MANAGEMENT (FIRST PARTIAL) HANDOUT A.Y. 2020 – 2021 EDITION Written by: Phillip Crandall, Clemence Coudreau, Francesca Berardi 1 This handout has been written by students with no intention to substitute the University official materials. Its purpose is to be an instrument useful to the exam preparation, but it does not give a total knowledge about the program of the course it is related to, as the materials of the university website or professors. Introduction and theory of the firm What is management? It is the process of acquiring and coordinating resources (human, physical, intangible) to achieve the goalsof an organization. Leadership VS management Scan to test yourself on all of Management with our pre-made flashcard resources! Management makes systems of resources work well on a daily basis • problem solving and execution Leadership creates the systems that managers manage, and changes them to create opportunities • vision and direction In some firms it is hard to disentangle the two roles. Both roles can be separated from that of the owners. Management and economic activities Economic activity takes place within (human) societies and serve to satisfy human needs. Goals are people’s purposes and aspirations. They drive all human activities. The pursuit of these goalsgives rise to needs Needs arise as the feeling and awareness of dissatisfaction owing to the lack of something. • Natural (a product of human biology) vs. social needs (from spiritual self and social interactions) • Essential/primary needs (universal) vs. non-essential/seconday needs (influenced by imitation, interactions etc.) Needs are hierarchical and dynamic. Human needs are structured in hierarchy and prioritized according to differences in consumers choices as disposable income varies. As it increases, consumers can access certain goods, and abandon others. The opposite occurs as incomedecreases. Priorities are somewhat fixed for the lowest needs and the income levels; conversely, individual preferences varya great deal with higher income levels. According to Maslow, needs can be put in a hierarchicalorder: People start with their basic needs and go up the pyramid aseach need is satisfied. Goods and services satisfy our basic needs, and usually physiological needs. One way that people satisfy their needs is through economic activity, which means producing and consuming economic goods and service. 2 Classification of goods: Essential vs non-essential: essential goods satisfy our primary necessities, whereas non-essential goods are not necessary to survive Complements vs substitutes: complementary goods are goods that you need to consume together.Substitute goods, on the other hand, are goods that can be used for the same purpose and are interchangeable Economic vs non-Economic: economic goods are scarce with respect to people demand. Non-economic goods are free and unlimited (sunlight) Differentiable vs homogeneous: an homogeneous product is one that cannot be distinguished from competing products from different suppliers, it has essentially the same physical characteristics and qualityas similar products from other suppliers. An example are raw materials with similar features. Differentiable goods are products of different producers with particular features. Industrial vs. consumer: goods utilized to produce other goods and goods directly used by prople to satisfy their needs. Goods for individuals and goods for the collectivity Disposable vs durable goods: the first ones are only used ones, the others are usable over timePublic vs private: • Economists define a public good as being non-rivalrous and non-excludable. Non-rivalrous meansthat my consumption does not affect your consumption of a good; I do not ‘use it up’. Non excludable means that I cannot prevent you from consuming it. o pure public goods (national defense) o natural monopolies (railways, electricity, water) Industries in which the infrastructure cost is too high and it makes difficult for privates the entrance. Also, competition in those sectors would be bad for costumers • A private good is rivalrous and excludable. Problems with public goods: • due to non-rivalry and non-excludibility people can consume them without paying. • incentives to hide true preferences for the public good and let others pay its provision: free loading • firms cannot recover costs due to non-excludability: public goods may end up being under-supplied To overcome this problem: • heterogenous preferences: some individuals care more than others about certain public goods orservices • altruism: individuals care about others as well when they make economic decisions • State intervention: subsidies, direct provision etc Economic activity NON-PROFIT ORGANIZATIONS Private organizations which are not allowed to distribute net earnings but instead use them to help pursuesocial, cultural, educational or political goals • The aim is to satisfy the portion of demand for these goods that the State does not meet • Very heterogeneous group of organizations in different economic areas, e.g. education, health, culture, development, environment, philanthropy and religion • Similar to “normal” companies Why non-profits exist? • Mostly economic and technical reasons: private producers of public good (market failure) • Exploit regulatory advantages granted by States, e.g. tax breaks, preferential tariffs, flexible work • Gather some resources at non-market conditions, and benefit from e.g. voluntary work, low-interestloan, donation 3 Where does it take place? • Social bodies: – families – business firms – States – nonprofit organizations • tend to coexist and have different goals Organizations: • A system of consciously coordinated activities of two or more persons • An abstract social entity (family is a social entity but not an organization because there are nowritten codes) • Set of elements and factors, personal and material resources • Directed towards a set of common goals • The product of joint efforts is distributed among all participants • Organizations vary across time and space, but at any point in time there is a stability of rules and models of behavior for individuals and groups (institutions) But why social groups and not single individuals?efficiency: sources of efficiency in groups: • more diversified (and potentially) complementary skills: – skill set of a worker is more constrained than one of a group – you can assign tasks to the workers that are most skilled • easier to achieve risk-sharing –less risky to invest resources when payoff depends on multiple potentially uncorrelated activities –diversification – it is easier to monitor the workers, as well as their training • easier to accumulate resources: - accruing from risk-diversification, limited liability and social preferences • specialization economies: – the learning curve for workers is very strongSocial needs: to fulfill the human need for sociality An example is Henry Ford, who incorporated new features like moving slides and assembly line in theprocess of making the model T. - car manufacturing split in 84 steps - separate stations, moving slides and interchangeable parts - production time and costs decreased significantly - increased productivity by specialization in the production Specialization: (by specializing we improve the overall wealth of the organization) Weʼre 3 students that want ADVANTAGES to make learning faster. Scan to test yourself on 1. Learning processes specialization - and Repeating the same activity leads to: download Kado to stay tuned for more! a) Developing manual dexterity b) Discovering more efficient and effective ways to perform the activity c) Creating an inventory of problems and solutions 2. Individual skills Specialization allows to assign tasks to those people who are most skilled at them, increasingefficiency. 3. Technical and managerial orientation 4. Reduction in costs of preparing for and transitioning from phase to phase 5. Use of specialized facilities & equipment 6. Enhances Job identification and motivation a) Very specialized people tend to identify with their job and enjoy a sense of the command overthe work situation 4 b) Mastery contributes to self-esteem, provided that the task is difficult enough to be motivating DISADVANTAGES 1. Costs of coordination: greater the degree of specialization, greater is the number of interfaces between workers. 2. Cost of rigidity and specific investments: varied skills and multi-purpose facilities can be easily redeployed to new tasks, while specialized resources are less flexible. 3. Demotivation: simple and repetitive tasks can reduce esteem and self-fulfillment. What is a business firm? • Legal entity that engages in the production of economic goods • many interests converge, but they do not necessarily come together spontaneously • stakeholders are all subjects that contribute to the firm in exchange of some rewards • often complex and bureaucratic, resulting in inefficiency Economic production is the mean to the firm’s purpose, which is to produce revenues for its employees andshareholders. it’s obtained by combining certain production factors: • purchasing raw materials from other companies • building facilities industrial plants and buying equipment • operational, managerial and governance work • public goods STOP! Time for some active recall ‒ scan to test yourself • free goods on what youʼve read so far! Primary production factors are: • labor • equity capital, originated by savings Thus the importance of employees and shareholders is vital and remarkable. Main features of corporations Corporations are independent of the identity of their shareholders, unlike a partnership. Legal personality: • Corporations are recognized as legal entities distinct from their shareholders, executives, etc. • May sue and be sued in ways distinct from the individuals involved: company will pay the fee, notthe owner himself • They own assets, have debt positions and survive as long as capital is available (perpetual succession): as long as the company does not go bankrupt or liquidate their assets Limited liability: • main principle is to separate what the corporation owns from what shareholders own • if the corporation goes bankrupt, shareholders are not individually liable (usually): - creditors will go after the assets of the company, not the owner’s individual health - decreases the risk for the individuals by separating their wealth with the company. They might usetheir equity shares, but the creditors won’t go after their personal wealth Transferability of shares: • shareholders are free to buy and sell company shares • shares are transferred via financial transactions between buyers and sellers - stock markets for listed companies - private deals for unlisted or privately held companies - while shares are tradeable, their liquidity can be limited 5 LIQUIDITY: how easy it is for you to transfer shares, a market’s feature where an individual or firm can quickly purchase or sell an asset without causing a drastic change in the asset’s price. Centralized management: • shareholders own the equity capital of the corporation • but daily activities are often delegated to a few professional individuals (CEOs, very often a single person at the top of the company), top executives (many executives with more specialized areas), managers (charged by the day by day work) If there is a CEO who is in charge: • centralized decision making, less discussions by leaving the power to a single person • some companies had more than one CEO, the benefit is usually skill complementation but whenthey all have balanced power in the company: problem in decision making process If there is separation between ownership (shareholders) and control (CEO): • makes decision-making more efficient • can bring out agency conflicts Markets vs firms: Price systems are great at generating information about what people want to buy and sell • prices give producers incentives to shift production to goods with higher prices • prices give consumers incentives to reduce quantity of products with high prices • goods are rationed to those willing to pay Transaction costs: Conducting economic activities within firms minimizes transaction costs, However, using market transactions entails costs beyond the simple market price: • search and information costs • bargaining and decision costs • policing and enforcement costs • opportunity costs of inefficient resource allocation TCE (transaction cost economics) – firm view Firms have significant advantages over markets • fewer transactions • information specialization • •reputational concerns • scale benefits TCE perspective helps understand what drives firm size: transaction costs shape the boundaries of marketsvs firms. (how many activities are carried out internally vs being outsourced to contractors? When would a firm find itbeneficial to integrate forward/backward activities of its value chain? Drawbacks of grouping activities within one social entity: • Increase in coordination costs • Concentration of power • Inefficiencies in managing information How companies fund their activities: 1. internal funds – cash flows from operating and financial activities 2. equity – individuals or financial investors 3. debt – individuals or financial institutions 6 Trade debt: debt provided by the suppliers • time given to make the payments of the supplies Financial stakeholders: they make contribution and wait to get a reward - equity providers: reward (financial reward, dividends/capital gain), voting rights (not to everyone) - debt providers: reward (repayment for the initial amount) STAKEHOLDERS Primary (core) stakeholders: • often, investors and employees • they contribute to set firms’ objectives and strategies • vital to the growth and survival of the business Obviously, the importance of stakeholders varies across organizations Secondary stakeholders: groups that can affect the primary relationships Challenges: - Investors might have different purposes, some expect to gain their money as soon as possible, while some prefer long term investments Solution: assign governance to a set of actors - Opportunism and free riding Solution: create coordination and monitoring mechanisms Shareholders view of the firm (Friedman) Shareholders have social responsibilities, and executives are employees of the owners. Their only responsibility is to run the business in accordance with owners- desires (generally, to make as much money as possible). The company’s only social responsibility is to generate profit. If executives pursue other socialresponsibility acts, they are spending the money of company owners for general interest. However, they are just agents who serve the principle, and they cannot impose tax like governments do. Stakeholder view of the firm (Freeman) According to Freeman, the main priority of the firm should be to keep the stakeholders happy. Business is about how costumers, suppliers, employees, financiers, communities, managers interact and create value. By focusing on clients, employees and suppliers, the firm ensures that they are satisfied, thus becoming more efficient and profitable. Without this satisfaction, the firm would not generate profit and would eventually go bankrupt. What is a stakeholder? A stakeholder is a party that has an interest in the company’s success or failure. • internal stakeholders: have a direct relationship with the company either through employment, ownership or investment; like employees, shareholders and managers. • external stakeholders: parties that do not have a direct relationship with the company but may beaffected by the actions of the company; like suppliers, creditors, communities and public groups • primary stakeholders: vital to the growth and survival of the business • secondary stakeholders: groups that can affect the primary relationships Examples of stakeholders: • employees (can go on strike/switch to the competition) • suppliers 7 • • consumers (can stop buying/ boycott) government Managing for stakeholders means balancing and keeping an alignment among the various stakeholderinterests (including those of shareholders) 1. The different interests of the stakeholders go together overtime a. Long time perspective 2. Firms should have a purpose for costumers and employees 3. Firms cannot put aside ethics and value questions 4. Managing for stakeholders its not confined in abstract principles, but also in everyday business process Stakeholder management has a difficult task: • Interests of different stakeholders may conflict with each other. • Identifying central vs. peripheral stakeholders • Complex nexus of relationships What is a shareholder? A shareholder, commonly referred to as a stockholder, is any person, company, or institution that owns atleast one share of a company’s stock. Because shareholders are a company’s owners, they reap the benefits of the company’s success in the dorm of increased stock valuation. If the company does poorly and the price of its stock declines, however, shareholders can lose money Stakeholders vs shareholder Generally, a shareholder is a stakeholder of the company while a stakeholder is not necessarily a shareholder. A shareholder is a person who owns an equity stock in the company and therefore holds an ownership stake in the company. On the other hand, a stakeholder is an interested party in the company’sperformance for reasons other than capital appreciation Shareholders are ordinary people who, in their daily lives, are not just concerned about money. They alsohave ethical and social concerns. Privately held firms tend to be more socially- oriented. If consumers and owners of a private firm take social issues in account, why would they not want the publiccompanies they invest in to do the same? Milton’s hypothetical response: Separate money-making from ethical activities • firms make money • individuals deal with problems But the separation assumption is not often satisfied: profit-making and damage-making are intertwined • often hard or impossible to find reversible projects that counteract the social costs of corporateactions Letting the government deal with externalities makes sense in theory, but there are issues: • lobbying • government failures • sometimes government cannot intervene due to constitutional boundaries Firm objectives • • • should be consistent with the preferences of their investors closely held firms or companies with a single investor solve this problem easily coordination problems and difficulties in aggregating preferences in listed firms Potential solutions: • voting by shareholders on corporate policies • polling investors on specific issues Phew! Thatʼs the end of the first chapter ‒ but do you know it? Scan to test yourself! 8 Corporate governance and structure of organizations Homo oeconomicus – rational individual view Homo oeconomicus is what we define as a perfectly rational individual. This theory was first put forth byAdam Smith, with the self-interest theory. Common assumptions used in economic models to characterize decision making: • rational preferences – they see the potential of all their decisions and can choose based on whatthey prefer • ability to use all the information available • utility maximization – because of rational preferences, they are more likely to behave opportunistically There are many advantages to this theory: • allows formalization of individual behavior in theoretical models • provide a benchmark of individual behavior useful e. g. to understand the effect of certain policies There are however drawbacks to this theory, labelled “Bounded rationality”, as not only it is impossible to have perfect knowledge for any transaction, but that as such there are always risks to consider. Additionally,it is not possible to know your priorities are truly laid out. Behavioral view • • • • • Limited information - Information is costly and may not be retrievable Uncertainty - In most managerial decision, the probabilities are unknown Unclear priorities Cognitive limitation Time limitation Decision makers can satisfice either by finding optimum solutions for asimplified world, or by finding satisfactory solutions for a more realistic world. Neither approach, in general, dominates the other. Cooperation: o Allows people to attain results which cannot be achieved by individuals acting independently o Produces a rent shared to all participants • Altruistic behavior: is consistent with maximizing personalwellbeing (like building social relationships) • Opportunistic behavior: results from impossibility to ascertain individual contributions and overall results Decision making in groups Often, firm-level decisions are made by groups: • top management teams, boards of directors, shareholder assembly, workgroups..But do groups make more rational decisions as compared to stand – alone individuals? • with groups, we have greater pool of knowledge, allowing for social learning • discussion and comparison of different viewpoints help to ‘get it right’ 9 • random individual biases cancel out in the aggregate • rational agents will drive irrational ones out of the market Economic payoffs of trust • The more trust a company has in itself, the more delegation it has • greater venture capital investment (high-risk investment with the potential for above-averagereturns) • better ability to get funding for suppliers • greater GDP per capita o mostly done for the sake of community Drawbacks of group making decisions • social pressure impairs individual capabilities • conformity and imitation of bad practices • excess risk-taking due to dilution of responsibilities: in a group, individual responsibilities arecounted as less relatively important • small amounts of irrationality could trigger large aggregate effects Herding behavior the error rates in decision making tend to be higher than an individual decision process when in a group. Others in the group giving a different answer may affect the decision of the other individuals prospect theory 1979: “an analysis of decision under risk” by Daniel Kahneman and Amos Tversky2002: Daniel Kahneman received the Nobel Prize in economic science value function and reference point 1. Diminishing sensitivity of the value function 2. Loss aversion 3. Reference point Whatʼs the behavioral view? If you need a refresher scan to test yourself! Consequences for managers: – Aspiration levels o Firm have an aspiration level as reference point o Firms that anticipate returns below that level will be risk seeking, and those that anticipatereturns above it will be risk avoiding • Incentives o Greater productivity increase when incentive is framed as potential loss than potential gains • Marketing o Accounting for the effects of reference dependence and loss aversion can improve our understanding of brand choice – Overconfidence • The tendency for decision makers to overestimate their own abilities to perform tasks or to make accurate diagnoses or other judgments or decisions • Overconfident investors trade more than rational investors (lower return) 10 ANCHORING BIAS • Insufficient adjustment from starting point • Expert forecasters - Professional macroeconomics experts put too much weight on the value of the previous month’s dataReal estates specialists influenced by the list price • Finance - Historical values, such as acquisition can act as an anchor. • Negotiation - The first offers have a strong anchoring effect when great ambiguity exists • Availability Bias o The tendency for decision makers to consider information that is easily retrievable from memory as being more likely, more relevant, and more important for a judgment o Easily retrievable: Recent or vivid Corporate governance • Financial economics definition “deals with the way suppliers of finance assure themselves of getting a return on their investment • Relationship definition “it is the framework by which the relationships among the management, Board of Directors, controlling shareholders, minority shareholders and other stakeholders are balanced” • Stakeholder definition “activities of the board and its relationships with the shareholders or members, and with those managing the enterprise, as well as with the external auditors, regulators, and other legitimate stakeholders” • Operational definition “procedures and processes according to which an organization is directed and controlled”“Good corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and shareholders, and should facilitate effective monitoring, thereby encouraging firms to useresources more efficiently.” • Societal definition “the whole set of legal, cultural and institutional arrangements that determine what public corporations can do, who controlsthem, how that control is exercised and how the risks and returnfrom the activities they undertake are allocated” At the beginning of its existence a firm tend to have very simple structureLater on, several conditions change the scenario: • company growth in size • need to seek outside capital • need for a more professionalized management The consequence is the progressive separation between ownership and control • Efficient separation of ownership and managerial control - This separation allows shareholders to purchase stock, giving them an ownership stake andentitling them to income after expenses 11 • - This right implies a ‘risk’ for shareholders that expenses may exceed revenues This risk is managed through a diversified investment portfolio Shareholder value is thus reflected in the price of the firm’s stock Shareholders specialize in risk bearing while managers specialize in decision making The separation and specialization of ownership and managerial control should produce thehighest returns for the firm’s owners PUBLIC VS PRIVATE LIMITED COMPANIES (limited liability, you only lose what you invested) The public company appears in US in the ‘30s, and represents today thetypical ownership structure in the Anglo-Saxon context Boosted by: • greater effectiveness and transparency of the financial markets • development of managerial schools • access to broader sources of capital Agency problems 1. Contracting The principal and the agent sign a contract that specifies what the manager does with the funds and how todivide the returns, and for the agent to fulfill a certain task. The agent gets to take decisions in the name of the principal Consequences of the principal-agent relationship: • both the agent and the principal are utility maximizers, and the agent will probably act in their own interest • as such the principal is forced to arrange safeguard mechanisms (contract controls and incentives) to protect their investment, usually at a high cost. There are many things that are outside of the manager’s control, which makes it harderto the contract to be complete. It must be noted that there are certain sources of agency conflict: - Moral hazard: a lack of managerial effort or lack of investment in a positive Net Present Value project could signal that a manager is focusing more on investing into assets that best suit theirskills and as such will increase their own value. - Earnings retention: investment into projects instead of redistributing the benefits - Time horizon: managers are short term whereas shareholders are long term - Risk aversion: shareholders can diversify their portfolio while managers salary is tied to results of the company 2. Managerial discretion • schemes to take the cash out, e. g. setting up a company and then engage in related party transaction • use company funds to engage in activities that generate personal benefits • entrenchment: CEOs who make themselves irreplaceable - they are working on the behalf of the shareholder. There should be a way to fire them in caseof failure. We want a setting where when the company’s activity goes down, the likelihood of the manager getting fired increases. - despite the manager being prestigious, the board still might want to get rid of him One goal of corporate organizations is to minimize agency costs, given a certain ownership structure, and acontext in which the firm operates. 12 There are three types of agency costs: • Monitoring (principle needs to monitor agent’s work) - Audits, writing compensation contracts - Having a board of directors - Financial statements Bonding cost - Provide accurate information to shareholders - The agent may commit to contractual obligations that limit or restrict the agent’s activity Residual loss - Arise from conflit of interests - The action that would promote the self-interest of the principal differ from those that would promote the self-interest of the agent, despite monitoring and bonding activities • • Other symptoms of bad governance • overinvestment • excessive risk-taking, usually stemming from distorted CEO incentives • extremely long CEO tenures (time in office) • little or absent shareholder or board dissent (disagree) • dissipation (excess) of cash holding As such, there are the organizational mechanisms: • ex-ante (before the deed) incentive contracts to align directors and managers interests to those ofinvestors (high powered incentives), like making the manager a shareholder - stock options and/or stock granting (risk of self-dealing) Buying the restrictive stock is usually proposed to the managers, so that they can’t sell it for a limited period of time and they will have an incentive to do the firm’s interests to get an high stock price for when they cansell it. (however the risk is not excluded: if by the end of the restriction, the stock price is lower the manager will do everything to increase it, even faking numbers, not caring about the firm’s interest.). • Reputation Directors and managers have to defend their reputation on the capital market, where they usuallyask the money) And on the market for top managers (if they want to keep their job) An example of this is the difference that occurs for the CEO that have the options between the stock optionsand the actual shares. Whereas stock options only have an upside, the latter has an upside and downside. A stock option can only have payoff when the company is doing well and grows in value, and so the CEO gets rewarded for a good job but loses nothing when the company stagnates or even falls. On the otherhand, with actual shares (stock awards), their value follows that of the company, and so if the company isn’tdoing well, then their value falls. An example of this is the former CEOs of BP oil were given more stock options that awards and some questioned if this pushed them to pursue more short-term profits by cutting safety expenditures and thus increasing the likelihood of harming the environment. It was found that a CEO that got all option equity compensation was 65% more likely to break environmental law than a CEO who had all stock equity compensation. As such, the first CEO received a fine twice as heavy as the second. The former also had a higher change of being investigated by the SECfor accounting restatements. Back to contracting • elaborate a contract where the manager is paid according to his/her actual effort BUT • managerial effort is unobserved-and that generated the key problem • we could use performance as a proxy (agent) of managerial effort o when the company does well (net of industry effect, business cycle etc.) the manager must have done a good job 13 - if the manager invests in wasteful projects, the company will underperform: the manager will underperform The contract will align the interests of principal and agent We want a managerial scale which is cleaned from all the external effects and managerial compensationmight be a very powerful incentive to managers to work well Compensation Companies pay CEOs in 3 ways: • fixed salary • bonuses • stock options (long term incentive plans): a benefit in a form of an option given by the company toan employee to buy a stock of the company at a discounted or fixed price Is this a good thing for the performance of the managers? Yes, it is, because when the manager is in a fixed salary rate, he has no incentives to increase his performance. This makes the manager’s performance worse in the long run. But at the same time, it can lead managers to fraud. Opposing views: • managerial power - CEOs have been found to be paid for ‘luck’ (e. g. increase in pay due to increase in performance,such as oil price, which is not attributable to them) - entrenched managers set the pay package for themselves If the CEO is extremely powerful, then he can basically decide the compensation for himself.Increasing the number of principals Companies are held not just by one investor but by a myriad of shareholders • more time to monitor the manager, questioning the manager frequently Investors often small and uniformed about the corporate decisions: they won’t exercise the control rights they actually have. They could actively engage in monitoring the agent. But remember the problem of freeloading with publicgoods • monitoring under-provided in equilibrium • if we increase the number of shareholders, the lower incentive to engage in monitoring. You hope that somebody else will do it for you. That’s why idea of increasing the number of principals is a badidea. Board of directors The board is the agent of the shareholders. The board will go after the CEO and challenge his decisions.They hire and fire the CEOs. Shareholders elect a group of specialized individuals to deal with the management in their behalf. We can divide the board of directors in two tasks: – Governance: the role is to direct the company Protect the company’s interests and the shareholders’ assets and ensure a return on their investment STOP! Time for some active recall ‒ scan to test yourself on what youʼve read so far! 14 – Management: The role is to run the business and execute the strategy “The board’s primary role is: • to monitor management on behalf of the shareholders, • to keep it going in the right direction • and, when that fails, to make the necessary repairs and replacements. They are there • to hire, evaluate, incentivize, and replace the top managers, • to make sure that the financial reports are appropriate and accurate, • to oversee the overall strategy and direction, • to manage risk, • and to set the tone at the top to ensure the integrity of the company’s operations and employees • (shareholders can’t do this) Alternative board structure: • All-executive director board - Small family firms - Start up There are no directors or managers • Majority executive directors board - Need for additional expertise (new market, technology,…) - More complex managerial issues - Capital growth Executives are in majority: power • Majority of non-executive directors board - Outside directors should have no relationship with the company (delegate the strategy formulation to the CEO) • Independent directors - Not a recent employee - Has not received compensation from the company - No relative is employed by the company • All non-executive directors board (none of the executives is a manager) Ex: non-profit organizations BOARD DIVERSITY Having some outside directors brings diversity for business effectiveness (experience, knowledge, skills..) Stakeholder diversity (to make the stakeholders part of the important decisions is a wise idea to add at theboard of directors some representative seats for them) Societal diversity to balance the interests of the company with the interests of society However in the US about 50 % of the firm’s have only one person as a chairman and CEO. This means that it becomes impossible judging their own performance impartially. 15 Issues with the board? 1. Board capture: • directors have incentives to be loyal to the CEO to get promotion in other companies or othersorts of favors • CEOs are generally more powerful, so that they can make promises to the board members‘bribe’ 2. Busy board: • directors are often appointed in so many companies (40% in two or more firms) which do notgive them the time to work effectively • board members end up being ineffective because they work in too many companies 3. Tokenism: • board appointments often for symbolic management reasons Questionable board practices - Demographic homogeneity leading to conformity in group-thinking: o if you have a very homogeneous board, you will have the problem of herding behavior o gender diversity or a lack thereof - weak independence criteria in turn weaking monitoring - CEO-chairman duality again weaking monitoring: o we basically ended up empowering the CEO o however, it reduces bureaucracy and so will promote information flow and make the decision-making process easier. Ownership • Institutional investors • Concentrated ownership (block holding) A block holder is someone who has concentrated ownership, such as large financiers. These shareholdersare large enough to have an incentive to monitor the managers and replace them • block holders who sell a firm’s stock based on private information impose downward pressure onprices • this effect hurts management through its equity investment in the firm • management increases productive effort to increase firm value and dissuade block holders fromexiting • governance mechanism comes from threat of block holder exit, not actual exit • in order for the threat to be credible, the stock should be highly liquid Product market competition Monopoly (and competition itself) is a great enemy to bad management (Adam Smith) Competition forces firms to minimize costs: inefficient firms due to lazy management won’t survive in the long run. As such, we can observe a takeover mechanism: • in a market where there is a major company which can take a business opportunity and buy theshares of the ‘lazy’ company. • managerial inefficiency is detrimental to market value • a bidder makes an offer to the shareholder of the firm Once they acquire control, the first thing they will most likely do is fire managers. However, the managers might have anticipated this possibility, and would internalize their work better. Acquisitions may be the manifestation rather than the cure of agency problems. Takeovers are often regulated by law and firms have the opportunity to introduce legal obstacles to the likelihood of beingacquired. 16 ATP (Anti-takeover production system) and innovation To promote innovation, some degree of managerial entrenchment may be needed to protect the management from short-term failures • for some activities that are risky, it can be better to shrink the company to protect the managers Large shareholders as principals They can coordinate and monitor management better, which lowers the risk of free-loading. Additionally, they have power and influence, seeing as they are widely represented in the board, and mayeven influence the board directly. As such, they themselves are often the managers of the firm. This means that there is no separation between ownership and control, with the board acting. • Sources of cross-country differences rule of law: - family ownership is less frequent in countries with common law legal origins. This is because thereis better protection of minority shareholders, which in turn facilitates equity financing • cultural values: - family ownership is more prevalent in countries where the role of family is culturally tronger andwhere social capital is weaker • institutional characteristics: - family ownership works better in contexts that are connection-centric, meaning more entrenchedwith the political system and aren’t held accountable at the same level. Family control and agency advantage How can the minority shareholders make sure that the larger shareholders are managing the company inthe way the minorities want? In family companies sometimes even if the heir is not suitable or good enough for the position, they will endup at the top of the company. Consequently, in Japan for example, some companies ended up ‘adopting adults’ to manage the country in the name of their family. It must be noted however that in European countries, the percentage of firms that have a CEO from thefamily is around 50%. Although there are certain agency disadvantages, from a broader point of view, there are actually advantages of working with a family company. We know that the company cares about its reputation andalso the family’s reputation Propping This is the use of private resources by family members to support the company: • families manage companies for the long run • propping is often used to rescue the legacy of the family company Minority shareholders benefit at the expenses of the majority shareholders Family firm boards Listed firms must have a board by regulation by law. But privately held firms may choose not to haveboards. Organization design Organization design is a formal, guided process for integrating people, structure, process, and culture of an organization. It is used to match the form of the organization as closely as possible to the purpose of the organization seeks to achieve. Through the design process, organizations act to improve the probabilitythat the collective efforts of members will be successful. 17 Organizational structure Organization refers to the division of labor and patterns of coordination, communication, workflow andformal power that control organizational activities. As such, it divides work into specific jobs and organizational units: • division of labor as the main driver of productivity • specialization: degree to which organizational tasks are divided into separate jobs • departmentalization: grouping of given tasks It needs to be noted that with a larger and more elaborate organizational structure, there are issues that arise. Although tasks and responsibilities are assigned, they must be coordinated both within the variousareas of the company and then for external communication purposes. The more labor divisions, the more coordination is needed between them, due to different tasks anddeadlines. This creates the possibility of multiple issues: - misalignment - duplication - mistiming These issues can lead to an inefficient allocation of resources, signal unnecessary difficulty, and demotivatedue to low success. To solve coordination problems: sharing information & informal communication. • small groups: - mental models: common way of looking at something/processing information “shared, organized understanding and mental representation of knowledge about key elements of theteam’s relevant environment”. • Larger firms: - technology: knowledge management, internal messenger, blogs/wikis BUT you are not sure people actually accessed the information - liaison role: operators at the top of the operation that communicate the proper information to the teams. Possible issues: the operator could be incompetent and miscommunicate, conflict of interest, language barrier.giving a huge power to this person - integrator role: product/project manager, a person supposed to check everything is working wellPossible issue: lack of hierarchical power, rely on persuasion - temporary teams Elements of organizational structure 1. Span of control This is the number of people directly reporting to the next level of command.A wider span of control is possible if: - other coordinating mechanisms are present - the necessary tasks are performed routinely - employees skill’s are standardized - low interdependence between employees As a firm grows, there are different ways in which they can expand theirpower structure. 1) Tall hierarchy -> the workers talk to intermediate managers andthere are many steps to get to the highest level. Problems? a) Not all information that comes from the bottom levels reaches certain desired levels at the top of the structure b) There are more overhead costs, due to a lot more managers 18 2) Flat hierarchy -> lots of workers report to few managers Problems? a) Overcomplicates the managers jobs due to more direct reports b) There is a lot less efficiency 2. Centralization A formal decision-making authority that is held by few people, usually at the top. As a company grows, decentralization (delegation) increases. There are varying degrees of centralization in different areas of the company: sales, information systems, etc. The more dispersed the decision making, the less centralized the organization. There are advantages to decentralization: ‘tournament incentives’, which allows the managers compete, and the best comes out of them. It increases the provisional effort put in promotion (vertically, or a bonus). The process of decentralization is key to create larger firms: - CEOs are time constrained over the number of decisions they have to make - as firms become larger and more complex, CEOs need to increasingly decentralize decision-making power to senior management Conversely there are advantages for centralization: - higher control over the firm for the management - easier coordination between leaders - in scarce environments, delegation is not that widespread. 3. Formalization This is the standardization of behavior of rules, procedures, training, etc. As a firm grows and gets older, formalization increases. The issues are however that there is less organizational flexibility. There is a demotivation with regard to creativity, less organizational creativity and increases job dissatisfaction and work stress due to rules and procedures becoming a focus of attention. There are two main structure forms: a) Mechanistic structure: narrow span of control, with high centralization b) Organic structure: wide span of control, with decentralized decisions and low formalization. This can however create a responsive rather than a proactive behavior, as different workershave different long vs. short term goals and could prioritize projects that have high and predictable return for the company. 4. Departmentalization: Specifies how employees and their activities are grouped together. People of the same unit usually sharethe same mental model. Strategic decisions: establish the chain of command as well as interdependence, resource sharing and supervision. Focus people around common mental models, coordination through informal communicationwithin departments. The main area where we observe departmentalization are: • functional areas: subsets of processes characterized by: - a common function (purchasing, manufacturing, marketing...) - a specialized set of skills (buying, producing...) • 19 business areas: are sets of processes related to the same product/market. (pesticides, antibiotics..) Business areas have their own costs and revenues. - Firms may have one business area (mono business) or more (multi-business or diversified). Functions and divisions are the way firms choose to organize their functional and business area • Functional areas and business areas are activities (R&D, producing..) • Functions and divisions are organizational units Functions are the organizational units that perform activities related to a functional area. They are alsocalled ‘departments’. Divisions are the organizational units that perform activities belonging to a business area. They are also called business units. Functional areas 1. Institutional structure design: creation, basic configuration, transformation termination of an organization. These processes determine the overall design by which the firm is created and how it evolves. This is where decisions are made as to: • founding the organization, • defining or changing its illegal status, • designing governing bodies, • defining shareholders structure, • mergers/ acquisitions/break ups, • partnerships and alliances, • liquidating the organization Related to corporate governance classes + strategy 2. Operations: set of activities for which the firm carry out their economic production of goods andservices - Core operations: they refer to the extensive set of activities by which the firm actually carries out economic production • (R&D) Establish product features and production methods: o fundamental research o technology/competition watch o evaluation of costumer needs o new product development Scan to test yourself on the o problem solving with existing products and upgrades Functional Areas with our o quality check pre-made flashcard resources! • Purchasing, Buying long-term use equipment/facilities, raw materials, services o Recognition of needs o Forecast and Plan requirements o Supplier identification/evaluation/selection o Analyzing quotations and bids o Placing orders o Spend analysis o Contract management o Supplier relationship management Good contract development and management could improve profitability by the equivalent of massive 9%of annual revenue • manufacturing, o processing and assembling raw materials and parts o planning, equity control, maintenance 20 o technical skills (+ economics) • sales and marketing o Selling the firm’s product while optimizing economic profitability o Understand customers, competitors’ offering, define sales policies, advertising and communication campaign o Sales and marketing skills + technical skills • logistics o Transport, store and move raw materials, semi-finished or finished products o Multidisciplinary skills Core operations – Transversal processes Those functions are not all separated but are strongly linked to each other. The development of a newproduct doesn’t need to come from R&D but on the contrary can start from all of them depending from thesingle occasion. - Debt and Equity Management/Finance Set of activities undertaken by firms to collect money to cover their financial needs.Financial needs come essentially from payments the firm has to do. • Forecasting and analyzing financial need • Optimal mix of equity capital and debt capital • Planning and executing transactions involving capital (equity/loan) • Handling contracts Money comes from financial resources Sources: equity (risk capital) + debt (loan capital) - Management of non-core investments When the firm invest available financial resources in excess of requirements for other operations (surplus funds). The goal is to create investment revenues such as interest, capital gains, rents..Noncore investments must be liquid (easy to sell when needed. § Treasury bonds and other low risk securities (lend money to the government) § Stocks § Mutual funds § Real estate Instead of giving it back to the shareholders firms invest money on low risk activities - Tax management • Firms are required to pay various kind of taxes in exchange for the right to utilize public goodsprovided by the State • Income tax and goods/services taxes - Insurance management • Organizations are subjects to general economic risk (the chance that general economic activitiesgenerate profits or losses which promote or threaten the longevity of the organization) • Organizations are also exposed to particular risks which can be covered by insurance (like theft orfire) 3. Organizations: designing the organizational structure, assigning tasks and responsibilities, managing personnel Many processes classified in two groups: Organizational design: centers primarily on designing the organizational structure of the firm;certain tasks are defined and assigned to units to make up the structure of the organization • Human resource management: the implementation of organizational system pertaining to personnel 21 Can be seen as the implementation of organizational systems pertaining to personnel • o o o o o o Recruiting of personnel Employee relations (union, job satisfaction) Compensation and benefits (not only how much you are going to pay your employees) Analyzing tasks, workloads, skills and performance Promotion Training and development 4. Information: Gathering, processing, and disseminating data and information to internal decision makers and external stakeholders • Provide data and information to firm’s decision makers, and firm’s stakeholders who need information to decide if/how to establish and grow their relationship with the firm • Extreme variety and complexity of recipients, purposes, rules, and technologies involved • A central component of a firm’s information system is given by financial statements which measurea firm’s performance VALVE CASE: Valve in an entertainment company with no hierarchy ‘It’s our shorthand way of saying that we don’t have any management, and nobody “reports to” anybodyelse. We do have a founder/president, but even he isn’t your manager. This company is yours to steer—toward opportunities and away from risks. You have the power to green-light projects. You have the power to ship products. A at structure removes every organizational barrier. A flat structure removes every organizational barrier between your work and the customer enjoying that work. If you’re thinking to yourself, “Wow, that sounds like a lot of responsibility,” you’re right. And that’s why hiring is the single most important thing you will ever do at Valve. Any time you interview a potential hire, you need to ask yourself not only if they’re talented or collaborative but also if they’re capable of literally running this company, because they will be. We tend to gravitate toward projects that have a high, measurable, and predictable return for the company. So when there’s a clear opportunity on the table to succeed at a near-term businessgoal with a clear return, we all want to take it. And, when we’re faced with a problem or a threat, and it’s one with a clear cost, it’s hard not to address it immediately. This sounds like a good thing, and it often is, but it has some downsides that are worth keeping in mind. Specifically, if we’re not careful, these traits can cause us to race back and forth between short-term opportunities and threats, being responsive rather than proactive. So our lack of a traditional structure comes with an important responsibility. It’s up to all of us to spend effort focusing on what we think the long-term goals of the company should be.’ Organizational structures Functional structure: • organizational units are arranged by task similarity • functional managers with functionally - specialized staff • executive coordinate and integrate the activities of the various functional managers e. g. Barns & Nobles The benefits of the functional structure are: • favored specialization, allowing for technical excellence • good control: cross function integration occurs at the top STOP! Time for some active recall ‒ scan to test yourself on what youʼve read so far! 22 • • • scale and learning economies, which cut costs support professional identity and career paths single accountability for each function The limitations to this form are • functional management develop idiosyncratic (individual) values/norms preventing the integration across functions. Priorities lie with subunits rather than the whole • little accountability for losses • increases the workload of executives to whom the functional managers’ report (problems of coordination and cooperation) • difficult to expand to new products and markets • difficult to develop general management expertise (only the CEO had the general view of how the organization works) This structure is common in small, flexible, young, and fast-growing companies with single business and asimple product line (focus on efficiency) and a stable market. It is unsuited for large firms with complex product lines and in various markets. Divisional structure: • • • organizes employees around outputs, clients or geographic area operating divisions each representing a separate profit center (could be products, geographic markets or costumer segments (large business, small business, federal government, local government) well distinct divisions, each generate their own benefits. Each have their own functions inside them. The benefits of the divisional structure are: • specialization and decentralized decision making • better communication and innovation • closer to costumers, with more focus on them • develop general managers and reduces the burden of CEOs The limitations of this system are: • Duplication of resources across divisions (lack of coordination) • Units may have to compete for scarce resources • Difficult to obtain synergies (innovation, technical excellence, marketing...) across divisions/product lines (e.g., silos of knowledge) Typically used when products, regions, costumers require different management logic or when there is a distinct producttechnology. This type of structure is unsuited for simple firms aiming at strong scale economies. Geographic structures are becoming less common because there is less need for focal representation, reduced geographicvariation, more global clients 23 Matrix structure • mixes elements of functional and multidivisional structures and formalizes their relationship The benefits of this structure are: • Uses resources and expertise effectively • Potentially better communication, flexibility, innovation • Focuses specialists on clients and products • Supports knowledge sharing within specialty The flaws of this structure are: • complexity and confusion of command, with excessivestaff • risk of conflicts due to poor communication • more conflict between managers that share power • strong (costly) cooperation required • could be slow at responding at market changes • two bosses dilutes accountability This structure in unsuited for simple firms who cannot benefit for scale. This system is made for firms that are diversified across the markets and products. SO: • • • organizational structures divide firms and workloads into specific units and establish authority relationships between them functional, divisional and matrix structures have pros and cons that depend on the nature of economic activity and the context where the firm operate strategy is closely intertwined with organizational structures Team-based structure • • • Self-directed work teams organized around work processes Typically organic structure o Wide span of control o Highly decentralized o Low formalization Usually found within divisionalised structure Benefits • Responsive, flexible • Lower admin costs • Quicker, more informed decisions Limitations • Interpersonal training costs • Slower coordination during team development • Role ambiguity increases stress • Team leader issues – less power, ambiguous roles/career • Duplication of resources Organizational system They provide rules, procedures, mechanisms of communication, decision making and control that allowcompanies to solve the problems of achieving both coordination and cooperation. • Information system • Financial planning and control • Human resource management Phew! Thatʼs the end of the chapter ‒ but do you know it? Scan to test yourself! 24 UNDERSTANDING THE PURPOSE OF THE SYSTEM OF FINANCIAL STATEMENTS SESSION 12 ACCOUNTING DEFINITIONS: • The language of business • The “system of recording and summarizing business and financial transactions and analyzing, verifying, and reporting the results” • "The process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information” • “Accounting is an information science used to collect, classify, and manipulate financial data for organizations and individuals. Accounting is instrumental within organizations as means of determining financial stability. Accountants are responsible for determining an organization’s overall wealth, profitability, and liquidity. Without accounting, organizations would have no basis or foundation upon which daily and long-term decisions could be made.” • Communicate with external investors to ensure that their firms' securities are fairly priced and that they are able to access capital • Measure and evaluate their firms' economic performance • Improve resource allocation and strategy implementation within their firms • Build accountability for performance through effective external and internal • governance All those financial transactions can be divided indifferent types of activities: • Operating activities: involve transactions that enter into the determination of net income and are primarily activities that comprisethe day-today business functions of a company. • Investing activities: activities associated with the acquisition and disposalof longterm assets, such as equipment. • Financial activities: activities related to obtaining or repaying capital to beused in the business. DIFFERENT TYPES OF ACCOUNTING: Are used by: • investors • government • •creditors (lenders/suppliers) • •customers • •analysts 25 FINANCIAL STATEMENTS: • Balance sheet: statement of the financial position of the firm at a certain point in time • Income statement: “Information on the financial results of a company’s business activities over aperiod of time”, “how much revenue the company generated during a period and what costs it incurred in connection with generating that revenue”. • Statement of cash flows: classifies all the sources and uses of cash over a period of time • Statement of changes in owners’ equity: reports changes in the owners’ investment in the businessover time • owners’ funds (stockholder equity) The two sides of the balance sheet must be equal, and the basic account formula is:Assets = Liabilities + Owners’ funds (SE) ASSETS Resources owned or controlled by the firm that are expected to yield economic benefit for the firm and thatare the results of past transaction • Fixed assets Fixed assets are assets that are not expected to be converted into cash within 12 months o Net fixed assets Long-lasting physical items needed for the operations of the firms (Property, Plants, and Equipment: PPE).Net because their financial value evolves over the time: depreciation Impairment: sudden and unexpected lost of value o Investments Long-term holdings of shares in other companies they don’t control o Intangibles Assets that do not have a physical presence but have a value for firm’s activities - Patents: " A patent is the granting of a property right by a sovereign authority to an inventor. This grant provides the inventor exclusive rights to the patented process, design, or invention for a designated periodin exchange for a comprehensive disclosure of the invention. " Goodwill: the value of intangibles in another company that the focal one has acquired, as reflected in at theprice it paid (reflected only in the consolidated.) • Current assets assets that are expected to be converted into cash within 12 months o Inventories: goods, raw materials and work in process held to be for purpose of resale o Account receivable: amount due from customers within a year (trade credit) o Cash and equivalents: liquidity means available to the firm (cash, short term loans, cheques) o Miscellaneous, covers any short-term assets not included elsewhere like advances to employees and pre-paid expenses (insurance) Products are not always fixed or current assets 26 LIABILITIES/FUNDS Financial obligations a company owes to outside parties • Current liabilities (less than 1Y) o Short term loans = debt towards financial entities o Accounts payable = amount due to suppliers o Miscellaneous = other debts • Non-current liabilities (further than 1Y) o Bank loans o Bonds issued • Owner’s funds o Issued common stock: shares of ownership of the firm held by investors o Capital reserves: amounts retained in the company which have been generated from sources other than normal trading (surplus deriving from the re-evaluation of an asset) o Revenue reserves: amounts retained in the company which have been generated bytrading So many formulae! Scan the code and use active recall to remember them all. 27 Income statement / profit and loss Account Revenue: the monetary value of the firm’s sale of goods and services to its customers. It is the top line of where the income process begins. Revenue can grow by increasing volumes, raising prices or improvingthe product mix. Operating costs: the expenses incurred by manufacturers, retailers and service firms. These are usually items such as: materials (purchase), administration costs (overhead), labor costs, sales and marketing expenses, etc.. EBITDA: earnings before interest, taxes, depreciation and amortization When the EBITDA/sales is at a good ratio, usually the market is an oligopoly Formula for depreciation = cost – residual value / estimated useful life 1. Depreciation: indicates how much of an assets value has been used up 2. Amortizations: spreading out of capital expenses for intangible assets of a time period EBIT: Earnings before taxes Net Income (earnings after taxes): this is the bottom line, which is commonly used as an indicator of acompany’s profitability. If expenses > income, this account will read as a net loss. Dividends: the part of earnings that shareholders get in cash. A firm can decide how much to pay out individends. Retained earnings: the part of the net earnings not paid out as dividends but retained by the company to bereinvested in its core business or to service debt. Firms retain earnings often in order to be able to create growth opportunities, such as buying new machinery and R&D. 28 The cash conversion cycle measures how many days it takes to convert production inputs into cash receipts. It shouldn’t last long, with the help of effective management of inventory and credit sales. If thecycles lasts a long time, this means that it takes a longer time to spend the company’s product, as it takes longer time to receive payments from costumers. You made it! Now test yourself on all of Management with our premade flashcard resources. 29 30 31
