Producing Goods and Services

Factor Inputs • Functions of the entrepreneur

• Human resources: the rise and decline

of employment sectors, changing
working patterns.
Physical Resources • Land, raw materials, equipment,
machinery, and vehicles.
Financial Resources • Features of various sources of internal
and external funds available to
business
Methods of • Job and batch. Flow/continuous
Production production.

Scale of Production • The survival of small firms.

• Organic and external growth.

• Franchising

• Horizontal and vertical integration.

• Internal and external economies of

scale and internal and external
diseconomies of scale.
Location • Factors affecting business decisions
about location – local, national and
global

• Optimisation of location.

Functions of the Entrepreneur

An entrepreneur is an individual who accepts financial risks and
undertakes new financial ventures. The word derives from the French
"entre" (to enter) and "Pender" (to take), and in a general sense applies to
any person starting a new project or trying a new opportunity. An
entrepreneur is able to combine the other three factors of production
(land, labour and capital), and profitably produce a good or service.
Many societies place great value on the entrepreneur. It is easy to
understand this if we look at some of the important functions of
entrepreneurs:
Innovators. Entrepreneurs bring new ideas to the market and drive new
technologies. Trevor Bayliss developed windup technology in his garden
shed. In June of 1996 his Freeplay radio, was awarded the BBC Design
Award for Best Product and Best Design. His technology has been
expanded from radios to torches, and there is even hope of windup PCs.
But this ‘home made’ type of innovation is becoming harder and harder.
Though there are still exceptions to the rule, most new ideas are costly
and difficult to develop. To help new technologies come to market, many
universities establish business incubators for entrepreneurs hoping to turn
leading edge research into marketable products.

An entrepreneur is an individual who accepts financial risks and

undertakes new financial ventures ... is able to combine the other
three factors of production and profitably produce a good or
service.

 Wealth Creators. Economists who are concerned with developmental

economics will tell you that one of the great drivers of economic growth is
enter-prise. Even in a developed country like the UK we are still
dependant on small firms building wealth to drive ex-ports and increases
in the UK’s output
 Job Creators. As an entrepreneur builds his or her business then of
course jobs are created. Small businesses account for around 30% of
employment in the UK.
 Society Builders. Entrepreneurs often give something back to society.
The Gates foundation intends to give $Billions to charitable causes across
the world. Many of the schools, hospitals and libraries in our towns and
cities were originally funded by entrepreneurs.
To encourage entrepreneurial activity, entrepreneurs may be offered
access to inexpensive capital, tax exemptions and management advice.
An entrepreneur has the greatest chance of success by focusing on a
market niche either too small or too new to have been noticed by
established businesses. . The important role of the entrepreneur is
becoming much more widely recognised, both by the government and the
public in general. Some of the biggest TV hits of recent years have
followed the efforts of budding entrepreneurs (Apprentice, Dragons Den,
and Tycoon). The government in Wales tries to encourage enterprise from
a relatively early age, supporting school and college based activities such
as Enterprise Week, and Young Enter-prise This interest in developing
tomorrows business people is founded on the importance of entrepreneurs
to wealth and job creation. Unfortunately in Wales we are not a very
enterprising society, with a much lower than average figure for new
business start-ups.
What makes an Entrepreneur?
Characteristics of an entrepreneur include

 Creativity, the ability to come up with new concepts or ideas. Stanley

Kalms who built up the Dixons, Currys, PC World retailing empire, started
with just his father’s camera shop. Success was built on changing the
whole approach to selling and relationships with customers that had
previously existed within the photography industry.

 An appetite for hard work. Entrepreneurs in the UK average around

52 hours work a week, plus another 40 hours thinking or worrying about
their business venture.

 Desire to work for themselves: Entrepreneurs like to work for

themselves rather than work-ing for an organisation or any other
individual.

 Fast and decisive decision making. The ability and willingness to

make decisions in the absence of solid data or complete information.,

 A risk-taking personality. They will mort-gage the house and give up

well paid jobs to live their dream

 Profit orientation: They want to make a profit; this profit motive

drives to work long hours and take risks. Profit is also used as a measure
of success.

 Persistent personality. As new enterprises have low success rates,

an entrepreneur must also have considerable persistence, and be willing
to keep trying.
Entrepreneurs are generally highly independent, which can cause
problems when their ventures succeed. In a sole trader situation the
entrepreneur is able to personally manage most aspects of the business,
but this is not possible once the company has grown beyond a certain
size. Once a business has outside investors or other major shareholders
then management conflicts often arise when the entrepreneur does not
recognize that running a large stable company is different from running a
small growing company. The problem is often resolved by the
entrepreneur either leaving to start a new venture, or being forced out by
shareholders. At Apple Computer one founder, Steve Wozniak, left to
pursue other interests, while the other, Steve Jobs was ultimately fired
and replaced with a CEO from a much larger company. Many years later,
Jobs returned to the lead Apple and since his return Apple’s sales have
boomed.
 EXAM QUESTIONS

DUTTSONROCKS
Six months in the Royal Marines followed by six years as a DJ is perhaps
not the most obvious route to starting up a business selling diamonds.
Neil Duttson left school with no qualifications and at 26 he realised that
his life was going nowhere. It was at this point he started thinking about
diamonds. “I had always had a passion for diamonds. When I was 18, I
bought a book on gemmology,” said Duttson. He searched the internet
and found a school in Antwerp that ran a six month course. He mortgaged
his flat and took out £50 000 equity to pay for the course and support
himself while doing it. He said: “I loved it. At the weekends I travelled
around Europe going into jewellery shops pretending I was getting
engaged”. Armed with his new-found knowledge, Duttson set himself up
as a diamond jeweller. Duttson’s first clients were friends who were
getting engaged. Without funds to buy stock, he adopted the innovative
approach of showing potential customers a selection of fakes in every
single cut and shape of diamond, and only when they had chosen and
paid a deposit, would he buy the real diamond. The diamond was then
passed on to a jeweller to be made into a ring. Neil Duttson was
successful and in 2002 he formed Duttson Rocks Ltd.
Adapted from the Sunday Times, 2
September 2007

(a) In what ways does Neil Duttson exhibit the

characteristics of a typical entrepreneur? [6]

Richard Branson (Virgin), Stelios Haji-Ioannou (easyJet) and Anita Roddick

(Body Shop) are three of the best known entrepreneurs in business
today. They have all created hugely successful enterprises recognised the
world over. Although very different individuals, the organisations that they
created have one important feature – a strong corporate culture, which
helped to achieve the various objectives of their businesses.

(a) Why are entrepreneurs so important to the success of the

United Kingdom economy? [4]
 Human Resources
The rise and decline of employment sectors.
Over the past century the UK has seen huge changes in its employment
structures. The demand for labour in manufacturing and agricultural
sectors has declined, whereas demand for labour in the services sector
has increased. In 1901 38 per cent of the economically active population
were employed in the manufacturing sector and 9 per cent in the
agricultural sector. By comparison, 21 percent were employed in the
services industries, 4 per cent in the commerce and finance sector, and
28 per cent in other industries. .
By 1991 the proportion of the economically active population employed in
the manufacturing and agricultural sectors had fallen to 20 percent and 2
per cent respectively, and in other industries to 14 per cent. The service
sector’s share of employment rose over this period to 32 per cent, as did
the proportion in the commerce and finance sector (also 32 per cent).
Over the last 15 years this trend has continued, with booming
employment in services, including the public sector, and further falls in
industrial employment.
The government has made a number of predictions for future trends in
employment patterns in different sectors.
These include:
 Employment in agriculture, manufacturing and utilities will continue to
decline but 1.8 million extra jobs are forecast between 2007 -2014 in
business and related services.
 The professional services are projected to in-crease by 45%.
Employment in the distribution and transport sector is expected to
increase by over 600, 000 jobs - with most of the growth accounted for by
jobs in distribution, hotels & catering. Manufacturing
 employment decline
is expected to continue, with a loss of 400, 000 jobs between 2007 and
2015. Engineering is the largest contributor to job losses, as employment
declines by almost 240, 000 jobs over the same period.

It is worth noting that the decline in manufacturing employment is not as

bad as it seems. Many of the jobs lost are those transferred to outside
functions, so previously a large firm may have had its own in-house
accountants, cleaners, cooks, distribution teams etc. All of these were
counted as manufacturing jobs, but now these services are sub contracted
or bought in on short term contracts – so a decline in manufacturing
employment but an increase in business services – but the same jobs are
being done.
In total there has been a strong growth in employment over the last 15
years, in 2006 there were 28.8 million people in work in the UK, this
compares with 25.4 million in 1992.
Over the next ten years the government predicts three major occupational
types where employment growth is expected to be strongest. These are;
Managers & senior officials: within this group employment growth
is expected to be particularly strong for corporate administrators: most
notably, specialist managers working in private commercial organisations
although the UK already has a higher share of managers in employment
than Europe or the US.
Professional occupations: the highest growth is expected for
business & public service professionals, particularly financial specialists.
Personal service occupations: growth is expected in
caring/personal services particularly health and child-care – this gives
greater opportunities for female employment, but many of these jobs are
likely to be low paid.
Changing working patterns
The changes in employment patterns found are not simply from
manufacturing industry to the service sec-tor, there are other key areas of
change, these include;
 growth in part-time employment
 rising prominence of women within the work-force
 gradual ageing of the labour force
 growing importance of temporary and self employment
 the adoption of a variety of flexible working practices
Growth in part-time employment
There are around 6.3 million part time workers in the UK. This compares
with 3.5 million in 1971. This growth has occurred for a number of reasons
including, increasing number of women in the work force (40% of women
work part time compared to 11% of men), employers requirements for
flexible working practices and growth of hospitality, and leisure sectors of
the economy.
Rising prominence of women within the work-force
In 1981, men filled 3.2 million more jobs than women. Now the numbers
are almost equal, with men performing 12.8 million jobs and women 12.7
million, although 40% of those jobs filled by women are part time. There
has been some closing in the pay gap between women and men, and
there are more and more women operating at senior level in large
numbers of professions.
Gradual ageing of the labour force
In 1992 there were 2.8 million males over the age of 50 in the UK’s
workforce, by 2006 that figure had increased by 1 million to 3.8 million. At
the same time the number of older self employed people also increased.
This increase in older self employed could be due to difficulty in selling on
small firms, or a need to maintain income levels past expected retirement
age.
Growing importance of temporary and self employment
Men are more likely than women to be self-employed – 73 per cent of the
3 million self-employed people in spring 2001 were male. Around a fifth of
all self-employed people worked in construction, with similar proportions
in sales and distribution, hotels and restaurants; and in banking, finance
and insurance. Temporary work has grown rapidly over the last 20 years.
Traditionally temporary work existed because of seasonal factors, but
more and more temporary work is found in non seasonal, modern
industries where workers are employed on short term contracts—flexible
employment.
The adoption of a variety of flexible working practices
More and larger firms contract out work, letting outside firms or
individuals bid to provide services. This results in short term contracts for
employees. Flexible working also includes giving employees core hours,
but allowing flexi-time outside these hours. Home working has also
increased, with more and more employees spending part of their time
working from home, part of their time in the office. There are of course
both advantages and disadvantages to both employers and employees of
adopting flexible working practices. These include.

Advantages of flexible working

 Less stress suffered by workers.
 Less days taken on sick leave—lower absenteeism.
 Lower staff turnover.
 Increased skill retention.
 Higher levels of productivity.
 Less traffic congestion and pollution
 Better worker health

Disadvantages of flexible working

 Employees feel more isolated and have difficulties interacting with co-
workers.
 Possibility of lower wages.
 Difficulties of motivating and organising a work-force.
 Flexible working could be an obstacle to promotion

The Skills Gap

The government sees that the number of those without basic skills is a
cause for concern. 20% of adults have poor literacy and numeracy skills,
costing employers £4.8bn. It is estimated that 3.5 million working adults
are functionally illiterate.
 How this section of the working population will be able to find long term
well paid jobs in the new UK economy is hard to see. 20% of firms report
an internal skills gap – measured by the firms estimate of the proficiency
of the current workforce. The majority of these firms are in retail,
manufacturing, financial services and public administration.
Of this 20%, deficiencies in communication (54%) and customer handling
(51%) were the skills most sought by firms reporting an internal skill’s
gap. So the skills lacking in many sectors are not the old fashioned trade
skills, but modern, customer facing skills.
Conclusion
Net growth in employment over the last 25 years has been in ‘new jobs’
such as design, finance and lei-sure services, which demand a different
kind of intermediate or higher level skill than those associated with
manufacturing, for example creativity and problem solving skills. Linked
to the increase in this type of job, there has been a high level of growth in
con-tract type employment. Short term contracts give employers labour
force flexibility, and reduce administration and employment costs, such as
pensions and holiday pay. For full time employees in high skilled jobs it is
therefore likely that long term job stability will become less and less
typical.
It is very likely that more jobs will require a higher level and range of
skills, including ICT, and communication skills in the future. High
performance skills such as communication and team working will be
required by a majority of organisations seeking to improve product or
service quality in the UK. We can see a relationship between these skill
gaps and government policy—most notably the 50% of 18 year olds into
Higher Education target.
There will in the future be more part time jobs, particularly in the service
sector. Part time employment as a share of total employment grew from
21% in 1984 to 25% in 1999 – a total of 1.5 million jobs - and is still rising.
Part time jobs are concentrated in hotels, catering and care work, with a
decline in construction and manufacturing—so again the bias is to-ward
increased female employment.

EXAM QUESTIONS
We are constantly being reminded that we are an ageing population and
the Government is introducing legislation allowing people to remain in
their jobs beyond the age of 65 in order that they can maintain a decent
standard of living. This change in the pattern of employment is well
illustrated by Asda, the supermarket chain, which recently announced
plans to take on 3,300 over fifties for the festive period. This followed an
initiative earlier in the year called the ‘Goldies’ campaign to boost the
number of over fifties working in its stores by 20%. [BS3 June 2003; 1a]

(a) Identify and explain two recent changes in the

pattern of employment, other than the recruitment of
older workers. [4]
(b) Analyse, with the use of examples, reasons for
the decline in the UK’s secondary sector. [8]
 (c) Discuss the view that the secondary sector is the most
important industrial sector for the success of the UK
economy. [8]

EXAM QUESTIONS
Foot-and-Mouth returns to the UK in 2007
British farmers were horrified to hear the news that yet another case of
foot-and-mouth disease had been discovered on a farm in Surrey, just
when it was hoped that the outbreak on a farm some 30 miles away in
August was an isolated case. The European Commission has banned
British meat exports and this will place some farmers in severe financial
difficulties. This is yet another blow to workers in the UK’s primary
sector where the number of workers employed continues to decline.
Adapted Daily Telegraph, 13
September, 2007
(a) What is the primary sector? [3]
(b) Explain why the number of workers employed in the
UK’s primary sector continues to decline. [6]

Physical Resources
Whatever the product or service provided by firms, they will all need some
combination of all four factors of production to be produced. The actual
mix will depend on the product or service, for example the key factor for
an oil well is land, but without the other 3 factors no oil will be produced.
For a bank, capital is the most important factor, and for a football team
labour - but again without the other factors there is can be no Barclays
Bank, no BP or Tesco and there is no Manchester United.
The four factors of production are:
 Land
 Labour
 Capital
 Enterprise
Of these the Physical resources are Land and Capital.

Land

Land is often described as the free gifts of

nature. The factor of production Land includes natural re-sources such as
minerals, oil, coal, the sea, the fishes in the sea, plus land itself. One of
the problems of describing what is meant by land is that as soon as some-
thing is added to it, for example fertilizer to soil, it quickly becomes
someone's capital, (see below). So when describing land, it is best to stick
to the free gifts of nature definition.
When we consider physical resources in relation to business we might be
interested in the features of land that can be profitably exploited by firm’s
without involving themselves in farming or extractive industries, so

 the physical relief of the landscape, such as mountains for climbing,

beaches for swimming and sunbathing, rivers for fishing become
important
 ecosystems such as rainforest or tropical grass-lands are an invitation
for business investment in specialist tourism
 firms will consider weather and climate, and take advantage of the
ultimate free gift of nature—sunshine.

Raw Materials
From land we can extract raw materials. Raw Materials are the inputs from which manufactured
goods are produced. Oil, iron ore, and coal are examples of raw materials. Access to raw
materials is currently a major concern especially for rapidly developing economies such as China
and India. As a result the price of raw materials has been increasing over the last few years as
demand has boomed.

Capital
Capital means money invested into a business. But be-cause the money
invested does not just sit in a bank, but is turned into productive goods
that are used within the business, a businesses capital can include,
machinery, buildings, vans, computers etc., as well as cash.
 It is important for businesses to turn money capital into
physical capital that produces a profitable return for the business. So firms
purchase with money capital producer goods such as equipment, machinery
and vehicles that can be efficiently used within the business. Capital
intensive firms rely on invested capital the produce the greatest part of value
added. Management of physical resources is a complex part of large firms.
Capital has to produce targeted rates of return, oil fields and mines are
expected to achieve set levels of output, and equipment must be quickly and
effectively integrated into the production process.

Labour
Labour is perhaps the most important resource in any developed country.
Labour includes the skills of those who work, as well as the quantity of people
who work or who are available for work. In the UK there are labour shortages,
often for skilled jobs, but also for manual workers in areas where the cost of
living is high. For more information on Labour as a resource, read the notes
on ‘Human Resources’.

Enterprise
Enterprise is the ability to combine the other factors of production, and then
to use them to provide profitably, goods or services. Your local plumber will
be an entrepreneur, and so are Richard Branson the founder of Virgin Group,
and Alan Sugar, famous for the Apprentice programme. For more on the
importance of entrepreneurs see notes on ‘Functions of the entrepreneur’.

Financial Resources
Businesses can use a wide range of sources of funds to help finance their
expansion plans and their trading activities. Not all of them take the form
of cash, some take the form of assets that the business can use, which
then releases cash for other uses.

External Sources of Finance

Owner's Capital
This is often the only source of capital available for the sole trader starting
in business. The same often applies with partnerships, but in the case of
partnerships there are more people involved, so there should be more
capital available. Owners capital though, when invested is often quickly
turned into long term, fixed assets, which cannot be readily converted into
cash. If there is a need for increased finance, the business owners could
invest more money in the business. This option though, may be
unavailable. In many small businesses the owner may already have all his
or her capital invested, or may not be willing to risk further investment.

 Shareholders' Capital
Shareholders are of course the owners of a Limited Company, they invest
money in the hope of capital growth, (that is the business makes profits,
grows, makes more profits, so as the business becomes bigger their
investment will be worth more), and Dividend (the shareholders share of
the companies profits).

It is normal for limited companies to issue new shares in an

attempt to raise capital ... in some cases shares are issued to
solve a cash flow problem, - this is occurring more and more
with .com businesses..

It is quite normal for limited companies to issue new shares (a Rights

Issue), in an attempt to raise capital, and this is normally for investment,
funding expansion or restructuring. In some cases shares are issued to
solve a cash flow problem, this is occurring more and more with .com
businesses. Ordinary share capital is referred to as permanent capital; this
means that it does not have to be repaid. But some types of share capital
do require the payment of annual interest or dividend.

The main types of share capital are:

 Ordinary Shares
The holder of an ordinary share has a share in the ownership of a limited
(or joint stock) company. Ordinary share holders will expect to receive an
annual dividend (their share of the profits), but this is in no way
guaranteed. Payment of dividend depends upon the performance of the
company, and the dividend policy adopted by the company.

 Preference Shares
These will pay a fixed annual amount to the holder, again known as a
dividend. Preference share holders will receive their dividends from
profits, or reserves, before the dividend to ordinary shareholders is paid.
This means that preference shares are less of a risk that ordinary shares,
but the payment of dividend, or return of capital is not guaranteed.

 Debentures
These are a form of loan stock. The holder of a Debenture has made a
secured loan to the business, and these Debentures will have a fixed
redemption date (the time the loan must be repaid). Debentures are more
secure than ordinary shares or preference shares, but again if the
business fails there is no guarantee of repayment of capital. But
Debenture holders do get their 'bite of the cherry' before ordinary and
preference share holders. From the businesses point of view Debentures
are an effective way of raising capital because the Debenture holders
have no say in how the company is run. This means that the issue of
Debentures does not dilute control; the directors still run the business.

 An overdraft
An overdraft is a form of bank loan. A business becomes overdrawn when
it withdraws more money out of its cheque account than there is in it, this
leaves a negative balance on the account. This is often a cheap way of
borrowing money, as once an overdraft is agreed with the bank, the
business can use as much of the overdraft as it needs at any time, up to
the agreed overdraft limit. But the bank will of course charge interest on
the amount overdrawn, and will only allow an overdraft if they believe the
business is credit worthy i.e. is very likely to pay the money back. A bank
can demand the repayment of an overdraft at any time. Many businesses
have been forced to cease trading because of the withdrawal of overdraft
facilities by a bank. Even so for short term borrowing an overdraft is often
the ideal solution, and many businesses often have a rolling (on going)
overdraft agreement with the bank. This then is often the best solution for
overcoming short term cash flow problems, e.g. funding purchase of raw
materials, whilst waiting for payment on goods produced and sold.

Bank Loan
This is lending by a bank to a business. A fixed amount is lent e.g.
£10,000 for a fixed period of time, e.g. 3 years. The bank will charge
interest on this, and the interest plus part of the capital, (the amount
borrowed), will have to be paid back each month. Again the bank will only
lend if the business is credit worthy, and it may require security. If
security is required, this means the loan is secured against an asset of the
borrower, e.g. his house if a sole trader, or an asset of the business. If the
loan is not repaid, then the bank can take possession of the asset and sell
the asset to get its money back!
Loans are normally made for capital investment, and if a loan is obtained
then this frees up other capital held by the business, which can then be
used for other purposes.
 Leasing
With leasing, a business has the use of an asset, pays a monthly fee for its
use and will never own it. If a sole trader set up business as a parcel
delivery service, he could lease the van he needs from a leasing company.
He will have to pay a monthly leasing fee, say £250, which is very useful if
he does not wish to spend £10,000 on buying a van. This will free up
capital, which can now be used for other purposes.
A business looking to purchase equipment may decide to lease if it wishes
to improve its immediate cash flow. In the example above, if the van had
been purchased, the flow of cash out of the business would have been
£10,000, but by leasing the flow out of the business over the first year
would be £3,000, leaving a possible £7,000 for other assets and
investment in the business. Leasing also allows equipment to be updated
on a regular basis, but in the long run, it does cost more than outright
purchase.

 Hire Purchase
This is similar to leasing, but at the end of the hire period the asset
belongs to the company that hires it.

 Buying on Credit
This creates Creditors. If a business which sells shoes buys on credit from
Clarkes shoes, it may not have to pay Clarkes until 30 or 60 days after
delivery. This means it could sell the shoes at a profit, and have the
money at the end of the credit period, to pay its bill to Clarkes. Extending
a credit period will help solve short term finance problems. Extension of
credit could be achieved by delaying paying bills for an extra 14 days,
meaning there will be more cash in the bank for this period. Unfortunately
this type of action may upset businesses' suppliers; after all they have
their own cash flows to think of. The next time the business wanted credit
from a supplier that they had been very slow in paying in the past, they
may be turned down!
Slow payment by debtors is a problem for many businesses, and in fact
the government has tried to take action against this type of behaviour in
several budgets.

 Selling Assets
A business can sell assets it owns to raise capital! This is often a last gasp
measure as assets are usually vitally necessary to business activity. In
some cases the business may lease back the asset, so that it still retains
its use. But this often the preserve of big business e.g. the sale and lease
back of office blocks.

 Debtors
If a firm is in immediate need of cash it could chase its debtors for
repayment. This may involve giving discounts for early repayment.
Chasing debtors for early repayment may lead to long term loss of trade,
as the debtors may buy from another business next time, but it can be an
effective method of solving short-term finance problems.
 Factoring
For larger firms, with a turnover (sales) of £100,000 or more a year, it is
possible to let a Factor manage your debts for you.
The factor (a type of finance company) will pay 80% of the value of an
invoice at the time of sale, and will take responsibility for receiving
payment from the debtor. The balance of the debt will be passed on when
the money is received by the factor. There is of course a charge for this
factoring service and the amount of charge will depend upon several
issues such as, number of debtors, size of debts, and past bad debt
history. But factoring does improve a business’s cash flow and it
popularity amongst small to medium size businesses, proves that many
managers and owners regard this service as good value for money.

 Venture Capital
A venture capital company is a business that specialises in investing in
small to medium sized firms that are expected to grow quickly,. The
venture capital company will purchase a shareholding in the business –
providing needed funds, and will help manage the business. The venture
capitalist will expect to sell their share holding, at a profit, with 3 to 5
years. Venture capitalists can provide investment funds from £10,000 up
to £10’s of millions.

 Private Equity Funds

Private equity funds include forms of venture capital and MBO
(management buy out) financing. Private equity funds buy companies that
are likely to be listed on a stock market, and then take them private de-
list. Private equity funds have injected huge amounts of capital into the
take-over market in recent years.
In some deals, private equity funds use a technique known as a
"leveraged buy-out" (LBO) for all or part of the purchase costs. In an LBO,
the buying group uses loans, bonds or other debt instruments to raise the
capital necessary to buy the target. Often, they use the target company's
own assets as collateral. In the UK one of the largest private equity deals
was the takeover of Boots, costing £10 billion. Of which £7 billion was
financed by debt.
Because of the amount of debt that can arise from a private equity take-
over, and the costs associated with servicing this debt, the tax paid by a
taken over company can fall dramatically. When the managers of a
company work with private equity groups to raise the money necessary to
buy the stock of the firm they're running, then a MBO is occur-ring.

Internal Sources of Funds

If a business needs to raise finance, it is good management to look for
internal methods of solving the problem. Internal methods of raising
finance should be used because firstly, internal methods are generally
less expensive than external methods, and secondly, keep raising of
finance ‘in-house’, prevents an increase in the influence of external
factors on the management of the business.
Some of the more successful methods of raising finance internally are
outlined below.

 Retained Profit
At the end of the trading year a business will complete it’s Profit and Loss
Account. All of this profit earned can be taken by the owners, (this would
be a dividend in a Limited Company), or alternatively some or all of it
could be reinvested in the company, to help the business grow and
therefore make even more profit in the future. If a business needs to raise
finance it can increase the proportion of profit it retains within the
business, but this does mean that dividends paid will fall.

 Stock management
Often finance problems arise because too much of a business’s capital is
tied up in working capital, such as raw materials, work-in-progress and
stock.
Many firms are now implementing practices such as just-in-time, and Kan
Ban, which are designed to reduce working capital levels and release
capital, which can then be used in more effective ways within the
business.

 Manpower management
Examining and restructuring labour costs can reduce outflows of cash. Is it
necessary to have permanent contracts for all workers? Can some work
be sub-contracted, or can some work be transferred to temporarily
contracted workers? Restructuring Human Resources in this way can save
expenditure on pensions, National Insurance, holiday pay etc.

 Improved Budgeting
Why base next years budgets on last year's budgets? Why not start with a
clean slate and opt for zero budgeting? Also budgets need to be managed
effectively, and variances analysed as they arise.

These internal methods can save on business costs and in larger

organisations often prove the best long-term solution to finance and
liquidity management problems.

EXAM QUESTION
Expansion for CareBeds Ltd
Following a recent trip to research the hospital beds’ market in the USA,
Gareth Palmer, CareBeds Sales Director, had reported his findings to the
rest of the Board of Directors. He believed they should try and compete
for a share of the huge American market. To do so, he felt that the
company needed to expand by investing in a factory extension as well as
new machinery. Gareth had done some preliminary costing and
anticipated a cost of around £8 million to £10 million. Lucy Cartwright, the
Financial Director, felt it necessary to point out that both the US and UK
economies were facing difficulties and that interest rates were fairly high
at present. In addition, she pointed out that the business was
experiencing some bad debts at present and the working capital
situation was a matter of some concern. She felt the proposals needed
very careful consideration and asked for another meeting in two weeks’
time. By then, every member of the Board could have given some
consideration as to how such a significant investment might be financed.
(1) What is meant by the term ‘liabilities’ when used on a
balance
sheet? [1]

(2) Suggest one example of a current liability, other than trade

creditors,
that a business like CareBeds might have. [1]

(3) Explain why the ‘debtors’ is shown as an asset on the

balance sheet
of CareBeds Ltd. [2]

(4) Using the information provided in the balance sheet of

CareBeds Ltd.,
calculate:
(i) net current assets (working capital); [1]
(ii) total assets less current liabilities; [1]
(iii) net assets; [1]
(iv) capital and reserves. [1]

(5) Explain why net current assets (working capital) are such an
important figure on a company’s balance sheet. [4]

(6) Evaluate the various sources of finance that CareBeds Ltd.

might use
in order to pay for the proposed investment in the factory
extension
and in the new machinery. [8]
 Methods of Production
There are three types of production

 Job,
 Batch
 Continuous/flow production

Job Production
With Job Production single items, usually to the buyer’s specification are
made. Examples of goods made by Job Production are bridges, wedding
dresses, tailor made suits. Employees producing goods using job
production can be highly skilled, and there-fore paid well, and have
interesting a challenging jobs. Goods can take a long time to make
compared to goods made by mass production; prices are also likely to be
a great deal higher. Firms may use Job Production to differentiate their
products from the mass market, and allow them to target niches within
the market, or it may be the nature of the product that forces the firm to
apply Job Production methods.

Batch Production
With Batch Production goods are produced in sets (batches) and then
other using the same equipment and labour, batches of different goods
are made. An example of an industry us-ing batch production is baking,
where bakers will use ovens to make bread, and then use the same ovens
to make cakes, then savouries etc. Batch production is also used by
potters, and furniture manufactures. Cadbury apply Batch Production
techniques in their Birmingham factory. One type of bar is produced for 5
days, then the equipment is adjusted to produce an-other type of bar.
Employees are likely to be semi-skilled, and there can be a reliance on
capital investment. Batch production allows firms to aim at niche markets,
using the same assets or capital equipment to produce a range of goods.
But time is lost when ma-chines have to be reset for new production
(down time), and the firm may not be equipped to deal with large scale
orders.

Continuous or Flow Production

Continuous or flow production involves the production of products on
production lines. These mass produced products surround us in our lives,
from TV's to Cd's, from cars to videos. In the Mass production process the
making of the product is broken down into a number of small, simple
tasks, so machines or robots can complete the job or workers can be
employed who are un-skilled, or have skills limited to particular tasks.
Employing workers with few skills can of course keep the costs of labour
down, and allow firms who do not need a highly skilled labour force to
locate where labour costs are lowest. Continuous production implies large
amounts of capital investment. Firms will benefit from economies of scale,
reducing costs
The type of production used will depend upon a number of factors. The
most important are:

 the product being produced

 the cost of labour
 the cost of capital
 the skills of labour
 the size of the targeted market

Large v Small Scale Production

When we look at poorer regions that are trying to develop an
entrepreneurial base, there are a number of arguments over whether
small or large scale production should be used to help with industrial
development.
There are advantages and disadvantages to both types of production;

Small Scale Production

 Reduces regional imbalances
 Keeps employment local
 Reduces long distance transportation
 Keeps ownership local

Large Scale Production

 Benefits from economies of Scale
 Allows increased us of expensive technology and high level skilled
operatives
 Attracts international investment

EXAM QUESTION

FROM RAIN TO SUNSHINE

Sally Jean discovered her talent whilst at school when she was asked to
decorate a local restaurant for the end of year ‘prom’ or ball. She chose a
rainforest theme with lots of bamboo and this was the birth of her small
business with bamboo as her trade-mark material. She set up her interior
design business to cater for the niche market. Since then, the orders have
come in regularly for the design of places like restaurants, wedding
venues, children’s nurseries, playgrounds and children’s bedrooms. As the
business grew, she expanded into the small-scale manufacturing of
conservatory furniture for some of her clients. Her boyfriend Billy helped
her; she designed it and he hand-crafted it. The business, although
successful, is still small and Sally is eager to move into the mass market.
She also intends applying for a BSI Kitemark. She wants to expand into
the large-scale production of bamboo conservatory furniture. Much of the
design work at the moment is done using a CAD package, and she thinks
that she can use her skill to link this with a CAM package for the
manufacture of the conservatory furniture. With expansion in mind, Sally
Jean has been gathering opinions from various sources and has received
conflicting advice. Jim, her father, says she should start slowly and stick to
job production. However, her boyfriend, Billy advises her that, unless she
goes for batch or flow production, the venture won’t be profitable because
she won’t be able to benefit from internal economies of scale. The
local business development agency says that she should consider sub-
contracting the work to a factory in China.

Briefly explain:
(1) Why Sally Jean wants a BSI Kitemark? [2]

(2) The meaning of internal economies of scale. [4]

(3) Explain the advantages to Sally of using

CAD and CAM packages. [6]

(4) Compare the suitability of job, batch and flow

production methods for Sally Jean’s proposed
new venture. [8]
 Organic and External Growth
One of the major objectives of businesses is growth, and there are a
number of ways of measuring growth

 Growth in market share

Market share is the proportion of the market that buys a firms product, so
it could be said that Ford has 16% of the car market, or Tesco has 23% of
the re-tail grocery market. An increase in market share indicates that a
firm is succeeding against competitors.

 Increase in sales
This could be measured in units or value. A firm may increase sales from
50,000 to 55.000 sales or alternatively from £1,000,000 to £1,200.000.
This though may not be the best judge of growth as it ignores growth in
the market and the effects of inflation. To overcome some of these
problems of measurement firms may look at increases in like-for-like
sales.

 Increase in profits
If profits increase this is normally a sign of growth, but alternatively could
be caused by a reduction in costs.

 Increase in brand awareness

The more people that know about a product or firm, then this growth in
consumer awareness is a strong indicator of business growth.

So how do firms achieve growth?

There are a variety of methods of achieving growth, some are internal
others are external.
Organic Growth
Organic Growth, also called Internal growth, is based on investing in what
the business already does. This type of growth can be achieved by:

 Expanding product range

Once a product is established on the market, further related products can
be introduced. So for example Minis-try of Sound, which was once just a
nightclub, now releases CDs, puts its brand on hi-fi equipment. Owns a
radio station and sells holidays.
 Targeting new markets
This means selling your products to new market sectors, mobile phones
were once just sold to business people, then the market become all
adults, then teenagers were actively targeted.
 Expanding the distribution network
Make your product available in more places.
 Benefiting from economies of scale
Economies of scale reduce costs, meaning that prices can be reduced,
which should gain new customers.

Organic growth is a good indicator of how well management has

used its internal resources to expand profits.

Organic growth also identifies whether managers have used their skills to
improve the business. Many firms show how well they have performed by
giving like-for-like comparisons, this represents an accurate measure of
organic growth for the firm.
For more detail on methods of achieving organic growth, it is worth
reading up on how the Ansoff Matrix gives firms a structure for using
existing customers and markets to achieve growth.

External Growth
Growth can also be achieved through external methods. This type of
growth is sometimes called inorganic growth and involves taking-over or
merging with another business. Growth through mergers or take-overs
can come in 4 varieties.
These are:
 Horizontal Integration - occurs when a firm mergers with or takes
over another at the same stage in the production process. So Somerfield
merged with Kwik Save, Lloyds bank took over the TSB. Often the
objective is to benefit from economies of scale, and so reduce costs and
in-crease profits. Sometimes the word synergy is used in this type of
growth - synergy implies that the 2 firms together will, because of the way
they work, and the products they offer, be more profitable together than
apart. A good ex-ample of this synergy is the merger of Guinness Brewers,
and “Grand Met” the hotel chain to form Diageo.
 Backward Vertical Integration - this is when a firm mergers with or
takes-over another at the previous stage in the production process. The
objective here might be to reduce costs or secure supplies. An example of
backward vertical integration would be Birdseye owning large farms,
Dunlop owning rubber plantations.
 Forward Vertical Integration - when a firm mergers with or takes-
over another at the next stage in the production process. This will
guarantee outlets for products. Examples include Life Insurance
Companies taking over chains of Estate Agents, Oil Companies buying up
service stations.
 Conglomerate - in this case there is little if any obvious relationships
between different parts of the business. A conglomerate may include
companies as diverse as concrete producers, hotels, and pharmaceutical
companies, all under the same overall ownership. Conglomerates can
arise simply because the directors see the chance of buying firms cheap,
or because they wish to enter entirely new market areas.

Growth and Risk

The major objective of growth is to increase profit-ability, and improve
profit margins. This is what firms desire as they grow. But all types of
growth bring problems and carry some degree of risk. Simple organic
growth (internal) can mean that managers or owners are forced to spend
more time on man-aging people or paperwork, and less time on what
made the business successful in the first place, there will be increased
distance between business owners and managers (divorce of ownership
and control), other stakeholders will be impacted by increased pollution,
or traffic, or a firm may lose it's distinct local identity.

Money also needs to be raised to pay for growth (unless profits are
reinvested). Money can come from banks, shareholders, venture capital
companies. All these methods imply some loss of control, and perhaps
high borrowing costs, and increased risks. Also shareholders may receive
less in dividends if profits are used to pay for investment.

Also mergers, take-overs and expansions can be mistimed or misjudged.

Also too high a price can be paid. The take-over of chains of Estate Agents
by Insurance Companies that occurred in the late 1980's was expected to
produce high sales of insurance products, plus high profits from selling
houses. In-fact Insurance Companies lost £100's of millions from this badly
planned venture. BMW paid over £500m for Rover group, after several
years of massive losses they sold it for £10. The risks associated with
growth are one reason why many firms prefer to stay small.

Mergers and Take-overs can bring fast growth, and can be especially
useful in achieving growth in new product or geographic markets. On the
other hand there have been plenty of examples in recent years where
incredible rates of growth have been achieved organically, for example,
Google, Face Book, Friends Re-united etc.
 Franchising

Franchisee. Individual or firm who buys or leases the right to use the
brand name, products and trading style developed by the franchisor
The financial relationship between the franchisor and franchisee does not
end with the payment of the franchise fee. The franchisee will often be
required to buy supplies, raw materials, stock etc from the franchisor (the
seller of the franchise), pay annual fees, and may even have to pay a
share of his profits to the franchisor. The franchisor will also regularly
check on the performance of the franchisee to ensure that the brand is
not being de-valued in any way and that standards are being maintained.
So the franchisee is in somewhat of a straightjacket, paying a monopoly
supplier for stock, paying over to the franchisor a portion of his profits and
being regularly checked on. So with these restrictions, why is franchising
so popular? There are in fact, a number of advantages to the franchise
system for the franchisee, these include:
 Use of an established brand name– this should help guarantee
customers.
 Help in training and recruiting staff, and set-ting up business
systems
 Nationwide marketing campaigns - from franchisors like McDonalds
and Body Shop.
 Easier to sell a franchise, than an unbranded business.

The franchisee will received guidance on general business matters, and a

good franchisor will do everything they can to help guarantee the success
of franchisees. One way of looking at a franchise is that it helps over-come
many of the problems inherent in setting up business as a sole trader.
The franchisor by selling a franchise obviously gains as well. The
advantages from the franchisors point of view are;

 Fast growth - with lower risk

 Economies of scale - bulk buying for the franchises
 Increased income from franchise fees
 Managers (franchisees) who are committed to the success of
the business and hard working

There are nearly 800 franchising firms operating in the UK, covering
everything from accountancy, to pet care. Some are very similar to each
other, for example there are 4 franchisors whose business model is based
on lawn care, each claim-ing to be the leading lawn care specialist.
Fastest growing franchise chains include coffee shops such as Coffee
Republic, and community magazines.

Buying a franchise does not guarantee success, not all franchise formats
succeed, and not all people will be successful entrepreneurs, no matter
how much back-up they receive. But figures show that franchises are a
good way of starting up in business, and greatly reduce the risks of going
it alone. Before buying a franchise, the potential franchisee should
research the market carefully, and find out exactly what they are paying
for. Franchises can cost anything from a few thousand to £100,000 plus
and the potential franchisee should ask the question ‘would the cash
spent in buying the franchise, be better used by myself in setting up my
own business’?

EXAM QUESTION

SPORTSMANIA HOTS UP PACE WITH FRANCHISES

David Hoskins has developed a chain of sports stores, called Sportsmania,
located on industrial estates. He is a discount retailer selling sports gear
at bargain prices. Sportsmania is five years old and already has sales of
£12 million. In 1997 he started looking at franchises and now twelve of his
eighteen outlets are franchised out. Hoskins spent £25,000 in the first six
months on his search for franchise applicants and still spends £20,000 a
year to attract franchisees. He has refined his selection technique and
now insists that applicants come and work with him for a week before he
agrees to sign them up.

(a) Briefly explain the term franchise. [2]

(b) Evaluate the view that creating franchises is a sound method

of expanding the business of Sportsmania. [6]

RECOVERY STRATEGY PAYS OFF FOR THORNTONS

Its chocolate season - Valentine’s Day, Mother’s Day, and Easter are all in
close succession, and Thornton’s has been innovating on products to lure
chocolate lovers into its stores. Thornton’s Moments, described as a family
treat, are just hitting the shops shelves this week. Further work is also
under way on design and layout, and the new look will be trialled at 10
stores this summer. Mike Davies, the chief executive, joined Thornton’s
from Mars in October 2006, pledging to revive the fortunes of the
company which began as a single shop in Sheffield in 1911. His recovery
strategy appears to be paying off. Yesterday, Thornton’s reported a 14%
jump in half-year profits as it notched its fifth successive quarter of sales
growth. Revenues rose 13.9% to £126.7m in the 28 weeks to 12 January
while profits increased to £11.9m from £10.5m. Thornton’s trades from
378 owned stores and 252
franchises and its products are also available through supply deals with
major supermarkets and retailers. Its website and catalogue service,
Thornton’s Direct is also making steady progress, enjoying revenue
growth of 25.6% to £5.3m in the period.
Cliff Feltham, The Independent, 21 February
2008

(a) Outline two economies of scale that Thornton’s will benefit

from if it continues to be
successful. [4]

The Mattress Doctor expands through franchising

Former accountant Bryan Walters and his business associate Bruce King
were looking at various business options. Bruce’s wife suffered from
asthma and in their research they came across businesses in Germany
and the USA which cleaned mattresses to try to get rid of dust mites and
ease the asthmatic symptoms. They discovered that no one was running
such a business in the UK, where allergy rates are the highest in Europe,
and so the Mattress Doctor was born. Business was doing very well and
Bruce and Bryan started to think about growing it. They decided that
franchising would be the most suitable route for expansion. A Mattress
Doctor franchise costs from about £8000 and there is a monthly charge
of £250 to cover repair and replacement of equipment and continued
support. Their main business objective is growth, and inside one year they
had 24 UK franchises with the aim of reaching 100 within the next three
years.
Adapted: Franchising, Working
Lunch BBC

(a) Apart from growth, outline two other business

objectives that the Mattress Doctor might have. [4]

(b) Explain the benefits to both franchisors and franchisees

when operating a business such as the Mattress Doctor.
[8]

(c) Briefly explain two problems that Bruce and Bryan may
face when operating as franchisors. [4]

BODY SHOP
Dame Anita Roddick, who died recently aged 64, was the energetic founder
and guiding spirit of The Body Shop, the international cosmetics and toiletries
empire built on a combination of soap, bubble bath and ethical conviction. In
countless ways, Roddick was an inspiration: she was a grafter, a risk taker,
and that rarest of creatures – a successful female entrepreneur who, from a
single shop in Brighton in 1976, presided over a franchise of 2,000 stores in
53 countries just 30 years later. All this was achieved with a bank loan of just
£4,000, which she was at first refused! However, returning to the bank with a
convincing business plan, she finally persuaded her bank manager to back
her. The key to The Body Shop’s success was the identification of its
products (e.g. Fuzzy Peach Shower Gel, Brazil Nut Conditioner, Raspberry
Shampoo) with the social and political preoccupations of the young women
who constituted its main customer base: such as animal welfare, the
protection of the Brazilian rain forest, Third World poverty and, of course, the
age-old pursuit of youth and beauty. Her husband, Gordon was considered by
many to be the financial and business brains behind the enterprise, while
Anita provided the passion, the activism, the ideas and the publicity.
Source: Adapted from The Guardian, 10 September,
2007
(a) (i) What is a franchise? [2]
(ii) Briefly explain two requirements of franchisees that you might expect
to find in a
Body Shop franchise agreement. [4]

(b) Explain the benefits to a business of taking out a franchise with The Body
Shop rather than operating independently. [6]

(c) Evaluate the importance of a business plan to the success of a small

business. [6]

Concrete drainage systems constitute a niche market worth about

£80million a year in the UK, but operations are concentrated in the hands
of the three large players, the largest of which is CPM, which is based in
Mells in Somerset. CPM manufactures concrete drains as well as laying
them; earlier this month the firm bought Hughes Concrete, a firm
specialising in supplying high quality concrete to firms manufacturing
concrete products, creating an overall business with a turnover of
£26million. Recently CPM firm has diversified into areas such as
landscaping and flood protection, with the help of a £3.5million funding
package from Bank of Scotland.
Adapted from The Daily Telegraph
15/10/2008

(1)Describe the type of integration that occurred when CPM bought

Hughes Concrete. [4]
 Economies of Scale
As businesses grow and their output increases, they commonly benefit
from a reduction in average costs of production. Total costs will increase
with increases in output, but the cost of producing each unit falls as
output increases. This reduction in average costs is what gives larger
firms a competitive advantage over smaller firms. This fall in average
costs as output increases are known as Economies of Scale.
Economies of Scale are an important aspect of efficiency in production.
Economies of scale can be defined as:
'the reduction in average costs of production, that occur as a firm
increases it’s scale of production'.
Costs in the short and long run
When examining economies of scale it is worth looking at both the short
run and long run average costs of the firm. In the short run costs can be
both variable and fixed, but in the long run all costs become variable. It is
this switch to all costs becoming variable that separates the short run
from the long run.

To understand this division between short and long run, we can look at a
simple example. Jenkins Carriers are a local delivery firm, they run 2 vans
both of which are leased, with 2 years to run. The leasing charges of £300
per month are fixed for the term of the lease. For the firm (assuming that
they have no other longer term commitments), the short run will be two
years, as part of their costs are fixed for this period of time. If at the end
of the two year period they are able to negotiate better leasing terms
because they have established the company as a good risk, or because
they now wish to lease 6 vans, they are benefiting from economies of
scale. Alternatively they may wish to buy the new vans or, if things have
not gone well, even withdraw from the business. The fixed costs, until
they commit themselves to a new agreement, become variable. Each
firms long run average cost curve is made up of a series of short run
average cost curves.
As a business grows it moves and from one short run average cost curve
to another short run average cost curve, each one being progressively
lower and so reducing average costs of output - e.g. cheaper leasing of
vans. This is represented in the graph below.
If we look at a second example we can see how average costs are reduced
in the short run. Imagine a building site with one foreman and one worker.
The workers role is digging trenches the foreman's role is to oversee the
digging of trenches. The foreman earns £10 an hour the workers wage is
£5 an hour. The worker is capable of digging 5 metres of trench in an
hour. With one worker each metre of trench would therefore cost £3, that
is the £5 wages of the worker and the £10 wages of the supervisor divided
by 5 meters dug, = £3 per metre.

If another worker was taken on then we would now have 10m of trench
per hour at a total cost of £20, therefore the cost per metre of the trench
is now £2. With three workers we now have 15 m of trench at a total cost
of £25 which gives is a cost of £1.66 per metre. We therefore see
decreasing average costs in the short run.

In the long run the building site could instead of using workers and spades
use a digger. This would allow a move on to a second average cost curve
and therefore lower potential average costs. This is how economies of
reduce average costs of production.
 Internal and external economies of scale
We can break down economies of scale into two broad groups, these are Internal and External.

Internal Economies of Scale

Reductions in average or unit cost because of increasing internal efficiencies of the firm.

External Economies of Scale

Reductions in average or unit cost because of increasing efficiencies of the firm that have resulted
from external factors.

Internal Economies of Scale

Internal economies of scale include:
 purchasing
 technical
 financial
 managerial economies
 advertising

Purchasing
As firms grow, they increase the size of orders for raw materials or
components. This will then result in discounts being given, and the cost of
each individual component purchased will fall. This will therefore reduce
the average cost of production.
Technical
As businesses grow they are able to use the latest equipment and
incorporate new methods of production. This increases efficiency and
productivity, reducing average costs of output.
Financial
As firms grow they will have access to wider range of capital, such as
equity capital (share issues), this reduces the cost of borrowing for
investment. Also as the assets of the firm grow, businesses are able to
offer more security for borrowing, reducing the risk to the lender and
reducing the cost of borrowing.
Managerial
As businesses grow they are able to employ specialist managers. These
managers will know how to get the best value for each £ spent, whether it
is in production, marketing or purchasing. This will increase efficiency,
reduce the average costs of producing goods and selling the goods
produced.
Advertising
As firms grow each £ spent on advertising will have greater benefit for the
firm. Imagine a chain of local supermarkets; a TV advertisement is placed
to cover the region. If there were 10 stores in the chain, the cost of the
advert must be borne by each of the 10 stores, but if they have 20 stores,
then the cost of the advert would be spread across each of the 20 stores
and the benefit of the advert applies to each of the 20 stores.
 External Economies of Scale
The largest firms often benefit from external economies of scale. These
include:

The setting up locally of supplier firms

Often in competition with one another, this reduces buying costs and
allows the use of systems such as Just-in-Time.
Local colleges will set up training schemes
Suited to the largest employers needs, giving an available pool of skilled
labour, this reduces recruitment and training costs.
Financial services can improve
With banks and other financial institutions providing services, such as
factoring, that reduce costs and improve cash flow.

These economies of scale can be regarded as quantitative in nature i.e.

they can be measured using financial methods. We know exactly how
much is saved on purchasing raw materials; we know exactly how much is
saved when a loan is renegotiated at a lower interest rate.

Diseconomies of scale
Firms can also suffer from diseconomies of scale. When diseconomies
occur, the average costs of production rise with output. Let's go back to
the example of the building site.
Maybe the foreman is capable of looking after 10 workers effectively and
ensuring that each digs 5m per hour, but if there were 15 workers
average output may start to fall. This happens because the supervisor
isn't able to supervise all the workers and ensure that each is working at
maximum capacity. Efficiency of production falls and there is increasing
average costs of output. We now have diseconomies of scale.
Like economies of scale, diseconomies can also be internal and external.

Internal diseconomies include:

Problems with communication

As a firm grows and levels of hierarchy increase the efficiency and
effectiveness of communication breaks down this leads to increasing
inefficiency and therefore increasing average costs.
Motivation
With larger firms it is harder to satisfy and motivate workers. This means
they do not give of their best, and again as the firm grows average output
falls, and average costs increase.
These diseconomies of scale are often qualitative in nature, hard to
measure financially, but still reduce the efficiency of the business.

External diseconomies include:

Traffic congestion
The firm grows, suppliers move in, the area becomes an industrial centre,
and the roads are clogged with cars, vans and Lorries. Deliveries are late;
drivers spend time stuck in traffic jams etc.
Breakdown of relationships
With suppliers and buyers. When a firm is small, there is often a direct
relationship between owner managers and customers or suppliers. As the
firm grows, these relationships are hard to maintain as the owner
manager finds his time is taken up with administration or problem solving.
Competition for labour
More firms mean increased demand for labour, making the best workers
harder to recruit and keep.
Increasing employment costs
More firms mean increased demand pushing up the price of labour -
wages.
 Location of Business
Regional Location of Business
The main determinants of where businesses locate are:
 access to markets
 the cost, nature and availability of factors of production
 social factors
 historical reasons
It is the varying importance to businesses of these three, which in the long
run determines where businesses are located.
Access to Markets
For some businesses it is the availability of, and access to markets, that is
the prime consideration that determines the location of the business. This
is most obvious when we look at retailers of consumer goods. In this case
the business has to be near customers.
It used to be true that retailers had to be in the city centre if they wished
to access a mass market, but the increased availability of private
transport has led to a growth of out of town shopping centres. But this
location relationship between retailer and customer is being broken down
by the growth of e-commerce and mail order purchasing.
Manufacturers of components in many industries (supplier firms), need to
be located close to the users of their products. This has become
increasingly true with the increased use of just-in-time systems, where
being 'on the doorstep' is now the expected norm.
Access to markets can be limited because of trade restrictions, or the
existence of 'trading blocks', such as the EU. To overcome these
restrictions it is often necessary to set up a manufacturing base within the
trading block.
Type and quality of infrastructure also affect access to markets.
Infrastructure used to mean roads, rail, and shipping. But a more modern
definition includes electronic communication systems, training agencies,
financial services, as well as the three traditional components. For many
modern businesses, such as those that are E-commerce based, or the
rapidly growing call centre industry, quality infrastructure has a very
different meaning from that understood by road hauliers, and steel
manufacturers.
Sometimes existing access to markets can break down. External
diseconomies of scale force firms to reconsider their location - congestion,
and competition for workers pushing up wage rates, are just 2 examples
of factors that can force relocation.
Cost and nature of factors of production
When firms use bulky, difficult to handle raw materials, then location close
to the source of these raw materials can substantially reduce costs. This is
why the world’s major paper manufacturers are located close to where the
wood is logged and pulped.
The factor of production Labour can also be a deciding factor in
determining location. By labour we mean cost of labour, availability of
labour, and the skills of labour.
Highly skilled labour, such as that in the finance industry, can be located
around one major centre in the UK. For finance that is the City of London.
A business with a need for this type of skilled labour, must therefore
locate in this area.
The cost of labour is also a determining factor. International location has a
habit of following low cost labour to wherever it is available. Shipbuilding
moved from the Clyde, and the Tyne, to Japan in the 50's and then to
Korea in the 70's, and is now moving to Indonesia, call centres are moving
to India, and manufacturing of clothes to China and India.
The cost of Labour can be affected by the availability of government
grants, giving incentives to move to particular regions of a country, and
by government taxation policies. Availability of grants can reduce the cost
of all factors of production - but most especially labour and land.
The availability of land is also an important factor. Most large investments
are based on 'green field' sites. And local government, along with
development agencies, often work hard to ensure that planning
permission is available to allow large developments to proceed.
Social Reasons
Managers want to live in an environment that suits them and their
families. They want leisure facilities, good schools, and low crime. This is
why it can be difficult to attract businesses to depressed areas.
Alternatively managers can often retain a commitment to their existing
work force, even when it makes economic and business sense to relocate
a business.
Historical Reasons
For a good number of firms, the original reason for their location has long
since disappeared, but they still remain in the locality where they were
originally established. Around the country there are steel and tin plate
plants that had their historical origins in the availability of local raw
material—raw materials that were exhausted decades ago. But the plants
remain.
Regional location of business is then dependent upon the interaction of
several traditional factors. But at the same time it is worth noting the
changing nature of industry in the UK and the increased reliance upon and
availability of telephone, the internet and other communication networks
has, in recent years, made location decisions a great deal more flexible. .
International Location
The largest firms, though still influenced by the same factors that dictate
national location of business, do have the alternative of locating their
production facilities virtually anywhere in the world. As long as there is a
stable political background and an available work force, most countries
will offer the possibility of hosting a production base.
The main influences on international location beyond politics and labour
force factors are:
Maximising Economies of Scale
If firms are able to have a single plant supplying all their requirements for
a type of product or range of components, then the firm's average costs of
production can fall. So we see huge factories providing cakes to sell
throughout Europe, or producing injection moulded plastics for distribution
throughout the world.

Access To International Markets

Access to a trading block such as the EU, or NAFTA (North American Free
Trade Association) may depend on setting up a production facility within
that trading block. Europe has received a massive inflow of investment
from US and Far Eastern companies wanting free access to European
markets.

Access to Cost and nature

trading Blocks of Factors of
Production Taxation
Reasons
 Economies of Social Freedom from
Scale Reasons Restrictions

Tax Advantages
Companies sometimes establish operations where taxation levels are
lower than their home base. This can allow Transfer Costing to take place.
Transfer Costing is a process by which firms are able to inflate their profits
in countries where taxation levels are relatively low, and decrease their
profits where taxation levels are relatively high.

Freedom from restrictions

Firms can reduce their costs if they locate operations in countries where
red tape is less present or employment law is less complete. For example
many merchant ships now use flags of convenience. This means that the
ships are registered in counties that impose fewer restrictions on wages,
manning levels etc. This switch leads to loss of employment in the country
where the ship was originally flagged.

Firms when locating in these less regulated countries may also attempt to
reduce costs by ‘cutting corners’. Practices or systems that would have
been unacceptable in economically developed countries may be the norm
in less developed nations.

Foot Loose Firms

A foot loose firm is one that is not tied to any particular location or
country, and can relocate across national borders in response to changing
economic conditions. Many manufacturing industries seem to have this
characteristic. Foot loose firms follow cheap capital, low cost labour and
tax advantages. Multinationals aware of changing production conditions
and costs that occur between different countries often structure
production so that flexibility of location is built in, for example leasing
factories for just a few years, negotiating short term tax breaks, get-ting
host countries to pay for necessary improvements in infrastructure etc.

EXAM QUESTION
FACEBOOK
Facebook began as a social networking site for university students in the
USA. Mark Zuckerberg started it up while at Harvard University, then
followed Bill Gates’ example in dropping out of Harvard to turn his idea
into a real business. Initially only US university students could use
Facebook; now nearly 28% of its 24 million subscribers are from outside
the USA, with Canada and the UK leading the way.
To fund the start-up in 2004 Zuckerberg raised $500,000 from a ‘business
angel’, an individual willing to provide high-risk venture capital. Now the
business is able to finance its growth from its cash flow. From the early
days of the business, the single most important driving force has been to
find technological solutions to cope with the crazy growth rate. However,
in addition to coping brilliantly with the pressures of growth, Facebook has
also tried to keep moving ahead. New facilities are offered regularly, most
designed in-house, but some designed by users. Facebook is unusual in
providing its computer programming information freely to anyone who
wants to use it to develop a new service.
Adapted from ‘The Facebook Phenomenon’ by Roger Hammond (Business
Review Sept 2007)

a) Explain why Facebook can be considered to be operating

within the global economy. [4]

FOLLEYS, THE TENT MANUFACTURERS

Candice and Simon Folley have been running a business manufacturing tents
quite successfully for the last eight years. They currently employ twelve
people. Now their son, Patrick, has joined them as a partner with the long-
term view of taking over the business. This means they need to increase the
scale of the business to provide a comfortable living for them all. The tent-
making business is currently situated in premises just off the Aberystwyth
Road not far from the town centre. Candice suggests that they move to a
large unit on the local industrial estate near the motorway. Here they could
have a large internal display area and a large sales area. Whether Folleys
moves or not, the business wishes to improve both the quality of its
products and its stock control. Tent sales tend to be seasonal and
consequently it does not have a steady flow of orders. This means that it has
to discount its stock heavily towards the end of each season to make way for
new designs.

(a) (i) Explain the meaning of stock control. [2]

(ii) What problems might Folleys face as a result of poor stock
control? [4]
(b) Explain two ways in which Folleys could improve the quality of
its products. [6]
(c) Consider the factors that Folleys should take into account when
deciding whether or not to relocate. [8]
WAGON WHEELS CONTINUE TO ROLL AT MORETON,
CHESHIRE
Burton’s Foods, which make Jammie Dodgers, Wagon Wheels and a range
of own-label biscuits, owns factories in Blackpool, Moreton (Cheshire),
Edinburgh and Llantarnam (South Wales). Due to overcapacity in the
biscuit industry, it has decided to close one of its factories. After
considering various alternatives, it proposed to close the Moreton,
Cheshire factory, axing 821 jobs.

After negotiations with the Transport and General Workers Union (TGWU)
and having carried out a benchmarking exercise, a deal was agreed to
keep the factory open with half of the workforce losing their jobs. In
exchange, the company guaranteed the remaining workers a minimum of
five years’ work. The deal involves a £7.3 million package of savings and
changes to the layout of the plant.
Paul Kitchener, Burton’s chief executive said “We’ve developed an
alternative proposal for the Moreton factory that will see the creation of a
centre of excellence for our seasonal ranges. The factory is in need of
updating and we have decided to invest in it because of its suitable
location. We also propose to introduce Total Quality Management
(TQM).”

Source: Adapted from The Daily Express, 17

August 2007
(a) Explain the meaning of the following:
(i) overcapacity in the biscuit industry; [2]
(ii) benchmarking. [2]
(b) (i) What is meant by Total Quality Management? [4]
(ii) Explain two benefits which Burton’s might hope to gain from the
introduction of
TQM. [4]
(c) Consider the factors that the owners of Burton’s might have taken into
account when
deciding which one of its factories to close. [8]