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Business Studies AS & A2 Level


Contents
Business objectives and strategy Objectives Strategy Stakeholders Business organization Starting a small firm Legal Structure The Growth of Business Marketing Market Research Market Strategy Marketing Planning Marketing Budget Marketing Mix Elasticity Budgeting, Costing, and Investment Budgeting Costs Investment Appraisal Company accounts Balance Sheets Depreciation Profit and Loss Account Cash Flow Ratio Analysis Ratio Analysis Introduction Liquidity Ratios Profitability Ratios Financial Efficiency Ratios The Gearing Ratio Shareholders Ratios Limitations on Ratio Analysis Production Control Stock control Quality Lean Production Production Decision Making Basics of Production Scale of Production External Environment The Economic Environment The Technological Environment The Social Environment The Legal Environment The Political Environment Management, Leadership, Motivation and Communication Management and Leadership Leadership Schools of Thought Motivation Communication People in the workplace Human Resource Management (H.R.M) Trade Unions 2 4 10 15 17 20 27 30 38 39 45 53 56 62 71 75 76 79 83 83 84 86 87 88 90 94 96 98 104 107 118 123 124 127 128 134 137 137 141 144 152 159

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Business objectives and strategy Objectives


An objective is a goal that needs to be achieved.

Mission statements Under both UK and EU law, a company must state what it is in business to do - this is known as its overall aim and it can be embodied in a mission statement. This is often a simple and memorable sentence which explains what the organisation is in business to do and what it wants to achieve. A mission statement can often be found in the front of a company's annual report and it is, effectively, a summary of its day-to-day activities and long-term objectives, showing a sense of underlying purpose and direction.

It is often argued that mission statements are best when they are simple and informal. For example:

Ford Motor Company PLC "...is a worldwide leader in automative products and services, as well as in newer industries such as aerospace and communications. Our mission is to improve continually and meet our customers' needs, allowing us to prosper as a business and to provide a reasonable return for our shareholders." Cadbury Schweppes PLC "...is a major international company with a clear focus on its two core businesses - confectionery and beverages. Our quality brands are bought and enjoyed in more than 110 countries around the world..." The Body Shop PLC "...to dedicate our business to the pursuit of social and environmental
change..." A good mission statement should be clearly defined, realistic and achievable, and at the same time it should ensure that the employees' attention is focussed towards the overall company aim. Mission statements normally express the organisation's objectives in qualitative terms, (as opposed to quantitative, that is, facts and figures) and many businesses include the following variables in their mission statement: their number one priority, their product definitions, their non-financial objectives and their overall values and beliefs. Although many people view mission statements as a focus for employees and for other stakeholders, they are still viewed by their critics as nothing more than a publicity seeking exercise.
Business objectives It is important to understand how business ojectives 'fit in' with business aims and strategies.

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-An aim states what you want -An objectives set out what you need to have achieved to get what you want -A strategy is a course of action which enables you to meet your objectives. In order for objectives to be effective, they must: 1.provide detail about what specifically needs to be achieved (often in a quantitative form) 2.have a time limit by when they need to have been achieved 3.need to state the necessary resources that they require in order to be met. Setting clearly defined and realistic objectives will enable many employees to understand exactly what their job entails and achieving clearly stated objectives might be linked to bonus payments - this can easily act as an incentive and motivator to employees.
Primary and secondary objectives A primary objective is an ultimate long-term goal of the business (e.g. survival, profit maximisation, diversification and growth). They are often referred to as strategic objectives.

A secondary objective is a day-to-day objective, and it makes a direct contribution to meeting the primary objectives (e.g. increase sales by 5% each year, keep labour turnover at less than 4%). They are often referred to as Tactical objectives.
Private and public sector objectives

Private sector
Private sector objectives will often differ considerably from objectives set in the public sector. Profit maximisation is often quoted as the over-riding objective for businesses in the private sector. This will involve trying to produce at the point where there is the maximum difference between the firm's total revenue and its total cost - resulting in large dividend payments for the shareholders. However, it is far more likely that businesses will aim to profit satisfy rather than profit maximise (that is, they will aim to earn a satisfactory level of profits to keep shareholders content, and then use the remaining resources to pursue other objectives such as diversification and growth). Another objective in the private sector, for a rapidly growing business, may well be to maximise sales (or sales revenue) and so increase their market share in order to gain a competitive advantage. Many businesses set objectives to improve their image and to appear more socially responsible and environmentally friendly - this is often achieved through strategies of recycling materials,

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sponsoring local events and strictly adhering to all employee legislation (e.g. pay levels, Health & Safety, discrimination, etc.).

Public sector
Public sector objectives have, traditionally, been centred around providing a public service, rather than make a profit (e.g. when British Gas was a public corporation it had to provide gas supplies to all areas of the UK, many of which were isolated and very unprofitable for the organisation). This regularly led to loss-making organisations being subsidised by the government, and complacency crept in with regards to customer service, quality levels and response times. However, in the UK in the 1980s and 1990s, a massive privatisation programme by the government was implemented and many large utilities such as British Gas, British Telecom and the Electricity Boards were sold to the private sector. The remaining public sector organisations were told to run in a more cost-efficient manner and to improve the quality of their services to consumers. Performance targets were set for many Local Health Authorities, Local Education Authorities and council services in an attempt to make them more accountable, to reduce their costs and to improve the quality of their output.
Short-term and long-term objectives Short-term objectives will often differ from long-term objectives, especially if the business is experiencing poor financial performance at present. A short-term objective may be to consolidate, or even simply to survive the difficult trading conditions that it is experiencing. Once this has been achieved and the business has stabilised its performance, then it may well look to achieve its long-term objective of diversification into new products and new markets, or growth through amalgamation.

Strategy
A strategy is a way of achieving an objective

Decision-making Businesses of all sizes have to make many decisions each day - some are fairly simple and routine, whilst others are more complex and require significant management time and effort. Some examples of decisions that all businesses need to make are:

Where should we locate the business? What goods should we produce? What price should we charge? What should we do if a supplier fails to deliver on time? Which job agency should we use to provide us with some temporary workers? Which employee appraisal system should we use?

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Decision-making is the basic task of all managers in all departments of the business, and both in the private and the public sectors. These decisions are, effectively, designed to influence the actions of other people. A strategic decision is one which is very high-risk and is likely to influence the overall longterm policy and direction of the business. As such, it is likely to be dealt with by senior management (e.g. what new products to develop). A tactical decision is a fairly routine, predictable, short-term decision, which is normally handled by middle management (e.g. what price to charge for products). Other decisions which are repetitive, day-to-day and fairly risk-free are handled by lower-level management, and are generally referred to as operational decisions (e.g. how long should tea-breaks be?). Businesses have to make decisions in order to achieve their objectives. There are eight key stages involved in the traditional decision-making process:
1. Set objectives. The decision-making process cannot proceed without an achievable, realistic and identifiable target to be met. 2. Gather data. Use market research to collect as much information as possible from inside and outside the business, so to enable the decision-makers to have the necessary data with which to make an effective decision. 3. Analyse the data. Look at the different courses of action and decide which ones look the most achievable and realistic to meet the objective. 4. Make a decision. This stage is vital to the whole process. The decision-makers must ensure that they follow the correct course of action and do not reject a better alternative. 5. Communicate. This to the whole organisation. The relevant people, both inside and outside the organisation, need to be informed about the decision and how it may affect them. 6. Implement the decision. The course of action that has been decided upon is implemented, using the available resources of the business. 7. Look at the results. Obtain as much feedback as possible concerning the recently implemented decision, from as many sources as possible. 8. Evaluate the outcome. Did the decision work ? Was it the best course of action ? How can it be improved next time? What went wrong?

Businesses can rarely carry out their decision-making in a totally open and risk-free environment, and there are often many constraints which exist, that will limit the possible options available to a business. These constraints can be internal (such as the lack of available finance, or the lack of a multi-skilled workforce) and external (such as a rise in interest rates, a new competitor entering the market, or new legislation which restricts the activities of the business). There are many tools available to a business that will help it limit both the risk involved and the chance of failure, when making a vital decision (such as launching a new product, taking over a competitor, or breaking into foreign markets). Three types of decision making tools are shown below:

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Decision tree A decision tree is a diagram that sets out the different options that are available to a business when making decisions and it also shows the chance (or probability) of their occurrence. It sets out the actual values to be expected should a particular course of action be followed. These can then be multiplied by the relevant probability of that event happening, to give an expected value, which represents the average pay-off if the decision was taken many times.

For example: Mr. Smith owns a piece of land and he wants to sell it to raise some money for his ailing business. He has been informed that he has just two options open to him: 1.He could sell the land now for a guaranteed price of 250,000, with associated selling costs of 5,000. 2.He could wait for 12 months for the market price to hopefully rise and he could then sell it, with associated selling costs of 7,000. An estate agent has informed him that the chance of receiving a higher price for the land is 0.6, while the probabilities of the price remaining the same or worsening are 0.3 and 0.1 respectively. If the market price does rise, then the land is likely to be valued at 325,000. However, if the price deteriorates, then it is likely to be valued at 200,000 in 12 months. The decision-tree below illustrates the above scenario:

Calculation of expected value at node B: 325,000 x 0.6 = 195,000 250,000 x 0.3 = 75,000 200,000 x 0.1 = 20,000 Total expected value = 290,000 The tree diagram points in favour of delaying the sale of the land for 12 months, since it predicts that IF THE DECISION WAS TAKEN MANY TIMES then Mr.Smith would ONAVERAGE receive 283,000 (290,000 minus 7,000 costs), instead of the 245,000

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(250,000 minus 5,000 costs) that he would receive by selling the land now. There are several points to note from the diagram: 1. The tree diagram is laid out from left to right. 2.Node A is represented as a square and it is called a decision node (i.e. at this node, the decision-maker can only choose one branch to follow). 3.Node B is represented as a circle and is called a chance node (i.e. there are several possible outcomes from this node, one of which will definitely happen). 4.Each event stemming from a chance node has a probability attached to it (these probabilities must always add up to 1). 5.The actual values are always listed at the end of each branch. In order to calculate the expected value at a chance node (e.g. node B) then the decisionmaker must calculate along the branches from right to left, by multiplying the actual value by the probability and adding the results. Hence, 325,000 is multiplied by 0.6, the 250,000 is multiplied by 0.3, and the 200,000 is multiplied by 0.1. These are then all added together to give the expected value of 290,000 at node B. The cost associated with each branch is written beside it, and these costs have to be deducted before a decision can be made. Each branch is cut-off as it is rejected (this is represented by two parallel lines cutting through the start of the rejected branch). This leaves just the best alternative option remaining. There are several advantages of using decision trees to analyse a particular situation: 1.They set out problems clearly and logically. 2.They show the likely amounts of money involved in the decision, and the probabilities of their occurrence. 3.Constructing a decision tree may show possible courses of action which had not been previously considered. 4.They are tangible and therefore people can easily see the issue that they are faced with, rather than attempting to visualise somebody's description. However, decision trees are not without their faults: 1.The probabilities are only estimates and are, therefore, subject to change. 2.They can only show quantitative data - they do not take account of peoples' feelings, legal constraints, etc.

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3.The results can be biased, in order to show just one side of an argument. 4.There can be significant time delays whilst making the decision, and some of the data may be out-of-date by the time the decision is finally made.
S.W.O.T. Analysis This is another method of helping management to reduce the risk involved in making decisions in a dynamic industry. It involves analysing the current position of a product, a department or even the whole organisation, and trying to identify its possible future courses of action, by looking at its Strengths, Weaknesses, Opportunities and Threats.

A strength is a factor which a business currently possesses and which it performs effectively, such as having a strong management team, a profitable portfolio of products, or a loyal customer base. A weakness is an area in which the business currently performs poorly, such as having a high level of industrial disputes, falling profitability, or falling productivity levels. An opportunity is a potentially successful or profitable activity that the business could take advantage of in the future, such as the take-over of a competitor, the development of new products, or breaking into new markets. A threat represents a potential future problem which the business may face in the future, such as new competitors entering the industry, new legislation restricting the use of certain raw materials, or the possibility of being taken-over by another company. Remember, the strengths and weaknesses are internal factors which the company currently faces. The opportunities and threats are external factors which the company may face in the future. The S.W.O.T. analysis is represented in a simple four-box diagram, as illustrated below: Example of a S.W.O.T analysis for a Chocolate manufacturer.
Strengths: Weaknesses:

Plenty of R&D, leading to many new product ideas Achieving economies of scales in production High level of customer loyalty and repeat purchasing Effective promotion
Opportunities:

Several of our products are reaching the end of their life-cycle Too many marketing personnel are leaving the business Restricted product range

Threads:

New markets in Far East

Competitors are threatening a price war

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A joint venture with a foreign chocolate manufacturer Product extensions, such as different sizes of bars

Take-over by domestic rival New legislation may affect the source of our ingredients

This diagram is simple and easy to follow, and it can provide the basis for discussion of business strategy at meetings. The results of a S.W.O.T. analysis may often identify possible courses of action that had not been considered, as well as categorising and prioritising the problems that the business faces. In most large businesses, the marketing department will carry out a S.W.O.T. analysis as part of its annual marketing audit - this highlights the products which are performing effectively, those which are reaching the end of their lifecycle, potential new markets to break into and the overall effectiveness of its personnel.
Contingency Planning and Crisis Management Not all the opportunities and events that a business faces will go to plan, and some may prove detrimental to the continuity of the business (such as a huge downturn in demand for their products). Contingency planning means preparing for these unwanted and unlikely possibilities. A business may produce a contingency plan in case of:

1.a severe recession; 2.an environmental disaster; 3.a sudden strike by its workforce. Contingency plans enable a business to be in a better position to manage a crisis, rather than to try and simply cope with it when it occurs. Before contingency planning can take place, a business must consider many possible threats and crises that it may face, in order to be able to react to them swiftly and efficiently if they do ever occur. These potential scenarios are often computer-simulated, and they can predict to a high level of accuracy the likely effects of a crisis on the finances and resources of a business. Crisis management is the response of an organisation to a crisis (e.g. a fire, terrorist activity, natural disaster). Many companies will have some sort of contingency plan to cater for such situations, but it is rare that the actual crisis will go according to plan. It is likely that the person in charge at the time of the crisis will manage the crisis in a very authoritarian fashion, as he needs to make quick and effective decisions without the time for discussion and consultation with others. Effective planning should reduce the impact of a crisis on a business, but nevertheless to overcome any crisis is likely to cost the business a significant amount of time and money. Some crises will be long-lasting and will affect the whole economy (such as a recession, or a natural disaster), some crises will affect all the businesses in a particular industry (such as the

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collapse in demand for UK ship building) and others crises will simply affect a single business (such as the Perrier Water contamination scandal, or a strike by a workforce). Any crisis is likely to have implications for the finances of the business, the effectiveness of personnel and communications and the production patterns. The business must be seen to be acting swiftly when faced with a crisis, and it must try to ensure that the damage to the business (especially to its reputation and its image) is minimised by using which ever resources are at its disposal. Successful public relations campaigns, adequate finance, strong leadership, rapid action and effective communication (both internal and external) are the key ingredients for a crisis to be solved effectively. Crises will always pose a number of unexpected and unforeseen problems and dilemmas for businesses. However, as long as the business is seen to be limiting the effects of the crisis upon its various stakeholder groups (especially its customers) then its reputation may well remain intact.

Stakeholders
There are many groups of people who have an interest, financial or otherwise, in the performance of a business - these different groups are known as stakeholders. The main stakeholders are considered to be:

Shareholders
These people have a clear financial interest in the performance of the business. They have invested money into the company through purchasing shares and they expect the company to grow and prosper so that they receive a healthy return on their investment. The return that they receive can come in two forms. Firstly, by a rise in the share price, so that they can sell their shares at a higher price than the purchase price (this is known as making acapital gain). Secondly, based on the level of profits for the year, the company issues a portion of this to each shareholder for every share that they hold (this is known as adividend). The shareholders are also entitled to vote each year at the A.G.M. to elect the Board of Directors, who will run the company on their behalf.

Employees
This group also has an obvious financial interest in the company, since their pay levels and their job security will depend on the performance and the profitability of the business. It is employees who perform the basic functions and tasks of the business (producing output, meeting deadlines and delivery dates, etc.) and over recent years their traditional role has started to change. They are often now encouraged to become involved in multi-skilled teamworking, problem solving and decision making - thus having a significant input to the workings of the business.

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Customers
Customers are vital to the survival of any business, since they purchase the goods and services which provides the business with the majority of its revenue. It is therefore vital for a business to find out exactly what the needs of the consumers are, and to produce their output to directly satisfy these needs - this is done through market research. The goods and services must then be promoted in such a way as to appeal to the target market and to inform them of the availability, price, etc. Once the goods and services have been purchased by the customer, it is essential that after-sales service is offered and that the customer is happy with his/her purchase. The business must try to keep the customer loyal so that they return in the future and become a repeat-purchaser.

Suppliers
Without flexible and reliable suppliers, the business could not guarantee that it will always have sufficient high quality raw materials which they require to produce their output. It is important for a business to maintain good relationships with their suppliers, so that raw materials and components can be ordered and delivered at short notice, and also so that the business can negotiate good credit terms from the suppliers (i.e. buy now, pay at a later date).

The Government
The government affects the workings of businesses in many ways: 1. Businesses have to pay a variety of taxes to central and local government, including Corporation tax on their profits, Value-Added Tax (V.A.T) on their sales, and Business Rates to the local council for the provision of local services. 2. Businesses also have to adhere to a wide-ranging amount of legislation, which is aimed at protecting the consumers, the employees and the local environment from business activity. 3. Businesses will be affected by different economic policies, (for example, if interest rates are increased, then this will discourage businesses from borrowing money since the repayments will now be significantly higher). However, businesses can also benefit from government incentives and initiatives, such as new infrastructure, job creation schemes and business relocation packages, offering cheap rent, rates and low-interest loans.

The Local Community


Businesses are likely to provide significant amounts of employment for the local community and often will produce and sell much of their output to the local residents. The sponsorship of local events and good causes (such as local charity work) can also help the business to establish itself in the community as a caring, socially responsible organisation. Many businesses develop links with local schools and colleges, offering sponsorships and resources to these under-funded institutions. However, businesses can also cause many problems in

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local communities, such as congestion, pollution and noise, and these negative externalities may often outweigh the benefits that the businesses bring to the community.
Disagreements between stake holders Due to the demands placed on businesses by so many different stakeholders, it is no surprise that there are often disagreements and conflict between the different groups. Some of the more common areas of conflict are:

Shareholders and management


Profit maximisation is often the over-riding objective of shareholders - resulting in large dividend payments for them. However, it is far more likely that the managers of the business will aim to profit satisfy rather than profit maximise (that is, they will aim to earn a satisfactory level of profits, and then use the remaining resources to pursue other objectives such as diversification and growth). This conflict between these two groups is often referred to as divorce of ownership (the shareholders) and control (the management).

Customers and the business


Customers are unlikely to remain loyal and repeat purchase from the business if the product that the have purchased is of poor quality and/or is poor value for money. More customers are prepared to complain about the quality of products and after-sales service than ever before, and the business must ensure that it has in place a number of strategies designed to satisfy the disgruntled customer, reimburse any financial loss that they may have incurred and persuade them to remain loyal to the business.

Suppliers and the business


Suppliers are often quoted as complaining about the lack of prompt payments from businesses for deliveries of raw materials, and if this became a regular problem then the suppliers may well refuse credit to the businesses or may even cease all dealings with them. On the other hand, many businesses have been known to complain about the late deliveries of raw materials and components from suppliers, and the dubious quality of the parts once they have been inspected.

The community and the business


As outlined previously, the local community can often suffer at the hands of a large company through the negative externalities of pollution, noise, congestion and the building of new factories in areas of outstanding beauty. However, if the business faces strong protests from residents and from pressure groups concerned about its actions, then it may decide to relocate to another area, causing much unemployment and a fall in investment in the community it leaves behind.

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Exam-Style Questions
1. a) Why is it important for a business to specify its objectives? b) Explain, with examples, why differing stakeholder and organisational objectives might cause problems for managers. (Marks available: 10) Answer outline and marking scheme for question: 1 Give yourself marks for mentioning any of the points below: a) Focus for all employees, measure by which to judge the performance of the business, informs strategic planning. (5 marks) b) Conflict, e.g. local community objective - clean environment, company objective - profit (cost cutting creates pollution). Decision making: e.g. Shareholders may demand high dividends, but management seek to invest profits for long term. (5 marks) (Marks available: 10) 2. Explain, with examples, what is meant by the stakeholders in a company. Is it in the interests of all stakeholders that a company should try to maximise its profits? (Marks available: 20) Answer outline and marking scheme for question: 2 Stakeholders are those persons who hold a stake in the company; they include shareholders, banks, the local community, customers, employees, government - if the American definition of "anyone who may be affected by the actions of the corporation" is adopted, even competitors. (max 12) A candidate might wish to refine the question and write of "long term" profits and then argue, with Milton Friedman, that the objective of the company is to increase shareholder wealth. Many will argue that the company has a duty to other stakeholders. Johnson and Johnson, for example, put the customer first, then the employees, and the shareholders last. Green issues may be mentioned.

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(max 12)
Excellent A clear and concise explanation of the stakeholder concept and a well sustained argument for or against the maximising of profits. An informed account of the stakeholder concept and a reasoned argument for or against maximising profits.

Competent

Adequate A knowledge of what is meant by stakeholders and some reasons for or against maximising profits. Weak A limited knowledge of what is meant by stakeholders and ill-connected comments for or against maximising profits.

(Marks available: 20)

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Business Organization Starting a Small Firm


Identifying an Opportunity It is vital for the success of a business that it manages to identify an unsatisfied consumer need in a market and then produce a product, or provide a service, which meets the consumers' needs. The new product / service can be protected against competition by the use of copyrights and patents. These protect the owner / inventor from having their products, ideas, etc. copied and reproduced by other people without their permission.

Some of the most common reasons for starting up a new business include the need for independence; to achieve your personal ambitions; being bored with your current job; links with your hobbies and interests; redundancy from your previous job. Many businesses which have started in the UK over the past 25 years have failed within the first 3 years of trading. To reduce the probability of failure, it is vital that businesses carry out market research in order to establish if a profitable gap exists in a market and to see if their business is in a strong enough position to fill this gap. In order to make a success of the new business venture, the entrepreneur must be hardworking, ambitious, firm, decisive, organised, a good negotiator and must be able to recognise an opportunity when it arises.
The Business Plan Once an entrepreneur has recognised an opportunity, he/she must draw up a business plan. This is a document which outlines the marketing, production and financial plans for the proposed business. It is used to try and persuade investors (banks, etc.) to lend money to the entrepreneur to fund his/her new business.

The main sections of a business plan include: - the aims and objectives of the business - details of the new product or service being offered - an outline of the existing market details (i.e. size of the market, number of existing competitors) - how and where the product will be produced - the proposed number of employees - a cashflow forecast, a projected profit and loss account and balance sheet for the end of the first year's trading

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- details of the finance required and the forecasted rate of return on this.
Patents and Copyrights An entrepreneur can use patents and copyrights to protect a new product, process, invention or information against copying and reproduction by other people without the entrepreneur's permission.

A patent gives an entrepreneur or a business the legal right to be the sole owner or user of a particular production process or of a new product. The Copyright, Designs and Patents Act (1988) gives this right for a 20 year period following registration. In order for the patent to be approved, then the Patent Office has to be supplied with the original drawings and designs of the new product, and the inventor must state that the ideas and features of the product are his own work and have not been copied from other products. Patents are often sold to larger businesses in order to provide a large injection of capital, which can help the small business to grow and expand its product range. A copyright is the legal right of the creators of certain kinds of material (books, films, sound recordings) in order to control the copying and duplicating of the owner's original work. The law on copyright is governed by The Copyright, Designs and Patents Act (1988). People using copyright material without permission risk legal action.
Problems of Start-ups Most new businesses will face a number of problems when they are starting up and if these problems are not tackled immediately, then they may lead to the insolvency and failure of the new venture. Below are listed some of the major problems faced by a new company:

Raising finance and meeting the repayments Raising finance and meeting the repayments is often cited as the major reason for the failure of many new business ventures. It can often be difficult for a budding entrepreneur to persuade banks and other financial institutions to lend money to a new business, and often they will only lend the money at a high rate of interest. These repayments can cripple the business and eventually lead to its insolvency. As well as the repayments, the bank will insist that some security (or collateral) is provided by the business, so that if the business defaults on the loan repayments, then the bank will take ownership of an asset of the business which will cover the amount of the outstanding loan. Having a positive cashflow Leading on from this previous point, having a positive cashflow is vital for the survival of the business. Liquidity is the financial term given to express the ability of a business to raise cash at short notice. Any new business must have sufficient cash available to meet its short-term needs (such as paying employees, paying suppliers, rent, utility bills, etc.).

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Many businesses have a lot of cash tied up in stocks, which are often difficult to sell and therefore the business may find it difficult to raise cash quickly. Further to this, if the business gives its customers credit (i.e. buy now, but pay us at a later date) then this will simply add to any cash flow problems that the business is facing. Paperwork and legal requirements All businesses face a variety of paperwork and legal requirements, and if any of these are overlooked or completed inaccurately, then this could lead to the failure of a new business. Taxation and insurance payments are vital for the smooth running and survival of new businesses. Any oversight on these payments could land the entrepreneur with a large tax bill or, perhaps worse, property and stock which will not be insured against fire, theft, etc. Enticing consumers to try the new product Enticing consumers to try the new product / service can also be a major problem for any new business, especially if there are already a handful of established businesses which dominate the market. Ensuring that consumers try your product and then buy it again at a later date (consumer loyalty) can often only be done through extensive (and costly) advertising and promotional campaigns.

Legal Structure
Sole Trader A sole trader is a one-person business, commonly found in trades where only small amounts of finance are required to set up and where there are very few advantages to the existence of larger organisations (e.g. hairdressing, newsagents, market traders).

Sole traders often employ waged employees, but they alone have to provide all the finance (often savings and bank loans) and bear all the risks of the business venture. In return, they have full control of the business and enjoy all the profits. A sole trader faces unlimited liability for his/her debts and it is referred to as an unincorporated business - this means that there is no legal difference between the business and the owner.
Partnership To overcome many of the problems of a sole trader, a partnership may be formed. A partnership is an association of individuals and generally there will be between 2 and 20 partners.

Each partner is responsible for the debts of the partnership and therefore you would need to choose your partners carefully and draw up an agreement on the responsibilities and rights of each partner (known as a Deed of Partnership or The Articles of Partnership). The most common examples of a partnership are doctor's surgeries, veterinarians, accountants, solicitors and dentists.

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As stated earlier, most partners in a partnership face unlimited liability for their debts. The only exception is in a Limited Partnership. This is where a partnership may wish to raise additional finance, but does not wish to take on any new active partners. To overcome this problem, the partnership may take on as many Sleeping (or Silent) Partners as they wish - these people will provide finance for the business to use, but will not have any input into how the business is run. In other words, they have purely put the money into the business as an investment. These Sleeping Partners face limited liability for the debts of the partnership. A partnership, just like a sole trader, is an unincorporated business.
Private Limited Company This is a type of joint-stock company (that is, it is an incorporated business - where the business has a separate legal identity from the owners). Often private limited companies are small, family run businesses which are owned by shareholders.

Each shareholder in a private limited company MUST be a part of the business and under no circumstances can any shares be sold to members of the general public. Each share entitles the owner to 1 vote at the company's Annual General Meeting (A.G.M.) and also to a share of the company's profit at the end of the financial year (a dividend). Each shareholder has limited liability for the company's debts and can, therefore, only lose the value of their investment in the company. A company is run by a Board of Directors (who are elected by the shareholders) and this is headed by a Chairman. Before a company can be formed, a number of legal documents must be completed - most important are the Memorandum of association and the Articles of Association. These cover details such as :

the objectives of the business its headquarters and registered office the amount of capital to be raised from the sale of shares details concerning meetings within the business the arrangements for auditing the accounts of the business.

When these are completed, they are sent to the Registrar of Companies, who will then issue the business with a Certificate of Incorporation which allows the business to trade as a Private Limited Company. The company's name must finish with the wordLimited and it must raise less than 50,000 of share capital. It can be very difficult for a shareholder in a private limited company to sell their shares, since a buyer must be found within the framework of the company.
Public Limited Company (P.L.C.) This is the other, much larger, type of joint-stock company and, just like a private limited company, a PLC is an incorporated business, is run by the Board of Directors on behalf of

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the shareholders and has an A.G.M. at which shareholders vote on certain key issues relating to the company. The main difference between a PLC and a private limited company is that a PLC can sell its shares on the Stock Exchange to members of the general public and can, therefore, raise significantly more finance than a private limited company. If a private limited company wishes to become a PLC, then it must change its Memorandum and Articles of Association and re-submit them to the Registrar of Companies. If the company is considered to have acted legally and for the best interests of its shareholders, then it will be issued with a new Certificate of Incorporation and also with a Certificate of Trading, which will allow it to sell its shares on the Stock Exchange. The price of the shares will then fluctuate according to investors' perceptions of the PLC. It is often the case with a PLC that the owners of the company (shareholders) will wish the PLC to make as much profit as possible, so that the shareholders will receive a very handsome dividend per share. However, the Board of Directors and the management will often wish to devote some of the PLC' s resources to growth and diversification (such as the introduction of new products) and this will clash with the shareholders' desire for maximum profits. This is known as thedivorce of ownership and control. The PLC has to publish its annual accounts (known as disclosure of accounts) and therefore is extremely vulnerable to investors' and bankers' perceptions about its progress and success. Following on from this, a PLC is also at risk from a takeover from an outside body, if they manage to accumulate over 50% of the shares in the PLC.
Public Sector Organisations The public sector refers to all the businesses and organisations which are accountable to central or local government. They are funded directly by the government and they tend to supply public services rather than produce products for a profit.

The public sector provides 3 types of good / service.


A public good is one which would not be provided by private sector businesses because it would not be profitable to do so (such as the emergency services and the armed services). A merit good is one which the government feel that everyone should have, whether or not they could afford them in the private sector (such as education and healthcare). Essential services (such as street lighting, refuse collection, street cleaning, parks, libraries, swimming pools, etc.).

A public corporation is the term used to describe a nationalised industry which is providing a good or a service to the general public. Until the successive Conservative governments of Thatcher and Major (1979-1997), there were many public corporations in the UK providing a

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huge range of services to consumers. However, the Conservatives sold many of these public corporations to the private sector - this process is known asprivatisation. Central government pays for the public goods and merit goods through taxation (e.g. Income Tax), whereas local governments pay for the services they provide through Council Tax (formerly Community Charge and, before that, through Rates).
Franchising Franchising has led to a rapid growth in the presence of many high-street stores in the UK over the past 10 years (e.g. McDonalds, Tie Rack, Perfect Pizza, and The Body Shop). A business franchise involves the franchisor (the owner of the business) selling a business format to a franchisee (the purchaser of the business name) in return for a fixed sum of money and a percentage royalty on sales revenue.

The franchisee will be based locally and is likely to be making his initial business venture. He buys the business format, which has been tried and tested in other areas, and it is therefore a far less risky venture than setting up his own business. The franchisee has a licence to trade under the franchisor's name and also to use the logos, trademarks, etc. the licence that the franchisee buys is usually restricted to a specific geographical area and for a limited period of time. This process of selling the rights to use a company's name, logo, etc. can result in the parent company experiencing rapid expansion in a country, with little of the investment that would have been required had the company bought the outlets itself. The franchisee is provided with a ready-made product, financial and management help and advice, lower start-up costs than for a business of his own, and help with the store layout. However, the royalty must be paid to the franchisor even if a loss is made and the franchisee can have strict restrictions placed on their actions and promotions within the store, not leaving the franchisee much room for initiative and flair.

The Growth of Business


Internal -v- External Growth There are two main ways in which a business can grow - internal growth and external growth.

Internal growth (Often referred to as organic growth) refers to a situation where a business increases its size through investing in its existing product range, or by developing new products. This will normally be financed through the use of retained profits (from previous trading years), bank loans or, if the business is a PLC, through the issue of shares. This is a slower and safer method of expansion than external growth.

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External growth Involves much greater sums of money and takes place through the use of mergers and takeovers (often known as growth through amalgamation, or simply integration).
Regardless of the method of growth, there are several reasons why firms wish to grow:

To To To To To

achieve economies of scale and see the average cost of production decline. achieve a greater market share. satisfy the ego of the businessman. achieve security through becoming more diversified. survive in an increasingly competitive market.

Mergers and Take-Overs A merger occurs where two firms combine, with the consent of both groups of shareholders and Directors.

A takeover (also known as an acquisition) refers to a situation where over 50% of the shares in another company have been purchased - therefore giving the predator full control of the newly acquired company. Both mergers and takeovers are referred to as growth through amalgamation, or simply as integration. There are several different classifications of integration:

Horizontal. This occurs when two firms in the same industry join together who produce the same product and are at the same stage of the production process (e.g. the Nestle takeover of Rowntree). The new, larger business is likely to be more powerful, have a larger market share, and achieve higher sales revenue and profits. However, the new business may become complacent and inefficient and find that it suffers from diseconomies of scale and / or falling profits. Vertical. This occurs when two firms combine who are in the same industry, but at a different stage of the production process. Forward vertical integration. Occurs where a company merges with, or takes-over, another company which is closer to the retail stage (i.e. nearer to the consumer). An example of this would be a car manufacturer taking-over a range of car showrooms. Forward Vertical integration is often the result of a desire to secure an adequate number of market outlets and to raise their standard. Backward vertical integration. Occurs where a company merges with, or takesover, another company which is closer to the source of the raw material (e.g. a car manufacturer taking-over a supplier of car components). Backward Vertical integration is often the result of a company being able to exercise much greater control over the quantity and quality of it supplies, as well as securing its supplies at a lower cost.

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Conglomerate. This occurs where two firms merge which are in different industries and produce different goods - in other words, it is pure diversification. The major advantage to the new, larger firm is that it has diversified its product range and spread its risks. Lateral. This occurs where two firms combine which are similar in some way, but are not in the same industry (e.g. Cadbury-Schweppes). Here, both companies produced products which were sold to similar market segments (confectionery and soft drinks). Often, the firms can benefit from the management and marketing techniques employed by the other.

The underlying motive for most mergers and takeovers is to achieve synergy. This is often called the "2+2=5 Effect", since the end result will hopefully be more than what the two firms put in to the venture. If it is believed that a proposed merger or takeover is likely to act against the public interest, then it may be referred to the Competition Comission for investigation. In general, any merger or takeover which will result in a market share of 25% or more will be investigated by the Competition Comission. This body does not have the power to take legal action against the company, but instead it can recommend to the Office of Fair Trading (O.F.T.) that some action needs to be taken against the recently merged companies.
Internal and External Sources of Capital The amount of finance required by a business will depend on a range of factors, including the age of the business, the track-record and profitability of the business, the industry that it is in and the state of the economy.

Internal finance is generated from within the business and is likely to come from one of three sources: 1. Retained profit refers to profits made from previous years, which have remained after corporation tax has been paid to the Inland Revenue and after dividends have been distributed to shareholders. It is a useful source of finance to fund new products, etc. 2. The sale of fixed assets, such as machinery, vehicles or even land and buildings which are idle, can also be a large source of cash to fund new projects. 3. Making more effective use of working capital, such as chasing debtors for prompt payment, selling off any available stocks and negotiating longer credit periods with suppliers all release cash for use within the business. External finance is generated from outside the business in a variety of ways:

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Bank overdrafts allow the business to withdraw more money from the bank than it has in its account. It is a flexible, short-term method of borrowing extra cash. However, interest is calculated on a daily basis and it can be recalled at very short notice. Trade credit involves the business obtaining goods from another business, but not paying for them for a period of time. Factoring involves a business selling its debts to a factor company, who will immediately give the business 80% of the money owed to it by its customer. At a later date, having collected the debt from the customer, the factor company will give the business the remainder of the money less a fee. Leasing is a common way to fund new fixed assets, as opposed to purchasing them outright. The business will sign a contract committing it to using some vehicles, machinery, premises, etc. for a fixed period of time (often 3-5 years) with a monthly payment made to the company who owns the assets. The business leasing the assets cannot put these items on its balance sheet (since it never owns them). Loans and mortgages are often used to purchase new fixed assets (machinery, vehicles and land and property). They require monthly repayments to be made for a significant period of time (up to 25 years for a mortgage) and the bank will also want an item to be placed as security (collateral) to cater for the event of the business defaulting on it loan repayments. The danger is that too many loans and mortgages will increase the company's gearing to a dangerously high level. Debentures are sold by companies to investors as a way of raising finance for use within the company. They are long-term, marketable securities, which will pay the holder a fixed amount of money every year until its maturity date - at which time the holder will be able to sell the debenture back to the company for it market price. However, debentures, like loans and mortgages, will increase the gearing level of a company. Venture capital is a very risky type of investment that entrepreneurs (calledventure capitalists) will make in a small to medium sized business, which they believe has massive growth potential. These funds will clearly help the business to grow and achieve its potential.

Whichever source of finance is chosen, the business must ensure that it is adequate for the needs of the business (i.e. it is enough to pay for the new product development, new buildings, etc.) and that it is appropriate (i.e. it will not leave the business with large monthly interest repayments, when they are already burdened with high gearing).
Problems of Growth Rapid and unexpected growth can lead to a host of problems for businesses. Probably the most common problem is the effect that the growth has on the company's finances specifically upon the liquidity and gearing of the company.

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Extra expenses and increased long-term liabilities (such as loans and mortgages) may reduce the liquidity and increase the gearing levels of the company and leave it dangerously close to insolvency. It may simply be the case that the managers cannot cope with the extra responsibilities and workloads that they are faced with - this could lead to a rapidly expanding workforce, with the problems of recruitment, training and lengthy communication channels that this will inevitably lead to. It is also possible that the company may become inefficient and it may experiencediseconomies of scale (rising average costs). This could lead to a significant fall in profits, which in turn could persuade shareholders to sell their shares - this would result in a falling share price. A major problem that a PLC can experience as it grows is the divorce of ownership and control. This refers to the fact that the owners of a PLC (shareholders) are usually interested in maximising the company's profits and, therefore, their own dividend payments. However, the control of the company is in the hands of the management and the Directors. They too want the company to be profitable, but would also like some of the company's resources and money to be invested into new products and new markets. This, clearly, reduces the short-term profits of the company and, therefore, also reduces the dividend payments to shareholders.
Management Buy-Outs and Management Buy-Ins Management Buy-Outs

Management Buy-Outs involve the management team buying an equity stake in the company that they work for (i.e. they become the owners, or part-owners, of the company). Each member of the management team will be expected to invest much of his own money into the venture, but the majority of the finance required to buy the company will come from financial institutions and from venture capitalists. One of the most common examples of Management Buy-Outs is when the management team of a company that is facing receivership decides to buy-out the company, rather than let it be acquired by an outside organisation. The management team, when deciding whether to buy-out the company, should make an assessment of the business in terms of its cashflow, profitability, product range, assets and the different markets in which it operates. If the company looks as if it has potential, then the management team may well take the risk and buy-out the company. The managers often make a success of such a venture because they are more in touch with the workings of the company and with the markets in which they operate. The managers are often a highly motivated group of people and they realise that the success or failure of the

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company rests with their activities. An example of a Management Buy-Out that was a tremendous success was Denby Pottery, and one that failed was M.F.I. Management Buy-Ins Management Buy-Ins exist where the management team of an outside company buy enough shares in another company to control it. The managers buy the shares because they believe that they can run the company more efficiently and profitably than the existing management team. A Management Buy-In is likely to be financed predominantly through borrowed funds, which will cause the gearing ratio to be high.

Exam-Style Questions
1. a) What is meant by "tall" and "flat" organisational structures? b) Why have many organisations moved away from tall to flat organisational structures? (Marks available: 10) Answer outline and marking scheme for question: 1 Give yourself marks for mentioning any of the points below: a) Tall structures refer to hierarchical organisations with many layers of management/levels of responsibility. Flat structures have very few levels of responsibility. (5 marks) b) Tall organisation structures have become less popular due to moves towards leaner organisations, teamwork ethos, increased customer focus and the ability to respond quickly to external changes and customer demands. (5 marks) (Marks available: 10) 2. a) What services do banks offer to small businesses? b) How might the purpose of a loan influence the period over which it is borrowed? (Marks available: 10) Answer outline and marking scheme for question: 2
.

Give yourself marks for mentioning any of the points below:

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a) Banks offer a range of services to small business, lend money and offer advice. The extent of the help will depend on a number of factors such as the financial standing of the company, i.e. the length of time it has been trading, sales turnover. If it is a new company, the small business may find difficulty in raising finance through banks, they may have to pay higher rates of interest, and the banks may be less flexible if the business deviates from its business plan. (5 marks) b) Considerations should include, what the finance is to be used for, for example, current or fixed assets. Will the purchase be obsolete before the loan is paid back. (5 marks) (Marks available: 10) 3. a) What is the difference between organic growth and growth through acquisition? b) Is growth necessarily good for a firm? (Marks available: 20) Answer outline and marking scheme for question: 3 Give yourself marks for mentioning any of the points below: a) Organic growth is growth through increased sales, resulting in capital investment, perhaps in new plant. Growth through acquisition (Hanson is a good example) occurs through takeovers of other businesses, so that there is no growth in the industry as a whole, simply a concentration among fewer and larger, financial groups. (max 10 marks) b) The second question can be answered in several ways. A candidate might note that a firm may change its character as it grows: A family firm may find that growth entails bringing in outsiders and relinquishing some family control. Overtrading might be discussed: a firm can overextend its borrowing and find itself starved of working capital (more firms go bust in the upturn following a recession than during the recession itself). (max 10 marks) (Marks available: 20)

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Marketing Market Research


Market research involves gathering and analysing data from the marketplace (i.e. from consumers and potential consumers) in order to provide goods and services that meet their needs.
Primary research This is research designed to gather primary data, that is, information which is obtained specifically for the study in question. It can be gathered in three main ways - observation, questionnaires and experimentation.

Observation involves watching people and monitoring and recording their behaviour (e.g. television viewing patterns, cameras which monitor traffic flows, retail audits which measure which brands of product consumers are purchasing). Questionnaires are a means of direct contact with consumers and can take a variety of forms. Personal questionnaires (such as door-to-door interviewing), postal questionnaires, telephone questionnaires and group questionnaires (such as asking for the attitudes of a group of consumers towards a new product). Questionnaires can be a very expensive and time-consuming process and it can be very difficult to eliminate the element of bias in the way that they are carried out. It is important that every respondent must be asked the same questions in the same order, with no help or emphasis being placed on certain questions / responses. Experimentation involves the introduction of a variety of marketing activities into the marketplace and then measuring the effect of each of these on consumers. For example, test marketing, where a new product is launched in a small, geographical area and then the response of consumers towards it will dictate whether or not the product is launched nationally.
Secondary research This is the collection of secondary data, which has previously been collected by others and is not designed specifically for the study in question, but is nevertheless relevant. Secondary data is far cheaper and quicker to gather than primary data, but it can be out-of-date by the time that it is researched. The main sources of secondary data are reference books, government publications and company reports.

The primary and the secondary research will provide the business with much data relating to its markets and its consumers. This data can then be used to describe the current situation in the marketplace, to try to predict what will happen in the future in the marketplace, and to explain the trends that have occurred. The business may also use the market research data to segment the market. This involves breaking the market down into distinct groups of consumers who have similar characteristics,

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so as to offer each group a product which best meets their needs. The main ways of segmenting a market are: By consumer characteristics: this involves investigating their attitudes, hobbies, interests, and lifestyles. By demographics: their age, sex, income, type of house, and socio-economic group. By location: the region of the country, urban -v- rural, etc. Effective segmentation of the market can lead to new opportunities being identified (i.e. gaps in the market for a product), sales potential for products being realised and increased market share, revenue and profitability.
Quantitative vs Qualitative research Quantitative research

Quantitative research involves carrying out market research by taking a sample of the population and asking them pre-set questions via a questionnaire (normally 200+ respondents) in order to discover the likely levels of demand at different price levels, estimated sales of a new product, and the 'typical' purchaser of the company's products. The data is numerical and can be analysed graphically and statistically. There are several types of sample that can be used to gather quantitative data: Random sampling - this gives each member of the public an equal chance of being used in the sample. The respondents are often chosen by computer from a telephone directory of from the Electoral Register. Quota sampling - this method involves the consumers being grouped into segments which share certain characteristics (e.g. age or gender). The interviewers are then told to choose a certain number of respondents from each segment. However, the numbers of people interviewed in each segment are not usually representative of the population as a whole. Cluster sampling - this normally involves the consumers being grouped into geographical groups (or 'clusters') and then a random sample being carried out within each location. Stratified sampling - the consumers are grouped into segments again (or 'strata') based upon some previous knowledge of how the population is divided up. The number of people chosen to be interviewed from each 'strata' is proportional to the population as a whole. Qualitative research Qualitative research attempts to gain an insight into the motivations that drive a consumer to behave in a particular way. It is usually conducted through group discussions (often called focus groups) in order to discover the rationale behind consumers' purchases. The group discussion is often chaired by a psychologist in a relaxed manner, which should

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encourage the consumers to discuss their shopping habits and pre-conceptions concerning certain products and brands.
Forecasting This involves attempting to estimate future outcomes (e.g. the level of sales). Forecasting can be done in a number of ways:

Extrapolation - this involves identifying the trend that existed in past data and then continuing this into the future. This is often done by using a software package to establish a line of best fit for past data, and then simply extending this line into the future. The Delphi Technique - this involves using a panel of business and forecast 'experts' who discuss and agree long-range forecasting for important issues and events. Market research - this can be used to try and establish the purchasing intentions of consumers. Time Series analysis - this also attempts to predict future levels from past data. There are 4 main components of time-series data : the trend, cyclical fluctuations (due to the economic cycles of recessions and booms), seasonal fluctuations and random fluctuations. Clearly, trying to predict and forecast what will happen in the future is not easy and many variables will change in both the short-term and in the long-term which will affect the accuracy of forecasts. It is always advisable for businesses to use a variety of forecasting techniques to arrive at suitable and acceptable figures for the future (e.g. costs, revenues, sales levels, profits, etc).
Statistical Analysis There are a variety of techniques that a business can use to analyse the data that it collects through its market research methods.

The mean - this is the sum of the items divided by the number of items. The median - this is the middle number in a set of data. The mode - this is the number, or value, that occurs most frequently in a set of data. The range - this is the difference between the highest value and the lowest value in a set of data. The interquartile range - this considers the range within the central 50% of a set of data. It therefore ignores the top 25% and the bottom 25% and is less prone to distortion by extreme values. The standard deviation - this is a measure of the deviation from the mean value in a set of data.

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Confidence Interval - this is a measure of the likely accuracy of the results of a sample. With a 95% confidence interval, there is a 0.95 probability that the true average will be where the sample believes it will lie (in other words, the results of the sample will be correct 19 times out of 20). Index numbers - this is a statistical measure which is designed to make changes in a set of data (such as sales figures) easier to manage and interpret. It involves giving one item of data a value of 100 (the base period), and adjusting the other items of data in proportion to it. For example, if the sales for a particular business are 200,000 in year 1, 220,000 in year 2 and 270,000 in year 3, then index numbers can be used to help identify the trend within the data. The sales in year 1 will be given an index number of 100 (this is known as the baseyear). Year 2 has 20,000 more sales than in year 1 - this is a 10% rise, so the index number in year 2 will be 110. Year 3 has 70,000 more sales than year 1 - this is a 35% rise, so the index number in year 3 will be 135. Moving average - this is another way of identifying the trend in a set of data. It allows extreme values to be glossed over, so as to show the underlying pattern in a set of data. For example, consider the following data referring to sales over a 5 year period for a business :
Year 1 Year 2 Year 3 Year 4 Year 5 100,000 120,000 65,000 132,000 146,000

The mean value of sales over this 5 year period is found by adding all 5 values together, and dividing the resulting answer by 5 (563,000 / 5 = 112,600). However, a 3-year moving average can give a more realistic indication of the changes in the trend over the 5 years. This is calculated by adding together the first three year's data, and dividing the resulting figure by 3 (285,000 / 3 = 95,000). This process is then repeated for the next 3-year period (i.e. years 2, 3 and 4). This gives a figure of 317,000 / 3 = 105,667. The next 3-year period covers years 3, 4 and 5. This gives an answer of 343,000 / 3 = 114,333. These figures show how the trend has moved within the data over the 5 year period.

Market Strategy
Niche Marketing This involves a business selling its product(s) in small, often lucrative, segments of a market. It is the opposite strategy to mass marketing. Many small businesses can identify unsatisfied

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consumer needs in a particular segment within a large industry, and they can develop products to meet these needs. This allows the small businesses to exist in industries that are dominated by large businesses (e.g. Classic FM in the radio broadcasting industry, SAGA in the holiday industry). However, if larger rivals appear within the niche market, the smaller businesses will often find it difficult to compete effectively with these well-resourced businesses. It is also dangerous for a business to offer just one product within the market, since any larger rivals are likely to be more diversified and have a wider product portfolio. Theses larger businesses could, therefore, reduce their prices to such a low level that the small business cannot compete profitably. Nevertheless, during periods of economic growth and higher consumer spending, then niche markets can offer a very lucrative opportunity to many small businesses to offer a personalised, high value-added service/product.
Product Life-Cycle This shows the various stages that a product is expected to pass through and it also indicates the likely level of sales that can be expected at each stage.

The length of the lifecycle will vary from product to product and from industry to industry (e.g. Oxo Cubes, Levi Jeans and Kellogg's Cornflakes have lifecycles that have lasted for over 50 years, but various pop groups and childrens' toys have a lifecycle that can last less than 12 months). Generally, there are six stages to the lifecycle - development, introduction, growth, maturity, saturation and decline, as illustrated on the diagram below :

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During the development stage, much time will be spent designing and testing the product concept. A prototype will often be test-marketed, in order to assess the potential sales and profitability of the new product. A decision will then be made whether or not to launch the product. The business will, therefore, incur many expenses during the development stage of the product lifecycle and the product will produce a large, negative cashflow. It is estimated that only 1 in every 5 new products actually pass the development stage and reach the introductory stage of the lifecycle. The introduction stage commences with the launch of the product onto the market. Sales are low and costs are still very high (especially advertising and distribution). The product is, therefore, unprofitable at this stage. The length of this stage will vary considerably according to the product. Some products will take a long time to reach the growth stage of the lifecycle (e.g. new novels) whereas others will head straight from introduction into growth in a matter of days (eg new pop-music album releases). Once the business has made customers aware of the new product and it has managed to achieve a high level of repeat-purchasers, then the product will head into the growthstage of the lifecycle. This is where the product starts to become profitable. Advertising is still extensive. Competitors may launch similar products to cash-in on the successful new product. The business will try to prolong the growth stage for as long as possible, but sooner or later it will reach the maturity stage of the lifecycle. The growth in sales will start to slow down and the product will nearly reach its maximum market share. There will be several competing products on the market. The saturation stage of the lifecycle will occur where the sales of the product have reached their peak and the number of competing products will have grown significantly. It is during this stage of the lifecycle that the business may decide to use an extension strategy to prolong the lifecycle and boost sales, sales revenue and profits. The final stage of the lifecycle is where the sales of the product go into decline. This is usually an inevitable result of changing customer tastes and fashions, new technology and the loss of market share to new products introduced by competitors. Extension strategies If a business believes that a product which has reached the saturation stage of the lifecycle can still produce a higher level of sales, then it may choose to implement one or moreextension strategies to improve the product's ailing level of sales, such as :

changing the appearance and the packaging of the product; trying to find new uses for the product; trying to find new markets for the product; trying to entice customers to use the product more frequently; ltering the ingredients of the product.

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The effects of an extension strategy on a product lifecycle can be represented in the diagram below:

The purpose of the extension strategy is to delay the decline stage of the lifecycle and produce extra sales and revenue for the business.
Boston Matrix This is a method of analysing the product portfolio of a business (that is, the number and range of different products which a business produces at a particular point in time). This model was developed by a group of management consultants called the Boston Consulting Group, and it divides the products that are produced by a business into 4 categories, according to their market share and the level of market growth. The 4 categories are :

Problem Child Sometimes referred to as Question Marks or Wild Cats). This is a product which has a low market share in a high growth industry. These products have often been launched quite recently and have not had the necessary time to establish themselves in the market. They will require a significant amount of money to be spent on their promotion in order to achieve a healthy market share. They are at the 'Introduction' stage of the product life-cycle. Stars These products have a high market share in a high growth market. They are very successful products which create a large amount of revenue for the business. They still require a large amount of money to be spent on their promotion, in order to keep ahead of the rival products in the marketplace. They are at the 'Growth' stage of the product life-cycle.

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Cash Cows These products have a very high market share in a stable market (i.e. market growth is low). These products are at the 'Maturity' and 'Saturation' stages of their product life-cycle and produce a very large amount of revenue for the business. This money is often used to promote the 'Problem Child' products and to develop new products. Dogs These products have a very low market share in a low growth market. They produce very little revenue for the business and are at the 'Decline' stage of the product life-cycle. The business has to decide whether to try and extend the life-cycle and boost sales revenue, or whether to delete the product from the portfolio. These different categories can be represented in a Boston Matrix, as illustrated below:

As you can see from the above diagram, this business has five products in its portfolio. The size of each circle is proportional to the amount of revenue which each product generates. Some important points to note from the diagram : Product 1 is a 'Dog' and is clearly in decline - the business would be advised to delete this product from its portfolio. Product 2 is a 'Cash Cow' and produces large amounts of revenue to fund new product development as well as to fund 'Problem Child' products (such as Product 3). Product 4 is a 'Star' and is generating a high level of sales, but is probably likely to face strong competition in the near-future. It will, therefore, require much money to be spent on its advertising and promotion, in order to protect its sales from rival brands.

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Product 5 is another 'Dog', but it clearly still produces a reasonable level of sales revenue. The business may decide to use an extension strategy to prolong the life-cycle of the product and to boost its sales level. Otherwise product 5 may well go into terminal decline like product 1.
Asset-Led Marketing This refers to the situation where a business develops its strategy based upon its existing strengths and assets. This involves the business focussing on what it currently performs effectively, and then using this as the base for developing new products or breaking into new markets.

For example, many chocolate manufacturers (such as Cadbury, Nestle and Mars) have built on the tremendous success of their confectionery products to break into the ice-cream market (e.g. brands such as Crunchie, Starburst and Rolo have become high sales-volume ice-cream lines, as well as maintaining their high sales levels for the confectionery lines). Niche marketing capitalises on the consumer loyalty that a business has, and helps it to develop new products and devise new marketing strategies.
Adding value This refers to the amount of money which is added on to the raw material cost in order to arrive at the retail price for a product.

For example, the raw materials needed to manufacture a car might include steel, plastic, rubber, aluminium, glass, electronics, etc. These may total 6,000 for a particular car, which retails to customers for 19,000. The difference of 13,000 is added value. It represents what the customer is actually prepared to pay for the final product. This 13,000 is not the profit that the manufacturer receives from selling the car, since part of it will be used to pay for wages and factory costs - so the profit will be less than the 13,000. Some products have a very high added value figure (e.g. McDonalds 'Big Mac', Sunny Delight, and Manchester United football kits. The customer is prepared to pay a price which is several hundred percent higher than the cost of the raw materials. This could be due to the speed of service, the quality of the image / brand, the taste, the design, the advertising or the quality of the finished product.
Marketing Model This is a framework for making marketing decisions in a scientific manner. It is derived from Frederick Taylor's method of decision-making. The model has five stages:

Stage 1 - Set the marketing objective (normally based on the company's objectives). For example, if the company's main objective is growth, then a marketing objective may be to increase the number of markets in which it sells its products.

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Stage 2 - Gather the data that will be needed to help make the decision. This will involve the extensive use of market research to gather qualitative and quantitative data concerning the market size, the market growth, customers' perceptions of the company and its products, the competitors, etc. Stage 3 - Form hypotheses, (theories and strategies about how best to achieve the objective). For example, a medium-sized UK manufacturer of shoes may start selling products in the lucrative North American market, or it may decide to concentrate on new segments of the UK market (e.g. sports-shoes). Stage 4 - Test the hypotheses. Each hypothesis will be analysed to see its potential profitability and the likelihood of success. This will be carried out through further market research, possibly by test marketing a product in a small geographic area in order to assess its potential for success. Stage 5 - Control and review the whole process. This involves implementing one of the hypotheses, via the marketing mix, and looking at its outcome (ie did it meet the objective? could it have been improved?). This will help the business to set future strategies and plans which will be achievable and realistic.

Exam-Style Questions
1. a) Why do well established companies, such as Coca Cola and McDonalds advertise? b) Briefly outline a media mix which might be suitable as part of the promotion policy for a school or college (Marks available: 10) Answer outline and marking scheme for question: 1 Give yourself marks for mentioning any of the points below: a) Coca Cola and McDonalds advertise in order to retain brand loyalty and re-buy, maintain market share, update the brand image in order to attract young customers. (5 marks) b) The media mix is the combination of media for publicity purposes. Schools and colleges may use local press, cinema and local radio advertising, their own publications, open evenings, feeder school visits, internet. Local and national TV is expensive and reaches too wide an audience. (5 marks) (Marks available: 10)

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2. a) Why do marketing managers use the official socio-economic classification of the population i.e. A,B,C1,C2,D and E. (5 marks) b) Two new socio-economic groupings have been identified which make up 15 per cent of UK households. They are defined as: 'Silkies are single ladies on high income defined as 25,000 a year or more with kids up to 15 years old. They are classically time-poor, money rich, and have an expensive lifestyle with childcare and associated costs. Slinkies are also on high income. There are no kids. Slinkies are clever, ambitious and status conscious.' (Source: Financial Times) How might such new groupings affect marketing strategy? (5 marks) (Marks available: 10) Answer outline and marking scheme for question: 2 a) To enable segmentation of the market, so that the marketing is more effective in that marketing is targeted at a specific audience. (5 marks) b) New groupings means that the marketing strategy of price, product place and promotion will have to be changed to meet the changing market. (5 marks) (Marks available: 10)

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Marketing Planning Marketing Budget


The marketing budget is a plan for the forthcoming year for the marketing department, outlining what it hopes to achieve in terms of sales volume, sales revenue, expenditure and profit. It will often outline the month-by-month targets for the department and show the departmental personnel the objectives that they need to achieve over the next 12 months. The marketing department must ensure that it sets a budget based on the overall objectives of the business, as well as taking into account any expected changes in the external environment (e.g. if there is expected to be an economic downturn, then this needs to be translated into the sales and revenue targets for the next 12 months). There are several ways that a business may set its marketing budget:

Based on the amount of finance available. The amount of money and finance that is available for the whole business will clearly affect the amount of planned expenditure within each department. The biggest source of expenditure within the marketing department is often the promotional campaigns. Based on previous years' budgets. Some businesses will set the forthcoming year's marketing budget based on last year's figures, including a small percentage change in each category. Based on the budgets of competitors. In very competitive industries (such as supermarkets) the amount spent on advertising and other promotional campaigns may be in relation to that spent by your main rivals. Based on the sales levels from previous years. It may be the case that a business will use a set percentage of last year's sales revenue figure for its budgetary expenditure figure for the forthcoming year. Based on the expected size of the product portfolio this year. If a business is planning to expand its product portfolio this forthcoming year, then the marketing expenditure budget will probably need to be set at a significantly higher level to reflect the extra money spent on the launch and advertising of the new products.

Any differences between the budgeted figures and the actual outcomes are known as avariance. Positive (i.e. favourable) variances occur where the actual amount of money flowing into the business is more than the budgeted figure, or where the actual amount of money flowing out of the business is less than the budgeted figure. Negative (i.e. unfavourable) variances occur where the actual amount of money flowing into the business is less than the budgeted figure, or where the actual amount of money flowing out of the business is more than the budgeted figure.

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Marketing Mix
Product Products can generally be classified under two headings - consumer products andproducer products...

Consumer products Purchased and used by individuals / citizens for use within their homes and these products fall into 3 categories:

Convenience products. Fast-moving consumer goods (f.m.c.gs) sold in supermarkets, such as soap, chocolate, bread, toilet paper, etc. These often carry a low profit-margin. Shopping products. These are durable products which are only purchased occasionally, such as dishwashers, televisions and furniture. They often carry a very high profit-margin. Speciality products. These are very expensive items that consumers often spend a large amount of time deliberating over, due to the large investment requires to purchase the product. Examples include cars and houses. The profit-margins are, again, very high.

Producer products Purchased by businesses and are either used in the production of other products, or in the running of the business. For example, raw materials (timber, steel), machinery, delivery vehicles, and components used to make larger products (e.g. tyres and headlights for vehicles). A product line is the term used to describe a related group of products that a business produces (e.g. a business may produce televisions, and its product line may include portable televisions, 12-inch screen models, 18-inch screen models, televisions with a built-in video facility, etc). Product mix is the term used to describe the different collection of product lines that a business produces (eg the same business may also produce video recorders, camcorders and computers, as well as televisions). Most businesses will wish to change their product portfolio over time. This can be the result of changing consumer tastes, replacing those products which have entered the 'decline' phase of the product life-cycle or to try to break into new markets or new segments within an existing product. There are generally considered to be a number of stages in the development of new products:

The generation of ideas. A number of issues need to be considered, such as will the new product meet the objectives of the business? Does the business have the spare capacity to produce the product? Will the new product contribute to the continued growth of the business? Will new personnel be required, or will the business have to re-train the existing staff? Testing the new concept. Is there a sufficient market for the new product? This stage of the product development process will involve carrying out extensive primary market research to test consumers' reactions to the suggested product. Consumers may suggest slight alterations and modifications to the suggested product in order to make it more marketable and desirable.

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Analysing the costs/revenues. What will be the costs of production? How many units will the business be able to produce? What will the selling price be set at ? What will be the profitability of the new product? Developing a prototype. The design, materials, quality and safety of the product will now become paramount. A prototype of the product will be developed using the details that the market research indicated that consumers wanted. It is essential to ensure that this stage of the development process is detailed and extensive, since to make alterations and modifications at a later date will be extremely expensive and time-consuming. Test marketing the new product. The business may often decide to test market the new product in a small geographic area, in order to test consumer response, before it launches the product nationally. If the consumer response is favourable, then the product is likely to be launched nationally. However, if the consumers indicate that some element of the marketing mix is ineffective (price, packaging, advertising, etc) then this is likely to be changed before the national launch of the product. National launch. This is where the product enters the 'Introductory' stage of its product lifecycle. This is a very costly operation, since a national launch needs to be supported by extensive advertising and promotional campaigns.

It is inevitable that many new product ideas will not get to the market place, and many of those that do succeed in being launched will fail within a few months of their commercialisation. However, the businesses which seem to be most successful in bringing new products to the market place tend to meet a number of vital criteria:

they develop 2 to 3 times the number of new products as their competitors; they get the product to the market place quickly; they compete in many different markets; they provide strong after-sales service.

Price The price level that a business decides to sell its product(s) at will affect both the quantity of sales and the profit-margin received per unit. There are many considerations that a business will need to take into account before it decides upon a selling price for a new product, such as:

The objectives of the business if the main objective of the business is to maximise profit, then it is likely that the product will be priced at a high level. The degree of competition in the industry the number of competitors in the industry will affect the price level that the business decides upon for its product(s). The channels of distribution the more intermediaries that are used in getting the product from the factory to the consumer, then the higher the selling price is likely to be. The business image if the image of the business is prestigious and up-market, then a higher price is likely to be charged for the product(s).

There are many methods and strategies that a business can use in order to arrive at a selling price for its products: Cost-plus pricing. This is where the cost of producing each unit is calculated, and then a percentage profit is added to this unit cost to arrive at the selling price.

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Mark-up pricing. This is where the business adds a profit mark-up to the direct cost for each unit in order to arrive at the selling price. This profit mark-up will need to cover the fixed overheads and then contribute towards profit. Predatory (or destroyer) pricing. This method of pricing involves a business setting its prices at such a low level that other (often smaller) competitors cannot compete profitably, and as a result they are forced out of the industry. This leaves the larger business in a dominant position, and it can then raise its prices to a much higher level in order to recoup any losses that they incurred when their prices were low. Skimming pricing. This is a pricing strategy for a new product, designed to create an upmarket, expensive image by setting the price at a very high level. It is a strategy often used for new, innovative or high-tech. products, or those which have high production costs which need recouping quickly. Penetration pricing. This is a pricing strategy for a new product, designed to undercut existing competitors and discourage potential new rivals from entering the market. The price of the product is set at a low level in order to build up a large market share and a high degree of brand loyalty. The price may be raised over time, as the product builds up a strong brandloyalty. Prestige pricing. This strategy is used where the business has a prestigious, up-market image, and it wishes to reflect this through high prices for its products (e.g. Rolls Royce). Demand-orientated pricing. This method of pricing involves setting the price of the product at a level based upon customers' perceptions of the quality and value of the product. Competition-orientated pricing. This method of pricing ignores both the costs of production and the level of customer demand. Instead it bases the price level on the prices charged by the competitors in the industry -either undercutting the competitors, charging a higher price, or charging the same price. 'Going rate' pricing is the term used to describe a business charging a similar price to competitors for a similar product.
Promotion Promotion refers to the tactics that a business uses to make consumers aware of their product(s) and to entice them to purchase the products, creating sales revenue for the business. Promotion can often be referred to as either:

'above the line' - promotional activity refers to extensive promotional campaigns on national media, such as television and newspaper advertisements.
Or,

'below the line' - promotional activities include more short-term tactics such as personal selling, sales promotions, packaging, branding and direct mail.

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Most businesses will use a combination of 'above-' and 'below the line' tactics in order to create the desired impact on consumers. Advertising Advertising is the most expensive of all the promotional activities undertaken by businesses. It can be carried out on television, at the cinema, on the radio, on posters, in newspapers, in magazines, and on the internet. Advertising can allow the business to easily reach a vast audience, to have a great impact on consumers and to reinforce other types of promotion that it is carrying out (e.g. competitions). Advertisements can generally fall into two categories:

informative advertisements - informative advertisements attempt to purely let the consumer know the availability of the product, its function and purpose and to inform the consumers about the characteristics of the product (e.g. Government information films). persuasive advertisements - persuasive advertisements attempt to get the consumers to purchase the product, by emphasising certain aspects of the marketing mix (e.g. the taste, style and moving images). Another category of advertising is 'corporate advertising', where the business advertises its name and image, rather than any of its product range.

There are several criteria that must be met in order for an advertisement to be considered'effective':

Firstly, it must reach the desired target audience (i.e. those consumers who are most likely to purchase the product- this can be discovered through market research). Secondly, the advertisements must be attractive and appealing to the target audience (this can be done through using certain images, pictures, words and personalities). Thirdly, the advertisements must create far more money through sales revenue than the business spends on the advertising campaign.

There are two bodies established by the government which monitor advertisements in the UK. The Advertising Standards Authority (A.S.A) monitors any advertisements in newspapers, magazines and posters, and ensures that they are true, decent, fair and legal'. Any complaints by consumers can lead to the advertisement being investigated and possibly banned from publication. The Independent Television Commission (I.T.C)monitors any advertisements on the radio, on television and at the cinema. Again, it has the powers to investigate any complaints about certain advertisements and ban the business from advertising in the future. Branding and packaging Branding and packaging are another common way of differentiating the product from rival products in the market place. Businesses will try to stress the distinctiveness of their products and therefore create a certain image for their products in the eyes of the consumers. A brand is simply a name for the product, often reflecting the character of the product, and businesses will try to build up brand loyalty (that is where consumers are happy with their

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purchase of a particular product, and will return to purchase it again in the future). A strong brand can enable it to be sold at a high price, resulting in a high profit-margin for the product. It can also provide a strong basis for the business to launch new products, using the reputation of its existing products to break into the market. Packaging is also important because it is another way that the consumers can distinguish between different products (eg through the colours, size, shape and logos used on the packaging). Packaging also offers protection for the product during transportation and can contain competitions and prizes to further promote the sales of the product. Loss Leaders Supermarkets often sell a few of their own brands of products at a loss- these are called'loss leaders'. The purpose behind these loss-making products is that they attract many consumers into the stores, who will consequently purchase a selection of profit-making products as well as the loss leader. Personal selling Personal selling can take the form of door-to-door selling, trade fairs, and exhibitions. These allow an opportunity for the salesman to show how the products actually work, to see the consumers' reactions to the product, and to allow the consumers to discuss the performance of the product with an employee from the business. This is otherwise known as direct marketing, since the business deals directly with the consumers, rather than through an intermediary such as a retail outlet. Direct mail Direct mail (sometimes referred to as 'junk mail') involves posting promotional literature directly to consumers' homes, which are selected from a list of known customers (e.g. 'Britannia Music Club'). It is more of a personalised way of promoting the business, but it often fails to produce a large enough sales revenue to justify its use. Telephone selling can be used as a slightly cheaper method of direct contact with potential consumers (e.g. double-glazing, insurance etc). Sales promotions Sales promotions are a short-term method of boosting sales volume and sales revenue, using such tactics as a price discount, free products, competitions, and discount coupons. They are often used to complement national advertising campaigns and can also include product endorsements by sports stars or television personalities, and may offer easy payment terms for the consumers. These have become a very popular way of boosting sales over recent years (e.g. Walkers Crisps 'Cubix' cards, McDonalds 'Who Wants To Be A Millionaire' scratchcards, etc).

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Place This refers to:


firstly to the stores and the retail outlets where consumers can purchase the products of the business, secondly to the channels of distribution that the business uses to get its products from the factory to these outlets.

The channels of distribution refer to the intermediaries that a business chooses to use to transport its product and make it available to consumers (e.g. wholesalers, distribution companies and retail outlets). Often, a manufacturer will sell its output in a large quantity to a wholesaler, who pays a low price per unit (this is known as 'bulk purchasing'). The wholesaler then breaks this large quantity into smaller batches, and sells each batch to a retailer after adding on a profit margin (this is known as 'breaking bulk'). The retailer then sells each batch of products to the consumer, after adding on a profit margin. The more intermediaries that exist in the distribution of a product from a factory to the consumer, then the higher the final price of the product, since each intermediary will add on a profit margin in return for offering their services. In order for the distribution channel for a product to be efficient, then the following criteria must be met:

It must be able to make products available to consumers quickly and cheaply. Some products, such as perishable and fragile products (fruit, glass products) need to have minimum handling and travelling time, in order to minimise the risk of damage to the products. Large and dispersed markets will require many intermediaries -these must be chosen carefully to ensure the swift transportation and availability of the products to the consumers. Heavy and bulky goods will often need a direct channel of distribution from the factory to the retail outlets.

The trend over recent years has been for businesses to eliminate many of the intermediaries in the distribution channel, and for the product(s) to be sold directly from the factory to the retail outlets, or even directly to the consumers themselves. This reduces the final price of the product that the consumer has to pay, and it also speeds up the delivery and distribution process. Retailing is a fast-changing sector of the economy and there have been many developments in this sector over the last decade, including the development of out-of-town shopping centres, the widespread use of Electronic Point Of Sale (E.P.O.S) systems, longer opening hours to fit in with busier lifestyles, and an increasing demand from consumers for many products to be sold in one outlet. These developments are enabling the larger businesses to dominate markets and hold a significant percentage of the overall market share. These retail outlets can, therefore, exercise

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more power than ever before when buying stock from factories and warehouses -enabling them to dictate the prices that they will pay for their supplies. The factory providing them with their stock and supplies will have little alternative than providing the supplies at a low price, since they cannot afford to lose such a large and important client.

Elasticity
Concept
This is the responsiveness of demand for a product to changes in one of the factors that influence demand. In other words, it measures the change in demand following a change in another variable (such as the price of the product, peoples' incomes, or the advertising of the product).

Price Elasticity of Demand


This is the responsiveness of demand for a product to a change in the price of the product itself (i.e. when the price of the product changes, by how much does demand change?). Diagram 1 represents a product which has an inelastic demand:

At a price of P1, quantity Q1 is demanded. An increase in price to P2 results in only a small fall in the quantity demanded to Q2. In other words, the percentage change in quantity demanded is far less than the percentage change in price that brought it about. Products with an inelastic demand curve include fast-moving consumer goods (f.m.c.g) such as bread and milk, and habit-forming goods such as alcohol and tobacco.

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Diagram 2 represents a product which has an elastic demand:

At a price of P1, quantity demanded is Q1. An increase in price to P2 results in a large fall in the quantity demanded to Q2. In other words, the percentage change in quantity demanded is far greater than the percentage change in price that brought it about. Products with an elastic demand curve include luxury goods such as holidays, cars, dishwashers and televisions. Diagram 3 represents a product which has a perfectly inelastic demand:

This shows that demand is completely unresponsive to changes in price. In other words, regardless of the change in price, the quantity demanded would stay at Q1.

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Diagram 4 represents a product which has a perfectly elastic demand:

In this case, there is only a demand for the good at the price P1. At any other price, there would be no demand at all. In other words, demand is completely unresponsive to changes in price. Both diagrams 3 and 4 are theoretical extremes and there are no realistic examples. The formula for calculating price elasticity of demand:

Example 1. If the price of product A rises from 8 per unit to 10 per unit, and the quantity demanded falls from 100 units to 50 units, then the price elasticity of demand for product A is:

=2 Example 2. If the price of product B falls from 10 per unit to 9 per unit, and the quantity demanded rises from 80 units to 84 units, then the price elasticity of demand for product B is:

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= 0.5

An answer of zero indicates that demand for the product is perfectly inelastic (see diagram 3). An answer of between zero and one indicates that demand for the product is inelastic (see diagram 1). An answer of one indicates that the demand for the product is unitary elastic. An answer of greater than one but less than infinity indicates that the demand for the product is elastic (see diagram 2). An answer of infinity indicates that the demand for the product is perfectly elastic (see diagram 4).

Income Elasticity of Demand


This is the responsiveness of demand for a product to a change in peoples' incomes (i.e. if a person's income changes, by how much does his / her demand for the product change?). If an increase in income leads to an increase in demand for the product, then the product is a normal product. If an increase in income leads to a fall in demand for the product, then the product is an inferior product, (e.g. supermarket own-branded products, where an increase in income will often lead to an individual buying less of an own-brand product, and more of an expensive brand). The formula for calculating income elasticity of demand:

Example 1. If a person's income rises from 200 per week to 250 per week, and his demand for product C rises from 10 units to 14 units, then the income elasticity of demand for product C is:

= 1.6 Example 2. If a person's income falls from 400 per week to 360 per week, and her demand for product D rises from 100 to 105 units, then the income elasticity of demand for product D is:

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= -0.5

A positive answer indicates that the product is a normal product. A high positive answer would suggest that the product is a luxury product. A negative answer indicates that the product is an inferior product. The larger the negative value, the more inferior it is. An answer of zero indicates that changes in income have no effect on the demand for the product (i.e. the product is completely income inelastic).

Advertising Elasticity of Demand


This is the responsiveness of demand for a product to a change in the advertising expenditure used to promote it (i.e. if a business spends more money on the advertising of a product, by how much does the demand for the product change?). The formula for calculating advertising elasticity of demand:

Example 1. If a business increased its advertising expenditure on product E from 1 million per year to 1.2 million per year, and the demand for product E rises from 10 million units to 14 million units, then the advertising elasticity of demand for product E is:

= +2

Example 2. If a business reduced its advertising expenditure on product F from 2 million per year to 1.8 million per year, and the demand for product F rises from 1 million units to 1.1 million units, then the advertising elasticity of demand for product F is:

=-1

A positive answer indicates that the advertising campaign is effective, since either an increase in advertising expenditure leads to a rise in demand for the product, or a decrease in advertising expenditure leads to a fall in demand for the product. A negative answer indicates that the advertising campaign is ineffective, since either an increase in advertising expenditure leads to a fall in demand for the product, or a decrease in advertising expenditure leads to a rise in demand for the product.

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Exam-Style Questions
1. a) Define price elasticity of demand and explain why some products are price-elastic and other products are price-inelastic. b) Outline the factors which may influence an organisation's pricing policy. (Marks available: 10) Answer outline and marking scheme for question: 1 Give yourself marks for mentioning any of the points below: a) Price elasticity of demand is the sensitivity of quantity demanded to changes in price. Price elasticity depends upon the characteristics of the product. Availability of substitutes, proportion of income spent on the good are factors which with determine the degree of price elasticity. (5 marks) b) The factors which may influence the organisations pricing policy: Whether the product is new. The competitiveness of the market. The ability to discriminate between different groups of consumers. (5 marks) (Marks available: 10) 2. a) What is meant by a random sample. b) A marketing manager's experience has been that between 10% and 20% of women purchase a new brand of cosmetics within one month of its introduction. She wishes to estimate, by sampling, the percentage of women who will purchase a particular new Brand X, within one month of its introduction. How large a random sample should be taken if she wants the estimate to be at 95% confidence level. (Marks available: 10) Answer outline and marking scheme for question: 2

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Give yourself marks for mentioning any of the points below: a) Random sample, everyone is likely to be chosen. b)

= 1600 approx. (Marks available: 10) 3. a) What is the product offered by a lottery firm such as Camelot? b) How might a lottery firm optimise its marketing mix? (Marks available: 20) Answer outline and marking scheme for question: 3 Give yourself marks for mentioning any of the points below: (a) "A lottery ticket" is the straightforward answer, but a thoughtful candidate may mention some of the characteristics associated with the product: The excitement at the possibility of winning. The pleasure of staking a small sum linked with numbers of special significance to oneself. The feeling of being party to a syndicate which buys several tickets each week. (Max 10 marks) (b) Candidates might do well to comment on the four headings of product, price, promotion and place. Camelot have done well to have a midweek draw and to have set the ticket price at 1, a sum which most people will "invest" without discomfort and to make tickets available in a multitude of shops so nobody has to go far to buy one. Camelot have been fortunate to have free publicity in the televised draw and winner notification on the news. Camelot have done well to emphasise the proportion of receipts that goes to charitable causes and the relatively low proportion that goes to administration: punters may feel they have a small chance of winning, but they are not throwing their money away.

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(Max 10 marks) (Marks available: 20)

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Budgeting, Costing and Investment Budgeting


Purpose of Budgeting A budget is simply a financial plan for the forthcoming year, that is drawn up to help a business achieve its objectives.

Budgets are often used to exert a degree of control over the costs of the business, in an attempt to achieve gains in efficiency. When a business draws up its budget, it is essentially a series of smaller budgets covering all areas of operation. The main budgets that are drawn up are :
1. A sales budget. This forecasts the number of units of each product that the business aims to sell next year, the price level that will be charged, and the corresponding amount of sales revenue that is likely to be received. 2. A production budget. This forecasts the number of units of each product that the business aims to produce over the next year. It will include the materials budget, which will indicate the raw materials that need to be purchased. 3. A staffing budget. This will specify the direct and indirect staff that are required throughout the business for the forthcoming year, in terms of the number of staff and their wages. 4. A production overhead budget. This attempts to forecast the fixed overheads that the business will incur in the forthcoming year, which can be related to production. 5. An administrative expenses budget. This forecasts a wide range of expenses for the forthcoming year (e.g. managerial salaries, office expenses, utility bills, and rent or mortgage payments). 6. A selling expenses budget. This represents the various costs associated with selling the products of the business (e.g. advertising, sales promotions and distribution).

These budgets are then consolidated into the master budget. This also includes several other forecasted documents - specifically, a profit & loss account, a balance sheet, a cash flow and a capital expenditure budget (showing the fixed assets which the business forecasts that it will purchase in the forthcoming year). It is vital that each department involves all their staff in the planning and budgeting process, firstly in order to identify their needs for the forthcoming year and secondly to act as a motivator, by making the employees feel valued by the business. It follows on from this, therefore, that each budget that a business sets must be realistic and achievable, since any which cannot be met may leave the workforce with low levels of morale and motivation. Common mistakes that many businesses make when preparing their budgets for the forthcoming year include:.
1. Repeating last year's figures.

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2. Each department ignoring the overall objectives of the business, and concentrating instead on their own goals. 3. Setting unrealistic and unachievable budgets. 4. Sticking rigidly to the budget, (i.e. forgetting the fact that it is only a plan and a guide for the next year, and consequently it can be changed accordingly).

Variance Analysis It is vital that a business regularly reviews and revises its budgets. Any discrepancies that exist between the budgeted figures (i.e. for sales, costs, etc) and the actual results are known as variances.

The business needs to investigate these variances and attempt to establish the reasons for their existence - this is known as budgetary control. Variances can be either positive or negative. Positive (i.e. favourable) variances occur where the actual amount of money flowing into the business is more than the budgeted figure, or where the actual amount of money flowing out of the business is less than the budgeted figure. This could be due to a variety of reasons, including an increase in the demand for the products of the business, a reduction in the labour costs, or competitors ceasing to trade. Negative or adverse (i.e. unfavourable) variances occur where the actual amount of money flowing into the business is less than the budgeted figure, or where the actual amount of money flowing out of the business is more than the budgeted figure. This could be due to a variety of reasons, including price discounts on the products of the business, an economic recession or a rise in labour costs. For example, consider the following data which has been extracted from the budgeted figures and the actual results for a business:
Budget 000 Sales revenue 500 Raw materials 200 Labour costs 100 Advertising 50 Delivery 20 Utility bills 15 Actual 000 605 220 110 45 20 16 Variance 000 105 F 20 A 10 A 5F 0 1A % 21 F 10 A 10 A 10 F 0 7A

The business has six budget-heads listed. It budgeted to have sales revenue of 500,000 for the year, but actually managed to sell 605,000 of products.

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This leaves a variance (the difference between the budgeted sales revenue and the actual sales revenue) of 105,000 (or 21% of the budgeted figure). This is a favourable variance (F), because it results in the business receiving more revenue than it budgeted for. The business budgeted to purchase 200,000 of raw materials. It actually spent 220,000 on raw materials. This is a variance of 20,000 (or 10% of the budgeted figure). This is an unfavourable or adverse variance (A), because it results in the business spending more money than it budgeted for. Similarly, the business budgeted to spend 100,000 on its labour costs (wages and salaries). It actually spent 110,000 on its labour costs. This is a variance of 10,000 (or 10% of the budgeted figure). Again, this is an unfavourable or adverse variance (A), because it results in the business spending more money than it budgeted for. The business budgeted to spend 50,000 on its advertising for the year, but it actually spent only 45,000. This is a favourable variance (F) of 5,000 (or 10% of the budgeted figure), since it results in the business spending less money than it budgeted for. The distribution budget was 20,000 and the actual cost of distributing the products was 20,000. Therefore there is no variance, since the actual figure was the same as the budgeted figure. The budgeted figure for the utility bills was 15,000. However, the utility bills actually cost 16,000. This is an adverse (A) variance of 1,000 (or 7% of the budgeted figure), since it results in the business spending more money than it budgeted for. When investigating and analysing the variances, it is common for managers to concentrate on the large positive and large negative variances and ignore the smaller variances. This is known as management by exception and involves the managers focussing their attention on those areas which have resulted in large overspending or underspending, and attempting to discover the reasons behind it.
Zero Budgeting This is where a budget is set to zero for a given time-period, and the manager of the particular division or department then has to justify any expenditure which they wish to make.

It is often used in an economic recession or a downturn in the industry, when money is not as readily available and the business wishes to make cutbacks in its expenditure.

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Zero budgeting helps the business to identify those departments which require large amounts of essential capital and day-to-day expenditure, as well as identifying those departments which require minimal expenditure. However, zero budgeting can result in managers spending far more of their valuable time on the budgeting process than would be the case if budgets were set more traditionally.

Costs
Fixed, Variable and Total Costs Generally speaking, a business will incur two types of cost when it produces goods and provides services to consumers:
1. Fixed costs. 2. Variable costs.

A fixed cost is one which is totally independent of the level of output, and it would be incurred even when output was zero. Examples include rent, mortgage payments, managers' salaries, and loan repayments. They are often referred to as overheads. Total fixed costs (TFC) are represented in diagram 1:

Variable costs are those which vary directly with output (i.e. as the level of output increases, then variable costs increase). Examples include raw materials, production wages, other direct production costs, and utility bills.

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Total variable costs (TVC) are represented in diagram 2:

When fixed costs are added to variable costs, then the total costs (TC) of the business can be calculated. In other words, TFC + TVC = TC. This helps the business to calculate its total costs at any given level of output. Total costs are represented in diagram 3:

Note that TC starts at the same point as TFC.


Average costs Average fixed costs (AFC) are calculated by dividing total fixed costs by the level of output.

In other words:

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Average fixed costs are represented in diagram 4:

It is clear to see that average fixed costs decline continuously - this is because the total fixed costs remain constant and they are, therefore, spread over a larger and larger amount of output. Thus, the average fixed cost (the fixed cost per unit) will decline. Average variable costs (AVC) are calculated by dividing total variable costs by the level of output. In other words:

Average variable costs are represented in diagram 5:

It is clear to see that average variable costs will start to decline over time. This is because the business becomes more efficient at producing its output, and it can produce each unit for less - hence AVC will decline. However, the business is likely to reach a level of output where it

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becomes less efficient at producing its output and its average variable costs (the variable cost per unit) will start to rise again. Average costs (AC) are calculated by dividing total costs by the level of output. In other words:

Average costs are represented in diagram 6:

It is clear to see that average costs will also start to decline over time. When this occurs in the long-run, then the business is said to have achieved economies of scale. However, the business is likely to reach a level of output where average costs (the cost per unit) will start to rise again. In these circumstances, the business is said to be experiencing diseconomies of scale. When average fixed costs are added to average variable costs, then the average total costs (AC) of the business can be calculated. In other words: AFC + AVC = AC This helps the business to calculate its average cost at any given level of output.
Contribution Analysis Contribution is one of the most important concepts in A-level Business Studies. Contribution is the term given to the amount of money that remains after all direct and variable costs have been deducted from the sales revenue of the business.

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It is called 'contribution' because it represents the amount of money which is available to contribute towards covering the fixed costs of the business and, once these are covered, it represents the amount of money which will contribute towards the profit of the business. In other words, contribution - fixed costs = profit.

Contribution can be analysed in two ways:


1. Contribution per unit sold Contribution per unit sold = Sales price per unit - Variable costs per unit. For example, if a product has a selling price of 10, and its variable costs (labour, raw materials, etc) is 3 per unit, then it has a contribution of 7 per unit. If a product is loss-making, but it nevertheless makes a contribution towards covering the fixed costs of a business, then it would be unwise to delete the product from the product portfolio. This is because the total profit of the business will actually decrease if the contribution from the loss-making product is no longer received. Therefore it is vital that a loss-making product is not deleted simply because it fails to produce a profit - if it produces a contribution towards fixed costs, then it is still worthwhile to produce it. 2. Total contribution Total contribution = Total sales revenue - Total direct and variable costs. For example, if a business has total sales revenue of 4 million, and its total variable and direct costs are 2.5 million, then the total contribution for the business is 1.5 million. This contribution will hopefully cover the fixed costs and then contribute towards profit.
Break-Even Charts This is a graph showing the total revenue and the total costs of a business at various levels of output. It is a form of Management Accounting and it enables a manager to see the expected profit or loss that a product will face at different levels of output.

The break-even point is the point on a break-even chart where the total revenue (T.R) of a business (or product) is equal to its total cost (T.C). It can also be calculated mathematically by using the following formula:

For example: A business produces just one product, which it sells for 9 per unit. The variable cost of each unit is 4 and the business faces fixed costs per year of 1 million.

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The business currently produces and sells 500,000 units. What is the break-even level of output and what profit will the business make if it sells all of its output? In order to assist the drawing of the break-even chart, we can calculate the break-even level of output and the amount of profit using simple formulae:

In other words, the business will need to produce 200,000 units before it breaks-even. Any level of output below 200,000 will yield a loss. Any level of output above 200,000 will yield a profit. The profit is equal to total revenue minus total cost (or profit = TR - TC). Total revenue (TR) is calculated by multiplying the selling price by the number of units sold. In this example, the selling price is 9 and the number of units sold is 500,000. Therefore the total revenue (TR) is 9 x 500,000 = 4.5 million. The total cost (TC) is calculated by adding together the total fixed costs (TFC) to the total variable costs (TVC). In this example, the fixed costs are 1 million and the total variable costs are 4 x 500,000 units = 2 million. Therefore the total cost (TC) is 3 million. The profit is, therefore, TR - TC, which gives us: 4.5 million - 3million = 1.5million. We can now draw a break-even chart and check the figures on the chart with the answers above. In order to have an accurate break-even chart, three lines must be plotted: Total Fixed Costs (TFC), Total Costs (TC)

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Total Revenue (TR). The x-axis is labelled as 'Output' (in units). In this example, the axis will go up to 500,000 units. The y-axis is labelled as 'Costs, Revenue and Profit' (in ). In this example, the axis will go up to 4.5 million.

As you can see, the answers on the chart correlate with the answers calculated using the two formulae above. The break-even point (shown as a red dot) is the point where the TC and the TR lines cross. This is then measured by dropping a vertical red line down to the x-axis, to give 200,000 units. The profit at 500,000 units is then calculated by taking a red vertical line up from the 500,000 unit mark to where it hits the TC line. This is then measured across to the y-axis (again using a red line) to give us total costs of 3 million. The vertical red- line from the 500,000 unit mark is then extended to where it hits the TR line. Again, this is then measured across to the y-axis to give us a total revenue of 4.5 million. Therefore, the profit is the difference between TR and TC (i.e. 1.5 million). Although break-even analysis is a very useful tool, it does have several drawbacks:
1. It assumes that the TFC, the TC and the TR functions are linear. In reality, this is very unlikely. 2. It assumes that the selling price is constant, in reality the selling price is likely to vary from customer to customer and region to region. 3. It assumes that the business only produces one product.

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4. It assumes that the business can sell all of its output. In reality, very few businesses will be able to do this and some will remain as unsold stock.

The data used to construct the break-even chart may well be out-of-date and therefore inaccurate.
Cost Centres and Profit Centres A cost centre is an area of a business where costs stem from and can easily be recorded (i.e. a department or a person where costs can be identified as being incurred). These costs include wages and salaries, raw materials and capital expenditure (e.g. machinery).

Cost centres are used for several reasons:


1. Allowing the business to see which departments and people are spending the most money. 2. To see if the departments and people are generating enough benefits for the business with the money that they spend.

Direct costs (i.e. those costs which are incurred directly as a result of production) are easy to allocate to cost centres, but indirect costs (e.g. rent, rates, loan repayments, etc) are far more difficult to allocate to a specific cost centre. A profit centre is an area of a business where revenue can be identified as being earned, (and, hopefully, profit will be made). Profit centres generally include different product lines and retail outlets, and they are frequently used by businesses which are large and diversified. They allow a business to see which parts of the business and which products generate the most revenue. The main reasons for using cost-centres include: 1. Loss-making departments of the business and loss-making products can be easily identified. 2. Each profit centre can be viewed as operating independently and this can lead to higher levels of motivation amongst the staff in each profit centre. Overall, the use of cost centres and profit centres allows a business to exercise a degree of financial control over its operations, and to monitor the efficiency and profitability of its various departments and product-lines.

Investment Appraisal
Purpose All businesses require capital equipment (fixed assets) such as machinery, premises and vehicles. The purchase of such assets is known as capital investment and is undertaken for the following reasons:

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1. To replace existing equipment which is out-of-date or obsolete 2. To expand the productive capacity of the business 3. To reduce the production costs per unit (i.e. to achieve economies of scale) 4. To produce new products and, therefore, break into new markets Capital investment, like all other business activities, involves an element of uncertainty, because expenditure is incurred today in order to produce some benefit in the future. Investment appraisal techniques are designed to aid decision-making regarding such investment projects. There are 3 methods which can be used to appraise any investment project: 1. The Payback method 2. The Average Rate of Return (A.R.R) method 3. The Net Present Value (N.P.V) method.
Payback Method This is the simplest method of investment appraisal and is usually preferred by small businesses because of its simplicity. Larger businesses may use it as a screening process before embarking on one of the more complicated techniques.

The payback period is the time taken for the equipment, (machinery etc.), to generate sufficient net cash flow to pay for itself. For example: A manufacturing firm is considering investing 500,000 in new machinery. The equipment is expected increase the firm's cashflow by 150,000 per year. How long is the payback period ? After 1 year, the cashflow will be 150,000. After 2 years, the cashflow will be 300,000. After 3 years, the cashflow will be 450,000. The firm will need 50,000 (or one third) of the cashflow from year 4 in order to reach the payback point. Therefore, the payback period is 3 1/3 years (or 3 years, 4 months). Firms can use this technique in one of two ways:

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Firstly, a firm could set an upper limit on the time allowed for payback, and any project which is not expected to payback within this period is rejected. Secondly, when faced with a choice of projects, the payback method can be used to rank projects according to the speed at which they payback.

However, the payback method ignores the following two important factors: 1. The total return on the investment project (i.e. the earnings after payback). 2. The timing of the return prior to payback. The payback method clearly discriminates against projects which produce a slow but substantial return, resulting in the danger that highly profitable projects will be rejected because of the delay in producing a return (yield). Example: Each of the three alternative projects below involve an initial cost of 1 million, and produce net cash flow as shown:
PROJECT A B C YEAR 1 0m 0.5m 0m YEAR 2 0.5m 0.5m 0m YEAR 3 0.5m 0.5m 0.5m YEAR 4 0.5m 0m 1m YEAR 5 0.5m 0m 1m

Project A pays back in 3 years ( 0 in year 1 + 0.5m in year 2 + 0.5m in year 3). Project B pays back in 2 years ( 0.5m in year 1 + 0.5m in year 2). Project C pays back in 3 1/2 years ( 0 in year 1 + 0 in year 2 + 0.5m in year 3 + half of the 1m in year 4). Using 'The Pay-back Method' to decide between these projects, project B would be selected. But if you looked at the total revenue over the full life of each project, project C actually brings more cash into the business and would be the better project to select.
Average Rate of Return (A.R.R.) Method This method takes the total return (yield) over the whole life of the asset into account and therefore overcomes one of the defects of the payback method.

In order to understand the arithmetic, consider an item of capital (e.g. a machine) which will cost 1 million to purchase, is expected to last 5 years, and will produce an annual net cash flow of 0.5 million. The total return (yield) is: 5 x 0.5 million = 2.5 million

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If we now deduct the initial cost of investment ( 1 million) we are left with a total return (yield), net of the initial capital outlay, of 1.5 million. Annually, this works out at:

When we express this annual figure as a percentage of the original capital outlay we get the Average Rate of Return for the project:

To recap, the 4 steps for calculating the A.R.R. are: 1. Add up the total forecasted net cash flow 2. Deduct the capital outlay from this 3. Divide the resulting figure by the expected life (in years) of the capital 4. Express this annual figure as a percentage of the capital outlay As with the Payback method, we can use the A.R.R. in two ways. Firstly, the firm might set a predetermined level and reject any project which has an expected A.R.R. less than this percentage. Secondly, when faced with a choice of alternative projects, then the projects can be ranked by their A.R.R. Further examples. A firm is considering three alternative investment projects. The maximum life of each asset is three years and the capital outlay is 100,000 in each case.The table below depicts net cash flow in each of the three years:
PROJECT YEAR 1 YEAR 2 YEAR 3 A 50,000 50,000 50,000 B 100,000 20,000 0 C 0 50,000 140,000

Project A: Total forecasted net cash flow = 150,000 Total forecasted net cash flow - capital outlay = 50,000

16,666.67 (this is the amount of profit per year)

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16.67%. Project B: Total forecasted net cash flow = 120,000 Total forecasted net cash flow - capital outlay = 20,000

6,666.67 (this is the amount of profit per year)

6.67% Project C: Total forecasted net cash flow = 190,000 Total forecasted net cash flow - capital outlay = 90,000

30,000 (this is the amount of profit per year)

30% The great defect of the A.R.R. method of investment appraisal is that it attaches no importance to the timing of the inflows of cash. A.R.R treats all money as of equal value, irrespective of when it is received. Hence, a project may be favoured even though it only produces a return over a long period of time. The more sophisticated methods of investment appraisal take the timing of the cash inflows into account, as well as the size of the inflows. A sum of money in one year's time is worth less than that same sum of money now (i.e. inflation will erode the real value of that sum of money over the year). This is where the notion of present value is used.
Net Present Value (N.P.V.) Method The return on an investment comes in the form of a stream of earnings in the future. The N.P.V. method of investment appraisal takes into account the size of the cash inflows over the

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life of the equipment, but also makes adjustment for the timing of the money. A greater weighting (or importance) is given to the inflows of cash in the earlier years. The weighting can be calculated from the following formula:

A = the actual sum of money concerned r = the rate of discount (called the 'Discount factor') n = the number of years This enables us to calculate the present value of money, net of operating costs, to be received in a certain number of years. Hence, 1000 in two years time, at a 3% rate of discount, has a present value of:

In examinations you will usually be given the discount factor, so that you do not have to work it out! The present value of each year's cash inflow are then aggregated (this is called thediscounted cashflow, or D.C.F) and this figure is compared with the initial capital outlay. If the sum of present values (minus the capital cost) is positive, then it is worthwhile proceeding with the project. If the resulting figure is negative, then the project should not be undertaken. Example: In appraising a 300,000 investment project, a firm uses a discount rate of 5%. The equipment will produce a cash inflow (net of operating costs) of 75,000 per year, over a five year period. At the end of the five years, the firm expects to sell the equipment for 10,000. What is the Net Present Value of the project?
Year 0 1 2 3 4 5 cashflow - 300,000 + 75,000 + 75,000 + 75,000 + 75,000 + 85,000 Present Value - 300,000 + 71,428.57 + 68,027.21 + 64,787.82 + 61,702.69 + 66,599.72

Year 0 is the present day (i.e. when the initial capital outlay is spent). The cashflow of 75,000 in year 1 has a present value of:

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71,428.57 The cashflow of 75,000 in year 2 has a present value of:

68,027.21 The process continues for the remaining years. The discounted cashflow is the sum of the present values for the 5 cash inflows (i.e. from year 1 to year 5). This figure is 332,546.01 The net present value is found by deducting the initial capital outlay from the discounted cashflow. In other words: 332,546.01 - 300,000 = 32,546.01 Since this result is positive, then it is advisable for the firm to go ahead with the investment project. If the result had been negative, then the investment project should not be undertaken.
Other Influencing Factors There are many other factors that a business will need to take into consideration when appraising an investment project, other than the financial (quantitative) factors.

Qualitative factors such as the objectives of the business must be considered at all times, as well as the effect upon the employees of new machinery, new working practices and changes to their working conditions. The external environment needs to be considered before any decision can be taken regarding a proposed investment project. These factors include the state of the economy (e.g. it may be dangerous to attempt to expand during a recession, because demand for products may be falling), pressure group activity, the level of technological progress in the industry (e.g. competitors may already be using the new machinery), and any legislation (e.g. restricting the use of certain materials, components). The effects of the actions of the business on the environment must also be taken into consideration, since any external costs (e.g. pollution) will have a detrimental effect on the image and reputation of the business.

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Finally, as with any investment decision, the business will also need to consider the amount of finance that is available for expansion, and the effect that any borrowing to raise extra finance will have on the gearing ratio.

Exam-Style Questions
1. a) What is meant by Net Present Value in relation to investment appraisal? b) The following are net cashflows from three projects, A, B and C, which have an initial investment of 40,000:

Using investment appraisal methods with which you are familiar, state which of the projects above you would recommend. Give reason for your answer. (Marks available: 10) Answer outline and marking scheme for question: 1 Give yourself marks for mentioning any of the points below: a) Net present value is the present value of future income from an investment project, less the cost. (5 marks) b) Payback method. B is fastest. Return on investment. A is best. NPV. B is best B is the best choice. (5 marks) (Marks available: 10)

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Company Accounts Balance Sheets


A balance sheet is a statement of a firm's assets, liabilities and owners' equity at a specific date (i.e. it is a "snapshot" of the financial strength of a business at a particular moment in time). It summarises the financial state of the business at that date. When added together, the liabilities and owners' equity represent the sources of capital (i.e. it tells us where the money came from) and the assets represent the uses of the capital (i.e. it tells us how the money was spent). The two sides of the account must always balance, since every penny raised as capital must have been used for some purpose and must be accounted for.
Assets An asset is an item that will give present or future monetary benefits to a business as a result of economic events. Therefore, an asset is basically an item or money that the business owns.

There are two main types of classification of assets - fixed assets and current assets. a) A fixed asset b) A current asset
Fixed Assets A fixed asset is acquired for the purpose of use in the business and is likely to be used by the business for a considerable period of time (more than 12 months).

There are three categories of fixed assets: a) Tangible fixed assets (physical items such as land, buildings, machinery, and vehicles, the purchase of which is known as 'capital expenditure'). b) Intangible fixed assets (non-physical items, which are very difficult to place a value on, such as brand names, goodwill and patents). c) Financial fixed assets (investments that the business has, such as shares and debentures in other companies).
Current Assets A current asset is either part of the operating cycle of the enterprise or is likely to be realised in the form of cash within 12 months.

There are five categories of current assets:

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a) Cash in the bank. b) Cash on the premises ("petty cash"). c) Debtors (customers who have purchased goods on credit, and have not yet paid). d) Stock (raw materials, work-in-progress and unsold finished goods). e) Prepayments (where the business has paid in advance for the use of an item, rent for example).
Liabilities A liability is the amount outstanding at the balance sheet date, which the business is under obligation to pay. Therefore, a liability is basically an item or money that the business owes to a third party.

There are two main types of classification of liabilities: a) long-term liabilities b) current liabilities
Long-term liabilities A long-term liability is a source of long-term borrowing and will exist on the balance sheet for more than 12 months. There are three categories of long-term liability:

a) Bank loans. b) Mortgages (essentially a long-term loan to purchase land and buildings). c) Debentures.
Current Liabilities A current liability can be simply defined as amounts of money owing to third parties which will be settled within 12 months. They arise mainly through the process of day-to-day trading and there are five categories.

a) Bank overdraft. b) Creditors (suppliers who the business has not yet paid). c) Accruals (debts for which a bill has not yet been received). d) Corporation tax (owed to the Government). e) Dividends payable.

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Shareholders funds There are several other items that appear on a Balance Sheet - most notably shareholders' funds (also called 'owners equity') and reserves.

These items show us where the business got its original capital from (i.e. the money it used to start-up), how much money the shareholders have a claim on within the business and what the business has done with any retained profits over the years. It also shows us the effect of a rise in value (an appreciation) of any of the assets owned by the business. In a sense, owners' equity is a liability of the business, in as much as it is a claim on the assets. However, it differs from other liabilities in that it does not have a definite date by which it is to be repaid and it is not a fixed amount. The owners' equity is usually left in the business as long as it is required and it can fluctuate in value. Owners' equity is a residual claim on the business after all the other liabilities have been settled. Using simple algebra, we can see that:
If Assets = liabilities + owners' equity

Then Owners' equity = assets - liabilities

Therefore, the owners of the business own the assets of the business less what the business owes to other bodies.
Balance sheet format The usual layout for a balance sheet is as below:

Balance Sheet for 'My company PLC', as at 01/04/00


Fixed Assets Current Assets: Cash Debtors Stock Total Current Assets Less Current Liabilities: Overdraft Creditors Total Current Liabilities Net Current Assets [=Working Capital] Net Assets [=Assets Employed] (000) (000) 500 100 150 50 300 20 140 160 140 [300-160] 640 [500+140]

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Represented by: Long-Term Liabilities 200 Share Capital 250 Reserves 190 Capital Employed 640 [200 + 250 + 190]

ASSETS EMPLOYED = CAPITAL EMPLOYED: the two parts MUST always balance. Remember, a balance sheet shows what a company owns (assets), what it owes (liabilities) and where the company got its money (capital) from at a specific point in time. One of the most important parts of a balance sheet is the 'net current assets' section. This is the day-to-day finance that is needed for running a business. It is also referred to as 'working capital' and it is calculated by deducting current liabilities from current assets. Working capital is used to pay for expenses such as wages, raw materials and utility bills. If a business does not have sufficient working capital then it can face problems when paying its short-term debts (current liabilities). It may be the case that the business suffers a liquidity crisis and has to sell off some fixed assets, for example, in order to raise the necessary cash to meet its debts. It is vital, therefore, that close control is kept over working capital, and the business must ensure that it does all that it can to keep enough cash available to pay its current liabilities. On the other hand, if the business has too much cash tied-up in working capital, then it can be argued that this cash is not being used productively to help the business grow and diversify into new products and markets.
The purpose of a Balance Sheet The purpose of a Balance Sheet is to communicate information about the financial position of the business at a particular moment in time. It summarises information contained in the accounting records in a clear and understandable form.

It can give an indication of the financial strength of the business and can also indicate the relative liquidity of the assets. It also gives some information on the liabilities of the business and when they will fall due. The combination of this information can assist the user in evaluating the financial position of the business. It should be remembered, however, that the Balance Sheet is only one part of the financial statements required to give an accurate appraisal of the financial position of a business, and as such the importance of just one of these statements should not be over-emphasised.

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It is only by collectively analysing the Balance Sheet, the Profit & Loss account and the Cash Flow Forecast of a business that an overall impression can be gathered on the financial strength of the business.

Depreciation
The lives of fixed assets are not limited to a single accounting period (i.e. to 12 months). Depreciation represents the fall in the value of these fixed assets, either due to their use, due to time, or due to obsolescence. Essentially, depreciation divides up the historic cost of a fixed asset over the number of expected years that it will be used by the business.
Straight-line depreciation The most common method of depreciation is the straight-line method -this method of depreciating a fixed asset charges an equal amount to each year of its expected useful life.

The formula for its calculation is: The depreciation charge per year

Example: If a new machine is purchased by a business for 100,000 and it is expected to have a useful life of 5 years, at the end of which it will be sold for a scrap value (residual value) of 10,000, then what is the depreciation charge per year? The depreciation charge per year

=18,000 This means that after 1 year, the fixed asset will have a net book value (historic cost minus depreciation) of 82,000. After 2 years, the net book value will be 64,000. After 3 years, it will be 46,000. After 4 years, it will be 28,000.

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At the end of year 5, it will have a value of 10,000 (this is the same value as the residual or scrap value). The depreciation charge per year will be entered in the profit and loss account of the business as an expense, since it represents that part of the cost of the fixed asset that has been usedup (i.e. expired).

Profit and Loss Account


The profit and loss account is a financial statement which represents the revenue that the business has received over a given period of time, and the corresponding expenses which have been paid. It also shows the profit that the business has made over a period of time (usually 12 months) and the uses to which the profits have been put.
Revenue Revenue is the inflow of money to the business in the course of the ordinary activities of the enterprise.

There are a number of different sources of revenue;


cash sales credit sales (i.e. where the business has sold goods to customers, but has not yet received the cash) interest royalties dividends that the business receives on its investments or fees for hiring-out the resources of the business to a third party.

Revenue is recognised at either the receipt of the cash OR at the point of sale (if the goods are sold on credit).
Expenses Expenses are expired costs (i.e. costs from which all benefits have been extracted during an accounting period). Examples include wages, raw materials, and utility bills -often known as revenue expenditure.

It must be remembered that expenses are not necessarily the same as costs. For example, if a business purchases a new fixed asset (such as a machine) then it will clearly incur the monetary cost of purchasing the machine (say 50,000). However, this 50,000 will not be written-off as an expense, since the benefits from the machine will last for more than a single accounting period (i.e. for more than 12 months). Instead of writing-off the total cost of the machine, a portion of the 50,000 will be written-off

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as an expense each year over the useful life of the machine -this is known as a 'depreciation charge'.
Format of the Profit and Loss account The usual layout for a profit and loss account is as below:

Profit & Loss Account (01/04/99 - 31/03/00)


000 Sales Revenue Cost of Sales: Materials Direct labour Production overheads Gross profit Less selling expenses Less administrative expenses Trading [Operating] Profit Add non-operating income Profit before interest and tax Less interest expense Profit before tax [Net Profit] Less taxation Profit after tax Less dividends Retained Profit 000 1,000

300 200 100 (600) 400 100 120 (220) 180 (10) 190 (30) 160 (60) 100 (20) 80

The first line gives the Sales Revenue for the business from selling its goods and services. From this, we deduct the "Cost of goods sold" (costs directly associated with the production of the goods and services - such as the cost of the raw materials, the labour charges associated with the production, and the production overheads. These are sometimes referred to as direct materials, direct labour and direct overheads). Sales revenue less C.o.G.S. is known as Gross profit. However, we have not yet accounted for selling and administrative expenses (such as advertising costs, distribution costs, salaries, utility bills, etc.). When these are deducted from the Gross Profit, the result is known as trading or operating profit. These refer to the profit made from normal trading activities. The next adjustment is to add on any income from other activities, known as non-operating income (e.g. renting out premises). The resulting figure is known as profit before interest and tax .

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We then deduct a figure for interest charges. The resulting figure is known as profit before tax or net profit. The final part of the account is known as the appropriation account. It provides information on the way in which the profit is dispersed. Some is taken in corporation tax and goes to the Inland Revenue, some is drawn from the business as dividends to be distributed to the shareholders and the remainder isretained within the business for re-investment.
Window Dressing This is a form of creative accounting and it basically involves manipulating various figures in the financial accounts of a business, so to flatter its financial position.

There are two key variables that a business may like its shareholders (and other stakeholders) to believe are stronger than they really are:

liquidity (the ease with which a business can raise cash quickly) profitability.

If a business is experiencing a deteriorating liquidity situation, then it can temporarily improve this figure either by selling off fixed assets, or by using a 'sale and leaseback' scheme. This involves a business selling a fixed asset (often land and buildings) to a third party, and then paying a sum of money per year to lease it back. The business still retains the use of the asset, but no longer owns it. The cash from the sale of the asset will improve the liquidity of the business, and it will imply to the readers of the accounts that cash is readily available. However, there are two drawbacks to this:
1. The 'fixed asset' figure on the balance sheet will have fallen after the sale of the land and building. 2. The business is not tackling the cause of the liquidity problem.

Profitability can be improved by bringing some of the revenue for the next financial year's confirmed orders into the current financial year. This artificially boosts the 'sales revenue' figure for the current financial year and, therefore, also boosts the profit figure for the business. Again, however, there are two drawbacks:
1. The business will not be able to count the money again for the next financial year when the orders are dispatched -therefore the profit figure for the following year will be depleted of this revenue. 2. The business is not tackling the cause of the low profit figure.

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Cash Flow
Cash Flows Cash is the most liquid of all the assets of a business -it represents the bank balance and the cash that the business has available on the premises (otherwise known as 'petty cash').

Cash flow refers to the difference between the cash flowing into the business (e.g. through sales revenue) and the cash flowing out of the business (e.g. bills and wages).
Cashflow problems Having a positive cash flow is vital for the survival of a business, since without the ability to pay workers and suppliers then the business will soon have to cease trading.

This potential problem is compounded by the fact that businesses often have to pay many expenses several weeks or even months before any cash actually flows into the business. For example, wages and salaries will have to be paid to employees, suppliers will have to be paid for any raw materials, and the rent or mortgage payments will have to be paid before the products can be manufactured and sold to customers. Further to this point, if the products are sold on credit to customers, then the time delay between the cash outflows and the cash inflows will be even longer. The major causes of cash flow crises for a business are:
1. Overtrading -where the business attempts to expand too rapidly, without a sufficient financial base. 2. Having too much money invested in stocks. 3. Allowing too much credit to their customers. 4. Unexpected changes in demand for their products. 5. Overborrowing -therefore having large monthly loan repayments, which have to be met.

There are many actions that a business can take when it is experiencing a liquidity crisis:
1. 2. 3. 4. 5. Offering price discounts to boost sales and sales revenue. Selling off fixed assets. A 'sale and lease back' arrangement. Chasing debtors for the monies owed to the business. Selling off stocks.

Whatever action is decided upon, the business must ensure that it is implemented quickly and that a careful eye is kept on the liquidity (cash flow) position in the future.
Cashflow statement A cash flow statement is a Financial Accounting document, which shows the cash inflows and the cash outflows for a business over the past 12 months.

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It indicates those months in which the business suffered a cash flow crisis (where cash outflows were greater than cash inflows) and it will also highlight those months in which the business was cash-rich (i.e. more cash inflows than cash outflows). It allows a business to prepare a cash flow forecast for the forthcoming year, by basing the estimated cash inflows and outflows on the results from the previous year.
Cashflow forecast A cash flow forecast is a Management Accounting document, which outlines the forecasted future cash inflows (from sales) and the outflows (raw materials, wages, etc) per month for a business over an accounting period.

Example:
Total Jan Feb Mar Apr Sales revenue Other revenue Total cash inflows Total cash outflows 2850 650 3500 3400 900 850 750 350 200 200 100 150 1100 1050 850 500 700 950 1200 550 400 100 (350) (50) 600 700 350 300

Net monthly cash flow 100 Bank balance 300

The business forecasts that in January it will experience cash inflows of 1,100 and cash outflows of 700, leaving a positive net monthly cash flow of 400. This is added to the 200 bank balance which existed at the end of December, to give a forecasted bank balance at the end of January of 600. In February, the forecasted cash inflows are only 100 more than the forecasted outflows, leaving a bank balance of 700. However, in the months of March and April, the business is forecast to experience negative net monthly cash flows (i.e. its cash outflows are forecast to be greater than its cash inflows). This gradually reduces the bank balance to just 300 by the end of April. It is important for a business to produce a cash flow forecast, so that it can prepare for those months in which it is forecast to experience a cash flow crisis (i.e. the business needs to arrange extra borrowing or overdraft facilities to provide extra cash).

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Alternatively, in the months where the business is forecast to be cash-rich, it can use this money profitably elsewhere within the business (e.g. new product development).

Exam-Style Questions
1. The data summarised in the table below show the performance of two firms A and B, over five years.

a) Using the information in the table explain the comparative attractiveness of the two firms to a potential investor. b) Why is it important that potential investors should be aware of the ratio of ordinary share capital to other forms of long term finance, (known as the gearing ratio)? c) Why might a company use various sources of finance? d) Using examples, explain why it is important that potential investors should consider nonfinancial factors before making their investment decision. (Marks available: 20) Answer outline and marking scheme for question: 1 Give yourself marks for mentioning any of the points below: a) It would appear that As performance is deteriorating compared with B. This seems to be confirmed by the net profit as a percentage of capital employed. On this basis B would seem to be the better bet. But with regards to liquidity it would seem that B is sailing close to the wind and may find itself with cashflow problems. A seems to be more secure but has it got too much cash?

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More information is needed to make a true assessment. b) The gearing ratio shows the relationship between equity capital and interest bearing capital. For example if the gearing ratio is less than 100 per cent a company is said to be low geared. This means that the majority of long term funds comes from the owners of the company, usually implies that a company is not a risk taker and the potential for growth is higher. c) Sources of funds can be internal or external. Internal sources sources the company has control over compared with external funding. There is the time period for borrowing and charges made that have to be taken into consideration. Expenditure can be for revenue or capital expenditure. Capital expenditure is on goods which can be used over a long time period such as machines and can be financed over a long time period. Revenue expenditure is spent on items such as raw materials or labour. This will be consumed quickly. Trade credit is a source of funds used to purchase raw materials. d) Examples other than financial help to give a fuller picture of the likely future performance of the company. For example it is important to look at the previous performance of the company to identify trends and compare them with what is happening in the market place. For example if company sales are increasing in a shrinking market, this should send alarm bells to a potential investor. Why is the market shrinking? The state of the economy might indicate the timing of investment, for example: is the economy entering a downturn or is the economy enjoying a boom? (Marks available: 20)

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Ratio Analysis Ratio Analysis - Introduction


Ratio analysis is an accounting tool, which can be used to measure the solvency, the profitability, and the overall financial strength of a business, by analysing its financial accounts (specifically the balance sheet and the profit and loss account). Accounting ratios are very easy to calculate and they enable a business to highlight which areas of its finances are weak and therefore require immediate attention. There are five main categories of accounting ratio: 1. Liquidity ratios, these measure the solvency of the business and its ability to meet short-term debts. 2. Profitability (or 'performance') ratios, these analyse the profit made over the last year. 3. Financial efficiency (or 'activity') ratios, these analyse the efficiency of the business in terms of the use of its resources in generating sales. 4. Gearing ratio, this measures the proportion of the capital of the business which has come from external sources, and must be repaid with interest. 5. Shareholders' ratios, these measure the strength of the company, its share price and its dividends.

Liquidity Ratios
There are two main ratios that can be used to measure the liquidity of a business:
1. The current ratio 2. The 'acid-test' ratio

The current ratio The current ratio. This measures current assets as a proportion of current liabilities. It is calculated using the following formula:

For example, if a business has current assets of 250,000 and current liabilities of 180,000, then the current ratio would be:

This means that for every 1 of current liabilities, the business has 1.39 of current assets available. Ideally, the answer should be between 1.5 and 2. A figure less than 1.5 indicates

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that the business may experience difficulties in meeting its short-term debts (i.e. a liquidity crisis). An answer of more than 2 indicates that the business may be holding cash in an unproductive and unprofitable form, and it may be better used elsewhere.
The acid test ratio The 'acid-test' ratio. This measures current assets less stock as a proportion of current liabilities. It is calculated using the following formula:

Stock is excluded because a business may not be able to convert it into cash quickly. For example, if a business has current assets less stock of 150,000 and current liabilities of 180,000, then the current ratio would be:

This means that for every 1 of current liabilities, the business has 0.83 of cash available at short-notice. Ideally, the answer should be between 1 and 1.2. A figure less than 1 indicates that the business may experience difficulties in meeting its short-term debts (i.e. a liquidity crisis). An answer of more than 1.2 indicates that the business may be holding cash in an unproductive and unprofitable form, and it may be better used elsewhere.

Profitability Ratios
There are three main ratios that can be used to measure the profitability of a business:
1. The gross profit margin. 2. The net profit margin. 3. Return on Capital Employed (R.O.C.E).

The gross profit margin This measures the gross profit of the business as a proportion of the sales revenue. It is calculated using the following formula:

For example, if a business has gross profit of 4 million and sales revenue of 6 million, then the gross profit margin would be:

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This means that for every 1 of sales revenue, 0.67 remains after all direct expenses have been deducted. This money then contributes towards covering the other expenses of the business. The business would want this margin to be as high as possible, since a high margin will leave more profit for covering the remaining expenses and, if the business is a 'company', for covering the dividend payments to shareholders.
The net profit margin This measures the net profit of the business as a proportion of the sales revenue. It is calculated using the following formula:

For example, if a business has gross profit of 1 million and sales revenue of 6 million, then the net profit margin would be:

This means that for every 1 of sales revenue, 16.7 pence remains after all direct and indirect expenses have been deducted. This money then contributes towards covering the corporation tax that must be paid on profits to the Inland Revenue and, if the business is a 'company', covering the dividend payments to shareholders. Any profit which remains is kept in the business for re-investment and is called 'retained profit'. Again, the business would want this margin to be as high as possible, allowing both large dividend payments to shareholders and a significant amount of profit to be retained for growth.
Return on Capital Employed (R.O.C.E) This is often referred to as the 'primary accounting ratio' and it expresses the annual percentage return that an investor would receive on their capital. It basically relates the profit to the size of the business and it is calculated using the following formula:

For example, if a business had a net profit of 2.2m and a capital employed of 7.6m, then the Return on Capital Employed figure would be:

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This means that for every 1 of capital invested in the business, the annual return would be 28.9 pence. Capital employed is equal to shareholders' funds plus long-term liabilities, and it is the final line in the balance sheet (remember that it is the same value as 'assets employed'). Clearly an investor would like to receive as high a R.O.C.E. as possible, although the figure would need to be compared to last year's return, to competitors' returns and to the returns on other investments.

Financial Efficiency Ratios


There are three main ratios that can be used to measure the financial efficiency of a business:
1. The asset turnover ratio. 2. The stock turnover ratio. 3. The debtor days ratio.

The asset turnover ratio This measures the productivity of the business (i.e. how many pounds worth of sales revenue can be generated from the assets employed?). It is calculated using the following formula:

For example, if a business has sales revenue of 8 million and net assets of 5 million, then the asset turnover ratio would be:

This means that for every 1 of net assets, the business generates 1.60 of sales revenue. Clearly the higher the answer, the better. It is normal for service industries (e.g. supermarkets) to have a much higher asset turnover ratio than manufacturing industries, since service industries generate very high sales in relation to their net assets.
The stock turnover ratio This measures the number of times in a 12-month period that a business sells its stock. It is calculated using the following formula:

For example, if a business has a 'cost of goods sold' figure of 2 million and an average 'stock' figure of 0.5 million, then the stock turnover ratio would be:

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This means that the business would turn its stock over (i.e. sell the lot and order some more) four times per year, or every 91 days on average. However, care must be taken when comparing the stock turnover ratios of different businesses, since a supermarket, for example, is likely to have a much higher stock turnover (especially for vegetables, fruit and other perishables) than a retailer such as 'Dixons' (for televisions, washing machines, etc).
The debtor days ratio This shows how long, on average, a business takes to collect the debts owed to it by customers who have purchased their goods on credit. It is calculated using the following formula:

For example, if a business had debtors of 1.2m and a sales turnover of 9.1m, then the debtor days figure would be:

This means that, on average, it takes the business 48 days to collect its trade debts. This may be due to a poor debt-collection system, or it may be due to the fact that it allows customers a number of weeks before payment is due as part of its marketing strategy. Ideally, the sooner the business receives all the cash from sales revenue, the better, since it can be used to boost the day-to-day capital (working capital) that is available to pay bills, etc.

The Gearing Ratio


This measures the proportion of capital employed (i.e. the value of the business) which is funded by long-term liabilities (i.e. the proportion of the value of the business which is interest-bearing debt). It is calculated using the following formula:

For example, if a business had long-term liabilities (loans, mortgages and debentures) totalling 3.5 million, and a 'capital employed' figure of 8.3 million, then its gearing ratio would be:

An answer of more than 50% indicates that the business is 'highly geared', since it has to make large monthly debt repayments. This can become a problem (especially if the economy

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heads into a recession or the industry goes into decline) because the business will still have to make its monthly repayments, even though its cash inflows may be deteriorating. A business with a gearing ratio of less than 50% is said to have 'low gearing', since its monthly debt repayments do not form a significant proportion of its monthly outgoings.

Shareholders Ratios
There are five main ratios that can be used by shareholders in order to assess the worth of a particular company and their shares:
1. 2. 3. 4. 5. Earnings per share (E.P.S). Price/ Earnings (P/E) ratio. Dividend per share. Dividend yield. Dividend cover.

Earnings per share (E.P.S) This measures the company's potential dividends that it could pay to shareholders. It is calculated using the following formula:

For example, if a company has profit after tax of 12m and it has issued 40 million ordinary shares, then its E.P.S. would be:

This means that every ordinary share could pay a dividend of 30 pence IF all the profit after tax is distributed as dividends. However, it is most likely that some of the profit after tax will be kept in the company for re-investment (this is called retained profit). Clearly the shareholders would want as much of the profit after tax as possible to be payable to themselves.
Price Earnings (P/E) ratio This measures the market price of the share as a proportion of the earnings per share calculated above. It is calculated using the following formula:

For example, if the current market price for a company's share is 1.50, and the earnings per share is 30 pence, then the P/E ratio would be:

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This answer indicates that it would take an investor 5 years to recover the cost of the share. This figure would need to be compared to other companies' P/E ratios before a judgement could be made. In general, the higher the P/E ratio, then the better the expectations of the company's future profitability. However, the share price of the company is likely to fluctuate frequently, and therefore the P/E ratio of the share will not be the same for very long - this can make it difficult to compare the P/E ratio with other companies.
Dividends per share This measures the size of the dividends that the company actually pays to its shareholders. It is calculated using the following formula:

For example, if a company has profit after tax of 12m (and issues 25% of this as dividends) and it has issued 40 million ordinary shares, then its dividend per share would be:

This means that every ordinary share would pay a dividend of 7.5 pence. The remaining 9m of profit after tax would be retained for future investment. Clearly, the shareholders would want the dividend per share to be as high as possible, in order to maximise their return on their investment.
Dividend Yield This shows the dividend per share expressed as a percentage of the market price of the share. It is calculated using the following formula:

For example, if a company had a dividend per share of 7.5 pence, and a market price of 1.50, then the dividend yield would be:

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This is not a very high return for the risk involved in investing money in shares. This figure would need to be compared to other investments (e.g. other companies, banks, etc) to see if it is providing a competitive return.
Dividend cover This measures how many more times the dividends could have been paid out of the profit after tax. It is calculated using the following formula:

For example, if a business had profit after tax of 12m and it paid total dividends of 3m, then the dividend cover would be:

This means that the company did not pay the shareholders a significant proportion of the profit after tax in the form of dividends - the company has actually only paid a quarter of their profit after tax as dividends. This means that the company kept much of the profit after tax as retained profit for reinvestment.

Limitations to Ratio Analysis


There are many different groups of people (or stakeholders) who are interested in the accounts of a company, including: 1. The management and the employees - to see if pay rises are likely, or to ensure that their jobs are secure. 2. Creditors - to ensure that the business has the necessary money to repay them. 3. Potential lenders - to see if the business is solvent and profitable enough to repay any loans. 4. The community - to ensure that jobs and services for the local community are assured. Using financial ratios can assist these people in identifying the financial strengths and weaknesses of a company, as well as indicating to the company itself those areas that need corrective action. However, ratio analysis does not provide a complete and exhaustive analysis of a company, and there are several other factors that the stakeholders and the company will need to take into account, in order to get the 'full picture' of its financial position:

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The state of the economy (i.e. if the economy is in a recession, then the ratios are more likely to be unsatisfactory than if the economy is experiencing a 'boom'). The performance of competitors (i.e. it may be the case that the industry is in decline, in which case all the rival businesses are likely to be experiencing deteriorating ratios). Comparison year on year, The ratios for the business from the current year must be compared to the ratios from previous years, in order to see any marked improvement or deterioration in the financial performance. External factors. The financial ratios do not take into consideration any effects on the local community or the environment (i.e. they ignore the effects of pollution, job losses, etc). Therefore, in order to measure the performance of a business, factors other than mere financial ratios need to be considered.

There are many different groups of people (or stakeholders) who are interested in the accounts of a company, including: 1. The management and the employees - to see if pay rises are likely, or to ensure that their jobs are secure. 2. Creditors - to ensure that the business has the necessary money to repay them. 3. Potential lenders - to see if the business is solvent and profitable enough to repay any loans. 4. The community - to ensure that jobs and services for the local community are assured. Using financial ratios can assist these people in identifying the financial strengths and weaknesses of a company, as well as indicating to the company itself those areas that need corrective action. However, ratio analysis does not provide a complete and exhaustive analysis of a company, and there are several other factors that the stakeholders and the company will need to take into account, in order to get the 'full picture' of its financial position:

The state of the economy (i.e. if the economy is in a recession, then the ratios are more likely to be unsatisfactory than if the economy is experiencing a 'boom'). The performance of competitors (i.e. it may be the case that the industry is in decline, in which case all the rival businesses are likely to be experiencing deteriorating ratios). Comparison year on year, The ratios for the business from the current year must be compared to the ratios from previous years, in order to see any marked improvement or deterioration in the financial performance. External factors. The financial ratios do not take into consideration any effects on the local community or the environment (i.e. they ignore the effects of pollution, job losses, etc). Therefore, in order to measure the performance of a business, factors other than mere financial ratios need to be considered.

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Exam-Style Questions
1. The data summarised in the table below show the performance of two firms A and B, over five years.

a) Using the information in the table explain the comparative attractiveness of the two firms to a potential investor. b) Why is it important that potential investors should be aware of the ratio of ordinary share capital to other forms of long term finance, (known as the gearing ratio)? c) Why might a company use various sources of finance? d) Using examples, explain why it is important that potential investors should consider nonfinancial factors before making their investment decision. (Marks available: 20) Answer outline and marking scheme for question: 1 Give yourself marks for mentioning any of the points below: a) It would appear that As performance is deteriorating compared with B. This seems to be confirmed by the net profit as a percentage of capital employed. On this basis B would seem to be the better bet. But with regards to liquidity it would seem that B is sailing close to the wind and may find itself with cashflow problems. A seems to be more secure but has it got too much cash? More information is needed to make a true assessment.

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b) The gearing ratio shows the relationship between equity capital and interest bearing capital. For example if the gearing ratio is less than 100 per cent a company is said to be low geared. This means that the majority of long term funds comes from the owners of the company, usually implies that a company is not a risk taker and the potential for growth is higher. c) Sources of funds can be internal or external. Internal sources sources the company has control over compared with external funding. There is the time period for borrowing and charges made that have to be taken into consideration. Expenditure can be for revenue or capital expenditure. Capital expenditure is on goods which can be used over a long time period such as machines and can be financed over a long time period. Revenue expenditure is spent on items such as raw materials or labour. This will be consumed quickly. Trade credit is a source of funds used to purchase raw materials. d) Examples other than financial help to give a fuller picture of the likely future performance of the company. For example it is important to look at the previous performance of the company to identify trends and compare them with what is happening in the market place. For example if company sales are increasing in a shrinking market, this should send alarm bells to a potential investor. Why is the market shrinking? The state of the economy might indicate the timing of investment, for example: is the economy entering a downturn or is the economy enjoying a boom? (Marks available: 20)

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Production Control Stock Control


This is the system used to ensure that the business always has sufficient stock available to meet customer requirements.
Re-Order Levels This is the minimum amount of stock that a business will hold before it re-orders from its suppliers. The re-order level will vary from business to business and from industry to industry.

For example, a supermarket is likely to have a higher re-order level than a car dealer, since in
the time taken to receive its supplies, a supermarket is likely to sell far more stock than a car dealer.
Re-Order Quantities The re-order quantity is the amount of stock and raw materials that a business orders from its suppliers each time it reaches its re-order level. This again will vary from business to business and from industry to industry.

For example, a business selling fast-moving consumer goods (e.g. chocolate bars or baked beans) is likely to order a far larger amount of stock from its suppliers than a manufacturer of goods with a slower stock turnover (e.g. televisions or washing machines).
There are several factors which will influence the amount of stock which a business orders, including:
1. 2. 3. 4. Lead times. The expected level of customer demand. The costs of stockholding. The type of stock, whether it is perishable or durable.

Buffer Stocks This is the minimum stock level which will be held by a business to meet any unexpected occurrences.

For example, A sudden large order from a customer, deliveries of raw materials not arriving on time, or computer re-ordering systems breaking down.
Lead Times This is the amount of time that elapses between a business placing an order with a supplier for more stock or raw materials, and the delivery of the goods to the business.

The business will wish the lead-time to be as short as possible, so that it can meet its customer orders and minimise the time between paying for the stock and receiving the revenue from the customer.

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However, this may not happen due to a number of factors, such as delays in the supplier receiving the order, or the breakdown of the suppliers' lorries delivering the stock to the business. An effective stock control system, combining the above four elements, can be seen below:

From this diagram, it can be seen that:


1. 2. 3. 4. The The The The re-order level (i.e. the amount of stock remaining when an order is placed) is 20,000 units. re-order quantity (i.e. the amount of stock ordered from a supplier) is 20,000 units. buffer stock (i.e. the minimum stock holding) is 10,000 units. lead-time (i.e. the time delay between placing an order for stock and receiving it) is 8 days.

Stock Rotation Many businesses use a stock rotation system. This is the process of ensuring that the older batches of stock are used first rather than the newer batches, in order to avoid the possibility that the older stocks will become obsolete or go past their sell-by-date.

This is often referred to as a First In First Out (F.I.F.O) system, to encourage the older batches of stock to be used first, therefore avoiding the possibility that the older stock will be left in a warehouse, possibly becoming unusable.
Link to Information Technology (C.A.D/C.A.M) The production process and stock control systems in a business can be assisted by the use of Information Technology (I.T).

Sophisticated software packages can enable a business to keep detailed and accurate records on its purchases of stock and its sales to customers, using such systems asElectronic Point of Sale (E.P.O.S).

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This records every transaction made by a business and can, therefore, enable it to monitor its stock levels and sales of products to a 100% level of accuracy. This system can automatically re-order stock when numbers fall to a certain level in the warehouse, as well as monitoring the quantity of each component that is used in the production process. This enables a tight control to be kept on both costs and waste, as well as recording the amount of revenue received from customers and any outstanding customer debts. Computer Aided Design (C.A.D) is the use of sophisticated computer software to design three-dimensional images of products quickly and relatively cheaply. Computer Aided Manufacturing (CAM) is the use of computers and software for a wide variety of production tasks, including automated production lines and stock control systems.

Quality
Total Quality Management (T.Q.M) This is the attempt by a business to stop errors and waste from occurring at all levels within the organisation, and to try to encourage all employees to make 'quality' paramount within their daily activities (whether in production, marketing or personnel).There are a number of components of T.Q.M:
1. Internal relationships between workers and their superiors and subordinates are seen to be as important as the external relationships that exist between the business and its customers and suppliers. 2. TQM must be seen to be a policy that is followed by, and has the commitment of, all workers, from senior management to shop floor employees. 3. The business must monitor all its activities and processes in order to identify any areas for improvement and to ensure that quality is being achieved. 4. Team-working is important, since a group of people working together will develop a wider range of skills, co-operation, and higher motivation than if workers were performing repetitive tasks on their own. 5. Regular market research must be undertaken to ensure that customers are happy with the level of service that they receive (any complaints can be used to improve the existing systems).

Quality Circles This is a group of workers that meets at regular intervals during the working week in order to identify any problems with quality within production, to consider the alternative solutions to these problems, and to then recommend to management the solution that they believe will be the most successful.

The members of the quality circle are also involved in the implementation and monitoring of the solution. This should help to improve the level of motivation amongst the workers because it makes each person in the group feel valued and that they are making a significant contribution to the improvements on the factory-floor.

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Zero Defects This is the ultimate objective for a business, to produce every product with no defects, therefore eliminating waste and the time taken to correct mistakes.

Zero defects can lead to an improved business and customer reputation, as well as increasing levels of both sales and profitability. In order for the objective of zero defects to be achieved, it requires the involvement of every employee in the business, making sure that they are all committed and suitably trained.
Continuous Improvement (Kaizen) Kaizen is a Japanese word which means 'change for the better'.

A business will often be facing increasing demands from customers to add new features to their products, as well as facing pressures from their competitors who are producing new and improved products, or offering improved after-sales service. The business will need to continually update and improve their products and marketing, in order to stay ahead of their competitors and boost revenue and profitability. It is widely held that any aspect of the business can be improved, not just the production processes and, as with zero defects, it is vital that every employee in the business is involved in this philosophy, not simply those in the production department, but also those in marketing, finance and personnel. Kaizen aims to eliminate waste, and reduce both the time and the costs of production. It links in with other concepts such as TQM, quality circles, productivity improvements and new product development.
Quality Standards The British Standards Institution (BSI) is the body that is responsible for setting quality and performance standards in UK industry.

The BSI 'kitemark' on a product implies to customers that it has been manufactured and produced to a high level of quality, and will be fit for the purpose for which it was advertised. Quality assurance refers to the attempt to achieve customer satisfaction, by ensuring that the business sets certain quality standards and publicises the fact that these standards are met throughout the business. British Standard 5750 (BS 5750) was the most common quality certification in the UK. It is now known as ISO 9000, which is an international standard that tells customers that a business has reached a required level of quality in its products and processes. Quality of output is vital for retaining customer loyalty and, therefore, it is necessary for quality to be an important consideration in the design, the production, the distribution, the sale and the after-sales service of products.

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Employee involvement and participation in quality programmes (e.g. quality circles and suggestion-schemes) will serve two purposes:
1. Improve the overall quality of the output and processes. 2. Help motivate the workers by making them feel that their contributions and their suggestions are highly valued.

Quality control is the process of checking the quality and the accuracy of raw materials and supplies as they arrive at the business, and also of the finished products as they leave the business en route to retailers and customers. This is usually carried out either by quality inspectors or by the employees themselves. The philosophies of zero defects and Kaizen require stringent quality control systems, in order to reduce the costs and time associated with both waste and the correction of low quality output.

Lean Production
Lean production is the term given to a range of measures traditionally used by Japanese businesses in an attempt to reduce waste and costs in production.
Just-In-Time This is a method of manufacturing products which aims to minimise:

the production time the production costs the amount of stock held in the factory.

Raw materials and supplies arrive at the factory as they are required, and consequently there is very little stock sitting idle at any one time. Each stage of the production process finishes just before the next stage is due to commence and therefore the lead-time is significantly reduced. With a just-in-time production system, the level of production is related to the demand for the output (i.e. the number of orders) rather than simply producing finished goods and waiting for orders. This means that raw materials and stock only needs to be ordered from suppliers as required - this reduces the amount of money tied up in stocks, and leaves more money available for investment elsewhere. The advantages of a just-in-time production system are:
1. Cashflow is improved, as less money is tied up in raw materials, work-in-progress and finished goods. 2. Less need for storage space for raw materials and finished goods. 3. The business builds up strong relationships with its suppliers. 4. Communication and co-operation between the marketing and the production departments are improved.

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The disadvantages of a just-in-time production system are:


1. The business may struggle to meet orders if their suppliers fail to deliver the raw materials on time. 2. The business is unlikely to 'bulk-buy' its raw materials and, therefore, it may lose the benefit of achieving economies of scale. 3. Buffer stocks are minimal and this may lead to the business having to reject customer orders requiring delivery immediately.

Cell Production This method of manufacturing an item organises workers into 'cells' within the factory, with each cell comprising several workers who each possess different skills.

Each cell is independent of the other cells and will usually produce a complete item, and each cell will usually have an output target to achieve for a given period of time. It is often argued that if the group of workers in each cell can see the completion of the finished product, then their work will have more meaning and therefore their levels of motivation and job satisfaction will be greatly enhanced. This method of production is often combined with the just-in-time approach. The advantages of cell production are:
1. 2. 3. 4. 5. 6. Improved job satisfaction and motivation. Improved quality as the group of workers take responsibility for the output. Multi-skilling of workers means that job rotation can occur. Stockholdings are reduced (leaving less money tied up in stocks). The factory space can be used more efficiently. Lead-times are reduced.

The disadvantages of cell production are:


1. Output may not be as high as a 'flow' production system. 2. Different 'cells' may work at different speeds (leading to conflict and tension). 3. The business may need to invest heavily in new machinery and equipment, as each cell will require the same capital items.

Benchmarking This refers to a business finding the best methods and processes that are used by other businesses, and then trying to emulate these in order to become more efficient in its operations.

Benchmarking can be used in all areas and processes in a business, not just for production.

For example, it can be used to improve customer service, advertising campaigns, Human Resource Management, and budgeting procedures.

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Data for benchmarking is collected and used with the full co-operation of the other businesses, and often the results will help both businesses to improve their systems and procedures. There are several stages involved in implementing a benchmarking system:
1. 2. 3. 4. 5. Researching the areas in a business which need improving. Deciding how an improvement in these areas can be measured. Identifying 'best practice' in other businesses. Agreeing the exchange of information with other businesses. Comparing the 'best practice' with the existing processes, systems and procedures in the business. 6. Altering the processes, systems and procedures in order to improve performance. 7. Evaluating how successful the changes have been.

In order for benchmarking to be successful, the business must ensure that firstly every employee is committed and involved in the system, (from senior management to shop-floor employees), and secondly that sufficient time and finance is available for the gathering of data and the implementation of new procedures. Benchmarking will fail to deliver improvements to the business if there is a lack of willingness by other businesses to disclose information, or if the systems and procedures used by the 'best practice' businesses are not appropriate for the business in question. In summary, benchmarking can help a business identify those areas in its operations which need improvement, as well as considering alternative processes and procedures for achieving its objectives. 'Best practice' can be emulated and the competitiveness of the business should improve as it strives to improve and become more efficient.
Time-based Management Time is a very valuable resource and time-based management is concerned with reducingboth the length of time taken to produce the product and also, therefore, reducing thelead-time (the time lag between the customer placing an order and the business delivering the finished product).

In order for a business to successfully operate a time-based management system, it is important that machinery is flexible and production runs can be shortened or lengthened at short notice, in order to produce more of an existing product or to start the production of an alternative product. It is also essential that staff are multi-skilled and can rotate between different tasks, as they may be required to perform a number of different jobs in a short space of time. Time-based management makes it easier for a business to implement other lean production techniques (such as just-in-time and cell production), and since these techniques require less time and fewer stocks of raw materials than more traditional mass production techniques, then the business will save money.

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However, it is often argued that the move away from mass production and lengthy production-lines will reduce the chance of the business benefiting from economies of scale in its manufacturing techniques. It is also likely that a business will be able to implement the time-based management philosophy to its R&D processes, as well as to the production-line. A business which can develop and launch more products in a shorter time than its competitors will benefit from a number of advantages:
1. If the business is the first to launch a product on the market, then it can charge a premium price to reflect the innovative nature of the product. 2. Premium prices help to quickly recoup R&D costs, as well as earning the business a significant profit-margin per unit sold. 3. Brand loyalty is likely to develop - enabling the business to use this strong customer base as a 'launch pad' for new products in the future. 4. The diversity of products that are on sale will increase the product portfolio of the business, as well as reduce the risk of business failure should one or two of the products prove unsuccessful.

Exam-Style Questions
1. A graph representing a statistical process control chart for the production of gnomes.

a) What are the functions of lines x and y shown in the control chart and how are they set? b) What recommendation would you make if you saw the results shown in the chart? c) How are control limits likely to be affected by the size of the sample taken and the variability of the production process? d) Explain whether or not ideas of TQM have had an effect on statistical quality control techniques?

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(Marks available: 20) Answer outline and marking scheme for question: 1 Give yourself marks for mentioning any of the points below: a) Upper and lower action and warning limits. Standard Deviation (usually) y=2 and x=*3 (5 marks) b) Alarm bells would start to ring. There is an upward trend away from the base. (5 marks) c) The larger the sample size the more accurate the outcome. The more consistent the production run, again the more accurate the outcome, for example identifying problems. (5 marks) d) TQM is a concept which involves all workers within an organisation. TQM is more concerned with continuous improvement in all company processes whereas statistical control of quality is concerned with control of processes and their resulting outcomes. (5 marks) (Marks available: 20) 2. 'Kaizen' is defined as continual improvement involving a commitment from everyone in the company. a) How might kaizen improve customer satisfaction? b) Does kaizen eliminate the need for market research? (Marks available: 10) Answer outline and marking scheme for question: 2

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Give yourself marks for mentioning any of the points below: a) Kaizen is continuous improvement and product quality should therefore be continually improving. Through the removal of defects and waste, cost should be reduced and therefore prices may fall. Customers get high quality, low price goods. (5 marks) b) No. Market research is required to identify customer needs and the situation in the competitive marketplace. Market research enhances kaizen. (5 marks) (Marks available: 10)

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Production Decision Making Basics of Production


Industrial Location This is the decision that a business or an industry makes concerning its geographical placing in a country. There are many factors which influence the precise location of a business or an industry, including:

The cost and the availability of land. Land in an urban area is clearly less abundant (and therefore more expensive) than land in rural locations or on the edge of towns and cities. Therefore it would be advisable, and also more feasible, for a business which requires a large amount of land to locate away from the centre of an urban area. The cost and the availability of labour. The unemployment rate varies in different areas of the UK, and a business which is labour-intensive may choose to locate near to an area of high unemployment in order to take advantage of the availability of labour at a fairly low wage. Communication links. Many businesses choose to locate near to motorways, rail links, seaports or airports if they either have a significant amount of raw materials to receive, or a significant number of products to distribute across a wide area of the country. Transport costs/proximity to the market. Some businesses will locate in certain areas of the country in order to minimise their transportation costs. For example, producers of fastmoving consumer goods (f.m.c.gs) will often have to distribute their products nationwide, and therefore will try to locate as near to the market as possible so their transportation costs are not excessively high. Availability of raw materials. Some businesses will try to locate near to their suppliers or to the source of their raw materials. For example, businesses which require bulky raw materials, such as timber, will often try to locate near their suppliers so to reduce the lead-time between ordering and receiving the raw materials. Government location incentives. The UK government has over the past 30 years offered a range of incentives to businesses to locate in depressed areas of the UK, in order to reduce the unemployment rates in those areas by creating jobs. The incentives (such as grants, tax breaks, and reduced rent and rates) are offered both to existing businesses to relocate to the depressed areas, as well as to new businesses which are about to set up.

Industrial inertia refers to the situation when a business or an industry decides to remain in its original location and is very reluctant to relocate, even after the reasons for it locating there in the first place are exhausted. Possible reasons for this include:
1. The cost of moving may be very large. 2. Strong links with the local community and with other local businesses may have been developed and a move away from there may destroy those links. 3. Some areas and products have an international reputation which may be difficult to establish if the business were to locate elsewhere (e.g. Scottish whisky).

However, industrial inertia can actually make an area become depressed if that area depends on a particular industry or business for employment and wealth-creation. If the industry goes into decline and no other industries or businesses wish to move to this area, then mass

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unemployment is created, and many of these unemployed will not be trained to perform any other jobs.
International location International location of industry is also a very important factor in today's global business environment. As well as the reasons for location mentioned earlier, there are a number of other factors that a business will need to consider before choosing a foreign country in which to locate.
These factors include:

the language spoken legal differences the economic environment the stability of the political structure.

Over the past 25 years, the UK government has encouraged much foreign investment into the UK from outside Europe - specifically from Japan. These Japanese companies (e.g. Nissan, Sony) create wealth for the UK by providing employment and income to workers, and paying tax to the UK government. They can help to rejuvenate depressed areas and often purchase their supplies and raw materials from other UK businesses. The Japanese companies are enticed to locate in the UK through a number of factors:
1. 2. 3. 4. English is the first foreign language taught in Japan. Low wage rates in the UK. Government incentives to locate in the UK (e.g. cheap rent, rates, etc). Gateway for selling goods to other EU countries.

Production Methods There are four ways for manufacturing businesses to organise their production - job production, batch production, flow production and cell production.

Job production
This method of production involves an item being manufactured entirely by one worker or by a group of workers. These items are often made to customer requirements, rather than being mass produced. This type of production is usually undertaken by small businesses and craft industries (e.g. carpenters), although larger businesses which specialise in 'one-off' products (e.g. bridges) may also use this production method.

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Batch production
This method of production involves the manufacture of an item being divided into a number of small tasks. A collection (or 'batch') of items each have one of these tasks completed, and then the batch moves onto the next manufacturing task. In other words, several items have the same task performed on each of them and then they move onto the next task together in a group. This production method can result in the build-up of large amounts of stock and work-inprogress. This may be a problem if the business is in a fashion industry, where customers' tastes can change quickly and unpredictably, leaving the business with much stock that it is unable to sell.

Flow production
This method of production involves the tasks which were identified in 'batch' production becoming continuous for each unit, often with the use of a moving conveyor belt (e.g. a car assembly line). Each unit is produced individually, instead of being produced in batches. This type of production is usually undertaken by large businesses. This method of production was first established by Henry Ford in the 1920s, when he developed the world's first automated production line. This involved each car passing the workers on a moving conveyor belt, rather than the workers continually moving to the car. This method should boost labour productivity and reduce average cost of production even further. It is often argued that flow production leads to high rates of alienation, demotivation and absenteeism amongst the employees - it is for these reasons that much machinery is today used on these production lines to perform simple, repetitive tasks which humans may easily become bored in performing.

Cell production
This method of manufacturing an item organises workers into 'cells' within the factory, with each cell comprising several workers who each possess different skills. Each cell is independent of the other cells and will usually produce a complete item, and each cell will usually have an output target to achieve for a given period of time. It is often argued that if the group of workers in each cell can see the completion of the finished product, then their work will have more meaning and therefore their levels of motivation and job satisfaction will be greatly enhanced.
Research and Development (R&D) All businesses need to develop long-term strategies, and an important part of this strategy must be the continual development and launch of new products, or amendments made to existing products. This is the purpose of research and development (R&D).

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R&D can basically be defined as:

'carrying out extensive scientific research into the product and its design, and then developing a range of prototypes, each to a slightly different specification.'
The prototype which best meets the needs of the customers and the business is then likely to be commercialised. The development of products can take several years to complete and many businesses spend a huge amount of money on this process (e.g. Unilever spent over 600 million on R&D in 1997). It can often be a very risky process, since much money can be spent on ideas that will never be commercialised. It is within the 'sunrise' industries (i.e. industries which are fairly young and have rapid growth potential, such as computers and aerospace) that extensive R&D spending today can result in a huge competitive advantage in the future. The benefit of being the first company to launch a new, innovative product is immeasurable, since the company can charge a high price and build up a strong market share as it faces no competition. It is estimated that only about one product in the pharmaceutical industry reaches the commercialisation stage (i.e. launched onto the market) for every ten which are developed and test-marketed. Therefore, the company will have massive R&D costs to recoup when it actually launches a new product, and it will probably take several years before it will have broken-even and covered all the R&D costs. The businesses which are most likely to succeed in the future are those which develop more new products than their closest rivals, bring their new products to the market in less time than their rivals, compete in more product- and geographic-markets than their rivals, and provide very strong after-sales service to customers.

Scale of Production
Economies of scale As a business grows in size and produces more units of output, then it will aim to experience falling average costs of production (i.e. on average, each unit of output costs less to produce). This is known as benefiting from economies of scale. In other words, the business is becoming more efficient in its use of its inputs to produce a given level of output.

Economies of scale can be divided into internal and external economies:


Internal economies of scale simply benefit a single business as it grows (i.e. its average cost of production starts to fall). External economies of scale, however, benefit all the businesses in a particular industry (i.e. the average cost of production will fall for all the businesses in a particular industry).

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Internal economies of scale


Internal economies of scale fall into four main categories:

Technical. This refers to the fact that the use of automated equipment and machinery to produce output is far more cost-effective than using labour, since the machinery can be used 24 hours a day, with no breaks and with a constant level of output per hour. Purchasing. Larger businesses are more likely to be able to bulk-buy their supplies and their raw materials, and therefore secure their supplies at a far lower cost per unit than a smaller business. Financial. Banks and other financial institutions are more likely to offer a lower rate of interest on a loan repayment to a larger business than to a smaller business, since the larger business represents less of a risk because it is more financially secure. Managerial. Larger businesses are more likely to be able to afford to employ managers who are specialists in a particular field. These managers can therefore devote all their time to specialising in one particular field (resulting in higher levels of efficiency and hopefully falling average costs). Smaller businesses will often employ managers who have to perform a variety of tasks and therefore cannot specialise in a single area of the business.

External economies of scale


External economies of scale fall into three main categories:

Labour. A large pool of available labour in a particular area of the country which has been trained at a local college, or even at a rival business, will possess specialised skills which will be useful to the whole industry, rather than simply to just one business. Joint ventures. Two or more businesses may decide to join forces (perhaps for R&D) in order to spread the costs and the risks of developing a new product or manufacturing process. Support services. A wide range of commercial and support services often cluster together in a certain area near a number of rival businesses (e.g. waste disposal, cleaning, component suppliers, distribution, etc). Clearly this benefits all the businesses in the area, rather than just one of them.

However, it is also possible that as a business grows in size and produces more units of output, then it will actually experience rising average costs of production (i.e. on average, each unit of output costs more to produce).

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Dis-economies of scale It is also possible that as a business grows in size and produces more units of output, then it will actually experience rising average costs of production (i.e. on average, each unit of output costs more to produce). This is known as experiencing diseconomies of scale. In other words, the business is becoming less efficient in its use of its inputs to produce a given level of output.

Diseconomies of scale can also be divided into internal and external economies:

Internal diseconomies of scale simply affect a single business as it grows (i.e. its average cost of production starts to rise). External diseconomies of scale, however, affect all the businesses in a particular industry (i.e. the average cost of production will rise for all the businesses in a particular industry).

Internal diseconomies of scale


Internal diseconomies of scale fall into three main categories:

Communication. This refers to the fact that as a business grows in size, the channels of communication lengthen and are more prone to delay and distortion. This can result in inefficiency in terms of the time taken to perform a task and, therefore, this can lead to higher costs. Co-ordination. As a business grows in terms of the number of employees, the number of departments and the number of different plants, then the overall co-ordination of all these can become very difficult. More and more meetings will be required and this all costs both time and money. Motivation. As the number of workers increases in a business, each worker will be seen to be making only a very small contribution to the finished product. This can result in falling levels of job satisfaction and motivation, which in turn can result in falling levels of productivity and, therefore, higher costs.

External diseconomies of scale


External diseconomies of scale often result from the overcrowding of businesses in a particular area and the resulting congestion, the late arrivals of supplies and raw materials, the late deliveries of finished goods to customers or warehouses, and the late arrival of employees to work. All these factors will affect all the businesses in a particular area and therefore push up their costs of production and distribution.
Critical Path Analysis This is often referred to as 'Network Analysis' and it is a way of showing how a lengthy and complex project (e.g. a building project) can be completed in the shortest possible time.

The project is broken down into a number of separate activities, and each activity is then placed in the correct sequence, so to minimise the duration of the project. It shows which of the activities are 'critical' - this means that if these activities are delayed, then the project will not be able to be completed on time. Management effort and resources

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can then be concentrated on ensuring that these 'critical' activities are completed on schedule. Other activities (which are not critical) have a degree of flexibility in the amount of time taken to complete them. This ensures that the waste of time and resources are minimised, and the profitability of the project is maximised. A critical path diagram shows:
1. the order in which each activity must be undertaken 2. the duration of each activity 3. the earliest date at which later activities can commence

Each diagram is composed of 'Activities' and 'Nodes':


An activity is that part of the project which requires time and resources - it is represented by an arrow, running from left to right. A node is the start or finish of an activity, and it is represented by a circle. Each diagram must start and end on a single node and no activity lines must cross each-other.

Diagram 1 illustrates what a node looks like and diagram 2 illustrates a simple network : Diagram 1.

The Earliest Start Time (E.S.T) is calculated from left to right on the diagram, by adding the duration of the previous activity to its own E.S.T. The Latest Finish Time (L.F.T) is calculated from the right to the left after the E.S.Ts have been calculated. Work backwards through the diagram, starting with the E.S.T in the final node, and deduct the duration of each activity to arrive at the L.F.T in each node. Diagram 2.

Activity Activity Activity Activity

A is the start of a project (duration 3 days) B can start when activity A is completed (duration 5 days) C can start when activity A is completed (duration 7 days) D follows all the other activities (duration 2 days)

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The critical path is ACD, since if any of these activities are delayed then the project will not be able to be completed in 12 days. The critical path is represented by double arrows. The only activity with any spare time (called 'float time') is activity B, which takes 5 days to complete, but has 7 days in which to be completed (i.e. between day 3 and day 10). Therefore it has 2 days 'float time'. It is clear to see from diagram 2 that if more than one arrow feeds into a node (as in node 3), then the EST at this node is determined by the longest preceding activity (in this case activity C). The LFTs are calculated by working backwards from right to left. In node 4, the LFT will also be 12 days, because the earliest completion time for the project is day 12, so the management would want the LFT to also be 12. (The first and the last nodes will ALWAYS have the same EST and LFT). The LFT at node 3 is simply 12 days minus the 2 days that it takes for activity D to be completed. This gives an LFT at node 3 of 10 days. The LFT at node 2 will be 10 days minus the duration of activity C of 7 days (since this is longer than activity B). This gives an LFT at node 2 of 3 days. The LFT at node 1 is simply 3 days minus the duration of activity A (i.e. 3 days - 3 days = 0) Diagram 3 illustrates a more complicated network: Diagram 3. Consider the following table and use it to draw up a fully labeled network showing ESTs, LFTs and the critical path.
Activity A B C D E F G H Order/ dependency 1st dependency must follow A must follow A must follow B must follow C must follow C must follow F must follow F Duration (days) 4 4 6 4 2 8 2 1

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* Critical path is ACFG * Therefore, activities B,D,E and H all have 'float time' available, (8 days, 8 days, 8 days, and 1 day respectively) The minimum time in which the project in diagram 3 can be completed is 20 days. Any delay to activities A, C, F, or G (i.e. the critical activities) will cause the duration of the project to be more than 20 days. The activities which have some float time available (i.e. activities B, D, E, and H) can be completed when appropriate, and any resources which are not being used at these locations can be transferred to the critical activities to ensure that these are completed on time. Critical Path Analysis is a very useful management tool when a large and complex project is being undertaken, since it can help to reduce the total time and the resources that are needed to complete a difficult project, as well as identifying the potential areas which may cause problems. However, it does need to be followed strictly and rigidly if it is to be a success and it does not allow for any changes in the external environment having a detrimental effect on the length of the project (e.g. poor weather conditions for a building project, or a high level of absenteeism amongst the employees).
International Competitiveness This term refers to the ability of a business to compete effectively with foreign competitors in a particular industry, based on factors such as price, design, quality, and lead times.

The competitiveness of a UK business with overseas rivals will often be affected by theexchange rate of the pound () against foreign currency, since a strong pound may result in a fall in demand from both foreign and domestic customers and a corresponding increase in imports entering the UK.

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Over recent years, the price of the product has been less of a consideration for many customers as the main reason for purchasing one brand over another. Instead, other factors such as the quality, reliability and after-sales service offered (e.g. warranties, guarantees, etc) have become important selling-points for products. Companies and brands such as BMW and Technics have achieved high sales levels and profits through selling well designed, well built, high quality products, which are more expensive than many other rival products on offer. Selling these products at high prices enables the business to establish an upmarket, quality image, as well as producing high value-added products which contribute greatly towards the overall profitability of the business. The UK is seen to have a distinct international competitive advantage in several industries, including fast moving consumer goods (f.m.c.g's), insurance and banking, and pharmaceuticals. In order to retain this competitive advantage over other foreign rivals then there are a number of criteria which must be met:
1. Develop strong marketing and branding (i.e. find out what the customer wants and develop a strong corporate image to help sell the products). 2. Become more capital intensive in the production of the products. 3. Look for long-term growth and profitability, instead of short-term gains. 4. Develop a strong reputation for customer service and after-sales service (helping the customer as much as possible is likely to keep them loyal to you). 5. Don't assume that a low-priced product will outsell its higher-priced rivals (price no longer provides the competitive edge that it once did).

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Exam-Style Questions
1. The decision tree below represents the problem faced by a manager considering the introduction of a new product. Cash flows are shown in million and probabilities are marked. The manager could employ a firm of consultants to give advice on either "launch" or "do not launch". The cost of employing the consultants is 100,000.

a) (i) Calculate the probabilities A and B. (ii) Calculate the expected values (cashflows) at C and D. b) Advise the manager whether she should employ the firm of consultants. (Marks available: 10) Answer outline and marking scheme for question: 1 Give yourself marks for mentioning any of the points below:

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A = 0.3 B = 0.45 C = 4.15 D = 4.17 b) Candidate argument and calculation to decide whether to employ consultans and take their advice. (Marks available: 10) 2. a) State briefly the key production decisions a business must make to supply its market. b) How might the objectives of the production department conflict with the objectives of the marketing department? (Marks available: 10) Answer outline and marking scheme for question: 2 Give yourself marks for mentioning any of the points below:

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a) Key production decisions a business must take to supply its market: what goods to produce, quantity of product to be supplied, variations of the product to be supplied, which markets to produce for, the nature of raw materials and its suppliers and the conversion of raw materials into the finished product. b) The production department will wish to keep the volume of production steady so that incoming raw materials, workload and finished goods remain constant and predictable The marketing department will wish to increase sales through promotional campaigns and will expect the production department to respond immediately to changes in levels of demand. They will also expect the production department to accommodate changes in customer orders, to implement the production of newly developed products rapidly and easily. (Marks available: 10) 3. The owner of a shopping centre plans to extend the centre by building new shopping units and finding tenants for them. He has listed the jobs to be done and the time each job will take.

a) Draw a critical path diagram. Identify the critical path and state the total time required to complete the whole project. b) If the time required for job F could be reduced by 2 weeks, what would be the effect on the time required for the project and what would be the new critical path? (Marks available: 10) Answer outline and marking scheme for question: 3 Give yourself marks for mentioning any of the points below: a) PICTURE Total time 30 CP A E F G I

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b) Total time 29 CP A D G I (Marks available: 10) 4.


a) How may the roles of a manager and a leader differ in business?

b) Explain briefly in what situations a manager might adopt different management styles. (Marks available: 10) Answer outline and marking scheme for question: 4 Give yourself marks for mentioning any of the points below: a) A leader normally sets objectives. A manager organises resources to achieve the objectives. (5 marks) b) Depends on situation, time, and the decision to be made. For example: a logistics manager of a transport company will tend to direct his drivers. He may adopt a different style when managing office staff. (5 marks) (Marks available: 10)

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External Environment The Economic Environment


Macro-Economic Issues Economics is concerned with the process of satisfying the needs and wants of the population, by using the limited resources of the economy (land, labour, capital and enterprise, otherwise known as the 'factors of production') in the most efficient way. There are generally considered to be four main objectives of an economy:
1. 2. 3. 4. A low level of unemployment A low level of inflation A high level of economic growth A good foreign trading position

Unemployment is defined as the number of people in the workforce in a country who are looking for a job, but cannot find one. The two major measures of unemployment are the 'claimant count' (where people must declare that they are out of work, capable of working, available to work and actively seeking work) and the 'International Labour Force' count (where people must be out of work, have been looking for work in the past 4 weeks and must be available to start work in the next 2 weeks). The main types of unemployment are:
1. Structural: where people are unemployed due to changes in the structure of the economy. 2. Frictional: where people are unemployed because they have left one job and are waiting to start another job. 3. Seasonal: where people are unemployed due to the seasonal nature of their jobs. 4. Cyclical: where the level of consumer demand is low.

Unemployment can be very damaging to an economy because it can lead to falling output, high government spending, and falling aggregate demand. There are several methods that a government can use to reduce the amount of unemployment in an economy:
1. Policies to increase demand: such as reducing taxation or reducing interest rates. 2. Retraining incentives offered to the unemployed. 3. Helping new businesses to set-up, and offering incentives to existing businesses to relocate to areas of high unemployment.

Inflation is defined as a general and sustained rise in the average prices of goods and services within an economy over a period of time. It is calculated by reference to the Retail

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Price Index (R.P.I), which is a weighted index, designed to indicate any changes in the average price level in the UK. The main types of inflation are:
1. Cost-push: where an increase in the costs of the business, such as raw materials or wages, forces the producers to increase their prices. 2. Demand-pull: where the level of customer demand outstrips the number of products that the business can produce. 3. Increases in the money supply: this can cause inflation where rises in the money supply have increased at a faster rate than the output of products.

Inflation can be very damaging to an economy because it leads to the reduced purchasing power of the pound, uncertainty about the future, a fall in investment and savings, and increasing costs for businesses. There are several methods that a government can use to reduce the rate of inflation in an economy:
1. Increasing interest rates to discourage high levels of customer spending. 2. Reducing the amount of credit (borrowing) that is available to customers. 3. Incomes policies, where pay increases are limited, so to deter high levels of costs and expenditure.

Economic growth. This term refers to a real growth (i.e. accounting for the effects of inflation) in the income per capita (or income per head) of the population over a given period of time. It is normally measured by reference to Gross Domestic Product (G.D.P) and Gross National Product (G.N.P). Gross Domestic Product is the total value of a country's output over a period of time (usually 12 months). Gross National Product is calculated by adding G.D.P. to the net income from abroad (i.e. the income earned on overseas investments by UK citizens and businesses, minus the income earned by foreigners investing in the UK). Economic growth is likely to lead to an increase in the amount of investment in the economy, as well as an increase in the number of new businesses starting up, leading to increases in output, expenditure and income. The diagram below illustrates how an economy moves through a number of 'highs' and 'lows' over time, which indicates the level of growth in the economy :

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This diagram is known as the 'Trade Cycle'. It refers to the fluctuation of employment, income, expenditure and output in an economy over time -thus showing us the level of economic growth. We can identify several feature from the diagram: 'Peak' or 'Boom'. The economy is at its peak. Consumption and investment will be at high levels, and pay rises are likely to be large. Businesses are likely to be making high levels of profit and there will be strong inflationary pressure. 'Recession'. This refers to a situation where the G.D.P. of an economy has fallen for two successive quarters (6 months). It is characterised by falling customer demand, low investment, and rising unemployment. Other features of a recession include falling house prices, and falling business and consumer confidence. 'Slump' or 'Trough'. This is the bottom of the trade cycle, and this stage is characterised by a high level of unemployment, very low levels of consumption and investment and a poor international trade situation. 'Recovery' or 'Expansion'. Income, output and employment start to rise again, consumption and investment gradually increase and the economy starts to expand again. In order to improve the G.D.P. or the G.N.P. per capita (i.e. in order to achieve a faster rate of economic growth), then the government must ensure that the workforce is adequately educated and trained to perform their jobs effectively, significant amounts of investment in new machinery and production techniques are undertaken, and natural resources must be used to their optimum efficiency. Balance of payments. This is a record of a country's financial transactions with the rest of the world over a given period of time (normally 12 months).

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The current account of the balance of payments measures both 'visible' trade (that is, the imports and exports of tangible goods such as furniture and cars) and 'invisible' trade (that is, the imports and exports of intangible services, such as banking, shipping, and insurance). The capital account of the balance of payments measures any flows of capital between the UK and other countries (purchase of shares and other forms of investment). Protectionism is the term that refers to a government's policies of protecting its domestic businesses from more competitive foreign imported goods. The government can use a variety of these protectionist policies (also known as barriers to trade):
1. Quotas: These place a physical restriction on the number of units of a product allowed to enter the country. 2. Tariffs: A tariff is a tax, which is placed on an imported good, which makes the imported good more expensive, making the domestically produced good more appealing and competitive. 3. Embargo: This is a ban on all trade with a certain country. 4. Technical barriers: This involves imposing strict technical standards for the supply of a product in a country, making it difficult for foreign producers to sell their products in the UK.

The exchange rate is the external price of a country's currency, expressed in terms of another currency. For example, 1 = 3.1 Deutschmarks. A free-floating exchange rate system involves the value of the currency being allowed to float (fluctuate) according to the supply and demand for the currency. A demand for sterling is created when the UK exports goods and services (foreigners must pay for these goods and services using sterling, which they purchase in exchange for their own currencies). A supply of sterling is generated when the UK imports goods and services (i.e. the UK must pay for these imports using the foreign currency of the country concerned). These foreign currencies are purchased in exchange for sterling on the world currency market. An increase in the value of the pound is known as an appreciation, and a fall in the value of the pound is known as depreciation.. A strong pound makes goods and services produced in the UK more expensive for foreigners to purchase, but makes foreign goods and services cheaper to import. A fixed exchange rate system involves the value of the currency being fixed against other currencies and not being allowed to fluctuate in response to the demand and supply for it. This involves government intervention on a regular basis, buying the currency when its value is threatening to fall, and selling the currency when its value is threatening to rise. Under this system, the government can devalue the currency if it feels that its value is too high against foreign currencies, making their goods and services uncompetitive. This devaluation of the currency boosts the international competitiveness of the country's exports, by making them cheaper for other countries to purchase.

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Alternatively, the government can revalue the currency if it feels that its value is too low against foreign currencies, making the level of demand too high for their goods and services and leading to inflation.
Competition The competitive structure of an industry will directly affect the level of output, the amount of employment, and the price level of the goods and services produced. According to economic theory, there are several different types of competitive structure that can exist in an industry:
1. Monopoly: This is where a single producer dominates the industry, having the freedom to charge whatever price he feels he wants to and having the ability to restrict the levels of output and quality. 2. Duopoly: This refers to a situation where 2 businesses dominate the industry (for example, 'Unilever' and 'Proctor & Gamble' dominate the detergent market). They will often not compete on the price of their products, but instead will compete on other aspects such as advertising, and after-sales service. 3. Oligopoly: This is where a small number of businesses (3 -8) dominate the industry (e.g. supermarkets, banks, oil companies). Again, they are very large businesses and they have the ability to earn very high levels of profit. 4. Monopolistic Competition: This refers to a situation where many businesses exist in an industry, and each has a wide product range and a degree of product differentiation. Profits are not as high as in an oligopolistic industry. 5. Perfect Competition: This is a theoretical extreme, which does not exist in reality, there are a large number of very small businesses, each of which produces an identical product. The price for each product is the same and all businesses only make what are termed 'normal profit' in the long-run (i.e. they make enough revenue to simply cover their costs).

European Union (E.U) European Union (E.U). This was formed in 1993, following the Maastricht Treaty, replacing the European Community (E.C), which had, in turn, replaced the European Economic Community (E.E.C).

It consists of the following 15 member countries: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, Sweden, and the UK. The Treaty of Rome (1957) established the E.E.C, and the main objective was to remove all the trade barriers (financial, physical and technical) between the member states. This should encourage the free movement of people, businesses and goods and services between the member states, the Single European Act was passed in order to try and achieve this goal, giving members until 1992 to abolish all barriers to trade between members. The main institutions within the E.U are:
1. The Council of Ministers: This is the main decision-making body of the E.U. It agrees and adopts pieces of legislation that are referred to it by the European Parliament. It performs a similar role to that of the Cabinet within the UK government.

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2. The European Commission: This proposes E.U. legislation, which is then passed to the Council of Ministers. The result of the deliberations of the Council of Ministers is then implemented by the European Commission. 3. The European Parliament: This has over 600 Members of European Parliament (M.E.Ps), who are elected every 5 years. They advise the Council of Ministers on a variety of issues and they have the power to dismiss the European Commission.

The Maastricht Treaty was signed by all member states in 1991, taking effect as of 1st November 1993. This aimed to create greater unity between the member states in political, monetary, social and welfare areas (including education and health). With the exception of the UK, all members have agreed to monetary union -this led to the development and the launch of the Euro (the single currency) on 1st January, 1999. The currency is mainly being used by the business-sector, but will be available for all E.U. citizens on 1st January, 2002, with the withdrawal of all national currencies by 30th June, 2002. The ultimate aim of the E.U. is economic, monetary and political union of all the member states, but there is still much that needs to be done in preparation for this aim. All member states will be required to harmonise aspects such as taxation, interest rates, etc, as well as adopting the single European currency and allowing the free movement of people and businesses throughout all E.U. countries.

The Technological Environment


Advances in Information Technology (I.T) The effects of new technology are many and varied. It is leading to a rapid increase in teleworking (that is, people working from home using telecommunications equipment), increasing levels of output and productivity, more flexible manufacturing systems and shorter product-development times.

However, new technology is also leading to job losses, shorter product life-cycles and more flexible working patterns (where job security is becoming a rather outdated concept). Many processes and systems in businesses can be assisted by the use of Information Technology (I.T). Sophisticated software packages can enable a business to keep detailed and accurate records on its purchases of stock and its sales to customers, using such systems asElectronic Point of Sale (E.P.O.S). This records every transaction made by a business and can, therefore, enable it to monitor its stock levels and sales of products to a 100% level of accuracy. This system can automatically re-order stock when numbers fall to a certain level in the warehouse, as well as monitoring the quantity of each component that is used in the production process. This enables a tight control to be kept on both costs and waste, as well as recording the amount of revenue received from customers and any outstanding customer debts.

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Computer Aided Design (C.A.D) is the use of sophisticated computer software to design three-dimensional images of products quickly and relatively cheaply. Computer Aided Manufacturing (CAM) is the use of computers and software for a wide variety of production tasks, including automated production lines and stock control systems.
Opportunities and Threats of New Technology An increasing number of businesses rely on computers and information technology systems for their communications (as well as for their financial, production and personnel records).

These records are never 100% secure, and there have been many stories in the media concerning information stored on computers that has been 'hacked' into, as well as computers 'crashing' and losing vital data for which there was no duplicate copy. Added to this is the increasing amount of business being conducted using electronic mail (email) and the Internet (it is estimated that by 2005, any businesses, which are not using the Internet to trade and interact with customers are likely to lose any competitive edge that they may have). So it is clear to see that the 'information-age' and the 'digital-age' are going to be a major influence on how business is conducted in the future. Any business which does not employ computer-literate staff and does not use Internet-trading is likely to suffer falling levels of sales and profits as a result. However, there are many problems inherent in what is termed 'the electronic office', a work environment that is highly computerised and relies heavily on software and communications equipment. The main problems can be summarised in the list below:
1. Much time is often required to train staff in the use of the new equipment and software 2. Computer fraud (e.g. 'hacking' into the computer-held information and changing the data or embezzling the business funds) 3. Huge initial capital outlay required in order to purchase the equipment and software 4. Equipment and software may become obsolete within a few years 5. Resistance from employees and from trade unions to the new working practices

The Social Environment


Ethics and Social Responsibilities Ethics are moral principles and judgements that many people believe should be considered when a business makes any decision (for example, what is 'right' and 'wrong'? What is 'good' and 'bad'?). Social Responsibilities are the duties that a business has towards the people who are affected by its activities, for example, customers, employees, suppliers, and the local community.

A 'good' business is deemed to be one which acts in a socially responsible fashion, and takes ethical decisions and actions at all times. It minimises waste, it creates wealth, it treats its employees well, it respects the environment, it does not employ 'fat cat' executives, it is

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efficient in its use of resources, it meets consumers' expectations and it returns some of its profit to the community in which the sales are generated. Topical ethical issues in today's business world include:
1. 2. 3. 4. The exploitation of cheap labour in foreign 'sweatshops'. The use of child labour. Dealing with corrupt foreign governments and businesses. Causing damage to the environment.

There are many advantages that businesses can gain from taking a highly ethical and socially responsible stance:
1. 2. 3. 4. Attracting and retaining high quality employees. Attracting new consumers. Generating good publicity. Attracting ethically-minded investors.

However, taking a highly ethical and socially responsible stance can lead to a variety of shortterm problems, including increasing costs, reducing profits, and conflict between the management and the shareholders.
Pressure Groups Pressure groups are organisations that develop in order to tackle a matter of vital interest to the members of the group (e.g. campaigning against businesses which cause pollution, or test their products on animals).

They do not have any direct political power, but they often aim to influence the actions of local government and central government, as well as the actions of businesses. Pressure groups can generally be classified as:
1. Interest groups: These groups are established to further the interests of its members and to make the general public aware of its cause (e.g. trade unions). 2. Cause groups: These groups are established to further a particular cause (e.g. animal welfare) as to make the general public aware of this cause.

The basic difference between the two groups is that interest groups are motivated by selfinterest, whereas cause groups are more concerned with other people and the environment. Pressure groups try to exert influence in a number of ways, including arranging boycotts of products, creating adverse publicity for the business, holding public demonstrations, and 'lobbying' the government (i.e. attempting to get the cause noticed and acted upon by MPs). Basically, pressure groups aim to raise as much publicity and awareness of their cause as possible, in the hope that this will stop the businesses from continuing their actions.

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The success of a pressure group in achieving its aim(s) will depend on a number of factors, the most important of which are:
. 1. 2. 3. 4. 5. Their available funds and resources. Their organisational ability. The level of public sympathy. Their access to politicians and people in powerful positions in industry. Their reputation.

Social Audits A social audit is an independent and critical review and appraisal of the business in aspects such as its level of environmental damage, its use of recycled materials, and the health and safety of the workforce.

Traditional business audits purely measure financial ratios and performance, but social audits take into account both external costs (the detrimental consequences of the activities of a business that are paid for by society as a whole, such as pollution and congestion) and social costs (which measure the total cost to society of the activities of a business). In other words, social costs are equal to the internal costs of the business plus the external costs faced by society. An increasing number of businesses are carrying out social audits due to rising environmental awareness amongst consumers and investors. Concerns are being raised about the negative aspects of business activity such as waste by-products, air pollution, water pollution, congestion, noise and damage caused to the environment. As a result of these concerns, businesses are engaging in a number of environmental schemes which aim to promote the business in a socially-responsible fashion, including recycling schemes, sponsorship of local communities, and developing long-term trade-links with suppliers and communities in third-world countries (i.e. ensuring that these suppliers and communities receive a fair price for their services). By becoming more environmentally aware and considerate of their effects on society, it is hoped that businesses will reduce the number of social costs that they impose on communities and on the environment, and instead they will be able to produce a range of social benefits (such as sponsorship of schools and local events, job creation, and the provision of a range of services that can be used by the local community).

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The Legal Environment


Consumer Protection The government has passed many pieces of legislation over the past 40 years which aim to ensure that consumers are protected from the negative aspects of the operations of businesses.

The main pieces of legislation aimed at protecting consumers in the UK are:


1. The Trade Descriptions Act, 1968: This makes it illegal for a business to provide false or misleading descriptions of their products, services, accommodation and facilities. 2. The Unsolicited Goods Act, 1971: This stated that unsolicited goods become the property of the recipient if the sender does not retrieve them from the recipient within 30 days of notice. 3. The Consumer Credit Act, 1974: This states that any business which offers credit facilities must obtain a licence from the Director-General of Fair Trading and must also display the annual percentage rate (A.P.R) that will be charged. 4. The Sale of Goods Act, 1979: This states that goods must be of merchantable quality, as described in their advertisements and fit for their purpose. 5. The Consumer Protection Act, 1987: This states that it is an offence for a business to give a false or misleading price indication on its product(s) AND businesses are liable for any damage and injury that their defective products cause to consumers. 6. The Food Safety Act, 1990: This states that it is an offence for a business to sell food if it is not registered to do so and also if those handling the food have not been appropriately trained. It also states that the food must be of the expected nature and quality that is demanded by the consumer.

Employee Protection The government has passed many pieces of legislation over the past 30 years which aim to ensure that businesses treat all of their employees fairly and meet a variety of health and safety regulations. The main pieces of legislation aimed at protecting the employees in business are:
1. The Employment Relations Bill, 1999: Stating that employees who have been in employment with the same business for a period of one year have the right not to be unfairly dismissed. 2. The Employment Rights Act, 1996: Covering unfair dismissal, redundancy and maternity. 3. The Public Interest Disclosure Act, 1998: Covering employees who disclose confidential information. 4. The Health & Safety at Work Act, 1974: Covering working conditions and the provision of safety equipment, hygiene, etc). 5. The National Minimum Wage Act, 1999: Making it illegal for employers to pay less than 3.60 per hour to its full-time staff who are aged over 21. 6. The Equal Pay Act, 1970: stating that pay and working conditions must be equal for employees of the opposite sex who are performing the same work. 7. The Sex Discrimination Act, 1975: Stating that it is illegal to discriminate against an employee, or an applicant for a job, on the grounds of their sex and/or their marital status. 8. The Race Relations Act, 1976: Stating that it is illegal for an employer to discriminate against an employee, or an applicant for a job, on the grounds of their ethnic background.

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9. The Disability Discrimination Act, 1995: Stating that it is illegal for a business with 20 or more employees to discriminate against an employee, or an applicant for a job, on the grounds of their disability.

Competition Legislation In the UK, the government body that is responsible for ensuring that anti-competitive business practices are abolished and consumers are protected is the Office of Fair Trading (O.F.T). This ensures that businesses meet the requirements of the Fair Trading Act 1973.

The O.F.T. has the power to recommend any business to the Monopolies and Mergers Commission (M.M.C) for further investigation, if it feels that they are acting against the public interest (e.g. charging very high prices, or restricting consumer choice). The O.F.T. will also investigate any claims of restrictive practices, that is, where businesses act together to reduce the degree of competition in an industry (e.g. price fixing). The O.F.T. has the power to set maximum price increases to prevent monopoly exploitation, sets quality standards for businesses to achieve, and establishes 'Watchdog' bodies to protect consumers' interests and monitor business practices. The Competition Commission is an organisation that was established by the government in 1948, and it was designed to investigate and monitor proposed mergers and take-overs of large businesses and to ensure that any businesses with monopoly power do not act against the public interest. In general, any business with a market share of 25% or more is likely to be investigated. The Competition Commission cannot take legal action itself against any businesses that are acting against the public interest, but instead it can recommend to the O.F.T. that action is necessary.

The Political Environment


Some countries in the world can be labelled 'command' economies (e.g. China, Cuba, and North Korea). This involves the allocation of resources being decided upon by the government (the public sector), with little or no private sector activities. The UK (like most of the developed countries in the world) is a mixed economy, that is, its goods and services are provided partly by the public sector (the government) and partly by the private sector (which consists of privately run businesses and organisations). A government is said to adopt a 'laissez-faire' approach to managing the economy if it allows the operations of the free market to exist (i.e. it does not intervene in the economy in order to change the workings of the market mechanism from deciding how to allocate resources).

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However, most governments adopt an 'interventionist' approach to managing the economy and there are a number of policies that the government can use to influence the workings of an economy.
Fiscal Policy This is a government policy, which aims to influence the economy by raising finance (through taxation) and then spending this finance on public services such as education, health, and transport). Taxation can be classified in 2 ways:
1. Direct and Indirect: Direct taxation is tax that is paid directly from the income, wealth or profit of an individual or a business (e.g. income tax, corporation tax). Indirect Taxation is tax that is paid on goods and services, (e.g. VAT and excise duty). 2. Progressive, Regressive and Proportional: A progressive tax is one where the proportion of income that is paid in tax rises as the income of the taxpayer rises (e.g. income tax). A regressive tax is one where the proportion of income that is paid in tax falls as the income of the taxpayer rises (e.g. the 'community charge'). A proportional tax is one where the proportion of income that is paid in tax remains the same as the income of the taxpayer rises (e.g. V.A.T).

The main taxes in the UK are:


1. Income tax: This is a tax on individuals' incomes and it is the single most important source of revenue for the government. 2. National Insurance contributions: This is also paid by every employee, and the money raised goes towards financing state pensions, sick pay and unemployment benefit. 3. Corporation tax: This is a tax on the profits of businesses. 4. Capital Gains tax: This is a tax on the profits (or 'capital gains') that are made on investments (shares and other assets). 5. Inheritance tax. This is a tax on the value of assets left on the death of an individual. 6. Excise duties. These taxes are levied on fuel, alcohol, tobacco and gambling. 7. Value-Added tax. This is a tax on individuals' expenditure. 8. Council Tax. This is a tax that is levied by local councils, as opposed to central government. It is based on the size, location and value of domestic property. The money raised is spent by the local councils on libraries, parks and refuse cleaning.

The government will spend the money that it raises through taxation on a variety of items, including social security, health, education, defence, public order, transport and housing. If the government needs to spend more money on these items than it raised through taxation in a particular year, then it is said to have a Budget deficit. It therefore needs to borrow the extra money that it requires through selling Treasury Bills to individuals or to businesses. This is known as the Pubic Sector Borrowing Requirement, (or P.S.B.R). If the government raises more money through taxation than it needs to spend in a particular year, then it is said to have a Budget surplus. It can therefore repay some of its borrowings from previous years. This is known as the Pubic Sector Debt Repayment, (or P.S.D.R).

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Monetary Policy This is a government policy designed to control the amount of spending in an economy, by altering the money supply, interest rates, exchange rates and the amount of credit that is available to customers. For example, in the past, if the economy was believed to be overheating and inflation was considered to be too high, then the government was likely to increase the base-rate (that is the interest rate which all banks use in order to set their own rates of interest).

By increasing interest rates, making borrowing less attractive to both individuals and to businesses, as well as increasing the amount of the repayments for people who already had a loan or a mortgage. Therefore, fewer people applied for loans and mortgages, and expenditure in the economy was reduced, thus reducing the rate of inflation. However, the control of interest rates is now no longer in the hands of the government, but instead it is decided upon by the Monetary Policy Committee (M.P.C) at the Bank of England. Similarly, by restricting bank loans or by placing more stringent restrictions on giving credit agreements to individuals, the government can use monetary policy to restrict the amount of money that consumers and businesses will borrow, therefore reducing their demand for goods and services. This, in turn, should allow inflation to fall.
Regional Policy Regional Policy. This is a government policy that attempts to reduce regional inequalities of employment, income and wealth. The government can use regional policy in one of two ways:
1. Giving a variety of incentives to existing businesses to relocate to less affluent areas of the country in order to create employment and wealth in these areas. 2. Enticing new businesses to set-up in these less affluent and depressed areas.

The measures that the government can use include giving grants to the businesses, offering rent-free and rate-free premises, providing training programmes for employees, giving financial and legal advice and support, and providing cheap loans and mortgages. The Department of Trade and Industry (D.T.I) has labelled several areas in the UK asAssisted Areas, which areas which require revitalisation, but which have huge development potential (i.e. an abundant labour force, relatively low wage-rates, and significant amounts of under-utilised land and premises).
Nationalisation -v- Privatisation Nationalisation occurs when businesses and industries are transferred from the private sector to the public sector. It is often argued that consumers benefit from lower prices with a nationalised industry (public corporation), since it does not need to make massive profits, and therefore it can charge a price to consumers that barely covers the costs of production.

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Any loss incurred can be subsidised by the government. Further to this last point, nationalisation often results in loss-making services (e.g. rural bus routes) being kept running and therefore providing a vital service for many small communities, which may not exist if the network was privatised. Privatisation refers to the transfer of public sector organisations and resources to the private sector. It generally falls into three categories:
1. Deregulation: the removal of any government rules and regulations from the operation of an industry, often allowing new competitors to enter the industry. 2. Contracting out: private sector contractors are given the opportunity to place a bid to secure public sector contracts (e.g. refuse collection and cleaning contracts). 3. The sale of public corporations: These are transferred to the private sector and become Public Limited Companies (P.L.Cs) which are floated on the stock market.

The Conservative government from 1979 - 1997 was a firm believer in the privatisation of public corporations for a number of reasons:
1. It generates a large amount of revenue for the government. This 'windfall' can be spent on areas such as education, health, etc. 2. The public corporations become far more efficient when in the private sector, since they have to become competitive and provide a service to the consumer at a profit in order to survive. 3. It widens share ownership amongst the population. 4. Revenue that is raised from the sale of these public corporations can be used to reduce taxes.

The following businesses were privatised by the successive Conservative Governments of Margaret Thatcher and John Major between 1979 and 1997: British Telecom, British Gas, British Airways, British Steel, Rolls Royce, British Petroleum, British Airports Authority, British Water Authorities, Electricity Boards, Jaguar Cars, and Sealink. The privatisation of many of these public corporations has resulted in many cases in a rapid increase in their profitability, as well as a significant rise in the price of their services. Many public corporations have faced strong competition and have been forced to improve their image and their marketing in order to protect their market share.

Exam-Style Questions
1. "British sugar, Tate and Lyle which together hold more than 90 per cent of the British sugar market and two sugar distribution companies are likely to be fined by the European Commission for running a price fixing cartel."

(The Guardian - 4th October 1998)


a) What is the justification for action of this kind by the European Commission? b) Outline other measures which might be taken to encourage competition. c) Explain how small firms are able to exist alongside multinationals producing similar goods.

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d) Why do most small firms remain firm? (Marks available: 20) Answer outline and marking scheme for question: 1 Give yourself marks for mentioning any of the points below: a) To encourage competition in markets and to punish those companies who seek to reduce consumer choice. (5 marks) b) Government assistance for new businesses. Reduce restrictive practices to allow free entry into the marketplace. Investigate industries with few produces which make huge profits. (5 marks) c) Niche markets, market too small for multinational to invest in, local market. (5 marks) d) Owner desire control over business, lack of finance to invest, small demand, lack of knowledge. (5 marks) (Marks available: 20) 2. a) Why, at a time of impending recession, is there often a call for a reduction in interest rates. b) How might a downturn in economic activity affect a business. (Marks available: 10) Answer outline and marking scheme for question: 2 Give yourself marks for mentioning any of the points below: a) Interest rates can be reduced at the time of a recession to attempt to stimulate the economy. Firms will find it cheaper to invest in new machinery and equipment, exports are encouraged and imports discouraged. Consumers may buy more credit as it is cheaper, mortgages are also less expensive, giving consumers more discretionary income.

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(5 marks) b) A downturn in economic activity will affect a business as less demand for a product may be experienced. This may result in a cash flow problem. Any change in demand for a firms product depend on the product itself, electricity would not be greatly affected by a downturn in economic activity. (5 marks) (Marks available: 10) 3. a) Explain briefly why governments might need to intervene in the market economy, what intervention methods could be used? b) How might a bus service run by a local authority differ from one operated by a private company? (Marks available: 10) Answer outline and marking scheme for question: 3 Give yourself marks for mentioning any of the points below: a) Governments may need to intervene in the market economy in order to provide public and merit goods. Government watchdogs oversee privatised companies to prevent exploitation of the customers. (5 marks) b) A bus service run by a local authority may operate profitable and non-profitable routes and use cross subsidisation. The private company will tend to operate on more profitable urban routes and regulate their service to customer demand. The objective of the local authority is to provide a service, not necessarily to seek a profit to satisfy shareholders. (5 marks) (Marks available: 10)

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Management, Leadership, Motivation and Communication Management and Leadership


Different styles of management Management is the process of achieving the objectives of the business by using its available resources effectively.

In a small business, the owner is likely to be the manager as well, responsible for all the managerial tasks. However, as a business grows, then some of these tasks can be delegated to others. The main functions of management are:
1. 2. 3. 4. 5. 6. Planning: setting clear objectives. Organising: dividing the work into smaller tasks and delegating to others. Staffing: having the 'right' person in the 'right' job (known as Human Resource Management). Directing: decision-making and giving instructions to others. Budgeting: preparing a detailed financial plan for the next trading year. Co-ordinating: Bringing the various parts of the business together.

One of the most important skills of management in a large business is knowing how, when and what tasks to delegate to others. Delegation occurs when managers pass a degree of authority down the hierarchy to their subordinates. The managers must ensure that the subordinates are sufficiently competent to cope with the task, and that they have the necessary skills and time available to complete the delegated task. In general, management can be categorised as senior management (setting long-term plans and strategies, appraising middle management), middle management (establishing departmental strategies, appraising departmental staff), and supervisory management(monitoring the regular and routine day-to-day tasks). The relationship that exists between the management and their subordinates in a business can be represented diagrammatically in the form of an organisational chart:

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An organisational chart shows: a) The different departments within the business. In this example, there are 4 different departments (Production, Marketing, Finance and Personnel). b) The chain of command. In this example, a chain of command exists between person A (senior manager), person B (middle manager), person C (supervisor) and person D (shop-floor worker). c) The span of control of each manager. This refers to the number of people directly accountable to a single superior. In this example, the span of control is 4 people. d) The channels of communication used. This diagram indicates that this business has four layers in its hierarchy and that there are many 'line' and 'staff' relationships which exist. A 'line' relationship exists where there is direct authority (in the diagram, an example of a 'line' relationship is between person B and person C). A 'staff' relationship exists where there is no direct authority. Instead, it is a relationship in an advisory capacity (e.g. an expert who provides advice on, say, computers or staff training). In the diagram, an example of a 'staff' relationship is between person B and person D. A recent trend in many large businesses has been delayering the organisational chart. This means stripping out one layers of management from the hierarchy. This is done to reduce costs and to improve the speed of communication flows within the business, as well as to provide each employee with more responsibilities. However, delayering can actually overstretch employees by giving them too much work and can, therefore, actually have a negative effect on their level of morale and motivation.

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Traditionally, many businesses had highly centralised decision-making, with all they key decisions being made by senior management, with little responsibility and authority being passed down the hierarchy. The advantages of this method of management are:
1. The business has tight control over its operations. 2. people can specialise in the jobs to which they are best suited.

However, the disadvantages include :


1. The business becomes rather inflexible and bureaucratic in its operations. 2. Decisions can take a long time to be made. 3. There is very little use made of employees further down the hierarchy.

An alternative management method is for decentralised decision-making to occur. This is where responsibility and authority are passed away from the top of the business to regional offices and departments. The advantages of this method of management are:
1. The development of many employees by empowering them. 2. The business becoming faster and more efficient in its operations. 3. Higher levels of morale and motivation amongst the employees.

However, the disadvantages include:


1. A loss of control / power at the top of the business. 2. Getting too many employees involved in decision-making may lead to mistakes being made.

A common management method as business try to become more flexible is matrix management. This involves a situation where a number of employees from different departments within the business are asked to temporarily work together to achieve, say, the successful launch of a new product. Each person in the team will then be accountable to their departmental manager as well as the team manager. This can lead to problems of loyalty and prioritising of workloads, as the employee can neglect their departmental duties in favour of the new project they are involved in. Another management technique is management by objectives, which involves each manager setting objectives for himself, based on the overall objectives of the business. It was first developed by Peter Drucker in the 1950s, but has become a very popular management tool over the past 20 years. It should lead to improved levels of morale, as the managers are more committed to the achievement of their goals. It forces managers to plan

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carefully for the next year and the performance of the manager is judged on how effective he has been in the achievement of his objectives for the year.

Leadership
Leadership is the process of influencing people so that they will perform a variety of tasks in an effective manner. It is, therefore, crucial to have a strong leader who can inspire and motivate the employees. A leader is different to a manager, since a manager is often appointed to a position of power, whereas a leader may often emerge as the best to cope in a given situation (i.e. an employee who is very competent at computing may well be viewed as a leader, even though he may be towards the bottom of the organisational hierarchy). There are a number of styles of leadership: 1. Autocratic. This is often referred to as an authoritarian leadership style, and it basically means that the people at the top of an organisation make all the decisions and delegate very little responsibility down to their subordinates. Communication is top-down, with no opportunity for feedback to the leader. It can cause much resentment and frustration amongst the workforce and it is not very common in today's business world. 2. Democratic. This involves managers and leaders taking into account the views of the workforce before implementing any new system. This can lead to increased levels of morale and motivation amongst the workforce, but it can also result in far more time being taken to achieve the results since many people are involved in discussing the decision. 3. Laissez-faire. This is where employees are set objectives, and then they have to decide how best to achieve them using the available resources. This method of leadership can result in high levels of enthusiasm for the task in-hand, but it can at times rely too much on the skills of the workforce. 4. Paternalistic. This is fairly autocratic in its approach to dealing with employees, although their social and welfare needs are taken into account when a decision is made that will affect them. The leader is likely to consult the workforce before implementing any decision, but he is unlikely to listen to much of the feedback.

Schools of Thought
There are a number of different 'schools' of management thought that have been developed over the past century. The main 'schools' of thought are:

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Classical Management. This was developed by Henri Fayol and it emphasised the following factors as being essential to an effective management process: a) The division of labour. b) A wide span of control. c) A tall organisational structure. d) An authoritarian style of management.

Scientific Management.
This method was developed in the USA in the early part of the 20th century by Frederick Taylor, building on the earlier work of Henri Fayol. Taylor also believed that a high division of labour was needed to produce more output, and he introduced a piece-rate style of payment for the workforce (this meant that the workers received an amount of money per 'piece' that they produced, thereby linking their pay to their productivity). Taylor also worked very closely with Henry Ford in developing the world's first moving production-line for the model 'T' Ford car. This method of management paid close attention to 'time and motion' studies, where each worker is timed when performing a task, and then this provides the basis for the worker's level of output per day (e.g. if it took a worker 2 minutes to perform a task, then this could be done 30 times per hour, and 240 times in an 8-hour day). If the worker completed more than his designated number of tasks per day, then he would be eligible for a monetary bonus. Taylor believed that efficiency and discipline were the two greatest features of a good manager and a good workforce, but what he failed to recognise was the high level of alienation and low levels of morale and motivation that this system produces in the workforce.

Human Relations Management.


The Human Relations 'school' of management thought looks beyond mere financial and productivity variables in deciding the best way to manage a workforce. These managers believe that a worker's performance can be improved by being given praise and recognition for their efforts, that workers should be consulted in any decision that affects them, and that the leader should be democratic rather than autocratic.

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Probably the most famous study of Human Relations Management was carried out by Elton Mayo between 1927 and 1932 at the Western Electric Company, at Hawthorne in Chicago, USA. He studied a group of six female workers over this time, and tried to establish a link between their working conditions and their productivity levels. He changed many of the working conditions (e.g. hours of work, rest periods, lighting, heating), and he discovered that the level of output rose each time. He concluded that the only factor that was needed to consistently achieve a high level of productivity was a strong level of social interaction and teamwork amongst the 6 employees. He called this the 'Hawthorne Effect'.

Neo-Human Relations Management.


There are a number of management writers and theorists who built on the earlier work of Mayo, agreeing that the way that employees are treated, and the praise and recognition that is given to them by their managers, can have a tremendous psychological effect on their productivity levels. The main writers in this field are Abraham Maslow, Frederick Herzberg and Douglas McGregor. Abraham Maslow's 'Hierarchy of Needs' can be seen in the diagram below:

We first need to satisfy the basic requirements of continued existence (i.e. physiological needs). Once these needs are satisfied, then we seek to satisfy the higher level needs. Until a lower order need is satisfied, you cannot progress onto a higher level need. Hence, once the lower level needs are satisfied, then further motivation for the employee can only come by giving them greater scope for using skill, initiative and creativity.

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Most people reach the safety and social categories, some reach the ego category, yet very few reach the self-fulfilment category (and those that do reach it will not remain at it for very long). As a result of this progression, the size of each of the sections in Maslow's hierarchy diminishes the higher they get, as fewer and fewer people reach them. Applying this theory to employees, physiological needs include pay and working conditions, safety needs include Health & Safety protection and pension schemes, social needs include the need to work in a team and mix with others, and ego needs may include a company car, job title or size of office. Self-fulfilment needs will depend on the individual employee, whether he has achieved his full potential or not. Frederick Herzberg carried out several studies of management and motivation and he attempted to identify the factors that motivate employees. His most famous theory is called the 'Two-Factor Theory', in which he distinguished between what he called Motivators (which actually give an employee positive satisfaction) and Hygiene / Maintenance factors (which do not give positive satisfaction, but their absence will cause dissatisfaction). Herzberg studied 200 engineers and accountants, who represented a cross-section of Pittsburgh industry. They were asked about events they had experienced at work, which had either resulted in a marked improvement or a marked reduction in their job satisfaction. The motivators are concerned with the content of the job and include a sense of achievement, being given responsibility, using initiative and creativity, and being involved in decisionmaking. In other words, these motivators equate with the ego and self-fulfilment categories in Maslow's Hierarchy. The Hygiene / Maintenance factors are concerned with the context of the job and include such items as pay, working conditions, supervision, company policy, bureaucracy ("red tape") and interpersonal relations. For managers, the implications of Herzberg's work are that it is necessary to provide strong motivational factors, whilst at the same time ensuring that the negative, hygiene factors are minimised. Douglas McGregor developed what he termed 'Theory X' and 'Theory Y' management styles. A Theory X manager is very authoritarian, assuming that employees need constant supervision, they will avoid performing their jobs if they can, they do not seek responsibility, they prefer to be told what to do, and they are really only interested in job security. A Theory Y manager, on the other hand, assumes that employees wish to be given praise and recognition for their achievements, they like to be given responsibility at work, and they wish to use their imagination, creativity and initiative.

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Contingency Management.
This management 'school' of thought was developed in the 1960s and, unlike the other theories, it believes that there is no single approach to management which will suit all businesses and all employees. In other words, some situations in a business will call for a more authoritarian management style (e.g. a crisis), whereas in other situations a more participative 'hands-on' approach to management will be required.
Link to Motivation It is clear that the management and leadership styles that are adopted by a business and its management will have a measurable effect on the motivation level, the morale and the job satisfaction of the employees.

Today, it is very rare to find a business using management styles similar to Fayol and Taylor. Most businesses use elements of Human Relations management, since these theories tend to be preferred by all concerned (the managers, the employees and trade unions). Nevertheless, the relationship between the management style that is used within the business and the level of motivation within the workforce is a subject of much debate within industry. Most managers find that the situation that they are in and the people that they are dealing with will influence the style of management that they use.

Motivation
Having a motivated workforce is vital for most businesses, since it can lead to higher rates of productivity, better quality output, and low rates of absenteeism and labour turnover. The main factors which affect the motivation of workers are pay levels, job security, promotional prospects, being given responsibilities, working conditions, fringe benefits, participation in decision-making and working in a team.
Motivational Theories There are two basic theories of motivation; content theories and process theories. Content theories focus on what actually motivates people, they study the needs that must be satisfied in order for the employee to be motivated.

The need is either satisfied by an extrinsic reward (e.g. pay) or an intrinsic reward (e.g. recognition and praise). The Classical (Fayol), the Scientific (Taylor), the Human Relations (Mayo), and the Neo-Human Relations (Maslow, Herzberg, McGregor) schools of management thought are all content theories. Process theories, do not concern the needs which must be satisfied in order to achieve motivation, but instead they are concerned with the thought-processes that influence workers' behaviour. There are two such theories: Expectancy theory:

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This states that workers will only act when they have a reasonable expectation that their work will lead to the desired outcome. If they believe that they possess the ability and skill to achieve the goal, then their level of effort will be great and they will be motivated. Equity theory: This states that each worker will wish to receive a remuneration package (equal to their pay plus fringe benefits) in return for their efforts. Each worker will only be motivated if their remuneration package is seen to be fair (or equitable) in relation to the remuneration packages received by the other workers for their efforts.
Financial Methods There are many different methods of payment that a business can choose from, each of which can have different effects on the level of motivation of the workforce. The main methods are:

1. Time-rate ('flat rate') schemes. This payment method involves the employee receiving a basic rate of pay per time period that he works (e.g. 5 per hour, 50 per day, 400 per week). The pay is not related to output or productivity. Any time that the employee works above the agreed number of hours per week may make him eligible for overtime payments, often at 'time and a half' (e.g. 7.50 per hour instead of 5 per hour). 2. Piece-rate schemes. This payment method involves the employee receiving an amount of money per unit (or per 'piece') that he produces. Therefore his pay is directly linked to his productivity level. However, it is possible that in order to boost his earnings, an employee may reduce the quality and craftsmanship per unit, so that he can produce more output in a given period of time. 3. Commission. This is a common method of payment for salesmen (e.g. insurance, double-glazing, telesales). The employee receives a very small percentage (say 0.5%) of the value of the goods that he manages to sell in a period of time. 4. Performance-related pay (PRP). This is a method of giving pay rises on an individual basis, related to the employee achieving a number of targets over the past year. This is common with managerial and professional workers.

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5. Profit sharing. This involves each employee receiving a share of the profit of the business each year, effectively representing an annual pay rise. It aims to increase the levels of effort, motivation and productivity of each employee, since their annual pay-award will be related to the profitability of the business. However, if the business makes low profits (or even a loss) then this is likely to have a detrimental effect on the level of motivation of the employees. 6. Share ownership. A common form of payment in many PLCs is what is termed 'share options'. This basically involves each employee receiving a part of each month's salary in the form of shares (usually at a discounted price). This forms a profitable savings-plan for the employee, and he can sell them after a given period of time. This should motivate the employees to work harder and increase their efforts, since the share price will rise as the company becomes more profitable, therefore increasing the capital gain on their shares. Many of these different methods of pay are likely to be supplemented by fringe benefits (or 'perks') such as private health schemes, pension schemes, subsidised meals, discounts on holidays and travel, cheap mortgages and loans, company cars and discounts when buying the company's products. The total package of pay plus fringe benefits is known as theremuneration package.
Non-Financial Methods There is no universal rule for motivating employees, and there are many methods which are used by different managers to achieve the goal of a motivated and satisfied workforce. These include:

Delegation. This occurs when managers pass a degree of authority down the hierarchy to their subordinates. Empowerment. This involves a manager giving his subordinates a degree of power over their work (i.e. it enables the subordinates to be fairly autonomous and to decide for themselves the best way to approach a problem). Job enlargement. This involves increasing the number of tasks which are involved in performing a particular job, in order to motivate and multi-skill the employees. Job enrichment. This is a method of motivating employees by giving them more responsibilities and the opportunity to use their initiative. Job rotation. This involves the employees performing a number of different tasks in turn, in order to increase the variety of their job and, therefore, lead to higher levels of motivation.

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Quality circles. This is a group of workers that meets at regular intervals in order to identify any problems with quality within production, consider alternative solutions to these problems, and then recommend to management the solution that they believe will be the most successful. Teamworking. This is the opposite production technique to an assembly-line which uses an extreme division of labour. Teamworking involves a number of employees combining to produce a product, with each employee specialising in a few tasks. Cell production is an example of teamworking. Worker participation. This refers to the participation of workers in the decision-making process, asking them for their ideas and suggestions. Works council. This is a type of worker participation and it consists of regular discussions between managers and representatives of the workforce over such issues as how the business can improve its processes and procedures (in production or marketing, for example). Worker-directors. These are workforce representatives who participate in the meetings held by the board of directors. Worker-directors are not very common in the UK, since employers often believe that they can slow down the decision-making process, as well as 'leaking' confidential information to employees. Symptoms of poor motivation amongst the workforce include high rates of absenteeism and labour turnover, poor timekeeping, high rates of waste, low quality output and an increasing number of disciplinary problems. When a poor level of motivation exists in a workforce, then the management should: a. Develop a strong corporate culture and team-spirit. b. Ensure that pay levels are fair. c. Design more challenging jobs. d. Introduce decision-making at lower levels in the organisation. e. Give praise and recognition to employees for their efforts and achievements. f. Ensure that communication flows are effective and that the relevant messages get to the relevant personnel.

Communication
Many managers devote a significant proportion of their time to communications both within and outside the business.

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Communication can be simply defined as the flow of information from one person to another. Effective communications are, therefore, vital to the success of the business, since the delegation of work, the feedback of information and the controlling of the business all rely on accurate, quick and effective communication flows. Good communication will reduce conflict and will prevent any misunderstandings of what is required by employees.
Formal -v- Informal Communication Formal communication refers to the official channels of communication which exist in a business, such as information being passed through 'line' and 'staff' relationships (e.g. between superiors and subordinates, or between people on the same level). These information flows will be concerned with the content of the jobs and may be in one of several forms, spoken, written, or electronic for example.

Informal communication refers to the unofficial channels of communication that exist in a business (often spoken as opposed to written communication). This is often referred to as the 'grapevine'. This can be concerned with the content of the jobs (e.g. two employees commenting on the poor performance of a task by their superior), or it can be discussing non work-related matters (e.g. arranging a staff social function). It could also refer, for example, to the anonymous passing of information to the media relating to unethical business practices. Communications can also be classified in terms of direction, vertical or horizontal. Vertical communication can be top-down (e.g. directions and instructions given from superior to sub-ordinate) or it can be bottom-up (e.g. feedback from sub-ordinate to superior). Horizontal communication refers to contacts and flows of information between people at the same level in the business. Where there is no facility for feedback, (often under an authoritarian management style) then this is referred to as one-way communication. There is a danger here, however, that the message will be misunderstood or poorly performed, since the employee performing the task is unable to ask his superior for assistance or clarity. It is a widely-held view among many businesses today that communication must be multidirectional (i.e. top-down, bottom-up and horizontal) in order to involve employees and make them feel valued by the business (e.g. implementing systems of quality circles or works councils). This will help to improve their job satisfaction and level of motivation, as well as encouraging lower rates of absenteeism and labour turnover.

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Quantitative communication involves the transmission and interpretation of data and numerical information (e.g. sales figures or financial data). Qualitative communication involves the use of language, either spoken or written. However, these messages are often complicated by the use of non-verbal communication (e.g. body language), which can often confuse the recipient of the message and lead to the misinterpretation of the information.
Channels of Communication The basic communication process involves the transmitter (the sender) encoding a message (i.e. putting the message and the information into a form that can be easily understood).

The transmitter then chooses the communication channel that he wishes to use in order to send it to the receiver (the target for the message). On receipt of the message, the receiver will decode it (i.e. interpret what the message is conveying) and act upon it as necessary. There are a number of communication channels that the transmitter of the message can use to send the message to the receiver. The choice of communication channel will usually depend on the type of stakeholder that the message is being sent to (i.e. whether the receiver is an employee, a customer, or a supplier). The main communication channels are: a. Face-to-face contact (eg a meeting) b. Telephone c. E-mail d. Facsimile ('fax') e. Letter f. Memorandum g. Video-conferencing h. Advertising i. Videotape j. Notices k. In-house publications Whichever communication channel is chosen, the message will have the same objectives, to be simple, fast and efficient. However, if a business believes that it needs to improve

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the communication channels that it uses, then the following criteria should be considered: a. Encourage the use of simple language b. Shorten the communication chain c. Encourage feedback d. Use a variety of media to convey a message e. Make employees aware of communication problems
Communication Breakdown This is often referred to as 'noise' and simply means anything that will distract the recipient of the message or cause either a failure to receive the message or a misinterpretation of the message. There are a number of factors which can cause communication breakdown:

a. Too much technical language ('jargon') being used b. Poor presentation and use of grammar c. Too much information being sent ('information overload') d. Geographical and time problems (e.g. communications between different countries in different time-zones) e. Length of the communication channel f. Employees already being overworked and ignoring the message g. Technology breakdown (e.g. computers 'crashing') This last point has become a growing problem over the last 10 years and is likely to continue to grow, as an increasing number of businesses rely on computers and information technology systems for their communications (as well as for their financial, production and personnel records). Added to this is the increasing amount of business being conducted using electronic mail (email) and the Internet (it is estimated that by 2005, any businesses which are not using the Internet to trade and interact with customers are likely to lose any competitive edge that they may have). So it is clear to see that the 'information-age' and the 'digital-age' are going to be a major influence on how business is conducted in the future. Any business which does not employ

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computer-literate staff and does not use Internet-trading is likely to suffer falling levels of sales and profits as a result. However, there are many problems inherent in what is termed 'the electronic office' - that is, a work environment which is highly computerised and relies heavily on software and communications equipment. The main problems can be summarised in the list below: a. Much time is often required to train staff in the use of the new equipment and software b. Computer fraud (e.g. 'hacking' into the computer-held information and changing the data or embezzling the business funds) c. Huge initial capital outlay required in order to purchase the equipment and software d. Equipment and software may become obsolete within a few years e. Resistance from employees and from trade unions to the new working practices

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Exam-Style Questions
1. a) What are the advantages and disadvantages of performance related pay? b) Other than through performance related pay systems how can managers motivate their sales force? (Marks available: 10) Answer outline and marking scheme for question: 1 Give yourself marks for mentioning any of the points below: a) PRP advantages: creates incentive. If targets are clearly set, then sales person has clear objectives. Targets can be set for each individual sales person. Disadvantages: Unrealistic targets without looking at the market place. Other motivating factors may be missed out. (5 marks) b) Group incentives, holidays, fringe benefits, job satisfaction and working as a team. (5 marks) (Marks available: 10) 2. a) What qualities should a good leader possess? b) Explain, using examples, why leaders vary their leadership style in different circumstances (Marks available: 10) Answer outline and marking scheme for question: 2 Give yourself marks for mentioning any of the points below: a) The qualities of a good leader include having a clear vision and direction, being able to communicate, and being able to motivate people towards achieving organisational objectives. (5 marks) b) To suit their style and situation. For example, directive: suitable for instructing workers for structured tasks. Paternalistic: suitable for dealing with new, inexperienced or young workers. Constitutional: suitable for resolving conflict or areas of uncertainty.

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Participative: suitable for qualified, specialist and experienced workers. (5 marks) (Marks available: 10) 3. a) Describe two ways in which employees can be empowered. b) Give two advantages of empowerment from the point of view of: (i) The organisation (ii) The employee. (Marks available: 10) Answer outline and marking scheme for question: 3 Give yourself marks for mentioning any of the points below: a) Refers to devolving responsibility down to the lowest levels within an organisation. The power to make decisions is given to those who previously acted on orders from more senior staff. (5 marks) b) (i) Saves management time, lower staff costs, employees are aware of business needs, able to respond quickly to market changes. (ii) More interesting work, more responsibility, autonomy over work, sign of employers trust. (5 marks) (Marks available: 10) 4. a) How may the roles of a manager and a leader differ in business? b) Explain briefly in what situations a manager might adopt different management styles. (Marks available: 10) Answer outline and marking scheme for question: 4 Give yourself marks for mentioning any of the points below: a) A leader normally sets objectives. A manager organises resources to achieve the objectives.

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(5 marks) b) Depends on situation, time, and the decision to be made. For example: a logistics manager of a transport company will tend to direct his drivers. He may adopt a different style when managing office staff. (5 marks) (Marks available: 10) 5. a) What are the advantages to an organisation of encouraging teamwork? b) How do reward packages, such as pensions and share option schemes, help motivate the work force? (Marks available: 10) Answer outline and marking scheme for question: 5 Give yourself marks for mentioning any of the points below: a) Greater range of skills, knowledge to solve problems. Increase in employee morale. Problems across the organisation can be solved more easily. Team ideas more creative than individual. (5 marks) b) Reference to motivational theory required. Pension may depend on the age of person. Share option depends on size offered, compare between chief executive and a shop floor worker. (5 marks) (Marks available: 10)

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People in the Workplace Human Resource Management(H.R.M)


Human Resource Planning (H.R.P) Human Resource Planning (H.R.P) is the process of forecasting the workforce requirements of the business for future years.

It looks at how many employees the business will require in the future, as well as the type of employee that will be required (e.g. graduate trainees, skilled-manual and supervisors). H.R.P. also ensures that the 'right' employee is in the 'right' job, to ensure maximum efficiency and effectiveness of the workforce. Clearly the process of H.R.P. requires that the business make estimates of the number of workers that it believes it will require at all levels in the business in the future. This can be done in a number of ways:
1. Using past data (e.g. if the workforce has grown at 4% per year over the past 3 years, this trend may well continue). 2. Analysing the expected levels of customer demand and sales (e.g. more employees will be required if the number of customer orders is estimated to rise significantly). 3. Estimating the level of labour turnover. For example, if the number of employees that are expected to leave the business next year is 50 (due to retirement or transfers), then the business will have to recruit many new employees to replace those that are leaving. 4. The views of the management (the management are often in the best position to estimate the number of new employees that will be required in their department or division). 5. Expected changes in working practices. For example, if a manufacturing business is wishing to change its production technique from labour-intensive to capital-intensive, then it is not likely to require many new employees in the future.

It is possible that a business may decide to meet any requirements for employees at the supervisory and management levels from within the existing workforce. This can be done by promoting those employees who have already demonstrated their potential and effectiveness in their current posts. These employees have the advantage of already knowing about the systems and the routines of the business, but they would still require the relevant training and development in order to prepare them for their new, more senior positions. Alternatively, the business may decide to fill these (and more junior) positions from outside the business. There are a number of factors, however, that will affect the availability of external labour for a business:
1. The rate of unemployment in the area.

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2. The extent of the infrastructure in the area (e.g. price and availability of housing or availability of public transport). 3. Government incentives and subsidies (paying the training costs for the business). 4. The availability of workers with the necessary skills and qualifications. 5. The number of competitors in the area.

However, there are a number of problems associated with Human Resource Planning, including:
1. Will the 'new' employees mix effectively with the existing workforce? 2. Changes in the external environment (e.g. a recession) could lead to the business having to make redundant several of the recently-appointed employees.

It will always be difficult for a business to accurately forecast the number of new employees that it will require, because both the business-world and the internal requirements of the organisation are very dynamic.
The Human Resource Management (H.R.M) Process Human Resource Management is the management of the people within the business, by recruiting, training and retaining employees with the necessary skills and competencies to perform their jobs effectively. H.R.M. was often referred to as 'Personnel' in the past, and it covers all the following areas:
1. Human Resource Planning (H.R.P). 2. Recruitment and selection of new employees. 3. Training and development. 4. Performance appraisal. 5. Remuneration packages. 6. Disciplinary procedures. 7. Grievance procedures. 8. Health and Safety issues. 9. Looking after the employees' welfare. 10. Dealing with the termination of contracts of employment.

The recruitment and selection process commences when the business realises that there is a vacancy in the organisational hierarchy which needs to be filled. A job description needs to be written, this outlines the job title, as well as the tasks and the responsibilities that will be covered by the successful applicant. Once this is completed, then a job specification needs to be written, this goes beyond a description of the job, and it lists the physical and mental attributes that will be desirable or essential for the successful applicant (such as the level of intelligence, their disposition and their interests). The H.R.M. department will then need to write an advertisement for the job and to place it in a variety of media (newspapers, job centres, job agencies, the internet, radio, and internal notice-boards), in order to get as many people as possible to apply for the post.

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The advertisement will include the hours of work, the pay and fringe benefits, the job title, the relevant experience and qualifications that are required, and a contact name and address. It is likely that the job will be advertised within the business as well as through external media. The advantages of recruiting from within the existing workforce include the fact that a shorter training and induction period is necessary, as well as far less time and money being spent on the whole process. The H.R.M. department will then need to send out application forms to, and request Curriculum Vitae (CVs) from, all those people who write to the business expressing a desire to apply for the job. It is vitally important that the application form is tailored to the specific post that is being advertised, as well as asking questions that are relevant, legal, inoffensive and essential. Once these application forms have been completed and returned to the business (often with a CV and a covering letter) then the short-listing process will ensue, this involves analysing the CVs and the application forms and deciding which applicants appear to be most suitable for the post. Once this is done, then the H.R.M. department will contact the successful applicants and ask them to attend an interview. The interview process is very time-consuming but is, nevertheless, an essential factor in getting the 'right' person for the 'right' job. A good interviewer will have studied the job description, the job specification and the job advertisement before interviewing the applicants, as well as studying their application forms, CVs and covering letters in order to know as much information as possible about the applicants before the interview commences. A good interview needs to be well structured, uninterrupted, and conducted in a friendly manner, with the use of open-ended questions which will give the applicants the chance to talk openly about themselves. The interviewer must listen carefully to the applicants' comments and make notes as necessary. At the end of the interview, the applicants must be given the opportunity to ask questions about the job and about the business, and then the interviewer must inform the applicants when they will be notified of the decision. It is likely that applicants for a job will be interviewed by a number of people. This can be in sequence (i.e. the applicant will have one interview quickly followed by another) or it can be simultaneous (i.e. the applicant will be interviewed by a panel of people). Whichever method of interviewing is chosen, the purpose remains the same, to select and appoint the 'best' applicant for the job. It is possible that the business may choose to use a variety of tests to complement the interview process, in order to measure the applicants' intelligence, their performance in certain scenarios, and their personality traits.

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Once a business has selected the most suitable applicant for the available post (often involving much discussion between the different interviewers), then he/she will be appointed. This will involve the new employee being given a Contract of Employment, which is a written statement covering the terms and the conditions of employment (e.g. date employment commences, job title, pay, hours of work, holiday and pension entitlements), as well as the process for disciplinary and grievance procedures. Once a new employee has been appointed to a business, it is likely that they will receive induction training in order to help them settle into the new job. This induction training covers the basics of the new employee's job, as well as the background details and the history of the business (e.g. number of employees and the range of products). However, training is not limited to the new employees of a business. Training courses are likely to be targeted at all employees in the business at various stages in their career (e.g. management training courses, training on how to use new machinery and technology). There are many reasons for the extensive use of training across the workforce of a business:
1. 2. 3. 4. Training can improve employee productivity. Training can create a multi-skilled, flexible workforce. Training can increase the levels of job satisfaction and motivation of the employees. Training employees increases the chances of their promotion.

Training can be classified as either 'on-the-job' or 'off-the-job'. 'On-the-job' training involves the employees receiving their training at the place of work (using such techniques as work-shadowing, apprenticeships, and mentoring). 'Off-the job' training involves the employees attending courses away from their workplace (e.g. at local colleges, conference centres and universities). It is also imperative that all training courses that are attended by employees are evaluated in order to determine if the training course provides value for money for the business. This evaluation is often carried out by asking the employees to complete short questionnaires and provide feedback to the H.R.M. department. The final role of the H.R.M. department is to make the termination of the employees' contracts of employment as smooth and efficient as possible. There are a number of different ways in which employees can have their contracts of employment terminated, including:
1. Redundancy. It will be necessary at certain times (e.g. during a recession, or a decline in the industry) for a business to 'downsize' its workforce (make a certain proportion of them redundant).

This process could be done in several ways,voluntary redundancy (where workers opt for a redundancy package), compulsory redundancy, 'last-in-first-out' (where

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the most recent appointments are the first to be made redundant), orretention by merit (where the least effective employees are made redundant).
2. Retirement. At the end of their working-life, employees will wish to retire and stop offering their services to the business. In return, they will often receive a lump-sum payout, as well as both their state pension and their private pension. 3. Transfers and Resignation. This occurs when an employee leaves the business and transfers their services to another business (the employee may apply for a more senior job at another business). 4. Dismissal. This is where the employee is deemed to have broken their contract of employment, and told that their services are no longer required by the business. Fair dismissal can be on the grounds of sexual harassment, racial harassment, bad timekeeping, sleeping on the job, and destruction of business property.

However, if an employee feels that they have been unfairly dismissed (e.g. on the grounds of pregnancy, ethnic background, or union membership), they can apply to have the case heard at an industrial tribunal. This is a small court that deals with claims of unfair dismissal and discrimination from employees against their (former) employers. If the employee is successful in claiming that they have been unfairly dismissed, then they are eligible for re-instatement in their previous job, as well as a financial award (to cover loss of earnings, and pain and suffering). In all areas of the activities of the business, but especially it seems within Human Resource Management, the business must ensure that it abides by every piece of legislation, regardless of the stakeholder group which the legislation protects (e.g. employees and customers). The main pieces of legislation affecting the successful operations of the Human Resource Management department are:
1. The Employment Relations Bill, 1999 (stating that employees who have been in employment with the same business for a period of one year have the right not to be unfairly dismissed). 2. The Employment Rights Act, 1996 (covering unfair dismissal, redundancy and maternity). 3. The Public Interest Disclosure Act, 1998 (covering employees who disclose confidential information). 4. The Health & Safety at Work Act, 1974 (covering working conditions and the provision of safety equipment and hygiene). 5. The National Minimum Wage Act, 1999 (making it illegal for employers to pay less than 3.60 per hour to its full-time staff who are aged over 21). 6. The Equal Pay Act, 1970 (stating that pay and working conditions must be equal for employees of the opposite sex who are performing the same work). 7. The Sex Discrimination Act, 1975 (stating that it is illegal to discriminate against an employee, or an applicant for a job, on the grounds of their sex or their marital status). 8. The Race Relations Act, 1976 (stating that it is illegal for an employer to discriminate against an employee, or an applicant for a job, on the grounds of their ethnic background). 9. The Disability Discrimination Act, 1995 (stating that it is illegal for a business with 20 or more employees to discriminate against an employee, or an applicant for a job, on the grounds of their disability).

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Performance Appraisal This is the process of measuring the effectiveness of an employee, often using it as the basis for a promotion or a pay rise. After a period of time working for a business, each employee is likely to be appraised in order to measure their strengths, weaknesses, qualities and value of their contributions to the success of the business.

It is common for employees to be appraised annually, although some employees may be appraised every six or even every three months. There are a number of reasons why a business will use systematic and regular appraisals of its employees:
1. To identify any barriers which exist to inhibit their effective performance. 2. To provide the basis for performance-related pay. 3. To provide some constructive criticism of the employee's performance at their job and to suggest some areas in which the employee needs to improve. 4. To set objectives for the employee for the next year.

Appraisal generally involves a discussion between the job holder and his appraiser. There are many different ways in which an appraisal can be carried out, but some of the most common are:
1. Peer appraisal. This is carried out by an employee on the same level as the employee being appraised, often someone who works closely with him. 2. Appraisal by subordinates. This is a less common method, since many subordinates are often unwilling to criticise their superior for fear of recrimination. 3. Grading system. This involves each employee being graded (by a letter from A to E) according to their overall effectiveness at their job. 4. Rating system. This method of appraisal breaks the job down into many specific areas, and then each area is rated on a scale (from A to E, or from 1 to 5, for example). 5. Objective setting. This involves the employee and his appraiser setting objectives for the employee for the next year. Then, at the end of the year, the employee's achievement of these objectives is measured. 6. '360 degree' appraisal. This involves the appraiser gathering as much information concerning the employee from as many different groups of stakeholders as possible (e.g. superiors, subordinates, peers, customers, suppliers, etc). 7. Self-appraisal. This involves the employee appraising himself, being honest about his strengths and his weaknesses and setting himself realistic improvements which need to be made.

Although a regular and systematic appraisal is vital for the benefit of both the employees and the business, there can be many problems associated with appraisal systems:
1. The time and the cost of the appraisal can use up scarce resources which could be used elsewhere within the business. 2. Appraisal can be a very subjective process. The appraiser should not let his personal feelings interfere with the objectivity of the process. 3. Some appraisers are not trained sufficiently in the appraisal process, leading to poor results.

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The appraisal process is a waste of time and resources if it is not followed-up with feedback sessions.
Personnel Effectiveness Many businesses spend a significant proportion of their total costs on their workforce (e.g. interviewing costs, training, pay, and fringe benefits). Businesses will, therefore, wish to discover if the money that they have invested in their workforce has been spent effectively and if it has improved the effectiveness of the employees.

There are four main measures that a business can use in order to measure the effectiveness of its employees:
1. Labour Turnover. This measures the number of employees who leave a business per year, expressed as a percentage of the total number of people employed. It is calculated using the following formula:

A high labour turnover rate could be a sign that the workforce have low levels of job satisfaction and motivation. This could be due to poor wages, poor management techniques, or better remuneration packages being offered by competitors. This high rate will inevitably lead to the business having to spend a large amount of money on recruitment and training of new employees.
2. Absenteeism. This measures the proportion of the workforce who are absent from work in a particular period of time. It is calculated using the following formula:

Ideally, the business would wish the figure to be as low as possible, since a high figure could indicate that the employees have low rates of morale, job satisfaction and motivation. A high rate will inevitably lead to the business having to spend a large amount of money on training and paying temporary workers who are performing the jobs of the absent employees.
3. Labour Productivity. This reflects the efficiency of the workforce, and it is measured by the amount of output per worker. It is calculated using the following formula:

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It can be argued that labour productivity is the most important measure of employee effectiveness, since it directly affects the average cost of production and, therefore, the competitiveness of the business. An increase in labour productivity will benefit the business since it means that more output can be produced for a given amount of inputs, hence the production cost per unit will fall.
4. Waste levels. 'Waste' products refers to lost and damaged raw materials, poor quality output which has to be reworked, and output which has to be discarded due to its poor workmanship. It is calculated using the following formula:

If a business has a high percentage of 'waste' products, then this could be due to a poorly trained workforce with low levels of both motivation and job satisfaction. In this case, the business should ensure that the employees are all adequately trained for their specific tasks, and investigate any other reasons for the poor quality of the output. It is vital that the reasons for this are discovered quickly, since the effect on customer loyalty and reputation could be disastrous if the business supplies poor quality output to its customers.

Trade Unions
Types of trade Union A trade union is a group of workers who join together in order to protect their own interests and to be more powerful when negotiating with their employers.

Each employee who wishes to join a trade union must pay an annual fee, which contributes towards the costs and expenses that the trade union incurs when it provides services to its members, and supports industrial action by the workers. Trade unions have a number of aims:
1. 2. 3. 4. To improve the pay of its members. To improve the working conditions and the working practices of its members. To support the training and the professional development of its members. To ensure that their members' interests are considered by the employers when any decision is made which will affect the workforce.

There are four main types of trade union in the UK:


1. General Unions. These are for skilled and unskilled workers performing different jobs in different industries (e.g. cleaners, clerical staff, transport workers).

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2. Industrial unions. These are for different workers in the same industry (e.g. the National Union of Miners (N.U.M), covering workers at all levels in the hierarchy). 3. Craft Unions. These are fairly small unions for skilled workers, performing the same or similar work in different industries (e.g. musicians). 4. White-collar Unions. These are for 'white-collar' (or professional) workers who perform the same or similar tasks in different industries (e.g. teachers, scientists).

Pay Bargaining Trade unions are most closely associated with negotiating with the employers of a business on behalf of their members over the issue of pay. This is known as the 'pay-bargaining process', and it is an example of collective bargaining.

The first stage in this process is for each side (the employer and the trade union) to decide on its objectives. As well as deciding the amount of a pay rise, both the trade union and the employer will also need to decide how the money will be distributed amongst the members of the trade union (i.e. will the pay rise be a 'blanket' coverage giving every employee a fixed percentage rise, or will different groups of workers receive different percentage pay rises?). Further to this point, will the pay rise be awarded in a lump sum per employee, or will it be staggered over time? The second stage involves both sides (the trade union and the employer) presenting their arguments at a 'pay-talk' discussion. A trade union will put in a 'pay claim', which will be based on one or more of the following points:
1. An increase in the cost of living (i.e. inflation) requires that workers have a pay rise in order to maintain their purchasing power. 2. An increase in labour productivity rates will mean more sales revenue and profits for the business, this extra profit should be shared with the workers by giving them higher rates of pay. 3. A pay rise is required in order to recruit and retain the 'best' workers that the business can find. 4. If workers are using new machinery and working practices, then they need to be compensated for this extra work by being given a pay rise.

The employer will put forward a 'pay offer', which they believe will reflect the current trends in the labour market (i.e. the rates of pay which are being offered by rival businesses), as well as maintaining the competitiveness of the business (i.e. not increasing their costs by a large percentage). The third and final stage involves a negotiation process between the trade union and the employer. In order for this to be a success, both sides will be required to compromise and be prepared to accept less than their original objectives. It must be remembered that there are many other issues that a trade union will negotiate for its members other than pay rises (e.g. length of the working week, working conditions, and proposed redundancies).

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Industrial Action If the negotiation process collapses (whether it was negotiating for pay or for working conditions), then there are a number of different methods of industrial action which the trade union can propose to its members that they use in order to achieve their demands :
1. Non co-operation. Refusing to attend meetings and use new machinery or processes. 2. Work to Rule or 'Go Slow'. Refusing to perform any tasks not in the contract of employment and keeping the output of products to a minimum. 3. Overtime Ban. Refusing to work any hours over and above the required weekly number of hours. 4. Picketing. Standing at the entrance to the workplace and not allowing any person or vehicle to cross the 'picket line' and enter the workplace. 5. 'Blacking'. Refusing to deal with certain employees or suppliers because they have refused to participate in the industrial action. 6. Strikes. This is often the last resort for a trade union. It involves the employees stopping their work, leaving the workplace and refusing to return.

Whichever method of industrial action is implemented, the trade union and the employees are using it in an attempt to reduce output (therefore also reducing sales and profits) and hoping that the employer will give-in to their demands.
Employee Participation This refers to employees being given more responsibilities at the workplace and being involved in the decision-making process. The aim of participation is to increase the levels of motivation and job satisfaction amongst the staff by making them feel more involved in the business.

Trade unions often try to increase the amount of worker participation in the workplace, since it provides a sound justification for pay rises for the employees. The main types of worker participation include Employee shareholders. These are a common form of payment in many PLCs and are often termed 'share options'. This basically involves each employee receiving a part of each month's salary in the form of shares (usually at a discounted price). This forms a profitable savings-plan for the employee, and he can sell them after a given period of time. This should motivate the employees to work harder and increase their efforts, since the share price will rise as the company becomes more profitable, therefore increasing the capital gain on their shares. Empowerment. This involves a manager giving his subordinates a degree of power over their work (i.e. it enables the subordinates to be fairly autonomous and to decide for themselves the best way to approach a problem). Kaizen. This is a Japanese word meaning 'continuous improvement'. It is widely held that any aspect of the business can be improved, not just the production processes.

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Quality circles. This is a group of workers that meets at regular intervals in order to identify any problems with quality within production, consider alternative solutions to these problems, and then recommend to management the solution that they believe will be the most successful. Teamworking. This is the opposite production technique to an assembly-line which uses an extreme division of labour. Teamworking involves a number of employees combining to produce a product, with each employee specialising in a few tasks and the whole team taking the responsibility for production. Works council. This is a type of worker participation and it consists of regular discussions between managers and representatives of the workforce over such issues as how the business can improve its processes and procedures. Worker-directors. These are workforce representatives who participate in the meetings held by the board of directors. Worker-directors are not very common in the UK, since employers often believe that they can slow down the decision-making process, as well as 'leaking' confidential information to employees.
Advisory Conciliation and Arbitration Service (A.C.A.S.) The Advisory Conciliation and Arbitration Service was set up by the government in 1975 as an independent body that helps to settle industrial disputes and claims of unfair dismissal by employees. As the name suggests, there are three main services that are offered by ACAS, advice, conciliation and arbitration.

A.C.A.S. representatives can be invited into a business by the two feuding parties (employers and trade unions) in order to offer their advice to both parties on the industrial unrest and the 'best' way to proceed in order to settle the unrest. Conciliation is an attempt to get the two sides in an industrial dispute to resolve their differences. A conciliator listens to the arguments of both sides, and then tries to encourage the trade union and the employer to negotiate and compromise so that they can reach a solution that is acceptable to both parties. Arbitration is the process of resolving an industrial dispute by using an independent person to decide the appropriate outcome. The arbitrator will look at the arguments put forward by both parties, and then he will arrive at a decision. The decision can be legally binding on both parties if this was agreed prior to the arbitrator's decision. Pendulum arbitration is a type of arbitration in which the arbitrator will decide completely in favour of one party or the other, with no compromise or negotiation being allowed. It is likely, therefore, that both parties (the employers and the trade union) will make their demands more conservative and realistic than if the arbitrator was allowed to choose an outcome which was somewhere between the two.

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Exam-Style Questions
1. Study the information and answer the questions below on workforce characteristics of the UK and France.

a) What is meant by the term flexible workforce? b) Compare the flexibility of the labour markets of France and the UK. c) What are the main advantages of flexible working to the employer and the worker? d) How, if at all, is it possible to improve flexibility of the workforce to benefit the whole economy? (Marks available: 20) Answer outline and marking scheme for question: 1 Give yourself marks for mentioning any of the points below: a) 'The flexible workforce' refers to those workers who are multiskilled or those workers whose hours are changed according to the demand of the employer. (5 marks) b) The UK would appear to have a more flexible workforce as shown for example by the percentage of part- time workers of the total labour force, a higher percentage of temporary contracts of less than one year. France has a higher proportion of companies who have increased their use of shift working.

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(5 marks) c) The employer can meet peaks in demand they have lower add on costs on pensions and insurance. They can use the temporary contract as a form of long term recruitment. The employee can work hours to suit their needs, gain work experience, can be a stepping stone to a permanent job. (5 marks) d) Flexibility of the workforce depends to the extent that restrictions or barriers within the labour market have been reduced or eradicated. For example the reduction of demarcation lines and the increased use of Japanese working methods such as cell production can improve productivity and reduce labour turnover. The increased flexibility of the employed may have caused higher employment or made it difficult for those unemployed to obtain jobs. Output per person may have increased at the expense of unemployment and the waste of this resource. Some types of flexibility such as part-time work might have held wage costs down enabling UK firms to become more competitive. (5 marks) (Marks available: 20) 2. a) Why might a change in working practices and rewards imposed on the workforce by the employer be a source of conflict between employer and employee? b) What is the role of trade unions in resolving conflict? (Marks available: 10) Answer outline and marking scheme for question: 2 Give yourself marks for mentioning any of the points below: a) Resistance to change is usually applicable to any form of change. Depends on communication beforehand, the amount of training given. Rewards might mean Differentials are eroded and new reward system might be seen as inequitable. (5 marks) b) Represent members in disciplinary matters with the employer, are often consulted by employers prior to changes in workforce being made and their agreement sought, negotiate with employers on terms and general conditions for employees, abide by rulings of conciliation and arbitration bodies. (5 marks)

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(Marks available: 10)