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
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ISBN 978-0-230-40043-6
Text © Jerome Pitterson, 2014
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First published 2014
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Sincere gratitude is also extended to my family, for their support
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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)
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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:
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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.
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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
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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
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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)
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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
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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,
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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.
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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.
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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)
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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.
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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.
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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
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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:
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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
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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
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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)
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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
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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.
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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.
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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
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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,
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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
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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
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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
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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.
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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
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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:
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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)
Net cash inflow/(outflow)
15 400
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
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
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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.
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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.
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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.
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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.
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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
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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
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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)
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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
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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
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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
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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
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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.
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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
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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
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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.
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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
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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
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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
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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
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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.
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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.
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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:
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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
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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
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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.
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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
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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.
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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
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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.
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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
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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
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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
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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
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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 – for example, two for the price of one on movie tickets
Table 30.1: Possible responses from marketers to characteristics of services
CHAPTER SUMMARY
The marketing mix consists of four
marketing tools, namely: product,
price, place and promotion (often
termed the ‘Four Ps’ of marketing)
A product can be tangible (goods) or
intangible (services)
A product often has three important
attributes: the core product, the
actual or formal product and the
augmented product
The dimension of the product mix
refers to the width and depth of the
firm’s product offering:
• The breadth measures the amount
of product lines or different
products that the firm has
• The product mix depth speaks to
the variations or features of each
product line
The Boston Matrix postulates four
categories under which a product
can fall: star; cash cow; dog; and
question mark or problem child
The seven-stage new product
development process consists of the
following steps: idea generation; idea
screening; concept development and
testing; business analysis; develop
prototype; test marketing; and
commercialisation
There are four distinct stages in
the product lifecycle: introduction;
growth; maturity; and decline.
However, sometimes a further
stage (saturation) is included after
‘maturity’ and before ‘decline’
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
There are four notable
characteristics that distinguish a
good from a service: intangibility;
inseparability; variability; and
perishability.
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296 MODULE 2 | UNIT 2 | FUNDAMENTALS OF MARKETING
MULTIPLE CHOICE QUESTIONS
1. Which of the following is NOT one of the Four Ps of the
marketing mix?
a. Price
b. Production
c. Place
d. Promotion
2. Which of the following attributes of the product focuses
on the additional benefits and services that the consumer
receives from purchasing and using the product?
a. Core product
b. Actual product
c. Augmented product
d. Byproduct
3. Which of the following is NOT included in the depth of the
product mix?
a. Product lines
b. Size
c. Model
d. Design
4. Which of the following represents a product with high market
share and high market growth?
a. Star
b. Cash cow
c. Problem child
d. Dog
5. Which of the following represents a product with low market
share and high market growth?
a. Star
b. Cash cow
c. Problem child
d. Dog
6. The Boston Matrix can be used to make decisions about ALL
of the following EXCEPT which one?
a. Produce a new product
b. Build on the existing product
c. Harvest the product
d. Divest the product
7. In which stage of the new product development process would
the firm check the financial viability and estimated cost of
production for the product?
a. Idea generation
b. Screening of ideas
c. Business analysis
d. Developing prototype
8. Which of the following represents the correct order of the
stages in the product lifecycle?
a. Introduction, maturity, growth, decline
b. Introduction, decline, growth, maturity
c. Introduction, growth, maturity, decline
d. Introduction, decline, maturity, growth
9. A combination of words, letters and numbers which can be
spoken of or verbalised best defines which of the following?
a. Brand
b. Brand mark
c. Trade mark
d. Brand name
10. Which one of the following characteristics of services outlines
that the service may be different from time to time?
a. Intangibility
b. Variability
c. Inseparability
d. Perishability
CHAPTER 30 | PRODUCT MANAGEMENT
Extended Essay Questions
Question one
Total 25 marks
a. Explain briefly what is meant by the ‘width’ and ‘depth’ of the product mix.
(4 marks)
b. You are the Production Manager of a notable company in the fashion industry. The company has decided to send
out a new line of clothing for the summer. You have not yet decided on the product line, however, you need to meet
your deadline for presentation of the product at a fashion show which will be held in May of next year. Using the
new product development process, outline the steps that you will take to decide which product your firm will offer
the public.
(21 marks)
Question two
a. Identify the stage of the product lifecycle that ‘cash cows’ are likely to reach. b. With the use of a diagram, discuss the different stages of the product lifecycle. c. Briefly explain four (4) ways in which a firm can extend its product lifecycle. Total 23 marks
(1 mark)
(16 marks)
(6 marks)
297
298
31
LEARNING OBJECTIVES:
At the end of this chapter students should be able to:
Discuss the role and importance of pricing in firms
Discuss the factors that influence a firm’s pricing
decisions
Evaluate the different pricing strategies
I
n Chapter 30, we discussed the topic of product management and the important concepts that are associated
with it. Having made the product, the firm has another
very important task to carry out which is to attach a price
to the product. This process has to be done carefully, as the
firm would not want to price the product too low and make
losses or price too high and lose sales. As discussed earlier,
price represents the second ‘P’ of the marketing mix.
Introduction to pricing
A price is the value that is placed on a product. It is the
amount of money that the firm requires the consumer to
pay in order to acquire the product or service. Consumers
often use the price of the product as an indication of its
quality and to compare the product with other products to
measure whether they are getting ‘value for money’. For
example, some of you reading this book may often think
that ‘cheap cannot be good’. Even though there is some
truth to that belief at times, it is not always the case. The
marketer must then price the product in order to invoke the
correct or desired response from the target market. The price
attached to the product is often as a result of the objective
that the firm hopes to achieve. Some of the popular pricing
objectives include:
Profitability
The firm’s main aim will be to increase or maximise its profit
or return on investment. The truth is that most people,
except for non-for-profit organisations, enter into business
with an aim of making profits. Profit is the amount of funds
that remain when the firm has covered all it costs – that is:
Pricing Decision
Revenue – Costs = Profit
The firm may use high prices to gain a quick profit or
it could use low prices to make profit through high sales
volume.
Volume
A firm pursuing a volume objective will seek to maximise
its sales and grow its market share. It would want to sell as
many products as possible in the least time possible. For this
to be accomplished, though, the firm must do the necessary
due diligence to come up with a price that will increase its
sales volume. Sometimes firms may also use discounts and
sales promotion to accomplish this.
Meeting competition
Remaining competitive is another objective that firms may
use in pricing their products. A firm could either align its
price to the price of the competitors in the market or it could
set the price below the going price in order to undermine a
competitor. This type of pricing is often seen in markets that
are price sensitive, such as our telecommunications industry.
These firms often get involved in what are referred to as
‘price wars’, where firms continue to reduce their prices to
undercut competitors.
Social and ethical
This is often the objective of non-for-profit organisations.
They often price their products with the aim of covering the
cost of production and any operating cost involved.
Status quo
Firms using this objective will price their products to meet
the customer’s expectations or to maintain their public
image. The intention of the firm may also be to maintain
price stability and avoid price wars among the competing
firms.
Utilisation of capacity
Firms that want to utilise their production capacity will use
this objective. The price that is charged must be such that its
product will be in demand enough so that the Manufacturing
Department can produce its maximum possible output.
CHAPTER 31 | PRICING DECISION
Survival
Demand
This objective is often used when the market has declined
or become saturated. The firm may then decide to price its
product so that it will cover its costs in order to preserve
its life in the market. A firm using this objective will often
see survival as being more important than profit at that
particular period of time. However, this pricing objective is
not always sustainable and so it is often used at a temporary
measure.
As was defined earlier in the Unit, demand is 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’s want backed by the ability to
pay. Demand is therefore price sensitive, meaning that the
price of the product has a lot of bearing on whether or not
it is demanded or purchased. The law of demand states that
there is a negative or inverse relationship between price and
demand. Therefore, as price increases, quantity demand will
decrease. It follows that if firms want to increase demand
then they must decrease the price of the product.
Factors influencing pricing decisions
Other than the pricing objectives of the firm, there are
factors that will influence the firm’s pricing decisions. Being
aware of these factors will give the firm a better chance of
attaching the best possible price to the product. There are
several factors that may have an impact on the firm’s pricing
decision, some of which will be further explored below:
CASE STUDY
Pricing for success
Best Toys is a small retail store selling toys for both girls and
boys. The store operates in a fairly competitive and seasonal
market. As might be expected, it makes most of its sales
during the Christmas season. During this time the store can
increase its prices slightly, as toys will be in greater demand.
The firm has been doing this for the last three years and has
reaped success from doing so. This success can also be as a
result of the brand loyalty that is created, especially during
off-season periods.
However, the firm has a different strategy for out-ofseason times. While some of its main competitors maintain
their prices throughout the year, Best Toys does not follow
suit. Instead, it reduces its prices by 5 per cent, cutting its
mark-up to 15 per cent on cost. Since the firm started this
strategy it has realised a 10–15 per cent hike in off-season
sales. This has been able to offset and often outweighs the
fall-out in profits as a result of the price cut.
Questions
1. Outline two (2) reasons why pricing is important
to businesses.
(4 marks)
2. Describe two (2) pricing objectives that may
be influencing the actions taken by Best Toys. (6 marks)
Total 10 marks
Price elasticity of demand (PED)
Before discussing price elasticity of demand, let us define
‘elasticity’. Elasticity measures the responsiveness of a
change in quantity demanded due to a change in another
variable such as price, income or supply. PED measures
the responsiveness of a change in quantity demanded due
to a change in price of that product. Therefore, generally
speaking, if the price of a product decreases, it is expected
that the quantity demanded will increase. The firm can
calculate its PED by using the formula:
Percentage change in quantity demanded
PED =
Percentage change in price
Please also note that we calculate percentage change as:
Present amount – Previous amount
× 100
Previous amount
Consider the following example:
Example
Look at the information in Table 31.1.
The price elasticity of demand would then be:
8 – 10
× 100
10
130 – 120
× 100
120
Price of phone
card
Quantity of phone
cards purchased
(demanded)
Initial price and
quantity
$120
10
New price and
quantity
$130
8
Table 31.1: Information for calculating price elasticity of demand
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300 MODULE 2 | UNIT 2 | FUNDAMENTALS OF MARKETING
Bearing in mind that the two 100s will cancel each other,
when simplified you will end up with – 2/10 all divided by
10/120.
This can then be shown in decimal as: – 0.2/0.08.
The price elasticity of demand will then be – 2.5.
Alternatively, you could have left the percentage and
ended up with – 20 per cent divided by 8.333 per cent.
This would have given you a result of – 2.4. Note that the
difference in the answers is due to rounding-off issues.
The rule of thumb is that we ignore the negative sign
and just use the absolute figure since the sign is really there
because of the slope of the demand curve. Just having an
elasticity of 2.5 does not say much unless you understand
what this means or know the interpretation. With this in
mind, Table 31.2 gives a clear understanding of the meaning
of the price elasticity of demand.
Therefore, looking back at our earlier calculation, we can
draw the conclusion that phone cards have an elastic price
elasticity of demand because the PED is 2.5 which is greater
than 1.
EXERCISE
A street-side vendor estimates that the daily demand
for his bottled drink will be as follows:
Price($)
100 80
50
35
Amount demanded 125 175 250 300
a. What is the price elasticity of demand for a price
increase from $35 to $50? Interpret your result.
b. What is the price elasticity of demand for a price
reduction from $100 to $80? Interpret your result.
The price elasticity of demand of a product depends on
different factors referred to as the ‘determinants’ of price
elasticity of demand. These include:
The degree of necessity – a product that is necessary is
more than likely to have a low elasticity of demand as,
no matter how the price changes, people will still need
to buy the same amount. Therefore there will be little, if
any, change at all. A product that is a necessity will more
than likely have an inelastic price elasticity of demand
The definition of the product – this defines a product
in terms of how narrow or broad the definition is. A
narrow definition of a product refers to a single product
such as Bigga or Busta while a broad definition speaks to
the group of products such as soft drinks. The narrower
the definition of the product, the greater the price
elasticity of demand will be; the opposite is also true
Time available for adjustment - consumers usually
do not respond immediately to a price change. It may
take some time for the consumer to adjust his/her
consumption pattern. An initial price increase may not
affect demand as greatly as when consumers have had
time to adjust consumption to meet the price increase
Level of income spent on the product – products that
will not take out a big part of an individual’s income
usually have an inelastic price elasticity of demand,
as people are more likely to continue purchasing the
same amount. For example, if the price of a candy
moves from $5 to $6, most people will still buy it even
though the $1 increase is a 20 per cent increase in price.
However, if the price of a phone moves from $50 000
to $60 000, some people will not buy the same phone
because the $10 000 increase, which is still 20 per cent,
will take a bigger chunk out of their income
Number and closeness of substitutes – the availability
of substitutes gives consumers the ability to choose
between alternatives. The closer and more available
substitutes are, the better able consumers will be to
switch from buying one product to buying another.
Degrees of PED
Meaning
Results
Perfectly elastic
Quantity demanded changes even though there is no change in price
PED = infinity
Elastic
The percentage change in quantity demanded is greater that the percentage change in price
– that is, a decrease in price will lead to a greater than proportionate increase in quantity
demanded and vice versa
PED > 1
Unitary elastic
The percentage change in quantity demanded is equal to the percentage change in price
PED = 1
Inelastic
The percentage change in quantity demanded is less than the percentage change in price
– that is, an increase in price will lead to a less than proportionate decrease in quantity
demanded and vice versa
0 < PED < 1
Perfectly inelastic
There is no percentage change in quantity demanded even though price is changing
PED = 0
Table 31.2: Degrees of elasticity
CHAPTER 31 | PRICING DECISION
Therefore, a product which has a number of close
substitutes will have a greater price elasticity of demand.
Income
One of the biggest sins that a marketer or firm can commit
is to price a product without ascertaining the attributes of
the target market. One such attribute is the average level of
income for most people. Consumers will make a decision to
buy a product based on their purchasing power – in other
words, the ability of their income to afford it. If the firm is
targeting a predominantly low-income community, then the
product’s price must be within the reach of those customers.
In order to offset the shortfall in revenue in some cases, the
firm may choose to undertake price discrimination. This is
where a different price is charged to different customers,
depending on where they are. This is only possible if the
firm is able to segment the market while preventing people
from buying in the cheaper market and underselling the
firm in the more expensive market.
Consumer preference or perception
One question that should be asked in any market research
regarding a product is the price that the consumer is willing to
pay for the product. Consumers often attach a value in their
minds to a product. This is what they think is its real worth.
As a result, in pricing its product the firm has to ensure that
the price of the product is on par with the perceived value
of the consumer. Any significant disparity may lead to low
sales and huge losses for the firm. We should also be aware
that some consumers prefer a particular product and will
purchase that product regardless of the price (brand loyalty).
This could also influence the price that is charged for the
product.
Price
Costs
Any prudent firm will definitely seek to at least cover its
costs in pricing its product, unless it is undertaking a ‘loss
leading strategy’. A loss leader is a product that is sold below
cost in order to generate sales for other products. Without
covering its costs, the firm will not be able to sustain itself
into the foreseeable future. A price must then be charged so
that enough revenue can be generated to cover its total cost,
at least in the long run. Some firms may be comfortable with
breaking even in the short run but expect that they should
start to generate profits as time progresses.
Government policy
The policies of government can have a serious impact on
the pricing decisions of the firm. The price that is charged
by the firm is affected by the government’s taxation policy.
Taxation, as we know, it will increase the price that is paid
by the consumer for the product. The firm must then price
its product, bearing in mind the level of tax to be charged, as
it would not want the tax charged to bring the price out of
the reach of the majority of consumers.
Government policy may also include that of price control.
This involves the government setting either a maximum
price (price ceiling) or minimum price (price flooring) that
can be charged. A price ceiling is set by government and
is set below the prevailing market price. It is illegal for firms
to charge a price above this one. A price ceiling is used to
protect consumers who would otherwise be charged a high
price for the product. This is sometimes used with utility
firms (electricity and telecommunications). This is shown in
Figure 31.1. Price flooring is the minimum price that can
be charged for a product. The price is set by government and
is set above the prevailing market price. Charging a price
below the price floor is illegal. This is seen in Figure 31.2.
Price
Supply curve
Supply curve
Price flooring
Prevailing market price (equilibrium)
Prevailing market price
Price ceiling
Demand curve
Demand curve
Quantity
Figure 31.1: Price ceiling
Quantity
Figure 31.2: Price flooring
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302 MODULE 2 | UNIT 2 | FUNDAMENTALS OF MARKETING
Stage of the lifecycle
Review Chapter 30 on the different stages in the product
lifecycle. A different price may be charged depending on
where in the lifecycle the product currently is. For example,
a product that is within the growth stage is more likely to
have a higher price than if it were in the maturity or decline
stages.
Pricing strategies
‘Cost plus’ pricing
‘Cost plus’ pricing is sometimes referred to as ‘mark-up
pricing’ and is a cost-based pricing strategy. This is where the
firm arrives at a price for the product by adding a percentage
or an amount to the unit cost of the product. The firm
arrives at the total cost of the product by adding its variable
and fixed costs. Variable costs are those which change with
output while fixed costs are those which remain constant
regardless of the level of output. (At this point it is advisable
that you review Chapter 21 to refresh your knowledge of
costing.) Once the total cost is ascertained, the firm will then
add the desired percentage to it, to arrive at the product’s
final price. For example, if the cost of providing a lunch is
$120 and the cafeteria wants to make a 25 per cent profit
on each lunch sold, the price of the lunch would be $120 +
$30 = $150. The lunch will therefore be sold for $150, with
$120 being the cost of the lunch and $30 being the mark-up.
‘Cost plus’ pricing is easy to use and it takes away some of
the uncertainties of whether or not the price charged will be
able to cover the cost of making the product. This method
of pricing is quite popular in the retail industry and small
corner shops and markets in your communities. Care must
be taken in the use of this method, however, as some firms
CASE STUDY
A puzzling price policy
Some business analysts were puzzled when news broke on The Financial Review, a programme aired on the local television
station, that Zing Burger had hiked its prices by 5 per cent across the board. For some analysts this was a puzzling pricing policy.
While the firm is one of the leading providers of burgers within the country, it operates under very competitive conditions. Some
people are of the view that this is a bad change for the firm and it is sure to see some fall-out in sales.
In an interview, the firm’s General Manager, Mr Vidal Zing, stated that this was a strategic move at this time when the firm is
faced with a number of challenges. He said that the firm operates within a market where consumers will buy a product that they
like and these consumers like Zing Burger. Most of the stores are located near upper-income earners’ communities and these
people do not just buy the firm’s products but also come for the serene environment and the customer service that is second to
none.
Mr Zing suggests that while it may lose some customers, the fall-out may not have a significant impact on the firm since,
based on the firm’s analysis, it operates in a fairly inelastic market. As a result, the price hike may even increase revenue. To
offset the possible fall-out from burger sales, however, Zing Burger has lowered its price for side orders such as yogurts, pies
and beverages. These products, he believes, are more price sensitive and so consumers should respond positively.
Some business analysts are now saying that they are expecting other firms to increase their prices due to a new thrust being
pursued by the government. In its budget debate, the ruling party had said that legislation will be coming in to reduce the amount
of imported beef coming into the country, as this is hurting the local farmers. The main users of beef have been complaining
that this move could cause some fall-out in the sector, as the local beef is too expensive and they may not be able to absorb all
of that cost. Now everyone is waiting to see how the other firms will respond.
Questions
1. Outline two (2) negative effects that this price hike could have on Zing Burger.
2. Discuss why Mr Zing would suggest that there could be an increase in revenue even with the price increase.
3. Discuss three (3) factors that influenced the firm’s decision to change its prices.
4. If the government follows through with its plan to stop the importation of beef, discuss the possible impact
that this could have on burger prices.
(4 marks)
(6 marks)
(12 marks)
(3 marks)
Total 25 marks
CHAPTER 31 | PRICING DECISION
might price their products too high so that they become
uncompetitive. Another drawback of this strategy is that it
does not take customer demand into consideration, as some
firms are of the belief that profits are guaranteed since the
strategy is based on costs.
Competition-based pricing
Competition-based pricing is a method that seeks to
price the product based on the firm’s competitors’ prices.
This strategy is particularly appropriate for firms who are
selling similar products and are involved in price competition
or ‘price wars’. In such cases one firm may be trying to
outdo the other by consistently reducing its prices. A price
reduction, rather than a price increase, is usually followed
by the competitor in this case. In order for this strategy to
work well, the firm must have sufficient information about
its competitors’ prices and also be able to anticipate their
next move to some extent.
A firm using this strategy may choose to set its price above,
below or at the same level that of the competitor. However,
in order for the firm to set its price above the prevailing
market price and be successful, it has to offer some product
advantage over its competitors, such as improved quality
or customer service. Likewise, a product that is priced too
far below the prevailing price may be perceived as being
inferior and of poor quality. This method can be dangerous
for the firm, especially if its costs are not as low as those
of the competitor. In a bid to price its product at or below
that of the competitor, the firm could begin to accumulate
huge losses, especially if the lower prices are not bringing
the desired success.
Competition-based pricing incorporates other