18 650 31 Total transferred to Purchases account GL 12 78 320 Purchases Ledger D Reece 2009 May 2 Purchases p. 10 Folio PJ 19 $ 12 000 O Smith 2009 May 6 Purchases p. 13 Folio PJ 19 $ 14 670 K Perkins 2009 May 15 Purchases p. 24 Folio PJ 19 $ 25 000 S Wilson 2009 May 18 Purchases 2009 Folio May 31 Credit purchases PJ 19 for the month p. 12 $ 78 320 Trial balance At the end of the accounting period, the balances in the ledger accounts are summarised into a statement known as the trial balance. This is a statement showing the list of balances of all the accounts. The main purpose of the trial balance is to check the mathematical accuracy of the accounts that have been prepared. Once all the account balances are listed in the trial balance, both the debit and credit sides must be equal. If everything is accurate, the company will then prepare an income statement and a balance sheet. It is important to note that the trial balance is not a final account but acts as proof that the ledger accounts were done accurately. Components of financial statements According to the International Accounting Standard (IAS), firms need to follow a prescribed standard when presenting their financial statements. The objective of this is to provide users with vital information about the financial position and performance of the firm in addition to its cash flows. In general, the business will be required to prepare three different financial statements, including an income statement, a balance sheet and cash flow statements. Income statements An income statement is sometimes referred to by the IAS as a ‘statement of comprehensive income’. However, there are slight differences between the two, especially in terms of how profit and loss is calculated. The income statement is a financial statement that assesses the firm’s financial performance over an accounting period (usually a year). It shows how revenues are earned and expenses incurred by the business. The income statement is divided into the following sections: p. 31 Folio PJ 19 Trading account $ 8 000 S Haynes 2009 May 27 Purchases General Ledger Purchases A/c p. 40 Folio PJ 19 $ 18 650 This shows the calculation of gross profit from trading. Gross profit is calculated as: Sales – Cost of Sales The gross profit gives an indication of the level of efficiency with which materials and labour were used to produce the goods and services. Cost of sales is calculated as: CHAPTER 14 | ACCOUNTING INFORMATION AND FINANCIAL STATEMENTS Opening inventory + Purchases – Closing inventory Now let us take a closer look at the breakdown of the cost of sales: Sales represents the total amount of money earned from the provision of goods and services to customers Opening inventory is the cost of the inventory at the beginning of the accounting period. Please note that ‘inventory’ only refers to those items which are to be sold and form part of the firm’s regularly traded goods. These could include finished goods, work in progress and raw materials Purchases – this represents goods that are bought with the intention of reselling Closing inventory is the cost of the inventory at the end of the accounting period. Profit and loss account This shows the calculation of net profit, by adding any additional income to gross profit then subtracting all the expenses: Revenues (receivables) – this represents income earned by the firm outside of its regular trading activities. They may include rent received, commission received and discount received Expenses are also known as overheads and represent costs that are incurred for the purpose of earning income. Some common examples of expenses include, but are not limited to, wages, salaries, utilities payments, stationery, rent, rates and interest payments. A simple format for the trading and profit and loss account is shown below: [Business name] Trading, profit and loss account for the year ended [date] Details Sales Less: Returns inward (Sales returns) Less: Cost of sales Opening inventory Add: Purchases 50 000 Less: Returns outward (Purchases returns) (1 500) Add: Carriage inwards 1 000 Less closing stock $ 5 000 49 500 54 000 (4 000) Gross profit Add: Receivables (commission received, etc.) Less: Expenses: Wages Rent Lighting and heating Carriage outward General expenses, etc. Net profit 12 000 7 500 5 400 1 200 2 000 $ 100 000 2 000 98 000 (50 500) 47 500 1 000 48 500 (28 100) 20 400 Balance sheet The balance sheet is another important statement for businesses. It is referred to as a ‘statement of financial position’ by the IAS. As stated, it shows the financial position of the firm at a given point in time – that is, its assets (what it owns) and its liabilities (what it owes). The balance sheet is organised under headings such as ‘Non-current assets’ (Fixed assets), ‘Current assets’, ‘Current liabilities’ and ‘Share capital’. A common format is shown below: [Company name] Balance sheet as at [date] Cost Non-current (Fixed) assets Premises Fixtures and fittings Equipment Motor van, etc. $ 30 000 12 000 15 000 18 000 75 000 Current assets Inventory 15 000 Accounts receivable Less: Provision for bad debts (1 200) Cash at bank Cash in hand Prepayment Less: Current liabilities Accounts payable Short-term loans Accruals Working capital Less: Non-current liabilities Long-term loans Capital employed Depreciation NBV $ 8000 1 600 3 000 3 600 16 200 $ 22 000 10 400 12 000 14 400 58 800 9 000 13 800 5 500 3 200 900 32 400 13 000 4 400 800 (18 200) 14 200 73 000 (7 000) 66 000 Financed by: Opening capital Add: Net profit (loss) for the year 41 100 20 400 61 500 Less: Drawings Closing capital (4 500) 66 000 Now let us take a closer look at each of the main components of the balance sheet: Non-current assets (Fixed assets) – these include assets that are durable (for example, physical properties) and are used in the operations of the business. Their useful life is usually longer than a year. These assets appear on the balance sheet in order of permanency – that is, the most permanent first, then least permanent Current assets – represent assets that can easily be converted into cash, sold or consumed within a one-year 153 154 MODULE 3 | UNIT 1 | BUSINESS FINANCE AND ACCOUNTING period. These assets appear in the balance sheet in the order of liquidity, starting with least liquid and moving to most liquid Current liabilities – these are monies owed by the business that are expected to be repaid within the next 12 months Working capital or Net current assets – this is the difference between Current assets and Current liabilities. It is the money that is used for the day-to-day expenses of the business. Low working capital can result in serious liquidity problems for the firm Non-current liabilities – these are monies owed by the firm which are not expected to be paid within a oneyear period Capital employed or Net assets – this is the total of Fixed and Current assets minus Current and Longterm liabilities. Total assets are usually financed by the owner(s) of the business in terms of the capital they put in the business. This figure should be equal to the final figure in the ‘Financed by’ section Financed by – this segment shows how the business acquired finance for the business. Now let us look at the following worked example: P Johnson Trial balance as at 31 July 2013 Details Capital Bank Drawings Accounts receivable Loan to be repaid in 12 years’ time Accounts payable Heating Motor vehicle at cost Interest paid on bank loan Returns outward Motor vehicle expenses Carriage outward Carriage inward Rent and rates Purchases Rent received Salaries and wages Returns inward Sales Premises Inventory at 1 August 2012 Discount allowed Discount received $ Sales Less: Returns inward Less: Cost of sales Opening inventory Add: Purchases Less: Returns outward 590 000 Add: Carriage inward $ 1 150 000 50 000 1 100 000 660 000 70 000 10 000 Less: Closing inventory Gross Profit Add: Revenues: Rent received Discount received Less: Expenses: Heating Interest payment Motor vehicle expenses Carriage outward Rent and rates Salaries and wages Discount allowed 160 000 600 000 760 000 200 000 (560 000) 540 000 20 000 2 000 22 000 562 000 16 000 10 000 30 000 6 000 80 000 115 000 1 000 258 000 304 000 450 000 44 000 130 000 105 000 100 000 95 000 16 000 220 000 10 000 70 000 30 000 6 000 10 000 80 000 660 000 250 000 160 000 1 000 _________ 1 887 000 $ Net profit $ 115 000 50 000 Required: An income statement and the balance sheet as at 31 July 2013 Solution: P Johnson Income statement for the year ended 31 July 2013 20 000 1 150 000 2 000 1 887 000 Note that Inventory at 31 July 2013 is $200 000. P Johnson Balance sheet as at 31 July 2013 $ Non-current assets: Premises Motor vehicle Current assets: Inventory Accounts receivable Bank Less: Current liabilities Accounts payable Working capital Less: Non-current liabilities: Loan Financed by: Opening capital Add: Net profit Less: Drawings $ 250 000 220 000 470 000 200 000 105 000 44 000 349 000 95 000 254 000 724 000 100 000 624 000 450 000 304 000 754 000 130 000 624 000 CHAPTER 14 | ACCOUNTING INFORMATION AND FINANCIAL STATEMENTS Now try the following exercises: EXERCISE 1 Benny Jobs Trial balance as at 31 March 2013 $ Capital Drawings Loan to be repaid in 8 years’ time Bank Cash Accounts receivable Accounts payable Opening inventory Purchases Motor vehicle Sales Equipment Returns inward Returns outward Motor vehicle expenses Carriage outward Carriage inward Rent Utilities Wages and salaries Office expenses Loan interest Insurance $ 9 000 16 500 4 200 12 000 7 200 74 200 23 000 24 500 1 050 5 800 3 600 4 000 18 000 6 400 12 000 3 250 2 000 6 500 233 200 63 000 15 000 13 800 140 500 900 of financial position gives a snapshot of the business’s assets and liabilities during a particular period of time. It shows all the assets and liabilities along with the equity of the business. It gives readers a clear picture of the financial health of the business. While the statements are separate, they are closely related and both must be published as part of the firm’s final accounts. One such relation is that the total comprehensive income at the end of the period must be transferred from the statement of comprehensive income to the statement of financial position. To this end, if a profit is made in the statement of comprehensive income, it will increase the net assets of the firm in the statement of financial position. Cash flow statement According to IAS 7, all companies should publish a cash flow statement showing how inflows were generated and outflows spent. A cash flow statement shows the movement of cash into and out of the business. In order to understand this statement better it is important to define ‘cash’ to include cash in hand and demand deposits (a bank deposit where withdrawal can be made freely, without prior notice) and ‘cash equivalents’, which are short-term, highly liquid investments that are easily and readily converted into known amounts of cash. 233 200 Purposes of cash flow statement Closing inventory was $8 400. You are required to prepare the trading and profit and loss account for the year ended 31 March 2013 and a balance sheet as at that date. EXERCISE 2 A firm sold $160 800 worth of goods which were purchased for $125 000 before $5,000 worth of the goods was returned to the supplier upon arrival because of poor quality. The cost of carriage was $3,500. It started the year with inventory valued at $9,650 and at the end of the period inventory valued at $6,200. Some customers later returned $2,550 worth of goods. Calculate the firm’s gross profit for the period. Relationship between statement of comprehensive income and statement of financial position The statement of comprehensive income records the changes to the business’s net assets over a given period of time. It shows the gains or losses that the business experienced within that time frame. On the other hand, the statement The main reasons for preparing a cash flow statement are: Sourcing finance – most financial institutions will require a breakdown of the firm’s cash flow statement, showing how it will repay the money borrowed Monitoring and control – the statement will enable the firm to monitor its income and expenditure on a monthly or annual basis, matching them to the actual figures Provides timing for large expenditures – the firm can budget to purchase capital equipment in times when large amount of funds are available. Advantages of the cash flow statement Fosters proper judgement on the amount, timing and degree of certainty of future cash inflows or outflows Provides information on the firm’s liquidity and financial viability Is not easily manipulated and so is not affected by judgements or accounting policies Allows for comparison of the present and future values of fund passing through the business Shows the relationship between profitability of the firm and its ability to generate cash. 155 156 MODULE 3 | UNIT 1 | BUSINESS FINANCE AND ACCOUNTING Disadvantages of the cash flow statement $ While cash flow is necessary for short-term operations, the firm needs profit in order to be viable in the long term. As a result, it may need to sacrifice cash flow for large investments Since they are based on past data, cash flow statements may not provide accurate information about future cash flow. Cash inflows and outflows Table 14.2 gives an idea of the items that will lead to a cash inflow or outflow. Cash inflows Cash outflows Loans to the firm Start-up capital Sales (decrease in stock) Interest receipts Tax rebates Profits Increase in creditors Sale of fixed assets Purchase of fixed assets Purchase of stock or raw material Loan repayments Payment of expenses Tax payments Losses Decrease in creditors Interest and dividends payments 5 000 2 500 (450) (1 600) (800) 4 650 15 400 (3 500) 11 900 At the end of the cash flow statement, firms complete an analysis of changes in cash during the year. The format for this is shown below: Balance at the start of the year (3 500) 15 400 Net cash inflow/(outflow) Balance at the end of the year 11 900 EXERCISE The following was extracted from the books of Jane Jamieson: Table 14.2: Cash inflows and outflows Format of cash flow statements According to IAS 7, cash flow statements should have three standard headings: Cash flows from operating activities Cash flows from investing activities Cash flows from financing activities. A full format is seen below, showing the breakdown of each section: Cash flow statement for the year ended [date] Details $ Cash flows from operating activities Net profit before taxation Add: Depreciation charges (for the year) Loss/(profit) on sale of non-current assets (Increase)/decrease in inventories (Increase)/decrease in debtors Increase/(decrease) in creditors Less: Preference dividends Interest payment Income taxes paid Net cash from operating activities 9 500 1 000 (350) (500) 2 400 (950) (1 000) (650) (1 300) Cash flows from investing activities Receipts from the sales of tangible assets Less: Payment to acquire tangible fixed assets Interest received Dividends received Net cash used in investing activities Cash flows from financing activities Proceeds from issue of shares Proceeds from long-term borrowings Less: Payment to finance lease liabilities Ordinary dividends paid Payments to redeem debentures Net cash used in financing activities Net increase/(decrease) in cash Cash and cash equivalents at the beginning of the period Cash and cash equivalents at the end of period $ $ Details Cash flows from operating activities Net profit before taxation Add: Depreciation charges (for the year) Loss on sale of non-current assets Decrease in inventories Decrease in debtors Decrease in creditors Less: Preference dividends Interest payment Income taxes paid Net cash from operating activities Cash flows from investing activities Receipts from the sales of tangible assets Less: Payment to acquire tangible fixed assets Interest received Dividends received Net cash used in investing activities 8 150 4 000 (2 150) 200 350 Cash flow statement for the year ended 31 August 2012 2 400 Cash flows from financing activities Proceeds from issue of shares Proceeds from long-term borrowings Less: Payment to finance lease liabilities Ordinary dividends paid Payments to redeem debentures Net cash used in financing activities Net increase in cash $ $ 74 900 14 230 340 4 050 2 440 (11 150) (17 500) (6 500) (13 000) 47 810 2 240 (28 500) 1 950 10 250 (14 060) 25 000 61 200 (32 000) (18 500) (25 600) 10 100 43 850 + 9500 53350 CHAPTER 14 | ACCOUNTING INFORMATION AND FINANCIAL STATEMENTS 1. Analyse the cash flow situation of Jane Jamieson in terms of the following headings: Cash flows from operating activities Cash flows from investing activities Cash flows from financing activities. 2. If the cash and cash equivalent balance at the beginning of the year was $9 500, what would be the amount at the end of the year? An explanation of operating activities Net profit before taxation – since taxes are dealt with in the operating activities, the profit used in this section is taken before taxes are paid. This will prevent the firm from subtracting the figure twice Depreciation – since this does not actually represent cash flowing out of the business but is just an estimated reduction in the value of the assets, it should be added back to profit Loss/profit on disposal – a profit or loss on disposal of an asset is dependent on the amount by which the firm had depreciated the asset. As a result, a loss on disposal should be added back to net profit since the firm is not really losing funds. While a profit on disposal of assets is subtracted, there is no real gain Increase or decrease in inventories – an increase in the stock figure suggests that new stock was purchased over the period and hence money was paid out to acquire this; whereas a decrease in stock suggests that an amount was sold hence the firm would have had revenue from the sale Increase or decrease in debtors – an increase in debtors means that the firm has sold stock for which it has not yet received payment, hence an outflow of cash; whereas a decrease means that the firm has received payment from its debtors Increase or decrease in creditors – an increase in creditors means that the firm has received inventories that it won’t have to pay for now, therefore an inflow of cash; whereas a decrease means that the firm has paid some of it debts, resulting in an outflow of cash Preference dividends and interest paid are normally accounted for in the operating activities, according to IAS 7 Income taxes paid should be disclosed separately in the operating activities instead of being carried over in the net profit from the trading account. Possible solutions for a cash shortfall A shortfall of cash may pose a number of problems for businesses, especially liquidity problems. Firms may not be able to pay for their expenses and debts and this may lead to insolvency or bankruptcy. As a result, firms have to find the most appropriate ways to solve a shortfall of cash. Below are some suggestions for doing this: Raising cash from a new issue of shares Switch its debt from short-term to longer-term debt Reducing capital expenditure Tightening credit to its debtors while delaying payments to its creditors (if possible) Disposing of non-productive assets. CHAPTER SUMMARY There are two main categories of users of accounting information. These are internal users (managers, employees and internal auditors) and external users (shareholders, lenders, governments, creditors, customers, competitors and the community) Several concepts are used in accounting, including going concern, accrual concept, realisation, historical cost, etc. These concepts act as a guide for accountants as they draft the final accounts of a business The accounting equation states that: Capital = Assets – Liabilities purpose and records specific transactions The double entry system holds that for every debit there is an equal and corresponding credit Final accounts include the drafting of a statement of comprehensive income (income statement), statement of financial position (balance sheet) and statement of cash flow Capital and liabilities accounts increase on the credit or right-hand side of accounts, while asset accounts increase on the debit or left-hand side There are six books of original or prime entry and each has a specified IAS 7 stipulates that all companies should publish a cash flow statement showing how cash inflows are generated and outflows are spent. 157 158 MODULE 3 | UNIT 1 | BUSINESS FINANCE AND ACCOUNTING MULTIPLE CHOICE QUESTIONS 1. Businesses keep accounting records for ALL of the following reasons EXCEPT which one? a. Show details of each transaction between buyers and sellers b. Provide information necessary for management and owners c. It is a requirement of the business sector to do so d. Provide information for taxation purposes 2. Which of the following would be an internal user of accounting information? a. Shareholders b. Government c. Managers d. Customers 3. All the following are external users of accounting information EXCEPT which one? a. Lenders b. Community c. Employees d. Creditors 4. What are the two accounts that would be affected by a transaction in which Mr James bought ten computers on credit from Best Computers Ltd? a. Computers and Mr James b. Computers and Creditors c. Computers and Best Computers Ltd d. Mr James and Best Computers Ltd 5. Calculate the gross profit if Sales is $300 000, Opening stock is $20 000, Closing stock is $25 000, Purchases is $200 000 and Returns outward is $5,000. a. $110 000 b. $100 000 c. $60 000 d. $105 000 6. Which of the following is defined as ‘a statement showing the list of balances of all the accounts’? a. Trading account b. Profit and loss account c. Trial balance d. Balance sheet 7. According to IAS 7, a cash flow statement must have three standard headings. Which of the following is NOT one of those headings? a. Financing activities b. Analysing activities c. Investing activities d. Operating activities 8. Which of the following would NOT solve a cash shortage problem? a. Reducing capital expenditure b. Reducing debtor payment period c. Issuing new shares to the public d. Transferring money from retained profit 159 15 Financial Statements Analysis LEARNING OBJECTIVES: At the end of this chapter students should be able to: Discuss the use of accounting ratios Outline the advantages of ratio analysis Discuss the limitations or disadvantages of ratio analysis Identify the different categories of ratios Calculate the different ratios used for financial analysis Interpret each ratio to assess the business’s financial position Financial analysis A s was discussed in Chapter 14, there are a number of different users of accounting information. Each of these users may have a different purpose for seeking information on a particular company or business. For example, a manager may need information for control purposes or to improve profitability; creditors may need information for lending and credit purposes; and shareholders may need information in order to make investment decisions. Regardless of the reason(s) behind the need for accounting information, one thing is common among all three user groups, which is that information is needed for financial analysis. Importance of financial analysis Enables the firm to know whether or not it can meet its debts when they become due The necessary steps can be taken to correct any problems identified during the analysis Enables the firm to compare its performance over a number of years Gives a clearer view of the accounting data since it is broken up into ratio analysis. Ratio analysis Just inspecting financial statements may be of limited value, especially when there are certain key decisions to be made. Seeing a group of figures may not be as effective as using percentages and ratios to make comparisons from year to year. For example, if you are given the data in Table 15.1, what conclusion could be drawn? Is it simply true to say that Firm B is more profitable than Firm A or can we say that Firm A is underutilising its resources? In fact, we cannot draw any meaningful conclusion from the data given. Firms Net profit Firm A Firm B $20m $40m Table 15.1: Net profit figures for analysis If we add the following data to the table: sales for Firm A = $40m and sales for Firm B = $120m, which firm is now more profitable? This information can now be ascertained by calculating the percentage of sales that goes toward profit. The end result would see Firm A being more profitable than B, with 50 per cent and 33.3 per cent respectively. As a result, ratio analysis gives senior management and other stakeholders a better picture of the business’s performance over a given period of time. The ratios that are calculated will foster comparison of: The business’s performance with that in previous years Budgeted and actual performance or targets for the financial year The business and other businesses of the same nature in the industry. While accounting ratios are good, it should not be misconstrued that analysis ends with the calculation and comparison of these ratios. The figures and the comparison thereof may just highlight trends in the final accounts of the business. However, interpretation and analysis of these accounts lie in the reasons given for the trends and features identified by doing ratio analysis. Advantages of ratio analysis Provides the framework and information to compare a business’s performance with other businesses in the same industry or of the same nature 160 MODULE 3 | UNIT 1 | BUSINESS FINANCE AND ACCOUNTING Can produce vital information about the performance of the firm A good tool to use to assess the financial position of the business Can be used to identify possible weaknesses within a business which would not have been detected from simply drafting final accounts Helps management to formulate future plans and policies regarding the firm Can be used as a guide in making investment decisions Gives meaning, clarity and perspective to the accounting data presented in the final accounts. Limitations or disadvantages of ratio analysis Ratio analysis is predominantly quantitative and hardly focuses on quality, customer service and the morale of employees Ratio analysis focuses on historical data, with little emphasis on the future, though it can be used to make projections Any ratio that is calculated is only as accurate and reliable as the information that was used in its calculation – that is, if the financial report is not credible, then the ratio cannot be either Its usefulness is dependent on the skill of the user. It requires experience to interpret properly and place in context Ratios can only be used to compare similar companies and present with previous data If the ratios are not adjusted for inflation, they might be misleading. Types of ratio There are a number of ratios that are available to accountants. These are grouped into five categories: Profitability ratios or performance ratios – these measure how well the business is doing in terms of profit, turnover or sales and capital employed. They reflect the performance of the company and management Liquidity ratios – these show whether or not the company can effectively pay its debt. They also reflect the firm’s short-term strength or solvency Investors’ ratios or shareholders’ ratios – these measure the returns on the capital invested by shareholders or other investors. They also show the relationship of ordinary shares and their price to the profits, dividends and assets of the company Efficiency ratios – these measure how efficiently resources are utilised. They also determine the efficiency of the firm in collecting its debts Financial ratios or gearing ratios – these ratios assess the financial structure of the business, including the proportion of its financing that is obtained from debt capital. In order to illustrate the ratios in each category, the balance sheet for KJ Home Appliances is shown below: KJ Home Appliances Ltd Balance sheet as at 31 December 2008 Fixed assets Premises Fixtures and fittings Equipment Motor van Current assets Inventory Accounts receivable Less: Provision for bad debts Cash at bank Cash in hand Prepayment Less: Current liabilities Accounts payable Accruals Net current asset (working capital) Capital employed Cost Dep NBV $ 500 000 100 000 75 000 300 000 975 000 _______ $ $ 65 000 (5 000) 25 000 5 000 15 000 30 000 75 000 475 000 95 000 60 000 270 000 900 000 150 000 60 000 50 000 5 000 5 000 270 000 75 000 5 000 Financed by (Capital and reserves) Capital Add: Net profit for the year Less: Drawings (80 000) 190 000 1 090 000 900 000 240 000 (50 000) 1 090 000 Gross profit for the year was $400 000 and Sales was $1 200 000. Profitability ratios Return on Capital Employed (ROCE) This ratio shows the amount of money that has been made on the capital that was employed over the period. This is sometimes referred to as the ‘primary efficiency ratio’ because of its importance. It is calculated in one of two ways: Net profit or Net profit × 100 × 100 Capital employed Average capital* *Average capital is the sum of the Opening capital and Closing capital balance divided by 2. CHAPTER 15 | FINANCIAL STATEMENTS ANALYSIS Using the data from the balance sheet above, the value for the ROCE would be: ROCE (using Capital employed): 240 000 × 100 = 22.02% 1 090 000 ROCE (based on Average capital): 240 000 × 100 = 24.12% (900 000 + 1 090 000/2) From these ratios we can say that, based on capital employed, the company earned $22.02 for every $100 invested. While the ROCE may vary, depending on the industry, the general rule is that the higher it is, the better it is. Potential investors will use this ratio to assess whether their investment will be feasible. The aim of investors is to have sufficient or high returns and so they will refrain from investing if the firm is falling below expectations. The ROCE should be above the rate at which the company borrows money. This will ensure that shareholders can receive some form of return on their investment. Where the firm is not making a sufficient return on its capital employed it can take the following steps to improve it: Cutting costs, as this will improve its profits Reducing the amount of capital employed Seeking a cheaper source of raw materials. Gross profit percentage This is also known as ‘gross profit margin’. It shows gross profit expressed as a percentage of sales or turnover. It shows the percentage of the firm’s sales that goes to gross profit. The higher the ratio, the more desirable it is. It is calculated as: Gross profit × 100 Turnover Using the data above, KJ Appliances Ltd’s gross profit margin would be: 400 000 × 100 = 33.33% 1 200 000 The business would want to improve its gross profit margin, especially where it has a number of expenses. In our example above, while a gross profit of 33.3 per cent is acceptable, firms would want to push that figure closer to 50 per cent. Higher gross profit suggests that management has been able to use the available resources to generate high profits. A firm earning higher profit could plough back some of that profit into research and development, which should improve its operations. Improving gross profit should be the desire of most, if not all, firms but what are the options available for doing so? Some of the steps that firms could take to improve their gross profit margin would include: Increasing sales revenue – this could be done by either selling more or increasing prices Buying material in bulk in order to benefit from discounts Sourcing a cheaper supplier without sacrificing the quality of the materials Reducing the cost associated with the production of the goods. Net profit percentage This is also known as ‘net profit margin’. It shows net profit expressed as a percentage of sales or turnover. It gives a good idea of how the firm controls its expenses or overheads – that is, whether or not its overheads are too high and are depleting the gross profit earned. It also shows the firm’s level of efficiency. It is calculated as: Net profit × 100 Turnover Using the data from above, KJ Appliances Ltd’s net profit margin would be: 240 000 × 100 = 20% 1 200 000 A ratio of 20 per cent shows that the firm is profitable. However, the desire should be to improve this ratio. The firm would want to keep its net profit margin and gross profit margin close to each other. This will show investors that the firm is not incurring huge selling and distribution and administrative expenses. A net profit margin that is close to a gross profit margin suggests that overheads or expenses are low, which is desirable as the firm would be converting its revenue into actual profit. Where the firm may have a high gross profit margin but low net profit margin it is indicating that the overheads are too high. This can be dangerous, as a decline in sales could see the firm making net losses. The net profit margin can be improved in one of two main ways: reducing costs or increasing revenues. Mark-up This ratio measures the percentage that is added to the firm’s cost of sales in order to arrive at the selling price of its product. The ratio will therefore be susceptible to changes in costs. It is calculated as: Gross profit × 100 Cost of sales In the above example, let’s say that Cost of sales was $800 000 – so mark-up would be calculated as: 400 000 × 100 = 50% 800 000 This ratio would be saying that a mark-up of 50 per cent was added to cost to arrive at the selling price for the firm’s 161 162 MODULE 3 | UNIT 1 | BUSINESS FINANCE AND ACCOUNTING product. It shows the amount of profit that the firm makes on the cost of its product being sold. To improve the ratio, the firm could: Increase selling price Reduce the cost of sales. Liquidity ratios There are two types of liquidity ratios that assess the solvency of the company. These ratios are: Current ratio This is also known as the ‘working capital ratio’. The current ratio assesses whether the firm’s current assets (if liquidated) can cover its short-term obligations or current liabilities. It compares the firm’s current assets with its current liabilities: Current assets Current ratio = Current liabilities Note that this ratio is not expressed as a percentage, but instead the result should be expressed to 1, depicting the amount of times that the current assets can cover the current liabilities. Using the data from the balance sheet of KJ Appliances Ltd, the ratio would be calculated as: 270 000 = 3.4:1 80 000 It is normally said that a ratio of 1.5:1 is generally acceptable and good for the business. Also, a ratio of 1:1 might be acceptable for a business that predominantly sells for cash, such as wholesalers and supermarkets. Also, the acceptable level of the ratio may depend on the industry in which the business operates and also the type of business. A ratio that is too high above the 1.5:1 is not necessarily good. This often suggests that the business has too much of its money tied up in assets (for example, stock) that are not being productive and could have otherwise been invested to earn more money. This is true in the example above where KJ Appliances Ltd has a current ratio of 3.4:1, which is far outside of the norm. At the same time, though, a ratio that is too low or below the 1.5:1 range may mean that trouble is brewing for the firm. This would suggest that the firm may not be able to meet its obligations should the creditors call on it. It could also suggest that the firm has too little working capital or has too much debt outstanding. To improve current ratio, the firm could: Sell unproductive assets to gain cash Shorten the collection time from debtors Improve current assets through equity financing rather than debt Reduce the amount of funds taken out of the business as drawings. Acid test ratio This ratio is also known as the ‘quick ratio’. Its assessment is similar to that of the current ratio, however, stock is omitted from the total of the Current assets. The reason for this is that stock may take a long time to sell, therefore funds may not be forthcoming. To include stock would mean that, though the business has a good acid test ratio, its current assets may not be as liquid. This ratio is calculated as: Current assets – stock Current liabilities This ratio is also expressed to 1. Using the data given above, the acid test ratio would be: 270 000 – 150 000 = 1.5:1 80 000 A firm with an acid test ratio of less than 1:1 cannot cover its current liabilities. This could be problematic for the firm. In most cases, a low or decreasing acid test ratio signifies that the firm is over-leveraged, bills are being paid too quickly, there is a lengthy collection time for debtors or it is struggling to maintain and increase sales. However, as with the current ratio, the firm would not want to have an acid test ratio that is too high, as it could have found better and more profitable use for the funds. The acid test ratio shares the same suggestions for improving current ratio as mentioned above. Investment or shareholders’ ratios There are four major ratios under this category. These are calculated below. For the purpose of illustrating how the ratios are calculated we will use the list of balances extracted from a final account as shown in Table 15.2. Balances $ Profit after interest and tax Dividend proposed and paid 320 000 40 000 Table 15.2: Data for calculating investment or shareholders’ ratios * Note that 1 000 000 $1 ordinary shares were issued and the current market price for each share was $4.00. Earnings per share (EPS) This ratio is generally used to assess the financial performance of a company on an annual basis. It gives the shareholders a good idea of the portion of the company’s profits that goes to them. With this ratio, investors can compare the earnings CHAPTER 15 | FINANCIAL STATEMENTS ANALYSIS from year to year with each other. It is sometimes used as a stock market indicator of performance. This is calculated as: Net profit after interest and tax and preference dividends Number of ordinary shares issued For example: 320 000 = $0.32 EPS = 1 000 000 EPS is a good indicator of the profitability of the company and its ability to pay out dividends to existing shareholders. Potential investors will tend to gravitate to companies that have increasing earnings per share. The higher the EPS, the more attractive it is for investors who may want to make an investment. Price/earnings ratio (P/E) This ratio is sometimes referred to as the ‘stock market ratio’. It gives a good idea of the prospects of the company. If the P/E ratio is high then the company may experience growth in the demand for its shares, as investors feel that they will get better returns on their investment. It is calculated as: Market price per share Earnings per share For example: 4.00 = 12.5 times P/E ratio = 0.32 Dividend cover The declaration of dividends and the percentage given rests in the hands of the board of directors of a company. At any given time the company’s earnings will be greater than the amount of dividend that is declared for the ordinary shareholders. This ratio measures the number of times that the earnings of the company cover the dividend paid to the ordinary shareholders. A higher dividend cover is indicative that the current level of dividend is more likely to be sustained in the future. It is calculated as: Net profit after tax and preference dividends Declared dividend on ordinary shares For example: 320 000 Dividend cover = 40 000 = 8 times Efficiency and activity ratios There are four main ratios that will be dealt with in this section. These are calculated below. Table 15.3 will be used as a guide for calculation. It contains data from which the ratios will be calculated $ Dividend yield This ratio gives a comparison of the dividend yield to the market price of the share. This can also be used to compare one investment option with others. Shareholders that are looking for a steady stream of income might invest in a company that has a relatively high and stable dividend yield. However, it is often said that a company with lower dividend yields has more potential for growth in the future and is financially secure. As a result, investors may gravitate to such businesses rather than a high-yield one. How investors invest will depend on their objectives – that is, looking to earn quick profits or to have a secure financial option. The ratio is calculated as: Gross dividend per share × 100 Market price per share For example: 30 000/1 000 000 × 100 Dividend yield = 4 = 0.75% However, it must be noted that the dividend yield is not the only factor that may affect an investor’s decision. Also important will be the price of the share when it was purchased and what it is now. If the price is higher now, then the investor could sell these shares to earn additional rewards. Opening inventory Debtors Sales Purchases Creditors Closing inventory 8 600 12 500 62 500 56 000 30 000 9 800 Table 15.3: Data for calculating efficiency and activity ratios Debtor to sales ratio This ratio attempts to assess how much of the company money made from sales it tied up in debtors. It is normally advisable to collect debts as soon as possible, since money owed to the firm is unproductive and could be put to better use. This ratio is measured in terms of days in order to ascertain the length of time that debtors are taking to clear their debts. It is calculated as: Debtors × 365 Credit sales For example: 12 500 × 365 Debtor/Sales ratio = 62 500 = 73 days The higher the ratio, the longer the period of time being given to debtors to make payments. In such a case, it is more likely that the business might run into liquidity problems. 163 164 MODULE 3 | UNIT 1 | BUSINESS FINANCE AND ACCOUNTING This denotes inefficiency. It is also important for the firm to match its debtors ratio to its creditors ratio as it wouldn’t want to give its debtors too much time to pay but is being given a shorter period of time to pay its creditors. This could cause cash flow problems. To improve its debtors ratio, the firm could offer early payment incentives such as cash discounts. Creditor to purchases ratio This ratio shows the time period given by suppliers for the firm to pay its debts. Just examining the ratio may not be enough to decide whether it is good or bad, as the firm may have been given a longer time than usual to clear its debts. What is important here is to ascertain whether the firm is able to meet its deadlines for payments when they become due. This ratio is calculated as: Creditors × 365 Credit purchases For example: 30 000 × 365 Creditors/Purchases ratio = 56 000 = 195.5 days The ratio is sometimes calculated using Cost of sales rather than Credit purchases. The firm would want to take as long as possible to pay its creditors. However, taking longer than the agreed time frame could lead to a fall in the business’s credit ratings and possibly legal action by suppliers. In general, firms would want to keep the payment period for creditors longer than that for debtors to ensure that it will have the funds needed to make the payments to creditors. Like the debtors ratio, the ideal time for this ratio will depend on the industry and the relationship that exists between the firm and its suppliers. Stock turnover This ratio measures the number of times that stock turned over in the financial year – that is, the amount of time in which stock was sold and replenished. It also indicates how efficient the business is in maintaining the best possible level of stock. A low stock turnover indicates that stock might be piling up and the business is not selling its stock as quickly as it should. The more quickly stock turns over, the more quickly profits can be made and the higher sales revenue will be. Stock turnover is calculated as: Cost of sales Average stock Note: Average stock is calculated as Opening stock plus Closing stock divided by 2. For example: 54 800 (8 600 + 9 800)/2 = 5.95 or 6 times *Cost of sales = 8 600 + 56 000 – 9 800. The firm can seek to improve its stock turnover by: Getting rid of obsolete or slow-moving stock Offering discounts or conducting sales promotions to increase sales Improving stock-taking strategies by seeking to keep the optimum stock level. Stock turnover = Asset turnover Asset turnover measures the effectiveness of how assets are being used to generate sales. The result of this ratio is best compared with the ratio of similar businesses or competitors. Where a business’s asset turnover is lower than those of its competitors, there may be over-investment in assets. This is calculated as: Sales Asset turnover = Total assets – Current liabilities For the purpose of this example, Total assets is equal to $48 000 = 62 500 Asset turnover (48 000 – 30 000) = 3.47 times Gearing ratio This is also called the ‘leverage ratio’. It shows the relationship between a company’s equity capital and its debt capital. Put another way, it is measuring the proportion of the total assets invested in the firm that is financed by borrowing. This ratio is very essential when it comes on to the long-term financial health and stability of the business, as investors need to know that the capital structure of the company is not too dependent on borrowings. The ratio is normally interpreted in terms of high gearing and low gearing. A highly geared company is one that has more of its capital being financed by debt capital or fixed-interest securities – that is, more than 50 per cent. A low-geared company would be one that has most of its capital being financed by equity. The implication for ordinary shareholders is that they are less likely to be paid dividends if the company is highly geared, as the company would have to honour its interest payments on debentures and preference shares before dividends can be paid to them. This is further exacerbated by the fact that, unlike dividend payments, payment of interest and debt is not optional. There is more than one formula to calculate the gearing ratio, however, the most popular is: CHAPTER 15 | FINANCIAL STATEMENTS ANALYSIS Debt × 100 Capital employed In calculating the ratio it should be noted that ‘debt’ refers to long-term debt while ‘Capital employed’ refers to Fixed assets + (Current assets – Current liabilities). EXERCISE The following is accounting data taken from the books of K Francis: Balance sheet as at 31 May 2012 $ Non-current assets Premises Equipment 12 000 18 000 30 000 Current assets Inventory Accounts receivable Bank 160 000 62 000 8 000 230 000 Less: Current liabilities Accounts payable 90 000 Income statement for year ended 31 May 2012 $ Sales Less: Cost of sales: Opening inventory Purchases Less: Closing inventory Gross profit Less: Expenses: Wages and salaries Lighting and heating Rent and rates Other expenses $ 300 000 120 000 230 000 350 000 160 000 (190 000) 110 000 16 000 4 000 10 000 5 000 Net profit Add: Previous year’s balance Less: Dividend (35 000) 75 000 15 000 90 000 (27 000) 63 000 $ Financed by: Ordinary share capital (50 000 @ $2) General reserves Profit and loss 140 000 170 000 100 000 7 000 63 000 170 000 Using the above data, calculate the following ratios and comment on your answers: Stock turnover Gross profit margin Net profit margin Current ratio Acid test ratio Debtor/sales ratio Creditor/purchases ratio Dividend yield. CHAPTER SUMMARY There are four main financial statements. These are: balance sheet, income statement, cash flow and statement of retained earnings • Budgeted and actual performance or targets for the financial year • The business and other businesses of the same nature in the industry The ratios that are calculated will foster comparison of: • The business’s performance over previous years There are five main categories of ratios: profitability, liquidity, investment, financial and efficiency Ratios are compared over a two-year period or more, so that a clear view can be given of the firm’s average performance. 165 166 MODULE 3 | UNIT 1 | BUSINESS FINANCE AND ACCOUNTING MULTIPLE CHOICE QUESTIONS 1. If a shareholder wants to see the changes in his equity position over the financial year, in which of the following financial statements would he be better able to view this information? a. Balance sheet Extended Essay Questions Study the following accounts carefully then answer the questions that follow: Trading profit and loss account for year ended 31 March 2012 b. Income statement c. Statement of retained earnings d. Cash flow statement 2. The ratios CANNOT be used to compare: a. The business’s performance over previous years b. Budgeted and actual performance or targets for the financial year c. The customer base over a given period of time d. The business and other businesses of the same nature in the industry. Turnover Less: Cost of sales Gross profit Less: Expenses Profit before interest and tax Interest payable Taxation Profit after interest and tax Dividends Retained earnings (profit) 8 2 b. The firm’s Current assets can cover its Current liabilities 3.5 times c. Current assets is 3.5 times greater in value than Current liabilities d. The firm is very liquid 4. A company that has more of its capital being financed by debt capital or fixed-interest securities than shares is said to be: a. Highly geared b. Medium geared c. Low geared d. Average 5. Which category of ratio is BEST suited for measuring the returns on the contribution of shareholders? a. Profitability b. Liquidity c. Investment d. Financial (10) 75 (50) (25) Balance sheet as at [date] 2012 $m 210 3. What is the BEST explanation for a current ratio of 3.5:1? a. Current liabilities covers Current assets 3.5 times 2012 $m 500 300 200 115 85 Non-current assets Current assets: Inventory Accounts receivable Bank Less: Current liabilities Working capital Less: Non-current liabilities Financed by: Issued share capital of $2 shares Reserves Question one 15 10 5 30 15 15 235 35 200 120 80 200 Total 20 marks Calculate the following ratios for 2012. Round off to two decimal places. a. ROCE f. Stock turnover b. Gross profit margin g. Debtor/sales ratio c. Asset turnover h. Earnings per share d. Current ratio i. Dividend yield e. Acid test ratio j. Gearing. Question two Total 20 marks Comment on the following ratios by comparing them with those for 2011. The figures for 2011 are in brackets beside each ratio. d. Gearing (25%) a. ROCE (10%) b. Stock turnover (30 times) e. Debtor/sales ratio (5.5 days) c. Current ratio (2:1) 167 16 LEARNING OBJECTIVES: At the end of this chapter students should be able to: Explain why businesses make projections Outline how data is collected for budgetary purposes Define the term ‘budget’ Describe the different types of budget Outline the purposes of budgets and their limitations Prepare cash budgets Discuss budgetary control methods and reasons for variances W e all practise budgeting, sometimes even without knowing it. For example, some students are given lunch money at the start of the week and must ensure that it will last until the week is finished. Parents make a budget for how their income will be spent over the month and governments budget how the revenue of the country will be spent over the financial year. So, you may ask, what is a budget? It is a financial plan or statement which shows specific objectives or targets that a business hopes to achieve over a given period of time. Firms may prepare different budgets, including master budgets, production budgets, sales budgets and cash budgets. In order to draft a credible and practical budget, the right information has to be gathered and analysed. Budgets are mostly prepared from previous years’ data along with that gathered through research. It is important that information gathered is accurate and reliable or the projections made from that data will be flawed. Data needed for budgetary purposes can be gathered from bank accounts, previous financial reports, industry magazines, market research and other departments in the business, among other sources. Projections It is prudent for the firm to see itself as a going concern. This means that it will continue to operate in the foreseeable future. As a result, managers must make a projection or forecast for future happenings. A forecast is a prediction of Budgetary Accounting the result of the operations of the business over a future period of time. It may also show the position that the business should be in at the end of the period. A projection can be made over different time periods and this may be based on the size of the business, the type of business and its corporate goal and mission, among other things. Projections are made from the data gathered over time. The business should match its actual results to its budgetary figures so that any necessary adjustments can be made to the budget. Firms make projections and budgets for the following reasons: To set targets and business objectives Budgets can indicate possible future stumbling blocks such as shortage of resources Allows the firm to identify and assess alternative courses of action To monitor performance of the business over time Enables the firm to allocate resources effectively By setting realistic targets, employees could become more committed to the business and its objectives. The budgeting process For an overview of the process, see Figure 16.1 (p 168). Advantages of budgeting Acts as a guide for managers in the achievement of business objectives Fosters communication and coordination within the organisation Allows for the proper employment of capital when matched against the planned levels of activity Provides control for income and expenditure, thus minimising inefficiency and wastage. Drawbacks of budgeting A stringent budget may lead to inflexibility in the adaptation to change Since budgets are prepared on previous data, they may be inappropriate for current conditions A budget may lose its credibility and usefulness if the actual results vary greatly from budgeted figures Budgeting can be a costly process for the firm 168 MODULE 3 | UNIT 1 | BUSINESS FINANCE AND ACCOUNTING Flexible budget Establish objectives A flexible budget is adjusted when there are changes to the business environment of the activity. It is more representative of the current happenings in the business and its environment. As variable and fixed costs change, this budget would be adjusted to reflect such changes. Budgets and plans prepared by cost centres Zero-based budget A zero-based budget is drafted based on the need of each activity as opposed to the basis of past spending, bearing inflation in mind. The principle is that each activity must first be weighed against its benefits to the business before it is included in the budget. This will help to eradicate any previous inaccuracies and inefficiencies of the previous year. Coordinated by budget officer and presented to finance committee Final budgets agreed and budget centres informed Comparisons made Feedback for future control Actual performance recorded Feedback for future planning Variances investigated Operational budgets An operational budget focuses on the revenues and expenses related to the day-to-day use of resources by the business. They generally include such things as labour, materials, overheads, administrative costs, sales and cash. Operational budgets are usually done on an annual basis but they can be broken down into shorter reporting periods such as monthly. By doing so, managers can assess the performance of the firm to date and take the necessary steps to make corrections or improvements. Remedial action where possible Figure 16.1: The budgetary process Can cause conflict among the different departments as they fight for scarce resources Unrealistic targets could discourage workers. Categorisations of budgets Budgets are categorised under three main headings. Which of these the organisation chooses to use depends on its needs or present situations. These categories are: Fixed budget A fixed budget is one that remains the same even if the activity level of the firm is different from the projected figures. For example, a firm may draft a budget on the premise that 1 000 000 units of its product will be sold. At half year it may realise that sales have slowed drastically, to 300 000. Regardless of this, the firm would not adjust the budget to the changing conditions. Types of budget There are several types of budgets that a firm may have to draft in its financial year. These budgets serve different purposes and are outlined below: Sales budget The sales budget is usually the first one to be made, as the others are dependent on the forecasted sales figures. It is a plan showing forecasted sales for the period. The forecasted sales are often arrived at from historical data and current and expected economic patterns. The sales budget should include the expected number of each type of product that will be sold and the expected price at which they will be sold. A typical sales budget will resemble the following: Details $ Estimated unit Times selling price per unit Total estimated sales 20 000 $50 1 000 000 CHAPTER 16 | BUDGETARY ACCOUNTING Production budget Details The production budget is often dependent upon the sales budget, since production is driven by sales in most cases. Once the budgeted sales have been determined, the company must move to forecast the number of units that should be produced. Therefore the production budget refers to the determination of the products to be produced during a particular period of time. The production budget can be determined by using the following calculation: Details $ Budgeted sales Plus: Budgeted closing stock of finished goods Total units needed Less: Budgeted opening stock of finished goods Budgeted production 60 000 15 000 75 000 (9 600) 65 400 Material budget Having identified the production requirement, the material budget is then coined from the production budget. This would include the quantity of raw materials that are needed. The firm would then work out its budgeted raw material purchases as follows: Details Budgeted raw material usage Plus: Budgeted closing stock of raw materials Less: Budgeted opening stock of raw materials Budgeted raw materials purchases $ 25 000 12 000 37 000 (15 000) 22 000 Jan Cash budget The cash budget is a statement showing the estimated cash inflows and outflows including revenue and capital items. The following layout is normally used for cash budgets: Feb Mar April Receipts [list all receipts] Payments [list all payments] Net receipts/Payments Balance brought forward Balance carried forward The question that may be on your mind is: what should be included in the cash budget? The answer to this question would include: Receipts and payments should be recorded in the period when the money is expected to be received or paid Depreciation should not be included since it does not involve the movement of cash Receipts and payments from before the budget period should be brought forward as opening balance of cash Receipts may include: cash sales, receipts from debtors, interest received, sales of fixed assets, loans, issuing of new shares, and royalties Payments may include: purchases, wages and salaries paid, overheads and expenses, purchase of fixed assets, taxation, interest and dividends paid, and loan repayments. Now examine the following fully worked example: Example Refreshing Juice Ltd is a small family-owned company. The following data was taken from its books during the financial year ended 31 December 2008: Labour budget The determination of the number of units that are to be produced has now paved the way for the firm to ascertain the number of labour hours needed to produce the products. Once this is done, the firm can calculate its cost of labour by applying the rate of pay for each grade of workers to the labour hours in a labour budget. Periods December 2007 January 2008 February March Sales ($) Purchases ($) 35 000 30 000 22 000 19 000 20 000 17 000 15 000 20 000 Other notes include: Sales revenue is divided as follows: Cash sales 20 per cent and one month credit is given to the debtors. The company also receives one month’s credit on all purchases Wages are paid on a monthly basis, amounting to $2,500 Rent of $9,000 per annum is paid one month in advance, on 1 January of each year Miscellaneous expenses per month is $1,500 169 170 MODULE 3 | UNIT 1 | BUSINESS FINANCE AND ACCOUNTING A machine was sold on 12 February for $3,000 and a new one was purchased in March of the same year for $4,500 The manager draws $1,200 every month for his personal travelling expenses The bank balance at 1 January 2008 was $7,000. Prepare a three-month cash budget from January to March 2008. Workings: Refreshing Juice Ltd Cash budget for 3 months to 31 March 2008 Receipts January February March Cash sales (20% of present month) Credit sales (80% of previous month) Sale of machinery 6 000 4 400 3 800 28 000 24 000 17 600 Total receipts 34 000 31 400 21 400 Creditors (purchases) 20 000 Wages 2 500 Rent 9 000 Miscellaneous expenses 1 500 Purchase of machinery 17 000 2 500 15 000 2 500 1 500 1 500 4 500 1 200 1 200 1 200 34 200 22 200 24 700 3 000 Payments Drawings Total payments Net receipts/ (payments) Balance b/f Balance c/f (200) 9 200 7 000 6 800 6 800 16 000 (3 300) 16 000 12 700 EXERCISE Build Quick Construction Company Ltd is a small privately owned company. The following data is its plan for the first six months of its financial year starting 1 January 2012. Turnover for the first quarter is $20 000 per month for the second quarter and $30 000 per month. All work done by the firm is paid for on one month’s credit. The debtors for last December totalled $12 000. Materials are purchased on one month’s credit and the company is expected to purchase materials totalling $8,000 per month from January to April and $11 000 for the next three months. Outstanding payment for material purchased in December of the previous year is $10 000. Wages amounting to $4,000 for the first quarter and $5,000 for the second quarter are to be paid. There will be a $16 000 investment in machinery and equipment in June. Corporation tax payable in March amounted to $3,000. Miscellaneous expenses of $1,500 are to be paid each month. The cash balance from last year was $6,000. Prepare a cash budget for the six months ending June 2012. Master budget Once the firm has drafted its subsidiary budgets (sales, production, material, labour and expenses) it can then determine its master budget. The master budget is a summary of the firm’s plans for a particular period of time. It normally incorporates a budgeted income statement, a budgeted balance sheet and a cash flow budget. Budgetary control This involves the use of budgets to monitor performance of the business and make plans to combat future difficulties. It is a process whereby a firm’s actual results are compared with the budgeted figures. The budgetary control process consists of two distinct elements: Planning, which involves the drafting of budgets for a specified future period and Control, which involves the comparison of budgeted figures with the actual results over the specified period. Variance analysis An important part of budgetary control is variance analysis. Now, when we speak of ‘variance’ in budgetary control this refers to the fact that at times there is a difference between actual results and the budgeted figures of the firm (Actual – Budgeted). To this end, you will realise that a variance analysis can only be done at the end of the budgetary period, when the firm is aware of its actual figures. The main purpose for variance analysis is to provide management with practical reasons for below par performance. Management can then use this information to improve its operations, reduce operating costs and improve efficiency. A variance can be either: Favourable (positive), where actual figures are higher than budgeted. This could be as a result of lower than expected costs and/or higher than expected revenues Unfavourable (adverse), where actual figures are below budgeted figures. This could result from costs being higher than expected and/or revenue being lower than expected. A variance can be caused by a number of factors, some of which are: CHAPTER 16 | BUDGETARY ACCOUNTING Poor budgeting – this is where management makes impractical and ill-advised estimates, resulting in cost overruns Changes in the price of inputs (for example, materials). This could result in higher than budgeted costs Unpredictable events such as natural disaster can halt production, causing variance in sales and production Improper recording of data, costs or revenue could misrepresent the accounts and cause variances. Types of variance Sales variance This is a measure of the amount by which actual sales are above or fall below the budgeted sales. This disparity could be caused by a different price being charged per unit than was budgeted; stiff competition could be affecting sales; and an increased advertising campaign could improve sales. Sales variance is often subdivided into sales price variance and sales volume variance. For example: a company’s budgeted selling price is $100 and quantity of 800 units for the month. However, at the end of the month the actual figures showed that the selling price was $98 and only 750 units were sold. The variances would be: Sales price variance = (Budgeted price – Actual price) × Actual units (100 – 98) × 750 = 1 500 adverse Sales volume variance = (Budgeted sales volume – Actual sales volume) × Budgeted price (800 – 750) × 100 = 500 adverse Labour variance This is a measure of the amount by which the actual labour costs differ from the budgeted labour costs. This could be caused by changes in the planned wages and/or differences in the planned and actual labour hours worked. For example: A firm has a labour cost of $4,000 for every 5 hours’ work – that is $800 per hour. In a particular month, 1,000 units of the product were produced, using 160 hours at a total labour cost of $120 000. Calculate the total labour cost variance. Budgeted costs of direct labour for actual output (160 × 800) $128 000 Actual labour cost 120 000 Total variance 8 000 favourable Labour variance could be caused by one of two other variances. These are outlined below: Labour rate variance This is calculated as: (Standard rate – Actual rate) × Actual number of hours An adverse variance could be as a result of the use of more qualified or a higher grade of workers; wage increases negotiated by trade unions; unrealistic budget; labour shortages; and higher inflation rate causing higher wages. The converse of the aforementioned could cause a favourable variance. Labour efficiency variance This is calculated as: (Standard time for actual production – Actual time) × Standard wage rate A favourable variance could be caused by an improvement in the workers’ morale; the use of more qualified workers; and a significant decrease in ‘down’ or idle time. Direct material variance This is a measure of the amount by which the actual costs of material used differ from the budgeted amount. This difference could be caused by disparity in the price paid for the material and the budgeted price and also a greater or lower use of material per unit than budgeted. For example: a manufacturing company budgeted that 3,000 units of a product should have been produced in the period, at a material cost of $15 000. However, at the end of the period only 2,500 units were produced, at a material cost of $14 000. The material variance report would be: Budgeted costs of 2,500 units (2,500 × 5) $12 500 Less: Actual costs (14 000) Total material variance (1 500) adverse Direct material variance is often caused by one of two variances which could result in costs being different from budgeted. These are: Material usage variance This is calculated as: (Standard quantity for actual production – Actual quantity used) × Standard price An adverse material usage variance could be caused by an unrealistic budget; theft; inferior materials being purchased; poor inventory management; and outdated or faulty machines resulting in wastage. Note that the converse would be the cause of a favourable variance. This variance shows the efficiency with which materials were converted into finished goods. Material price variance This is calculated as: (Standard price – Actual price) × Actual quantity of material purchased A favourable material price variance could be caused by an unpredictable reduction in the price of materials; the firm may have received discounts or a special deal; low- 171 172 MODULE 3 | UNIT 1 | BUSINESS FINANCE AND ACCOUNTING quality materials were purchased instead; or the budget was unrealistic. This variance shows the efficiency of the Purchasing Department in buying materials at relatively low cost. CHAPTER SUMMARY A budget is a financial plan or statement which shows specific objectives or targets that a business hopes to achieve over a given period of time. The budgets prepared by firms include master budgets, production budgets, sales budgets and cash budgets Budgetary control is used by firms to monitor performance and plan effectively for the future MULTIPLE CHOICE QUESTIONS 1. A financial plan or statement which shows specific objectives or targets that a business hopes to achieve over a given period of time is called a: a. Cash flow statement b. Budget c. Forecast d. Profit statement 2. A distinct feature of budgetary control is: 4. Cash equivalent includes: a. Bank deposits b. Cash in hand c. Demand deposits d. Short-term liquid investments 5. Which of the following would lead to an outflow of cash from the business? a. A reduction in the inventory figure b. A loan given to the firm a. Organising c. A reduction in the creditors figure b. Managing d. Sales of fixed assets c. Planning d. Delegating 3. There are three main types of budgets: fixed budgets, flexible budgets and zero-based budgets. ‘This budget is drafted based on the need of each activity as opposed to the basis of past spending bearing inflation in mind.’ This definition best describes a: a. Master budget b. Zero-based budget c. Fixed budget d. Flexible budget 173 17 LEARNING OBJECTIVES: At the end of this chapter students should be able to: Define ‘investments’ Identify the types of investment Define ‘investment appraisal’ State the usefulness of investment appraisal Discuss the four methods of investment appraisal Calculate each method of investment appraisal Discuss the qualitative factors that influence an investment decision Outline the limitations of investment appraisal Investment T his is generally defined as the purchase of capital goods – that is, goods used to produce other goods and services. In other words, it includes the expenditure by businesses or people on items which are used to produce goods and services in the future, such as equipment and buildings. Businesses make the decision for a number of reasons, including: For expansion of productive capacity Purchasing modernised equipment Replacing obsolete assets To foster automation of the company For expansion of the firm itself through mergers or joint ventures. Regardless of the reason(s) for investment decisions, the firm needs to take into consideration the different methods used in the appraisal of investment. Investment appraisal This a quantitative technique used by firms to assess the attractiveness and viability of different capital projects. It describes how businesses compare and evaluate investment projects in order to ascertain whether or not they will be profitable. Since these projects are usually funded by large amounts of expenditure, which cannot easily be reversed, Investment Appraisal care must be taken in making such decisions. In doing so, firms will consider the initial costs, expected benefits and costs, risk involved and possible alternatives. The firm may consider the following methods of investment appraisal: Payback period Average rate of return Net present value Internal rate of return. Analytical methods of appraisal Payback period Payback period is the time that cash inflows from a capital investment will take to be equal with the initial outflow of funds. Firms will normally invest in the project that takes the shortest time to be repaid – that is, the shortest payback period. This is calculated as: Amount required × 12 Net cash flow per year For example, the initial capital outlay for Project A is $30 000 and it is expected that the project will earn $15 000 annually. The payback period would be equal to: 30,000 × 12 = 24 months or 2 years 15,000 ACTIVITY KEP Industry is thinking of investing in a new machine, at a cost of $35 000. It is expected that the machine will generate cash inflows of $10 000 and has an expected life of five years. Calculate the payback period. Alternatively, payback can be calculated in a tabular form, as seen below. KEP Industry is analysing two investment options in an attempt to make a decision on which one to invest in. Table 17.1 (p 174) shows the initial capital outlay and the annual cash inflow that each project is expected to return. 174 MODULE 3 | UNIT 1 | BUSINESS FINANCE AND ACCOUNTING Year Initial investment 0 Cash flow 1 2 3 4 5 Project A Project B (15 000) 5 000 3 500 3 000 2 500 1 000 (15 000) 1 500 3 000 5 000 6 000 6 500 Table 17.1: KEP Industry initial capital outlays and annual cash inflows Disadvantages of payback period Payback is mostly a measure of liquidity and not of the overall worth of the project It does not take into account the expected life of the project It is not adjusted for the time value of money More than one project may have the same payback period even though the annual inflows are different. Answer EXERCISE Project A Project B Years Annual Cumulative Annual Cumulative cash flow cash flow cash flow cash flow 0 1 2 3 4 5 (15 000) (15 000) 5 000 –10 000 3 500 –6 500 3 000 –3 500 2 500 –1 000 1 000 Nil (15 000) (15 000) 1 500 –13 500 3 000 –10 500 5 000 –5 500 6 000 500 6 500 7 000 Evaluating our answers: Year 0 represents the time when the investment would be made, while Year 1 means one year after the investment The brackets represent cash outflow Columns 3 and 5 show the balance at the end of each year Note that Project A would be paid for in Year 5, while Project B would be paid back within four years To calculate the months for Project B, express the remaining balance as a fraction of the total inflow for the year and multiply by 12. In Year 4, only $5,500 remained on the initial outlay, however, inflow was $6,000. The calculation is: 5 500 × 12 = 11 months 6 000 Therefore Project B has a payback period of 3 years 11 months, compared with 5 years for Project A, and so will be chosen. Advantages of payback period Projects that are paid back quickly can improve the firm’s growth and liquidity Payback is easy to calculate and interpret It is said to be more objective since its focus is on the project’s cash flows rather than on profitability A project which has a quick payback period minimises time-related risks – for example, a decrease in the value of money. Examine the data in Table 17.2 and then answer the questions that follow. Year Initial investment 0 Cash flow 1 2 3 4 5 Project A Project B Project C (30 000) (18 000) 6 500 2 500 7 200 3 100 10 600 5 600 9 800 4 200 10 200 6 900 (50 000) 15 000 12 000 10 550 9 640 9 000 Table 17.2: Initial capital outlays and annual cash inflows for three projects 1. Calculate the payback period for each of the three projects above. 2. Which project should be chosen? Give one reason for your answer. Average rate of return (ARR) Average rate of return is also referred to as ‘accounting rate of return’. It shows the average profit per year expressed as a percentage of the initial capital outlay. This is calculated as: Average return (profit) per annum × 100 Initial investment Before the calculation is done, the following steps should be taken: 1. Calculate the profit from each project. This is done by subtracting the initial capital outlay from the total cash inflows of the project 2. Calculate the average profit per annum by dividing the profit, from Step 1, by the duration of the project 3. Calculate the ARR with the formula given above 4. After the ARR is arrived at for each project, the project with the highest percentage should be chosen. CHAPTER 17 | INVESTMENT APPRAISAL Year Capital outlay Cash inflow 1 2 3 4 5 Total cash inflow Project A Project B 35 000 25 000 6 000 8 000 8 000 10 000 12 000 5 000 7 000 8 000 10 000 10 000 44 000 40 000 Table 17.3: Initial capital outlays and annual cash inflows for two projects For example, see Table 17.3: Step 1: Profit each year: Project A ($44 000 – $35 000 = $9 000) Project B ($40 000 – $25 000 = $15 000) Step 2: Average profit per annum: Project A ($9 000/5) = $1 800 Project B ($15 000/5) = $3 000 Step 3: Average rate of return: 1 800 × 100 = 5.14% Project A 35 000 3 000 × 100 = 12% Project B 25 000 Step 4: Project B should be chosen, since it has a higher ARR than that of Project A. EXERCISE A firm is considering producing one of two products. Table 17.4 contains the forecasted data for both products. Year Capital outlay Cash inflow Total cash inflow 1 2 3 4 5 Project A Project B 160 000 200 000 15 000 40 000 46 800 62 200 57 500 25 900 45 700 66 400 68 900 62 500 221 500 269 400 Table 17.4: Forecasted data for Projects A and B 1. Calculate the average rate of return for both products 2. State, with a reason, which of the two products should be made. Advantages of ARR It is easily calculated and understood It fosters comparison between the company’s profitability and the expected profitability after the project is implemented It accounts for all the cash flows over the life of the investment. Disadvantages of ARR The timing of outflows and inflows of cash is ignored There are a number of methods for calculating ARR but none are universally accepted Does not take into consideration the time value of money The average profit, used to calculate the ARR, may not be representative of any year The duration of the project is not considered in its calculation. Before we discuss net present value (NPV), it is important that you understand the concept of discounted cash flow, as this is used in the calculation of the NPV. Discounted cash flow (DCF) The discounted cash flow (DCF) is a technique that takes into account the time value of money by equating its future value to what it is worth now. The DCF is normally used when calculating the NPV and the internal rate of return. It is evident that whatever our money is worth now will not be the same as it will be in the future. In other words, money will lose its purchasing power, especially as inflation rises. The firm would rather receive money owed to it now, as deferring payment may mean loss of revenue if its debtors are unable to pay in the future and the firm could invest the money now in order to generate interest. Two important features of the discounted cash flow are that: Cash flows are used to calculate the return on a project instead of accounting profit The cash flow for each year should be discounted so that the annual return is representative of the present value of money. The discount factor can be calculated using the following formula: 1/(1 + r)n where ‘r’ is the interest rate and ‘n’ is the period in number, usually in years. However, you are not required to calculate this, as it is usually given. Table 17.5 (p 176) shows an extract of discount factors for $1. 175 176 MODULE 3 | UNIT 1 | BUSINESS FINANCE AND ACCOUNTING Interest rates (c)% Periods (n) years 6% 8% 10% 12% 14% 15% 16% 18% 20% 1 2 3 4 5 6 7 8 0.943 0.890 0.840 0.792 0.747 0.705 0.665 0.627 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.870 0.756 0.658 0.572 0.497 0.432 0.376 0.327 0.862 0.743 0.641 0.552 0.476 0.410 0.354 0.305 0.847 0.718 0.609 0.516 0.437 0.370 0.314 0.266 0.833 0.694 0.579 0.482 0.402 0.335 0.279 0.233 (Source: Table A from Costing by T Lucey (5th edn), p. 552) Table 17.5: An extract of discount factors for $1 If you examine the table carefully, you will realise that, first, the higher the interest rate, the less the figure at which the money will be valued at the present time and, second, the longer the period of time (years), the less will be the value of the money received. This is seen by observing the figures by row and then by column. The discount factors are used to calculate the present value of the net cash flow. This leads us to the next investment appraisal method. Net present value (NPV) Net present value represents the value that the firm obtains when it discounts its cash inflows and outflows of a future investment project. It is calculated by multiplying the annual cash flows by the discount factor for a given interest rate. At the end of the period (usually in years), the present value of the cash is added to give the final figure or NPV. The firm will evaluate the proposed investment by analysing the NPV after the specified years for the project. There are three main things to look for in the analysis of the NPV of a project. If the NPV is: Positive – then the cash inflows will yield higher returns than it will cost the company to invest in it. In other words, the NPV will be more than the interest rate paid by the firm to obtain the capital. The project would be feasible Negative – then the returns from cash inflows are lower than the interest rate being paid or the cost to obtain the capital. In this case the project would not be feasible Zero – then the cash inflows will yield a return that is equal to the interest rate or the cost to acquire the capital. The project is still feasible. This will be examined further in the next section. Now examine the following example. Example Furniture Depot is thinking of purchasing a new machine. The estimated cash flows are shown below: Year Cash flows ($) 0 1 2 3 4 5 (150 000) 40 000 60 000 50 000 30 000 15 000 The cost of capital is 10 per cent. Calculate the NPV of the project and then assess whether or not it should be undertaken. Answer Year Cash flow ($) Discount factor @ 10% Present value ($) 0 1 2 3 4 5 (150 000) 40 000 60 000 50 000 30 000 15 000 1.000 0.909 0.826 0.751 0.683 0.621 (150 000) 36 360 49 560 37 550 20 490 9 315 Net present value + 3 275 Based on the calculation, the present value of cash inflows surpasses the present value of the cash outflow by $3,275. This means that if the project is undertaken, it will earn discounted returns in excess of 10 per cent. The project should therefore be undertaken. EXERCISE J & K Ltd is thinking of investing in a new plant. The estimated cash flow is shown below: Year Cash flows ($) 0 1 2 3 4 5 6 (500 000) 240 000 200 000 150 000 110 000 80 000 50 000 CHAPTER 17 | INVESTMENT APPRAISAL The cost of capital is 8 per cent. Calculate the NPV of the project and then assess whether or not it should be undertaken. Advantages of net present value Takes into account the size and time value of cash flow Includes interest rates in the calculation of present values It is seen as a direct measure of the ‘per dollar’ contribution to investors It is flexible in terms of changing economic conditions, as discount rate can be adjusted to reflect the market situation. Disadvantages of net present value The results gained are largely dependent on the discount rates used in its calculation. Therefore if the expectation of interest rates is inaccurate, the results will also be inaccurate It may be difficult to calculate, as it is largely numerical It ignores the qualitative factors affecting a decision. firm may compare the IRR with the interest rates. Where the interest rate is less than the IRR, the project will yield a positive NPV and so is viable for investment. Conversely, where the interest rate is greater than the IRR, the project will yield a negative NPV and so should not be considered. The calculation of the IRR can be a very tedious process, even though it can be done with a programmed calculator or spreadsheet program. However, the options available to firms include an estimation of the IRR using an interpolation method. Knowing how to carry this out is not a requirement for students at this level. Alternatively, firms may randomly choose different discount rates until one returns an NPV of zero. Again, this may be time consuming. Based on earlier discussions (see DCF above), it is evident that the higher the interest rate or cost of capital, the lower the NPV. This therefore suggests that there is an indirect relationship between the NPV and the discounted rate. This relationship can be shown graphically, by using the following steps: 1. Choose two discount rates – one that will return a positive NPV and the other a negative NPV (for example, 10 per cent and 16 per cent, as seen in Table 17.7) EXERCISE Year DGF Company Ltd has three options in terms of projects to invest in. The information for the three projects is shown in Table 17.6: Cash flows 0 (initial outlay) 1 Net receipts 2 3 4 5 Net present value (10 000) 1.000 (10 000) 1.000 (10 000) Project L Project M Project N Initial cost 60 000 48 600 52 000 Year 1 2 3 4 5 12 200 13 400 10 200 9 600 8 750 9 400 12 400 13 500 14 800 16 800 16 000 17 200 17 400 18 000 18 650 Table 17.6: Investment information for DGF Company Ltd The cost of capital is 12 per cent. 1. Calculate the NPV for each of the three projects 2. Assess which of the three projects should be undertaken. Internal rate of return (IRR) Like the NPV, discounted cash flow is also used to calculate the internal rate of return. The IRR refers to a discounted rate of return which, when calculated, gives an NPV of zero. When assessing the viability of an investment project, the 10% DCF 16% DCF 3 000 0.909 2 727 0.862 2 586 3 000 3 000 3 000 3 000 0.826 0.751 0.683 0.621 2 478 2 253 2 049 1 863 1 370 0.743 0.641 0.552 0.476 2 229 1 923 1 656 1 428 (178) Table 17.7: Information for NPV/DCF analysis 2. Plot the two points on a graph. See Figure 17.1 (p 178) for an example. From the graph, you will realise that the NPV becomes zero somewhere between the discounting rates of 14 per cent and 16 per cent. The exact figure can be found by using the formula in Step 3 3. Use the following formula to calculate the IRR: C IRR = X + D × E where: X is the rate that gives a positive NPV D is the difference of the two rates used to calculate the NPV 177 178 MODULE 3 | UNIT 1 | BUSINESS FINANCE AND ACCOUNTING NPV $ 1600 1400 1200 1000 NPV 800 600 400 200 0 When assessing an investment project, it is also advisable to take into consideration the qualitative factors, including: How employees will react to the proposed investment project Whether or not there are any environmental implications of undertaking a project The social consequences of the investment decision The sources and availability of funds An assessment of the correlation of the firm’s objectives and the planned investment project. -200 -400 10% 12% 14% 16% Discounting rate (%) Comparison of methods of appraisal See Table 17.8 for an overview. Figure 17.1: NPV graph C is the positive NPV E is the sum of the positive and negative NPV (ignore the negative sign). Therefore: 1 370 IRR = 10% + 6% × = 15.31% 1 370 + 178 4. Compare the IRR with the cost of capital. If the cost of capital is less than the IRR, then the project can be undertaken, and vice versa. ( Appraisal Measurement method Similarities/Differences Payback Measures liquidity of the firm in terms of how soon a project can pay for itself While similar to NPV in terms of considering the ability of the annual cash inflows and the ability to recover the amount invested, it does not take the time value of money into consideration. This means that, in reality, the projected inflows could be overstated in real terms ARR Measures profits in terms of how profitable each investment project is expected to be Profits could be overstated, especially since it does not account for changes in the present value of money, unlike the NPV and IRR NPV Measures the time value of money. Shows how a project will be paid for using the present value of the cash inflows This is only as reliable as the discount rate that is used to calculate it. The wrong discount rate could distort the final calculation. However, considering the time value of money gives the firm a more realistic view of the project and its ability to generate inflows to pay for itself IRR Measures the returns to be received from investment. This is then compared with the interest rates While the IRR considers the time value of money, using it alone to make a decision regarding investment may not be advisable, as a very high projection for IRR may not be realistic ) Advantages of IRR It considers the amount and the time value of cash flows It is more concerned with the percentage return than cash flows, therefore can be used for meaningful comparisons among projects with different initial outlays. Disadvantages of IRR Its calculation can be a very tedious process It sometimes gives unrealistic rates of return. Limitations of investment appraisal The result of investment appraisal is only as reliable as the data. The projections made are based on expectations and should not be taken as a guarantee It only considers quantitative factors and ignores important qualitative factors such as employee and community reaction to the proposal made The techniques used depend on the skills and ability of its users in interpreting the results as it relates to an investment project. Table 17.8: Comparison of methods of appraisal CHAPTER 17 | INVESTMENT APPRAISAL CHAPTER SUMMARY Investment is more than just spending on goods and services. It includes spending on capital goods which are used to generate income or produce other products The main quantitative methods used by businesses to evaluate investment are: payback period, average rate of return, net present value and internal rate of return MULTIPLE CHOICE QUESTIONS 1. Which of the following is NOT a quantitative technique used for investment appraisal? Businesses evaluating investment projects should also take qualitative methods into consideration, including: employees’ contribution, social consequences and environment impact. 4. Discounted cash flow is used to calculate the: I. Net present value II. Payback period a. Payback period III. Average rate of return b. Internal rate of return IV. Internal rate of return c. Availability of funding a. I only d. Net present value b. I, II, III only 2. The IRR is found where the NPV is: a. Greater than zero but less than one b. Greater than one c. Less than one d. Equal to zero 3. A positive NPV suggests that: a. Cash inflows will yield higher returns b. Cash inflows will yield equal returns c. Cash inflows will yield lower returns d. Cash inflows will yield zero returns c. IV only d. I and IV only 179 180 MANAGEMENT OF BUSINESS UNIT 1 – PAPER 2 END OF UNIT TEST DURATION OF TEST: 2hr 30min INSTRUCTIONS TO STUDENTS 1. This test consists of THREE sections 2. Each section has TWO questions 3. Candidates MUST answer ONE question from EACH section END OF UNIT ASSESSMENT MODULE 1: BUSINESS AND ITS ENVIRONMENT Answer ONE question from this module Question 1 When Kerry was made redundant by her employer after 15 years she knew that it was time to create her own business to prevent a recurrence happening to her in the future. She has shared her idea with two friends who want to come on board and form a partnership. She is also considering the option of inviting the other nine people who were made redundant at the same time as her to invest their severance money. a. Outline three (3) features of EACH of the three (3) possible business organisations that Kerry is considering. 9 marks b. Discuss four (4) benefits that Kerry could derive from starting a private limited company as opposed to a sole trader. 16 marks Total 25 marks Question 2 a. Outline two (2) ways in which a firm could behave socially responsibly towards the following: i. The customer ii. The environment iii. Shareholders 6 marks b. Decision making is very important to any business organisation. A manager making a decision could follow a number of steps as outlined below: i.Definition of the problem ii.Data collection sources iii.Analysis and evaluation iv.Formulation of alternative strategies v.Implementation Discuss EACH stage in the decision-making process and outline how they would apply to a firm that is experiencing low profitability in the last two quarters. 15 marks c. Explain two (2) ways in which technology could NEGATIVELY affect the decision making of a firm. 4 marks Total 25 marks 181 182 END OF UNIT ASSESSMENT MODULE 2: THE MANAGEMENT OF PEOPLE Answer ONE question from this module Question 3 a. Frederick Taylor is often viewed as the ‘Father of Scientific Management’ and has made numerous contributions in the early days of the study of management. Discuss three (3) contributions that his theory has made to modern-day management. 9 marks b. Explain the terms ‘synergy’ and ‘entropy’ in terms of the System Theory. 4 marks c. Discuss four (4) functions that a typical manager has to carry out. 12 marks Total 25 marks Question 4 a. Explain the following two (2) concepts: i. delegation and ii. span of control. 6 marks b. Briefly discuss how the leadership style used by a manager can negatively affect the level of motivation among workers. 4 marks c. Outline the five (5) stages of team or group development. 10 marks d. Outline two (2) benefits and one (1) disadvantage of working in teams. 5 marks Total 25 marks END OF UNIT ASSESSMENT MODULE 3: BUSINESS FINANCE AND ACCOUNTING Answer ONE question from this module Question 5 a. Discuss three (3) ways in which a firm can manage its working capital. 9 marks b. Explain three (3) ways in which a firm having working capital problems can increase its working capital. 9 marks c. Given the following information, calculate the gross profit/ loss for JB Smart for the year ended 30 November 2013. 7 marks Details Amount $ Returns inwards Purchases Inventory at 1 Dec 2012 Sales Returns outwards Carriage inwards 5 800 80 400 22 450 120 050 6 740 8 750 *Inventory at the end of the period was valued at $18 645 Total 25 marks Question 6 At the end of the financial year, 31 May 2013, Trimmer Enterprise had the following data in its books: $ Fixed assets Current assets: Inventory Accounts receivable Cash at bank Less: Accounts payable Financed by: Capital (1 June 2012) Net profit Less: Drawings $ 30 700 7 320 4 000 23 260 10 500 11 940 12 760 43 460 36 470 10 680 47 150 3 690 43 460 Note that other important information from the profit and loss accounts reads: Opening inventory $9 600 and is already incorporated in the cost of sales figure; Sales $58 900; and gross profit was $15 250. a. Compute the following ratios: i. Gross profit margin ii. Net profit margin iii. Acid test iv. Stock turnover v. Return on Capital Employed (using average capital) 15 marks b. Evaluate your answers above and then explain what the implications for the firm are in terms of the ratio calculated. 10 marks Total 25 marks 183 184 Unit 2 APPLICATIONS IN MANAGEMENT 185 Module 1 Production and Operations Management 18 The Nature of Production LEARNING OBJECTIVES: At the end of this chapter students should be able to: Describe the production process Outline the four major decisions that are made in production Explain the factors that influence the decisions of what, how, when and where to produce Assess the advantages and disadvantages of the methods of production Outline the factors that influence the method of production used Now let us look at each stage of the process more closely: Input This is the raw materials or components of production. It represents the items that a firm is going to convert to a finished product. It includes things such as bauxite, gold and agricultural produce. These raw materials would come from the factor of production – land. It is important to note that a finished product from one industry could be used as an input in another industry. For example, flour, which is the end result of processing wheat, could now be used in a bakery as an input to bread production. Throughput B efore we discuss the major decisions in production it is important first to define production. The term ‘production’ is seen as any activity that a firm undertakes to add value to the factors of production by converting them into another product. For example, production takes place when bauxite is converted into alumina. The production of any good has to go through a process which is often referred to as the ‘production process’. The production process The production process outlines the steps involved in converting input to output. This process is divided into three sections: the input, the throughput and the output. See Figure 18.1. Input Throughput Output Figure 18.1: The production process This is the process that the raw materials or components go through before being converted into finished products. The range of processes will differ from industry to industry but may include things such as crushing, melting, moulding, welding, cooking and baking, etc. Output This is the outcome of the conversion of inputs (raw materials). The output represents the finished goods that have been generated from production. It includes such things as bread, aluminium, banana chips or a gold knob. Factors of production The production process would not be successful without the factors of production. These are land, labour, capital and entrepreneurship and they represent inputs into production for the purpose of making a profit. However, before production can begin there are certain decisions that must be made by the firm. These decisions are imperative because of the economic problem known as ‘scarcity’. This is a condition where resources are limited but human wants are unlimited. Therefore, the firm will never be able to fulfil the wants of everyone. It will then have to make decisions on what to produce, how to produce, when to produce and where to produce. Each of these questions will be explored in detail below. 186 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT What to produce? This question is particularly important to any organisation. Firms generally go into business to make profits and are driven by the profit motive. Therefore, they seek to produce those products that will return the highest profit. The revenue that will be gained from the production of any product must be able to cover the costs that will be incurred in its production. The decision of what to produce is largely influenced by the level of demand for the firm’s product. ‘Demand’ is defined as the willingness and ability of a person to purchase a particular product at a particular price at a particular period of time. Simply put, it is an individual want backed by the ability to pay. To this end, the product with the highest demand will be produced. In order to ascertain the needs and wants of consumers, the firm usually conducts market research. This will be discussed in Module 2. Essentially, though, market research is used to gather information from consumers for the firm. The information gathered can assist the firm in developing a product that caters to the need of the consumers. Another important, yet not very popular, influence on what to produce is the practice of producing what the firm can and then trying to find a market for the product. Some organisations will produce the products that they have the technology and machinery to produce. Instead of finding out what consumers want, the firm will produce the product that its current equipment and technology can produce. This practice is linked to the production concept that will be explored in Module 2. The financial viability of the product is another factor that would influence its production. The producer would want to know that the product will be able to make enough money to cover the investment costs and also earn a profit in the foreseeable future. Production methods Having made a decision on what should be produced, the producer must now decide on the method of production to use. The production methods available to the firm are discussed below: Figure 18.2: An example of job production CHAPTER 18 | THE NATURE OF PRODUCTION Job production Job production is used when a single product is produced to meet individual specifications. Such products are usually a one-time production built to the buyer’s design and specifications – for example, a custom-built car, a wedding dress, ship building or bridge building. Job production usually involves a single worker (for example, a dressmaker) or group of workers (for example, construction workers) working on the particular product. The following are some of the notable characteristics of job production: The focus is on the individual customer and not the entire market The product is usually highly priced The labour force is highly versatile and skilled Machinery and equipment are usually flexible so that they can be used for different jobs Only one product is made at a time. This form of production method is quite popular in the handcraft industry, where simple tools are used and each product is made at different times. While production may not be done on a large scale, there are advantages in using this method of production. Advantages of job production The product is tailored to the needs of the consumer It is easier to isolate any problem that may arise The workforce is greatly involved with the product, which will improve job satisfaction The product is usually of high quality. Disadvantages of job production Very high per unit cost Requires a very skilled and flexible labour force High spending on machinery and equipment Products are normally very expensive. Batch production With the increase in market sizes and demand, it would be impossible for firms to use the job production method to satisfy the needs of all their customers. There would then be a need to produce a number of the same products at the same time. This is made possible through the use of batch production. This method allows a group of products to undergo a production process at the same time. With batch production the work can be organised into a number of steps, with each batch of products going through each step at the same time before moving to the next step. For example, in the soft drinks industry, drink would be poured into a group of bottles, then corks would be fitted and then the batch of bottled drinks Figure 18.3: An example of batch production 187 188 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT would be labelled and so forth. Batch production is a popular method used in the food, chemical and pharmaceutical industries. Items that are made using this method carry a batch number which makes it easy for them to be traced in case of a problem with a particular batch of products. Batch production is known to have the following characteristics. Skill level of the labour force is relatively high but lower compared with job production Appropriate for repeated customer orders Equipment cost is lower, as one piece of equipment is used on a number of products Produces a standardised product Usually has a high inventory of work in progress Machines are organised and grouped based on the functions that they perform. Advantages of batch production Lower machinery requirement compared with job production Quality control can be done as the products pass through each process Lower labour costs, as workers are less skilled Takes less time to complete a product, so firms can respond quickly to orders Lower per unit costs as a result of large-scale production. Disadvantages of batch production Cash may be tied up in work in progress Machinery and equipment ‘down’ time as the firm switches between batches of products The level of motivation may be lower for the workforce Small batches of products may lead to an increase in unit costs. Flow production Where there is very high demand, flow production is the most suitable method to use. It involves the organisation of the work process in sequential steps so that each item passes through each stage before moving to the next. It uses a series of repetitive processes to produce standardised products. Unlike in batch production, the products are produced continuously and do not have to wait on a batch of products. The products pass through each stage via a conveyer belt or an assembly line. This method is used to mass-produce products and meet high demand. It makes use of division of labour and specialisation. Flow production has a very high capital outlay but cost can be recovered over time due to mass production and sales. Examples of flow production can be found in the car manufacturing industry and other large manufacturing plants. Flow production may take different forms, depending on the industry and the manufacturing process. These forms may include: Mass production – which involves the production of identical and standardised products. This type of production is done on a very large scale and requires the production of goods in a relatively short time. It is usually synonymous with high and sustained demand for the goods being produced – for example, household appliances Continuous flow production – this is where the product being produced goes through a continuous series of processes. There is no stoppage until the product is complete. This is often used in conjunction with process production Process production – as the name suggests, this form of flow production involves the product going through different processes until completion. It is used to convert raw materials into finished products, such as converting crude oil into petroleum products. The common features or characteristics of flow production are: Uses a greater amount of semi-skilled or unskilled workers The product price is lower due to mass production Firms experience economies of scale The process is highly automated Large amounts of raw materials and components A standardised product is produced Set-up cost is exorbitant. Advantages of flow production Lower ‘per unit’ costs as a result of economies of scale Large amounts of goods can be produced quickly Can be used to meet the ever-growing demands of the market There is a reduced need to store large amounts of finished goods due to the speed of production. Disadvantages of flow production Very high set-up cost If something goes wrong, the entire assembly line can be halted Quality is sometimes sacrificed for quantity Work can be repetitive and boring, which leads to low motivation for workers Usually inflexible, as it is difficult to alter the production process if consumers’ tastes change. CHAPTER 18 | THE NATURE OF PRODUCTION Figure 18.4: An example of flow production Cellular production Cellular production is also known as ‘cellular manufacturing’. It involves dividing the factory into cells that will carry out specific tasks on the product. Each cell is equipped with the machinery needed to complete that part of the product. Once the task is completed, the product will then move to the next cell. For example, in making a shirt one cell might be responsible for sewing sleeves and another collars or buttons. The shirt will pass through each cell before it is completed. Cell production could also be used to produce a particular product or product family. In this case, each cell would be independent of the others and the products produced will form a part of its production target. Cell production promotes teamwork and each member is responsible for maintaining quality and design of the product. Benefits of cellular production Quality is improved, as each cell has to ensure that quality is maintained Team working normally leads to increased motivation Improvement in the skill level of employees There is a reduction in the amount of floor space used, as each cell occupies less space than if an assembly line was being used The firm could see a reduction in work in progress. Disadvantages of cellular production The level of output may be less than if using a flow production method Capital and equipment costs could be very high. 189 190 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT CASE STUDY Must Stop Restaurant and Bar George Gino operated for years as a street-side cook, providing meals for the farmers and construction workers in his little community. The revenue received has been able to take care of his expenses at the shop and at home. For years, though, George has been saying that one day he is going to set up shop in the parish capital so that more people can taste his trademark cooking. A month ago, George came into some money that his grandmother left for him in her will. This receipt of this money was very timely and George decided to fulfil his dream of operating in the parish capital. Having satisfied the necessary legal requirements, he established Must Stop Restaurant and Bar. Initially the restaurant catered for walk-in customers. However, George has secured a contract to provide lunches for the staff at a nearby school. He collects orders in the morning, prepares the lunches and then sends them to the school. In any given day George normally offers three types of meat prepared in different ways. This is served with a choice of rice and peas, white rice or pumpkin rice. These choices were based on a survey carried out in the area and at the school. George is also considering implementing a ‘call to order’ policy. This would allow people to specify how they would like their meals to be prepared. However, there are a number of hiccups with this policy so it has not yet been implemented. Questions 1. What is the most likely production method for George Gino to use in his restaurant? (2 marks) 2. Discuss three (3) advantages and two (2) disadvantages of using this method of production. (15 marks) 3. If George should implement the ‘call to order’ policy, which production method would it represent? Give a reason for your answer. (2 marks) 4. Outline two (2) advantages and two (2) disadvantages to George of using the method mentioned in Question 3 above. (6 marks) Total 25 marks Factors that influence the method of production used In the above section, the different methods of production were discussed. However, with options come choices and there are certain factors that will assist management in choosing the method of production to employ. Below are some of more popular factors: Nature of the good – the type of product to be produced may require a particular method of production. For example, tinned food is usually produced using batch production, while roads or houses will be produced using job production Expected sales (demand) – the expected level of sales or demand will influence the method of production chosen. If the organisation is expecting high sales or demand, it may need to employ a flow production method where goods can be produced quickly and in large quantities Size of the market – this factor has some connection with the preceding one. Larger markets usually mean higher demand for the firm’s products. As the firm expands its market reach or share, it also must expand its scale of production. This might result in the firm switching from a batch production method to flow production Stage of the product lifecycle – later in the unit we will examine this concept. However, a product that is in its growth stage may require mass production but a slowing down of production as it reaches the decline stage The level of technology – flow production requires a large amount of automation compared with the other two popular methods. The level of technology to which the firm has access will definitely determine whether or not it can utilise the desired production method Initial capital outlay – the final decision of the firm in terms of its production method rests largely on its ability to afford the cost of setting up its production facility. The method of production used will be influenced by the firm’s ability to afford or secure funding for the machinery and equipment needed to start production. CHAPTER 18 | THE NATURE OF PRODUCTION CASE STUDY Do it when called Mr Woodcarver is a furniture maker with many years of experience under his belt. He is known for his carefully made furniture that is usually made to the customer’s specification. His little business employs four people who assist in the finishing of the items when ordered. For years Mr Woodcarver has waited until an order was made before he purchased raw materials and started building the piece of furniture. He keeps very little stock of wood and furniture spray because he doesn’t know the style and specifications of the customers’ orders until they place them. Over the years, Mr Woodcarver has recognised that furniture is affected by seasonal demand. He gets a spike in orders around the time nearing Christmas. Therefore he would not want to build the furniture in advance and have it taking up space for a while. Mr Woodcarver’s business is highly capitalised, with heavy-duty machinery of all kinds. This makes it possible for him to make almost any kind of furniture as soon as he receives the order to do so. Questions 1. What type of production method is described in the case above? 2. What are three (3) benefits and three (3) costs to Mr Woodcarver of using this type of production method? 3. Describe two (2) factors that could have influenced Mr Woodcarver in choosing this production method. When to produce? While the new Management of Business syllabus removed this area, it is worth discussing in brief. With marked improvements in production capabilities and technology, there are a number of products that you will see all year round. However, there are still a number of products that will only be produced or you will only be able to purchase during certain times. The producer must then ask the question ‘When to produce?’. The timing of production may be influenced by a number of factors: Storage space and costs The available space for storage and the cost of storing the products are two of the deciding factors of when to produce. If the rate of sales turnover is low, then the firm might find that a lot of money will be wasted in trying to secure stock and dealing with spoilage or outdated products. In order to minimise the aforementioned problems firms can utilise the principle of economic order quantity (EOQ). This principle is used to calculate the optimum level of stock that should be held by the firm in order to reduce costs. There will be further discussion on EOQ in Chapter 22. Seasonal demand Products that are sold year round are less affected by this factor and the firm can produce whenever it chooses. However, for seasonal products, such as some agricultural products, Christmas ornaments or Easter buns, the firm (2 marks) (12 marks) (6 marks) Total 20 marks may have a challenge. As it prepares for these seasons, the firm has to produce sufficient amounts to meet the peak in demand but has to ensure that it is not left with a lot of stock after the season has finished. To this end, careful research and planning have to be done so that the right amount can be produced at the right time. Lifespan of the product A product that perishes easily and quickly cannot be produced too long before its actual sale. This is particularly important for the food industry. A restaurant would not want to cook its meals too early, as it may have to discard everything due to spoilage. Products that have a long shelf life can be produced at varying times since spoilage may not be an immediate issue – for example, appliances. Location of production The last of the questions that are asked in production, though equally important as the others, is ‘Where to produce or locate?’. Location is the key to the success of the business. Identifying the ideal place for location may mean the difference between having a customer base or not. However, there are some businesses or industries where location is not paramount, as the firm’s success is not tied to its location. Such industries are referred to as ‘footloose industries’. These are industries whose location is neither influenced by the market or sources of raw material nor tied to any area so 191 192 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT that it cannot relocate – for example, an e-service centre as opposed to an oil refinery. It is also important in discussing location that the concept of industrial inertia be explained. This occurs when a firm refuses to relocate even after the original benefits of locating in that area have gone. The firm may not want to relocate because of the costs involved in relocating or it may have developed ties with the area by being a good corporate citizen and a household name. Before a firm chooses an area to locate in, it must take a number of factors into consideration. These factors can be broken down into two broad categories: quantitative factors and qualitative factors. Each category will be analysed further below. market. The costs of transportation are often tied to the quality of the transportation system in the area. A good system may offer quality at a lower cost than a poor and expensive transportation system. Labour costs Quantitative factors refer to those that can be measured in monetary terms. They include: Human capital is an integral part of the organisation and is taken into consideration when seeking where to locate. The firm needs to ensure that labour is available and has the different levels of skills as needed. Some firms may desire to have cheap unskilled labour while another may want highly skilled or semi-skilled but no very expensive labour. If the category of labour needed by the firm is not available in the area of location, then it may incur huge costs in sourcing the desired category. The nature of the goods to be produced and the expected production method can be used to assist the firm in making this decision. Site costs Government incentives These are possibly the first costs that would come to a potential investor’s mind when making a decision to locate in an area. Site costs are usually fixed and so should be of utmost concern to the business. This means that once the firm occupies the location these costs will be incurred even if it does not produce any unit of the product. Site costs usually include the purchasing of property, payment of rent or lease and modification costs or construction costs. Other costs such as payment of taxes, fees and utilities are sometimes added to the previous list. The firm may want to locate in an area where the site costs are manageable. It has to be careful, however, that it does not locate in a remote area because of the low costs. This could mean that sales will be low and the business may fail. At the same time, it should not locate in an area where costs are exorbitant as it might not be able to cover those costs and could go bankrupt fairly quickly. Some governments may give firms an incentive to locate their business in particular areas. This is particularly important where the government aims to develop or redevelop the area. It could grant firms tax breaks or holidays or the firm could benefit from zero-rated construction materials and customs-free shipment of equipment. An example of this would be the new Digicel headquarters building which was constructed on the waterfront in downtown Kingston, Jamaica in a bid to encourage other investments as a part of the redevelopment project for the capital city. Quantitative factors affecting location Transportation costs The firm would want to ensure that the transportation cost is not too high, whether transporting raw materials or finished goods. It should take the necessary steps to minimise such costs. This could be done by, for example, locating close the source of raw materials or close to the market. The firm would have to make a decision on which of the transportation costs would be greater – that is, transporting raw materials or finished goods to the market. The general idea is to locate closer to the one that will cost more to transport. For example, if raw materials cost more to transport then the firm may want to locate nearer to the raw materials and then transport the finished goods to the Revenue potential When all is said and done, the firm’s main aim is to make money – and lots of it. Therefore in addition to assessing the different costs that might be incurred in locating in a particular area, the firm must also examine the revenue potential of locating there. If the firm is able to generate huge revenues in a particular location it will find it easier to pay the costs associated with the location. For this reason some firms will locate in very expensive areas such as cities or towns because they can generate high revenues from that area. Qualitative factors affecting location Qualitative factors are those that cannot be measured numerically or in monetary terms. They include: Infrastructure This is an important factor in determining location, especially in this 21st century. A firm must consider the level of infrastructural development in the area in which it wishes CHAPTER 18 | THE NATURE OF PRODUCTION to locate. It should consider factors such as communication, quality of transportation system and quality of the physical infrastructure such as roads and bridges. Firms are quite aware that not all customers will walk into their buildings to make a purchase. This means that there must be a proper transportation system in the area of location. A good system is needed to bring raw materials to the firm on time so that production is not hampered. The higher the quality of the transportation system, the greater will be the freedom of the firm in choosing a location. For example, a firm could locate on the outskirts of the city and transport its products rather than paying the high rent on lands in order to locate in the city. With the rapid growth in e-commerce, firms would want to know that there is internet access in the location so that they can explore online options for sales and receipt of payment. Environmental and planning consideration With the realities of global warming reaching most, if not all, countries, environmental agencies have become more vigilant in their pursuit of firms that breach such laws. To this end, and with more firms displaying corporate social responsibility, the firm must take these issues into consideration when deciding on a location. Firms have to be mindful of the environmental effects of production and how locating somewhere will affect town planning activities. Management preferences This is a deliberate attempt by the most senior managers of a firm to influence where it is located. The fact that managers have certain preferences can sway the firm’s locating decision. Where the firm is new, the investor may have a particular preference for an area and so decide to locate the business there. Some investors set up businesses in their childhood communities, to give something back there in terms of job creation. Other factors influencing location Closeness to market If the firm’s products cannot reach the market, it may run into financial problems. Therefore the accessibility of the market is very important. The firm should ensure that its customers can easily access its products. Where the business is offering a service, accessing the consumers is even more important as where there are no consumers there is no sale. Large manufacturers of products that may need to be shipped will locate near to a port for ease in getting the products to the market. Available services and amenities The organisation needs to ensure that the place of location has some basic services and amenities. These include utilities (electricity and water), proper waste disposal and education and training facilities. A major problem in most Caribbean countries is that of the cost of electricity. This is largely because of their dependence on oil for energy. As a result, the firm has to assess carefully its location and how it can lower its energy bill. Locating in a country with high energy cost and little alternative could see the firm incurring huge costs of production. For example, the level of energy consumption by giant car maker Toyota would make it virtually impossible for its plant to be located in CARICOM. For many years, bauxite-producing countries such as Guyana and Jamaica have had to export alumina since they are not able to generate the electricity needed for aluminium production. Locating near educational institutions may help to solve the problem of finding skilled labour. This will also provide the firm with the opportunity of honing the skills of the present labour force. Some businesses may want to locate in an area with other services such as shopping facilities, entertainment and proper housing. Legal and political factors The firm has to think about the political stability of the area in which it wants to locate. If the area is known to have political upheavals and instability then it might not be a good idea to locate there. Locating in these areas could lead to a loss of investment. Firms must also consider the laws of the country in which they want to locate. There are some areas where businesses are not allowed to locate, such as residential areas or certain parts of cities. Other laws may include the Town and Building Act and the Noise Abatement Law. ACTIVITY Try to identify the laws that would affect the location of businesses in your country. Geographical factors This factor is most important for businesses in the agriculture industry. The climatic condition of some areas does not make it feasible to grow certain crops. The firm will have to assess the topography and chemical structure of the land before locating there. 193 194 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT CASE STUDY Finding the ideal location When Ms Optimistic decided to start her boat parts business, her biggest issue was finding the ideal location. The fact is that not many people on the island own boats but rather specialise in automobiles. This meant that she will have to locate where the owners of boats can gain easy access to the business. Ms Optimistic did some research and realised that to locate in the major town would be very expensive because of the high rental price for shop space. There was also a congestion problem and it would be difficult for the trailers that deliver stock to unload. She would need to explore other options. She heard of a house selling in her quiet residential community of Rosewell and decided to buy the property for the purpose of the business. The house has a large enough yard space and the roads are wide enough to accommodate the trailers carrying stock to her business. The house was purchased and the business started operating out of Rosewell. Things went on fine for the first couple of months until the community Citizens’ Association became concerned that their uptown residential community was being commercialised by this business and they now want it shut down by the authorities. Their argument is that the rest of the houses in the community are going to lose their value, there is increased commuting by customers, increased noise level, the trailers are damaging the roads and the business in general is defacing the community. The future is now looking dim for the young optimistic entrepreneur. Questions 1. Briefly explain why, in your estimation, location was so important to Ms Optimistic. (2 marks) 2. Describe one (1) quantitative and one (1) qualitative factor that influenced the location decision of the firm. (6 marks) 3. Based on your discussions in class about location, evaluate the decision that was made by Ms Optimistic to locate in Rosewell. (12 marks) Total 20 marks CHAPTER SUMMARY The four factors of production are: land, labour, capital and entrepreneurship Batch production method allows a group of products to undergo a production process at the same time Firms are faced with four major questions when deciding on production (what, how, when and where to produce) Flow production uses a series of repetitive processes to produce standardised products Job production is used when a single product is produced to meet individual specifications Industrial inertia occurs when a firm refuses to relocate even after the original benefits of locating in that area have gone Location is the key to the success of the business, as identifying the ideal place for location may be the difference between having a customer base and not. CHAPTER 18 | THE NATURE OF PRODUCTION MULTIPLE CHOICE QUESTIONS 1. ALL of the following are factors of production EXCEPT which one? a. Land b. Capital c. Enterprise d. Technology 2. What is the name given to the process of adding value to resources? a. Value added b. Pricing c. Production 7. Which of the following methods of production is MOST LIKELY to be associated with the assembly line? a. Flow production b. Job production c. Batch production d. Cell production 8. The following are factors that influence the type of production method that is used, EXCEPT which one? a. Experience of the workers b. Nature of the goods c. Size of the market d. Level of technology d. Mark-up 3. The production method that is MOST LIKELY to benefit from economies of scale is: a. Batch b. Flow c. Job d. Product 4. Which of the following methods of production is most likely to be used by a sculptor? a. Job b. Batch c. Process d. Flow 5. The willingness of consumers to purchase an amount of a product for a particular price at a particular period of time is BEST defined as: a. Wants b. Supply c. Demand d. Purchasing 6. Which one of the following factors is MOST LIKELY to impact on the location decision of a restaurant? a. Geographical factors b. Legal and political factors c. Closeness to market d. Closeness to raw materials Extended Essay Questions Question one Total 25 marks Best Job Ltd is considering switching from using job production to batch production. a. Outline three (3) characteristics of each of the two production methods mentioned above. (12 marks) b. Briefly describe the batch production method and explain three (3) benefits and three (3) drawbacks of changing from job production to batch production. (13 marks) Question two Total 25 marks a. With the use of an example, describe the production process. (7 marks) b. Outline two (2) features of the flow production method. (2 marks) c. Discuss four (4) factors that would influence the location of a food processing plant. (16 marks) 195 196 19 Forecasting Techniques LEARNING OBJECTIVES: At the end of this chapter students should be able to: Explain the importance of forecasting Explain the difference between qualitative and quantitative forecasting techniques Evaluate each of the forecasting techniques normally used in production planning Calculate moving averages and least squares regression Qualitative forecasting techniques A qualitative forecast focuses on value judgement and the individual’s opinions of the future outcomes. The predictions made by using these techniques are usually subjective and are normally used when there are no historical data about the performance of the product – that is, in the early stage of the product’s lifecycle. The following are the common qualitative techniques that are utilised in production planning. Sales force composite P lanning for production is an integral part of any manufacturing business. Proper planning can result in cost savings and improvement in efficiency in terms of how scarce resources are used. The focus in this section will be on the tools available to assist with production planning and other concepts which are pertinent to production planning. Before you examine these concepts you should be clear on what a production plan is. Production planning is the process of outlining the steps to be taken in the production of a product. The plan should include the material requirements, machinery and equipment that will be needed or used, the sequence of activities and a time frame in which the product should be completed. Forecasting techniques Generally speaking, a forecast is a prediction of upcoming events. In terms of the business, it is an estimate of the possible future levels of costs, sales, stock or production. The scale of forecasting can be divided between microforecasting and macro-forecasting. Micro-forecasting deals with a prediction of the future performance of a specific department of the firm – for example, the firm may forecast sales for a particular product. Macro-forecasting deals with making a prediction for the overall market – for example, predicting the demand for the firm’s products. Forecasting techniques are classified under two categories. These are qualitative forecasting and quantitative forecasting techniques. There is a notion that the people who interact the most with customers can be very good predictors of future sales levels. The sales force composite technique relies on the sales force of the firm to make projections of the future levels of demand for the firm’s product. Since the sales force interacts regularly with customers, they are furnished with a repertoire of knowledge about trends in the market, change in customer choice, the product and the competitors’ behaviour. This method of forecasting uses the opinions of salespeople to formulate a prediction of sales in the future. Their inputs may be taken individually and then aggregated as the sales manager tries to map the trend of future sales. One point to note, though, is that this type of forecasting is best used in conjunction with other techniques. The main reason for this is that the opinions of the salespeople might be limited to that geographical area or be misguided. Advantages of sales force composite Relatively inexpensive to get information Information is almost readily available Salespeople have direct contact with customers They are knowledgeable about the firm’s product and competitors’ behaviour Their job responsibilities can enable them to offer insight about developing marketing trends Drawbacks of sales force composite Since estimates may be used as a benchmark for salespeople’s performance, they may be underestimated CHAPTER 19 | FORECASTING TECHNIQUES The information received may be limited to a particular locale and cannot be used generally This technique is based on opinions and not on statistical data of previous performance They may not have sufficient time to develop an accurate forecast. Delphi Method This method of forecasting, while relying on opinion, eliminates the possibility of each person being influenced by others. The Delphi Method uses a group of experts anonymous to each other to make a forecast of sales, among other things. The way the method works is that when the forecast is received from each member of the group it is summarised and then sent back to the other members. The firm will note the concerns and the group will revise their forecasts as needed until a final prediction is reached. This can be a long and tedious process but the results are normally more accurate than other qualitative techniques. The Delphi technique has been credited to Norman Dalkey and his colleagues from RAND Corporation for the work they did in the mid-1900s. In doing their research to generate a reasonable and feasible forecast, the group used a series of questionnaires which was sent to qualified individuals in different locations. The participants never met face to face but only sent their responses back to the corporation. Their responses were summarised and a new questionnaire was issued, based on the summary of answers. This was replicated until a group consensus was reached. This technique is said to have been successfully used in the tourism industry of Singapore and in the information industry in Taiwan. The Delphi Method has three distinct features which determine how it works: Participants are anonymous to each other, so limiting influence Feedback is organised and managed by the firm The final result reflects inputs from all participants. Advantages of the Delphi Method There is no need to conduct face-to-face interviews, which can be difficult to arrange Participants opinions are not influenced by each other or by a dominant individual Participants have time to think about their responses carefully and thoroughly The interpersonal issues of struggle for power, personality clashes or leadership problems are eliminated since there is no physical meeting It utilises experts from a wide geographical base, since communication is done via telephone or internet. Drawbacks of the Delphi Method The quality of the results is linked to the quality of the panel used for the forecast A poor survey instrument may hamper the research process and the information being sought The method is usually time consuming and expensive There is still a possibility of panel members being indirectly influenced to side with the majority. Consumer (customer) survey Consumer survey is a form of marketing research that is used to ascertain the level of potential demand for a firm’s product. In trying to make a forecast of future sales some businesses may seek to gather information from the very people who will be purchasing the product – that is, the customers. Since it is impossible to question every potential customer, a representative sample is usually selected. Sample selection and techniques will be discussed further in Chapter 28. Information collected through consumer surveys is usually gathered through the use of research tools such as interviews and questionnaires. The information collected is then analysed and a forecast can be generated about the buying intentions of prospective customers. The marketing team that is conducting the research has to ensure that the research instrument, questionnaire or interview, is tailored to gather the information that is needed by the firm. If these instruments are biased or questions not clearly stated, the final analysis might be misleading. The problem of misleading information can be lessened with proper planning for the research on the part of all the stakeholders involved. Different authors have included different steps in the research process. However, there are four main steps to the research process or consumer survey. Below is the general sequence of steps that should be taken when conducting a consumer survey. 1 Problem definition and survey objectives This is probably the most difficult but important step in the process. If management is not able to define the problem clearly and to set research objectives, the firm may end up wasting a lot of money. The objectives of the consumer survey must be clearly defined in order to resolve the problem. 197 198 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT 2 Create a research plan for collecting information Having established the problem and stated the research objectives, the next step is to develop a plan for research. This plan will outline the information that is needed to carry out the research and how this information will be ascertained. It also outlines the sources of data and instrument to be used in the process. 3 Collecting and analysing data In this stage, the researchers collect the actual data, using primary and secondary sources. Primary data is information that has been collected for the purpose of the particular research while secondary data represents information that already exists. The information gathered is then analysed to see similarities and trends. 4 Interpreting and reporting the findings At this stage, the researcher will assess and interpret the findings and draw conclusions. The final findings have to be reported to management which will assess whether the problem has been solved or the objective achieved. Advantages of consumer survey Producers can acquire first-hand information from the prospective users of the product The use of a representative sample gives producers the opinions of buyers from a wide cross-section. Drawbacks of consumer survey The intentions of buyers may not transcend into actual purchase of the product It may be difficult for some buyers to forecast their future needs The result may reflect the subjectivity of a bias research team. Jury of experts or executives This technique is based on the notion that the managers of the different functional areas of the firm are armed with knowledge that can be used to predict sales. How this technique works is that the sales forecasts of the executives are combined and averaged to ascertain a final prediction. The group of executives or jury of experts may be taken from departments of the firm including Finance, Marketing, Production or Purchasing. This would mean that the forecasting team would have diverse knowledge and experience and, by extension, opinions. Advantages of jury of experts It utilises internal managers, which makes it less expensive Forecasts can be done quickly The forecast is based on the knowledge and experience of top executives in the firm Disadvantages of jury of experts Managers sometimes lack the necessary knowledge and experience to predict sales accurately There is a possibility that some managers will be influenced by others in their judgment It is still based on the manager’s opinion and not statistical or factual data. CASE STUDY Planning for the future The success of any business often rests on its ability to plan for the future effectively and to implement those plans. This has been the hallmark of Paper All Ltd. This business operates in an environment where the demand for paper products is great and growing. Its location is central and it has a number of offices and schools in close proximity. The firm is now thinking of expanding its operation and wants to know whether this would be feasible. In order to do so it would need to forecast its sales for the next three years. This will be matched against the capital investment that the expansion will require. The company believes that such a forecast will be integral to its decision to expand. Therefore, the choice of forecasting technique will be very important. Questions 1. What is a forecast and why is it important that Paper All Ltd conduct one? 2. Describe two (2) factors that could influence the firm’s choice of forecasting technique. 3. Discuss, giving reasons, the type of forecasting technique that the firm should implement under the circumstances. Total (2 marks) (6 marks) (7 marks) 15 marks CHAPTER 19 | FORECASTING TECHNIQUES Quantitative forecasting techniques Unlike qualitative techniques, which are based largely on opinions, a quantitative forecast uses historical data and previous experience to forecast sales. This type of forecasting is preferred by most firms once the necessary data is available. It is believed that the pattern of sales in the pass will continue into the foreseeable future. Two of the more popular quantitative techniques will be discussed in this section. Sales Linear trend Quarters Moving average This statistical technique analyses a set of data points by creating an average of a subset at a time out of the entire set of data. Moving averages is particularly useful when demand for the product is fluctuating because it removes the effects of these random fluctuations. Since the technique is taking an average of a subset of data, it eliminates the fluctuation while creating a forecast. In calculating moving averages and using them to make a forecast, there are some important concepts to note. These are: Sales Exponential trend Fluctuations These often include: Seasonal fluctuations – include regular repeating patterns in the short term (within a year) which is usually associated with the different seasons of the year Cyclical fluctuations – include regular repeating patterns in the medium term (more than a year) which is usually associated with the business cycle Random fluctuations – include unpredictable or irregular changes in the data which can occur at any time throughout the year. Periods Sales S-curve trend Trends A trend is the underlying movement behind the collected data. Moving averages attempt to identify a particular trend in the actual data. Trend lines are usually used as the starting point in developing a forecast. Once the trend has been identified it can then be adjusted for seasonal fluctuations and any other events that might affect the final forecast. However, your exam at the CAPE level does not require you to plot and interpret these trends, as it focuses more on the calculation of the moving averages. Some common trends that are seen in forecasting are illustrated in Figure 19.1. Two distinct ways of calculating moving averages will be explored here. Time Periods Sales Fitted line Figure 19.1: Examples of common trends Simple moving averages (SMA) This method of calculation simply adds all the months or years under review and then divides the total by the number of months. The method uses the following formula: S + St – 2 + St – n SMA Ft = t – 1 n 199 200 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT The explanation of the formula is as follows: Ft is the forecast for the next period using SMA St – 1 is the actual sales figure in the previous period St – 2 is the actual sales figure two periods ago St – n is the actual sales figure for as far back as desired n is the total number of periods to be averaged. Now let us examine how this method works. This will be done in table form, with the necessary workings below. Example Using Table 19.1, calculate the three-week forecast for demand, using the moving averages method. The actual demand is given in the second column. In Table 19.1, in order to get a three-week forecast there has to be three weeks’ worth of actual data that we will average to give us a forecasted demand for Week 4. The forecast of demand was calculated as follows: Week 4: 1 800 + 2 500 + 3 800 = 2 700 3 Week 5: 2 500 + 3 800 + 3 000 = 3 100 3 Week 6: 3 800 + 3 000 + 2 800 = 3 200 3 Period (week) Actual demand 1 2 3 4 5 6 1 800 2 500 3 800 3 000 2 800 2 000 }} } Three-week moving average – – – 2 700 3 100 3 200 Table 19.1: Data for calculating simple moving averages Note that, in Table 19.1, the first forecast for demand is placed in Row 4, showing that the first three weeks are averaged to predict the demand for the fourth week. To this end, the first week under Column 3 remained blank. Now try the next exercise. Weighted moving averages (WMA) In the simple moving average calculation, the actual figures were just totalled and averaged. However, with weighted moving averages a weight (per cent) is placed on each figure to be averaged. The sum of the weights used must always be equal to 1. The notion behind the weighted moving average calculation is that the most recent past data will most likely have a heavier bearing on future data. To this end, the heaviest weight should be placed on the most recent data. EXERCISE Calculate the four-week and six-week forecast for sales for Future Sales Ltd, given the actual sales in Table 19.2. Period (week) Actual sales 1 2 3 4 5 6 7 8 9 2 300 1 500 1 800 2 600 3 500 4 000 3 800 3 600 4 400 Four-week forecast Six-week forecast Table 19.2: Data for Future Sales Ltd sales forecasts The formula used to calculate weighted moving average is similar to that of simple moving average, with the exception of the weights placed on each actual figure. The formula is as follows: WMA Ft = w1St – 1 + w2St – 2 + wnSt – n The explanation here is: W1 is the weight given to the most recent past data. This is usually the heaviest weight W2 is the weight given to two periods ago and usually is the second heaviest weight Wn is the weight given to other periods and the weights are assigned in a descending order. Example Given the following weights (0.40, 0.30, 0.20 and 0.10) and the actual demand for the past four months (Jan 4 800, Feb 5 000, Mar 6 000 and April 4 000), forecast demand for the month of May. (The point to remember is that the most recent past, April, should be given the heaviest weight.) WMA F May = (0.40 × 4 000) + (0.30 × 6 000) + (0.20 × 5 000) + (0.10 × 4 800) = 1 600 + 1 800 + 1 000 + 480 = 4 880 Now try this exercise. EXERCISE Using the following weights (0.50, 0.30 and 0.20), forecast sales for Week 4 if the previous three weeks’ data were as follows: Week 1 (6 000); Week 2 (9 000); and Week 3 (12 000). CHAPTER 19 | FORECASTING TECHNIQUES An assessment of moving averages will generate the following advantages and disadvantages. Profits Line of best fit Advantages of moving averages Eliminates the problem of fluctuation in data when forecasting Smooths the data, thus giving a clearer picture on the current trends – that is, it gives a clearer picture of trends than actual sales figures It is a fairly accurate forecasting technique It relatively easier to calculate than regression analysis. Turnover Example of strong positive correlation Disadvantages of moving averages The firm has to keep a lot of past data from which the projections will be made Does not recognise complex relationship in the data Tends to lag trends in data Its calculation can become fairly complex especially where there is no prior knowledge. Least squares regression Least squares regression is a part of the broader concept of linear regression analysis. The term ‘regression’ is seen as the functional relationship which exists between two or more correlated variables. In addition, the term ‘linear regression’ defines a situation where the relationship between the variables results in a straight line. Involving a straight line, linear regression would use the same equation you were exposed to in mathematics or economics: Y = a + bX or Y = mX + c However, for this section we will use the former. In the equation, ‘Y’ is the value of the dependent variable; ‘a’ is constant or Y-intercept; ‘b’ is the slope; and ‘X’ is the independent variable (time). The reason behind using regression analysis for forecasting is that changes in the dependent variable (for example, sales) is as a result of changes in the independent variable (such as advertisement). If we can estimate the future value of the independent variable, we can predict the value of the dependent variable. The least squares regression utilises the concept of linear regression in making a forecast for future sales or demand. Least squares regression is defined as a method that fits a ‘line of best fit’ through a linear pattern of scatter points. The line of best fit minimises the sum of the squares between each data points. This relationship is seen in the scatter diagram in Figure 19.2. You will not be asked to plot the scatter diagram or the line of best fit for this course, but the syllabus requires that you be introduced to the concept. We will, however, examine simple examples of how to forecast sales or demand using Figure 19.2: A scatter diagram the least squares method. In order to do this, though, we must find the values of the ‘a’ and ‘b’ in the equation of the line mentioned above. The formulae used to calculate the values for ‘a’ and ‘b’ are: a = y – bx ∑xy – nx ∙ y b= ∑x2 – nx2 Where: x = the value of the x variable y = the value of the y variable n = the total number of data points x = the average of the x values y = the average of the y values. Now we will use the data in Table 19.3 to see how this works. Average x: 21/6 = 3.5 Average y: 15 900/6 = 2 650 Based on the two formulae, we must calculate ‘b’ before ‘a’: 56 200 – 6 (3.5 × 2 650) b= 91 – 6 (3.5)2 56 200 – 55 650 = 91 – 73.5 = 550/17.5 = 31.43 rounded to 31 Period (week) x Actual Demand Y Xy x2 1 2 3 4 5 6 21 1 800 2 500 3 800 3 000 2 800 2 000 15 900 1 800 5 000 11 400 12 000 14 000 12 000 56 200 1 4 9 16 25 36 91 Table 19.3: Data for least squares regression calculation 201 202 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT a = 2 650 – 31(3.5) = 2 650 – 109 = 2 541 Now that we have calculated the values of ‘a’ and ‘b’, we can now move to forecasting sales using the linear equation: Y = a+ bX. The forecast for the 7th to 10th weeks would be as follows: Y7 = 2 541 + 31(7) = 2 758 Y8 = 2 541 + 31(8) = 2 789 Y9 = 2 541 + 31(9) = 2 820 Y10 = 2 541 + 31(10) = 2 851 EXERCISE Now calculate the forecast for weeks 11 to 15. Having completed our discussions on the different techniques used for forecasting, what are some of the factors that influence the technique that is chosen? These may include any of the following. The extent to which information is available – where there is limited information about the product, the firm may want to choose a qualitative technique to generate the forecast. The older the product, the more likely it is that more people will know about it and can provide information that can be used for a forecast The required level of accuracy – as we have discussed above, even though sales forces and executives are very accessible, they may not be totally aware of everything that is happening, especially outside of their geographical boundary. The great degree of accuracy that is needed can help to determine whether quantitative or qualitative techniques should be used The time span of the sales forecast – a forecast that will cover a longer period of time will require greater effort on the part of those doing the forecast. This is because trying to forecast for an extended period, with the uncertainties of the future, poses greater challenges than forecasting for a shorter period. Management should therefore choose a forecasting technique that will give better long-term results The stage of the product’s lifecycle – a product that is about to be introduced to the market would not have any statistical data and so quantitative techniques could not be used for forecasting. However, as the product moves through the different stages of the lifecycle, more information will be available and the firm can employ quantitative methods of forecasting. CHAPTER SUMMARY Production planning is the process of outlining the steps to be taken in the production of a product Business forecasting involves the creation of an estimate of the possible future levels of costs, sales, stock or production Qualitative forecasting techniques focus on value judgement and the individual’s opinions of the future outcomes Qualitative forecasting techniques include sales force composite, Delphi Method, consumer survey and jury of experts MULTIPLE CHOICE QUESTIONS 1. The category of forecasting technique that focuses on value judgement and the individual’s opinions of the future outcomes is known as: a. Jury of experts b. Sales force composite c. Delphi Method b. Qualitative forecasting technique d. Moving averages d. Macro-forecasting technique Quantitative forecasting techniques include moving averages and least squares regression. 2. ALL of the following are types of qualitative forecasting technique EXCEPT which one? a. Micro-forecasting technique c. Quantitative forecasting technique Quantitative techniques use historical data and previous experience to forecast sales CHAPTER 19 | FORECASTING TECHNIQUES 3. Which of the following methods of forecasting uses a group of experts, anonymous to each other, to make a forecast of sales, among other things? 7. The method of forecasting used is dependent on ALL the following EXCEPT which one? a. The required level of accuracy a. Least squares regression b. The time span of the sales forecast b. Consumer survey c. The stage of the product’s lifecycle c. Delphi Method d. The product being produced d. Jury of experts 4. Which of the following is an advantage of using consumer survey to forecast sales? a. It gives producers the opinions of buyers from a wide cross-section b. The intentions of buyers may not transcend into actual purchase of the product c. It may be difficult for some buyers to forecast their future needs d. The result may reflect the subjectivity of a bias research team Use the data in Table 19.4 to answer Questions 5 and 6. Time period (week) Actual sales 1 2 3 4 5 6 Forecast 5 400 3 600 4 000 2 800 4 200 6 000 Table 19.4: Data for Questions 5 and 6 5. What would be the forecasted sales for Week 5, using a fourweek moving average? a. 4 200 b. 3 950 c. 6 000 d. 3 650 6. What would be the weighted moving average for Week 6 if the weights were 0.40, 0.30, 0.20 and 0.10? a. 6 000 b. 3 620 c. 3 680 d. 4 620 Extended Essay Question Question one Total 25 marks a. Describe how the Delphi forecasting technique works. (6 marks) b. Outline two (2) advantages and two (2) disadvantages of the Delphi Method. (8 marks) c. Mr Ignorant wants to forecast sales for his clothing business and has heard that this could be done by conducting a consumer survey. However, he has no knowledge of what that is. Advise Mr Ignorant on: i. What a consumer survey is ii. The steps involved iii. Two (2) benefits and two (2) drawbacks of conducting a consumer survey. (11 marks) 203 204 20 Production Design Strategies and Capacity Planning LEARNING OBJECTIVES: At the end of this chapter students should be able to: Describe a design brief and its elements Discuss the different product design strategies Discuss the elements and concepts that are associated with capacity planning Explain the concepts of economies and diseconomies of scale Assess the main types of layout strategies that are used by businesses Product design planning A good final product is likely to be the result of proper and careful planning. In planning a design for the product, management must create what is known as a ‘design brief’. This is a document outlining how the product will be produced in order to get the desired results. It also outlines how technology and resources will be combined to produce the product. The design brief will give everyone a clear sense of direction even before the production of the product commences. Once the product is completed it can be measured against the design brief to ensure that all steps were duly followed. In general, the design brief should include the following elements or features: The problem statement or the desired need to be fulfilled – this outlines the objective of the product, the problem being faced and/or what is to be produced. Usually, the need for a product will arise out of a need or desire of people. For example, the purchasing of this book may have arisen out of the need to pass the course being discussed The function of the production – the design brief should outline the functions of the product to be developed. What role will the product play in alleviating the problem mentioned above or ‘fulfilling the need’ are outlined above Required resources – the design brief should also outline the resources that will be needed to manufacture the product completely and successfully. Since this is a plan of what is to be done, the amount, type and quality of the materials that will be used should also be stated in the design brief. This will give management time to secure the require materials to be used in producing the product Technological need – having mentioned the required resources, the technology that will be needed to convert these resources into a finished product must be carefully analysed and documented. The elements of the design brief are by no means limited to those mentioned above. They could also include: current industry trends, the level of competition, the project’s budget and the expected time line for completion. Product design strategies In examining product design planning it is also imperative that we also explore the strategies that are used in the design process. These concepts are important to modern-day production and include the following. Modularisation If you take a computer, whether laptop or desktop, and look inside you will realise that it is made up of different parts, including a hard drive, memory, modem and DVD drive. These parts can be safely removed from the computer and replaced should anything go wrong with it. Therefore if the hard drive of your computer is damaged you can just replace the hard drive and not discard the entire computer. This move is made possible through a process known as modularisation. Modularisation is the process whereby a product is divided into subsets known as modules, which are used to assemble the finished product. These modules or modular products have their own distinctive functions and contribute to the performance and features of the final products that they are used to manufacture. Modularisation has changed the scope of manufacturing so that the different components of a product can be produced in different places and then assembled in yet another location. This also facilitates mass production using an assembly line, as the different modules CHAPTER 20 | PRODUCTION DESIGN STRATEGIES AND CAPACITY PLANNING can be fitted in the product along the line. Let’s take a car, for example – the engine, tyres, mirrors and windscreen can all be made in another location or even by another company and then assembled to the body of car by a car manufacturer such as Toyota or Nissan. Advantages of miniaturisation Benefits of modularisation Drawbacks of miniaturisation The individual module can be developed and tested separately before using it to build the product Since modules can be used in different products, a wide range of products can be made Modules can be made in very large quantities, thus lowering costs Makes product repair easier, since the affected module can be removed or replaced without damaging the entire product Adds flexibility to production, since some modules can be removed from or added to products as consumers desire Can lead to a reduction in production times, since the product will not be ‘built from scratch’ Ease of updating products, as outdated modules can be replaced with updated ones. However, since the company assembling the product may not be the one producing the module, quality control might be more difficult. Miniaturisation Do you remember the first types of cellular phones to be introduced to the Caribbean? They were huge and some had a very long pole that the user had to pull out when making or receiving a call. Now let us come back to the present: with recent improvements in technology, cellular phone manufacturers have been able to reduce the size of cellular phones drastically. This is due to the concept of miniaturisation. Miniaturisation is the development of very small products that have the same function and use as the larger products they replaced. It involves the development of smaller and smaller products over time, using less input of materials. Japan is one of the main countries leading the charge for the development of smaller products. New technologies have made it possible to make the same products but in much smaller sizes. The production process has also become faster, precise and more technical with increasing use of robotic technology. Producers carrying out product design planning must be aware of advancements in technology and use the concept to their benefit. Reduction in the cost of raw materials Increase in the pace of production Companies can produce large amounts of output Improvement in the portability of the product. While there are cost savings on materials, those for research and development and the cost of technology might increase The production process is highly dependent on machinery and automation. Integration As the global environment becomes a single marketplace through technology and firms are being faced with competition, the practice of integration has become of even greater importance. In order to remain competitive, firms have to ensure that all the departments involved with the product play a critical role in both its design and production. In past times, the functional departments would essentially work separately on the product. Each of these functional areas would have needed to know only about its own aspect of the work without concern for the others. However, today, teamwork is encouraged so that marketer, designers and the production team work together to produce the best possible product. With concepts such as TQM, each department working on the project has to contribute to the final product and help in improving quality. Integration is not only seen in the interdependence of the different departments within the firm – it also involves product integration. This involves the assembly of a product from different component parts that work together as the final product. Integration combines a number of product components into a complete product. For this to work properly, however, a detailed plan of activities should be developed. This plan would include how the components would be sourced and received, assembled and activated to create the final product. Value analysis Firms want to ensure that they get value for money whenever they purchase or produce a product. Value analysis is defined as a systematic attempt to minimise costs and/or improve performance of a product either purchased or produced by the firm. In order to do this, the firm has to examine everything involved in the production of the product, including the materials, information systems and 205 206 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT processes. The whole aim of value analysis is to improve efficiency and minimise production costs. This is done by evaluating whether or not each of the materials or components being used has a value which is proportionate to its costs. Costs may also be reduced by using cheaper materials, design and methods of manufacturing. Every small saving will add up – especially when the firm has undertaken large-scale production. Eventually, a good value analysis system should result in high cost savings over time and increases in profits. Benefits of value analysis Reduction in material costs Improvement in the firm’s profit margins and returns on investment Reduction in wastage within the firm Could result in improve product quality, as better materials and processes are identified Customer satisfaction can be heightened Improves employees’ level of motivation. Design can be shared with multiple users. Drawbacks of computer-aided design The initial costs of the software can sometimes be high and therefore expensive, especially for a relatively small firm It requires the use of other technologies such as personal computers The firm may need to conduct training of the staff to use the software. Computer-aided manufacturing (CAM) Computer-aided manufacturing works hand in hand with CAD. CAM uses computer software and hardware to convert CAD data and models into instructions to be used in the manufacture of the product. It works as the link between the product design and the manufacturing of the actual product. It can take the form of anything from an automatic conveyor belt to a labelling machine. Benefits of computer-aided manufacturing Drawbacks of value analysis If used too widely, it could become time consuming and expensive If not properly supervised and organised, it could become counterproductive. Computer-aided design (CAD) We are living in a world where technology changes regularly. We have seen improvements in the manufacturing process and the use of technology in businesses. To this end, firms can also make good use of technological improvements in the design process. One such technology being used to design products is computer-aided design. CAD involves the use of computer systems to create, modify and analyse a product’s design. The CAD software gives designers the ability to generate and store design while using various two-dimensional (2D) and three-dimensional (3D) designs. CAD has become a vital tool in the shipbuilding, aerospace, automotive and architectural industries, among others. Benefits of computer-aided design Less human error, as designs are more accurate than hand-drawn designs CAD offers the designer the ability to edit and save the designs Modification of designs is cheaper and less time consuming Products can be manufactured quickly, as designing time would be reduced Results in consistency in production – that is, the products are the same Improves the level of accuracy in production Is ideal for speeding up production Cuts the lead time between designing and manufacturing the product. Drawbacks of computer-aided manufacturing The software tend to be expensive, so the firm could incur high start-up costs Not economical for a ‘one-off’ production or product The firm will have to train employees to use the software, which is an additional cost. Capacity planning Capacity is very important to the organisation, as it needs to be aware of capability of its production facilities. Capacity refers to the level of output that the current system is capable of producing in a specified period of time. If the firm is not operating at full capacity or does not have the ability to produce more output, demand will be greater than its ability to supply and it may lose customers to competitors. On the flip side of things, if the firm is over utilising its capacity then too many products are being produced and it is indicative of the fact that resources are being wasted. There are two important definitions that you are expected to note once you are studying capacity. These are: CHAPTER 20 | PRODUCTION DESIGN STRATEGIES AND CAPACITY PLANNING CASE STUDY From a room to the palm Today we have all heard of tablet computers but computer technology has come a long way since the first one was developed. The computer is said to have begun in the 1930s when the first digital electronic computer was built and given the name ‘ABC’, after its developers. The military was also responsible for building computers and in 1946 the Electronic Numerical Integrator and Computer (ENIAC) was built which weighed some 30 tonnes and contained some 18 000 vacuum tubes. The second era of the computer started in 1947, with the development of transistors. Very soon afterwards, the integrated circuit was developed and this revolutionised the industry. These parts could be taken out and replaced and they also shrank the size of the computer considerably. The industry also saw the development of operating systems and programs that made the computer more interactive and user friendly. Today, we have moved from the regular use of desktop computers to laptops, to notebooks and now to tablets. We have even seen cellular phones being used as computers, based on their capabilities. Questions 1. Briefly describe the two (2) design strategies that can be inferred from the developments discussed in the case. 2. Discuss two (2) implications of each of these strategies for: a. The producer of the product b. The consumer of the product. Design capacity Design capacity refers to the total achievable capacity if all equipment and processes are working in perfect order. However, very few organisations achieve this level of output and few firms would want to operate consistently at design capacity since the depreciation of equipment and machinery could be significant. Efficiency or effective capacity Effective capacity refers to the estimated capacity that would result in the efficient operation of the business. It measures the maximum demand that the production system can manage before it becomes inefficient. Capacity utilisation In order to minimise the possibility of over- or underutilisation of capacity, the organisation can measure its capacity utilisation. This is the measure of the percentage of the firm’s total capacity that is being used. It is calculated using the following formula: Present output × 100 Total potential output For example, a manufacturing company is able, with its current resources and facility, to produce 500 units of a product per day in a five-day work week. In a particular (4 marks) (8 marks) (8 marks) Total 20 marks week it was able to produce 1 800 units of the product. Its capacity utilisation would be: 1 800 × 100 = 72% 2 500 The utilisation of capacity is important for the firm, as: It will result in lower ‘per unit’ fixed costs It will help the firm to cater for the volume needs of the market Idle machinery and equipment can be put to better use to generate revenue. There are a number of factors that may cause a firm to produce below full capacity. Some of these are: Deficient demand due to a lack of income or changes in tastes and preferences of consumers The firm may be faced with stiff competition and losing market share Seasonal demand may affect the industry’s capacity – for example, in the tourism industry Failed marketing campaign may result in depressed sales and hence low production. Producing below full capacity may result in some problems for the firm, including: Inability to cover its fixed costs, which will result in losses High ‘per unit’ cost of production, which may have to be passed on to consumers through price 207 208 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT Lower than potential returns on its investment, since the machinery is not generating enough income. Options available to increase capacity Having established some of the possible problems that may arise as a result of underutilising capacity, it is imperative that mention be made of how capacity might be increased: The business can increase sales through promotional activities such as advertisements or sales promotion Redeploy unused resources, such as labour, from one production location to another to assist with improving capacity Reduce ‘down’ times of machinery and equipment. Extensive machinery ‘down’ times may result in loss of productive time and underutilisation of capacity Employ seasonal or part-time workers – this is often used when there is high seasonal demand, as it helps the firm to produce more (for example, at Christmas, or in crop season in the sugar industry) The firm may also outsource aspects of its production process in order to boost production. However, there are a few problems with producing at full capacity, including: The firm may find it difficult to meet any unexpected increase in demand There will be limited time, if any, available for plant maintenance If the factory space becomes limited or overcrowded, diseconomies of scale may set in, which will lead to increased costs Pressuring staff to produce at full capacity can result in high staff turnover rate, especially where employees are not receiving incentives for doing so or feel that they are being overburdened. Economies and diseconomies of scale As firms expand and increase their scale of production they benefit from a lowering of ‘per unit’ cost of production. This is referred to as economies of scale which is the reduction of costs as the business grows. For example, if a business has a fixed cost of $10 000, the first unit it produces would bear all of that cost plus any variable costs. If the firm CASE STUDY A difficult 2012 for the Jamaican bauxite industry Having been one of the main earners of foreign exchange in the past, the bauxite industry has fallen from grace to be plagued with very low capacity utilisation, redundancies and declining sales. The results of 2012 were less than favourable when compared with those of the previous year. It is said that alumina production fell by more than 10 per cent, to level at 1.75 million metric tonnes. The interesting point is that neither this figure nor the 2011 figure of 1.96 million metric tonnes is anywhere near the real alumina capacity of Jamaica. This is so since that level of production only represents about 40 per cent of the country’s total capacity. Two main things have been blamed for Jamaica’s poor level of alumina production. The first is that the bauxite industry is grossly affected by the high energy costs in the country. Second, the global recession has basically collapsed aluminium sales worldwide and hence the demand for alumina from Jamaica. The industry is optimistic that if the global recession should ease then the country should see an increase in alumina production. It is said that JAMALCO can produce 1.45 million metric tonnes; WINDALCO’S Ewarton plant 670 000 metric tonnes and its Kirkvine plant 610 000 metric tonnes; and ALPART 1.7 million metric tonnes. Nowadays, the workers who were laid off, those who benefited indirectly and the country look on, wondering whether the industry will ever bounce back. Questions 1. What was the approximate capacity utilisation in the aluminium industry in 2012? 2. What reasons were given for the low capacity utilisation in the industry? 3. Outline two (2) drawbacks of producing below capacity. 4. How would you advise these companies to: a. deal with the continued reduction in demand? b. improve their capacity utilisation? (2 marks) (4 marks) (4 marks) (4 marks) (6 marks) Total 20 marks CHAPTER 20 | PRODUCTION DESIGN STRATEGIES AND CAPACITY PLANNING expands its production and produces 1,000 units, the fixed cost per unit now become $10. The firm therefore benefited from its decision to produce more, as its fixed cost per unit fell drastically. Economies of scale can be subdivided into internal and external economies of scale. Internal economies of scale This is the reduction in costs that a firm gains directly as it increase the size of its operations. Internal economies of scale include: Purchasing economies One of the benefits of being large is that the firm can afford to buy larger quantities of raw materials. In doing so, larger firms tend to receive better prices for these raw materials. They benefit from trade discounts and will be better able to bargain with their suppliers who do not want to lose their business. As the firm increases its order size, the administrative cost per unit ordered decreases. Since the firm buys in bulk, it may reduce its transportation cost since items would be bought regularly. Managerial economies There is a tendency for managers of small firms to multitask. They have to play many roles, such as accountant, marketing manager, public relations officer etc. These firms cannot afford to pay different managers to perform these tasks. However, as they get larger they can take advantage of specialisation of labour. Instead of having one person doing so many tasks, the firm can employ a specialist in the particular field to carry out each task. This may lead to an increase in efficiency. Larger firms are also able to contract outside management services to carry out tasks that they are not able to do within the business. They are able to afford to pay larger and more attractive salaries to attract and employ some of the best and most qualified people. Technical economies As a firm increases its size, it can take advantage of larger and more efficient machinery. For example, a small farmer may not be able to afford much, if any, machinery and so will have to toil daily using simple machines. As his farm increases in size he can afford to purchase a tractor to help with the ploughing of the soil. Larger firms are able to utilise flow production where the production process is done on an assembly line. This allows the firm to use highly specialised machines, replacing its sometimes large labour cost and increasing its productivity and output. Risk-bearing economies Going into business involves risk and all firms are subjected to such risk once they are in operation. For example, there is a risk of losing all of the investment funds if the business fails or risk of the changing business environment and factors such as demand. Factors such as the downturn in the world’s economy may lead to the closing down of many small firms. If the conditions of demand and supply change for the major or the only product of a smaller firm then sales may be greatly affected. Conversely, if the same problem exists for a larger firm, it can shift its production to another product or diversify the present product or diversify its market. Large firms are also able to invest in research and development which helps to minimise the risk involved in the development of a new product or setting up operation at a new location. Financial economies As discussed earlier, sourcing financing poses a big problem for most small firms and, even when they acquire the funding, it might be very expensive. Large firms have the advantage of sourcing finance. They have better bargaining power, more collateral and are more likely to receive financing through the issuing of shares or borrowing from lending institutions. Marketing economies Marketing is very important when conducting business. A number of firms fail because their products are not publicised properly. Marketing involves a large amount of funds and differs depending on the method of advertisement used. The firm needs to decide whether or not to advertise and whether to lease delivery vans or purchase them. Advertising can be very expensive and as a result some small firms are not able to advertise. However, as firms get larger they can implement advertisements and other promotional tools. The firm may also be able to purchase its fleet of delivery vehicles which may be cost effective. External economies of scale External economies of scale occur where all firms in an industry benefit from lower unit costs as the entire industry increases in size. External economies of scale include: Improvement in transport and communication links The Caribbean has benefited from improvement in communication over the last decade or so. With the liberalisation of most, if not all, telecommunications industries, firms now have more options and access to 209 210 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT communication. The quality of transportation in the region has also improved over the years. The number of courier services has also grown rapidly. These improvements have spun off on the firms which would see a reduction in transportation and communication costs. Transportation has also been aided by the improvement of the road network in some countries – for example, the building of Highway 2000 in Jamaica. Costs $ Optimum level of production (constant returns to scale) Economies of scale Diseconomies of scale Output Training and education As the number of training institutions grows in a country, the firms will benefit from improvement in the skill level of workers and the labour force in general. Universities and colleges have developed programmes and courses to meet the need of the industry. The HEART Trust NTA has been training and certifying workers in Jamaica. As a result, firms can benefit from these improvements while reducing per unit costs of production. Development of auxiliary services The growth of an industry sometimes attracts other small businesses which perform auxiliary services for the firms in the industry. The services offered may range from marketing to waste disposal, among others. The services being offered can be contracted by the existing firms that would otherwise have to perform the service themselves. Outsourcing these services might be cheaper for the firms in the industry than performing them themselves. Cooperation among businesses In Chapter 1 we discussed that cooperatives pool together to benefit from lower costs. When this occurs the firms benefit from external economies of scale. Diseconomies of scale Growing is not always good for businesses, as they can become too large so that instead of experiencing a reduction in ‘per unit‘ costs there is an increase. In other words, the average total cost will rise, as seen in Figure 20.1. Diseconomies of scale therefore occur when a business becomes so large that cost per unit increases. Figure 20.1 shows that as a firm expands its output, it benefits from a reduction in its average total cost, i.e. total cost divided by output. As it continues to increase, it will reach a point of optimum production. If the firm continues to expand, its average total cost will start rising and diseconomies of scale will set in. The following are some of the causes of diseconomies of scale. Average total cost curve Figure 20.1: Diseconomies of scale Poor communication Communication is key in any organisation, as managers have to ensure that their line of communication is working. However, the expansion of the business might make the communication process long and bureaucratic. Management may no longer be able to communicate with employees, and vice versa. The breakdown in communication may prevent employees from receiving clear instructions and may increase wastage. Demotivation This topic will be dealt with further in Module 2. Over time, workers may become discouraged if they are not treated fairly and properly. As some businesses grow, employees may feel isolated and unappreciated. This will lead to low motivation and, by extension, a reduction in productivity. As productivity falls, output will also fall and the average cost per unit will increase, leading to diseconomies of scale. Lack of control and coordination As a business grows, the span of control widens and it is more difficult to manage. Managers may find it difficult to ensure that all employees are working towards the goals of the business and operating to their full potential. As the business loses control and coordination, its costs of operating may rise and diseconomies of scale set in. Business layout The layout of the production facility can have a great bearing on the level of productivity and production of the firm. The business should be organised in such a way that the time it takes for a product to pass from one production unit to another is minimised. As a result, management should carefully and strategically make the decision as to how organise the facility. This decision may be influenced by the following factors: CHAPTER 20 | PRODUCTION DESIGN STRATEGIES AND CAPACITY PLANNING CASE STUDY Big growth Carib Spice Ltd has grown significantly over the years. It started out as a small family business in Spiceland and has been very successful. The company started out supplying a few bottled spices to the local market. However, when things started picking up the company decided to expand its operations. It introduced a few more blends of spices and expanded its market reach to include other regional countries.Things progressed rapidly until the company went public and also opened three other branches in three other countries. This expansion has realised certain benefits for the company, such as better access to cheaper raw materials, and it is able to employ more qualified management teams, among others. In recent times, however, the company has noticed a downward trend in sales and productivity. This is of concern to the directors and an investigation was launched to diagnose the problem. The findings of the investigation were that some members of staff felt alienated and some were demotivated. It was also felt that the increase in size might have adversely affected the quality of communication within the company and among the branches in the other countries. Now the directors must meet to find a solution to the problems that were identified. Questions 1. Define the term ‘economies of scale’ and state the two (2) types that were mentioned in the case. 2. Discuss two (2) other probable economies of scale from which the company could benefit. Give reasons for your choice. 3. Discuss, giving evidence from the case, how the firm’s expansion led to diseconomies of scale. The available space within the facility The possible level of demand that the product will have on each piece of machinery in the layout The amount of distance that must be travelled between each piece of machinery in the layout The amount of space that each machine or equipment will occupy The sequence of operations on the product being produced – that is, the stages of production that the product must go through. There are three basic formats of business layout: (5 marks) (8 marks) (7 marks) Total 20 marks A major challenge for management in using this type of layout is finding the optimal placement for the different departments so as to minimise cost and time. However, management can explore the following steps in identifying the best placement to use. 1. Creating a model of the possible layout and analysing and improving it as necessary 2. Ascertaining how much it will cost to company to move the product among the different departments – for example material handling costs Figure 20.2: Process layout Process (functional) layout In a process layout, machinery and equipment that are similar or have the same function are grouped together in specified areas of the facility and the product being produced is transported to the different areas. See Figure 20.2 for a typical layout. If you should visit a hospital, the organisation of the facility would be another example of process layout. The hospital has different wards on which different illnesses are catered for. In addition, there is the operation theatre, radiographic room, clinic, and so on. Cutting Welding 1 3 2 Sanding 4 5 2 5 3 1 6 6 4 Planning Assembly Product A Product B Spraying 211 212 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT 3. Reviewing the layout periodically and making changes that will reduce overall production cost 4. Ensuring that the distance between each department is minimised 5. The arrangement should be conducive to supervision and inspection. The final decision on whether to use process layout is also likely to depend on its advantages and disadvantages. Advantages of process layout Low start-up cost in terms of investment in machinery and equipment, since machines will be reused on a number of products If one machine breaks down, it does not halt the entire production process There can be specialised supervision – that is, having a supervisor for each department in the layout Relatively low overhead costs It is easier to expand the facility than is possible under product layout. Disadvantages of process layout The constant backtracking of unfinished products can increase material handling costs significantly Skilled labour is required, which also adds to the production costs Unless properly organised, process layout can result in serious production delays There will be a greater need for storage as a result of a lot of work in progress. Product (flow-shop) layout Product layout is a type of layout that facilitates flow or mass production. It is one where the machinery and equipment are organised according to the progressive steps that the product will go through during its production. It facilitates the continuous moving of the product through the Figure 20.3: Product layout Product (cake) Product (sugar) Blender stage 1 Harvester stage 1 Mixer stage 2 Extractor stage 2 Boiler stage 3 different stages. There is no going back and forth as the path is along a straight line. An example is the conversion process of chemicals. Products that are produced along an assembly line are also utilising the product layout. See Figure 20.3 for a typical layout. Like process layout, the grouping of machines and equipment is also necessary to minimise costs and time. The following are some of the steps that are taken when organising the facility under a product layout: Machines are organised based on the sequence of production along the assembly line The layout should prevent the crossing of different production lines, as this may be chaotic All the operations involved in the production of the product should be included along the production line. Benefits of product layout Relatively low material handling costs, since there is no backtracking The operation usually flows uninterrupted Reduced storage cost and space requirement as there is little work in progress Better use of the available floor space Time lags are minimised and output can be produced at a faster pace Mass production usually results in lower ‘per unit’ production cost. Drawbacks of product layout The initial capital outlay is usually very high If one machine along the production line breaks down, the entire process is halted There is little flexibility in terms of variations to a particular product. Fixed-position layout In the fixed-position layout, the product remains at a specific location while all the tools, machinery and equipment are carried to that location to work on the product. The underlying reason for this is that the product is usually bulky and weighty and so carrying it around is not practical. For example, when a house is being Oven Icing constructed all tools, equipment stage 3 stage 4 and machinery have to be taken to the location of the house since it cannot be built in its entirety Cooler Packager elsewhere and then brought to stage 4 stage 5 that location. As a result of the time that is spent on each product, production CHAPTER 20 | PRODUCTION DESIGN STRATEGIES AND CAPACITY PLANNING is usually low when using a fixed-position layout. Each task that will be done on the product will have to be organised properly and carefully to prevent crowding and overlapping. Production usually follows a very rigid sequence of activities, as most of the times the product is constructed from scratch. This type of layout is use for ship building where a base is first laid and then additions are made to the base until completion. The different equipment and technologies that are needed will be brought to the location and used or applied when required. See Figure 20.4 for a typical example. There is some amount of flexibility in production, since adjustment can be made to the design of the job The firm can save on material handling costs, since the product is not transported to and fro If there is a shortage of materials or workers it is easier to make adjustment than with the two preceding types of layout. Cellular or group layout Cellular layout is based on a concept called ‘group technology’, where dissimilar machines and equipment are grouped into a single work centre known as a ‘cell’. Each cell produces parts of the product with similar shape and that use similar processing requirements in manufacturing the product. Machines in each cell are laid out along a mini assembly line. This type of layout is often used where a large variety of products are being produced in relatively small batches. The cellular layout is a combination of the process and product layout. This is illustrated in Figure 20.5 (p 214). Benefits of cellular layout Since workers work in teams, their morale may improve Often leads to a reduction in inventory and material handling since it combines several stages of production Shorter production set-up time since tooling requirement is reduced Workers’ expertise is improved due to repetitive tasks Offers better quality control. Disadvantages of fixed-position layout Production is usually costly and takes a long time to be completed The business has to secure a very large storage space near to the product. This can be very costly If more than one product or project is being worked on at the same time, there might be stiff competition for the limited tools or equipment. This can result in conflicts. Drawbacks of cellular layout There may be a need for greater training and scheduling of workers Higher costs to set up production, since more capital investment is needed Some cells may have a higher production volume than others and so there might be poorly balanced cells. Figure 20.4: Fixed-position layout Supplies Project site Human resources Energy Material resources 213 214 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT Figure 20.5: Cellular layout Cu Cu Ca Sa A Key Cell 1 Sp Store for receiving Cu Ca A Sp A Cell 2 Cu Ca Sa Cell 3 Cu: Cutting Ca: Carving Sa: Sanding A: Assembly Sp: Spraying Store for shipping CASE STUDY A new era of housing solution With the development in technology and knowledge as it relates to housing solutions, the housing market is rapidly changing. The initial building techniques of using concrete blocks and steel are becoming less appealing in certain spheres, especially where people want to build a home in the shortest possible time. Houses are now being built in modular parts, such as the different rooms, and then installed at the site using heavy-duty equipment. Once the modular parts are installed then they are joined and the joints are covered, the floor tiled and the fixtures and fittings installed. The technology used to build these houses allows their owners to expand sideways and/or upwards. The walls of these houses are made from prefabricated materials and the modules are made at a factory and then transported to the site. Even though they are factory made, the tools and equipment are often taken to the module as it is being built instead of passing the modules through different departments. 1. Discuss two (2) reasons why having a proper layout strategy is important to businesses. (6 marks) 2. Which layout strategy is being used in the housing industry? (2 marks) 3. Justify the use of such strategy in the housing industry. (3 marks) 4. Indicate one (1) other industry in which this layout is used and explain why it is necessary. (4 marks) Total 15 marks CHAPTER SUMMARY A design brief is a document outlining how the product will be produced to get the desired results grows. This can be broken down into internal and external economies of scale and education, development of auxiliary services and cooperation among businesses The measurement of capacity utilisation can help firms to minimise the possibility of over- or underutilisation of capacity Internal economies include: managerial, purchasing, financial, technical, risk bearing and marketing economies of scale Diseconomies of scale occur when a business becomes so large that cost per unit increases ‘Economies of scale’ refers to the reduction of costs as the business External economies include: improvement in transport, training Four main types of business or facility layout are product, process, fixed-position and cellular layout. CHAPTER 20 | PRODUCTION DESIGN STRATEGIES AND CAPACITY PLANNING MULTIPLE CHOICE QUESTIONS 1. The constant change in size of cellular phones is as a result of which of the following concepts? a. Modularisation b. Miniaturisation c. Integration d. Design brief 2. Which of the following facility layouts would be BEST suited for airplane building? a. Process b. Product c. Flow d. Fixed position 3. Which of the following is NOT an internal economy of scale? a. Technical economies b. Purchasing economies c. Loss-minimising economies d. Risk-bearing economies 4. The firm experiences _________ when its average total cost curve is rising. a. Constant returns to scale b. Economies of scale c. Increasing returns to scale d. Diseconomies of scale Extended Essay Questions Question one Total 25 marks Product Design Planning requires the development of a proper design brief. a. Describe five (5) features of a design brief. (10 marks) b. Describe the ‘fixed-position layout’ and state two (2) advantages of using this layout in ship construction. (5 marks) c. Underutilisation of capacity can cause a firm to lose money while having a lot of unused resources. With this in mind, discuss three (3) strategies that can be used to increase capacity utilisation. (10 marks) Question two Total 25 marks a. Outline two (2) benefits of using value analysis as a product design strategy. (4 marks) b. Define the term ‘economics of scale’. (2 marks) c. Describe three (3) internal and two (2) external economies of scale that a firm may experience. (15 marks) d. Outline two (2) possible causes of diseconomies of scale. (4 marks) 215 216 21 LEARNING OBJECTIVES: At the end of this chapter students should be able to: Outline the different costs of production Describe the approaches to costing Calculate operating profit using marginal and absorption costing Analyse and calculate the concepts under breakeven analysis Plot breakeven charts Analyse the ‘make or buy’ decisions of firm A n important part of production and operation management is costing. The firm has to attach a cost to the goods that are produced and services that are rendered. This is done through a process called costing, which is defined as a system of computing the costs of producing a product or operating a business. A cost is the amount of expenditure incurred on, or attributable to, a specified thing or activity. There are a number of costs that incurred within production. These are classified in a number of ways, as outlined below: Direct costs Direct costs are those costs that can be directly identified with the production of a product or the rendering of a service. Direct costs are further broken down as follows: Direct materials Direct materials are those used in the production of a product and which can be apportioned to such a product. Direct labour or wages Direct labour is the remuneration, whether in terms of salaries or wages, that is paid to the workers who have worked on the production of a particular product or service. Direct expenses Direct expenses are those incurred in the production of a particular product, such as the rental of a machine to work on a particular product. Costing The sum of direct materials, direct labour and direct expenses results in prime cost. Indirect costs Indirect costs include all costs that cannot be classified as direct costs. This category includes: Indirect materials These are materials that make production possible but that are not directly related to the production of the product, including materials such as lubricant for the machines, cleaning material and protective apparel. Indirect labour or wages This includes the payment for labour which is indirectly linked to production and cannot be traced directly to a product – for example, the factory supervisor’s salary, maintenance workers’ wages and the cleaners’ wages. Indirect expenses These are other costs incurred by the factory but which cannot be traced or allocated to a particular department or product – for example, rent and rates for the factory or factory insurance. The sum of indirect materials, indirect labour and indirect expenses results in factory overheads. Fixed costs Fixed costs are costs that do not vary with the level of output – that is, they remain constant regardless of the level of production or output. Examples of fixed costs may vary (see Figure 21.1, p 217) but some of the common ones are lease, rent and insurance. Variable costs Variable costs are costs that vary with the level of output. They normally increase when production increases. Some of these costs include material costs, delivery costs and wages. See Figure 21.2 (p 217) for examples. CHAPTER 21 | COSTING Costs $2000 Costs Variable costs Fixed costs Quantity Figure 21.1: Fixed costs Quantity Figure 21.2: Variable costs Costs Costs Variable costs Fixed costs Fixed costs per unit Quantity Quantity Figure 21.3: Fixed costs per unit Figure 21.4: Semi-variable costs Fixed costs per unit are then incorporated when drafting the profit and loss statement. These costs are written off in the period to which they relate. Under marginal costing principles, all production costs are valued at variable cost only. Before we draft an operating statement using the marginal costing approach, there are a few concepts that must be explored. The first of these is contribution. This is the difference between sales and the total variable costs – that is: Contribution = Sales – Variable costs Contribution can also be calculated in terms of per unit of production. This is the difference between selling price and variable costs per unit – that is: Contribution per unit = Selling price – Variable costs per unit The format in Table 21.1 (p 218) is used to calculate operating profit under marginal costing. This is the level of fixed cost per unit of output. It is calculated as fixed costs divided by output. Fixed costs per unit decreases as output increases. It is illustrated as shown in Figure 21.3. Semi-variable cost Semi-variable cost is a combination of fixed and variable cost, as seen in Figure 21.4. Approaches to costing In this section we will be examining and calculating cost using two approaches: marginal costing and absorption costing. Marginal costing Marginal costing is a type of costing system which charges variable costs to the production of the product. Fixed costs 217 218 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT Details Sales Variable production costs: Direct labour Direct materials Direct expenses Less closing stock Contribution Less fixed costs and other expenses Operating profit $ $ xxxx x x x xx (x) (xx) xxx (xx) xx Table 21.1: Calculating operating profit under marginal costing Example A firm manufactures and sells a single product. The details of its statistics are outlined below: Selling price $40 Direct materials $12 Direct labour $6 Variable overheads $8 Fixed overheads $40 000 per month. The fixed overheads were absorbed on the basis of an expected production of 40 000 units for the month. If the actual production and sales amounted to 40 000 units for the month, calculate: 1. Contribution per unit 2. Total contribution 3. Total profit for the month. Solution 1. Contribution per unit Contribution = Selling price – Variable costs per unit = $40 – (12 + 6 + 8) = $14 2. Marginal costing Details Sales (40 000 × 40) Variable production costs: Direct labour (40 000 × 12) Direct materials (40 000 × 6) Direct expenses (40 000 × 8) Contribution Less: Fixed costs Operating profit $ $ 1 600 000 480 000 240 000 320 000 (1 040 000) 560 000 (40 000) 520 000 Alternatively, this could be calculated as: Sales units × Contribution per unit less Fixed costs 3. Total profit = (40 000 × $14) – $40 000 = $560 000 – $40 000 = $520 000. Note that there was no stock in this question. One such example will be given later. Advantages of marginal costing It is easily understood and is useful in terms of budgetary control since the contribution that is calculated can be used for comparisons Managers can use the information provided in making decisions in terms of pricing, ‘make or buy’ decisions or introducing new products, among other things Since the calculation of contribution does include fixed costs, it eliminates the need for fixed costs to be absorbed into production and so prevents the technicality of over- and under absorption Since closing inventory is valued at only variable cost, it prevents a portion of the fixed costs from being carried over into the next period The profits under marginal costing are calculated on the basis of sales volume rather than production unit. Disadvantages of marginal costing There can be difficulty in separating overheads into variable and fixed costs Since fixed costs are ignored, this approach may not be useful for long-term planning and decisions because variable costs should not be the only basis on which these decisions are made It is argued that the profit under marginal costing is distorted because the closing inventory does not reflect fixed costs This method of costing is not recognised for external reporting purposes. Absorption costing Absorption costing is a type of cost accounting system that includes both fixed and variable costs to arrive at production costs. This method uses what is termed ‘full cost’ – that is, fixed and variable costs – and each unit of stock is valued at such cost. The format for the calculation is shown in Table 21.2. Now let us apply this method to the example given above. Details Sales Production costs: Direct labour Direct materials Direct expenses Fixed costs Less: Closing stock Gross profit Less: Expenses or overheads Net profit $ $ xxxx x x x xx (x) (xx) xxx (x) xx Table 21.2: Calculating operating profit under absorption costing CHAPTER 21 | COSTING units of the 40 000 units produced were actually sold. This will result in a new calculation for both marginal and absorption costing. Solution Details Sales (40 000 × 40) Production costs: Direct labour (40 000 × 12) Direct materials (40 000 × 6) Direct expenses (40 000 × 8) Fixed costs (40 000 × 1) Gross profit $ $ 1 600 000 480 000 240 000 320 000 40 000 Marginal costing Details (1 080 000) 520 000 Note that the fixed costs are treated as a part of production costs. An alternative treatment would be to just total the costs of production and multiply the total by the number of units to arrive at one production cost figure: Per unit production costs: 12 + 6 + 8 + 1 = $27 and production costs: $27 × 40 000 = $1 080 000 Note also that since we were told that fixed cost is absorbed based on 40 000 units and fixed cost is $40 000, then fixed cost per unit is $1 – that is: $40 000/40 000 units Advantages of absorption costing A portion of fixed cost is incorporated into the value of closing inventory. This allows the costs of the period to be matched accurately with the revenues of the same period It gives a more accurate cost of production, so that prices can be set based on total costs and not just variable costs It is a more realistic method of costing, since both fixed and variable costs are incorporated It is accepted as a method for external reporting It avoids the need to separate costs into fixed and variable costs, as some costs are semi-variable and are difficult to separate. Disadvantages of absorption costing The absorption of fixed costs and determining whether they were over- or under absorbed can complicate the process It can be complicated to calculate. Including stock There are times when stock is not sold during the accounting period. This results in the firm having closing stock. Using the same example from above, let us say that only 36 000 $ Sales (36 000 × $40) Variable production costs: Direct labour (40 000 × 12) Direct materials (40 000 × 6) Direct expenses (40 000 × 8) $ 1 440 000 480 000 240 000 320 000 1 040 000 Less: Closing stock (4 000 × 26) (104 000) Contribution Less: Fixed costs Operating profit (936 000) 504 000 (40 000) 464 000 Note that closing stock is valued at the total variable costs only – that is: 12 + 6 + 8 = 26 Absorption costing Details Sales (36 000 × $40) Production costs: Direct labour (40 000 × 12) Direct materials (40 000 × 6) Direct expenses (40 000 × 8) Fixed costs (40 000 × $1) $ 480 000 240 000 320 000 40 000 1 080 000 Less: Closing stock (4 000 × $27) (108 000) Gross profit $ 1 440 000 (972 000) 468 000 EXERCISE The following data was extracted from the books of Ed Manufacturing Ltd. For the period, 100 000 units of Product V were produced. The company sold 94 000 units in the period. The costs and revenues were: Sales: $1 410 000 Production costs: $1 000 000 Administrative overheads: $250 000. Note that 75 per cent of the production costs are fixed and all of the administrative overheads are fixed. Required: Prepare operating statements under marginal costing and absorption costing principles. 219 220 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT Application of marginal costing Breakeven analysis This is the assessment of the interrelationship that exists among costs, volume and profits at different levels of output. Breakeven analysis is an important tool for management, as it assists in planning and making decisions. For breakeven analysis to work effectively, certain assumptions must be made, including: Costs are classified as either variable or fixed Selling price remains constant Volume is the only factor that affects costs and revenue The factors of production are constant The focus is on a particular product or product mix. Breakeven analysis is useful to businesses as it enables them to: Ascertain the profit or loss at different levels of production and sales Make predictions on the effects of price changes on sales Determine the breakeven point Determine the margin of safety Examine the relationship between fixed and variable costs Determine how changes in costs and efficiency will affect profits. Advantages of using breakeven analysis Its calculation is fairly simple It highlights the profit or loss at different levels of output It shows how a firm’s profit or sales will be affected by changes in price or cost Firms are aware of the level of sales that will cover their fixed costs Firms can determine the level of sales needed to make a certain level of profit. Disadvantages of using breakeven analysis Results can be misleading, since it assumes that all output is sold and so there is no closing stock Like most calculations, the effectiveness of breakeven analysis depends on the accuracy of the data There are a number of businesses that produce multiple products at varying costs and prices To construct a breakeven chart takes time. Breakeven analysis formulae Breakeven point The breakeven point is the level of output that enables the firm to cover its costs exactly. It is the point where neither a profit nor a loss is being made. It can be calculated in terms of units or sales, as seen below: Fixed costs Breakeven point in units = Contribution per unit Fixed costs Breakeven point in sales = Contribution to sales ratio The contribution to sales ratio (C/S ratio) = Contribution per unit × 100 Selling price Level of sales to result in target profit This can be done on a ‘per unit’ basis or sales volume: Level of sales to result in target profit (units) = Fixed costs + target profit Contribution per unit Level of sales to result in target profit (sales) = Fixed costs + target profit × selling price Contribution per unit Now let us look at an example: Example A–Z Ltd produces and sells a single product. The product is sold for $100 and its total marginal cost is $60. The firm’s fixed costs amounted to $100 000 per annum. Calculate the following: 1. Breakeven point in units 2. Breakeven point in sales 3. The number of units that must be sold in order to earn a target profit of $40 000 per annum 4. The level of sales that will achieve a target profit of $40 000 per annum. Solution Before we begin, let us calculate the contribution: C = Selling price – Marginal costs Therefore, contribution equals $100 – $60 = $40. 1. Breakeven point in units = 100 000 = 2,500 units. 40 2. Breakeven point in sales = 100 000 = $250 000. 0.40 Note: the C/S ratio is $40/$100 = 0.40. 3. Number of units for targeted profit = 100 000 + 40 000 = 3,500 units. 40 4. Sales for targeted profit = 3,500 units × $100 = $350 000. CHAPTER 21 | COSTING Margin of safety EXERCISE Black’s Block Factory is the maker of concrete blocks. Each block is sold for $60 and the variable cost associated with its making is $45. The factory incurs rent of $120 000 per month. Use the above information to calculate: 1. Breakeven point in units 2. Breakeven point in sales 3. Units to be sold to make a target profit of $80 000 4. The level of sales that will achieve a target profit of $80 000. Breakeven chart The breakeven point can also be seen graphically on a breakeven chart (see Figure 21.5 for an example). This shows the level of fixed costs, variable costs and total revenue at all levels of output from zero to full capacity. We can now draw a few conclusions from the breakeven chart: Fixed costs are constant over the levels of output Variable costs is the area above the fixed costs line but below the total cost line and is directly proportional to output, i.e. it increases as output increases Total revenue and sales volume are directly proportionate The breakeven point is shown where the total cost line cuts the total revenue line. At this point, both profit and loss are equal to zero Losses are made to the left of breakeven point, while profits are made to the right of breakeven point. EXERCISE Firm A makes and sells pillows. Each pair of pillows is sold for $500. The variable cost per unit of pillow is $200 and it has total fixed costs of $45 000. The total units sold were 200. 1. Use the above information to plot a well-labelled breakeven chart 2. Determine the margin of safety and illustrate this on your chart. ‘Make or buy’ decisions Revenue $ Profit 21 600 Breakeven Budget 18 000 Margin of Safety Total costs 6000 Since firms enter into business with an aim of making profits, no firm would want to produce consistently at breakeven point. Instead, it would want to produce and sell at a level of output greater than breakeven point. The amount by which sales exceed the breakeven point is known as the margin of safety. It shows the amount by which sales can fall before the firm starts making a loss. It is calculated as: Actual sales – Breakeven point For example, if breakeven point is 5,000 units and the firm is operating at an output level of 7,500 units then the margin of safety = 7,500 – 5,000, which is 2,500 units. If sales should fall by more than 2,500 units, the firm would start making a loss. Margin of safety can also be expressed as a percentage. This is done using the following formula: Margin of safety × 100 Expected sales The example above would then be 2,500/5,000 × 100 = 50 per cent. Loss Fixed cost 1000 2000 3000 Output/sales units Figure 21.5: A breakeven chart 3600 From time to time, management is faced with a decision on whether to make or buy a product or its components. There are a number of factors that could influence the firm’s decision on this: The cost involved – the firm will be mindful of the difference between the cost to buy and the cost to make and, barring poor quality, this will determine the firm’s decision The firm may be the only one producing the product It may want to produce its own brand The firm may want to ensure that the product is always available instead of depending on an outside supplier 221 222 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT The reputation of the firm may be placed on the line, especially if the outsourced firm makes an inferior product. Therefore the firm may want to protect its reputation. In order to make this decision, the firm must compare the variable cost to manufacture the product against the price it would pay to buy (outsource) the product. Note that only the variable or marginal costs are being compared to price, since the firm would incur its fixed costs whether it makes or buys the product. Let us look at the following example: Example Undecided Ltd manufactures a component to be used in the production of mind stimulators. The costs for associated with its current production of 20 000 units are outlined below: Direct materials $500 Direct labour $1,000 Variable overheads $750 Fixed costs $1,000. The same component could be bought at a cost of $2,000. Solution The marginal cost of making the component (per unit) is: Direct materials $ 500 Direct labour $1,000 Variable overheads $ 750 Marginal cost of production $2,250 Since it costs more to produce the component than buying it from an outside supplier, the company should purchase them from the supplier and cease producing it itself. EXERCISE Great Juices Ltd is a maker of fruit juices which it packages in boxes and plastic bottles. In an attempt to save costs, the company manufactures both packages in an adjoining part of the juice factory. In recent times the factory has been considering whether it should shut down this operation and buy the packages instead. However, doing this would leave that part of the factory idle and it would still have to pay the rental. The following are the costs incurred by the firm to make both products and the price each would cost if they were purchased from an outside supplier. Table 21.3 shows the costs based on production of 2,000 units or juice boxes and 1,000 units of bottles per month: Plastic bottles Juice boxes Direct materials Direct labour Direct expenses Fixed cost Price per unit if purchased 36 000 50 000 10 000 60 000 $80 9 000 26 000 8 000 36 000 $50 Table 21.3: Production costs for Great Juices Ltd Based on this information, should the company continue making one or both products or should one or both of them be purchased? Show your workings. CHAPTER SUMMARY Costs can be classified as direct and indirect. Direct costs can be attached to the production of a specified product while indirect costs cannot be attached to the production of a specified product While variable costs change with the level of output, fixed costs do not The sum of direct materials, direct labour and direct expenses is called ‘prime cost’ Absorption costing includes all costs into the value of the product The sum of indirect costs is known as ‘overheads’ Under the marginal costing principle, all production costs are valued at variable cost only Contribution per unit = Selling price – Variable costs per unit Breakeven point is the level of output that enables the firm to cover its costs exactly The amount by which sales exceed the breakeven point is known as the margin of safety. CHAPTER 21 | COSTING MULTIPLE CHOICE QUESTIONS 1. Which of the following is NOT a direct material used in a biscuit-making company? 7. What would be the breakeven point, in units? a. 100 b. 60 a. Flour c. 75 b. Sugar d. 150 c. Vinegar d. Biscuit packaging 2. Prime cost is made up of ALL the following EXCEPT which one? a. Factory overheads 8. What is the margin of safety for the firm? a. 150 b. 75 c. 100 d. 90 b. Direct expenses c. Direct labour d. Direct materials 3. Which of the following is an indirect expense? a. Wages of factory workers b. Rental for machine used in production c. Lubricant for machines d. Property insurance for the factory 4. A cost that changes as output changes is called a: a. Semi-variable cost b. Variable cost c. Fixed cost d. Sunk cost Use the following information to answer Questions 5–8: Sales for the period were $15 000 and 150 units were sold. Direct material was $40, direct labour was $25, direct expenses were $10 and fixed cost amounted to $1,500. 5. What is the contribution per unit? a. $100 b. $75 c. $25 d. $2,500 6. What would be the gross profit under absorption costing? a. $2,250 b. $3,750 c. $6,000 d. $1,1250 Extended Essay Question Question one Total 27 marks The information below has been extracted from the books of Fruitalicious Ltd: Sales $20 000 Direct material per unit $20 Direct labour per unit $10 Total fixed cost$8,500 100 units of the product were sold in the period. a. Using the information above, calculate the following: i. Gross profit, using the marginal costing format (5 marks) ii. Gross profit, using the absorption costing format (5 marks) b. Determine the following: i. Number of units required for breakeven ii. Breakeven point in sales iii. Margin of safety (3 marks) (3 marks) (3 marks) c. Use the information to plot the breakeven chart. (8 marks) 223 224 22 Inventory Management LEARNING OBJECTIVES: At the end of this chapter students should be able to: Discuss the importance of holding inventory Discuss the importance of inventory control systems Analyse the different inventory control management systems Calculate the economic order quantity Show the EOQ by means of a graph Explain the ‘just in time’ inventory system Importance of inventory I nventory (or stock) is an important part of any business. ‘Inventory’ refers to any item or resources owned by the business. Firms hold different types of inventory including finished goods, work in progress, raw materials and maintenance and operating supplies. Regardless of which type of inventory a firm has and the costs involved, it is important to hold inventory. Firms may do so for a number of reasons: Materials can be purchased in bulk to benefit from bulk discount and also to reduce the cost of transportation for regular purchases of lower quantity – for example, two or three months’ worth of stock could be purchased at once Holding stock ensures that materials are readily available when needed for production. This will prevent the firm from running out of materials, especially during critical times. Since the supplier may not be able to deliver the raw materials as fast as the firm may need them, it is advisable to hold stock The firm can respond to changes in demand quickly. As stated above, the firm also holds a stock of finished goods. If there is a sudden increase in demand then the firm would be able to meet that demand while producing additional units For expected future surges in prices. If the firm is expecting that prices will increase in the near future, it will hold enough stock now in order to take advantage of the increase in price Stock is held as a safeguard in case the supplier encounters unforeseen problems and the lead time becomes longer than expected. Importance of inventory control We must be aware that once there is inventory, there is going to be a need for a proper and secure control system. The firm must safeguard its inventory from events such as theft, spoilage or obsolescence. To this end, it is important to have and maintain a good inventory management system. Inventory control involves carefully assessing the material needs of the firm, given its projected output, providing proper and secure storage and issuing materials as required by the Production Department. Based on the fact that stock occupies a lot of space and may be perishable, the main aim of inventory control is to minimise the overall time that stock is held. The firm would want to convert its raw materials quickly into finished goods and then sell those goods as soon as possible. A good inventory control system will depend on factors such as available storage space, security, proper staffing and the inventory management system in place. In controlling stock, management has to be aware of three important concepts: maximum stock level, reorder level and minimum stock level. These concepts are illustrated in Figure 22.1 (p 225). Now let us examine the main concepts that are shown on the graph: Maximum stock level is the maximum amount of stock that the business can hold, based on its objective or storage space Reorder level is the point at which a new order will be placed to replenish the stock. This is done to prevent the firm from running out of stock entirely before the new order arrives Reorder quantity is the amount that is ordered once the stock level reaches the reorder level. In Figure 22.1, the reorder quantity is the difference between the maximum stock level and the minimum stock level Minimum stock level is the lowest amount of stock the firm would want to hold at any given time. This is done to prevent production ‘down’ times due to holdups in stock deliveries CHAPTER 22 | INVENTORY MANAGEMENT Lead time is the amount of time between placing an order and receiving the order. The lead time is measured on the horizontal axis by calculating the difference between when the order was made (at the reorder level) and when it reaches the firm (the vertical line on the graph). In addition, the slanting lines are showing stock being used, while the vertical lines show when stock is replenished. Inventory control management Holding the right amount of stock is a very important part of inventory control. Holding too much stock can lead to serious repercussions for the firm, including: Wastage as a result of spoilage Increased cost of storage Liquidity problems, since cash is tied up in stock Stock may become outdated. On the other hand, holding too little stock can lead to production hold-ups and loss of sales revenue. In order to decide on the optimal level of stock to hold, the firm may employ one of the following inventory management systems: Economic order quantity In this system, the firm has to determine a specific point when an order will be placed and the amount of stock that will be purchased so that it does not over- or under stock the business. In order to accomplish this and minimise the total costs of holding stock, the firm needs to calculate its economic order quantity. In order to calculate the quantity of stock that will minimise total costs, the following formula is used: EOQ = 2CD H where: C is the cost of placing the order D is the annual rate of demand or quantity H is the cost of holding one unit of stock for a year. For example: A firm’s annual demand for an item of stock is 24 000 units. It incurs a cost of $50 to hold one unit of the stock for the year and the delivery cost of the stock is $2,000. Its economic order quantity would therefore be: 2 × 2,000 × 20 000 50 80 000 000 50 EOQ = = 1 600 000 = 1,265. Ordering 1,265 units at a time will help to minimise total costs in terms of both space and stock holding costs. EXERCISE The annual demand for an item is 12 000 units. The order cost is $1,000 and the cost of holding one unit of stock is $20. Calculate the EOQ. In the above section, we calculated the economic order quantity but this level of stock can also be shown by means of a graph, as seen in Figure 22.3 (p 227). A few things to note about the graph are: The order and delivery cost is falling as more stock is ordered. This could be as a result of reduced transportation costs or discounts received by the firm from large purchases The stockholding cost increases with the amount of stock. The more stock the company keeps, the more will be the costs Maximum for storage, staffing and security stock level The total cost curve is U-shaped and is minimised when it is at its lowest point The EOQ is where the stockholding cost curve and the order and delivery cost curve cross Re-order level each other and the total cost curve is at its minimum. Units of stock Minimum stock level Time Lead time Figure 22.1: Stock control levels Fixed time period model This inventory control system is one where each unit of stock is counted at specified times – for example, daily, weekly or monthly. When the amount of the current stock is ascertained, an order will be made to replenish the stock if 225 226 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT CASE STUDY A pile of confusion Stock Disaster is on the horizon for Simpson Lumber levels Yard, as its lack of proper inventory management 300 is proving chaotic and costly. Over the years, the owner, Mr Simpson, would purchase lumber on a random basis and ask his suppliers to give him a 200 mix of the different lumber they have in stock. This method would work to some extent, even though Mr Simpson would end up receiving more of one type of lumber than others. 100 As the lumber yard expands and becomes more popular, he is now finding it difficult to keep track of his stock and he is frequently out of stock of Time some types of lumber. In addition, some of the Jan Feb Mar Apr lumber stays at the yard and becomes distorted because of the long period of time it has been Figure 22.2: Simpson Lumber Yard stock control graph there. It is also evident that Mr Simpson has too much of some types of lumber because of the huge pile in the yard. To lessen his problem and restore some amount of organisation to his business, he has started doing some research and has come across the concept of stock control. The graph in Figure 22.2 gives some general information in terms of the way forward and this is expected to improve the situation at the lumber yard. Questions 1. Briefly explain the importance of having efficient inventory management in place. 2. Determine the following: a. Maximum stock b. Minimum stock c. Reorder level d. Reorder quantity e. Lead time 3. What other inventory control management strategy can Mr Simpson employ? Discuss the pros and cons of this strategy for the successful management of his business. necessary. This type of system is common in corner shops, supermarkets and possibly your school’s cafeteria. At specific times the amount of items in stock will be counted and an order is placed with the supplier, who sends a delivery truck to replenish the stock. A second option would be where the delivery truck stops by the firm at specific times and the firm will replenish its stock as required. ‘Just in time’ model This technique is one where very little stock, if any, will be held at the firm. An order for raw materials will then be (5 marks) (10 marks) (10 marks) Total 25 marks made when they are needed for production just in time. For this method to work effectively, the supplier of the raw materials has to be very efficient, with readily available supplies. Since there is little time between when an order is made and the delivery time for the finished product, there has to be very strong synergy among the main stakeholders – that is, company, workers, suppliers and customers. The supplier has to deliver raw materials of high quality on time so that production can start within a specified time. This method will almost eliminate the costs of stock holding, while minimising waste. CHAPTER 22 | INVENTORY MANAGEMENT Vendor certification Cost Total stock Stock holding Order and delivery EOQ Order In order for the firm to have a highly rated product, quality has to be built into the product from the stage of raw materials. In addition, since raw materials are delivered just when needed, there may not be sufficient time to scrutinise and assess materials properly. With this in mind, firms using this strategy may seek to purchase items from suppliers who are certified. Vendor certification refers to a verification of the supplier’s processes, quality standards and delivery cycles, making him/her a legitimate seller of raw materials. Raw materials that are purchased from a certified vendor are more likely to meet the required standards. Figure 22.3: A typical economic order quantity graph Responsibility of the workers In order for the ‘just in time’ inventory control system to work, quality has to be built into the product – that is, there is very little room for mistakes. The suppliers of raw materials will also have to give an assurance of quality, as defective materials make defective products. For ‘just in time’ to be effective, the following elements or features must be present: Workers play a significant role in the ‘just in time’ strategy. They must be fully aware of the firm’s quality standards and adhere to these standards in the production of goods and services. Deviations from these quality standards may end up delaying the delivery date of the products or not meeting some other pertinent deadline. Workers must be committed to the maintenance of quality for the ‘just in time’ production method to work. Standardisation Benefits of using ‘just in time’ This involves the production of a variety of goods using the least possible variety of raw material, tools, part and processes. The firm would establish standards of units of measurement by which quality and performance may be compared or measured. Since materials will be delivered when they are needed for manufacturing, the firm has to ensure that the parts used in production are standardised. The main reason is that there will not be enough time to source a variety of raw materials that are not readily available. In order for ‘just in time’ to work, the product, raw materials, parts, tools and processes should be standardised. High-quality raw materials Poor-quality raw materials can be detrimental to any form of production, but the risk is even greater with ‘just in time’. A firm that stores finished goods may find it easier to correct a defect with those goods, since they are not sold immediately. However, in ‘just in time’, defects in the final product will set back delivery and the firm may lose the customer. There is little time available for careful assessment of raw materials which may be needed for production on the same day. Receiving high-quality materials is therefore an important step in creating high-quality products. Fewer funds being tied up in stock Space previously used for storage will be freed up Stockholding costs are reduced significantly It emphasises quality control among key stakeholders Since maintaining quality is integral, the firm can reduce the wastage of resources and defect rates while improving customer satisfaction. Drawbacks of using ‘just in time’ The firm may have difficulty in meeting any sudden increase in demand for the final product There is almost no room for mistakes, as only minimum stock is kept The reliance on suppliers to maintain quality can be risky Since large amounts of raw materials might not be purchased, the firm is less likely to benefit from purchasing discounts and economies of scale If machinery should break down it might be detrimental to the firm since no stock of finished goods is kept. 227 228 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT CHAPTER SUMMARY A good inventory control system will be dependent on factors such as available storage space, security, proper staffing and the inventory management system in place Holding too much stock can lead to waste of resources, increased costs of storage and liquidity problems Holding too little stock is also problematic for the firm, as it may result in production hold-ups and loss of sales revenue Four key elements of the ‘just in time’ model are standardisation, high-quality raw materials, vendor certification and responsibility of workers. Three main inventory management systems are: economic order quantity, fixed time period model and ‘just in time’ MULTIPLE CHOICE QUESTIONS 1. A typical firm has FOUR main types of inventory. Identify which one of the following options is NOT a type of inventory: a. Work in progress b. Finished goods c. Machinery d. Raw materials 2. ALL of the following are reasons firms hold inventory, EXCEPT which one? 5. A firm holding too little stock may run into which of the following problems? a. Wastage as a result of spoilage b. Stock may become outdated c. Production hold-ups d. Increase in cost of storage Questions 6–8 refer to the graph in Figure 22.4. Cost A a. To utilise the available storage space b. The firm can respond to changes in demand quickly B c. Stock is held as a safeguard in case the supplier encounters unforeseen problems d. Against expected future surges in prices 3. ‘Lead time’ is defined as the: C a. Amount of time between placing an order and receiving the order b. Amount that is ordered once the stock level reaches the reorder level c. Maximum amount of stock that the business can hold, based on its objective or storage space d. Lowest amount of stock the firm would want to hold at any given time 4. ALL of the following are elements of a ‘just in time’ production method, EXCEPT which one? a. High-quality raw materials b. High storage costs c. Standardisation d. Vendor certification D Order Figure 22.4: Economic order quantity graph for Questions 6–8 6. Which of the following letters represents the economic order quantity? a. A b. B c. C d. D CHAPTER 22 | INVENTORY MANAGEMENT 7. The order and delivery cost curve is represented by the letter: a. A Extended Essay Questions b. B Question one c. C a. Firms hold stock for a number of reasons. Clearly outline five (5) reasons why they do this. (10 marks) d. D 8. Which of the curves represents rising storage cost as the number of stock increases? a. A b. B Total 25 marks b. With the use of examples, describe the fixed time period model of inventory control. (6 marks) c. Identify and discuss three (3) problems that firms may face as a result of holding too much inventory. (9 marks) c. C d. D Question two Total 25 marks a. Briefly explain how the ‘just in time’ model works. (3 marks) b. Briefly describe four (4) key elements of the ‘just in time’ model. (12 marks) c. Describe three (3) benefits and two (2) drawbacks of the ‘just in time’ model. (10 marks) 229 230 23 Lean Production and Quality Management LEARNING OBJECTIVES: At the end of this chapter students should be able to: Outline the importance of quality Apply the dimension of quality to goods and services markets Assess the different techniques that are used to improve quality Discuss the concept of lean production Understand the scope of Total Quality Management Importance of quality Q uality is defined by ISO 8402-94 as ‘The set of characteristics of an entity that give that entity the ability to satisfy expressed and implicit needs’. Generally speaking, ‘quality’ measures the degree to which a product meets or exceeds the desire of the consumer. Quality is normally measured in terms of performance, reliability and durability. It should be the desire of every firm to maintain quality at all times, since defective products can quickly ruin a firm’s reputation. Firms that maintain quality can also gain a competitive edge over their competitors. Customers often become loyal to any product that they believe give them the highest quality. With these in mind, firms should ensure that quality is always maintained within the firm. Dimensions of quality This concept was developed by David A Garvin, a professor at Harvard Business School, in the late 1980s. He proposed that there were eight distinctive dimensions of quality which are discussed below: Performance This dimension deals with the primary operating characteristics of the product. It is what the product was created for. For example, the primary operating characteristic of a cellular phone is to make and receive calls. If the phone cannot make and receive calls, then it would not fulfil this dimension. Performance is assessed by using measurable attributes so that each brand can be ranked objectively. Features This dimension includes the secondary aspects of the product’s performance. The features are the characteristics of the product that are used to supplement its basic functioning or performance. Going back to the example of the cellular phone, its features might include a camera, Wi-Fi technology and voice dialling, among others. Consumers should be able to use the features of the product to make judgements of quality and not just base these on their individual prejudices. Reliability A product’s reliability is judged against the possibility of it malfunctioning or breaking down within a specified period of time. The three most common measures of reliability are the average time of the first failure; the average time between failures; and the failure rate per unit produced. It is important to note that this measure would only be plausible for consumer durable goods which will be used over time, as opposed to services which are consumed instantly. As for the cellular phone in our example, the manufacturer would have to measure the average time that it will take before it starts malfunctioning. Conformance This measures the extent to which the product’s design and operating characteristics adhere to the established standards. Conformance is usually measured against the defect rates in the factory and frequency of service calls after the product is sold. In measuring conformance, deviations from the standards on matters such as labels with incorrect spelling or inferior construction, which do not result in service or repair, are not considered. Durability Durability is a measure of the expected lifespan of the product. It measures the product’s life in terms of economic and technical dimensions. Technical durability refers to the amount of use the consumer gets from the product before it deteriorates. It may also be defined as the amount of use the consumer gets from the product before it breaks down and has to be replaced instead of repaired. For example, when you purchase a pair of shoes, you may replace the tips or CHAPTER 23 | LEAN PRODUCTION AND QUALITY MANAGEMENT reinforce the soles but there comes a time when you have to replace them. Upon purchase you would have expected that the shoes should last for a particular period of time – that is its durability. Therefore, it may be difficult to please everyone in terms of this dimension of quality. For example, what you like in a car may not be the same as what someone else likes. Serviceability This is the perception of the consumer at the initial contact with the product – that is, what comes to mind the first time the product is seen. At this stage the consumer usually has insufficient information about the product’s attributes and so quality may be inferred from its various tangible or intangible aspects. Consumers at times depend on images, advertising and brand names to judge the product’s quality. This measures the speed, courtesy, capability and ease of repair of the product. Most consumers are aware that the product will break down at some time but a greater concern would be whether or not it can be repaired and the length of time it will take. Serviceability also includes the quality of the service personnel, the manner in which service appointments are kept and whether or not servicing corrects the problem. The consumer wants to know that, having spent hard-earned cash on a product, it will be able to be repaired or serviced should something goes wrong with it. Aesthetics This dimension is subjective in nature and relates to how the product looks, feels, sounds, tastes or smells. Unlike the other measurable dimensions, aesthetics is based on the judgements and preferences of the individual consumer. Perceived quality Techniques for improving quality Quality control and quality assurance Quality control is the process of ensuring that the product meets its established quality standards. The main objective of quality control is to ensure that products being produced and sold are free of defects. The lower the defect rate, the lower will be the cost incurred in correcting the problem CASE STUDY The booming ‘cell’ market A little over a decade ago, landline was the main form of telephone communication in the Caribbean, as few people were privileged enough to own a cellular phone. In fact, even those who did own cellular phones found them a bit difficult to carry around because of their size. Those phones carried a pole that the user would have to pull out before making a call. Most of these phones did exactly what they were purchased to do – that is, make calls. Today, cell phones are effectively mini computers with a myriad of capabilities. The telecommunications industry within the region started changing with the passing of the millennium. In Jamaica, for example, Cable and Wireless’s monopoly licence was revoked to allow other players to enter the market. With this change came new technology including ‘pole-less’ phones, the introduction of SIM cards, phones having different ringtones, texting features and even colour screens. Customers from that era would remember the Nokia 3310 model, which was quite possibly the catalyst for the changes we now have in the cellular phone industry. Today, we have stiff competition in the industry and some companies are still finding their way within the region. Some of the more popular brands include BlackBerry, iPhone, Samsung Galaxy and Nokia smartphones. These companies have changed the way people view their phones and the things that they look for before buying one. Now, consumers are assessing the storage space, internet connectivity and speed, messaging ability, megapixels of camera and video, style, size and appearance. Importantly, though, they still assess the durability of the instruments and the ease with which they will be able to get them repaired if something goes wrong. With the changing technological industry one must now wonder what other addition is there to come. We may very well be communicating through our watches or rings in the future! Questions 1. Explain the concept of ‘quality’ and its importance to the manufacture of cellular phones. 2. Discuss how any five (5) of the eight dimensions of quality apply to cellular phones. (5 marks) (20 marks) Total 25 marks 231 232 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT or destroying the product. High-quality products will help the firm to gain the trust and loyalty of consumers who will be satisfied after their usage. A good quality control system is one that involves regular inspection of the product and correction of any defects found. The following concepts are integral to quality control. Zero defects This concept involves the production of products that are free of faults and which adhere to the standards. It is usually used to encourage quality in the work of employees, who would be rewarded if quality products were produced. Quality assurance Quality assurance is a guarantee to maintain an agreed or established set of quality standards. In doing this, the firm’s suppliers must also be involved, since poor-quality raw materials lead to poor products. Unlike quality control, which focuses on detecting defects once they have occurred, quality assurance emphasises that the necessary steps be taken to prevent the occurrence of the defects. It therefore attempts to build quality into the system from the very outset. Quality standards These are standards that are established by independent organisations to ensure that the interests of consumers are protected – for example, the Bureau of Standards in Jamaica. Some of these standards will be explored below. Benchmarking No one company knows it all and so it is always good to learn the best practices of others. Benchmarking is another method for improving quality. It is the process whereby a firm identifies the best practices of another firm then implements them to improve its own product. It can be a very good source of quality improvement, as the strategies used by other firms in the industry or other industries have been tested and proven. It must be pointed out, however, that the aim of benchmarking is not to copy other firms’ products but rather to assess their production methods or processes. The objectives of the firm in using benchmarking may include: Improving delivery time and frequency Proper waste management and disposal Inventory control management Improving consumer service Cost reduction Eliminating waste in the production process. The main steps involved in benchmarking are: A Identify the area for improvement The firm must examine its operations carefully and identify the areas that need improvement. It will then decide which of these areas will be improved through benchmarking. In identifying the area of the business that needs improvement, the firm may gather information from sources such consumers and workers. It could carry out extensive market research or use consumer feedback cards or suggestion boxes. B Choose the right company Once the areas for benchmarking have been identified, the next step is to procure a company that will be studied and assessed. The company under study must be contacted and the relevant parameters established. For example, sensitive information such as trade secrets and pricing policy are not normally disclosed. Instead, the focus should be on best practices in terms of maintenance of standards and quality and strategies used to improve performance. C Gather information The next step is to gather information from the company to be benchmarked. This information can be gathered through the use of questionnaires, interviews or observation. The firm should ensure that the information collected is relevant to the areas that need improvement and is also credible. D Analyse the information gathered The information collected is of little help unless it is carefully analysed and decisions made regarding variances between both firms. A comparison should be done between what the firm is doing and what the benchmark company is doing. The analysis will help the firm to identify the areas of the benchmark findings to implement. E Implement and evaluate the findings Finally, the firm must now implement the findings of the benchmarking exercise. In addition, it should reassess its operations over time to ascertain whether or not the policies that were implemented as a result of benchmarking are working. Benefits of using benchmarking Brings about faster awareness of important innovations and how to implement them successfully Usually much cheaper than some of the other methods that are used to improve quality Proper implementation will help to reduce waste and improve productivity CHAPTER 23 | LEAN PRODUCTION AND QUALITY MANAGEMENT Can improve the competitiveness of the firm both locally and internationally Facilitates team building and employee involvement in the decision-making process Gives the firm a better understanding of its consumers and how to keep them satisfied. Limitations of benchmarking The search for a suitable firm to benchmark can be a very tedious process, as not all firms will want to share information While possible, what works for one firm may not necessarily work for the another Needs qualified experts to make comparisons that will be meaningful. This can be a very costly exercise. CASE STUDY Benchmarking for a better future SP Supermarket is said to be the second largest supermarket chain in the country and has been doing well. The business started out as being a small family retail business in the rural part of the country. Over the years, the business has grown and it has now opened over 14 branches across the country. It is now considering the option of opening other branches across the Caribbean. However, as with any other business, going into unknown territories can be dangerous if proper research and due diligence are not carried out. To this end, SP Supermarket has made the decision to identify and study a successful supermarket chain in the United Kingdom or the United States of America. The business that is chosen for benchmarking should be a large chain; have a membership system; and offer online shopping. SP Supermarket believes that if it can implement the online shopping strategy it would be a force to reckon with in the local market – this would be a first for the small Caribbean island. SP Supermarket is hoping to get ideas about how to go about spreading its wings to other countries in the region. Questions 1. Explain the concept of benchmarking. (2 marks) 2. Discuss the steps that SP Supermarket would need to take to in order to carry out its pending benchmark strategy. (15 marks) 3. Outline four (4) benefits that SP Supermarket could derive from benchmarking. (8 marks) Total 25 marks Implementing new policies within the company could be stalled by resistance to change and the necessary resources. ISO quality standards The International Organization for Standardization (ISO) was established in 1947 with a mandate to publish international standards relating to businesses worldwide. The ISO is a network of national standards organisations around the world. A number of CARICOM member states, if not all, are members of the ISO. The organisation has developed a number of ISO quality standards that relate to a number of different things. However, for the purposes of this course, the focus will be on ISO 9000, which deals with Quality Management. ISO 9000 is a group of standards that address different aspects of quality management. For example, ISO 9001:2008 focuses on requirements of a quality management system, while ISO 9004:2009 focuses on how to improve the efficiency and effectiveness of quality management systems. ISO 9000 outlines the guidelines that firms should employ to improve their levels of efficiency and customer satisfaction. The main goals of ISO 9000 are to increase productivity, minimise costs and improve the quality of processes and products. The ISO proposed the following principles of ISO 9000: Focus on customers – they should be the primary focus of the business. Organisations should attempt to respond to the needs of their customers so as to improve customer satisfaction, resource allocation and efficiency Good leadership – firms should ensure that a good team of managers are employed who have the requisite skills and ability to motivate their subordinates and minimise miscommunication Involvement of people – leadership should employ a team working strategy, as this would improve the morale of employees and improve the quality of work Process approach to quality management – it is suggested that activities and resources should be managed together. The ISO believes that this will lower costs as a result of better use of resources, personnel and time Continual improvement – this is closely related to Kaizen, which is discussed further later in this chapter Factual approach to decision making – decisions should be based on analysis and interpretation of data. This will enable the firm to make informed and statistically sound decisions Supplier relationships – good supplier relationships will help to improve the quality of raw materials. 233 234 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT It is believed that firms that employ the ISO quality standards should enjoy the following benefits: High level of consistency in performance Reduction in costs Improvement in customer satisfaction Higher productivity levels and improvement in efficiency Improvement in the morale of employees. Outsourcing As firms face the economic crunch and seek to reduce operational costs, the concept of outsourcing is becoming more and more popular. For many businesses, labour cost takes up a significant portion of the budget and finding cheaper labour with the requisite skills is always of interest. The term ‘outsourcing’ refers to the process whereby firms subcontract some of their operations to independent suppliers of services. When a firm outsources these operations it can concentrate resources on its core product. A common trend today is to outsource some of the firm’s services to call centres, catering companies, cleaning firms and security firms. The firm may also outsource some of its stages of production or the production of some of its products. As mentioned above, a firm in its search for cheaper labour may outsource the manufacture of its products to countries with lower labour costs, such as China. A number of businesses in the United States have been using this policy over the years. Countries such as China and India have been beneficiaries of US business outsourcing. While firms can rack up significant cost savings as a result of outsourcing, it may lead to low motivation and job insecurity in their own workforces. Firms should also consider the cost of outsourcing as compared with the present situation before embarking on this approach. A number of Caribbean countries have been positioning themselves to be beneficiaries of global outsourcing. This has been made possible with the development of Information and Communications Technology (ICT). It should be pointed out, however, that outsourcing can be done within the country. A firm may choose to subcontract the services of another firm because it is more efficient in its delivery of the service or production of the product. Benefits of outsourcing The firm’s focus can be on its core products Usually results in cost savings, including labour costs Improvement in efficiency and quality Can boost productivity and competitiveness Usually leads to greater customer satisfaction. Drawbacks of outsourcing The firm’s financial success may be tied to that of another company It might be more difficult for the firm to maintain quality, since it is not involved in the production of some of its products. This is especially possible where proper quality standards are not in place Can be a potential source of conflict, as the firm’s own workers may be laid off with the outsourcing of aspects of the business Loss of managerial control, since the outsource firm has its own management. Quality circles In maintaining quality, a firm must be aware that its employees are a very important part of the process. They are the ones who manufacture and interact with the product on a daily basis. To this end, they should be a part of the quality process. One way in which firms ensure that their CASE STUDY Production hold-ups at Plastic Galore Ltd Plastic Galore Ltd is a small privately owned company on the little island of Jamrock and specialises in the production of plastic products. The business did quite well after its inception, for the first five years. However, things have not been the same in recent years, as the company is now faced with numerous challenges which are dampening its future. In recent times, world oil prices have been soaring and this has affected the energy cost in the island. It is now becoming very expensive to operate and compete with other companies in territories where energy costs are not as high. The company is also faced with a local dollar the value of which has been sliding against the US dollar for the last ten years. The company is now seriously thinking of halting its production of plastic products and becoming a distributor. The directors are now eyeing a Chinese supplier to make the products on their behalf and ship them to Jamrock. This move could be beneficial to the company, while posing a few challenges. Questions (2 marks) 1. What is meant by the term ‘outsourcing?’ 2. Evaluate how the decision by the directors of Plastic Galore Ltd to outsource its production may affect the company. (18 marks) Total 20 marks CHAPTER 23 | LEAN PRODUCTION AND QUALITY MANAGEMENT employees are a part of the quality process is by setting up ‘quality circles’. These are groups of lower-level workers who meet regularly to analyse and critically review the design and production of a product. The team may also discuss production problems and develop possible solutions to these problems. They are normally charged with a mandate to improve the quality of the firm’s product offering. In most situations, members are given some training to assist them in the group’s work. The group may consist of workers from a wide cross-section of the firm who work collectively to improve the product’s quality where possible. Some of the main objectives of quality circles are: Promotion of employees’ involvement Fostering better communication Engendering good leadership qualities Fostering effective teamwork Allowing workers to develop their problem-solving capabilities Improving productivity. Some of the main features of quality circles are given below: Decisions are made by consensus rather than a ‘majority rule’ approach Groups are usually small in size, consisting of just a few employees Members are not chosen but opt to volunteer their services It uses a ‘bottom-up’ approach Regular meetings are held to discuss issues. Quality circles can be very effective in maintaining quality but it takes great effort on the part of all the stakeholders. For them to be successful and reap their potential benefits, quality circles have to be supported by management and the people who are a part of these teams must be committed to the tasks to be done. The use of this type of quality improvement method will also be dependent on the leadership style of management, as it needs a more participative approach. Management also needs to facilitate and train both the quality circle leader and the members. Quality circles should not be used as an avenue to deal with grievances or personal problems. If quality circles are utilised properly it can help to: Improve motivation in the workplace Promote continuous improvement Develop good leadership qualities among their members Improve communication between management and subordinates Reduce defect rates as employees become more aware of the maintenance of quality Promote team working among employees. Kaizen or continuous improvement Kaizen is a Japanese concept of continuous improvement. The approach is based on the notion that the improvement of a product should be a never-ending process. As a result, improvements should be made on a small and gradual basis over the life of the product. A firm using this method of improving quality will seek to continually improve its machinery, production method, raw material and labour, among other things. The concept of Kaizen was developed by the car manufacturer Nissan and has been used in its manufacturing process to improve efficiency and quality. A major assumption of this approach is that the employees play a critical role in the maintenance of quality. Since they interact with the product, they are able to identify areas of the production process or the product itself that need improvement. This approach is at times used in conjunction with quality circles or teamwork. The groups will review and assess production regularly and make suggestions for improvements. The main features of Kaizen or continuous improvements are: Small improvements are made continuously, unlike a major overhaul or improvement that is done when using research and development The workforce is regarded as being talented, skilled and usually knows more about the product therefore they are able to suggest improvements to be made Suggestions are usually easier to implement since they come from the workforce Small improvements are less likely to require major capital investments Teamwork is often used to solicit suggestions for improvement and to maintain quality. The Kaizen approach can be an effective one but its level of success is dependent on the organisational culture and leadership style being used. Management and workers must be committed to the culture of on-going change. The leadership style employed by management should be one that involves the workforce in the decision-making process. An organisation where workers are not given the opportunity to share their inputs or team work is not encouraged is less likely to reap success from Kaizen. The lines of communication must be open both ways and workers should be given the autonomy to make certain decisions. Continuous improvement also requires that the necessary resources are available to make the changes that are identified to improve quality. Limitations of Kaizen or continuous improvements Some of the changes that are required cannot be done incrementally 235 236 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT The firm may incur short-term costs on a regular basis as it implements changes Its success is heavily dependent on the culture of the organisation and leadership style of management Employees may feel pressurised into continuously coming up with new ideas There is little room for stability since things are always changing. Research and development (R & D) Large companies sometimes spend millions of dollars on their research and development programmes. In order to improve quality and satisfy their consumers, firms must endeavour to produce the best-quality products. This is done through conducting constant research and developing the products based on the findings of the research. Research and development involves steps taken by a firm to improve either the product itself or the way in which is made. This is particularly important in an industry that it very competitive, as firms must improve or develop new products in order to remain competitive. Research is concerned with the discovering and uncovering of new principles and ways to do things, while development deals with the transformation of the research findings into the actual improvement of the product or production process. Process development deals with the improvement of machines and the layout of the plant. On the other hand, product development involves the improvement or creation of different products. These products must be tested and evaluated before the firm goes into their full production. It is important to note that companies can either undertake their own research and development programmes or they can purchase the ideas generated by other institutions such as universities. A good research and development programme should result in innovations and product development. Outside of this, the firm would have underutilised and wasted the large sums of funds that were invested. Research and development provides the company with the following benefits: May help to boost sales Extends the firm’s reach into new markets Can improve the firm’s reputation and brand Improvements in quality The company can gain a competitive edge over rivals Improvements in the product and the value received by consumers Reduction in costs over time. The extent to which a firm invests in research and development may be dependent on: The amount of financial resources it has. R & D can be very expensive and if the firm does not possess the requisite funds, it may not be done The desire for long-term competitiveness as opposed to short-term success – R & D requires investments to bring about long-term success and competitiveness. Firms must be aware that an investment made now may not pay off until some years later The level of innovation in the industry – an industry where firms are very innovated will force other firms in the industry to be innovative Objectives of the firm. Lean production This method of production is credited to the Japanese car manufacturer, Toyota. Lean production was developed to reduce wastage of resources by using as few resources as possible in production. To this end, the company is expected to save time, money, materials and human effort while improving quality and productivity. Lean production’s overall aim is to cut costs while increasing efficiency. In order for this to be done, the firm would need to ensure that quality is maintained at all times throughout the organisation. A key aspect or feature of lean production would then be Total Quality Management. Total Quality Management (TQM) The success of the firm is dependent on whether or not it can provide quality goods and services to its consumers. In order for this to be accomplished, quality has to be the concern of every person who has an impact on the organisation. Efforts by management to maintain quality can prove futile if all stakeholders are not attempting to maintain quality themselves. The desire to achieve quality in all spheres of the business has given rise to the philosophy of Total Quality Management. TQM is a management philosophy which ensures that quality is maintained in all areas of the organisation in order to meet customers’ expectations. It is people focused and aims to satisfy the firm’s customers continually. One of the main objectives of TQM is customer satisfaction. The firm aims to satisfy its customers by building quality into its products and every aspect of the business. Other objectives of TQM would include: The enhancement of performance in terms of quality, speed or response, cost and flexibility To foster a customer-focused organisation instead of one focused on functions Improvement in the business’s flexibility and ability to adapt to the changing environment CHAPTER 23 | LEAN PRODUCTION AND QUALITY MANAGEMENT To create an organisation that is people focused and involves stakeholders in all its activities To empower workers to work in teams focused on improving quality To produce a product with zero defects. Once we examine TQM, we must make mention of W Edwards Deming, who contributed a lot to the study of quality improvement in the mid-1900s. In his work he proposed 14 principles that can be used to improve total quality. These are summarised below: Creation of a consistency of purpose with a view to improving quality and customer satisfaction Adopting a philosophy of leadership to promote change Cease using inspection as a means to achieve quality and instead build quality into the product from the beginning Establishing long-term relationships with suppliers. These should be based on their performance and not price Constantly improving quality, production and service provision, with the aim of reducing costs Implementing on-the-job training Changing the focus of leadership to one that promotes quality as opposed to production numbers. The view here is that quality improvement will result in improvements in productivity Driving fear out of employees so that they can work effectively and therefore increase productivity Breaking down barriers that exist among departments. This will encourage teamwork and synergy while possibly reducing conflict among the departments Eliminating criticism of workers and unrealistic targets and slogans that are not supported by the relevant resources to accomplish them Eliminating work standards such as quota for factory workers and numerical objectives for people in management Removing the barriers in the workplace which prevent workers from taking pride in their work. These barriers may include performance appraisal, where workers are assessed based on their output Educating workers and encouraging self-improvement. A skilled labour force is always an asset to a firm. Therefore to improve quality the work force must be encouraged to improve their educational level and knowledge Encouraging everyone in the organisation to work on the transformation process. In order for the transformation to be smooth and successful, it has to be the initiative of top management and filtered to other workers. The main features of Total Quality Management are outlined below: Consumer inputs TQM requires the full commitment of firms to their customers, as they are very important to quality improvement. Information must be gathered frequently about customers’ needs and expectations. When this information is received the firm must adjust its products or processes to cater for the desire of its customers. Zero defects The concept of zero defects was outlined above, however, it is also a very important feature of TQM. Since firms aim to satisfy their customers totally, they have to produce a product that is free from defects. For this to be achieved will take tremendous effort and care on the part of every stakeholder of the firm – that is, from supplier to customer. Teamwork/Quality circles Teamwork has become the most effective method used in TQM to solve problems. Empowering workers can help to build trust and morale throughout the organisation. Teamwork also helps to improve communication and cooperation between management and subordinates. Teamwork is important to TQM since the suggestions for fixing problems with quality will come from the very people who produce the product and have day-to-day interaction with it. Control strategies A good and effective TQM system is one where there are proper control strategies in place to monitor quality and the processes that are used. Total satisfaction of customers will only be achieved if the business has control over the factors that influence the quality of the product. Such factors may include the workforce, technology and materials. The monitoring of quality and business processes can help the firm to identify areas that can be improved. Company culture and policies TQM is most likely to be successful where it is infused in the culture of the firm. It has to be fully supported by top management and filtered down throughout the organisation. There must also be a culture of accountability among every individual in the organisation. Quality chains This refers to the relationship between suppliers and customers (both internal and external). Quality chains can 237 238 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT CASE STUDY Total Quality Management at Auto Giant Having made a decision to locate in Sunderland, UK in 1984, Nissan Motor Manufacturing UK Limited quickly became one of the largest car manufacturers in that country. The cars pass through a number of processes during manufacturing and Nissan UK recognised that quality has to be a very important part of its production. To this end, each employee is responsible not only for the quality of their own work but also for the quality of their co-workers’ work. The firm believes that it is best to ‘build good quality in’ the product rather than trying to ‘inspect poor quality out’. Each employee is expected to maintain a certain level of quality and also to check the adherence of the previous worker to the prescribed standards. Nissan UK adopts a Total Quality Management approach to the way business is done. The workers are encouraged to focus on creating high quality by understanding their customers’ requirements, considering the processes involved in providing quality, prioritising and standardising tasks to deliver quality and educating all employees to work in the prescribed way. The company believes that quality should be a part of the organisation’s culture. The company has a ‘Plan, Do, Check and Action’ cycle which is inculcated in the mind of each employee. This cycle is used to help maintain quality in the operations of the company. Nissan is known to be closely associated with Kaizen or continuous improvement of quality. The company stated that ‘We will not be restricted by the existing way of doing things but will instead continuously seek improvements in all our actions’. These changes do not have to be big but should be worthwhile. The beauty about these changes is that they are sometimes initiated by employees who at times work in groups to find new and improved ways of doing things. Questions 1. What is meant by ‘Total Quality Management’? 2. Outline two (2) of W Deming’s principles of improving quality that would apply to the case. 3. Explain four (4) principles of TQM that were mentioned in the case. 4. Outline three (3) benefits that Nissan could derive from its TQM approach. be broken at any point if a person or piece of equipment fails to produce goods in line with the requirements of customers. TQM places great emphasis on this chain, as that is the only way quality will be maintained throughout the organisation. Two other key features of TQM are benchmarking and continuous improvement, both of which were explained earlier. The role of the customer in TQM Since one of the main objectives of TQM is to satisfy customers, their role is a very important one. The customers are the main purchasers of the products and their views should be considered in quality management. The firm should continuously assess customers’ needs and seek to satisfy these needs. Customers’ needs can be ascertained through regular market research. Customers and consumers are able to make suggestions to the firm on how to improve quality to meet their needs. Customers tend to purchase the product that they believe has the highest quality and will give them value for money. With this in mind, they are the (2 marks) (4 marks) (16 marks) (3 marks) Total 25 marks best judge of the effectiveness of the firm’s product. Since TQM places so much emphasis on customer satisfaction, complaints from customers should be treated with care and a desire to correct any problems. Consumer knowledge should be integrated with the objectives of the firm so that a quality good or service can be produced. The success of TQM may depend on the following factors: Involvement of trade unions in the planning process – this could lead to greater acceptance by workers of the wholesale changes that might occur There needs to be a strong sense of job security – this could make it easier for workers to buy into the quality initiatives proposed by the firm Constant training of employees – workers must be trained in the area of maintenance of quality and teamwork. This is particularly important for firms that do not have a culture of TQM The financial resources of the firm – TQM initiatives tend to be expensive and quality changes may come at a high cost. Therefore, financial stability of the firm is needed for the success of TQM CHAPTER 23 | LEAN PRODUCTION AND QUALITY MANAGEMENT Involvement of employees in the decision-making process – involving employees in the plans to implement TQM may result in an easier transformation and acceptance. Can improve the firm’s competitiveness Helps companies to identify areas of waste and inefficiencies and to correct them. Possible limitations of TQM Benefits of implementing TQM Promotes an improvement in quality and achievement of zero defects Results in the continuous improvement of production and processes Proper implementation can lead to greater customer satisfaction Implementation cost might be exorbitant To be successful, it needs the involvement of the entire business Management may have unrealistic expectations for success which cannot materialise If not handled properly it may lead to labourmanagement problems. CHAPTER SUMMARY Zero defects, quality assurance and quality standards are essential concepts of quality control Garvin’s eight dimensions of quality include performance, reliability, features, conformance, durability, serviceability, aesthetics and perceived quality Quality circles have to be supported by management and the people who are a part of these teams must be committed to the tasks to be done Benchmarking can be a very good source of quality improvement, as the strategies used by other firms in the industry or other industries have been tested and proven The International Organization for Standardization uses the acronym ‘ISO’ as it comes from the Greek word ‘isos’ meaning ‘equal’ One of the main objectives of Total Quality Management is customer satisfaction T Edwards Deming has been credited for the impact his 14 principles of quality have had on the development of TQM. Lean production aims to reduce costs and improve efficiency MULTIPLE CHOICE QUESTIONS 1. ‘The set of characteristics of an entity that give that entity the ability to satisfy expressed and implicit needs’ best defines: a. Design b. Inventory control c. Quality d. Quality assurance 2. Which of the following dimensions of quality refers to ‘The perception of the consumer at the initial contact with the product’? 3. Which of the following is a limitation of benchmarking? a. It is usually much cheaper than some of the other methods that are used to improve quality b. Proper implementation will help to reduce waste and improve productivity c. The process can improve the competitiveness of the firm both locally and internationally d. Needs qualified experts to make comparisons that will be meaningful. This can be a very costly exercise 4. Which of Deming’s 14 principles for improving quality encourages teamwork in the organisation? a. Performance a. Drive fear out of the employees b. Perceived quality b. Break down barriers that exist among departments c. Conformance c. Eliminate work standards d. Features d. Implement on the job training 239 240 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT 5. Deming states that managers should ‘cease using inspection as a means to achieve quality and instead’: Extended Essay Questions Total 25 marks a. Build quality in the product from the beginning Question one b. Base relationship with suppliers on performance and not price b. Zero defects a. Discuss the following dimensions of quality, making specific reference to the purchase of a cellular phone: i. Performance ii. Features iii. Reliability iv. Serviceability v. Perceived quality (15 marks) b. Define the term ‘outsourcing’ and outline two (2) advantages and two (2) disadvantages of using this method to improve quality. (10 marks) c. Pricing strategy Question two c. Eliminate work standards d. Educate workers and encourage self-improvement 6. Which of the following is NOT a feature of Total Quality Management? a. Consumer inputs d. Quality circles 7. Which of the following is a benefit of implementing Total Quality Management in the organisation? a. Implementation cost might be exorbitant b. For TQM to be successful, it needs the involvement of the entire business c. Management may have unrealistic expectations for success which cannot materialise d. Results in the continuous improvement of production and processes Total 25 marks a. Outline four (4) objectives of Total Quality Management. (4 marks) b. Discuss how the following concepts can be used to improve quality: i. Benchmarking ii. Outsourcing iii. Quality circles iv. Kaizen (continuous improvement) (16 marks) c. Outline three (3) benefits and two (2) limitations of implementing Total Quality Management. (5 marks) 241 24 LEARNING OBJECTIVES: At the end of this chapter students should be able to: Explain the concept of productivity Outline the difference between productivity and production Discuss the importance of productivity to an organisation Outline the internal and external factors that affect the level of productivity in a firm Discuss the methods of measuring productivity Analyse the different methods of improving productivity P roductivity is becoming more and more of a ‘catchphrase’ today – especially in trying economic times. Limited finances and, in some cases, less than favourable output have sparked moves by many firms to implement strategies to improve productivity. However, with all this talk about productivity, the question must be asked: what does ‘productivity’ mean? Generally speaking, it is a measure of how well a business is using its resources. However, it is more appropriately defined as the amount of output that is produced per unit of input (labour, land or capital). Productivity results in the enhancement of the production process. The more productive the firm is, the better able it is to transform inputs into output at a relatively low cost. This is as a result of producing more without using more input or resources. It is very important that we outline the distinction between productivity and production. The case in point is that, there can be an increase in production without an increase in productivity. An increase in production refers to an increase in the amount of output that is produced, while an increase in productivity refers to an increase in the output per input. To further illustrate this let us examine the following example: Example Each Christmas, 25 students are able to package 5,000 gifts for a children’s home, working for two hours each day for 20 days. What is the production and what is the level of productivity? Productivity Production = 5,000 gifts Productivity = 5,000/(25 × 2 × 20) = 5 gifts per labour hour. Now, suppose that for one Christmas the amount of students rose to 30 and the number of gifts packaged also increased by 1,000. What is production and what is the level of productivity now? Production = 6,000 gifts Productivity = 6,000/(30 × 2 × 20) = 5 gifts per labour hour. We can draw the conclusion that production increased by 1,000 gifts but the level of productivity remained the same. The level of productivity is very important to all stakeholders of the firm. Some of the general reasons for this are: Productivity is used to assess how well the firm is using its inputs to produce output The level of productivity gives managers the opportunity to plan, control and improve efficiency within the organisation Workers can benefit from increased productivity by receiving increased salary and incentives. This can improve motivation Higher levels of productivity can result in lower production cost for the firm Shareholders will also benefit for high productivity as the firm will generate more profits which will be shared among them. Factors that affect productivity These factors can be divided into internal and external factors. Internal factors These factors are those over which the firm has control, including: Labour–management relations This refers to the relationship that exists between management and the workforce. A good relationship can foster improvements in productivity, while the opposite 242 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT is also true. Knowing this, management has tried to improve its relationship with the workforce by improving communication and their level of motivation. Where workers become disgruntled and take industrial action, the firm loses productive times and in most cases suffers a reduction in productivity. Over the years, some unions, in protecting the interests of their members, have diminished productivity growth through their resistance to production and productivityimproving technology. The introduction of machinery and equipment to improve production and productivity, in most cases, means that some workers will lose their jobs. No union wants this and so they will seek to resist such changes. However, management has been able to get unions to ‘buy into’ improvement in productivity by having discussions outlining the long-term benefits to both the firm and workers. Required investor returns People enter into business to make profit and if this is not happening, it is more than likely that they will leave the business. Productivity is particularly important for these business people. As they invest in different business ventures, they expect to get sufficient return on their investments. A required return on investment is the minimum return that the investor requires in order to purchase an asset or make an investment. It follows that the more productive a firm is, the more likely it is for the investors to acquire their require rate of return on investment. If investors are not convinced that they will receive sufficient return on their investment then they may be reluctant to invest. Without investment in new and improved technology, the firm may suffer from inefficiency and poor productivity. External factors prices (land, labour or capital) will lead to a reduction in productivity. For example, an increase in wages means that the firm will have to pay more in order to produce the same unit of the product. This will result in a reduction in productivity. Increases in the price of consumer goods can also affect the emphasis that firms put into improving productivity. If inflation causes prices to rise, firms may be content that they can reap higher prices without seeking to improve the quality of their factor inputs. Productivity is usually low in these circumstances. Regulations and laws These can either enhance or impede productivity. Where regulations and laws result in an increase in the price of factor inputs, productivity will fall. For example, regulations such as import restrictions and anti-pollution laws usually cause an increase in input prices. In addition, barriers to enter in an industry (such as monopoly) provide an incentive for firms to be unproductive. If it were the case that there was competition in the industry, the firm would be force to improve productivity to maintain competitiveness. On the other hand, laws and regulations that encourage firms to improve working conditions can increase the firm’s productivity. As workers’ level of motivation increases, they tend to improve their work ethics and productivity. Market demand A product with a high demand usually generates a high level of productivity. In trying to meet this demand, the firm will seek to increase its productive capability. This could mean that production-improving technologies are employed or workers are encouraged to produce more with the given resources. Management would be well aware that the more productive the firm is, the more likely it is to meet its growing demand. Effort would then be made to increase the output per man and, hence, productivity. Technology Technology is always changing and improvements are made at regular intervals. This could offer significant benefits to firms if they are able to make use of such improvements. One of the benefits of technology is that it enables the firm to increase output even if it is using the same amount of resources. Improvement in technology can also help the firm to minimise wastage of resources. New and improved technology can also increase the level of output per unit of input – that is, productivity. Level of pricing The firm’s productivity can be affected by changes in the price of its inputs into production. An increase in factor Competition As stated before, lack of competition can impede improvement in productivity. For example, a firm operating as a monopoly may not be driven to improve productivity levels since it is the only supplier and restricting output can increase profits. Conversely, a firm operating in an industry where competition is fierce is forced to become more productive in order to survive. In order to maintain or improve market share, the firm must be able to produce high-quality products that will meet the demand of its customers at competitive prices. This goal will boost productivity, as greater output from each unit of input will both increase production and reduce costs. CHAPTER 24 | PRODUCTIVITY Quality of the labour supply Consumer feedback You would agree that productivity can be seriously affected by the quality of the labour force. Improvement in output per man is more likely to be achieved where the workforce is highly skilled and well trained. The more educated the workforce is, the more likely it is to improve productivity. With experience and the requisite ‘know-how’, workers will be able to improve their individual and collective output while reducing wastage of resources. When workers are new to the job and lack experience and training, it is more likely that their individual output will be low. Workers will spend time learning about the production process and how to use machinery and equipment. Without sufficient training and experience, the firm’s level of productivity could be dampened. In this section we will examine three main measures of productivity, with the first being the most commonly used method. Consumer feedback is a vital source of information on how well the organisation is doing in providing its goods and services. This feedback from consumers can be used to measure the level of productivity of the firm. Bad reviews from consumers are indicative of its failure to meet or exceed consumers’ expectations. Consumer feedback can be gathered through market research. Information about the performance of the product, the company and the quality of the service it offers can be ascertained. This information can then be used to improve quality, improve profitability and correct any flaws that the product may have. Consumers are the final users of the product and firms must capitalise on the information they provide. While this measure does not provide the firm with statistical data, the information can give the firm feedback on how well it has been able to supply consumer demand. The feedback can give information pertaining to costs, accuracy and timeliness of supply. If consumers complain of the unavailability of products, it is an indication that products are not being made quickly enough. Labour productivity or output per labour hour Quality assurance feedback Labour productivity is probably the simplest and most common method of measuring productivity. It measures the ratio of output to input and uses the formula: Total output Total input (labour) This measure indicates the efficiency with which labour is used in production. Now let us examine the following example. A firm produces 15 000 unit of output while using 250 labour hours. Labour productivity = 15 000/250 = 60 units per labour hour. The quality assurance approach to production ensures that pre-set standards and quality procedures are carefully followed. It builds quality into the product from the suppliers to customers. Management will receive periodical feedback on the effectiveness of the firm system of quality feedback. This feedback can provide management with information on the amount of finished products that meet these pre-set standards. The information can then be used as an indication of the level of productivity of the workforce. The more productive the workforce, the more likely it is that the products being produced will adhere to the quality standards of the firm. Quality assurance also incorporates consumers and their views of the product. Their level of satisfaction can be used as an indication that the products have met or surpassed their standards. Methods of measuring productivity EXERCISE A Harp Company Ltd is a manufacturer of netbooks. It produced 9 000 netbooks by employing 30 people at 8 hours per day for 30 days. a. Determine the: i. Production ii. Productivity b. If the company increased its production to 12 000 netbooks by employing 15 more workers at 8 hours per day for 30 days, how does this affect production and productivity? Methods of improving productivity Improving productivity is of utmost importance to most firms. In general, productivity can be improved by doing one of the following: Increasing output as costs remains constant, i.e. increasing output without employing any additional resources, or 243 244 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT Reducing costs while maintaining the same level of output. This can be achieved by employing cheaper labour or materials. The following are some of the popular methods that are used by firm to improve productivity: Good working environment From the knowledge garnered from the topic on Motivation in Unit 1 of the course, it should be clear that workers are more likely to be motivated to work in an environment that is safe and convenient. Employees usually perform better when they are comfortable with their surroundings and the conditions under which they work. Management should strive to maintain good working relations with employees so as to lessen the risks of industrial action which can slow productivity. Management should arrange the work area so as to improve efficiency and reduce accidents. In other words, the environment should be arranged ergonomically. ‘Ergonomics’ refers to the process of organising the work environment to improve efficiency and reduce accidents and work hazards. Providing the best possible environment for workers can help to improve productivity. It will lead to a reduction in time wasting and workers can instead focus on producing the goods or services of the firm. Reduction in accidents and the removal of work hazards will enable workers to work comfortably and productively. Profit-sharing plans Profit-sharing plans are an incentive for hard work done. They can also be used to encourage workers to put in extra effort in carrying out their responsibilities. In a number of cases employees are promised a share of the company’s profits if the firm does extremely well. Knowing that they will get a share of the profits will help to motivate workers to improve productivity and their work attitude. Review Chapter 8 for further information and also the advantages and disadvantages of using this method. Technological improvements While this method may not be very popular with trade unions and workers, technological improvements are known to improve productivity. With the use of modern machines and equipment, the firm can help to reduce waste, improve speed and quality in production and increase the amount of output that is produced from the inputs. Firms that have undertaken mass production are particularly keen to improve productivity at all times. This being the case, they will have to keep up with the latest technology so that they can meet the demand for their products. For example, automated or robotic technology has significantly changed the scope of mass production. Firms are now able to produce thousands of products within a week, as opposed to previous times. Improvement in technology has also helped to improve efficiency as quality in the manufacturing industry. Technology can reduce human mistakes while adhering to quality standards. Training This can also be a vital way to improve productivity, especially for organisations with large percentages of unskilled labour. Training people how to carry out a given task will help to improve speed, quality and productivity. As workers acquire new skills or better ways of carrying out their tasks, it is likely that there will be a reduction in waste and improvement in work habits. Some of you may agree that, all things being equal, the greater the level of education of the workforce, the greater will be the level of productivity. As was stated earlier in Unit 1, the firm can train workers either on the job or off the job. However, regardless of which method is used, it should reap the same benefits in terms of productivity. Staff participation in decision making When we discussed motivation in Unit 1, all three major theorists we discussed alluded to the fact that workers rather to be involved in the decision-making process of the firm. When workers are motivated it is more likely that they will work with alacrity. Workers who feel that they are not important to the firm may work slowly as they have no drive to improve productivity and work habits. The act of involving subordinates in decision making is referred to as ‘empowerment’. However, empowerment is more appropriately defined as a management practice that gives power to employees to make decisions, solve problems and uses their initiative to improve performance. CHAPTER 24 | PRODUCTIVITY CASE STUDY Poor productivity problems at Ping’s Pizza When the Ping family had the idea to establish a pizza business to sell their homemade pizzas, it was hoped that, by the third year, business would be flourishing. After three years running, the firm still has not achieved this goal. This has drawn the attention of Mr Ping, the manager. What has become evident to him is that the firm cannot meet its customer orders within 30 minutes and they are losing customers to a new competitor who has promised its customers pizza within that time. There are five employees on staff, consisting of two chefs, one cashier and two servers. There are two older-type ovens, with a maximum capacity of 40 pizzas on average per day in only two sizes. The pizza world is changing, but the chefs at Ping’s Pizza are from the ‘old school’ and are not familiar with some of the new forms of pizza and toppings. This has limited the firm’s variety of offerings. In addition to these problems, Mr Ping has been watching the rise in his input cost compared with his output. The cost of energy has risen significantly over the past three years and this has been coupled with higher wage demands. It is becoming quite evident that something needs to be done to keep the business afloat in these tough times. According to the Ping family, closing down the business is the last thing on their minds. However, there need to be some changes in the level of productivity at the firm. They have decided to take the necessary steps to turn around the business within this financial year. However, in order to do so, they need to get the commitment of all the parties involved in the pizza production – that is, from making to delivery. Questions 1. Define the term ‘productivity’ and state how it is calculated. (2 marks) 2. Calculate the labour productivity if the five workers work for eight hours each day. (5 marks) 3. Discuss three (3) factors that are contributing to poor productivity at Ping’s Pizza. (12 marks) 4. Based on the situation facing Ping’s Pizza, discuss two (2) steps that can be taken to improve overall productivity. (6 marks) Total 25 marks CHAPTER SUMMARY The more productive the firm is, the better able it is to transform inputs into output at a relatively low cost An increase in production refers to an increase in the amount of output that is produced, while an increase in productivity refers to an increase in the output per input The more productive a firm is, the more likely it is for the investors to acquire their required rate of return on investment Labour productivity indicates the efficiency with which labour is used in production In general, productivity can be improved by either increasing output as costs remain constant (i.e. increasing output without employing any additional resources) or reducing costs while maintaining the same level of output by employing cheaper labour or materials. 245 246 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT MULTIPLE CHOICE QUESTIONS 1. The amount of output that is produced per unit of input is referred to as: a. Production b. Output c. Productivity d. Efficiency 2. Which of the following is an internal factor which affects productivity? Extended Essay Questions Question one Total 25 marks a. Discuss the importance of productivity to the following stakeholders of society: i. The business ii. Trade unions iii. Government (12 marks) b. Define the term ‘productivity’ and discuss any three (3) factors that may have an impact on the level of productivity in an organisation. (13 marks) a. Labour management relations Question two b. Level of prices a. Discuss how management can use consumer feedback to measure productivity. b. Discuss five (5) factors that firms may use to improve productivity. c. Market demand d. Competition 3. Which of the following is MOST LIKELY to improve productivity? a. Centralisation b. Extended work day c. Training of employees d. Production standards 4. Calculate the labour productivity if output = 14 000; labour hours were 40; and there were 10 workers. a. 35 units per labour hour b. 40 units per labour hour c. 350 units per labour hour d. 280 units per labour hour 5. If output in Question 4 moves to 16 000, what is the increase in production? a. 40 units per labour hour b. 400 units per labour hour c. 2,000 units d. 1,950 units Total 25 marks (5 marks) (20 marks) 247 25 LEARNING OBJECTIVES: At the end of this chapter students should be able to: State the advantages and disadvantages of decisionmaking tools Construct critical path networks and decision trees Interpret the critical path and decision tree diagrams Identify float times and dummy activities P roject management is vital to the firm if it is to be successful in business. In order to minimise loss and wastage of resources, it is advisable that the firm’s projects be carefully managed on a step-by-step basis. This chapter discusses how to manage the different projects that a firm may be running. Two main techniques are utilised in project management: quantitative and qualitative techniques. Quantitative techniques involve the use of data that can be measured or quantified. Quantitative decisions are made based on statistical data such as market share or sale record. The following tools are used to make quantitative decisions. Critical Path Analysis (CPA) Critical Path Analysis is sometimes referred to as ‘Critical Path Method’ or ‘Network Analysis’. It is used to schedule a complex series of related tasks. CPA is a network map of a project or activity that traces the sequence of tasks from start to finish. The sequence of activities is very important, as any change in an activity may affect the entire network. Therefore the assumption is made that project activity times can be estimated accurately and they do not vary. Using CPA allows businesses to: Forecast the length of time needed for the completion of a project Monitor the progress of the project, while identifying delays Identify the resources needed for the project Highlight activities where timing is critical. Project Management CPA can be used in any situation where sequencing of activities is needed. It can be used to sequence anything from the activities you do while getting ready for school to the activities carried out by a construction or manufacturing firm. Understanding some important concepts before you draw your first network diagram is vital. Let us examine these. A node or circle is used to show the start or end of an activity. It is divided into three sections, as seen in Figure 25.1. Earliest start time (EST) Node number Latest finish time (LFT) Figure 25.1: The sections of a node EST is the earliest time (date) an activity can start LFT is the latest time (date) that an activity should end to prevent delaying the next activity Lines are used to represent each activity. Ensure that you put the name of the activity on top and the duration of the activity beneath. These lines should not cross each other. See Figure 25.2. Activity ‘x’ Duration Figure 25.2: Lines representing activity Total float is the maximum increase in time that an activity can take without causing an increase in the overall duration of the project. It is calculated as: LFT – duration – EST Free float is the maximum increase in the time taken by one activity that will not alter the floats available to other activities. This is calculated as: EST at end – duration – EST at start 248 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT Critical path is the sequence of activity in the network diagram which takes the longest time to complete. If any of the activity on the critical path is delayed, the entire project will be delayed. Therefore there can be no float time along this path. The critical path can be identified where the EST and LFT are the same, meaning that there is no float along that path. Now let us try a simple and common sequence of activity: getting ready for school in the morning. See Table 25.1. Please note that the times allotted are randomly chosen and you may add or subtract from the activity to fit your own situation. Activity Duration (minutes) Bathe 15 Get dressed 10 Eat breakfast 10 Watch morning news headlines 5 Pack school bag 5 Leave (go to bus stop or car) 5 Table 25.1: Getting ready for school Your network diagram should be as shown in Figure 25.3. The chart is drawn from left to right, while noting the preceding activity. A node is used to start and end the diagram. Node 1 represents the start of the network and has an EST and LFT of zero. To calculate the EST, start from the left and add the EST at the beginning of the activity to its duration until you reach the final node. Where there are two activities going to the same node, use the higher of the values (this will be examined in the next example). The values would be: 0 + 15 = 15 15 + 10 = 25 25 + 10 = 35 35 + 5 = 40 40 + 5 = 45 and 45 + 5 = 50. Note that the duration of the network would be 50 minutes. To calculate the LFT, start from the last node and minus the duration of each activity from the LFT until you reach the first node – that is, from right to left. Where there are two activities going to the same node, use the lower number for the LFT. The values would be: 50 – 5 = 45 45 – 5 = 40 40 – 5 = 35 35 – 10 = 25 25 – 10 = 15 15 – 15 = 0. In the above example, all the activities follow the same sequence. However, there are times when two or more activities can occur concurrently. For example, you could eat breakfast and watch the morning news headlines at the same time. See Table 25.2. Activity Duration Preceding activity (minutes) Bathe 15 Do first Get dressed 10 Bathing Eat breakfast 10 Get dressed Watch morning news headlines 5 Get dressed Pack school bag 5 Breakfast, news Leave (go to bus stop or car) 5 Pack bag Table 25.2: Getting ready for school (revised timings) Our new network diagram would look like Figure 25.4. Since you can now eat and watch the news at the same time, you save some time on the entire network. The EST now reads: 0 + 15 = 15 15 + 10 = 25 25 + 10 = 35* 25 + 5 = 30* 35 + 5 = 40 40 + 5 = 45. Bathe Dress Eat News Pack Leave 15 10 10 5 5 5 Figure 25.3: Network diagram Eat Bathe Dress 10 Pack Leave 15 10 News 5 5 Figure 25.4: New network diagram 5 CHAPTER 25 | PROJECT MANAGEMENT At node 4 there are two ESTs (35 and 30), therefore we use the higher value. The reason behind this is that if you delay eating, it will delay the time you have for the entire network. The LFT now reads: 45 – 5 = 40 40 – 5 = 35 35 – 5 = 30* 35 – 10 = 25* B25 – 10 = 15 15 – 15 = 0. At node 3 there are two activities depending on you to get dressed. Here, we choose the lower of the numbers, i.e. 25. The reason for this is that we have two activities waiting on you to get dressed so that they can begin. If you start eating after 30 minutes, there will not be enough time to finish, even though there will be enough time to watch the news headlines. Now we turn to an earlier mentioned concept: float time. You realise that there can be a delay in watching news for up to 5 minutes? Using the formula given earlier, the total float would be: LFT – duration – EST 35 – 5 – 25 = 5 minutes. The critical path would be: Bathe – Dress – Eat – Pack – Leave 15 + 10 + 10 + 5 + 5 = 45 minutes Bathe – Dress – News – Pack – Leave 15 + 10 + 5 + 5 + 5 = 40 minutes. The first option is the critical path since it takes the longest time to be completed. Try this exercise: Activity Duration (weeks) Predecessor/Preceding activity A 3 Do first B 4 A C 2 A D 6 B E 7 C F 4 E G 4 D, F Table 25.3: Information for critical path exercise Activity Duration Preceding activities A 5 -- B 4 A C 6 A D 3 B E 4 C, D F 7 C G 5 F, E Table 25.4: Information for critical path example B A C B C B EXERCISE C Look at the information in Table 25.3, then: 1. Draw the network diagram 2. Calculate the EST and LFT 3. Calculate the critical path 4. Calculate the total float and the free float. D D E Diagram 1 shows that activities B and C are dependent on A. They must wait for A to finish before they can start. Diagram 2 shows that activity D is dependent on both B and C. It must wait for B and C to finish before it can start. B D Diagram 3 shows that activities D and E are dependent on both B and C. They must wait for B and C to finish before they can start. C E Figure 25.5: Three possible situations in CPA Figure 25.6: New diagram, using dummy activity Using a dummy activity B 1 0 0 A 5 wks 2 5 5 4 wks C 6 wks Figure 25.7: Network diagram 3 9 13 4 11 11 D 3 wks 5 12 16 F 7 wks E 4 wks 6 In constructing the CPA, you will come across one or more of the three situations shown in the diagrams in Figure 25.5. Diagrams 1 and 2 are normal and can be represented on the network. However, Diagram 3 is problematic, as it might be complicated G 18 7 23 23 18 to show this relationship on the network 5 wks diagram. To solve this problem, a dummy activity is used to illustrate the relationship and dependency of D on B 249 250 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT and at the same time E being dependent on B and C. The new diagram would now be as shown in Figure 25.6 (p 249). The dummy activity is represented by a dotted line as it uses no resources and carries no value, i.e. it has a duration of zero. The diagram in Figure 25.6 shows the same relationship and dependency as Diagram 3 in Figure 25.5 (p 249) but it uses two different paths and a dummy line. Now let us examine the following example which uses the information in Table 25.4 and results in the diagram in Figure 25.7 (p 249). Example Critical path is: A ➝ C = F – G 5 + 6 + 7 + 5 = 23 wks Float times are: Total float : LFT – duration – EST B = 13 – 4 -5 = 4 wks D = 16 – 3 – 9 = 4 wks E = 18 – 4 – 12 = 2 wks Free float = EST at end – duration – EST at start E = 18 – 4 – 12 = 2wks Now try the following exercise on your own. Useful for the scheduling, controlling and monitoring of projects Minimises stock level and equipment costs, since items and equipment can be purchased or rented when needed Help firms to be more efficient, since wastage is minimised Management can identify activities with float time. Disadvantages of Critical Path Analysis Too many activities may make it difficult to construct a network diagram The estimates made may be incorrect, invalidating the entire project The scheduling of personnel and the allocation of resources cannot be represented on the network CPA can be complex and complicated, especially for larger projects Unforeseen events (for example, weather) may delay the project. Decision trees EXERCISE A Fisher Ltd is contemplating a project with the list of activities shown in Table 25.5: Activity Duration (weeks) Predecessors A 2 -- B 5 A C 4 A D 8 B E 7 C and D F 3 E and F G 8 D, F H 10 D I 5 G and H Table 25.5: Activities by A Fisher Ltd There are times when managers have to choose from different alternatives with different outcomes. In such cases, CPA cannot be used to make the decision. For example, management may have to choose between developing a new product and rebranding an existing product. CPA is not suitable for this decision. A second tool available to management is the decision tree. It is a graphical representation of a series of interrelated sequential decisions. The decision tree is used to trace alternative outcomes of decisions and compare each result before a decision is made. As the name suggests, the diagram is drawn in the shape of a tree, using squares and circles (known as ‘nodes’) and branches. A square (‘decision node’) is used at points where a decision has to be made about which course of action to take – for example, whether to develop a new product or rebrand. A circle (‘chance node’) is used when a course of action may lead to several outcomes – for example, if the firm rebrands, sales might be at a high or a 1. Draw the network diagram showing the EST and the LFT 2. What is the critical path? 3. Calculate the float times. High 1 Advantages of Critical Path Analysis Help businesses to identify resources needed and when Management can decide which activity should be closely supervised in order to prevent delays New uct prod Low High Rebr andi ng Figure 25.8: A decision tree Low CHAPTER 25 | PROJECT MANAGEMENT low level. Let us look at how to represent the example above using the decision tree. See Figure 25.8. To aid the decision-making process, managers will also look at the probability of each outcome happening. In Figure 25.8, there is a probability that the decision taken will result in either high or low sales. Probability is measured at between 0 and 1. If the possibility of an outcome occurring is certain, the probability will be 1. In contrast, if the outcome is impossible, the probability will be 0. We can now be more specific in our example. The probability of the sales of a new product being high could be estimated as 0.6 and low as 0.4, while for rebranding high could be 0.5 and low 0.5. This can now be added to our diagram, as shown in Figure 25.9. Profit/loss EV = 32 000 1 New .6 h=0 Hig $60 000 uct prod Low = 0.4 High = Rebr andi 0.5 $(10 000) $50 000 ng EV = 33 000 Low =0 .5 $16 000 Figure 25.9: The revised decision tree In addition to the probability of each course of action, the expected financial outcome of the decision should be calculated. This is known as the expected value. It is calculated using the profit (loss) of an outcome and the probability of its occurring. The expected value of each outcome is calculated as: Predicted profit (loss) × the probability of it occurring. To find the expected value of a course of action, add all the expected values of the possible outcomes. The course of action that is most profitable based on the expected value should be chosen. The discarded option is usually crossed off with two lines. Now we can expand on the diagram above, using the information from Table 25.6. Profit/Loss $ Projects Cost If sales are high If sales are low New Product $30 000 60 000 (10 000) Rebranding 50 000 16 000 $20 000 Table 25.6: Expected values Information gathered through market research suggests that there is a 0.6 probability of sales from a new product being high and 0.4 of it being low. The probability for rebranding is 0.5. The decision tree would now be as shown in Figure 25.9: The expected values are calculate as follows: New product = (60 000 × 0.6) + (–10 000 × 0.4) = $32 000 Rebranding = (50 000 × 0.5) + (16 000 × 0.5) = $33 000 Based on the expected values, management should choose the option of rebranding the product, since its expected value is greater than that for developing a new product. Note: The decision tree is drawn from left to right but the values are calculated from right to left. EXERCISE Finding the right location can be a challenge for businesses and James Duncan, a prospective entrepreneur, is faced with that challenge. Presently he has two options available to him. He could locate in either Jamaica or Guyana, depending on his market research. The data from his research is summarised in Table 25.7 (p 252). 1. Construct a decision tree from the above information 2. Calculate the expected value for both locations 3. Advise James Duncan on what the better option would be. Here is a more complex example: Example A firm is faced with the problem of declining sales and is thinking of ways to rectify this. It is considering three options: 1. Stay at the current location. The firm would make an average sale of $0.4m if this option is chosen. 2. Stay and advertise, in an attempt to increase sales. This presents two possible outcomes. If the advertisement is successful, sales will be $0.8m and the probability of this happening is 0.7. If the advertisement fails, sales will be $0.5, at a probability of 0.3. 3. Relocate to the town. If the firm relocates, it has two alternatives. It can sell the same product and the probability of this happening is 0.6 or there is a 0.4 probability of it changing the product. If the firm sells the same product, the chance of success is 0.8 and sales would be $1m, while, if it fails, sales would be $0.4m. If the firm decides to change the product, it has to make a decision between rebranding and developing a new product. If it rebrands the product, the probability of success is 0.6 and sales are estimated at $1.2m. If it fails, sales will be $0.4m. If it develops a new product, the chance of success is 0.5 and sales $1m, while, if it fails, sales will be $0.4m. 251 252 MODULE 1 | UNIT 2 | PRODUCTION AND OPERATIONS MANAGEMENT Jamaica Guyana Level of sales Probability Revenue/loss $ Level of sales Probability Revenue/loss $ High 0.5 100 000 High 0.4 120 000 Medium 0.3 60 000 Medium 0.3 75 000 Low 0.2 (30 000) Low 0.3 (12 000) Table 25.7: Data from James Duncan’s market research Sales revenue $ Stay at current location 0.4m Success 1 Stay and advertise 2 EV = 0.71m 0.8m p = 0.7 Failure 0.5m p = 0.3 Success Sell same product 4 p = 0.6 1m p = 0.8 EV = 0.96 Failure 0.4m p = 0.2 Relocate to town 3 Success EV = 0.93m Re brand Modify exchange 5 p = 0.4 As can be seen from Figure 25.10 (p 252), the conclusion that can now be drawn is that the firm should relocate to the town, since its expected value of $0.93m is greater than those for staying and advertising or staying at the current location. Upon relocating, the firm should sell the same product, as modifying it would result in a lower expected value of $0.88m compared with $0.96m. Advantages of decision trees Managers can think about alternative courses of action Allow managers to use mathematical tools to highlight the best course of action Managers can quantify the effect of a decision Suitable for decisions that involve a series of interrelated steps EV = 0.88 Failure 0.4m p = 0.4 EV = 0.88 New product Figure 25.10: A more complex decision tree 6 1.2m p = 0.6 Success 7 p = 0.5 EV = 0.7 Failure p = 0.5 1m 0.4m Help managers to consider the risks involved in making decisions. Disadvantages of decision trees The validity of the decision tree depends on the accuracy of the estimates made Not all alternatives are identifiable while preparing the diagram Subject to time lag, which may distort decisions in the future The diagram may become very large and complex where there are numerous alternatives. CHAPTER 25 | PROJECT MANAGEMENT CHAPTER SUMMARY A node or circle is used to show the start or end of an activity The dummy activity is represented by a dotted line as it uses no resources and carries no value, i.e. it has a duration of zero Total float is calculated as: LFT – duration – EST A circle (chance node) is used when a course of action may lead to several outcomes (for example, if the firm rebrands, sales might be at a high or a low level). The decision tree is use to trace alternative outcomes of decisions and compare each result before a decision is made Free float is calculated as: EST at end – duration – EST at start Critical path is the sequence of activity in the network diagram which takes the longest time to complete A square (decision node) is used at points where a decision has to be made about which course of action to take (for example, to develop a new product or to rebrand) MULTIPLE CHOICE QUESTIONS Figure 25.11: Network diagram for Questions 1–3 Use the diagram in Figure 25.11 to answer Questions 1–3. B 1 0 0 A 2 2 3 C 4 3 4 E 8 1. What is the total duration of the activity? 5 D 5 F 6 G 4 3 3. Which of the activities has a free float time? a. 14 days a. D b. 21 days b. E c. 19 days c. F d. 17 days d. G 2. Which of the following is the critical path? 7 4. The ‘squares’ in a decision tree are called a/an: a. A-B-C-D-E-F-G a. Chance node b. A-C-E-F-G b. Alternative c. A-C-E-F-G c. Decision node d. A-C-E-D-G d. Probability 253 254 Module 2 Fundamentals of Marketing 26 The Concept of Marketing LEARNING OBJECTIVES: At the end of this chapter students should be able to: Define the concept of marketing Describe the main concepts related to marketing Distinguish among the different marketing concepts Outline the main implication of each marketing concept A business could have the best product in the market but unless information about the product is available or communicated to the target market, the business may not be successful. If you were to assess some of the businesses in your country, you would realise that poor marketing strategies have robbed them of market share and revenue. To this end, marketing is very important to a firm’s success. The question then is: what is marketing? There are a number of definitions for ‘marketing’. Some of the commonly accepted ones are: Marketing is a set of human activities directed at facilitating and consummating exchange Marketing is a social and managerial process by which individuals and groups obtain what they need and want through creating and exchanging products and value with others. (Philip Kotler, Marketing Management) Needs, wants and demands Markets Core marketing concepts Exchange, transactions and relationships Figure 26.1: Core marketing concepts Products and services Value, satisfaction and quality One of the most comprehensive and accepted definitions of ‘marketing’ was given by the American Marketing Association. It states that: Marketing is the process of planning and executing the conception, pricing, promotion and distribution of ideas, goods and services to create exchanges that satisfy individual and organisational goals. The latter definition captures most of the marketing concepts that will be discussed in this module. This definition makes it clear that marketing is more than just advertising: it is more comprehensive and includes core concepts of pricing, distribution and exchange and, ultimately, the satisfaction of customers. See Figure 26.1. The core marketing concepts Markets The concept of a market has evolved over the years from being just a physical location to being a virtual space. Like marketing, the term ‘market’ also has a number of definitions. A market is defined as ‘a place where people meet to exchange (buy or sell) their goods or services’. This definition is evident in the Caribbean as you walk the streets of the major towns in different countries. It involves a physical location and the presence of both buyers and sellers as they seek to make exchanges. The buyers have the opportunity, most times, physically to see and inspect the good being purchased. Examples of this type of market are the agricultural markets, supermarkets and other business places. Moving on from the definition of being a physical location, though, a market can also be defined as an activity and in particular ‘the process by which buyers and sellers interact for the purpose of exchange’. This definition does not specify a place, as anywhere the buyer and seller interact is the market. The definition incorporates activities such as online shopping and telemarketing. Therefore a buyer could be in the Caribbean but doing business in China via the internet. The advancement of telecommunications technology has made the world into one big global marketplace where buyers and sellers can interact for exchange. CHAPTER 26 | THE CONCEPT OF MARKETING Another definition of ‘market’ is also explored from time to time. This time, a market is defined as the actual and potential buyers of a product. These buyers often share common characteristics and needs that the marketer aims to fulfil through market offerings. Human needs, wants and demands – what is the difference? Interestingly, there might still be some people who have not sufficiently established the difference among these three concepts. However, the Marketing Department must be aware of and clear on the difference. As commonly defined, a ‘need’ is a state of felt deprivation. It is seen as including those innate desires such as physical, social and individual needs. Therefore, this includes the basic needs of food, clothing and shelter. ‘Wants’ represent the ways in which human needs take form or shape – that is, how these needs are shaped by culture and individual personality. For example, there is a need for clothing but there is a want for skinny jeans or there is a need for food but there is a want for Indian cuisine. As it relates to ‘demand’, this is the ability to pay for the things we desire or want. The truth is that we can all desire to have a number of things but it is only the ability to pay that matters. As an implication for marketers, they must be aware of the difference between wants and demand. In the end, it is the demands and not just wants that will enable to firm to earn revenue. Value added Marketing should aim to add value to the products being sold. In most cases, the marketer adds value to the product through its performance of the marketing activities. A firm can add value to its products by improving the value attached to each component or raw material. Additionally, value can be added through the delivery of excellent service, attaching different features and benefits to the product and offering convenience such as delivery service or flexible payment plans. By doing so, the firm will increase the value placed on the finished product and the product will be able to meet or exceed customer expectations. Once this is done, the firm can create a brand image that is synonymous with quality. Adding value to a product will enable the firm to: Charge a higher price if necessary Gain a competitive edge over other players in the market Benefit from customer loyalty. Customer value and satisfaction These concepts are closely related to the previous concept of value added. When we purchase a product or service, there is an amount of value that is placed on owning the product. This value is often representative of the cost we are willing to pay to acquire the product. The value we placed on the product is usually a combination of the product’s quality, price and service acquired. Customer service is an integral part of any business and has the ability to improve customer value drastically. Think about it: would you rather receive below-standard service and pay a lower price for a product or pay more but get excellent service? Maybe most of you will choose the latter, as, when we consume a product or service, excellence should be the order of the day. To this end, marketers wishing to offer customers value will endeavour to: Disseminate the relevant facts about a product to the buyers Ensure that the product performs above expectations Place performance of the product over profit Avoid pricing policies that can be construed as unrealistic. As marketers strive to give customers value for money, they improve their chances of achieving customer satisfaction. The truth is that unless a product meets or exceeds the expectations of customers, there will not be a feeling of satisfaction. Customer satisfaction is therefore seen as an individual’s comparative judgement as a result of the perceived value that is placed on a product. Once the actual value received from the consumption of the product meets or exceeds expectation, the customer will be satisfied and vice versa. The concept of exchange transactions This concept is embedded in the very definitions of marketing that were discussed earlier in the chapter. It involves the transfer of something, whether tangible or intangible, between two or more people to receive something in return. It follows that a key element of marketing is to bring people together to create exchanges. The level of exchange created depends on the relationships that are created between the firm and its customers. Businesses should be interested not only in attracting new customers but in retaining these customers once they are attracted. One way in which marketers can establish such a relationship is by delivering the best service possible to its customers. The idea here is that customers will return to a firm if they feel that they have received value for their money in terms of both the product and the level of customer service. 255 256 MODULE 2 | UNIT 2 | FUNDAMENTALS OF MARKETING CASE STUDY Moving with technology Mia McKay is a small business owner who specialises in the sale of clothing, drapes and rugs. She plies her trade from a little retail outlet she created at the front of her property. People from the community come and buy her wares and refer her to others. To date, business has been going well and she is thinking of expanding her market reach. However, she is limited by space as she cannot expand on the current site. She has not been daunted, though, because her daughter, who is a final-year computer science student at the local university, has given her a good idea – that is, selling her goods online. However, Mia has some concerns, one of which is the fact that her customers love to see the things they are buying and being able to touch or feel the quality and texture. There are also some customers who bring their fabrics to her and she sews them according to their specifications. She feels that going online may dampen this part of her business. Mia now has to consider her options as time runs out. Questions 1. Define the term ‘marketing’. 2. With reference to clothing, differentiate between a ‘need’ and a ‘want’. 3. How did the case show the evolution of the most present definition of a ‘market’? 4. Discuss, citing evidence from the case, the concept and importance of ‘value added’. Marketing (business) concepts The approach that a business takes to marketing is largely influenced by the different and popular marketing or business concepts. Each concept will influence the way in which the firm produces and sells its products. The focus on business concepts started in the late 1800s and has evolved throughout the years. This evolution has influenced the different marketing concepts that are employed by the firm. Each of these concepts is discussed below. A Production concept This marketing concept is probably the oldest to be practised. The concept was used predominantly in the late 1800s to early 1900s. It is based on the notion that the business should produce those products that it can produce most efficiently. It also postulates that if the firm can produce large quantities of the product at very low cost, it will attract consumers to purchase it. To this end, it is imperative that the management of the firm find ways to continuously improve the efficiency of the production and distribution of the product. The production concept was developed during an era when demand for the available products was relatively high compared to their supply and the sales team only had to get the product to the customer at the prevailing prices. As such, marketing played a minimum role, if any at all. Though the concept is among the oldest, it is still applicable for some large manufacturing firms with advanced and sophisticated technology which can produce large quantities of a product. (1 mark) (5 marks) (3 marks) (6 marks) Total 15 marks The implications of this concept are: No consideration was given to marketing Customers’ demand was not ascertained prior to production Only products that could be produced efficiently were offered, limiting the choices available to customers Since only a few options were available and demand was high, firms didn’t spend a lot of resources on promotion With the rapid increase in competition over the years, the use of this concept can be detrimental to firms. B Product concept This concept is said to have prevailed in the early 20th century. Its focus is on the product and it was believed that consumers will demand products that are of high quality, give excellent performance and contain innovative features. Once the product is perceived to offer better quality and features than existing products, consumers will buy it. With this in mind, businesses using this concept focus on creating products that are superior to others. In order to maintain its competitive edge, such a firm would have to improve its products over time. It is clear that aspects of the product concept are still evident even today. Examine the market for cellular phones, for example, where quality, performance and features are still among the top factors influencing customers’ decision to purchase. Some of the implications of this concept include: CHAPTER 26 | THE CONCEPT OF MARKETING The product has to be carefully designed and quality must be maintained The firm’s product has to be superior to those of its competitors Firms using this concept have to continuously make improvements to its product in order to maintain a competitive edge There needs to be some amount of promotion to inform the market about the product and its features. C Sales (selling) concept As the years went by, most businesses were producing on a large scale and mass production was the order of the day. By the early 1930s, competition had increased and the high demand of previous years was diminishing. It was then becoming more and more difficult for firm to get rid of their products. These tough conditions led to the development of the sales or selling concepts, as firms realised that they now need to convince potential customers to buy their products. The notion held by these firms was that if it was left up the customers, they would not buy enough of the product. Steps then needed to be taken to motivate customers to buy. A number of firms then employed advertising and personal selling as promotional strategies. The main focus was no longer on whether the firm could mass-produce the product, but on how well it could convince customers to buy. One of the most vivid drawbacks of the sales concept, though, is its very low emphasis on the desires of consumers and whether or not they were satisfied with the product. This was largely because the firm’s focus was just on maintaining a competitive edge over other firms. The sales concept had the following implications for the firm: Mass production led to supply becoming greater than demand Firms using the concept had to convince consumers to buy Firms would now have to spend large amounts of resources on advertising The views and desires of consumers were still not considered The firm needed to employ a well-rounded and convincing sales force. D Marketing concept The genesis of the marketing concept came after World War II. By this time, convincing people to buy was losing its effectiveness and could no longer generate the level of demand needed for the firm to remain competitive. This time it was also marked by increase in the variety of goods available and also people’s income. These changes gave consumers choices and made the selling concept ineffective. There had to be a shift of focus towards ascertaining customer needs and the factors that lead to satisfaction. The marketing concept therefore holds that, in order to achieve its organisational goals, the firm should ascertain the needs and wants of its potential customers and fulfil their desired satisfaction more effectively than competitors. Firms using this concept will be focused on delivering value to the customer as the means of increasing sales and profit. To this end, the marketing concept postulated that the purpose of the firm is to satisfy customer needs. However, in order for this to be done, there have to be integrated and coordinated efforts throughout the entire organisation. The implications of the marketing concept for business organisations include: Consumers’ desires and choices must be taken into consideration when developing the product. This is done through extensive marketing research Consumer satisfaction must be given priority if the firm wishes to be successful Resources must be committed to doing marketing research and also promotion of the product Getting feedback from consumers can be used to improve product offerings and consumer satisfaction. E Societal marketing concept This is the most recent of all the business concepts. It was born out of the need for marketers to be more aware of the impact that their activities can have on society. To this end, organisations were expected to produce goods that are environmentally friendly. Companies were therefore encouraged to promote social and ethical considerations in the production and the marketing of their products. Firms using the societal marketing concept will make a concerted effort not to satisfy the desires and demand of consumers at the expense of the society. Over the years, we have seen where our environment has been degraded as a result of large firms trying to fulfil their profit motive. Our natural resources have been depleted and many Caribbean countries are at risk of being exploited by developed countries. This is further coupled with the problem of rapid population growth and increase in poverty. It has become even more imperative that marketers stay aware of these issues when they promote the firm’s products. The societal marketing concept also promotes and encourages firms to contribute to sustainable development. This concept is defined by the Brundtland Report as: 257 258 MODULE 2 | UNIT 2 | FUNDAMENTALS OF MARKETING Development that meets the needs of the present generation without compromising the ability of future generations to meet their own needs. To this end, the marketer should ensure that the firm is seen as a good corporate citizen. The firm should behave ethically and socially responsible, while improving customer satisfaction and profitability. The implications of the societal marketing concept are outlined below: The impact of its activities on the society or environment is considered by the firm while it tries to satisfy the needs of consumers The environmentally conscious consumer will support a firm that is aware of the impact of its activities on society. To this end, the firm must seek to preserve and protect the environment Firms may have to modify their products or produce new products that are environmentally friendly while still maintaining quality This business concept encourages firms to buy into the thrust of sustainable development – that is, meeting the needs of the present generation without preventing future generations from doing the same. CASE STUDY Perfect Cut Furniture Ltd – preserving the environment Perfect Cut Furniture Ltd was established in the early 1920s by two furniture makers. The company has moved from the use of manual tools to high-tech machinery and equipment. From its early days after inception, Perfect Cut Furniture Ltd was known for its carefully crafted furniture. Though viewed as expensive, people would still buy furniture from the company because of the high standard of quality. This emphasis on quality has been a hallmark of the company throughout the years. The depressed economic conditions of the 1930s forced the company to fight hard to stay afloat. Buying new furniture was the last thing on most people’s minds as they struggled to survive. During this time the firm implemented its B-Quality line which offered the same designs but made from lower-quality materials. This allowed the firm to produce more as the input costs were less for these products than its high-end line of furniture. With more furniture in stock, the company had to implement very aggressive promotion tactics geared towards convincing customers to buy its new line of products and not those of its main competitors. Now, in the 21st century, the company has changed its focus to one that includes interaction among the main stakeholders. It has instituted a vibrant marketing department which is keen on seeking the views and desires of customers. This new focus has seen the company making furniture which has been tailored to meet the changing tastes of customers. The firm’s furniture is being sold in a number of furniture stores across the country. This year, the firm took a very bold step by launching its ‘Go Green’ campaign. Ironic as it may seem, especially when one considers what makes up its input materials, the firm has decided to be more environmentally friendly. To this end, it refuses to buy lumber reaped from protected forestry areas around the country. The firm has also set out, with the help of the Forestry Department, to replant trees in areas where massive deforestation has taken place over the years. The company has also decided to use its wood chips and saw dust from production to generate manure for the Forestry Department. This move received high commendation from the Ministry of Environment and Business Week magazine. Questions 1. Describe the business concept that was used at the inception of this firm and outline three (3) implications of such a concept. (8 marks) 2. Citing evidence from the case, discuss three (3) other business concepts that were used. (12 marks) 3. Giving two (2) reasons for your answer, discuss which business concept is best suited for Perfect Cut Furniture Ltd. (5 marks) Total 25 marks CHAPTER 26 | THE CONCEPT OF MARKETING An overview of the business concepts discussed in this chapter is shown in Table 26.1. Business concepts Production Product Selling Marketing Societal marketing Main feature High production volume, efficiency and widespread distribution Product is of high quality and is continuously improved Persuade consumers Identification of to buy the product customer needs and making products to meet those needs Making products that meet customer needs while preserving the environment Strategy used Affordable pricing and distribution High-quality, performance and outstanding features Promotion and sales Using different marketing strategies, e.g. mass marketing Using different marketing strategies and environmentally friendly products How are profits made? Widespread distribution By how well the product performs From high sales Customer Customer satisfaction with the satisfaction and product being a good corporate citizen Examples Agricultural industry, e.g. sugar cane Automobile industry: hybrid cars, e.g. Toyota Prius Election campaign, the selling of insurance Mobile service providers and banks WalMart’s ‘Go Green’ campaign Table 26.1: Overview of business concepts CHAPTER SUMMARY ‘Marketing is the process of planning and executing the conception, pricing, promotion and distribution of ideas, goods and services to create exchanges that satisfy individual and organisational goals’ The view of a market is moving away from being simply a physical location to more of an activity or interaction between buyers and sellers Customer service is an integral part of any business and has the ability to improve customer value drastically Marketing has evolved throughout the years and this has influenced the different marketing concepts that are employed by the firm. These concepts include: • Production concept (late 1800s to early 1900s) – based on the notion that the business should produce those products that it can produce most efficiently • Product concept (early 20th century) – proposed that consumers will demand products that are of high quality, give excellent performance and contain innovative features • Selling concept (1920s to 1950) – borne of the notion that if it was left up the customers, they would not buy enough of the product. Steps must therefore be taken to motivate customers to buy • Marketing concept (1950s onwards) – holds that in order to achieve its organisational goals, the firm should ascertain the needs and wants of its potential customers and fulfil their desired satisfaction more effectively than competitors do • Societal marketing concept (1970s onwards) – proposed that organisations were expected to produce goods that are environmentally friendly. 259 260 MODULE 2 | UNIT 2 | FUNDAMENTALS OF MARKETING MULTIPLE CHOICE QUESTIONS 1. ‘The process of planning and executing the conception, pricing, promotion and distribution of ideas, goods and services to create exchanges that satisfy individual and organisational goals’ best defines: a. Exchange b. Marketing c. Market d. Customer value 2. A marketer wishing to provide or increase value to the customer will do ALL of the following EXCEPT which one? a. Disseminate the relevant facts about a product to the buyers b. Ensure that the product performs above expectation c. Place performance of the product over profit d. Charge unrealistic prices in order to recoup costs quickly 3. Which of the following concepts is defined as ‘the transfer of something, whether tangible or intangible, between two or more people to receive something in return’? a. Exchange b. Customer value c. Market d. Customer satisfaction 4. Which of the following concepts of marketing proposed that consumers will demand products that are of high quality, give excellent performance and contain innovative features? a. Production concept b. Product concept c. Selling concept d. Marketing concept 5. The societal marketing concept proposed that firms should: a. Produce high-quality products b. Convince people to buy the product c. Not produce products that are harmful to the environment d. Research what society wants before producing a product Extended Essay Question Question one Total 25 marks a. Briefly describe the five (5) marketing or business concepts. (15 marks) b. Outline one (1) implication of each of the concepts for the firm. (10 marks) 261 27 The Marketing Environment LEARNING OBJECTIVES: At the end of this chapter students should be able to: Define the ‘marketing environment’ Describe the composition of the marketing environment Discuss the forces in the micro-environment Discuss the forces in the macro-environment Discuss the impact of the marketing environment on the firm I t is important for us to realise that there are a number of factors that may affect the firm’s ability to implement its marketing plan successfully. We are living in a dynamic and changing world and these changes will have an impact on the firm. As a result, the marketing department has to be aware of these factors and to develop the necessary strategies to either lessen the impact on the firm or to help it to become more competitive. The marketing environment can be defined as the forces, whether internal or external, influencing a firm’s ability to conduct business with its target market effectively. The marketing environment is further divided into two categories: the micro-environment and the macro-environment. These categories are further broken down below. The micro-environment The micro-environment of a firm refers to the factors within its immediate environment that impact on its performance, decision-making process and ability to serve its customers. These factors are usually internal and close to the firm. The micro-environment factors affecting the marketing environment are outlined below. Company’s suppliers These people are very important to the firm and its ability to produce the high-quality products that it desires. Earlier, when we looked at quality assurance, it was said that maintaining quality has to be a part of the supplier’s mandate. The suppliers of the firm provide the necessary resources that are used to produce the firm’s goods and services. You will agree that using inferior or faulty materials will most likely result in inferior products which are below the quality standard of the firm. If the firm desires to provide value to its customers then it must be getting value from its suppliers. It must be highlighted that the firm should maintain close relations with its suppliers. This is important, as changes in the price of resources will possibly affect the price of the final product. Having a close relationship with its suppliers can also help the firm to plan for and implement strategies to deal with resource shortages or delivery hold-ups. Competitors As firms decide what to produce, they must bear in mind the products of their competitors. The Marketing Manager must also be mindful of the level of saturation in the target market. Producing a product in a market that is already saturated might lead to serious losses, except where the firm is able to bring out a better and more viable product than what exists already. Therefore, before deciding on the product offering, the firm should conduct a feasibility study and, in particular, a competitor analysis. This analysis will give the firm a clear view of what to expect in the market and whether or not to embark on the venture. Since profitability is essential to all businesses, the firm has to gain a competitive edge over its main rivals. In order to accomplish this, though, the Marketing Department has to work assiduously to promote the product in such a way that will win over consumers. This issue is rapidly becoming even more taxing on firms since the world is quickly becoming a single global market. As a result, firms are being faced with competition both locally and internationally. Marketing intermediaries It is almost impossible for especially large firms to reach every single buyer of their products. As a result, firms depend on marketing intermediaries to fill this loophole. Marketing intermediaries assist the firm in promoting, selling and distributing its products to the final customers. They play a vital role in the distribution process and so should be of utmost importance to the Marketing Manager. There are four main types of marketing intermediary: 262 MODULE 2 | UNIT 2 | FUNDAMENTALS OF MARKETING Resellers Demographic factors These are firms that purchase the manufacturer’s products with the intention of reselling them. They include wholesalers and retailers which are very common throughout the Caribbean – for example, PriceSmart or any corner shop in your community. The demographic factors of a population should be very important to the marketer as they are the ones who demand the firm’s product. The concept of demography refers to the study of the characteristics of human populations, including size, gender, growth, age, occupation, density and race. The marketer should continuously assess changes in these characteristics to ensure that the firm is able to meet the desires of its target market. Some of the trends that have been observed in our world today would include: Physical distribution firms These firms help to stock and transport goods from one location to the designated destinations. An example of this would be haulage contractors who transport goods on behalf of other companies. Marketing services agencies These agencies or firms offer their services to other firms and act on their behalf. They include marketing research agencies and advertising agencies, among others. Marketing services agencies are becoming increasingly popular in the Caribbean. Some of these firms are even operating as fully fledged online businesses – for example, Caribbean Web Advertising, based in Trinidad and Tobago. Financial intermediaries These firms focus on offering finance to buy the firm’s products or insuring the products that are purchased. Financial intermediaries would include banks, insurance companies, credit unions and other financial institutions. Customers These are the people who purchase the firm’s products. Understanding the firm’s customers is of utmost importance to the marketer. The Marketing Manager must be aware of customers’ changing tastes and preferences and other factors such as income. It is important to point out, though, that the final customer is not just the only buyer of the product. Other buyers of the firm’s product would include businesses, resellers, government and the international community. All five buyers of the product will present the firm with five different markets that it should assess in order to ascertain their viability. Changing family structure This would include trends such as female-headed households, marriage rates and divorce rates. For the most part, all three will affect the level of income of the household and their purchasing power. As more and more women head households, it creates a need for businesses such as aftercare services. Higher divorce rates may create a greater need for people to specialise in family law. Marriage rates would affect wedding services such as caterers and videographers, etc. Ageing population and improved life expectancy As populations age, there might be greater dependence on government assistance and pension schemes as income dwindles. An ageing population creates the need for certain goods and services as health deteriorates. Increased educational attainment The Caribbean has seen a significant increase in the number of universities operating either physically or online in the past two or three decades. Generally speaking, more students are matriculating to tertiary training institutions. Higher education attainment is often a signal of improved economic growth and development. It could also influence the quality of the labour force and the firm’s productivity. Changing population diversity While the Caribbean has always been a population of mixed ethnicity and race, further changes could affect some firms such as restaurants. Other firms may also have to adapt their products so as to be able to tap into certain markets, The macro-environment Economic factors The macro-environment of the firm refers to the external and uncontrollable factors which impact on its performance, decision-making process and ability to serve its customers. These are larger societal factors that the firm cannot control. We are living in tough economic times in the Caribbean. The latter part of the first decade of this century has seen many Caribbean countries’ economies contracting as unemployment levels rise. These economic conditions have affected a number of firms and how they do business. As a CHAPTER 27 | THE MARKETING ENVIRONMENT result, marketers have to be aware of these issues and devise ways to lessen their impact on the firm. Economic factors may be defined as those influencing consumer spending patterns and purchasing power. These would include economic growth rates, inflation rates, distribution of income and exchange rates. (For more on this, you should review Chapter 3.) Changes in these factors will affect the standard of living of individuals. Where the impact on standard of living is negative, consumers’ purchasing power will be likely to fall and their spending reduced. These changes will more than likely also affect the firm negatively, resulting in decline in revenues and profits, and some firms may even have to shut down. While creativity is often born out of adversity, it is also recognised that poor economic conditions may make it difficult for people to enter into business and be successful. Some people have taken the risk, however, and are successful but others have met stumbling blocks such as lack of financing. Likewise, as firms’ profits dwindle, less money is retained for further investment or expansion. A shrinking economy could also force some firms to become corporate entrepreneurs – that is, creating, innovating or renewing products or ideas within or outside of an existing organisation. This move could help to save the firm’s product or the firm itself in trying economic times. Natural factors Increasingly, a number of people and businesses are becoming more conscious of the environment. A concerted effort is being made to try to prevent the environment from further degradation. With the rapid increase in global warming, countries are taking steps to preserve their natural resources. Some consumers may even stage a boycott of products that are potentially harmful to the environment. As a result, marketers need to be aware of the natural environmental factors that may influence the firm. Natural factors refers to the natural resources that are used as inputs into production. This includes all the different variations of the factors of production – that is, land, labour, capital and entrepreneurship. As firms become more ethically and socially aware, marketers have begun to employ the societal marketing concept. As was discussed in Chapter 26, firms using this concept will make a concerted effort not to satisfy the desires and demand of consumers at the expense of society. They are now becoming more aware of the impact of the following on the firm: Shortages, exploitation or depletion of raw materials Increased levels of pollution – for example, land, air and water Environmental preservation strategies Use of renewable energy. Firms are now being asked to lessen the impact their products have on the environment. Some firms have even eliminated the use of plastic bags at their checkout counters and instead have encouraged shoppers to buy reusable shopping bags. Political factors While most Caribbean countries have fairly stable political systems, marketers still have to be mindful of the damaging effect political instability can have on the firm. For example, political protest can result in a reduction in productivity and loss of potential output. Political factors would include the laws and regulations that influence the operations of a firm in an industry. The political environment can be extended to include the different pressure groups (for example, animal rights groups) or other government agencies (such as the Office of Utilities Regulation) that also have an influence on the firm’s operations. It is quite evident that legislation will be updated and even repealed and this may have an impact on the firm. The Caribbean has seen changes in the Companies Acts of different countries which have affected different types of company. For example, one person can now start a company, unlike in previous times where seven people were required. The Marketing Manager must also be aware of the laws geared towards preventing the production and sale of certain products, especially as countries become more protective of the environment. Other laws in most Caribbean countries that should be of concern to marketers would include health and safety laws, quality standards, fair trade, consumer rights, anti-pollution laws, labour laws, laws preventing discrimination against people with HIV/ AIDS and those protecting consumers against misleading advertisements. You can do further research in your country to find out which of these laws apply there. Cultural factors Most, if not all, Caribbean countries are known for their rich cultural heritage. It is always interesting to see the diverse cultural backgrounds of Caribbean people. ‘Culture’ is defined as the attitudes, beliefs and values that influence how people think and act. The culture of a country or locale is expressed in the types of food we eat and the way we dress, music and dance among other things. The marketer is therefore expected to ascertain the culture of the firm’s target market and to create the right marketing mix to attract these customers. 263 264 MODULE 2 | UNIT 2 | FUNDAMENTALS OF MARKETING Cultural factors become even more important when the firm is operating within different countries. While most Caribbean countries would have similarities in their culture because of their heritage, there is still some amount of diversity. Therefore, a product that may do very well in Jamaica may not do as well, in its current form, in, say, Guyana. The Marketing Department will then have to promote the product differently or encourage the Production Department to adjust the product that will be sold in Guyana to suit the Guyanese market. One thing that is also evident is the fact that globalisation and improvement in communication technology are changing Caribbean culture to some extent. We have seen where even our food is being changed to a more Americanor European-style breakfast. Our supermarkets are flooded with cereals, instant mixes and frozen foods. The fashion industry has seen changes in the way we dress and can capitalise on that. CASE STUDY A struggling business environment AC & More Ltd has been operating on a small island for the past ten years. It has been supplying AC units to a number of household and businesses. Being in the tropics, the country can become very warm in the summer months. These months are the most vibrant and profitable for the company while December through to February is the slowest period for the business. The firm imports most of its raw materials from a supplier in the USA. This supplier has helped the company to maintain its high quality. To this end, it is known for its long-lasting products. In addition to building some of the units, AC & More Ltd also imports some of its larger units that it does not have the capacity to build. In recent times, the company has been faced with stiff competition as the AC market heats up with new entrants. These competitors have also made use of new technology such as energy savers and inverter-type models. This year, another company introduced solar AC units to the country. While this is costly, a number of customers are gravitating toward it because of the high electricity cost involved in the traditional units. The woes of the company have also increased with the downturn in the country’s economy which has led to higher than normal unemployment rates. Even with these challenges, however, the firm is committed to the task and wants to continue to provide the best-quality AC units to its customers. Questions 1. Outline the difference between micro-environmental factors and macro-environmental factors. (4 marks) 2. Describe two (2) micro-environmental factors affecting AC & More Ltd. (6 marks) 3. Identify two (2) macro-environmental factors that were mentioned in the case and discuss the impact these could have on the operation of AC & More Ltd. (10 marks) Total 20 marks CHAPTER SUMMARY The marketing environment is affected by both internal and external factors The micro-environment of a firm refers to the factors within its immediate environment that impact on its performance, decision-making process and ability to serve its customers, including: • Company’s suppliers • Competitors • Marketing intermediaries • Customers The macro-environment of a firm refers to the external and uncontrollable factors which impacts on its performance, decision-making process and ability to serve its customers, including: • Demographic • Economic • Natural • Political • Cultural. CHAPTER 27 | THE MARKETING ENVIRONMENT MULTIPLE CHOICE QUESTIONS 1. Which of the following is NOT regarded as a microenvironment factor? Extended Essay Questions Question one Total 25 marks b. Market intermediaries a. Define the term ‘micro-environment factors’. (1 mark) b. Discuss how four (4) micro-environmental factors can impact on the firm and its operations. (24 marks) c. Demographic factors Question two d. Company’s suppliers Your neighbour, Risky Ricky, wants to start a business in one of the CARICOM member states. He has a number of ideas but he is not certain which ones to explore. Seeking advice, Ricky consulted a friend who told him to be mindful of demographical, economic, political and natural factors that might affect any business idea he decides to explore. Knowing that you are a good business student, based on your CSEC passes and study of Unit 1 Management of Business, he has asked you to shed some light on these factors. a. Identify the environment with which these factors are associated. (1 mark) b. Discuss how these factors could either help or hinder Ricky’s business prospects. (24 marks) a. Competitors 2. Which of the following is NOT regarded as a macroenvironment factor? a. Economic b. Political c. Company’s suppliers d. Cultural 3. ALL of the following are marketing intermediaries EXCEPT which one? a. Retailers b. Distribution firms c. Advertising agencies d. Government agencies 4. Characteristics such as population size, ethnicity, race and age all relate to which one of the following factors? a. Cultural b. Demographic c. Economic d. Natural 5. The natural environment is said to involve all the factors of production. Which of the following is NOT one of those factors? a. Technology b. Capital c. Land d. Enterprise Total 25 marks 265 266 28 LEARNING OBJECTIVES: At the end of this chapter students should be able to: Explain the concept of marketing research Discuss the role and importance of conducting marketing research Discuss the importance of developing a research plan Describe the stages of marketing research Assess the sources of data collection Evaluate the types of sampling technique Evaluate the different research techniques used in marketing research Outline the limitations of marketing research W hen was the last time you consumed a product (for example, your favourite meal) or enjoyed a service (for example, an all-inclusive hotel) and were really satisfied? If you have had that experience with any product or service, it was the result of good marketing research. Even this book has been published after extensive marketing research that ascertained the need for it. So, what is marketing research? It is the process of collecting, analysing and interpreting data in order to make an informed decision about a product, customers, target market or industry. The key role of marketing research is to provide management with information that is current, accurate, valid, relevant and reliable. Once this is done, management can then use the information to make strategic decisions to improve the product, enter into business or solve a problem being faced, among other things. Importance of conducting marketing research Marketing research is a very important tool used by businesses, especially in an increasingly competitive market, for the following reasons, among others: Helps management to make informed decisions Marketing opportunities can be identified The needs of the target market can be ascertained Marketing Research The firm can gather information to assist it in pricing the product To assess the level of competition in the market To ascertain the features of a product that appeal to the target market To monitor the firm’s performance in the market Helps to prevent the firm from making uncalculated risks. Importance of developing a research plan There is a common saying that ‘If you fail to plan, then you plan to fail’. Planning is just as important in the research process. In order to reap the full benefits of conducting marketing research, a proper research plan must be developed. The research plan outlines the courses of action that will be taken throughout the research. It outlines the aims and objectives, methodology, research instrument, sources of data, management of data and analysis of data and publication of findings, among other things. Developing the research plan will give the researcher a clear vision of how the research will be conducted. It could also be used to measure the progress of the research and identify how closely the plan is being followed. Stages of marketing research See Figure 28.1 (p 267) for an overview of the various stages in developing a research plan. Stage 1: Management problem identification The entire research is dependent on this stage of the process. If the problem cannot be identified or if it is not clearly defined, it could result in valuable time and resources being wasted. A broad definition of the problem can be misleading and hence compromise the research. This may also lead to a lot of unwanted information being collected. Once there is a disjoint between what should be and what is in the business, it means that there is a problem. Another mistake that some firms make is to identify the repercussion of a problem instead of the underlying problem. For example, falling sales could be the result of a problem with the product. With the CHAPTER 28 | MARKETING RESEARCH Figure 28.1: Stages in developing a research plan ent Managemm proble n tio identifica Research s objective ction Data colle Sampling Research s e techniqu nd Analysis a on ti ta n se re p of data aforementioned issues in mind, management should ensure that the real problem is identified and clearly defined. This process can be a tedious one and it may take more than one department to identify the problem. It is also important to note that market research could be commissioned not to identify a problem but to seek an opportunity. This is especially true for new firms wanting to enter a market or an existing firm wanting to launch a new product or modifications to an existing product. Once the problem has been identified, management now needs to define it. This is done by drafting a problem statement which gives a clear and concise description of the problem to be solved by the researcher. The problem statement can be written as a question (for example ‘How have the improvements done on the product improved the level of demand?’) or a statement (for example ‘An assessment of the impact of the advertisement on sales’). A properly written problem statement usually has two variables that are being measured, namely the independent and the dependent variables. The ‘independent variable’ is defined as the factor that is manipulated in order to identify the effect on other variables, while the ‘dependent variable’ is the effects or outcome of the manipulation of the independent variable. The aim is to find out what will happen to the dependent variable if the firm changes the independent variable. In our examples above, the independent variable would be product improvement and advertisement and the dependent variables would be level of demand and sales. Stage 2: Research objectives The research objectives outline what is to be achieved by the research. They give a clear guide to the way forward. Both management and the researcher have to ensure that these objectives correlate with the problem statement. As was discussed in Chapter 2, objectives should be carefully written and must be ‘SMART’. They should also outline the ‘what’, the ‘where’ and the ‘why’ of the research. The objectives of marketing research are usually based on the research designs being used. The research design refers to the strategies or plans that are put in place to address the problem under research and can take one of three forms: Exploratory – this design involves the gathering of preliminary information which can be used to define the problem further and suggests what is needed to conduct more detailed research Descriptive – this design outlines the demographics and characteristics of the target market. It gives a clear description of the market and the potential for a new product offering in that market Causal – causal research aims to ascertain the cause and effects of an issue. It is usually done by using experiments to assess how changes in the independent variable will affect the dependent variable. EXERCISE Write three research topics highlighting the independent and dependent variables. Stage 3: Data collection This stage can have a serious impact on the result of the marketing research. The researcher has to ensure that sufficient and credible information is collected, upon which a decision can be taken or a generalisation made. In Chapter 3, it was pointed out that information should have certain essential features. It must be cost effective, accurate, relevant and on time. The same is true for the information that will be collected for the marketing research. Information for the research can be gathered from two main sources, namely primary and secondary sources. A primary data source is one where information is gathered for the purpose of that particular research problem. It follows, then, that primary data represents data collected specifically for the research being conducted. While this source of data can be expensive, it is current and specific 267 268 MODULE 2 | UNIT 2 | FUNDAMENTALS OF MARKETING to the research. This could give a better assessment of the particular problem under review. Primary data can be gathered through different means, including: Observation – this is where data is gathered by observing the people or process involve in the research. For example, the researcher could observe consumers in the business place or a restaurant could observe a location to ascertain the number of commuting members of the public who would be potential customers Survey – this is where information is gathered from a sample of a relatively large group of people which is referred to as the ‘population’. These people are usually asked to answer a series of questions pertaining to the problem being researched. A questionnaire or interview is often used to gather such data Experiment – this information can be gathered by conducting laboratory research where both variables are scientifically assessed. A secondary data source is where previously used data is gathered to be used in the current research. Secondary data can therefore be defined as data that has been collected for previous research. This data is not specific to the current research but can offer some guide as to how to proceed. A rule of thumb is that secondary data should be consulted before the researcher collects primary data. Secondary data has the advantage of being cheaper to acquire than primary data. It is also said to be obtained much more quickly than primary data. However, one of its drawbacks is that it is not always readily available or, even if it is, sometimes it cannot be used for the problem under review. Secondary data can be collected from a number of sources, including but not limited to: Company reports – these can provide information on the company’s sales Government publications or statistical institutions, such as the Planning Institute of Jamaica, the Central Statistical Office in Trinidad and Tobago and the Barbados Statistical Service, among others. These publications would include statistics on inflation, exchange rates and unemployment Articles from credible local newspapers Local libraries Journals containing experts’ opinions. Stage 4: Sampling Conducting research on an entire area can pose a number of challenges for the researcher. Of course, some of the most obvious reasons would be the lack of resources and also time constraints. To combat these constraints, researchers often select a sample of the desired population. Sampling is therefore the process of selecting a segment of the target population on whom the research will be conducted and a generalisation can be made. Before choosing a sample it is advisable that the firm drafts a plan of action, often called the sampling plan. This plan should include information on the following: Sampling unit – it is said that population consists of a number of sampling units. The sampling units consist of a collection of different elements that do not overlap but cover the entire population. For example, if the element is Sixth Form students and the population is all Sixth Form students within the country, the sampling units could be the different parishes or geographical regions Sample size – this refers to the amount of people who will make up the sample. Since only a segment of the population will be included within the sample, a larger sample would give a more accurate representation of the population. One must be cautious, though, as large samples are often very expensive and harder to work with Sampling procedure – this indicates how the sample of people will be chosen. The choice of people is often made using one of two techniques namely probability and non-probability sampling. A few other key concepts to note include: Population – this is the total target group that the researcher wants to study or gather data from Sample frame – this gives a clearer picture of those people within the population who will be within the sample. The sample frame would outline the strategy that will be used to identify the elements in each sampling units. Based on our example above, this would be the parishes or geographical regions Sample – this is the representative segment of the population that has been drawn from the sample frame to be studied. The process of sampling is very important, as it can have a lasting effect on the conclusion that is drawn at the end of the research. Therefore care must be taken when choosing the sample for research. There are two major sampling procedures that are used: probability sampling and non-probability sampling. Probability sampling Probability sampling methods give each member of the population an equal and known chance of being selected in the sample. No-one can be knowingly disqualified because the selection process is based entirely on chance. Probability sampling includes the following methods: CHAPTER 28 | MARKETING RESEARCH Simple random sample This method allows each member of the population to be eligible to be chosen as part of the sample. Each person is given an equal chance of becoming a part of the sample. While this method is not advisable for very large populations, it can work acceptably with a small group. The researcher would make a list of all the people in the population from which the sample is to be taken and randomly select the required amount of people. This method is probably the most unbiased of them all, since each person has an equal chance of being chosen. However, in order to make use of it, the researcher has to make the major assumption that each member of the population is fully aware of the issue to be researched. Systematic sampling This method is one where the researcher selects the ‘nth’ person to be a part of the sample. For example, the researcher may select every tenth person. While it is systematic, the list of the names of people in the population to be sampled is chosen randomly. As a result, this is seen as a probability sampling method. Unlike simple random sampling, where there is no awareness of who will be chosen, this can be determined when using this method. The method is such that once the first person is chosen, all subsequent people can be determined since it uses every ‘nth’ person – that is, if we are using every tenth person, once the first person is chosen you will know that next will be the person at number 20, number 30, and so on. To ascertain the ‘nth’ term, the researcher will have to use the total number of people in the population and the proposed sample size to determine the ratio. For example, if there are 100 people in the population and the desired sample size is 20, the ratio would be 20/100 or 1/5. It therefore means that one in every five people would be chosen, or every fifth person. However, since the sample is determined in this way, there is some evidence of bias, especially if the population is organised in a systematic way – for example, male/female. If every tenth person is used, the sample will be gender biased, as only females will be chosen. Stratified sampling As mentioned earlier, simple random sampling makes the assumption that each member of the population has the same characteristics. However, this assumption can be addressed by using this other method of sampling. The stratified sampling method seeks to identify the different groups or strata in the population which have the same characteristics within the group. The population is then divided into these groups – for example, by income or gender. A sample will then be randomly selected from each group identified to take part in the research. The stratified sampling method often gives a better representation of the population since the sample is drawn from the different groups or strata that exist. As a result, the findings of the research are more accurate than those of a simple random sample. Cluster sampling In cluster sampling, members of the population are assigned to a particular cluster or group. Each member is assigned to only one cluster. Once the cluster is identified, a sample is chosen via one of the probability sampling methods. This method is very close to stratified but has one notable difference. In the stratified sampling method, people from each stratum across the population are included in the sample but in cluster sampling only the people in the selected cluster(s) of the population are included. Multi-stage sampling This method draws on several sampling methods to arrive a decision. Therefore a researcher using this method will combine simple random, systematic and stratified sampling methods. A combination of the methods will give the researcher a variety of results to arrive at a better generalisation. Non-probability sampling Non-probability sampling methods do not give each member of the population an equal chance of being selected in the sample. In other words, elements in the sample are not chosen by chance. For the most part, they are chosen based on the researcher’s judgement, opinion or expertise. Some popular non-probability sampling methods include: Purposive or judgemental sampling The elements in this sample are selected subjectively by the researcher. The sample would consist of people who the researcher believes fits the purpose that he/she has in mind. This method is particularly appropriate for a situation where the population needed for the sample is not readily available. The elements may then have to be handpicked by the researcher. This technique has an innate bias, since the people within the sample were not given an equal chance of selection. Quota sampling In a quota sampling method, the people who are chosen to be a part of the sample possess a specific set of characteristics 269 270 MODULE 2 | UNIT 2 | FUNDAMENTALS OF MARKETING or traits. The researchers will therefore choose an amount of people with the desired traits. For example, a company could need a sample which consists of 18 year olds or people aged 50 and over. It is quite possible that using this sampling method will result in biases, as the choice of the sample rests in the hands of the researcher. Convenience/accidental This sample method is often used when the researcher has only a short time to complete the research. The people who are selected to be a part of the sample are chosen based on their convenience. The research is normally carried out in a busy area such as a plaza, and people are simply stopped and asked if they want to take part in the research. The sample would then consist of people who were accidentally chosen or who were available when the research was being conducted. It is quite evident that no serious and real meaningful decision can be made based on this method of sampling. However, it is useful for opinion polls or ‘vox pops’. Snowball sampling While we do not have snow in the Caribbean, this concept should be well known. This sampling method works like a snowball, as it gathers more the further it goes. The snowball sampling method is one where a person is used in a piece of research and then asked to suggest others with the same characteristics who would be willing to participate in the same research. For example, if an interview is done with a dentist, he/she could suggest other dentists that the researcher could also interview. Stage 5: Research techniques Before discussing the different methods used to collect data, it is important to make a distinction between qualitative and quantitative research. ‘Qualitative research’ refers to the collection of descriptive data that is not in a numerical form but is based on the respondents’ beliefs, attitudes and intentions. It includes the use of interviews or open-ended questions to gather data. Conversely, ‘quantitative research’ refers to the collection of data which is in a numerical form which can be measured and used for further illustrations CASE STUDY Researching for the right fit The fashion industry is one that is always changing and Kimmy’s Designs was well aware of this. The company wanted to introduce a new line of clothing for the upcoming summer. Bearing in mind that the Caribbean really does not have very clearly outlined seasons, getting it right was key to success. In order to capture the needed information, the firm decided to conduct some market research. This research was conducted in two countries where the firm sells most of its products. Having decided to carry out the research, the firm went on the look-out for information. It decided that it would send representatives to shopping malls for the four Fridays and Saturdays of the month of January, to speak with shoppers. This was done and the information was analysed. Once the information was received, the firm went into production in order to get the clothing ready for the summer. Once the target production was met, the firm was looking to cash in on the market but, instead, sales were less than favourable. While some of its clothing was sold, it seems as though some customers were not attracted to the fashion line. Information received by the firm suggested that the line was out of tune with what is ‘in style’ at the moment. Some people complained about the type of material that was used, especially when the temperature of the summer season is taken into consideration. Now Kimmy’s Designs is left with some unsold stock and money tied up in this stock. The question now is: ‘Where did we go wrong?’. Questions 1. Why was it important that Kimmy’s Designs carried out market research? 2. Assess the appropriateness of the source of data that was used by the firm. 3. Describe the sampling method that was used by the firm. 4. Was the sampling method used the most appropriate one to gather information on the issue? Give reasons for your answer. 5. State, with reasons, the sampling method that you would have implemented to gather the needed information. (3 marks) (6 marks) (3 marks) (8 marks) (5 marks) Total 25 marks CHAPTER 28 | MARKETING RESEARCH – for example, the construction of graphs or tables. This would include surveys and experiments. The market researcher has a number of research techniques available to him/her which will result in different advantages and disadvantages. Some of the techniques used are outlined below: Focus groups This is where a group of people come together to conduct an in-depth discussion on a specific topic. The group is guided by a moderator who is responsible for directing the discussion in the desired way. This group would include potential or existing customers who possess integral information on the topic of discussion. This technique is especially suitable for the launching of a new product or an advertisement campaign. The product or advertisement could be shown to the group before asking them to give their feedback. The firm can then use the information gathered to make certain critical decisions such as improvements or adjustments to the existing product or campaign. Surveys As discussed above, a survey is where information is gathered from a sample of a relatively large group of people which is referred to as the ‘population’. The marketer can gather information for the target population through the use of different survey methods. Three of the more popular methods are: Telephone survey – where the researcher calls a sample of people within the geographical area being studied. The researcher can either call a list of volunteers or could use the random digit dialling technique. For random dialling, the researcher could use the local directory or just call a number then change one number or a group of numbers in the subsequent calls Mail survey – this involves the researcher mailing a questionnaire to a representative sample via the postal service. The people receiving the questionnaire would complete it and return it to the firm. The questionnaire is often accompanied by a cover letter that outlines the purpose of the research and any other pertinent information. The instrument being used for this type of data collection method should be short, specific and unambiguous. It is best if the researcher uses closedended questions. In order for this method to work effectively, the members of the sample should be preinformed of the research Mall intercepts – this is where patrons in a busy area such as a shopping centre or shopping mall are stopped and asked to participate in the research. If they agree, the respondent would be asked to either fill out a brief questionnaire or participate in a brief interview conducted by the researcher. The advantage of mall intercepts is that the interviewer is able to read the customer’s body language and can have one-on-one interaction with them. We are living in a world where technology is changing rapidly and with this change firms are also changing the way they conduct research. To this end, internet survey is a growing method being used to gather information from the target population. With the proliferation of social network sites such as Facebook, firms are making use of these sites via the internet to conduct surveys. This is fairly cheap and is more far reaching than some of the older methods. In-depth interviews An interview involves a one-on-one interaction between the respondent and the researcher (interviewer). The researcher will pose questions to the customer and record his/her responses. This can be done by writing the down the answers or simply by using a tape or voice recorder. One of the benefits of personal interview is that the interviewer can ask follow-up questions or ask for clarification. Observation This method was discussed earlier in the chapter. As mentioned before, observation is also an effective way to garner information for a target population. The subjects of the research could be observed knowingly or unknowingly. Some firms have even used video cameras to observe consumer behaviour then used the information to make changes to the way they do business. Test marketing This will be explored further in Chapter 30. Test marketing can be a good way to ascertain data. When using test marketing, the product is placed in the market while observation is done to assess how customers are responding to it. Information can be gathered regarding whether or not the product will be purchased, whether any changes or improvements are needed and, generally, the level of interaction of consumers with the product. An evaluation of the different research techniques is shown in Table 28.1 (p 272). Stage 6: Analysis and presentation of data Analysis Gathering the data needed would be a good result for any researcher. However, it is what is done with the information that is most important. Successful market research is where 271 272 MODULE 2 | UNIT 2 | FUNDAMENTALS OF MARKETING Research techniques Advantages Disadvantages Focus group – – – – – – – – Relatively cheap to acquire Takes little time to collect Large amount of information can be collected Can gather a great deal of information Sample size is usually small Requires a competent moderator Members may face peer pressure It is qualitative and is harder to analyse Surveys: Telephone – Relatively cost effective – Speed of data collection – Can sample a larger group – Greater cost for long-distance calls – Difficulties in finding participants – Limited data usually collected Mail – Can collect information from a wide area – Few administrators needed – Can ask more complex questions than over the phone – – – – Difficult to get clarification Can be time consuming Limited data usually collected Difficulties in finding participants Mall intercept – – – – – – – – Time constraints More workers are needed to conduct the research Sample may not be representative of the population Information may be biased Internet – Reaches a larger group of people – Fairly inexpensive – Speed of collection – There can be some bias since people decide to take part in the research – Lack of information about the respondents – Information may not be reliable In-depth interview – – – – – – – – Observation – Overt behaviour can be captured – Information is gathered in a natural and unstructured manner – Sensitive data can be collected – Expensive – Time consuming – Unable to capture opinions or attitudes that cause a particular behaviour – Needs highly trained observers Test marketing – Needed improvements can be identified – Can save the firm money since the product is tested before actual production – Can be expensive – Usually very time consuming More people can be reached Fairly cheap to conduct Speedy collection of data Can observe body language Can ask for clarification Body language can be assessed Depth of information collected Gives researcher some level of flexibility Can become expensive Time consuming Uniformity may be sacrificed for flexibility Mostly qualitative and so harder to analyse Table 28.1: An evaluation of marketing research techniques the researcher is able to state findings and conclusions and make generalisations at the end of the process. In order for this to happen, though, the researcher has to comb through the data collected. Information about trends, similarities and correlations should be highlighted in the analysis of data. This is where the researcher organises the information in a logical manner and in relation to what is being studied. Care must be taken to ensure that the data is analysed in relation to the research objectives. The analysis and interpretation segment should help the researcher to determine the implications of the findings. For quantitative research, the researcher can assess the mean, standard deviation and frequency distribution, among other things. The mean of the research represents the average of the responses. Standard deviation indicates the degree of consistency in the responses given. It shows the distribution of the responses given by the respondents. A frequency distribution measures the amount of times a particular response is given. However, at the CAPE level you are not required to do such an in-depth level of research for your School-Based Assessment. Presentation of data Data can be presented in a number of ways. However, whichever form this may take, it must be clear and precise. Some of the popular methods of data presentation are pie charts, bar graphs, histograms, line graphs, scatter diagrams and tables. These are explained and illustrated in Chapter 40 on Internal Assessment. Limitations of market research Despite all the benefits that can be garnered from conducting market research, it is not without its problems. Market research is time consuming and so the final result might be out of date by the time it is published CHAPTER 28 | MARKETING RESEARCH CASE STUDY Finding the right technique As part of the Business Department initiative to give business students first-hand experience of the concepts being taught, the entire class was asked to establish a business in which each student would be a shareholder. The students were elated with this idea and committed themselves to seeing it through to the end and being successful. Once the company was formed, it was time to decide on a product and the target market. The company then decided to create a variety of juices from local fruits and their trademark pumpkin juice. They have received commitment from the Food and Nutrition Department to help create and preserve these beverages. Now they have to sell the idea to potential customers. In order to inform people about their products, the students decided to do research to find out whether the product would perform well in the market. The group decided to walk to the school and ask random students whether they would purchase the product. They also decided to make a few of the products and test them on the market, getting feedback from customers. Questions 1. Would you say that walking to the school and getting information orally from random students is an effective way to conduct this market research? Explain your answer. 2. State two (2) research techniques that were used by the students. 3. Assess the effectiveness of the two (2) techniques you mentioned in your answer to Question 2. If the sample is not properly chosen, the result can be biased A conclusion is drawn from the views of a small section of the entire population A proper marketing research campaign can be very costly for the firm and it may be inconclusive in the end (4 marks) (2 marks) (12 marks) Total 18 marks The final decision is based on value judgements and probabilities and so is not 100 per cent accurate The result of the research may also be biased in terms of the responses people gave and also how the questionnaire was organised. CHAPTER SUMMARY Marketing research is the process of collecting, analysing and interpreting data in order to make an informed decision about a product, customers, target market or industry Marketing research is a process which includes: • Problem identification • Research objectives • • • • Data collection Sampling Research techniques Analysis and presentation of data There are two types of data collection – primary data and secondary data – and both are equally important to the research Sampling can be divided into probability (every person has an equal chance of being chosen) and non-probability (not every person has an equal chance of being chosen) The firm has a number of research techniques available to it, including focus groups, surveys, interviews, observations and test marketing. 273 274 MODULE 2 | UNIT 2 | FUNDAMENTALS OF MARKETING MULTIPLE CHOICE QUESTIONS 1. The process of collecting, analysing and interpreting data in order to make an informed decision about a product, customers, target market or industry best defines which of the following? a. Sampling b. Market research c. Marketing d. Primary data 2. The research design that outlines the demographics and characteristics of the target market is which of the following? a. Expository b. Explanatory c. Casual d. Descriptive 3. Which of the following is NOT a primary source of data? a. Internet article b. Experiment c. Survey d. Observation 4. Which of the following would NOT be an advantage of secondary data over primary data? a. Usually cheaper to gather b. Faster access from existing sources c. Previously collected for other research d. Guides the researcher before primary sources are consulted 5. The total target group that the researcher wants to study or gather data from is referred to as which of the following? a. Sample frame b. Population c. Sample d. Respondents 6. Which of the following is NOT a probability sampling technique? a. Simple random b. Stratified sampling c. Systematic sampling d. Snowball sampling 7. The sampling technique which takes every ‘nth’ person to be a part of the sample is known as which of the following? a. Systematic sampling b. Simple random sampling c. Accidental/convenience sampling d. Stratified sampling 8. Which of the following is NOT a non-probability sampling technique? a. Purposive sampling b. Cluster sampling c. Quota sampling d. Convenience sampling 9. Which of the following is NOT an advantage of using focus groups? a. Relatively cheap to acquire b. Takes little time to collect c. Sample size is usually small d. Large amount of information can be collected 10. Which one of the following is a disadvantage of using in-depth interviews? a. Mostly qualitative and so harder to analyse b. Can ask for clarification c. Body language can be assessed d. Depth of information collected CHAPTER 28 | MARKETING RESEARCH Extended Essay Questions Question one Total 25 marks A few food and nutrition students at your school have developed a new drink that they have named ‘Energy Punch’. They are excited about their product and are hoping that it will be successfully introduced in the market and also generate income to help with their university tuition. Since you are a Management of Business student, you are asked to help them do some marketing research on the school compound before the product launch. a. What is marketing research? b. Discuss the six stages of the marketing research process, based on the scenario given above. Question two a. Explain the difference between primary data and secondary data. b. Distinguish between probability sampling and non-probability sampling. c. Describe four (4) probability and three (3) non-probability sampling techniques that can be used by an organisation. (1 mark) (24 marks) Total 25 marks (2 marks) (2 marks) (21 marks) 275 276 29 Principles of Segmentation LEARNING OBJECTIVES: At the end of this chapter students should be able to: Define the term ‘segmentation’ Discuss the importance of segmentation Outline the reasons for segmentation Outline the benefits and drawbacks of segmentation Explain the following concepts: niche, target and mass marketing Explain the criteria for effective segmentation Discuss the bases of segmentation Evaluate consumer buying behaviour Describe business buyer behaviour G enerally speaking, the firm’s potential market can span a very wide geographical area. With the development of communication and internet technologies, firms are able to reach markets across the globe. However, it must be pointed out that the customers within these markets are not the same. They have different beliefs, buying habits and attitudes. Therefore, to treat the entire market as one would be naive of the firm and could result in huge losses. In order to lessen the possibility of losses and prevent a production or marketing ‘backlash’, firms often use a segmentation approach. Market segmentation Market segmentation is the division of the market into subsets or segments of potential customers who have similar buying behaviour and characteristics. This approach bears in mind that the overall market for a product consists of segments of customers who respond differently to the firm’s marketing mix. As a result, the firm must develop its marketing mix in such a way that it caters for these segments of customers. If you should choose a product now in class and ask your classmates what they think about it, it is very likely that you are going to get various different and some similar responses. While most people might eat chicken, not everyone likes it when it is fried and some may like it stewed, baked or barbequed. Therefore within your classroom you could have four different segments of chicken lovers. It is no different within the business world. Firms may divide their markets into different segments for various reasons. Some of the common ones are: To maintain a competitive edge by catering to the specific needs of each segment To capture the market of minority buyers who have different attitudes and habits than those of the mainstream To get a better understanding of the firm’s target market To facilitate product differentiation as the firm aims to reach all its potential customers To improve profitability as firms try to sell to the different income groups. The firm can make up for shortfalls in the low-income market with an excess in the high-income market To broaden their customer base by including people from all age groups, genders, etc. While there is the potential of reaping huge success from market segmentation, the firm must be aware of the fact that there are drawbacks to this concept. Therefore, it should weigh the benefits against the costs before undertaking market segmentation. An evaluation of the concept is given below. Benefits of market segmentation Identifying the specific characteristics of each segment can better enable the firm to reach all its potential customers, thus increasing sales The firm can adjust its product to meet the needs of the different segments, improving customer satisfaction Knowing the needs of each segment can save money that would otherwise be spent on promotion campaigns that might have failed without prior information The firm can make better use of its limited resources and in the process reduce waste, since it would be knowledgeable about each segment’s needs A firm may choose to cater for one segment rather than the entire market. This could help the firm to improve efficiency. CHAPTER 29 | PRINCIPLES OF SEGMENTATION Drawbacks of market segmentation Researching information about each segment can result in very high administrative costs The firm may forgo revenues by focusing on just one or two segments Producing products for each segment can rapidly increase the number of products, some of which may be costly to produce. This could also lead to market saturation. There are three important concepts that must be considered when discussing market segmentation: Mass marketing Mass marketing is also referred to as ‘undifferentiated market’. It is where the firm does not practise segmentation but rather markets the same product to the entire customer base. This means that the firm would create a single marketing plan for the entire market. While this may not seem to be one of the best strategies to employ, it can help the firm to maximise sales. Firms using this strategy often benefit from economies of scale as a result of large production and sales volumes. Niche marketing Niche marketing is also known as ‘concentrated marketing’. This strategy is one where the firm identifies a small segment of the market and creates a marketing plan to satisfy that segment. The firm will then create a particular product that caters to the needs of that particular segment. This type of market usually has the following characteristics: Higher ‘per unit’ costs of production Lower sales volumes Higher prices to offset higher costs The product is tailored to the segment. Firms utilising niche marketing could reap the following benefits: Lower competition, since the focus is on a smaller group of customers Can recoup cost by charging a relatively high price for the tailor-made product Small firms may benefit, especially where the niche is overlooked by larger firms Since the firm focuses on a particular market, it can improve the efficiency with which the product is offered. However, the firm may also face a number of drawbacks: Small-scale production often nullifies economies of scale If the single product being offered fails, the business could also fail The niche might be very vulnerable to changes in the market. Target marketing Target marketing involves the division of the market into different segments for the firm to target. The firm may cater for one or more of these segments with the use of different strategies to reach them. It can accomplish this by using one of the following market coverage strategies (see Figure 29.1): Undifferentiated marketing The firm offers one product and uses the same marketing mix for the entire market. For example, Dettol is used by different people within the same market for different reasons. Concentrated marketing The firm uses the same marketing mix within a segment or different segments of the market. For example, Listerine Zero caters for people who cannot manage the high level of intensity of the standard product. Differentiated marketing The firm creates different marketing mixes for different segments within the market. For example, a dairy producer may produce different forms of milk (skimmed, low fat, regular) for different segments. A. Undifferentiated marketing Company marketing mix Market B. Differentiated marketing Company marketing mix 1 Segment 1 Company marketing mix 2 Segment 2 Company marketing mix 3 Segment 3 C. Concentrated marketing Segment 1 Company marketing mix Segment 2 Segment 3 Figure 29.1: Market coverage strategies 277 278 MODULE 2 | UNIT 2 | FUNDAMENTALS OF MARKETING CASE STUDY An undecided marketing strategy Mr Hickson is an entrepreneur in the chemical field. After much research and trial and error he developed bio-diesel, using the used cooking oil from a nearby restaurant. He believes that he has a sure and cheap supply of oil as it is waste material from the restaurant. The plan is to get other suppliers on board, such as schools’ canteens and even households who want to resell their used oil to the firm. The firm has not yet tested the product in motor vehicles that have diesel engines but in theory it should work. The firm also believes that until it can obtain sufficient amounts of used oil, it wouldn’t make sense entering into that industry. For the moment, the firm has decided to use its product to operate diesel generators. With the hurricane season coming up, Mr Hickson is optimistic that he will be able to sell his bio-diesel on a wide scale. Even though this is the plan, he has some reservations as he is exploring the possibility of focusing on a particular group of people. Being at a crossroads, he is now thinking of getting advice from a marketing consultant. Questions 1. Differentiate between mass marketing and target marketing. (4 marks) 2. Explain the concept of niche marketing and discuss whether or not it could be used by Mr Hickson in the marketing of his bio-diesel. (6 marks) 3. Give two (2) reasons for which of the following marketing strategies (mass, niche or target marketing) would be the most suitable for Mr Hickson’s bio-diesel firm. (5 marks) Total 15 marks Criteria for effective segmentation As discussed earlier, market segmentation can benefit the firm significantly. However, in order to reap these benefits the market has to be divided effectively. This must be done with the following criteria for effective segmentation in mind: Measurability – this assesses whether or not the size and purchasing power of the segment can be ascertained. For segmentation to make sense, the requirement data must be obtainable Accessibility – this criterion looks at the firm’s ability to reach the targeted segment effectively. The firm must be able to implement its marketing and distributing strategies in the targeted segments Substantial – the targeted segment should be able to generate enough sales or revenue for the firm to survive. This measures the financial viability of the segments and whether the revenue gained will outweigh the costs associated with the segmentation Differential responsiveness – this criterion assesses the response of each segment that is targeted by the firm. The notion is that, for segmentation to make sense, the segments should respond differently to the firm’s marketing strategies. Otherwise, there wouldn’t be any reason for segmentation Durability – creating different marketing mixes can be expensive, therefore the segments must remain clearly defined – at least in the foreseeable future. If the line of demarcation diminishes or disappears before the firm is able to recover its investment, it could incur massive losses Action oriented – the firm must be able to take the necessary steps to design and implement programmes that will enable it to serve its target market well. Bases of segmentation Demographic segmentation As was mentioned in Chapter 27, the concept of demography refers to the study of the characteristics of human populations. These characteristics include size, gender, growth, age, occupation, density and race. However, for the basis of demographic segmentation demographics will be broken down into the following variables: Age It is quite obvious that our consumption pattern changes with age, especially in our earlier years. Products that you would demand, for example, are unlikely to be demanded CHAPTER 29 | PRINCIPLES OF SEGMENTATION by your parents or grandparents. The firm can therefore create a marketing mix that appeals to the different age groups in the market. The generation in which a person is born also has some correlation to age. Psychologists have identified three such categories, including ‘Baby Boomers’, ‘Generation X’ and ‘Generation Y’. EXERCISE In your class discussions, read more about these sub-groups and discuss why they would be of interest to marketers. Gender This is where the marketers create different marketing mixes for male and female consumers. It is quite evident that some things that appeal to a woman may not necessarily appeal to a man. This base for segmentation is particularly popular in the clothing, cosmetics and tools markets, among others. Income Some firms may choose to target customers that they believe are well off. Instead of targeting everyone, the company may place its focus on people within a certain income group. The markets for luxury motor vehicles, designer wear and real estate are often segmented in such a way. Social class Sociologists will tell you that the population is normally divided into different social classes. These classes consist of people with similar wealth, influence and status in society. In many cases, the social class system will influence the consumer’s buying decisions. Consumers in the same class often shop at the same stores, drive certain brands and makes of motor vehicle and eat only at certain restaurants. With this information, the marketer can orchestrate the correct marketing mix to ensure that the firm benefits from the different classes. Occupation A person’s occupation will in most cases affect his/her income level and the social class in which he/she may be considered to belong. It is also quite evident that some occupations are more lucrative than others and so some people possess more purchasing power. A person’s occupation will also influence the products that he/she often buys. For example, a carpenter or mason would spend more money on tools than, say, a teacher would. Lifecycle As we go through the different stages of life, our demand for certain goods will eventually change. As people get older, they will have acquired an amount of assets along the way and therefore either create demand for different products or stop buying certain products. For example, people may take more vacations or spend more on health care as they move closer to retirement. Religion This often influences people’s choices of food and clothing. For example, trying to sell beef products to Hindus or pork to Seventh-Day Christians would not work. Therefore firms may want to create different marketing mixes to cater for the different religious backgrounds of the target market. Nationality and ethnicity The marketer can also segment the market based on people’s countries of origin or ethnic backgrounds (Black, Hispanic, Asian or White). The marketer must ascertain how consumers’ nationalities or ethnic backgrounds will influence their buying behaviour, and create the correct marketing mix accordingly. Geographic segmentation In cases where the firm is operating in different countries across the world, or even in different areas within a large country, geographic segmentation could be explored. The notion is that people living in the same geographical area will have similar buying patterns and behaviour. This could also be used in collaboration with another base of segmentation – for example, behaviour or demographic. Geographic segmentation relates to the climatic condition of the country, the size and density of the population. Climatic condition The weather pattern is different in different parts of the world and so this creates an opportunity for marketers to offer different products. The Caribbean is said to have a tropical climate which is basically the same all year round. The climatic condition of a country affects its agricultural sector, fashion industry and even the construction industry. If you look around in your country you will realise that there is no need for snow boots and the houses are not usually built like those in, say, the USA or England. In addition, Guyana is favoured for rice cultivation because of its climate as opposed to that in some of the other Caribbean countries. 279 280 MODULE 2 | UNIT 2 | FUNDAMENTALS OF MARKETING Density This measures the number of people per square mile or kilometre. It measures how populated an area is. As it relates to density, the country is normally divided into urban, suburban, rural and semi-rural areas. An area that is very densely populated will offer a larger target market to the firm. Since this model was developed, there has been a noticeable reduction in the age at which these stages begin. Some people are having children much younger and while still dependent on their parents. This change in lifestyle should also be of importance to the marketer. It could mean that there are more extended and single-parent families who will have lifestyles differing to those on paper. Region (country or world) Personality The firm may divide the target market into regions instead of targeting just one country. The region could be within a country or a group of countries such as the Caribbean region (CARICOM) as opposed to the western region of Jamaica. What is important is that the target market within that region should exhibit similar buying behaviour. The firm can then develop different marketing mixes to appeal to the different regions or countries. The fact is that, we are most motivated to do things by our personality – that is, the characteristics that make you into the person you are. People’s personalities can influence the buying decisions they make. Some people may dress to match their personalities and therefore the marketer will have to create products that will fit those different personalities. Size (city or town) Size does matter, as firms try to segment their market using the geographical segmentation technique. The firm could measure the size of the country, city or metropolitan area. This would give it an idea of the number of people to be targeted. Psychographic segmentation Psychology refers to the study of the human mind to ascertain the factors that influence people’s behaviour. Marketers can use this information to group people with similar behaviour patterns together. Psychographic segmentation is therefore the division of the market into groups or segments with similar psychological characteristics. These characteristics include values, lifestyles, interests, personality traits and opinions. Lifestyle Marketers can study people’s modes of living on a daily basis. Since we all have different lifestyles, this is very important to the marketer who must create and promote products that appeal to all our lifestyles. It is very likely that a person’s lifestyle will change as he/she progress through the different stages of life. The well-known ‘sagacity lifestyle model’ outlines four stages of lifestyle: 1. Dependent – here, children are still dependent on their parents and are most likely living with them 2. Pre-family – young adults start households of their own but have not yet started having children 3. Family – this is where these young adults start having children who now become dependent on them 4. Late – parents are now close to retirement and the children have left to start families of their own. Opinions, interests and attitudes We all have opinions, interests and attitudes which we display on a daily basis. Some of these may be similar; others may be very different. Whatever they are, though, they surely affect our buying behaviour. The marketer must carefully study the target market to ascertain people’s interests, hobbies and their attitudes toward and opinions of the product. The marketer can then use this information to create the right marketing mix for the particular segment. Behavioural segmentation A marketer using behavioural segmentation will segment the market according to consumers’ behaviour and the way they respond to, use or know about a product. This basis takes a number of factors into consideration, including, but not limited to, the following: Occasions This identifies when a product is usually purchased or consumed by the target market. In the food industry, products such as chocolate may be purchased most around Valentine’s Day or wine and liquors at Christmas, and so forth. Some marketers have managed to influence when some consumers consume the product through persuasive advertisements. User status With this method, the marketer will divide the target market into different usage categories. This may include non-users, first-time users, potential users, regular users and even ex-users. By doing this, the marketers can target a specific group of users. At all times, however, the firm should be thinking of how it can keep its first-time users and attract potential users and even non-users. CHAPTER 29 | PRINCIPLES OF SEGMENTATION Usage rates These measure the rate of usage of the product and categorise people into light, medium or heavy users. Once the market is segmented according to these usage rates, the Production Department, in conjunction with the Marketing Department, can get the right amount of products to the consumers. This information can also assist the firm in pricing its products, as heavier users may be charged more for some products such as electricity. Loyalty status The market can be divided according to customers’ levels of brand loyalty. The firm will try to maintain these customers while attracting others. It is important to note too that some customers may be loyal to a store instead of an individual brand. The marketer must also be mindful of this fact and use it to the firm’s advantage. Benefit segmentation This may also be treated as part of behaviour segmentation. Firms using this method seek to divide the market base of the benefits that consumers are seeking from the use of the product. The marketer must therefore be aware of the attributes and quality that the consumers are looking for in the product and create them. Having studied the marketing concept, you should now realise that this base of segmentation coincides with that concept as firms try to provide satisfaction and value to consumers. This method is very fitting for the market for computers or cellular phones. Different people want different features and also seek different benefits from the use of these products. The marketer can therefore employ the concept of product differentiation to cater for as many needs as possible. Consumer buying behaviour We are all consumers or customers in some way or other. While the two words are used interchangeably at times, their meanings are different. A ‘consumer’ is the final user of the product even though he/she may not be the one who made the purchase, while a ‘customer’ is the purchaser of the product but may not be the final user. For example, your parents purchase things that you end up using: so, they are customers but you are a consumer. It is important to point out here that we are all have a buying pattern. For some people, careful planning is the way to go; some are influenced by advertising while others just buy on impulse. It is therefore the marketer’s responsibility to ascertain how we go about buying a product. Consumer buying behaviour describes the actions that are displayed CASE STUDY Segmenting for success at All Fresh Toothpaste All Fresh Toothpaste started out as a small company producing one flavour of toothpaste and supplying it to the local market. This was its All Fresh Original brand. As time progressed, the company grew and its product became increasingly popular. This prompted the company to become innovative and to explore other flavours and types of toothpaste. With the change in taste and preference of consumers the company has introduced other flavours into the market. These include All Fresh Kids, All Fresh Whitening, All Fresh Sensitive, All Fresh 3 in 1 and All Fresh Minty Mist. All of these flavours have been tailored to meet the desires of different sets of customers. The company has also varied the sizes of the toothpaste. Each flavour, with the exception of All Fresh Kids, is available in three sizes – small, medium and large. In research conducted last month, the company found out that All Fresh 3 in 1 was its most popular brand. This is followed by its Whitening line. The company is now exploring the option of creating a baking soda line and Gel Plus line. The Gel Plus line will be a gel instead of the usual paste and will serve as a mouthwash and toothpaste in one. Questions 1. Define the term ‘segmentation’. (1 mark) 2. Outline three (3) benefits that All Fresh Toothpaste can derive from segmentation. (6 marks) 3. Referring to the products of All Fresh toothpaste, discuss three (3) bases of segmentation that may have been used to segment the toothpaste market. (18 marks) Total 25 marks by individuals in purchasing a product or service. It represents the process that consumers go through to select, acquire and use the product. The consumer decision-making process (the buying process) See Figure 29.2 (p 282) for an overview of the process. Need recognition and problem awareness This stage is characterised by an awareness of a need or problem. This need could come from an innate desire, such 281 282 MODULE 2 | UNIT 2 | FUNDAMENTALS OF MARKETING Figure 29.2: The consumer decision-making process gnition Need recoblem ro p d an awareness Internet sources, such as the firm’s website and social network pages Government agencies, such as consumer associations, bureau of standards, etc. Evaluation of alternatives on Informati search n of Evaluatioves alternati Purchase hase Post-purc on ti a lu a v e as hunger, or could be triggered by some stimulus such as an advertisement. Regardless of what triggers the need, though, it is quite evident that the process cannot begin until the buyer has entered this stage. With this in mind, the marketer has to be able to influence this stage in such a way to create demand for the firm’s product. So the truth is that we all need food, clothing and shelter but the marketer can influence the type of food we eat, the fashion we desire and the type and design of house we buy. Information search Having identified the need or problem, the consumer goes in search of information. Making an informed decision can help save the consumer money and time. Knowing the amount of information that is needed is imperative to the decision. The amount of information needed may be based on the level of spending, urgency of purchase and the nature of the product. For example, buying a house is a huge investment and is a long-term commitment therefore getting information on it is vitally important, as opposed to the process of buying lunch at the school’s cafeteria. The consumer can turn to a number of sources for information. However, the source used depends on the availability of the product and the decision to be made. Some of the common sources of information are: Personal sources, such as families, friends and other close relations Media, including newspapers, television and radio Commercial sources, such as salespeople, retailers, the product packaging or label and advertisements Once sufficient information has been gathered, the consumer needs to evaluate it in a bid to make an informed decision. The consumer has to choose between the different products and brands that are available. His/her choice may depend on the perceived quality of the product, the price of the product, his/her available income, the attributes of the product and consumer reviews, etc. With this in mind, the marketer must ensure that the particular product appeals to the consumer so that it can be chosen. The length of the stage is normally dependent on the importance and spending involved in buying the products. As mentioned earlier, buying a house is a huge investment and so more time will be spent evaluating the information gathered on that than on buying, say, a suit of clothes. Purchase Once the product is chosen from among the alternatives, the next step is to make the purchase. The consumer must now think of the method of purchase – will it be a cash, debit or credit card purchase and will the purchase be made at the firm’s outlet or online, etc.? Deciding when to make the purchase is also important. Some consumers may choose to buy certain items, such as clothes, during off season, as they are usually cheaper. The firm will need to make this stage as simple and problem free as possible in order to encourage repeat purchases. Once the product is purchased, the consumer moves to the final stage where the post-purchase evaluation is done. Post-purchase evaluation In this final stage, the consumer evaluates the purchase to ascertain whether or not the product met his/her expectations or if it was worthwhile buying it. If the consumer was satisfied with the purchase, then there may be a repeat purchase. However, if the consumer feels that an alternative would have been better, the item may not be purchased again. The firm often desires to have repeat consumers and so will have to do its best to achieve customer satisfaction in order to keep its customer base. A trend that is being taken by a number of firms is to offer after-sales service so that any queries can be answered quickly and the firm can maintain the consumer base. CHAPTER 29 | PRINCIPLES OF SEGMENTATION Factors influencing buying behaviour Reference groups As consumers, we are often influenced by a number of factors in making a buying decision. Some of the common factors influencing this process would include: These are the people with whom we are closely associated. They sometimes have the power to influence what we do and even how it is done. Reference groups include our peers, friends, families and mentors. Some people buy a product because of peer pressure, while others are simply ‘bandwagon buyers’. Culture A consumer’s culture will have an influence on what is purchased in some cases. Our belief system often guides our actions and it is no different when it comes to buying a product. As mentioned earlier in this module, culture often influences our choices of food, dress and music, among other things. Perception Consumers perceive a product in a particular way and their actions toward the product often match their perception. Our buying behaviour is often influenced by our perception of the product. For example, for some people, if a product does not carry a recognised brand name, then it is considered inferior even before it has been tried. Level of income To have a desire to acquire a product is good but it will not be attainable unless we have sufficient funds to purchase it. What we buy is very often dependent on the amount and frequency of our income or our ability to acquire credit. Personality People have different personalities – some are introverts and others extroverts. Introverts are those who would rather be alone and often make their decisions without much influence from other people. However, extroverts are usually friendly and outgoing and like social situations and as a result are more likely to be influenced by others. Our buying behaviour tends to match our personality. Marketing Our buying behaviour can be largely influenced by marketers, who can use promotion tools to appeal to our desires. Persuasive advertisement, for example, is known to create a desire for the product in people who have seen the advertisement. Think about how, sometimes after watching an advertisement about food, you suddenly feel hungry or you might have had a desire for a product once it was presented to you effectively. CHAPTER SUMMARY Market segmentation is the division of the market into subsets or segments of potential customers who have similar buying behaviour and characteristics Firms involved in market segmentation should consider the concepts of mass marketing, niche marketing and target marketing For segmentation to be effective, the following criteria must be present: measurability, accessibility, substantial, differential responsiveness, durability and action oriented The market is usually segmented on the basis of demographics, geographic, behavioural, psychographics and benefit sought. Each factor has its own set of characteristics A consumer is the final user of the product even though he/she may not be the one who made the purchase, while the customer is the purchaser of the product but may not be the final user As consumers, we go through different stages before buying a product. While some of these stages are not very distinctive, they include: need recognition, information search, evaluation of alternatives, purchase and post-purchase evaluation The consumer’s buying behaviour may be influenced by culture, perception, reference groups and level of income, among other things. 283 284 MODULE 2 | UNIT 2 | FUNDAMENTALS OF MARKETING MULTIPLE CHOICE QUESTIONS 1. Which one of the following is NOT a reason for segmentation? a. To maintain a competitive edge by catering to the specific needs of each segment b. To serve the market as a whole with one and the same product c. To capture the market of minority buyers who have different attitudes and habits than those of the mainstream d. To get a better understanding of the firm’s target market 2. ‘This strategy is one where the firm identifies a small segment of the market and creates a marketing plan to satisfy that segment.’ This best defines: a. Niche marketing b. Target marketing c. Test marketing d. Mass marketing 3. Which of the criteria for effective segmentation states that the segment should be able to generate enough sales or revenue for the firm to survive? a. Measurability b. Durability c. Substantial d. Accessibility 4. Demographic segmentation divides the market by ALL of the following variables EXCEPT which one? a. Age b. Gender c. User status d. Income 5. Which one of the following can be regarded as a geographical variable for segmentation? a. Density b. Occupation c. Lifestyle d. Usage rate 6. At which stage of the consumer buying decision process would the buyer assess whether or not his/her expectations have been met? a. Problem recognition b. Information search c. Purchase d. Post-purchase Extended Essay Questions Question one Total 25 marks Some firms are involved in market segmentation in order to maximise their profits and sales by catering for as many needs as possible. a. Outline three (3) advantages and two (2) disadvantages of market segmentation. b. Discuss how any three (3) of the bases of segmentation can be used to segment the market for clothing. Question two (10 marks) (15 marks) Total 25 marks You have been saving to buy a new computer for the last six months. One night, while doing your school work, your present computer finally turned itself off for the last time. Your work is still waiting to be completed and luckily you had managed to back up all you had done before the computer crashed. Your work must be handed in a week later and all that is standing in your way between now and then is buying a new computer. Using the consumer buying/decisionmaking process, explain how you would go about choosing and purchasing a new computer with the money that you (25 marks) have saved. 285 30 Product Management LEARNING OBJECTIVES: At the end of this chapter students should be able to: Define the term ‘product’ Explain the core, formal and segmented product Discuss the dimensions of the product mix Describe the Boston Matrix Assess the new product development process Illustrate and explain the product lifecycle Evaluate the effectiveness of branding and packaging Outline the characteristics of services T his chapter discusses in detail what is termed the ‘marketing mix’. The marketing mix is the combination of factors used by a firm to influence a customer’s buying decision. It is also seen as the set of tools combined by the firm to meet the needs and wants of the target market. The marketing mix consists of four marketing tools: product, price, place (distribution) and promotion. These four concepts are often referred to as the ‘Four Ps’ of marketing. (See Figure 30.1.) These concepts will be discussed further in subsequent chapters. The first of the Four Ps that we will explore is the product. wants. The product can be tangible (item) (for example, rice) or intangible (service) (for example, dressmaking). In order to maximise profitability, the firm has to develop its product carefully so as to attract consumers. This is especially important in a market where there are products of the same nature. Something about the product must stand out in a good way. The success of any product will depend on three important attributes. See Figure 30.2. The core product The core product represents the actual benefit that a consumer is seeking from the purchase and use of the product. What is the main or essential reason for purchasing the product? For example, the main reason for buying a laptop might be to do your school work. The actual or formal product The actual product focuses on the attributes or features of the product. More than likely, these features will be the differentiating factor between this product and other products. The actual or formal product includes such things as quality, brand name, packaging and design. Using the above example of a laptop, the actual product would include the specs of the laptop, the brand (for example, Sony or Dell) and the software that comes with it or is available for it. The augmented product The augmented product focuses on the additional benefits and services that the consumer receives from purchasing The concept of product A product is any item or service that is offered for sale to the market with the aim of satisfying a consumer’s needs or (A) Product Price Marketing mix (B) (C) Promotion Place (distribution) Figure 30.1: The Four Ps (C) (B) (A) Core product Formal product Augmented product Figure 30.2: Attributes of the product 286 MODULE 2 | UNIT 2 | FUNDAMENTALS OF MARKETING and using the product. It represents the post-sale benefits or features associated with the product. This may include such things as after-sales service, warranty, delivery and installation. In order to distinguish themselves from their competitors, a number of firms are now working assiduously to improve the augmented product. Many customers are looking for more than just the core product. This is further compounded by the fact that our global boundaries are being removed and so people can buy what they want from almost anywhere in the world. Dimensions of the product mix A firm that produces or markets more than one product is said to have a product mix. Therefore, the term ‘product mix’ can be defined as the group of products that are sold or distributed by the company. The dimensions of the product mix are measured in terms of its breadth and depth. See Figure 30.3. Breadth or width The breadth of the product mix measures the number of product lines or different products that the firm has. It shows the level of diversification within the firm and its ability to manufacture and/or sell different products. The more products that the firm has, the wider will be the product mix. Having a wide product mix can be beneficial, especially in a very competitive market. If one product or marketing segment fails, the firm might be able to survive on the others until its problem is sorted out. For example, the Jamaican conglomerate Grace Kennedy Ltd, in addition to having a number of companies, has a wide product mix. If we take Grace Foods for example, the product mix would include tinned foods, frozen foods, dairy and porridge etc. Depth The depth of the product mix relates to the variations or features of each product line. It includes such aspects Figure 30.3: Dimensions of the product mix Product line 4 Product line 3 Product line 2 Product line 1 Depth Breadth of the product mix as model, sizes, design, colour, flavour, etc. Using our example from above, Grace’s tinned food line would include mackerel, sausages, corned beef, baked beans, etc. Firms that desire to cover a number of segments usually have a very deep product mix. However, this can be counterproductive, especially where the products start competing against each other. Product line and extension A product line represents a group of products, offered by a firm, which has similar characteristics and similar intended uses. The length of the product line is often dependent on the objectives of the firm or the amount of resources to which it has access. The firm should also assess whether or not its product line is too short or too long. Firms that have product lines falling within any of the two extremes may find that they are operating inefficiently or even at a loss. If this is the case, then the firm may need to either shorten or lengthen the product line, depending on the situation. Where the product line might be too short the firm can develop new additions to its existing product line. This is referred to as a ‘product line extension’. This is usually done to gain more market share, profits or growth. Product line extensions can take one of two forms: line stretching or line filling. A firm can ‘stretch’ its product line by lengthening it either upwards or downwards or a combination of both, beyond its current length. For example, a brewing company may add another beer to its alcoholic beverages line. An upwards extension could be to offer a new product of higher quality and price to the lower end of the market, while a downwards extension could be to offer a new product of lower quality and price to the higher end of the market. Conversely, the firm could simply add new products to the existing range of the product line. This would then be referred to as ‘line filling’. These products would have slightly different features from existing products. The reasons for this action could include taking advantage of unused capacity, getting rid of gaps in the market and discouraging competition. Examples of line filling include Milo 3 in 1, Colgate Herbal and Sunshine Snacks’ honey roasted peanuts. The Boston Matrix This is also referred to as the ‘Boston Box model’ and was developed by the Boston Consulting Group. It is a wellknown method that is used for product portfolio analysis. It consists of an illustration showing the total percentage market share of each product and the rate of growth in the CHAPTER 30 | PRODUCT MANAGEMENT CASE STUDY ATL Group – taking it beyond sales Appliance Traders Ltd Group offers a number of products to the Jamaican market. These products include household items such as appliances and air conditioning units; office items such as printers, copiers, storage systems and servers; industrial items such as food service, laundry and industrial equipment and power generators; a parts business which sells parts for a myriad of appliances and equipment; and its energy solutions which include products such as solar heaters, LED lighting and energy management systems. While offering a number of items under different product lines, ATL has prided itself on being one of the best stores in the country. Guided by its slogan, ‘Unbeatable’, the ATL Group tries to offer the best service to its customers. The group believes that it should not only sell products but form relationships with its customers through its after-sales services. The company stated that these ‘Relationships begin before you pick up the phone or walk into a showroom, store or service centre and continue long after you leave’. Questions 1. Using the case as a guide for examples, outline the three attributes of a product. 2. Using examples from the case above, explain what the breadth of the product mix is. 3. Citing examples from the case above, explain the concept of the depth of the product mix. market, ranging from high to low. The Matrix postulates four categories under which a product can fall, namely: Star Cash cow Dog and Question mark or problem child. Each category gives the firm a clear view of the product’s position. This is seen in Figure 30.4. The proposed categories are broken down further as follows: ‘Star’: high market share and high market growth A star product is one that is doing extremely well in the market. It has a high market share and is growing in the Stars Question marks High Low market but needs heavy investment in order to continue doing so. This product is one that will generate substantial revenue and profits for the firm into the foreseeable future. In order to maintain this possibility, the firm may commit a large portion of its resources to such a product, especially in the form of promotion. Eventually, this product will slow down and may very well become a cash cow in the future. ‘Cash cow’: high market share and low market growth This product is very important to the firm and most firms have at least one of these products. Cash cows are known by their high market share that has been developed over the years and their low growth rate due to maturity. These products are termed this way because they generate substantial cash or revenue for the firm. This revenue is often used to finance and sustain other products such as stars. The firm is less likely to spend a lot of its resources on promotion for these products since they are well known in the market and are generating high volumes of sales. However, they need to be properly managed so that their lives can be perpetuated and more cash can be ‘milked’ by the firm. ‘Question mark’ (‘problem child’): low market share and high market growth Low Market growth Market share High (9 marks) (3 marks) (3 marks) Total 15 marks Cash cows Dogs Figure 30.4: The Boston Matrix This product is usually still in the development stage and is characterised by low market share and high growth rate. It is using up resources for promotion but is not established 287 288 MODULE 2 | UNIT 2 | FUNDAMENTALS OF MARKETING enough to generate much resources at the moment. There is some uncertainty about the viability and success of such a product but it has potential. Careful thought must be given by management to such products in terms of investment decisions. ‘Dog’: low market share and low market growth The dog represents those products with low market share and low growth rates. Such products are likely to be in the decline stage of life and are not offering many, if any, benefits to the firm. As such, they are not worth investing in since they may not be able to provide any returns on the investment. These products will soon be discarded by the firm as it concentrates on finding new investment options. Application of the Boston Matrix In our competitive economic climate, stakeholders want to know that their investment is being properly utilised on products that will generate substantial returns. Knowing what is happening with a product is therefore going to be vital to the firm and other stakeholders. Since the Boston Matrix divides the firm’s product into distinct categories, management can make certain important decisions regarding these products. This includes the decision to: Hold – in holding, the firm may want to maintain its present market position. This is especially so where there is a good combination of the four categories of products Build – taking such action will mean that the firm is willing to invest heavily to improve its market position. This investment could be geared towards expanding the market share of a ‘star’ product or trying to establish a ‘problem child’ Harvest – this may involve the process of milking as much from the ‘cash cow’ product in the short term. A firm using a harvesting strategy may not want to take on long-term investments but may simply want to gain short-term profits from the market Divest – where there are products that are underperforming or bleeding resources from the firm, with no hope of generating revenues, the best thing to do is to get rid of them. In most cases, the ‘dogs’ will be divested or discarded. Using the Boston Matrix provides management with the following advantages: The entire product mix can be examined together and closely scrutinised CASE STUDY Milking the <1 baby formula Hygrade Baby Products Ltd has been one of the leading manufacturers of baby food in this side of the hemisphere. When it was established, the firm’s main product was its <1 baby formula. This product has been doing extremely well on the market and is said to contribute a little over 30 per cent to the firm’s annual revenue. The firm believes that this product has captured a large percentage of the market share and is growing slowly but is reaping a lot of money. The success of its <1 baby formula encouraged the firm to invest in and develop a number of other products. These include its 1+ baby milk, a range of fruits and fruit cocktail and baby supplements. In recent times its baby fruit cocktail has taken off and is experiencing rapid growth, capturing a significant portion of the market share. Consumers are said to prefer this cocktail over others because it is made from local fruits and has a taste familiar to most infants. Two years ago, the firm introduced its diaper line but there are some concerns about this. The product is growing fairly well but has not yet been able to get a foothold in the market. This is largely because of consumers’ reservations over not knowing Hygrade Baby Products Ltd as a producer of diapers – most people are comfortable buying the brand they know. The firm is committed to capturing this diaper market but in doing so appears to be throwing caution to the wind. Questions 1. Describe the four (4) categories of product that were proposed by the Boston Consulting Group. 2. Which three (3) categories of products were highlighted at Hygrade Baby Products Ltd? Give evidence from the case to support your answer. 3. Under the circumstances, would you suggest that Hygrade Baby Products Ltd hold, build, harvest or divest its diaper line? Give reasons for your answer. (12 marks) (9 marks) (4 marks) Total 25 marks CHAPTER 30 | PRODUCT MANAGEMENT It gives a firm an overview of all its products and the level of success, failure or potential for each product It assists marketers in planning the firm’s promotional strategies. New product development process Whenever a firm launches a new product, it is often the end result of a sometimes long and tedious process. Most, if not all, products go through a process with different stages. Some processes may be shorter than others but there are certain stages that must be completed. In this section, a seven-stage new product development process will be examined. It must be pointed out that that some of the stages do not necessarily occur sequentially but can happen concurrently. Figure 30.5 illustrates a seven-stage new product development process. Generating ideas This is the very first stage of the process and is a very important one. A new product begins in the mind of someone and then it is created in the plant. The challenge at this stage is to generate ideas that will be successful and preferably ideas of a product that has not yet created. Even though building on a competitor’s product can be successful, creating something different is even better. New product ideas can be generated from a number of sources, including: Studying the product offerings of competitors in a bid to improve upon them Market research to find out what consumers want Advancement in technology creates an opportunity for other products Group discussions which bring a number of creative minds together to formulate ideas Employees’ input and ideas. The firm can generate a large number of ideas as it prepares for the next stage in the process. Screening ideas It should be obvious at this point that not all the ideas that have been generated can be transformed into product offerings. This is for various reasons, including financial viability, the Generating ideas Screening of ideas Figure 30.5: New product development process Concept development and testing firm’s plant capacity and technological capabilities. It means, therefore, that the ideas generated above will have to be screened so that the best ones are pursued by the firm. This process will help to reduce the number of generated ideas into a smaller and more realistic pool of potential products. To make this process effective, the firm should use a checklist with the factors that would make an idea worth pursuing. Each idea must be assessed against the checklist and a decision made concerning whether to keep or discard it. The checklist may be different for different firms but some general issues that could be covered would be: Financial viability Estimated cost of production Benefits to the target market The firm’s technical capability to produce the product. Concept development and testing Having settled on a new product idea or group of ideas, it is time to create a proper product concept. In this section the idea is refined and shaped into something more practical. The product concept would include things such as the product features, a possible design, cost of production and proposed pricing information. Once the concept has been developed, the firm can test the idea in the target market. The product could then be presented to the market by giving a full description, showing a picture or using simulation. Information can then be gathered from the potential consumers. This can be done by using one or more research techniques to gather consumers’ views on the idea of using such product. The information gathered can be further used to make adjustments to the product concept before initiating production. Business analysis If the product completes the above stages successfully, the firm will now do a business analysis on the product. This analysis will include the creation of a marketing plan for the product. In addition, information regarding estimated costs, sales and profitability must be fine-tuned and carefully analysed. The marketers may also be asked to draft a statement of forecasting sales for upcoming years. This is important, as the firm would want to ensure that it can recoup its initial capital outlay and maintain profitability. Business analysis Develop prototype Test marketing Commercialisation 289 290 MODULE 2 | UNIT 2 | FUNDAMENTALS OF MARKETING The business analysis will help to decide whether the product is worth investing in and should be developed. if this is favourable, the firm can move to the next stage of developing a prototype of the product. purchase and use the product. Their response to the new product can then be observed and used to make changes to the product if necessary. Developing a prototype This stage involves the roll-out of the final product to the market. It is the full-scale launch of the product to its target market. The Marketing Department is integral especially at this stage, as the word has to reach the customers. Having an effective product without properly informing the public about it is almost as bad as making an inferior product that is well known. So far, the idea has existed on paper but now the firm will move to create the actual product or, in cases such as buildings or very large items, it may create a model of the product. This stage helps the firm to get a clearer picture of what the product will look like and also the actual cost of developing it. Developing a prototype can be an expensive process and so the firm will also be able to shelve some ideas at this point. A prototype will also give the target market customers something tangible to view or, in the case of a service, something real that they can experience. Test marketing This stage involves the actual testing of the product and marketing strategy in the target market. The aim of this process is to ascertain how consumers will respond to the product and marketing strategy. This strategy is used regularly when new drinks or cosmetics are developed, where people are asked to try the product and give their feedback. The firm can used this feedback to make improvements to the product. Since the product will more than likely be tested on a representative sample of the targeted population, if their response is not favourable the firm could discard the idea at this stage. This would prevent it from incurring huge losses associated with creating a product that is a failure. Review Chapter 28 on the advantages and disadvantages of using this strategy. It must be pointed out here, though, that the firm may not necessary use the actual product but could also use simulated test marketing. Here, the firm would create a situation that mimics the actual situation in which consumers would Four-stage product lifecycle Commercialisation (launch) The product lifecycle If you stop and think for a while, you may be able to identify a product that you once knew but is not available any more. The truth is that no product lasts forever, especially without any improvement. It follows that all products go through different stages of life. This is known as the product lifecycle. There are four distinct stages in the lifecycle: 1. Introduction 2. Growth 3. Maturity and 4. Decline. The four-stage product lifecycle is shown in Figure 30.6. Stages of the product lifecycle Introduction The first stage of the product lifecycle begins with the commercialisation or launch of the product as was discussed earlier under the new product development process. This stage is characterised by low sales and low profits, if any at all. There is usually very high spending on promotion at this stage, as the firm tries to increase consumer awareness and create brand image and loyalty. Monitoring the product is especially important at this stage, to ensure that it become poised for growth. If the product introduction fails, it may be advisable to withdraw the product, make adjustments and reintroduce it. Product sales Growth Time Introduction Growth Maturity Figure 30.6: The four-stage product lifecycle Decline This stage is characterised by increasing sales and profits as the firm’s promotion efforts take effect in the market. Vigorous promotion will help to build customer loyalty and brand image. As sales increase within this stage, the firm may also benefit from economies of scale from large-scale production. However, increased success within the market will foster increased competition. Therefore, competition increases at this stage which also has the ability to force CHAPTER 30 | PRODUCT MANAGEMENT prices downwards even as growth starts to show signs of weakening. Firms may seek to maintain their competitive edge by changing their marketing and promotion strategies. Maturity By this time the product is well known in the market and has reached or has almost reached the point of market saturation. The product’s growth begins slowing down, sales peak and start levelling out while profits are maximised. As competition becomes fierce, the firm may attempt to sustain the life of the product and maintain its market share through promotions, product differentiation and/or price competition. The firm may also implement what is called ‘product life extension’. This concept is dealt with separately below. Decline Eventually, a product will reach this stage at some time in its life. This is where the product’s sales fall and profits decline. In some cases the fall in sales is not limited to the firm but the entire industry. At this stage the firm will withdraw investment from the product and abandon production. Products that reach this stage are referred to in the Boston Matrix as ‘dogs’. It is important to note that a sometimes a five-stage product lifecycle is used. In this version another stage called ‘saturation’ is added between ‘maturity’ and ‘decline’. Such a product lifecycle would then be: 1. Introduction 2. Growth 3. Maturity 4. Saturation and 5. Decline. This is seen in Figure 30.7. The saturation stage suggests that the product is well known and most people interested in it would have already purchased it. The stage also suggests that there are other competitors in the market who may have a superior and cheaper product. At this stage the firm would basically decrease sales and advertising expenditure since there is no incentive to spend on the product. Different products go through the stages of the lifecycle at different paces. The pace of a product may be dependent on: The marketing strategies of the firm Rate of changes in technology, especially where the product is technologically based The level and frequency of innovations in the market Volatility in consumers’ tastes and preferences. While the product lifecycle works as a good means of analysis and guide for decision making, it has some limitations: The stages of the cycle may not be very distinctive and so it may be difficult to place the product within a particular stage Not all products will go through all the stages, as some products have an almost endless life It focuses only on one product rather than the firm’s entire product offering The model may be self-fulfilling, as firms can still be successful without using the product lifecycle. As was mentioned above, maturity or saturation of a product does not mean automatic decline and discard. The firm can prolong the life of its product by implementing extension strategies. This will lead to an extension of the current product lifecycle diagram, as seen in Figure 30.8. Some of the possible extension strategies that can be utilised by the firm are: Making modifications to the product. This could be done by adding a new ingredient or mix or flavour – for example, Malta Refresh or Velvet Price Five-stage product lifecycle Product sales Product extension Time Time Introduction Growth Maturity Saturation Figure 30.7: The five-stage product lifecycle Decline Introduction Growth Maturity Figure 30.8: Extending the product lifecycle Decline 291 292 MODULE 2 | UNIT 2 | FUNDAMENTALS OF MARKETING CASE STUDY Diet Coke extends life Knowing when to change one’s strategy in business is the key to success. It is a fact that no product will last forever without some form of modification being done to it. This was obviously clear to the management of Coca-Cola when it decided to introduce its Diet Coke line. Coca-Cola has never been a company that is averse to change and development. This attitude has been responsible for the top position held by the company for a number of years. Development has helped to prevent the product from going into decline as that is where most products end up after maturity. Coca-Cola is said to have overcome this hurdle by constantly developing the brand image and reinforcing the core product benefits of taste and refreshment. This has allowed the brand to grow instead of decline. Over the years, Coca-Cola has evolved and has become more accessible, moving from an over-the-counter drink fountain to bottles which are available across the world. Once bottled, the product became available in different sizes and shapes, including its 330 ml, 500 ml and 2 litre sizes. With changing views on the health risks of carbonated beverages and people becoming more health conscious, Coca-Cola introduced its Diet Coke line in 1982. This drink has become one of the most demanded low-calorie soft drinks. The Coca-Cola portfolio also includes Lilt, Fanta and Sprite. Questions 1. Outline the four (4) main stages of the product lifecycle. 2. What would be two (2) limitations of applying the concept of the product lifecycle to Coca-Cola? 3. In relation to the product lifecycle, explain what is meant by ‘extension strategy’ and give one (1) reason why this is important to a firm. 4. Describe three (3) ways in which Coca-Cola extended its product lifecycle. Discovering new uses for the product – this will create fresh demand for it Rebranding or repackaging – this has been known to revitalise the product and create new demand Create a complementary product to increase the demand of the existing product. Branding and packaging While the development of a product is very important, the firm should also spend some time creating an image which distinguishes it from its competitors. Therefore branding and packaging are important elements of product management. Branding Every firm needs a brand for it products. Branding occurs where a firm places its name, mark, symbol and/or design on its product. This acts as a means of identification and helps consumers to differentiate the product from others. Before discussing this further, though, there are some important concepts that must be defined. (8 marks) (2 marks) (4 marks) (6 marks) Total 20 marks Brand This is a name, mark, sign or symbol or any combination of these factors which is used to identify the product and differentiate it from competing products or firms. Brand name The brand name can be a combination of words, letters and numbers which can be spoken or verbalised. Brand mark This is the non-verbal part of the brand which is easily recognised and is used to identify the product. Brand equity This refers to the amount of value that a brand adds to a product. Simply placing a brand name on a product can change the perception of it in the market because of the value that is associated with that brand name. Trade mark A trade mark can be a brand or part of a brand which the firm has the legal right to use exclusively. Any infringement of such a mark can lead to lawsuits. CHAPTER 30 | PRODUCT MANAGEMENT Reasons for branding Firms may brand their products for various reasons. Some of the most common reasons for branding are: It provides identification and differentiation of the product and firm since the brand is unique to that firm It provides legal protection of the firm and its product mix It can give an indication of the value that a company places on a product Successful brands can be used to launch other products within the product mix A successful brand can help to build the image of the firm A brand helps to create brand loyalty once the product is highly rated by consumers. Types of brand Generally speaking, firms have different types of brand for their products. Some of the most common types are: Family brand – this is where the company’s name (Grace) or a product name is used as the brand for all products (Ajax) Retail brand – this is where the retailer, instead of the manufacturer, attaches a brand name to the product – for example, PriceSmart’s ‘Member’s Selection’ brand or the WalMart brand Combination branding – this is where the firm incorporates more than one type of branding for a range of products – for example, Microsoft Windows and Microsoft Office Individual brand – this is where the firm attaches a different brand name to each product – for example, Heinz operating as Farley’s baby foods and WeightWatchers food. is being a good corporate citizen by using packaging that is in accordance with these requirements. Some companies have joined in this movement by using biodegradable plastic bags instead of those used previously. The firm should also ensure that the information provided on the packaging is not misleading, as this could lead to lawsuits. The correct design, size and material must be carefully chosen so as to minimise cost and at the same time provide convenience and ease of transportation and storage. Types of packaging There are two distinctive types of packaging. These are outlined below: Primary packaging – this is the material that is used to hold or encase the product. It is the part of the package that is in direct contact with the product (for example, a carton) Secondary packaging – this is the outer layer of the package which is often used to group the primary packages together (for example, a box in which the cartons are placed). See Figure 30.9. Characteristics of services As was pointed out earlier in the chapter, a product can be a good or a service. It was also pointed out that a good is a tangible item that can be seen and touched. A service, however, is an intangible economic activity that cannot be stored and is received by the consumer at the point of sale. There are four notable characteristics that distinguish a good from a service. These are discussed below: Packaging In a number of cases, the brand name of the product will not be placed on the product itself but on its packaging. While it may be seen as just a wrapper, the packaging also helps to: Protect the product from damage Promote the product to potential customers Give important information about the product Appeal to consumers. Care must be given to designing the packaging, as this can either attract or turn off potential customers. The product should also be properly labelled and meet all environmental requirements. With the emphasis recently placed on being environmentally friendly, coupled with the on-going ‘Go Green’ campaign, the firm may also want to ensure that it Figure 30.9: Secondary packaging 293 294 MODULE 2 | UNIT 2 | FUNDAMENTALS OF MARKETING CASE STUDY From Pan Caribbean Bank to Sagicor Bank This is not a take-over or merger but simply a name change. In December 2012, Pan Caribbean Financial Services rebranded to become Sagicor Investments Jamaica Limited. As a result, its commercial banking subsidiary, Pan Caribbean Bank, was renamed Sagicor Bank Jamaica Ltd. According to the firm’s Assistant Manager, such rebranding enabled the company to strategically align both subsidiaries with the parent company, Sagicor Financial Corporation, which is located in Barbados. The rebranding exercise is expected to strengthen the relationship with the Sagicor Group. The firm is set to benefit from greater name (brand) recognition for its suite of products and services. The firm will also benefit from the collaborations that will take place in terms of marketing. The rebranding exercise also became imminent as Pan Caribbean tried to clear up any confusion between itself and the Chinese-owned Pan Caribbean Sugar Company. The confusion started when Pan Caribbean Sugar Company was established in Jamaica and some people felt that the two companies were associated with each other. Questions 1. Outline four (4) reasons why branding is important to businesses. 2. Give three (3) reasons from the case to support the Pan Caribbean Financial Services’ rebranding exercise. 3. Explain one (1) possible drawback for Sagicor Bank as a result of the confused association with the Pan Caribbean Sugar Company. 4. Explain one (1) possible drawback of the rebranding exercise of Pan Caribbean Financial Services. Intangibility A service, being intangible, means that it cannot be seen, touched or tasted. As a result, unlike the case with goods, consumers will not be able to interact with a service before it is purchased. There is no tangible attribute that can be used to appeal to consumers before they purchase the product. In most cases consumers may have to depend on customer reviews, personal references and the reputation of the person or firm offering the service. Being aware of this, marketers often try to associate the service with something tangible – for example, ‘before’ and ‘after’ pictures of the results of plastic surgery. Some marketers also stress the quality of the service when it is being advertised. Inseparability The nature of the service industry is that it is highly labour intensive. As a result, it is difficult, if not impossible, to separate the service from the provider: they are inseparable. Therefore the provider and service being provided are viewed as one entity. What does this mean for the consumer? Once purchased, the service is produced and consumed simultaneously and both the consumer and provider become a part of the service. For example, if you purchase a massage, both you and the masseuse are part of the service and you cannot have the service unless the (8 marks) (6 marks) (3 marks) (3 marks) Total 20 marks masseuse is present. This fact forces marketers to improve and maintain quality levels consistently while also ensuring that service providers are competent in their respective fields. Variability Unlike most goods which are standardised and produced in mass quantities by a single producer then distributed to consumers, a service is provided and distributed together. To this end, a service will be more than likely different, depending on when, where and how it is provided and who provides it. It is for this reason that we often go to the same barber or hairdresser on every visit to the salon. As it is, it is difficult to give the same quality of service on each occasion and, as a matter of fact, maintaining the same quality comes with experience and training. The service provider must also be aware of the consumer’s expectations and try to meet or exceed those expectations. Perishability Based on the discussion so far, it should have become quite obvious by now that a service cannot be stored either. The fact is that a service disappears the moment it is provided or received: it can be described as perishable. Once a service is sold or provided it is not possible to store it for a CHAPTER 30 | PRODUCT MANAGEMENT further date. As a result, if the service is not consumed upon provision it will go to waste. In addition, in most cases, firms are not able to adjust the supply of the service to meet the demand. Therefore the quality of the service might diminish as it is demanded by more and more people. Have you ever wondered why the service you received gets poorer during peak season or peak hour at, say, a restaurant or bank? The fact is that the people who are rendering the service tend to become tired or stretched during these times and so quality of service tends to decrease. With this in mind, the firm must be aware of its supply capacity and so monitor its service quality periodically and bring in more staff when necessary. Having identified the characteristics of services, the marketer now has to formulate strategies to deal with each characteristic in order to achieve success. Table 30.1 gives some suggested responses that marketers may make. Characteristics Possible response from marketer Intangibility Match the service to something tangible where possible – for example, for a hotel the service could be tied to its physical structure, including aesthetics, room size or amenities. Focus should also be placed on quality and referral Inseparability Here, the marketer should focus on the service provider. The firm has to ensure that the workers are highly skilled and properly trained to offer the service. The marketer can also capitalise on the strengths of the people providing the service. This may involve good deployment decisions. The employees must also be highly motivated so that they can give of their best at all times Variability Since the service may vary, there has to be a degree of standardisation. This will mean that each person providing the same service must be given clear guidelines and instruction as to how the service must be performed. Some firms have also introduced technology to reduce the amount of variability Perishability While not within the responsibility of the marketer, staffing is very important here. During peak seasons, the firm may want to employ more workers. Where the supply of the service is greater than the demand, the firm could offer discounts to encourage utilisation –