Edexcel Business Studies Unit 4a - Making Business Decisions issue 1

A comprehensive guide to Unit 4a of the Edexcel GCE08      specification 

Making Business Decisions Edexcel A2 Business Studies – Unit 4a  Quazi Nafiul Islam 

2011

[email protected] 

Why give it away for free? People have started to e‐mail me about my previous notes on International Business, and I  am glad to tell you that all the feedback that I have received so far has been very positive.  But a key question that people continuously ask me again and again is the reasoning behind  giving all these resources away that I have worked so hard to make. The answer arises from  my personal philosophy, that education and knowledge should always be free regardless of  what form  it is  in. Our forefathers gave us the gift of knowledge not to keep to ourselves,  not  to  make  money  out  of  it  and  definitely  not  to  copyright  the  material  as  if  it  were  his  own. And that is the essence of knowledge. Because there are people out there that make  and share their notes, others are able to do better. Education thrives on selfless donations  from all the people of the world, regardless of their race, religion or gender: it is something  that  pulls  us  all  together.  At  CERN,  where  they  are  working  on  the  LHC  (Large  Hadron  Collider), scientists from over 80 nationalities are working together for the sake of discovery  – look at how the love and sharing of knowledge unites us all.  And  that  is  what  my  dream  is,  to  make  education  accessible  for  free  to  everyone  in  the  world, regardless of your background, and with the power of the internet I believe that this  is more possible than ever before.  Often, we do not give away our notes and resources because we don’t want the other guy to  win,  whereas  we  should  be  focusing  on  getting  better  ourselves  –  subconsciously,  it’s  not  about  doing  well,  but  rather  doing  better  than  the  other  guy,  simply  phrased  as  “It’s  not  about  winning,  it’s  about  making  sure  that  the  other  guy  loses”.  With  that  attitude,  humanity  never  got  and  never  will  get  anywhere.  If  we  were  to  co‐operate  instead  of  compete, it would enrich ourselves by helping other people where they are weak at, and in  return they would help us where we are weak  at.  In the end,  both the people are helping  each other and both of them are doing better because of this co‐operation, the only thing  that they are giving up is their ego.  And that is what I have learnt to give up through sharing my resources. Some people have  taken  advantage  of  more  than  my  business  notes;  they  have  taken  advantage  of  the  resources on my blog as well as asking me. At first it has hard giving everything up, but later  on it became easier. I realised that the more I gave the more I got, and on top of that I had  the support of all the people that had been beneficiaries of my benediction.  Next time you make a set of note that you are proud of, think of all the people that could  potentially benefit from your hard work, and think of how highly they would look at you.  Their smiles and sincerest gratitude are worth far more than our ego. 

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CORPORATE OBJECTIVES AND STRATEGY OVERVIEW

1. CORPORATE OBJECTIVES a. b.

Development of corporate objectives from mission statement/corporate aims Understanding the value of mission statements

2. STAKEHOLDER INFLUENCE ON CORPORATE OBJECTIVES a. b.

c. d.

Different influences on different objectives i. Use examples of conflicts between stakeholder objectives Conflicting and common aims between stakeholders i. Examine the business principles and objectives of a multinational company and consider how these conflicts with stories about their unethical behaviour. Potential conflicts of socially responsible and ethical behaviour with profit-based and other objectives Corporate Social Responsibility (CSR) i. Define corporate social responsibility and consider the CSR policies of major companies such as Cadbury and Coca Cola.

3. CORPORATE CULTURE a. b. c. d.

Strong and weak cultures Classification of company cultures How corporate culture is formed Difficulties in changing an established culture

Figure 1 - New employees at Google have to wear a 'Noogler' hat →

4. CORPORATE STRATEGY a. b. c. d.

e. f.

Development of corporate strategy Aim of portfolio analysis Aim to achieving competitive advantage through distinctive capabilities Effect of strategic and tactical decisions on: i. Human resources ii. Physical resources iii. Financial Resources Porter’s Strategic Matrix Competition vs. Co-operation i. Resource implications and the difficulty of changing corporate strategy in response to the influence of 1. A competitive environment 2. Political, legal or other influences that encourage co-operation between companies on strategy.

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CORPORATE OBJECTIVES CORPORATE OBJECTIVES Corporate objectives are company-wide goals that need to be achieved in order to keep the business on track to achieve its aims. These objectives have to be SMART: Specific, Measurable, Ambitious, Realistic and Time-bound. BUSINESS STUDIES FOR A LEVEL, THIRD EDITION BY IAN MARCOUSÉ • • •

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Corporate objectives are developed from the mission statement as well as the aims of the business. Corporate objectives will vary depending on the aim of the business which is determined by the type of business Public Limited Companies (PLCs) will tend to be more profit-centric as their key owners are the shareholders; shareholders have no direct influence on the day-to-day running of the business hence they only care about: o Price of Shares Shareholder’s Value o Dividends Sole-Traders, Partnerships, Private Limited Companies (PVT) may have more varying objectives as their mission could be different. For example, The Grameen Bank in Bangladesh is a bank whose main aim is to empower the poor through Micro-Credit loans, and Profitable businesses will therefore their main aim objective will not be want to go on and become profit maximisation; if Grameen chose to maximise leaders in the market. They profits then the poor would not receive lucrative will also want a good image loans. to prove to the public that Corporate Objectives that are the main focus of they are a force for good PLCs may include: o o o

MARKET STANDING GROWTH | PROFIT S

Maximising shareholder value URVUIVAL Growth Adopted by Diversification new  Essentially becoming a conglomerate businesses business  Very hard to achieve in practice Figure 2 - The hierarchy of corporate objectives; objectives any business could adopt.  If achieved, will give the business greater stability as a downfall in one sector or economy will not damage the business as much.

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CORPORATE AIMS Corporate Aims are a generalised statement of where the business is headed, from which objectives can be set. BUSINESS STUDIES FOR A LEVEL, THIRD EDITION BY IAN MARCOUSÉ •

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An example of an aim would be: o “To become a football league club” – AFC Wimbledon, who are currently in the Isthmian league o “To provide a friendly service in a relaxed, safe and consistent restaurant environment” – McDonalds Essentially as seen from the above example, aims are vague and do not have any specific or measurable progress plan through which it can be achieved, it is simply what the business wants to do, and objectives aid to realise that aim.

HOW VALUABE ARE MISSION STATEMENTS Mission statements are brief statements, written by the business, of its purposes and its objectives, designed to encapsulate its present operations. BUSINESS STUDIES 4TH EDITION, DAVE HALL Missions Statements are short sentences or paragraphs used by a company to explain, in simple and concise terms, their purposes for being. These statements serve a dual purpose by helping employees to remain focused on the tasks at hand, as well as encouraging them to find innovative ways of moving towards an increasingly productive achievement of company goals. INVESTOPEDIA •

A mission statement is likely to convey the o Purpose – the reason why the company exists o Values – what the company believes in, such as environmental friendliness o Standards and behaviour – the standards set by managers and essentially how staff are treated o Strategy – medium to long term pans adopted by the business to make aims and mission achievable o The mission statement should be capable of inspiring those who read it or hear it; it should be highly memorable. We create happiness by providing the finest in entertainment to people of all ages, everywhere. MISSION STATEMENT OF WALT DISNEY

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Some businesses however do not have mission statements such as M&S (Marks and Spencer) as they feel that their mission cannot be summarised in a sentence or paragraph. Often the mission statement is seen as little more than a public relations exercise and in truth they are often changed when perspectives change, such as Coca-Cola changing its mission statement. o If a business lacks a purpose or inspiration, it is far more useful to go to the root of the problem rather than writing a mission statement. Critical appraisal of Mission Statements means that students need to look at Mission Statements with a critical eye. In other words, do they genuinely outline the aims of the business, or are they more part of the marketing of the business and aimed at giving a good impression? Students could compare business mission statements with their recent actions to determine this.

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STAKEHOLDER INFLUENCE ON CORPORATE OBJECTIVES Stakeholders are individuals or groups that have an effect on and are affected by the activities of the organisations BUSINESS STUDIES FOR A LEVEL, THIRD EDITION BY IAN MARCOUSÉ

Managers Suppliers

Owners

Customers

Customers

Stakeholders Future generations

Employees

Government

Environment Communities

Figure 3 - Different stakeholders of an organisation

THE INFLUENCES BY STAKEHOLDERS ON AIMS, THEIR COMMON AIMS AND CONFLICTS • •

• •

Shareholders will always have conflicting aims, as they have interests in different aspects of the business. When dealing with shareholders, there are two types of approaches: o Shareholder approach  This gives priority to the shareholders meaning that managers focus on maximising shareholder value. This is very common in PLCs as the shareholders do not directly influence the day-to-day activities of the business. o Stakeholder approach  This treats all stakeholders equally and in theory should lead to long term benefits; this is increasingly being adopted by most businesses.  Managers have to take into account that they have a responsibility to all stakeholders. The shareholders of the business will want high returns on their investment i.e. short-term returns; however this may endanger the stability of the business by sacrificing long term growth. Managers will want growth for the business however this may lead to a fall in short term returns as more money is being kept for expansion. Some managers however are loyal to shareholders and are intent on maximising shareholder value.

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Employees of the business will want the maximum possible wage with the best possible benefits however, they have to be careful when bargaining for higher wages; if wages are too high this may lead to losses for the company and therefore employees may be laid off later on. Customers will want value for their money and this may be achieved by investing more into R&D. This will reduce the short-term returns, angering shareholders. Suppliers will want to charge high prices; charging too high may motivate the business to seek other suppliers The government will be keen on the business providing more jobs so will be keen on growth. However, there will be environmental consequences to expansion that the government will try to minimise through environmental and safety standards; hence costs will rise for expansion. Pressure groups will push the business to make more ethical decisions such as reducing their carbon foot-print or paying cocoa workers more for their produce (Fair Trade).

Figure 4 - Cadbury Schweppes' stakeholders

THE STAKEHOLDER APPROACH ADVANTAGES • Attractive employment policies will attract higher quality of applicants. This may lead to the business becoming more efficient. • Effective consumer care policies should lead to higher sales and greater customer loyalty in the long run • Good co-operation with supplier should lead to the purchaser getting value for money;

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Will be easier to sort out late deliveries or defective goods with whom the business has good co-operations • Aiding the community such as through charities or public funding will cause the business to acquire a better reputation and thus achieve greater market standing; excellent for PR. • Reducing environmental waste could reduce costs for the business itself as well as having a positive effect on PR.

DISADVANTAGES • Less importance to profit will likely cause less return on capital employed: this may detract investors. • Adopting the stakeholder approach may be a PR exercise as in practice successfully being able to execute the shareholder approach is very difficult as there will be mounting pressure from shareholders to focus on maximising shareholder value. • Owners have the most influence of the business but in a PLC, the managers have the most control. • GAP and Nike have often been criticised for having a stakeholder approach but still running ‘sweatshops’ in China.

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CORPORATE SOCIAL RESPONSIBILITY (CSR) Corporate Social Responsibility is the responsibility that a business has towards its shareholders BUSINESS STUDIES 4TH EDITION, DAVE HALL •

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Corporate Social Responsibility policies are now available from most major businesses, as it makes the business seem good to the public, and as a result it means that it will have a positive impact on sales and increase market standing as well as profits in the long run. Businesses have started to make auditing teams and indexes to take better care of its stakeholders o Employment Indicators  How well businesses treat their staff and this is comprised of many parts including pension, healthcare plans, accidents in work places payments etc. o Human rights Indicators  Whether the businesses uses child labour  Performance of businesses in establishing gender equality o Community Indicators  Donations to charity and public works o Business Integrity Indicators  How corrupt is the business? o Product Responsibility  How safe are the products? o The environment  The carbon foot-print of the firm  Rating on waste management systems  Fines due to environmental regulations Pressure groups claim that often businesses publish social and environmental audits simply as a PR exercise; laws and regulations need to be in place so that businesses are answerable to the law and that they are fined. o The history and policies of a business need to be examined with scrutiny in order to understand whether the business is really trying to do something good or whether it is simply trying to woo the public.

COCA-COLA CSR •

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If you go to the Coca-Cola website, you will see how they claim to be trying to change the world through their product, trying to make new and innovative products in order to become Figure 5 - CSR - fad or tradition? ↑ more socially responsible. Coca-Cola has been criticized for alleged adverse health effects, its aggressive marketing to children, exploitative labour practices, high levels of pesticides in its products, building plants in Nazi Germany which employed slave labour, environmental destruction, monopolistic business practices, and hiring paramilitary units to murder trade union leaders. In October 2009, in an effort to improve their image, Coca-Cola partnered with the American Academy of Family Physicians, providing a $500,000 grant to help promote healthy-lifestyle education; the partnership spawned sharp criticism of both Coca-Cola and the AAFP by physicians and nutritionists; its spends millions on advertising.

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CORPORATE CULTURE Corporate Culture is the values, attitudes, beliefs, meanings and norms that are shared by people and groups within an organisation BUSINESS STUDIES 4TH EDITION, DAVE HALL

STRONG AND WEAK CULTURES •

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Strong cultures are said to exist if the staff agree and believe in that particular culture o This usually leads to the firm performing most efficiently o People do this because they believe that it is the right thing to do Weak cultures are said to exist if the staff do not agree or have little affinity to the culture. o To make this culture practiced, it has to be enforced by bureaucracy.

CLASSIFICATION OF COMPANY CULTURES

Figure 6 - Click to view Google's corporate culture ↑

• Central source of power that makes all decisions (usually present in new business start-ups and sole-traders) • People compete to gain more influence making it a very political atmosphere

• Decisions based on rules and procedures • Power lays in the system and hierarchy • Marketing supervisors etc.

• Power is given to those who can accomplish tasks thus with those who have expertise • Present in firms that have team work central to its activity for example the R&D department of a firm

• The business is centred around a few individuals with expertise such as doctors or lawyers • The purpose of the business is to support the individual • Often, the individual is not directly related to the business personnel

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FORMATION OF CORPORATE CULTURES • • •

Corporate cultures are formed from the aims and behaviour of company executives Treatment of staff as well as the risk associated with making business decisions also aid to form the culture Recruitment and training procedures determine what type of people the business wants and what skills they are trying to promote

ADVANTAGES OF HAVING A STRONG CORPORATE CULTURE • • • •

Provides a sense of identity to workers and makes them feel like a part of the business. The business can rely on them at times of need. Facilitates team-work Employees become more committed and this leads to increased productivity Helps to reinforce values of business and senior management.

DIFFICULTIES IN CHANGING AN ESTABLISHED CULTURE Corporate culture has been argued to provide businesses will a competitive advantage. Japan in the early 70s and 80s promoted lean product and the idea of making quality the most important aspect of the product. This lead to Japanese cars dominating the market, however this change had many barriers to it in the western automotive industry. • •

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Change in culture forms a cultural gap, as there will be managers and workers that had an affinity to the previous culture and thus they will resist change. Change often means that there is a change in beliefs and values, which may conflict with the beliefs and values of the worker that were coherent with the previous beliefs and values. Often this has to be made in order to make the business more competitive. Change may threaten job and/or pay. Successful implementation of a culture change often means that change is slow and gradual so that workers become used to it. However when quick change in culture is needed, businesses may often resort to sacking workers and managers and hiring new ones.

CORPORATE STRATEGY Corporate strategies are the policies developed to meet a company’s objectives. It is concerned with what range of activities the business needs to undertake in order to achieve its goals. It also is concerned with whether the business organisation makes it capable of achieving the objectives set. BUSINESS STUDIES 4TH EDITION, DAVE HALL Essentially, objectives are what the business is trying to achieve and strategies are the plans via which the objective will be achieved.

DEVELOPMENT OF CORPORATE STRATEGIES • •

Corporate strategies are made to achieve corporate objectives and hence take into account the implication on business resources. Corporate strategies are formed from a series of strategies at each level of business; however the key decisions will always be made at the top.

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AIM OF PORTFOLIO ANALYSIS •

The aim is to allow the firm to consider its existing position of a product and plan what to do next, so that firms can make better corporate strategies. The main way that this is done is through the Boston Matrix.

These strategies may follow after analysis: POLICY

DESCRIPTION

PRODUCTS APPLIED TO

Building

This involves investing in promotion and distribution to boost sales

Problem Children (Often referred to as Question Marks)

Holding

This means marketing and spending on the product to maintain sales

Rising Stars

Milking

Maximising profits with as little new investment as possible

Cash Cows

Divesting

Selling off the product i.e. liquidising it

Dogs Problem Children

Figure 7 - The Boston Matrix was made by the Boston Consulting Group.

COMPETITIVE ADVANTAGE THROUGH DISTINCTIVE CAPABILITIES Competitive Advantage is an advantage which a business has that enables it to perform better than its rivals BUSINESS STUDIES 4TH EDITION, DAVE HALL Competitive advantages is an area of strength that matters to the consumer but cannot easily be copied by competitors BUSINESS STUDIES FOR A LEVEL, THIRD EDITION BY IAN MARCOUSÉ • •

Distinctive capability shown by a firm is the basis of competitive advantage; essentially making the business’ product seem superior to the consumer. Different businesses have different capabilities such as: o M&S has customer’s trust in its food. o Walls Ice cream is delivered to the retailer within 24 hours anywhere in England, so it has a powerful distribution system. o Toyota’s quality in combination with its cost and fuel efficiency makes it the first choice for first-time car buyers. It also has great expertise in the ‘green car’. o Companies such as apple differentiate their products on the basis of design and ease of use. o Businesses such as Gucci, Dolce & Gabana and Giorgio Armani, BMW, Mercedes Benz etc. rely on their brand image.

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PORTER’S STRATEGIC MATRIX • • •

Porter argued that 5 forces determined the profitability in an industry. The aim of competitive strategy was to turn these factors in favour of the business. Where the factors were not in favour of the business, the business would make little profit and even the amount made would fluctuate.

SUPPLIERS • • •

Will want to maximise profits The more powerful the supplier the less profits the business will make Ways to combat o Backward vertical integration o Seek new suppliers that offer better deals o Find cheaper substitutes for the materials required to make the product o Minimise information provided to suppliers so that suppliers cannot understand their influence over the business

BUYERS • •

The greater the bargaining power of customers, the lower the price will be; often results when there are few buyers Ways to combat o Forward Vertical Integration o Encourage similar businesses in the industry to make the same move o Make it difficult to choose another business:  Game manufacturers make cartridges so that they are incompatible with other devices and so that its devices are incompatible with others; you have no choice but to buy from them.  Printer makers have different types of cartridges that do not work with other printers. Lexmark cartridges will not work with HP printers and vice versa. Even if you refill the ink from a third party.

NEW ENTRANTS • • •

If entry and exit from a market is very easy, businesses specialising in the market can find it difficult to sell their products, when the market enters a recession or downfall (sales will be low). High rates of return could attract more businesses into the market, which lead to a reduction in price of the products due to increase in competition; profits will fall. Ways to combat (By erecting Barriers to Trade) o Patents and Copyrights o Develop strong brand image that encourage customer loyalty o Large amounts of advertising (so that new firms get the impression that market is expensive due to high marketing costs) o Give the impression that there are large sunk costs (A cost that has been incurred and cannot be reversed)

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SUBSTITUES • • •

The more the substitutes, the fiercer the competition. Little Competition means that businesses can charge high prices (niche markets). Ways to Combat o Invest into R&D and patent new and innovative products o Buy patents in order to prevent other companies from introducing a new product into the market

RIVALS • •

High competition will lead to low prices Ways to Combat o Price fixing (this is illegal) o Horizontal Integration (buying off rivals) o Innovation through R&D and the creation of a strong brand image though advertising.

THE EFFECTS OF STRATEGIC AND TACTICAL DECISIONS A strategic decision is one that is made in a situation of uncertainty and has medium to long term significance for the business BUSINESS STUDIES FOR A LEVEL, THIRD EDITION BY IAN MARCOUSÉ Tactical decisions are decisions that affect the business on a day-to-day scale, whereas strategic decisions affect the direction in which the business is headed. Often this is in response to an event. Mistakes in tactical decisions are unlikely to have a major impact on the business THE PERSON WHO WROTE WHAT YOU ARE NOW READING

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STRATEGIC DECISIONS Should we expand our business into China? Should we focus on strengthening our delivery services in order to gain a competitive advantage? Should we reduce our expenditure on employee benefits?

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TACTICAL DECISIONS Should we replace our old computing systems with new ones? Questionnaires have indicated that employees feel that there is too much pressure on them to work, should we have more recreational facilities in the lounge? Should we consider changing our opening times so that they are earlier in the morning?

In simple terms, strategic decisions have far higher implications on physical, financial as well as human resources because they affect the direction in which the business is headed. However, tactical decisions in general can affect all three types of resources but on a far smaller scale. Strategic decisions can be planned for, so it is expected that the human, physical, financial resources would be in place. With tactical decisions this may not be the case, thus limiting the business' ability to react tactically.

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COMPETITION VS CO-OPERATION

This part of the specification is not important to the examination The implications are simple in that they force businesses to become more competitive and this leads to the adoption of different corporate strategies: •

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Price Cutting o Reducing the price of the product to make the product more competitive by making it more affordable to the consumer Increase in product differentiation o DESIGN  Outstanding design such as apple iPads and iPhones differentiate its products from the competition. o BRAND IMAGE  Car companies such as Mercedes Benz and BMW rely on their image of unmatched quality and design to differentiate its products o UNIQUE PRODUCT FEATURES  Introducing truly innovative products in response to modern technology or popular demand o SUPERIOR QUALITY Find New Markets o Can be in response to market saturation e.g. when Vodafone began expanding in developing nations. Takeover o Large businesses will want to prevent new business with innovative ideas to take over their market share. Predatory Pricing o When a firm cuts its costs deliberately in order to put its rival out of business

More competition means that often there has to be changes in corporate strategies. Changing corporate strategies can be difficult as the business has made these strategies based on corporate objectives and aims. New strategies that will have to adapt to the current situation have to meet those aims, or the current situation may not allow those aims to be met. Often under new legal, political or economic circumstances may force the business to change its corporate strategy. External influences such as the recession in 2008 might force the business to become far more competitive through the abovementioned strategies because now businesses are fighting to gain market share in markets that have shrunk and as a result their revenue has shrunk. However, businesses might choose to co-operate instead becoming a stronger force due to the combination of two or more companies that will be able to dominate the market. Mergers can take place to keep the companies from failing. British Airways and Iberia merged in order to prevent further damage to their markets due to the recession; AIR FRANCE KLM and Lufthansa were already aiming to target the market share of the weakened BA after months of strikes from their workers. However sometimes especially when it comes to R&D, businesses might work together in order to gain access to new technologies that are very expensive to develop. In a few rare instances, businesses will break the law by through collusion e.g. price fixing etc.

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MAKING STRATEGIC DECISIONS OVERVIEW

1. DECISION MAKING MODEL a.

Use of Ansoff Matrix to communicate intended strategic direction. i. How the Ansoff Matrix can be used to show strategic direction of the business; e.g. if they're expanding into new markets, this would be seen as Market development, which is more risky than Market Penetration.

2. DECISION MAKING TECHNIQUES a.

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Investment Appraisal i. Simple Payback ii. Average Rate of return iii. Discounted Cash-Flow (Net Present Value only) Decision Trees i. Construction and interpretation of simple decision tree diagrams, limitations of technique. Project planning and Network Analysis i. Nature and purpose of Critical Path Analysis ii. Be able to draw simple networks iii. Calculate Earliest Start Time and Latest Finish Time iv. Identify the critical path and calculate the total float v. Limitations of technique Contribution and special order decisions, determining whether a special order is worth the effort.

3. CONTRIBUTION WITH RESPECT TO SPECIAL ORDER DECISIONS a. b.

c.

Need for contingency planning Consideration of risk of operating in a country or seeking growth in new overseas markets i. Use the Ansoff Matrix to consider why a company may seek to invest in a factory overseas, for example to reduce dependence on domestic market through planning for growth. Risk reduction through information from decision-making models

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DECISION MAKING MODEL THE ANSOFF MATRIX NEW

EXISTING

Product Development

Market Development

Diversification

NEW

INCREASING RISK

Market Penetration MARKETS

EXISTING

PRODUCTS

INCREASING RISK

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The Ansoff Matrix is essentially a tool developed to help people chose what strategy they should use in order to successfully develop their product. Essentially, these are marketing strategies for growth through the development of new products and markets.

THE DIFFERENT MARKETING STRATEGIES FOR GROWTH MARKET PENETRATION • • •

Concentrating on gaining greater growth in existing markets This has the least risk involved as the businesses has developed the product and knows the market Can be achieved through: o Increasing brand-loyalty of consumers so that they use alternatives less o Encourage consumers to increase usage; instead of selling a pack of chips in a medium sized pack, chips makers make large sizes available e.g. Lay’s Extra Large Figure 1 - Lay's XL Classic potato chips↑

MARKET DEVELOPMENT • •

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Finding new markets for existing products This is expensive as there needs to be investment into market research. However, there are considerable risks in understanding consumer behaviour as it is constantly changing. Can be achieved through: o Repositioning the product to target a different market segment o Moving into new markets, e.g. India, China etc.

Figure 2 - With saturated markets in the west Vodafone developed markets in Africa and South Asia. Nokia simply added torchlight to its previous model to help its phone-users in South Asia cope with power outages.

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PRODUCT DEVELOPMENT • •

•

Launching new products into existing markets One in five products succeed, even with heavy investment into R&D as well as aggressive marketing o Even the best companies such as Sony (Sony Egg), L’Oreal, Walls, Cadbury (Cadbury Aztecs) and Microsoft (Zune, Windows Vista) Can be achieved through: o Changing existing products  Shampoos offering new and improved formulas  Cars adding features to older models and releasing them as new yearly models every year o Developing new products from scratch

Figure 4 - The successful development of the iPod propelled Apple into the music industry.

DIVERSIFICATION • • • •

When a business tries to market new products in absolutely new markets; making it a conglomerate This has the greatest risks involved in doing this, but successful diversification has great rewards. It gives the business greater stability as a recession in one market can be buffered by another. It gives businesses more room to make riskier decisions – which will ultimately reap greater rewards.

Figure 5 - Nintendo was originally a card game making company and Nokia made tires. Successful diversification led Nokia to become the world's largest mobile manufacturers and Nintendo to become a successful console manufacturer.

Figure 3 - Shampoo Companies always claim that their 'new and improved' formulas are really new and improved. But personally, no commercial shampoo has worked for me, only medicated shampoo.

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DECISION MAKING TECHNIQUES INVESTMENT APPRAISAL Investment appraisal is the evaluation of an investment project to determine whether or not it is likely to be worthwhile. BUSINESS STUDIES 4TH EDITION, DAVE HALL •

Investment appraisal has a set of tools that we use in order to assess the return of an investment made by the company.

SIMPLE PAYBACK •

•

The payback period is essentially the time taken for a firm to cover its costs. Basically, if you invested $30,000 into a business, how long would it take the business to generator $30,000? Say, you have to invest $30,000 into capital and this capital is estimated to generate $10,500 a year and would take $3,500 to maintain. Calculate the pay-back period. Calculating payback: As you can see, Year Cash In Cash Out Net Cash Flow Cumulative Cash Flow that there is no NOW $ - $ (30,000) $ (30,000) $ (30,000) clear year that YEAR 1 $ 10,500 $ (3,500) $ 7,000 $ (23,000) the payment is YEAR 2 $ 10,500 $ (3,500) $ 7,000 $ (16,000) made up. So, we $ 10,500 $ (3,500) $ 7,000 $ (9,000) are going to YEAR 3 $ 10,500 $ (3,500) $ 7,000 $ (2,000) have to calculate YEAR 4 YEAR 5 $ 10,500 $ (3,500) $ 7,000 $ 5,000 it in months. th We can see that up till the 4 year, there was still a cumulative cash-flow of $2,000.

•

In the 5th year, $10,500 was generated. So we need to calculate how much was generated per month,

•

Therefore, we now need to calculate the number of months that it would take $2,000 to be generated,

• • •

• •

$10,500 12

= $875

$2,000 2 = 2 𝑚𝑜𝑛𝑡ℎ𝑠 $875 7

Therefore, the pay-back period is 4 years and 3 months. Often directors will set a pay-back period for the managers to suggest a suitable investment, such as being less than 20 months. This is referred to the criterion level.

Advantages Easy to calculate and understand Essentially, there is more effort being put into calculating finances over a comparatively shorter period of time. So, it is likely to be more accurate. Takes into account timing of cash-flows. So the discounted cashflow can be calculated to gain its NPV. Businesses with weak cash-flows will be able to seek out quick payback investments. This is useful for sectors with rapidly changing technology e.g. the electronics industry. New consumer electronics can be designed and introduced regularly. It is important to cover the cost of the investment before the new good is designed.

Limitations Ignores what happens after payback period. The method ignores the profitability of the project, since the criterion used is the speed of repayment. May encourage short-termism.

It is of limited use on its own (because it does not pay attention to profits) and is therefore used together with the Average Rate of Return as well as the Net Present Value

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AVERAGE RATE OF RETURNS • •

This is the profit an investment will give over the period of its lifetime. How to calculate:

S TEP 1 – I DENTIFY P ROFITS AND INITIAL INVESTMENT • •

Say, an investment will give $20,000 in profit over its lifetime. The firm invested a total of $25,000 to make this project happen.

S TEP 2 – D IVIDE THE PROFIT BY THE PERIOD OF ITS LIFETIME (I N YEARS ) •

Say, the period is 5 years. 𝐿𝑖𝑓𝑒𝑡𝑖𝑚𝑒 𝑝𝑟𝑜𝑓𝑖𝑡 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 =

$20,000 5

= $4000

S TEP 3 – C ALCULATE ANNUAL PROFIT AS A % OF THE INITIAL INVESTMENT 𝐴𝑅𝑅 =

• • • • • •

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑒𝑡𝑢𝑟𝑛 × 100 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 $4,000 × 100 = 16% $25,000

Usually, the exam will give you table from which you are going to have to interpret this from. However, there is another term that we must familiarise ourselves with, and that is ‘Reward for Risk’ Basically, the business is taking a risk in order to make a profit. However, it can simply put the money in the bank and get the interest out of it. Say the interest is 6%. So, the business can make 6% profit without even having to take any risks. The Reward for risk is the 𝐴𝑅𝑅 − 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡. So, in this case, the Reward for risk would be10%.

A DVANTAGES AND LIMITATIONS

Advantages

Limitations

Shows the profitability clearly and allows comparisons with other Not as accurate as payback as it makes assumptions over a large modes of investment such as interest etc. number of years Uses all the cash flows over the project’s life - Payback only considers cash flow up until the payback month - it might be that the project generates larger cash flows after this period, but the method ignores these. ARR looks at all the cash flow projections Ignores the timing of cash flows and included these, so it is fairer to projects that might generate large incomes in later years e.g. those that might require a lot of training and getting used to new equipment. Focuses on profitability

Ignores the opportunity cost of the money invested

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DISCOUNTED CASH FLOWS – NET PRESENT VALUE • • • •

$100 today will be worth a lot less in 3 years’ time. This is because of inflation that reduces the value of money and makes goods more expensive as well as the interest that banks provide that increase the value of money. The ARR and payback methods provide insight into profitability and cash flow. But, what we need to now is the opportunity cost of making an investment. What are we throwing away in order to make an investment? The higher the rate of interest and the longer the waiting time for the money to come in, the less money it is actually worth in today’s term. The predicted value of money in today’s terms is calculated from discount tables that will be given to you in the examination. Here is an example:

Years Ahead 0 1 2 3 4 •

4% 1.00 0.96 0.92 0.89 0.82

Rate of interest 6% 1.00 0.94 0.89 0.84 0.8

8% 1.00 0.93 0.86 0.79 0.75

So the value of $200 in 4 years’ time at 6% interest would be $200 × 0.6 = $160

CALCULATING NPV • •

•

Say a company has two projects, Projects X and Y. Say the rate of interest is 8%. Their cash-flows and Discounted cash flows are given below:

Year

Cash Flow

0 1 2 3

($250,000) +$50,000 +$100,000 +$200,000

Project X Discount factor 1.00 0.93 0.86 0.79

Discounted Cash Flow ($250,000) $46,500 $86,000 $158,000 𝑁𝑉𝑃 = $40,500

Cash Flow ($250,000) +$200,000 +$100,000 +$50,000

Project Y Discount Factor 1.00 0.93 0.86 0.79

Discounted Cash Flow ($250,000) $186,000 $86,000 $39,500 𝑁𝑉𝑃 = $61,500

Despite the fact that both projects have the same initial cost, and they bring in the same quantity of money over their lives, there is a large difference in the NVP, as project Y generates more income at the beginning, whereas project X generates more income towards the end. As the discount factor increases over time, the actual value of the money generated by X is reduced. Also, the predictions are less accurate the further we predict thus there is great uncertainty as to whether project X can generate the NVP even if the value of money decreases as expected.

A DVANTAGES AND L IMITATIONS Advantages Takes the opportunity cost of the investment into account

Limitations Complex to calculate and communicate

A single measure that takes the amount and timing of cash flows The meaning of the results is often misunderstood into account Only comparable between projects where the initial investments are the same Can consider different scenarios The rate of discount used is critical, if the rate is not accurate, the business could make big mistakes

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DECISION TREES • •

•

Decision trees offer a visual representation of the company’s possible choices that it can make. There are four parts to a decision tree: o Decision points are the decisions the business has to make; represented by boxes. o Outcomes are the possible outcomes of taking a decision; represented by circles.  Obtained often from back-data. o Expected Values are the financial outcomes of a decision i.e. how much profit or loss a decision will make. However, there is a term called the Expected Value – no s at the end. Expected Value Decision Point

Outcome •

•

Calculating the expected value of B: o 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑉𝑎𝑙𝑢𝑒 = (𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝐺𝑜𝑜𝑑 𝐶𝑟𝑜𝑝 × 𝑃𝑟𝑜𝑓𝑖𝑡) + (𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑟𝑜𝑝 × 𝑃𝑟𝑜𝑓𝑖𝑡) + (𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑃𝑜𝑜𝑟 𝐶𝑟𝑜𝑝 × 𝑃𝑟𝑜𝑓𝑖𝑡) o 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑉𝑎𝑙𝑢𝑒 = (0.3 × £50,000) + (0.3 × £30,000) + (0.4 × £10,000) o 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑉𝑎𝑙𝑢𝑒 = £84,000 Calculating the expected value of C: o 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑉𝑎𝑙𝑢𝑒 = (𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝐺𝑜𝑜𝑑 𝐶𝑟𝑜𝑝 × 𝑃𝑟𝑜𝑓𝑖𝑡) + (𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑃𝑜𝑜𝑟 𝐶𝑟𝑜𝑝 × 𝑃𝑟𝑜𝑓𝑖𝑡) o 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑉𝑎𝑙𝑢𝑒 = (0.5 × £40,000) + (0.5 × £10,000) o 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑉𝑎𝑙𝑢𝑒 = £25,000

A DVANTAGES AND LIMITATIONS

Advantages

Limitations

Construction of diagrams may highlight decisions that we not Much of the data including probability is estimated. previously considered Decisions often have several aspects. Decision tress only focus on Putting numeric values on these choices tends to improve the quantitative aspect. Qualitative data is also important, e.g. the results. effect on the environment of one particular decision. There are time lags in decision making, by the time a decision is finally made, some of the numeric information may be out of date. The process is quite time consuming. However, computers have Force management to take into account the risks involved in now made this a lot faster. making these decisions. This helps to separate the important Managers may manipulate the probability of a decision to suit risks from the unimportant risks. their preferences, distorting the final results. Decision trees cannot take into account the dynamic nature of a business. Sudden changes in the economic climate might render a decision based on the decision tree obsolete.

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PROJECT PLANNING AND NETWORK ANALYSIS • • •

In a production line, there needs to be proper organisation in order for the production to go on smoothly. In order to do this the needs to be a plan for the process to operate smoothly. This is done through a model called ‘Network Analysis’. A network path diagram helps to identify the critical path, which shows the activities that require the most careful management scrutiny. BUSINESS STUDIES FOR A LEVEL, 4TH EDITION – IAN MARCOUSÉ

• • •

There are different parts to a network diagram. The lines represent an activity: which is essentially that is a part of the process that requires time and/or resources; waiting for supplies is an example of an activity. A node (represented by circles) is the start of or end of an activity. This is what a Network diagram looks like: Start Node

Step Number

The Critical Path

Lines represent activity

Earliest Start Time

Latest Finish Time

End Node

INSTRUCTIONS FOR DRAWING NODES 1. 2. 3.

4. 5.

The network must start and end with a single node No lines in the network can cross When drawing an activity, do not draw the end node, as you cannot calculate where the whole process is going to end, this is not exactly a rule but rather a precaution. There cannot be any line that is not an activity. It is helpful to draw nodes with large circles and short lines, to save space and also because you

Advantages

•

•

need to put figures in those circles. 6. The start nodes all have an EST and an LFT of 0. The Critical path will have the following characteristics: o The EST and the LFT will be equal o It will be the longest past through those nodes 𝐹𝑙𝑜𝑎𝑡 𝑇𝑖𝑚𝑒 = 𝐿𝐹𝑇 − 𝐸𝑆𝑇

Limitations

Processes should be smoother as there is careful planning involved It shortens the length of time taken to complete a project, as tasks A complex process which will have many lines and will be long; are handles simultaneously – this can be very advantageous as getting computer rendering will be needed. Software may need to be made or a product first to the market can often be a positive factor, especially bought which will be expensive. with technology. Delays can be handled adeptly as time is accurately planned.

Drawing a diagram does not ensure success; it will be the effort of There is better time management, facilitating JIT management. Also, the managers that ultimately brings the results. due to better management, there is reduced pressure on Cash Flow.

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CONTRIBUTION AND SPECIAL ORDER DECISIONS • • • • •

• •

A business might get an unexpected order from a new customer. In these cases the business has to consider whether the deal will be profitable and often this is done through contribution costing. A business will have both fixed and variable costs. Based, on the contribution that each finished good provides, the business will need to make this decision. Say, there is a special order for 2000 extra laptops and the company needs to decide whether or not to accept. The customer is willing to pay $670 for each laptop. The fixed costs are at $500,000 per year and the variable cost is $350 for a laptop So, the total cost for the laptop, for the manufacturer will be $350 +

$500,000 2000

= $600.

•

Thus, the business can take the order and still make a profit. However, this is on the assumption that fixed costs remain the same. If they were to increase, which they likely will, then the profit made from making laptops would be very small.

•

If the fixed costs were to increase to $600,000, then the price of the laptop would become $350 +

$600,000 2000

= $650, the

business would be making very little profit. However, this might be a new customer that may become a regular customer for the business, like this there are many non-financial motives to take or decline an order: o Capacity: Whether the business has the machinery and the labour to take the order. Will taking this order sacrifice something more profitable? o Customer response: If existing customers find out that products were sold at a cheaper price to others, then it will damage the image of the business and may lead to a loss of customers. o Future Orders: Unprofitable orders might lead to more profitable orders in the future from the customer. o Current Utilisation: An unprofitable order may be accepted in order to keep staff occupied. It’s better to have permanent staff occupied with work that will give little contribution, than not working at all, because when permanent labourers have no work to do, the business is still paying for their wages. o Retaining customer loyalty: A business may accept an un-profitable order as a favour to a loyal customer. Greater co-operation from the business to the customer will increase brand loyalty.

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BUSINESS CONTINGENCY PLANNING NEED FOR CONTINGENCY PLANNING Contingency planning is the creation of plans of how particular crises which might affect a business will be dealt with should the arise BUSINESS STUDIES 4TH EDITION, DAVE HALL •

• •

Things do not always go according to plan, an employee might be sick – such as in a school, a class teacher may be sick and may not come to class. If this happens, then there needs to be a replacement teacher capable of taking the class. Contingency planning is essentially a back-up plan the business has. Similarly, in times of a crisis such as a fire or flood, the business will need a back-up plan to make sure that it can survive the crisis. But there are many other types of crises that may occur, and these may be financial, related to machinery, human resources, public relations etc. To combat all these problems, the business will need a contingency plan in place.

A DVANTAGES AND LIMITATIONS Advantages

Limitations

It gives the business some kind of plan as to what it can do in times It can be argued that there are relatively few contingency plans that of a crisis. are effective as there are many unforeseen eventualities.

CONSIDERATION OF RISK OF OPERATING IN A COUNTRY OR SEEKING GROWTH IN NEW OVERSEAS MARKETS •

• •

•

Developing a new market with existing products will fall into the market development category. Essentially, if the business fails to do well in the market, it will need a contingency plan to get itself out of the operations e.g. sell the operations, or go into a joint venture with a local firm in order to increase chances of survival and to gain additional knowledge about the market as well as getting information from the company. The extent of the risks will depend on how different the foreign market is in comparison to the domestic market. The product may need to be modified, as when Whirlpool set out to make the world washer, when it sold the washer to India, people stopped buying it because some special types of Indian clothes got stuck in the washer. Also, when PEPSI started out in China, when it translated its logo, the literal translation was something very insulting in Chinese culture. There needs to be thorough market research done, both primary and secondary in order to gain a comprehensive understanding of the market. Even after thorough market research businesses fail because of the ever changing nature of consumer taste.

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RISK REDUCTION THROUGH INFORMATION FROM DECISION MAKING MODELS •

•

•

Decision making models such as decision trees allow businesses to assess the risk of an operation, because it highlights the probability of both profits and losses. Investment appraisal shows how long a business will need to earn its investment back from the operation i.e. payback. Also, ARR will allow the business will allow the business to consider how much rewards it is getting for the risk it is taking. o When TESCO set up ‘Fresh & Easy’ stores in America, it calculated that the payback period would at least be 5 years. But it did so, in order to get a foothold into the lucrative American retailer market. Network analysis will make the business more efficient and will highlight critical paths, which have the most risks associated with them, so managers can proceed with more caution.

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ASSESSING COMPETITIVENESS OVERVIEW

1. INTERPRETATION OF FINANCIAL STATEMENT a. b. c. d. e. f. g. h. i.

Gross profit margin Net profit margin ROC (Return on Capital) ROCE (Return on Capital Employed) Acid test ratio Current ratio Gearing ratio Interpretations of these margins and ratios Limitations of ratios as a decision making tool

2. HUMAN RESOURCE COMPETITIVENESS a. b. c.

Labour productivity Labour turnover i. Unavoidable leavers Limitations of these calculations

INTERPRETATIONS OF FINANCIAL STATEMENTS Ratio analysis is an examination of accounting data by relating one figure to another. The approach allows more meaningful interpretation of the data and the identification of trends. BUSINESS STUDIES FOR A LEVEL 3RD EDITION BY IAN MARCOUSÉ Before we proceed onto actually calculating the ratios, it is very important to familiarise ourselves with a financial statement, as these statements are what we need to calculate these ratios. The gross profit margin, the net profit margin and the ROCE is calculated from the profit and loss account. The table to the left is an example of a profit and loss account. The expenses are essentially costs that are not involved in the production of goods and services such as advertising, wages of the administration staff as well as depreciation (the value of the company’s capital decreases with age). Cost of sales are the costs directly related to production including wages for labour as well as the overheads for rent, fuel etc.

Figure 1 - This has been taken from Dave Hall's book, Business Studies 4th Edition←

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GROSS PROFIT MARGIN First, we need to calculate the gross profit, and then we can calculate the margin. 𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 (𝑎𝑙𝑠𝑜 𝑘𝑛𝑜𝑤𝑛 𝑎𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟) − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠 𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 =

𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 × 100 𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 (𝑎𝑙𝑠𝑜 𝑘𝑛𝑜𝑤 𝑎𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟)

4 £400,000 × 100 = 44 % 9 £900,000 𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 ≈ 44%

𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 =

NET PROFIT MARGIN

First, we need to calculate the net profit, and then we calculate the margin. As a simple rule of thumb, the net profit is the profit before tax – essentially, after you have taken all the costs, other expenses not directly linked to the production of the product as well as interest payable, you get the net profit: the value that the business is taxed on. The net profit will be very clearly stated in the tables that the exam board will provide, because its exact location can vary depending on the financial transactions of each individual business. 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 =

𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 × 100 (𝑎𝑙𝑠𝑜 𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑘𝑛𝑜𝑤𝑛 𝑎𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟)

𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 =

2 £110,000 = 12 % 9 £900,000

𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 ≈ 12%

ROCE (THE RETURN ON CAPITAL EMPLOYED)

To calculate this value, we need to be familiar with the balance sheet. The balance sheet is essentially a financial statement that lists a firm’s assets and liabilities: in simple terms, it’s what a business owns and owes. We need to remind ourselves that long term loans are also counted as investment into the business and therefore do count as capital employed into the business. The business made an operating profit of £5,600,000. •

•

Fixed assets are assets that the business will have in the long term i.e. buildings, machinery etc. basically, assets that the business will have for more than a year. Current Assets are assets that will last for less than a year. These assets are the most liquid assets the business has; examples include things such as cash etc.

𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 (𝑁𝑒𝑡 𝐴𝑠𝑠𝑒𝑡𝑠) = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑒𝑠 𝑁𝑒𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 + (𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑒𝑠) 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑 = 𝑁𝑒𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 + 𝐿𝑜𝑛𝑔 𝑇𝑒𝑟𝑚 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 𝑅𝑂𝐶𝐸 =

𝑅𝑂𝐶𝐸 =

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 × 100 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑

£5,600,000 × 100 ≈ 22% (£17,400,000 + £8,000,000)

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ROC (RETURN ON CAPITAL) This essentially measures the profitability of a business. If a business invests into a project, it will want to know the profitability of the project. 𝑅𝑂𝐶 (𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐶𝑎𝑝𝑖𝑡𝑎𝑙) =

This value is expressed as a percentage.

𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 × 100 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑

THE CURRENT RATIO AND THE ACID TEST RATIO Both these ratio assess the liquidity of a business i.e. how easily a business’ assets can be turned into cash. Again, this is another ratio that is concerned with the balances sheets a business publishes.

CURRENT RATIO The current ratio of a business is essentially the ratio between its current asses and its current liabilities. 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 =

ACID TEST RATIO

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

The acid test ratio takes into account that stocks are the least liquid of all the current assets and should not be counted as an asset that can be easily liquefied. 𝐴𝑐𝑖𝑑 𝑇𝑒𝑠𝑡 𝑅𝑎𝑡𝑖𝑜 =

GEARING RATIO

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑆𝑡𝑜𝑐𝑘 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

This essentially is a ratio that gives an indication of how much debt the business is under, giving insight into the long term stability of the organisation. 𝐺𝑒𝑎𝑟𝑖𝑛𝑔 (𝑎𝑙𝑠𝑜 𝑘𝑛𝑜𝑤𝑛 𝑎𝑠 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒)𝑟𝑎𝑡𝑖𝑜 =

𝐿𝑜𝑛𝑔-𝑡𝑒𝑟𝑚 𝐿𝑜𝑎𝑛𝑠 × 100 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑

This value (like every other ratio that is multiplied by 100) is expressed as a percentage. In boom times, investors and banks find gearing a good thing, as the business is focusing on growth, however this entails great risk. However, if a recession suddenly hits, then the business will be in grave danger because now the business still has to pay back the interest with a reduced income from battered sales.

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INTERPRETATIONS OF THESE MARGINS ANS RATIOS

RATIO OR MARGIN

ANALYSIS

GROSS PROFIT MARGIN

The gross profit will differ from industry to industry and hence needs to be looked at with the context of the business in mind. Can be improved by: • Raising sales revenue without increasing total costs – i.e. make production cheaper e.g. can be done via automation.

NET PROFIT MARGIN

ROCE (RETURN ON CAPITAL EMPLOYED)

ROC (RETURN ON CAPITAL)

Similarly to the gross profit margin, this will vary from industry to industry and has to be looked at with the context of the business in mind. For example, the food industry has both a low gross and net profit margins, but since there is a very high volume sold, it is not a problem. Can be improved by: • Same as gross profit margin. This is a fundamental ratio that essentially shows how well the business is making use of its resources and essentially, how lucrative it is for investment. The ROCE of a business needs to be compared with previous years to identify a trend in its growth. Also, if the ROCE is less than 6 %, then there is little incentive to invest as if an investor were to invest this money into the bank instead, then the person would be much better off still making money with no risk. Can be improved by: • Increasing the efficiency of the business through generating greater profits from the same amount of capital invested. This measures the profitability of a project or operation and thus is a good indicator of how successful the project was to the business.

CURRENT RATIO

Shows the ratio between assets and liabilities. The business would do best to keep this at 1.5:1. However if this is too high, it means that the business has too much money that it is not investing. However, having too low a current ratio means that it may not be able pay back debts in times of crisis such as a downturn. Can be improved by: • Selling under-used fixed assets • Selling shares to gain more share capital • Postpone or reduce planned investments • Take long term-loans

ACID TEST RATIO

Arguably, the best ratio is 1:1. A result that is too low means that that the business may not be able to pay off its short term debts. However, companies such as supermarkets operate with very low liquidity ratios. In fact, some of the major companies such as BP, Imperial Tobacco and TESCO have very low acid test ratios. • Adopting JIT, this way you have not stock to worry about – and you can divert more capital into production • Selling under-used capital or selling old machinery • Selling shares to increase share capital • Take long term loans

GEARING RATIO

The more geared the business is, the more debt it has. By this, it means that investing in this business is risky as well as it will be hard for the business to gain finances from banks. However, whether a business that is geared will get investment will also depend on the state of the industry. Can be improved by: • Issue more shares to raise share capital • Buy back debentures (bonds) • Retain more profit • Repay loans

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VALUE AND LIMITATIONS OF THESE RATIOS AS A DECISION MAKING TOOL

VALUE

LIMITATIONS

Comparisons have to be made with businesses that are similar (same industry, similar operations) and also businesses in the same time frame in order to get a fair comparison. Ratios are very simple to calculate, most of them have a consistent Sometimes, businesses in the same industry are vastly different. formula. Sainsbury focuses on food and groceries alone, while TESCO is moving onto home appliances – these new products will have a different gross profit margin and will affect comparisons. Businesses might also have different accounting techniques, which Analysis can be carried out very quickly as they are very simple to will determine how their financial statements are made – financial calculate and demand only basic financial statements. statements determine ratios. Can be used to compare one company with another; they can be used to compare businesses in the same industry. Comparisons can also be made within the companies as it may have many ongoing projects.

The ratios are limited to the quality of the balance sheets – the balance sheet represents a ‘snapshot’ of the business at the end of a financial year and is not representative of the business’ circumstance over the entire year.

Qualitative information is ignored, making it quite ineffective in Can be used by decision makers to identify the strengths and the service industry. weaknesses of a business. For example, if gross profit margin is very high, but the Net profit margin is very low, then the business The ratios are only as good as the financial accounts. Inflation can may try to reduce operational costs as well as reduce its debts. make a business’ assets look more valuable – when there might not actually be a change in real value. WINDOW DRESSING Window dressing is the legal manipulation of company accounts by a business to present a financial picture which is to its benefit. BUSINESS STUDIES 4TH EDITION, DAVE HALL • •

• •

Business managers may want to paint a good financial image of the business in order to attract investors. Businesses might manipulate the financial picture to look bleak for the short term to make it look better in the long term – business tend to choose to get over with a financial crisis quickly than having poor financial performance for a long time; if the business shows strength in coming out of a financial crisis then they will become a favourite with investors. Making financial statements look worse can be used to reduce the tax on a business. Businesses trying to sell itself or one of its operations will do their best to manipulate accounts in order to get the best possible value for the business.

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HUMAN RESOURCE COMETITIVENESS Both labour productivity and turnover show the effectiveness of the work force and can be a very useful yard-stick for measuring the efficiency of the business in question.

LABOUR PRODUCTIVITY 𝐿𝑎𝑏𝑜𝑢𝑟 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑣𝑖𝑡𝑦 =

𝑇𝑜𝑡𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡 (𝑝𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑 𝑜𝑓 𝑡𝑖𝑚𝑒) 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑒𝑠 (𝑝𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑 𝑜𝑓 𝑡𝑖𝑚𝑒)

This essentially measures the how many products (on average) a worker produces over a specific period of time. There can be many ways to improve this: • • • •

Making production more capital intensive will reduce the need to labour as well as produce at a cheaper rate as machines can work continuously unlike workers. Often, changing the type of production can improve the efficiency of a business; using cell production instead of assembly line production is an example as it meets worker’s social needs. Training can make workers more able, allowing them to perform their work more efficiently. Overall, increasing the motivation of workers by giving them more power or authority is also a great way to increase productivity, as they can highlight the main problems with the production process and can therefore come up with a better solution.

High labour productivity will drive the costs of the business down and hence the business can sell cheaper products to gain greater sales or keep prices the same and get more profit – depending on the elasticity of the product. However, even after adoption these measures, often businesses are unable to compete: • • •

Often competing businesses may offshore production to places such as China, where the labour cost is very cheap. Rivals may be able to increase productivity at an even faster rate, than the business, through a combination of technology and cheap labour. Rival might also enhance the quality of the product while at the same time increasing the productivity of the business.

LABOUR TURNOVER 𝐿𝑎𝑏𝑜𝑢𝑟 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =

𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑆𝑡𝑎𝑓𝑓 𝐿𝑒𝑎𝑣𝑖𝑛𝑔 (𝑜𝑣𝑒𝑟 𝑎 𝑝𝑒𝑟𝑖𝑜𝑑 𝑜𝑓 𝑡𝑖𝑚𝑒) × 100 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠𝑡𝑎𝑓𝑓 𝑖𝑛 𝑝𝑜𝑠𝑡 𝑖𝑛 𝑝𝑜𝑠𝑡 (𝑜𝑣𝑒𝑟 𝑎 𝑝𝑒𝑟𝑖𝑜𝑑 𝑜𝑓 𝑡𝑖𝑚𝑒)

Labour turnover can be caused by a variety of reasons. Some being: • • • • • •

The company paying staff low wages Relatively few training programmes Poor methods in recruitment and selection process Poor working conditions – unsafe, bullying etc. Lack of transport may also be a reason Some turnover is unavoidable as some businesses may have passed the working age.

Problems with recruiting new staff: •

It takes time and has high administration costs o Induction programmed given by large companies increase the cost of recruitment

Why turnover may be a good thing: • • • •

New staff bring in new ideas Some workers may be ineffective If a business is shrinking, reducing business size can be good in cutting costs. If a business pays low wages, it might prefer hiring new workers than increasing the wage.

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USES AND LIMITATIONS •

These ratios give an indication of a problem in the business, but does not give any specific detail about the problems that the business and often business have to carry out additional research to get to the root of the problem.

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COMPANY GROWTH OVERVIEW

1. TYPES OF GROWTH a. b.

Organic External i. Mergers and Takeovers

2. BUSINESS INTEGRATION

3. EFFECTS OF GROWTH ON A BUSINESS AND THE ANSOFF MATRIX TYPES OF GROWTH Growth is of two types: organic and inorganic growth. Organic growth is when the business expands by setting up new outlets, factories or offices (service). Inorganic methods of growth involve combining with or taking over other businesses which happens in the form of takeovers or mergers. QUAZI NAFIUL ISLAM

ORGANIC GROWTH • • •

Slow growth through internal expansion and the increase of sales. Safer than inorganic growth as culture clashes are avoided. However, reliance on organic growth alone could lead businesses to miss out on lucrative deals that have the potential of making the business a lot of money, as well as gaining a lot of influence.

INORGANIC GROWTH •

Takeovers happen when businesses buy 51% of the shares in another business. Mergers happen when two businesses combine in order to form a bigger business with both businesses having mutual control over the business. o They both are in charge and there is a new board of directors formed when this happens. Arcelor and Mittal merged to become the world’s largest producer of steel, the board of directors consisted of both Arcelor and Mittal o

directors – this happened in 2006. Cadbury inorganically grew by taking over Green and Black’s organic chocolate – it sounds kind of ironic when someone inorganically takes over something organic!

Figure 1 - Cadbury was taken over by Kraft after the recession. Cadbury was financially very weak and unable to continue trading and needed financial assistance. Read more→

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WHY MERGE OR TAKEOVER? • •

• •

Can be a way for businesses to grow fast. The benefits of combining can be very significant – the power of synergy: o They both will benefit from greater economies of scale as a combination will lead to a reduction of administration costs (no need for two head-quarters – they can have one, less administration costs needed and this restructuring will lead to a fall in average costs) o They can both become more sophisticated businesses as they both gain access to each other’s R&D. Becoming a conglomerate can give business greater stability in times of recession. Both businesses benefit as they gain greater market power, which might enable them to increase their prices as consumers have fewer alternatives.

BUSINESS INTEGRATION

Backward Vertical Integration – When a business buys a supplier

Horizontal Integration – When a business buys another business in the same industry

Forward Vertical Integration – When a business buys a retailer

Diversification – When a business buys another business that it is totally unrelated to in the market.

Picture the diagram in your mind and think of the business as one straight line starting from the beginning till the end. In the production process, the supplier sends the product to the business and then when the business done with the product, it sends the product to the retailer. If the business reaches back, it will take over the supplier, and if it reaches forward, it will reach the retailer. Similarly, if the business reaches sideways, it will find another business that produces the same things it does. If it reaches towards wherever else it can, it will find something totally unrelated to its core business – a simply way of remembering the entire diagram.

EFFECTS OF GROWTH AND THE ANSOFF MATRIX Although there are benefits to inorganic growth, there are several problems associated with it as well. Businesses often grow too big for their own good; not being able to handle such a large business often leads businesses to demergers and retrenchments. A majority of takeovers are unsuccessful. This is mainly because businesses take into account the advantages, but forgets the problems associated with it as well. • • • •

Diseconomies of scale such as communication, co-ordination and culture are often a big problem with takeovers – many employees will not want to change their way of doing business and can often lead to culture clashes. Large businesses mean that there are likely to be large administration costs, if the business is not restructured properly. Co-ordination is also very important, as people need to co-operate within the business if the business wants to successfully do business. The Ansoff matrix gives an indication of the risk involved in expanding a business through the different types of growth – this has already been covered in a previous chapter.