Black A. - How Business Works - 2015.pdf [1q7jxjzj1vqv] - EU-Vietnam Business Network (EVBN)

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A GRAPHIC GUIDE TO BUSINESS SUCCESS

Contents Senior editor

Georgina Palffy

Project art editor

Saffron Stocker

Editors

Designers

US senior editor US editor Managing editors

Anna Fischel, Alison Sturgeon, Suhel Ahmed, Hannah Bowen, Joanna Edwards, Alex Beeden Natalie Clay, Stephen Bere, Phil Gamble, Vanessa Hamilton, Jemma Westing

Stephanie Farrow, Gareth Jones

Business ownership

Sole proprietorships and partnerships Corporations Private and public companies Multinationals Franchises Not-for-proﬁt

14 16 18 20 22 24

Sophia MTT

Start-ups

Ben Marcus, Nikoleta Parasaki

Start-ups from concept to launch Types of start-up Business plans Raising money Business accelerators and incubators

28 30 32 34 38

Buying and selling business

Mergers and acquisitions Divestitures Vertical vs. horizontal integration Management buy-ins and buy-outs

42 44 46 48

Who’s who

Board of directors Company hierarchy Stakeholders Business cultures

52 56 60 64

Publisher

Liz Wheeler

Deputy art director

Karen Self

Publishing director

Jonathan Metcalf

Jacket assistant Jacket design manager Pre-production producers Producer

Christine Heilman Lee Grifﬁths

Senior jacket designer

HOW COMPANIES WORK

Margaret Parrish

Senior managing art editor

Art director

Introduction

Phil Ormerod Mark Cavanagh Claire Gell

Christine Ni

First American edition 2015 Published in the United States by DK Publishing, 345 Hudson Street New York, New York 10014 A Penguin Random House Company 15 16 17 18 19 10 9 8 7 6 5 4 3 2 1 001—196402—Mar/2015 Copyright © 2015 Dorling Kindersley Limited All rights reserved. Without limiting the rights under copyright reserved above, no part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form, or by any means (electronic, mechanical, photocopying, recording, or otherwise), without the prior written permission of both the copyright owner and the above publisher of this book. Published in Great Britain by Dorling Kindersley Limited A catalog record for this book is available from the Library of Congress. ISBN: 978-1-4654-2979-7 DK books are available at special discounts when purchased in bulk for sales promotions, premiums, fund-raising, or educational use. For details, contact: DK Publishing Special Markets, 345 Hudson Street, New York, New York 10014 or

A WORLD OF IDEAS: SEE ALL THERE IS TO KNOW www.dk.com

HOW FINANCE WORKS

Financial reporting

100

The accounting cycle Financial statements

102 104

Financial accounting

110 112 114 116 120 122 124 128

Corporate structure

Functional structure Divisional structure Matrix structure Network structure Team-based structure

68 70 72 74 76

International accounting standards Proﬁt-and-loss statement Balance sheet Cash-ﬂow statement Environmental accounting Depreciation Amortization and depletion

Human resources

Management accounting

130

The human resources cycle Recruitment and selection Evaluating staff Motivation and rewards Leadership strategy and styles Leadership for team building Employee relations and communications Project management Negotiating strategy

80 82 84 86 88 90

Cash ﬂow Budgets Assets and inventory Costs Product costing and pricing

132 136 138 140 142

Measuring performance

144

Key performance indicators (KPIs) Financial ratios Forecasting Tracking fraud

146 148 150 152

Raising ﬁnancing

154

Internal ﬁnancing External ﬁnancing Going public Shares and dividends The capital market Gearing ratio and ﬁnancial risk

156 158 160 164 170 174

92 94 96

HOW SALES AND MARKETING WORKS

176

Marketing mix

178

Inbound marketing

220

Product Product positioning Product life cycle Price Place Promotion Market research Market segmentation

180 182 184 186 188 190 192 194

Outbound vs. inbound marketing Blogging Social media marketing Search engine optimization (SEO)

222 224 228 230

Business development

232

Marketing approaches

196

234 236 238 240

Niche vs. mass marketing Traditional marketing Digital marketing Engagement marketing Sensory marketing Relationship marketing

198 200 202 204 206 208

Branding and rebranding Lead generation Lead conversion Customer retention Return on marketing investment (ROMI) Intellectual capital

242 244

Information management

246

Outbound marketing

210

Traditional ofﬂine advertising Online advertising Direct mail Telemarketing

212 214 216 218

Business intelligence Business analytics Marketing and IT Collecting consumer data Data warehousing Customer proﬁling Big data Customer relationship management (CRM) Compliance

248 250 252 254 256 258 262 264 266

HOW OPERATIONS AND PRODUCTION WORK

268

Resources Index Acknowledgments

336 344 351

Manufacturing and production 270 Job production Batch production Flow production Mass customization Continuous production Hybrid processes

272 274 276 278 280 282

Management

284

Economies and diseconomies of scale Lean production Just-in-time Total quality management Time-based management Agile production Kaizen

286 288 290 292 294 296 298

Product

300

New product development Innovation and invention Design Quality management Product-process matrix

302 304 306 308 310

Control

312

Managing capacity Inventory Quality control Six Sigma

314 316 318 320

Supply chain

322

Value chain Outsourcing Offshoring Reverse supply chain Benchmarking Corporate social responsibility

324 326 328 330 332 334

Contributors Dr. Julian Sims (consultant editor) entered academia after a successful career in industry in the US and UK. He is a lecturer in the Department of Management at Birkbeck, University of London, UK; a Chartered Accountant (CPA Aus); and a Chartered Information Technology Practitioner (CITP). His work is widely published in academic journals. Philippa Anderson is a business writer and communications consultant, who has advised multinationals including 3M, Anglo American, and Coca-Cola. She collaborated with Lord Browne, former CEO of BP, on his memoir, Beyond Business, and was a contributor to DK´s The Business Book. Alexandra Black studied business communications before writing for ﬁnancial newspaper group Nikkei Inc. in Japan. While in Tokyo, she was an editor at the Risk Analysis division of investment bank JP Morgan. Now based in Cambridge, UK, she covers subjects as varied as business, technology, and fashion. She was a contributor to DK’s The Business Book. Joe Stanley-Smith is a reporter at the International Tax Review in London, UK, where he specializes in indirect tax and tax disputes. He graduated in journalism with a business specialty from Kingston University, UK, and has previously worked in social media and local news. Paul McDougall (US/Canada writer) is Deputy Technology Editor for the International Business Times. He has written for Scientiﬁc American, InformationWeek, SHAPE magazine, and others. A native of Toronto, Canada, he currently resides in New York City.

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HOW BUSINESS WORKS Introduction

8 9

Introduction The term “business” refers to an organization or commercial enterprise engaged in producing and trading goods and services for money. We can trace the origins of business to the very foundations of human society. When Homo sapiens evolved, mankind left behind the nomadic hunter-gatherer lifestyle to become farmers. This allowed for specialization of work, where individuals would become skilled at speciﬁc tasks to serve a particular community need. Over time, this enabled more complex goods and services to be produced and traded, in order to provide for all members of society. Thus, human society has been engaging in “business” for thousands of years. Today the world of business is inescapable—businesses are no longer just local providers of goods and services, but extend to vast corporate enterprises operating on a global scale. For governments to function and economies to ﬂourish, a successful and thriving business sector is essential. Whether businesses are small or large, public or private, for-proﬁt or nonproﬁt, they each play a key role in supporting the global economy, and together they form the backbone of the modern world. Business underpins every aspect of the world we live in today, and understanding how it works is the key to understanding society. This book explains the complex world of business in a simple and graphic way. It examines every aspect of how a business works, including forming a company, raising capital, product development and marketing, management strategies, tracking revenue, ﬁnancial reporting, and legal, social, and environmental responsibilities. Through visual explanations as well as real-life examples to make even the most complex concept immediately accessible, How Business Works offers a clear understanding of what business is all about and how business, in its many forms, shapes modern society.

HOW COMPANIES WORK Business ownership ❯ Start-ups Buying and selling business ❯ Who’s who Corporate structure ❯ Human resources

Business ownership Every type of business has to choose an ownership structure. Although there are variations globally, most countries offer similar types of legal entities, from a singleperson private enterprise to a massive organization trading on a stock exchange. There are three key considerations: how big the venture is expected to grow; the complexity of ﬁnancial recording, management, and reporting that the proprietor is willing to take on; and the amount of liability the owner is willing to accept.

Public companies Private companies Small and simple ❯ A sole proprietorship or partnership is simple to set up and requires little capital. ❯ One or more owners conduct business as a legal entity. ❯ Owners are personally liable for business debts. See pp.14–15.

❯ More complex to set up and run, a private company is a legal entity separate from its owner or owners. ❯ The company structure means the owners are not usually personally liable for business debts. ❯ Private companies are owned by shareholders, who are often the company’s managers. See pp.16–19.

❯ Companies that go public are large businesses, and they have many legal and ﬁnancial reporting obligations. ❯ The general public and other institutions can buy shares in public companies. ❯ The public company structure is good for a major capital injection, allowing the business to expand. See pp.16–19.

HOW COMPANIES WORK Business ownership

12 13

NAMING A COMPANY

of global economic activity is accounted for by the world’s 100 largest companies

Don’t

❯ Use a domain suggestion tool to search for available internet domain names and work back from there. ❯ Be descriptive so potential customers instantly grasp the nature of the business. ❯ Say the name out loud—it may come across differently from the written word. The goal is that people can search and ﬁnd it, especially online, just from hearing it. ❯ Keep it short and simple and avoid puns.

❯ Include your name—if the venture fails, your name will be associated with it. ❯ Ape competition, because if your name is unique, you have a better chance of topping search-engine results. If your name is similar to that of competitors, customers can’t distinguish. ❯ Spend time thinking of a name until your product and brand is ﬁnalized. Get the product right ﬁrst and the name will follow naturally.

Multinationals ❯ For both growth and ﬂexibility, multinationals have operations in various countries. ❯ Multinationals can save money by setting up operations in countries where costs are cheaper. ❯ Foreign branches can adapt to the local market and also ﬁnd new markets. See pp.20–21.

Franchises ❯ In this model, a business (the franchisor) authorizes a franchisee to set up a branch under its name, in return for a fee. ❯ The franchisor needs less capital than it otherwise would to develop a business. ❯ The franchisee takes on a known, successful business model and name, so minimizing risk. See pp.22–23.

Nonproﬁt sector ❯ Common nonproﬁt organizations include charities and trade associations. ❯ Their organizational structure is similar to that of a company. ❯ They may generate substantial sums of money, but plow it back into beneﬁcial causes rather than distributing proﬁts. See pp.24–25.

Sole proprietorships and partnerships The simplest business structures are those formed by one person as a sole proprietor, or by two or more people as a partnership, for commercial activity. Many cost little to set up and some are easy to run. How it works Many businesses start out as the most basic unit—either a sole proprietor or a partnership. A sole proprietor is an individual who is the only owner of the business. This structure is easy to set up and there are no extra taxes to pay, unlike with a company. Instead, the sole proprietor ﬁles a personal tax return. There is risk attached, though. A sole proprietor has unlimited liability, so if the business fails, the owner must personally pay debts. Partnerships have more than one owner, and each can be held liable for the whole debt of the business in case of failure.

Pros and cons Both sole proprietorships and partnership structures are excellent for anyone starting out or running a small business—as long as the business stays out of debt: owners are personally liable for business debts.

NEED TO KNOW

Unlimited liability: business debts paid personally

Tax-efﬁcient way to be self-employed

Working alone requires only simple administration and relatively few start-up costs.

Simple registration process

Little capital needed

Easy to move from sole proprietor to company status

Schedule C ﬁled with IRS Form 1040

Sole proprietorship

❯ Firm Collective term for individuals in a partnership ❯ Limited liability partnership (LLP) Partners not personally accountable for business debts

Trade under own name or chosen business name

Keep all business proﬁts after paying tax on them

HOW COMPANIES WORK Business ownership

FROM INDIVIDUAL TO MULTINATIONAL Sole proprietorships and partnerships may grow into global names. ❯ Richard Branson Sole proprietorship that expanded into Virgin empire ❯ Steve Jobs and Steve Wozniak Partnership that created Apple brand ❯ Bill Hewlett and David Packard Partners who founded HP technology ❯ John D. Rockefeller, William Rockefeller, Henry Flagler, Jabez A. Bostwick, Samuel Andrews, Stephen Harkness Partnership that grew into Standard Oil corporation

66%

of EU private sector jobs are in small or mediumsize enterprises

WHEN TO MO COMPANY STVE TO ATUS

If the need fo r ca increases (and pital potential debts grow), forming a company m ay be beneﬁcial. Se e pp.16–17.

Proﬁt and control of the business shared

Allows for specialization by each partner If partner leaves, new partnership needed

Each partner pays tax on own portion of proﬁt

Like sole proprietors, partners ﬁle only personal tax returns and are liable for business debts.

Option to set up a limited liability partnership

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Furnish Schedule K-1 (IRS Form 1065) to partners

Partnership

14 15

More partners mean more capital and expansion

New partners bring new business skills

Corporations A corporation is a business entity considered distinct from its employees and shareholders. The primary purpose of forming a corporation is for shareholders to avoid personal liability. How it works A corporate structure protects management and workers in the case of litigation or other claims. It is, however, a more complex structure and subject to greater regulation than the simpler business entities of sole proprietorships and partnerships. A corporation is owned by one or more stockholders, and is managed by a board of directors and run by the company’s ofﬁcers, who are appointed by the board of directors. The company retains any proﬁt made and may

distribute it to the stockholders in the form of dividends. Corporate and securities laws regulate the sale of shares. Legally, the stockholders cannot be held liable for the company’s actions and debts.

Types of incorporation Anyone who operates a business may incorporate by registering articles of incorporation. General incorporation (C Corporation) is the most common structure. An S Corporation, created through IRS tax election, provides limited liability; it is favored by small businesses because it combines the advantages of sole proprietorship, partnership, and the corporate forms of business structure. Nonproﬁts can also incorporate.

Publicly traded company A publicly traded company is usually a large business—such as a technology company— with stock traded on a stock exchange, such as NASDAQ.

NEED TO KNOW ❯ Stockholder An individual, group, or organization that owns shares in a company ❯ Doing business as (DBA) Operational rather than company name ❯ Professional corporation (PC) Corporate form used for primarily for doctors, lawyers, and similar professional service providers

Public characteristics ❯ Issues securities through an Initial Public Offering (IPO) ❯ Can sell future equity stakes ❯ Has greater access to ﬁnancing ❯ Must meet reporting requirements set out by Securities and Exchange Commission (SEC) ❯ Reduced control for initial owners

HOW COMPANIES WORK Business ownership

16 17

LIMITED LIABILITY COMPANIES IN THE US

Corporation Corporations operate as legally and ﬁnancially independent entities. They may be publicly traded or privately held.

A limited liability company (LLC) is a hybrid between a corporation and a partnership. The upside of an LLC is that it offers many of the advantages of a corporation, but is cheaper to create and maintain. Taxation rules vary, depending on the Articles of Organization of the LLC. Laws also differ from state to state. A limited liability company is an “LLC,” not an “Inc.” or “Corp.”

CANADIAN COMPANIES

Privately held company

56.5%

of UK limited companies have employees; the remaining 43.5% are single-member companies (SMCs)

In a privately held company, a limited group of private stock owners controls the company. These companies do not offer shares to the general public on stock exchanges.

Businesses in Canada can be sole proprietorships, partnerships, or corporations. A business can also be run as a cooperative, a business that is owned and controlled by its members. Canadian companies must register in the province or territory in which they are domiciled.

Private characteristics ❯ May issue stock and have shareholders. Shares, however, do not trade on public exchanges ❯ Management is not required to ﬁle disclosure statements with the SEC ❯ Dependant on private funding

Private and public companies While the owner-shareholders of a private company may buy and sell their shares privately (usually with director approval), any investor in the ﬁnancial market can trade the shares of a public company. How it works Although most of the world’s companies are set up as private, public companies are seen as more prestigious and proﬁtable. For business ventures requiring large amounts of capital, a public company offers greater opportunity for raising funds, since shares can be sold to public investors to generate cash. Private companies must rely on private investors or use the capital investment of their owners. Public companies are subject to more stringent legal controls than private ones, and are expected to disclose ﬁnancial details.

27 million the number of companies in the US, fewer than 1% of which are public

Differences between private and public companies Private company directors have to weigh up the potential capital increase of ﬂoating on the stock exchange against the legal red tape aimed at protecting public shareholders.

Private Directors Usually control all of the shares.

Reporting In the US, no disclosure is required outside the company; in the UK, it is mandatory to ﬁle accounts at Companies House.

Shareholders and management

FAMOUS PRIVATE COMPANIES

Shareholders are often actively involved in management so decisions can be made quickly.

❯ Mars Confectionery and pet food; third-largest private US company ❯ Rolex Swiss-based English company making status-symbol watches ❯ LEGO® Danish company producing household-name toy bricks ❯ Hearst Corporation Mass-media multinational based in New York City ❯ IKEA Swedish retailer registered in Netherlands selling ﬂat-pack furniture ❯ PwC Largest professional services network

Financing Company must rely on private investment, which is often harder to attract because there are fewer ﬁnancial details available.

Valuation Value of the company is more likely to ﬂuctuate; it is more difﬁcult to assess because there are fewer available ﬁnancial details.

Size Number of shareholders is limited, usually to fewer than 2,000.

HOW COMPANIES WORK Business ownership

$55 billion

the amount raised on 141 IPOs at the NYSE in 2013

18 19

GOING PUBLIC There are legal requirements at each stage of converting a company from private to public, such as voting in a board of directors and deciding on a new name.

Choose board members Usually at least three directors to allow future board decisions to be made with only two members present (representing a majority)

Inform staff

Public

Must notify in writing anyone with an interest (including employees and proposed board members) that company intends to go public

Vote for conversion Board meeting held to vote in favor of changing company’s Articles of Incorporation (specifying private or public company)

Directors Not necessarily shareholders.

Reporting Companies have a legal obligation to disclose accounts and submit regular ﬁnancial reports.

Shareholders and management Clear boundary is drawn between the role of shareholders and management; may lead to a conﬂict of interest.

Register company Documents setting out board resolutions sent to Secretary of State, who issues certiﬁcate declaring the company is public

Make public announcement Press releases issued, events for business held, and emails sent to inform contacts of change

Financing Can tap ﬁnancial markets to raise capital by selling stock or bonds.

Valuation Value of the company is easier to assess, from the trading price of shares and ﬁnancial statements.

Size Number of shareholders is unlimited.

NEED TO KNOW ❯ Unquoted/unlisted company Another term for a private company ❯ Initial public offering (IPO) Stock-market launch ❯ Secondary stock offering Second-round sale of shares to raise more capital ❯ Ticker symbols Unique code assigned to publicly traded companies and used by stock exchanges

Multinationals A multinational corporation has business operations in more than one country. It usually starts as a national company and sets up subsidiary (branch) companies abroad for production and sales. How it works Multinationals have several goals: to increase revenue by ﬁnding new markets; to streamline operations and production by taking advantage of global locations with lower labor and/or transport costs; and to adapt

to local cultural/market differences. A company may achieve such goals by outsourcing (using external suppliers) or offshoring (relocating functions). Companies may also insource (move operations in-house) to rightsource (ﬁnd a good balance).

Case study: mapping a multinational Sportswear company Nike has successfully spread around the globe from its corporate base in the US. It has manufacturing functions where technical expertise maximizes efﬁciency and keeps costs down; distribution hubs in strategic locations; marketing and retail departments in countries where it is establishing local markets; and call centers where they are cost-effective.

United Kingdom London One of many country HQs in major European cities, the London ofﬁce serves the UK market. Nike also has a product creation center in Italy. Regional HQ Management and core admin functions Marketing UK campaigns and merchandising

United States Beaverton, Oregon

GLOBAL VS. MULTINATIONAL A global company has facilities in different countries but operates as a single corporate culture with common processes. A multinational has facilities in different countries but each functions as its own entity, adapting locally, with little communication between geographic divisions.

Senior management are located at the company’s corporate base, or “campus”, its center for decisionmaking on global strategy, design, and marketing, and core functions.

Global hello

hola!

Apple is an example of a global company—the product is essentially the same except for a language change.

World HQ Management, ﬁnance, legal, IT, and admin Global marketing Branding and marketing R and D Sport research lab and design facilities

Multinational McDonald’s is a multinational—the product changes to suit the market. For example, it serves a shrimp burger in Japan and chicken rice porridge in Malaysia.

Retail Online sales and stores across North America

Memphis, Tennessee Distribution Hi-tech hub in location with good links

HOW COMPANIES WORK Business ownership

The Netherlands

20 21

NEED TO KNOW

Hilversum Based in a central location, a European headquarters supports operations across Western, Central, and Eastern Europe, and is close to the company’s European distribution center in Belgium.

❯ Transnational corporation Similar to a multinational but does not identify itself with any particular parent nation

❯ Platform corporation Multinationals that do not manufacture, but outsource products they have designed

European HQ Management, ﬁnance, legal, IT, and admin

China

Design HQ for global soccer apparel business

The company’s second-largest and fastest-growing market, China is also a major manufacturing base due to local expertise and low production costs.

Retail Online sales and stores across Europe

Shanghai

Chinese HQ Operations and core support functions

Manufacturing Sportswear factories and innovation hubs

Marketing Campaigns for the Chinese market

Retail Continually expanding retail network for sports brand

Japan Tokyo Most manufacturing is based in the Asia-Paciﬁc region, beneﬁting from expertise and lower wages. Regional ofﬁces in 13 countries also support production and retail.

Regional HQ Core operations and marketing Manufacturing Sites in several countries

Brazil

India

São Paulo

Bangalore

Operations, marketing, and distribution for the Central and South American market are based in Brazil, with ofﬁces and retail outlets in all major countries.

Call centers draw on a supply of English-speakers on lower wages.

Central and South American HQ Operational center

Distribution Hub for retail stores across the continent

Customer support Complaints and returns

Franchises The franchise is a business model in which an independent entity—the franchisee—is entitled to set up a branch of an established brand. There are advantages for both parties. How it works Rather than developing an original business idea, the franchisee pays for the right to represent an existing, successful brand in a particular location. The size of a franchise can vary from a single unit—one outlet only— to an area development in which the franchisee takes on the option to represent the brand through several branches in a city or region. The franchisor can

develop the business with modest capital outlay while the franchisee takes on a proven business model and brand name, so everyone reaps the beneﬁts.

NEED TO KNOW

“I put the hamburger on the assembly line.”

❯ Franchise disclosure documents (FDD) Preagreement information ❯ Microfranchising Support and training for small-scale businesses in the developing world ❯ International Franchise Association (IFA) The oldest and largest franchise organization

Ray Kroc, founder of McDonald’s

Three types of franchise The franchisor’s level of control varies from managing the contracts for the entire supply chain to input on every detail down to the last French fry. In a product franchise, the franchisor lends its trademark and brand but not an entire business system.

Manufacturing franchise

Product franchise This is a supplier-dealer relationship in which the franchisee sells the franchisor’s products. Examples include cars, gasoline, and tires.

A company that manufactures a speciﬁc range of products grants retailers the right to distribute its products and use its brand name and trademark. For example, a soft-drink makers sell syrups to the franchisee, who then bottles the drink.

HOW COMPANIES WORK Business ownership

TOP 10

22 23

CASE STUDY

Fastest-growing franchises worldwide

Business-format franchise: fast-food outlets

1. Subway fast-food sandwich outlets 2. McDonald’s fast-food outlets 3. KFC fast-food outlets 4. Burger King fast-food outlets 5. 7-Eleven convenience stores 6. Pizza Hut restaurants 7. GNC health and beauty products 8. Wyndham Hotel Group hotels 9. Dunkin’ Donuts bakery/coffee shops 10. Dia grocery stores

The business-format franchise, in which a franchisee takes on a whole blueprint for running a business as well as the product itself, was pioneered in the US in the late 1940s. Fast-food outlets were a new concept at the time and were generating great demand. To increase the rate of expansion, these original fast-food entrepreneurs developed a franchise system under which the franchisee was contractually obliged to run the outlet according to strict guidelines.

A limited and uniform menu was the key to the success of these franchises. The consistency of the menu, service, and surroundings helped to establish a strong brand identity, since customers were assured that the product and experience would be the same anywhere in the country. McDonald’s is the most successful example, collecting an estimated 11.5 percent royalty fee from its 31,000 franchises worldwide.

Business-format franchise

The most common type, this has high input from the franchisor including brand name and trademark, training, store identity, marketing plan, and company culture. The franchisee buys supplies from the franchisor and pays fees and royalties. Fast-food outlets are typical business-format franchises.

Not-for-profit Some organizations are run not for the beneﬁt of shareholders, but for the beneﬁt of their members or an external community or charity. Unlike conventional businesses, proﬁt is not the goal. How it works Organizations that do not intend to generate proﬁt for their shareholders, are self-governing, and committed to a common cause come under the broad umbrella of not-primarily-for proﬁt, not-for-proﬁt, and nonproﬁt entities. On this spectrum, cooperatives may disburse proﬁts to members, but charities are strictly nonproﬁt. Although their goals differ, not-for-proﬁts have a similar type of company status and structure to businesses.

The not-for-proﬁt universe There are many forms of not-for-proﬁt organization (NPO). Joel L. Fleishman, Professor of Public Policy and Law at Duke University, has characterized the not-for-proﬁt sector as a universe that embraces all NPOs, whatever their mission.

Private foundation Similar to a charity but funded by one source, not the public; generates revenue from investments; makes grants to other charitable bodies

9.2%

of all wages and salaries paid in the US come from the not-for-proﬁt sector

Cooperative Owned by members; can beneﬁt from proﬁt; clear ethos of pursuing common economic, social, or cultural goals; one member, one vote

Fraternal organization Based on common interests or beliefs such as social or academic interest or a benevolent cause; Freemasons and college fraternities are both examples

THRIVING SECTOR Despite being NPOs, many cooperatives and mutuals have a sizable annual turnover (gross revenue transacted). ❯ Japan Zen Noh cooperative: $53 billion ❯ France Crédit Agricole Group of cooperatives and mutuals: $32 billion

❯ US Nationwide Mutual Assurance: $23 billion ❯ Germany Edeka Zentrale AG cooperative: $16 billion ❯ UK Co-operative Group: $16 billion ❯ Spain Mondragon cooperative: $14 billion

HOW COMPANIES WORK Business ownership

NOT-FOR-PROFIT STRUCTURE

NEED TO KNOW ❯ Philanthropic sector Alternative umbrella term for the not-for-proﬁt sector or universe ❯ 501(c) corporation An IRSrecognized nonproﬁt; one of several types of nonproﬁts, organized for purposes speciﬁcally designated in the Internal Revenue Code

24 25

❯ Associated charity An organization related to a main charity that takes on a particular aspect of the charity’s work ❯ Payouts 5 percent of assets that private foundations must pay out each year; no such requirements exist for public charities

Nongovernmental organization (NGO) Funded by government or by international donor agencies such as the World Health Organization (WHO); operate independently

Chairman coordinates work of the directors.

Board of directors are usually unpaid; may also be called the board of trustees. Committees formed by board members carry out speciﬁc tasks such as fundraising. Administration staff often include a proportion of voluntary workers.

Mutual Raises funds from members (usually customers); often takes the form of ﬁnancial institutions; proﬁts reinvested in the mutual or to sustain or grow the organization Chamber of commerce Chambers from various regions gather to promote trade, investment, and cooperation; usually funded by subscriptions from local businesses

Social enterprise May sell goods or services to fund community projects; any surplus revenue reinvested in the enterprise for the community

Charity Must be registered as a charity; tax exempt; all resources must be devoted to the charity’s stated charitable activities; may be organized as a trust, corporation, or association

Start-ups A start-up is a new business in the early stages of development and operation, during which an entrepreneur or founding group comes up with an idea for a product or service, researches it, develops a business plan, raises funds, and launches with the goal of rapid growth. Registering intellectual property (IP)—a unique creation, not just an idea—to protect it is an important stage of the start-up process. Protection includes trademarks, patents, and copyright.

The early days Before a company is fully developed, with a working business model, it is known as a start-up. The start-up evolves from an entrepreneur, or group of entrepreneurs, with an idea or invention. It can take a few years to turn the initial concept or prototype into a viable, proﬁtable venture, so the start-up founder tries to attract support and ﬁnancial backing to achieve rapid growth. During this phase, which can take anything from a few months to several years, the business changes quickly.

NEED TO KNOW ❯ Internal start-ups Start-ups that originate from inside a large organization ❯ Patent trolls Companies or individuals who buy up the patents of failed start-ups and attempt to collect licensing fees from potential infringers of the patent

476,000

new businesses are started every month in the US

INTELLECTUAL PROPERTY (IP) VALUE The term ”start-up” became commonplace during the dot.com boom of the late 1990s, when thousands of entrepreneurs with web-based products and services found funding, many on the strength of their intellectual property alone. Giants Google and Amazon both started up at that time. Since then, technology businesses have become one of the most talked-about start-up types. Their value is often based 100 percent on intellectual property.

™ ® ©

HOW COMPANIES WORK Start-ups

26 27

big idea The Consider the IP ❯ Register IP ❯ Find a name ❯ Buy a domain ❯ Research market

Choose a start-up type? ❯ With a social conscience? ❯ Primed to grow big? ❯ To ﬁt lifestyle?

Launch ❯ Win? Lose? ❯ Research indicates that, in most Western countries, 80–90 percent of start-ups fail.

Prepare to launch ❯ Plan a marketing campaign ❯ Run a test launch and reﬁne message and offer

See pp.196–197.

See pp.30–31.

Make a business plan ❯ Explain how the business will make money ❯ Describe the unique aspects of the business ❯ Set out how much money the business will need and how much it will make

Find funding ❯ Invest savings ❯ Ask friends and family ❯ Take out a bank loan ❯ Seek venture capital ❯ Try crowdfunding

See pp.34–37.

See pp.32–33.

Seek help ❯ Join a business accelerator

❯ Enter a business incubator ❯ Go it alone ❯ Find an investor

See pp.38–39.

40%

the sales growth achieved by online start-ups in France, in 2011–2012

Start-ups from concept to launch A new business can be described as a start-up in the early phases of its launch, when an entrepreneur comes up with the idea for a product or service, and develops the concept into something that will sell. How it works The idea is just the start. Next comes the process of expanding the concept into a viable business. Specialized help may be needed in some areas—hiring a website and logo designer, for example, and an accountant to advise on the best structure and ﬁnancial setup. What the business and product or service are called can make or

break the start-up, so it is worth spending some time doing online research to make sure no one else is using an intended name, especially in a negative context. Location is another consideration with signiﬁcant cost implications. It may be possible to create a virtual ofﬁce and work from home. Finding premises is an extra stage, but the goal at start-up is to keep costs low.

Come up with a good idea

START

Develop a product, or an idea for a product.

Set up an online presence

NEED TO KNOW ❯ Lean start-up Method of learning fast and discarding what does not work to keep start-up costs down ❯ Start-up pivot Quickly changing direction or correcting mistakes based on customer feedback or technology changes

Decide on a name Check to determine whether your proposed name is available; check that the domain name is available; search online for competitors with similar names.

Create a look

Make a website

Design a logo and visual identity for the business.

Build a website. Research search engine optimization (SEO) words to use on it (see pp.230–231).

HOW COMPANIES WORK Start-ups

75%

START-UP STRUCTURE Business

Pros

Cons

Sole proprietorship

Low cost, easy to set up, minimum of ﬁnancial reporting

May be seen to lack credibility; challenge to raise capital

Partnership

More input, more potential to raise funding

Harder to dissolve in case of failure; partners liable for debts

Limited company

Low risk of personal liability; tax beneﬁts; dividends can supplement wages

More ﬁnancial reporting necessary; more paperwork

Limited liability partnership

Personal liability of partners is limited to the amount they invest in the business

Must ﬁle annual accounts; can be dissolved once a partner leaves

Decide structure

Study your proposed target market and potential competitors, and evaluate the viability of the idea.

Choose a business structure that suits your initial needs, but also allows ﬂexibility for growth.

Devise a plan Draw up a plan (see pp.32–33), including your goals, mission statement, and key ﬁnancial information.

Consider a business incubator if the business requires large-scale support.

of all US start-ups failed between 2004 and 2010

Research market

Obtain backing funds

28 29

Set up ﬁnances

Start marketing

Include an accounting and cash-ﬂow system, sales tax if applicable, and bank account.

Plan a marketing campaign. Run a test and make any reﬁnements to the message or strategy.

LAUNCH

Types of start-up Entrepreneurs go into businesses for many reasons. Some start-up decisions are based on personal ethos and conviction, while others are founded ﬁrmly on the desire to make money. How it works Not all start-ups ﬁt the same mold. Although they often follow a similar process in their initial evolution, they are as varied in type as the personalities behind them. Startups can broadly be divided into

those that are aimed from the outset to be large ventures within a corporate environment, and those intended to work on a more personal scale to suit the lives and passions of individuals.

Lifestyle Motivation Working is a passion

NEED TO KNOW ❯ Enterprise portal Dedicated website providing content for staff, usually intended for larger companies ❯ Micropreneur Entrepreneur who keeps their business small so they can control and manage it alone ❯ Burn rate How fast the start-up’s initial cash balance is going down, month by month

cial start-ups o S Motivation Making a difference Example Ex-athlete starts ﬁtness coaching business

173%

the projected revenue increase over three years for mobile gaming start-ups

Type of funding Self, friends, peers, bank loan

Example Malaria blood-test kit for smartphone

Type of funding Community, charity, government, donation

HOW COMPANIES WORK Start-ups

i iat

Init

all business Sm

Innovating

on at i or

n a large c or p Motivation

t hi wi

0101010011 0100010101

le startup alab c S Motivation Readiness to grow

Example PC manufacturer starts a separate business providing cloud data storage

Example Phone app developer

Type of funding Internal company funding

Type of funding Crowdfunding, angel funding

Motivation Feeding the family

on uisiti target q s Ac Motivation Example Small-town grocery store

30 31

Intent to sell the business on from the beginning

Type of funding Self, family, bank loan Example Biotech laboratory

Type of funding Outside investment

Business plans Writing a business plan is one of the most important steps in developing a start-up. The plan sets out the new business’s goals, market analysis, and projected income and proﬁt. How it works Before a start-up entrepreneur can write a business plan, they need to have done enough research to identify a clear opportunity in the market for the product or service, and to deﬁne how the proposed

Key elements Preparing a business plan can take several weeks, and it is worth doing thoroughly. It is a vital document for securing funding, so the ﬁnancial forecast must be both realistic and accurate. If showing it to others, pare the executive summary down to two pages, write it in plain English, and explain any technical terms.

Start-ups in the US are

2.5x

more likely to go into business if they have a written plan

new business will be uniquely positioned to capture that market, given the services or products offered. An outline of existing ﬁnances and an accurate projection of sales and proﬁt are essential components, especially if seeking external funding.

Executive summary Fill in this section last, bearing in mind that it may be the only part a busy person reads: ❯ Business summary Company structure, name, product or service, and customer proﬁle ❯ Business goals Three objectives over one, three, and ﬁve years ❯ Financial summary Expected sales and costs, and funding ❯ Elevator pitch Two-minute talk to sell your idea to a customer

Products and services

Business background Provide details of each person in the business: ❯ Experience Relevant work carried out to date ❯ Qualiﬁcations Credentials, such as diploma in horticulture for a gardening service ❯ Training Past and future, including business skills such as assertiveness

The market

Describe what the business is going to sell: ❯ Product or service With a picture if product is new ❯ Range If more than one, such as garden design and maintenance ❯ How it is different What makes the product or service stand out from the crowd?

Set out speciﬁc details of your potential market: ❯ Typical customer Businesses or individuals and their proﬁle; local, national, or international ❯ Market research What the local market is for similar products or services

Marketing strategy Choose about three of these methods: ❯ Word of mouth ❯ Advertising

❯ Business literature ❯ Direct marketing ❯ Social media ❯ Website

HOW COMPANIES WORK Start-ups

TOP FIVE REASONS TO WRITE A PLAN ❯ The process Working through each element ensures nothing is forgotten. ❯ Costing The only way to ﬁnd out whether the business is viable is to work out details of costs and sales. ❯ Funding A good business plan improves chances of getting a loan.

NEED TO KNOW

❯ Areas of expertise Making a business plan clariﬁes where outside help is needed—for instance, in bookkeeping or marketing. ❯ Getting to know the competition Conducting market research is the best way to give a business an edge.

Competitor analysis Show how the business idea compares with the competition: ❯ Table of competitors Who and where they are, what they sell and for how much, how good they are ❯ SWOT analysis Including how to remedy any weaknesses and combat known threats, such as a garden center opening nearby ❯ USP Unique selling point of the product or service See Need to Know box, above.

Costs and pricing strategy Work out how much the product or service costs and its sale price: ❯ Cost How much each unit or batch costs to make and deliver ❯ Price How much each unit or batch will sell for ❯ Proﬁt margin The difference between cost and price per unit

❯ SWOT analysis Stands for Strengths, Weaknesses, Opportunities, and Threats ❯ Unique selling point (USP) The feature that makes a product different from the competition

Operations and logistics Describe from start to ﬁnish how the business will run day to day: ❯ Supply and delivery How the goods or service will get from A to B ❯ Equipment Details of transportation, ofﬁce items, and premises ❯ Payment, legal, and insurance How customers will pay and how that translates into salaries; compliance with the law

Financial forecasts Predict sales and costs over the year, allowing for seasonal ﬂuctuation, such as spring demand for lawn services: ❯ Sales calculations For each month, the expected number of sales ❯ Costs calculations The costs of the predicted sales each month ❯ Cash-ﬂow forecast The money coming in and out of the business See How Finance Works, pp.98–175.

Back-up plan Make a Plan B in case something goes unexpectedly wrong: ❯ Short-term changes Cutting costs or boosting sales immediately

32 33

❯ Longer-term changes Shifts such as working online, not on premises ❯ Closure Lessons learned and skills acquired if the business closes

Raising money Almost every new enterprise needs funding to get it going, and to keep aﬂoat until it turns a proﬁt. Financial help is at hand from a variety of sources, suitable at different stages of start-up growth. How it works Capital for new enterprises comes from two main sources: lenders and investors. Lenders, such as banks, provide debt capital in the form of a loan that is returned with interest. Investors, such as business angels and venture

capitalists (VCs), provide equity capital in the form of a share in the business that may include a proportionate share of control and rewards. Both types of funding can be corporate—from a company—or more quirky and alternative, such as crowdfunding.

Lenders

Types of start-up funding

Debt capital most often takes the form of loans paid back with interest.

Corporate, traditional, and substantial funding comes largely from banks and VCs, while smaller sums come from more personal sources.

Term loan Paid back regularly over a set period of time

Bank overdraft or credit card Interest charged monthly if balance not paid in full

Factoring/invoice discounting Unpaid invoices sold at a discount to a company that collects them for commission

❯ Bank Offers either personal or business loans ❯ Government Offers low-interest start-up loans ❯ Credit union Cooperative that gives members low-interest loans ❯ Peer-to-peer (P2P) lending Unsecured personal loans ❯ Friends and family May give interest-free loans

❯ Bank or credit company Financial organization that makes loans to commercial ventures

❯ Factors and discounters Companies that offer advance on unpaid invoices, for a proﬁt

NEED TO KNOW

$ $

❯ P2P lending Loans made between individuals over internet ❯ Crowdfunding Debt or equity raised via internet platforms

p fund u rt

g in

Sta

HOW COMPANIES WORK Start-ups

5–10% of small and medium-sized enterprises in the UK need no start-up funding

Investors

Grants

Equity capital is paid to the start-up in return for a share of the business.

Financial awards and prizes are provided by public bodies.

Founders, friends, family (FFF) May buy shares in the company rather than lending money

Crowdfunding Large number of supporters, each contributing a small amount of money, usually online

Business angels Investors who give favorable terms because their focus is on the company’s success rather than proﬁt

Venture capitalists (VCs) Companies that provide capital for new businesses in the hope of making a proﬁt

34 35

Local, national, global Funded by a local authority, government initiative, or international charity

SUPER ANGELS ❯ What they are Serious investors in technology start-ups. Facebook was funded by super angels, some of whom are now famous in their own right. ❯ Who they are Former Silicon Valley professionals who invest their personal money in new ventures. ❯ How they differ from ordinary angels and venture capitalists (VCs) Funding level straddles the two, often reaching millions of dollars as what started out as a hobby becomes a profession. ❯ Pros and cons Super-angel investing acts like a magnet to other investors, but individual super angels can rarely provide the full funding of a VC.

RAISING MONEY

Since the start of the economic downturn that started in 2008, several innovative and more personal types of funding, such as crowdfunding and peer-to-peer (P2P) lending, have evolved and blossomed on the internet. All involve the principle of raising small amounts of money from large numbers of individuals who pool their resources to provide the loan or equity needed.

The key to successful funding is to choose the right type of ﬁnance at each stage of a company’s early growth. Start-ups usually begin modestly, with self-funding and help from friends, family, and anyone else who is prepared to take a high risk. Crowdfunders and business angels are amateurs willing the entrepreneur to succeed, while venture capitalists become interested when the level of risk goes down and they can expect a healthy proﬁt in return for injecting substantial funds. Public markets such as stock exchanges may step in as sales soar and success looks probable. At all stages, investors will conduct credit analyis to asses a company’s ability to repay its debt.

Capacity

Collateral

The borrower’s ability to repay the loan is shown by the business plan.

The borrower is often expected to pledge an asset that can be sold to pay off the loan if funds are too low to pay the monthly interest or repay the capital at the end of the term.

Capital The borrower’s net worth is assessed to check that assets exceed debts.

Character The lender usually looks for a borrower with a good credit history.

iends, fam , fr s r

(FFF) ily

Life cycle of investment

CREDIT ANALYSIS CRITERIA FOR LENDING

Foun de

Alternative models

Conditions The lender is swayed by the current economic climate as well as by the sum requested.

funde owd rs Cr

RISK

ENT STM E V IN

REVENUE

TIME

Idea

Seed

HOW COMPANIES WORK Start-ups

36 37

Start-up ﬁnance of small and medium-sized enterprises (SMEs) The chart shows sources of start-up ﬁnance of SMEs over a three-year period in the UK, taken from a 2004 survey by Warwick Business School. Most funding comes from individual savings, and least from equity (shares), a type of investment associated more with larger companies.

66% 12.5% 10%

Home mortgage

No funds used

$ 1.5%

Bank loan

t en

ure

capita lis ts

ss ang el sine u s B

Friends and family

Personal savings

Equity investment

marke blic ts u P

SALES

Early

Mid

Late

Business accelerators and incubators Starting a new venture can be a long process. Business (also called venture) accelerators and incubators are specialized organizations devoted to developing and supporting start-ups. How it works Business accelerators and incubators provide expertise and connections in the formative stages of a business in return for a percentage of ownership. They are two separate types of services. Business accelerators are short-term programs that offer wide-ranging

support including mentorship, business advice, and connections to potential sources of ﬁnancing. Business incubators, on the other hand, provide a supportive environment in which ﬂedgling start-ups can develop, with technical assistance, working space, and networking opportunities.

Business accelerators Suited to start-ups that have limited ﬁnancing, accelerators offer short–term (one to three months) boot camps. Clients include web and software developers.

Help with bank loans, funds and guarantees programs

Introduction to potential partners Access to mentors and advisory boards

Accounting and ﬁnancial services advice

Networking

Seed capital

Links to potential investors

Start-up pays accelerator % of equity in the business.

In return, accelerator provides help and services.

Marketing advice

Management of intellectual property

HOW COMPANIES WORK Start-ups

38 39

Business incubators Start-up pays incubator % of equity in the business. It may also pay rent to share part of the incubator’s work space. In return, it receives a range of beneﬁts.

Often sponsored by nonproﬁt organizations, incubators tend to be longer term (one to ﬁve years) and cater for a variety of clients, many science-based.

Start-up introduced to incubator

NEED TO KNOW

Support and education

Mentorship

Specialized facilities such as science laboratories

Ofﬁce space to work from

Interaction with other start-ups

Seed money to get started

❯ Incubator networks Collaboration of incubation centers, research facilities, and science parks ❯ Virtual business incubator Online hothouse for start-ups

months the average time US start-ups spent in an incubator, during 1999–2002

Buying and selling business Both private and public companies regularly change hands—they are bought, sold, and restructured to reﬂect changing business conditions. These deals all come under the umbrella term of mergers and acquisitions (M and A). Acquisition ﬁnancing is usually needed to pay for the purchase of another company, often in the form of a loan or venture capital.

How to acquire a company

A company is typically acquired in one of two ways—either by a management team or by another company. When a company is buying, the result can be a merger, in which two companies join forces, an acquisition (outright purchase), or a divestiture, in which part of a company is hived off and sold. Management team purchases are often funded by private equity.

Management team acquiring

FOR SALE

Private equity ﬁrms look for companies to buy and then sell their shares when proﬁts have maximized. They fund the management team. See pp.48–49.

Buy-out

Divestiture

The existing management team buys out the company they work for.

Part of company is split off to form new company; may become acquisition target. See pp.44–45.

Buy-in An external management team buys into the company.

pany m o tc e rg

HOW COMPANIES WORK Buying and selling business

$311.5 million

the average size of M and A deals, globally, in 2013

40 41

SIZING UP M AND A’S Measuring a big deal The corporate world categorizes acquisition deals according to the capitalization size (the value of the company’s shares).

Small Under $500 million

Mid-market $500 million to $2 billion

Large $2 billion to $10 billion $

Megadeal Above $10 billion

Another company acquiring

Due diligence

Companies may want to expand by joining with another business.

Before any company sale, the potential buyers see a detailed report prepared by lawyers, covering key aspects of the target business. ❯ Financial Identiﬁes problem areas that could affect the future value of the company.

Merger The company combines with another company. See pp.42–43.

❯ Legal Gauges possible legal risks attached to corporate status, assets, securities, intellectual property, and employee reshufﬂing.

Acquisition Horizontal The company buys another company that makes similar products. Vertical The company buys another company that makes different products. See pp.46–47.

❯ Commercial Includes industry trends, market environment, the company’s capabilities, and the competition. ❯ Environmental Uncovers potential liabilities such as land or water contamination and estimates remediation costs.

Mergers and acquisitions Two of the quickest ways to accelerate expansion are for a business to buy out another—an acquisition—or to amalgamate with another business in a merger. How it works Mergers and acquisitions (M and A) is a general term used to describe the ways in which companies are bought, sold, and recombined. In the case of either a merger or an acquisition, two separate legal entities are uniﬁed into a single legal entity. While a merger combines two companies on

a reasonably equal footing to create a new company, which will make both parties better off, an acquisition is usually a purchase of a smaller company by a larger one. This beneﬁts the company making the purchase but may not necessarily beneﬁt the target company. M and A can be friendly or hostile—agreed to or imposed.

REASONS TO PURSUE M AND A ❯ Improved economies of scale Wider operations streamline production and sales. ❯ Bigger market share Combining the existing markets expands share of the total market. ❯ Diversiﬁcation A different product lineup gives the chance to cross-sell or create more efﬁcient operations if the products are complementary.

Company A manufactures luxury cars in the US.

Merger

merges with

Acquisition

A Company A produces movies.

takes over

B Company B creates animations.

Company B manufactures luxury cars in Italy.

HOW COMPANIES WORK Buying and selling business

FRIENDLY AND HOSTILE

❯ The target company’s board of directors and management agree to be bought out. ❯ The acquiring company makes an offer of cash or stock to the target company’s board and management. ❯ The stock or cash offer is set at a premium level. ❯ Because the offer is above actual market level, shareholders usually agree to it.

NEED TO KNOW

❯ The acquiring company bypasses management and goes straight to the target company’s shareholders. ❯ The target company’s management ﬁght the deal. ❯ The buying company convinces shareholders to vote out the management (a proxy ﬁght) or it makes an offer to shareholders to buy shares at an above-market price (a tender offer).

❯ Pacman strategy The target company tries to take over the very company attempting the hostile buyout ❯ Swap ratio An exchange rate between the value of the shares of two companies when merging ❯ Defensive merger Undertaken to anticipate a merger or takeover attempt that threatens a company ❯ Economies of scale Beneﬁt to company of M and A expansion

$112 billion

New company A + B now has an expanded market spanning Europe and North America.

A+B

42 43

Expanded company A now has in-house expertise for producing animated ﬁlms.

the record annual spend by Japanese companies on overseas mergers and acquisitions, in 2012

Divestitures While a merger results in a bigger company, a divestiture reduces the size of a business by breaking it down into smaller components or divisions, which are then sold off or dissolved. How it works

of view, those which have promise but are not yet proﬁtable. The process of restructuring by divestiture is designed to free the company of divisions with low return, to reduce debt and ﬁnancing requirements, and to give the shareholders a stronger return. The market price of the parent company’s shares often bounces back strongly and its spin-off companies may thrive too.

The typical scenario for a divestiture is a company that is struggling to pay off debt it has taken on to expand into new areas of business that are not yet proﬁtable. To save the rest of the company from the burden of debt, management decides to start a divestiture. Generally, the goal is to shed the least proﬁtable areas of operation, or from the potential buyer’s point

SUCCESSFUL SPIN-OFFS Mondelez The spin-off of Kraft Foods owns snack foods Oreos, Ritz, and Trident. Coach Sara Lee food’s spin-off makes luxury leatherware. Expedia Media company IAC hived off online travel to Expedia.

Divestiture in practice Smith Industries Inc. is one example of an industrial paint conglomerate that has grown rapidly over the past ﬁve years, due to an increase in proﬁts from its expanding sales in China. It diversiﬁed into agricultural chemicals, textiles, and biotechnology, and set up a separate division for each. Share prices fell in response to poor ﬁnancial performance.

Making a decision

Announcing the sale

Faced with a downturn in business, the company divests the newer business areas that have not yet shown strong returns despite positive signs of growth.

Smith Industries Inc. now announces the sale of its three remaining divisions: agricultural chemicals, textiles, and biotechnology.

INDUSTRIAL PAINT

TEXTILES

Smith Industries Inc.

AGRICULTURAL CHEMICALS

INDUSTRIAL PAINT

Smith Industries Inc. FOR SALE

FOR SALE

AGRICULTURAL CHEMICALS

TEXTILES

BIOTECHNOLOGY

HOW COMPANIES WORK Buying and selling business

NEED TO KNOW ❯ Spin-off New company formed as the result of a divestiture; also called a hive-off ❯ Tracking stock Special type of shares issued by a parent company for the division or subsidiary they will sell; tracking stock is tied to the performance of the speciﬁc division rather than the company as a whole; also known as targeted stock ❯ Letter of intent Letter stating serious intention to do business, often concerning M and A

❯ Reverse merger Not to be confused with a divestiture, this is a quick and cheap method for a private company to go public by buying a shell stock— a public company that is no longer operating because it went bankrupt or was simply closed. ❯ Demerger Term commonly used in the UK for divestiture

44 45

52%

the potential rise in a parent company’s share price following a divestiture

The shareholders beneﬁt Shareholders in the original company also receive the same percentage holding in shares from the three new companies.

One company becomes four The three divisions are sold off to separate investors and become three separate companies. Shares for each are sold on the stock market. The parent company is reduced to its core business. Its share price rebounds.

Smith Industries Inc.

INDUSTRIAL PAINT

West Inc.

Jones Inc.

Brown Inc.

AGRICULTURAL CHEMICALS

TEXTILES

BIOTECHNOLOGY

Vertical vs. horizontal integration Companies that want to expand through a merger or acquisition may decide on a strategy of either horizontal or vertical integration, combining businesses involved in similar or dissimilar activities. How it works Companies can choose from several strategies when they merge or are part of an acquisition. Two of the most common are horizontal and vertical integration. Horizontal deals are always done between competitors that produce similar types of products, such as cars or mobile phones, and often share—or compete for—the same suppliers and clients. As a result of

merger or acquisition, the newly formed company can make cost savings in production, distribution, sales, and marketing. Vertical deals are usually between businesses involved in the same industry but at different stages—for example, a computer maker and a component manufacturer. These deals can be upstream (toward the market) or downstream (in the direction of operations and production).

NEED TO KNOW ❯ Lateral integration Another term for horizontal integration ❯ Horizontal monopoly When a company controls the market after buying up the competition ❯ Synergy The potential of merged companies to be more successful as a single entity

Integration models in practice In these hypothetical examples, a cluster of printers, publishers, and bookstores merge or acquire each other in horizontal or vertical deals that aim to strengthen their market position, take advantage of economies of scale, and exploit synergy.

Horizontal integration Two publishing companies, both involved in the process of book creation but with different areas of specialization, agree to a merger deal to gain a larger market share.

PUBLISHER AB

PUBLISHER A

Publisher A, a general publisher, acquires specialized academic Publisher B to strengthen its textbook division.

PUBLISHER B

HOW COMPANIES WORK Buying and selling business

ONLINE BOOKSTORE A

Forward (upstream)

PUBLISHER/ONLINE BOOKSTORE A Publisher A buys Online bookstore A to improve brand presence and provide direct sales.

Vertical integration A publisher acquires two related businesses— a printer and an online bookstore—so that it can have greater control over production of its books and their route to market.

46 47

31%

of businesses worldwide planned to expand through a merger or acquisition in the three years from 2014 MERGER AND ACQUISITION TYPES

PUBLISHER A

Conglomerate Combining two companies with nothing in common: for example, in 1985, tobacco-producer Philip Morris purchased General Foods, a new line of business unconnected to legal wrangles around smoking.

Market extension Backward (downstream)

PUBLISHER/ PRINTER A Publisher A buys Printer A to improve print capacity and production costs and provide warehouse space.

Combining two companies that sell the same products but in different markets: for example, in 1996, the Union Paciﬁc Railroad Company acquired the Southern Paciﬁc Rail Corporation to link railroads in adjacent US regions.

Product extension

PRINTER A

Combining two companies that sell different but related products in the same market: for example, in 2014, Microsoft bought Nokia’s mobile-phone unit to address ﬂagging PC sales and its weakness in the mobile device market.

Management buy-ins and buy-outs A company’s ownership may undergo a change, which can be driven either externally, known as a management buy-in, or internally, known as a management buy-out. How it works In a management buy-in (MBI), a group of managers or investors from outside the company raises the funds to buy a majority stake in the company and then takes over its management. This type of action occurs when a company appears to be either undervalued or underperforming. In a typical management buy-out (MBO), the

company’s existing management team purchases all or part of the company they work for. Despite the name, MBOs are not restricted to managers, and they can include employees from any level of the organization who wish to make the transition from employee to owner.

NEED TO KNOW ❯ Earnout A percentage of the purchase price paid to the sellers after acquisition if the business has performed as expected ❯ Leveraged buy-out Acquisition of a company using equity and borrowed money, with company as collateral for loan

Buy-in Some companies, such as investment banks or venture capitalists, can make sizable proﬁts by purchasing undervalued businesses and transforming them. Company

+ An outside management team or investment group sees that a company is undervalued.

$ They raise funds to buy a majority shareholding.

–

Company

= They ﬁre and replace the previous management team.

They overhaul the business to improve performance and realize its true value.

HOW COMPANIES WORK Buying and selling business

BUY-IN MANAGEMENT BUY-OUT (BIMBO) In this type of transaction, the existing management of a company stages a buy-out, but additional external management is brought in by ﬁnancers to strengthen the company’s leadership and to provide expertise in particular areas that might be lacking in the original team. Company

Company

+ Existing management members buy company

= Outside management members brought in

New management team

48 49

$22.2 billion Europe’s biggest ever leveraged buy-out—of chemist chain Alliance Boots in 2007

Buy-out A buy-out allows a large company to sell off a part of the business it no longer wants or helps a small business owner to retire or move on. Company

Company

+ The management team sees an opportunity to take ownership when their corporate division is put up for sale.

They raise funds via bank loans, private investors, their own capital, or a loan from the seller.

Company

= They buy the business.

The management team—which now owns the company— streamlines the business to make it more proﬁtable.

Who’s who Determining a company’s hierarchy—including how many layers of power it has, and how many staff to appoint at each level—is one of the biggest challenges of modern management. In family-run businesses, positions are usually ﬁlled by family members who answer to the head of the family. The emergence of public companies has meant that company ownership is separated from management, so that shareholder interests are prioritized.

Who’s who in an organization Stakeholders and shareholders Stakeholders are anyone with a vested interest in the company. Shareholders are stakeholders who have bought stock in the company. See pp.60–63.

Board of directors

C-suite executives

The board of directors makes sure the company is run proﬁtably to provide returns to shareholders. The board votes in a chairman, who is sometimes also the chief executive ofﬁcer (CEO). See pp.52–55.

The top level operates the company day to day and sets strategy. All titles of top management begin with a “C” for chief. Senior managers are headed by the CEO. See pp.56–59.

HOW COMPANIES WORK Who’s who

46%

50 51

STRUCTURAL WHYS AND WHEREFORES

of UK employees believe what senior managers tell them about what is happening in their organization

Overtime pay Managerial staff who are not paid for overtime hold exempt positions. Non-exempt positions usually belong to non-managerial staff who are paid by the hour and qualify for overtime pay.

Who bosses whom When one manager has formal authority (decisionmaking power) over another, it is called vertical specialization. Horizontal specialization means several managers have equal authority.

Mid-level management

Junior management

Division and department heads are usually called directors or managers. Jobs at this level are often the ﬁrst to go when a company downsizes or restructures. See pp.56–59.

Supervisors, managers, or team leaders directly manage groups of employees carrying out speciﬁc tasks. Examples include a head nurse or foreman. See pp.56–59 and pp.74–75.

Non-management employees The lowest ranks of the organization: skilled and unskilled workers carry out core tasks needed for the company to operate. See pp.56–59 and pp.74–75.

Board of directors Public companies are required by law to appoint a board of directors to provide oversight.

Board of directors The board of directors of a publicly listed company sits between the company and its shareholders.

How it works All companies must have at least one director. If a company goes public and issues shares, it is legally required to have a board of directors. The board is made up of experienced business advisers who provide independent oversight of the company for shareholders and are mandated by law to govern the company responsibly. Board members may come from within the company or be independent outsiders, and should cover a range of expertise— such as legal, ﬁnancial and marketing— or have specialized industry knowledge. Networkers are also highly prized for their ability to build connections with inﬂuential ﬁgures in the corporate and governmental spheres. From within their ranks, the board elects a chairman, vice-chairman, secretary, and treasurer.

REPORTS TO

Secretary Appointed by The board

Responsible for ❯ Publicly representing the company’s policies and leading board meetings

Treasurer Appointed by EVALUATES

The board

Shareholders Any person or institution that has bought shares in a publicly listed company is a shareholder. The board works for the shareholders, who effectively own the company.

Responsible for ❯ Presenting yearly accounts ❯ Leading audit committee

HOW COMPANIES WORK Who’s who

52 53

The average company board in the US has

Chairman Appointed by The board

Responsible for

9.2

❯ Publicly representing the company’s policies ❯ Leading the board, conducting board meetings ❯ Determining the composition of the board ❯ Mentoring and monitoring the CEO or managing director (MD) ❯ Communicating with shareholders

directors

Company Responsible for day-to-day production, sales and marketing operations, and ﬁnance. The company reports to the board via its chief executive ofﬁcer (CEO), who executes the board’s decisions.

Vice-chairman Appointed by The board

Responsible for

Directors Appointed by

EVALUATES

CEO REPORTS TO

❯ Standing in for chairman ❯ Undertaking special projects for chairman ❯ Assisting chairman in balancing experience, personality, and age of directors on board

Appointed by The board

Responsible for ❯ Performance of the company ❯ Implementing board strategy ❯ Leading senior management ❯ Reporting back to chairman and board

The board

Responsible for ❯ Determining strategy ❯ Monitoring achievement of implemented policies ❯ Appointing managers ❯ Accounting for company’s activities to shareholders and other stakeholders

REPORTS TO

EVALUATES

Management Managers pass the CEO’s decisions down to employees.

BOARD OF DIRECTORS

Balancing the board The board has three clear areas of responsibility: developing business strategy, advising the company, and overseeing how the ﬁrm is run. Selecting the right mix of directors to fulﬁll these functions is crucial. Board members may come from inside or outside the company. Those who work for the company (executive or internal directors) have more expertise in running the business, but independent members (non-executive or external directors) are better placed to offer perspective, scrutinize the actions

of company executives, and call them to account. When potential conﬂicts of interest arise between management and shareholders, independent directors can weigh decision-making in favor of acting in the company’s best interests. The ideal balance is a hot topic in corporate governance. In US companies, CEO and chairman roles have traditionally been combined, but following a spate of corporate scandals, the roles are now more often vested in two individuals. In Europe, keeping the roles separate has long been seen as best practice.

NEED TO KNOW ❯ NEDs Non-executive directors, also known as independent, external, or outside directors ❯ Executive directors Board members who also work for the company—not to be confused with the term executive director when used as a title for the CEO ❯ Model Business Corporation Act Developed by the American Bar Association, this model is used as the basis for corporate governance in the US

Board structure variations Independent board of directors

CEO as chairman

The board sits between shareholders and company. The CEO is the main channel of communication between board and company, while the chairman is the principal conduit between shareholders and board. This structure gives the board most independence.

A setup in which the company’s CEO serves as the board’s chairman. While this offers less independent scrutiny of ﬁnances, strategy, performance, and pay, it avoids duplication of roles. This setup is found in US corporations and in many small- and medium-sized companies in other countries.

Shareholders

Board of directors

Chairman and CEO

CEO

Management and employees

Key

Shareholders

Management and employees

Chairman

Treasurer

Secretary

HOW COMPANIES WORK Who’s who

PROS AND CONS OF CEO AS CHAIRMAN Pros

Cons

❯ Strong, central leadership Decisions hold fewer conﬂicts. ❯ Efﬁciency CEO/chairman can implement board decisions swiftly. ❯ Expertise CEO has company and industry knowledge (a CEO may become chairman after retirement). ❯ Balance of power Established hierarchy between CEO/chairman and other directors reduces risk of conﬂict on the board.

❯ Lack of transparency Conﬂicts of interest/corruption are more likely. ❯ Reduced objectivity Board headed by CEO is unable to monitor CEO’s work objectively. ❯ Higher remuneration Combined role generally commands higher pay than two separate individuals. ❯ Mentoring Chairman who is also CEO cannot offer independent mentoring and support for the role.

54 55

44%

of S&P 500-listed companies had distinct CEO and chairman roles in 2012—up from 21% in 2001

Senior management as directors

Two-tier board

A structure in which senior managers also sit on the board. The chief ﬁnancial ofﬁcer (CFO) is appointed board treasurer and the chief operations ofﬁcer (COO) is vice-chairman. In some countries (Germany, for example), employees must be included on the board by law.

An arrangement that is made up of separate supervisory and executive boards. The supervisory board is composed of outside directors, led by a chairman. The executive board comprises senior managers, including the CEO. The two boards always meet separately.

Shareholders

Supervisory board

Board of directors

Chairman and CEO

Executive board

Treasurer and CFO

Vice-chairman and COO

Management and employees

Vice-chairman

CEO and board member

Employee and board member

Management and employees

Other directors

CEO

Management and employees

Company hierarchy Almost every organization has a structured arrangement of levels for members, from the board of directors at the top to junior employees at the bottom. There is a trend toward reducing the number of levels. How it works There are ﬁve levels in the conventional corporate structure with a line of authority from top to bottom. The chief executive ofﬁcer (CEO) is the highest-ranking person in the company, reporting to the board of directors and sometimes also sitting on the board. Reporting to the CEO are a number of highlevel executives, known as C-level

C-LEVEL VARIATIONS The range of C-level positions varies for each company. In addition to the three top posts, there may be: CAO Chief Administrative Ofﬁcer CIO Chief Information Ofﬁcer CTO Chief Technology Ofﬁcer CPO Chief Product/Production Ofﬁcer, responsible for overseeing product development and production CMO Chief Marketing Ofﬁcer, responsible for marketing strategy and business development C-level positions are evolving, adapting to market conditions and business priorities. New roles are emerging while some traditional roles are disappearing. The role of COO, for example, is less popular in modern organizations. Some of the new roles include: CPO Chief Privacy Ofﬁcer CSO Chief Sustainability Ofﬁcer CDO Chief Digital Ofﬁcer CKO Chief Knowledge Ofﬁcer CCO Chief Customer Ofﬁcer

executives—their job titles begin with a “C” and end with an “O.” Below the C-level is management, in tiers that differ from company to company, with employees forming the bottom level. As well as skilled and unskilled employees, there may be staff on ﬁxed-term contracts, taken on for the duration of a project or for a set length of time, and casual temporary workers.

51%

of CIOs and CTOs say they are pioneering new digital approaches within their business

C-suite executives These are the most senior jobs in the company, with the CEO at the top, the COO and CFO traditionally on the next level down, and other C-positions below that. In many companies, the C-level positions have equal authority and all report directly to the CEO.

Mid-level management Responsible for overseeing speciﬁc functions in the organization, the most senior managers at this level head up different departments or divisions. These managers are often called directors (not to be confused with the board of directors) or, in the US, vice-presidents. The exact job titles, and the number of midlevel managers, vary depending on the company.

Junior management and other employees Team leaders, such as supervisors and assistant managers, implement management plans. They also coordinate teams of skilled and unskilled workers in, for example, production, customer service, and sales to carry out the core tasks needed for the company to function efﬁciently and proﬁtably.

HOW COMPANIES WORK Who’s who

CHIEF OPERATING OFFICER (COO) Responsible for day-to-day operations; reports to CEO and acts as second in command

15%

CHIEF EXECUTIVE OFFICER (CEO) Decides on corporate policy and strategy

CHIEF FINANCIAL OFFICER (CFO) Manages company’s ﬁnancial risk; reports to CEO

the average salary rise for a C-level executive reporting to the CEO, in the US between 1986 and 2006

FINANCE MANAGER Puts CFO’s plans or directions into action, instructing junior managers

MARKETING MANAGER Directs marketing department day to day

OPERATIONS MANAGER Oversees operations division; may also direct production department

R AND D MANAGER Heads up research and development (R and D) of new products

SUPERVISORS AND TEAM LEADERS

NON-MANAGEMENT EMPLOYEES

56 57

COMPANY HIERARCHY

Flattening hierarchies The trend in management over the past few decades has been to eliminate layers from company hierarchies, which means they are becoming ﬂatter—in other words, there are not as many levels to go through in order to reach the top. One example is the role of chief operating ofﬁcer (COO), which has been disappearing in recent years. Between 2000 and 2012, there was a 10 percent decline in the number of Fortune 500 (an annual list of the top US corporations compiled by Fortune magazine) companies with COOs. Only 38 percent of the

500 have a COO position now. CEOs have also eliminated layers of middle management, and in the US there was a 300 percent increase between 1986 and 2003 in the number of division heads reporting directly to the CEO. Sometimes companies decide restructure the other way round instead —from ﬂat to tall—by eliminating a number of senior management posts and replacing them with a greater number of junior supervisory roles.

NEED TO KNOW ❯ Span of control Number of employees reporting to a manager or other senior level; the greater the span of control, the more workers reporting to an individual above ❯ Line position Job role with responsibility for achieving the goals of the organization ❯ Staff position Job role providing expertise to assist someone in a line position

Tall vs. ﬂat hierarchies There are pros and cons for both types of hierarchy, and each company has to ﬁnd the number of levels, and positions within each level, that suits the nature of its CEO business.

Supervisors and team leaders

Non-management employees

The traditional model is suitable for a formal chain of command as, for example, in the army. ❯ Several layers from top to bottom ❯ Fewer employees reporting to each manager; close supervision possible ❯ More room for career advancement because there are many levels to rise through

D AN MM CO OF AIN CH

Mid-level management

Tall hierarchy

HOW COMPANIES WORK Who’s who

CASE STUDY Restructuring the big three US car manufacturers The economic crisis of 2008 caused the big three American car-making companies—General Motors (GM), Ford, and Chrysler—to rethink their corporate structures. Market share had fallen and the three companies needed to shed employees and ﬁnd ways to cut production. All three took similar action to reorganize the company hierarchy, removing some managerial roles from the mid-management level and installing more team leaders

at a lower level in the organization to create a ﬂatter, less top-heavy company hierarchy. ❯ Before restructuring Thirty technicians reported to one production supervisor. ❯ After restructuring Seventy-ﬁve technicians now reported to one production supervisor, through 18 newly created team leader positions.

58 59

25%

the decline in the levels of hierarchy between division heads and CEOs in the US, from 1986 to 2003

Flat hierarchy This looser model is more ﬂexible and suitable for companies that foster creativity. ❯ Only a few layers so mid- and low-level management are merged ❯ Large number of employees reporting to each manager; close supervision not possible ❯ More freedom for employees to make their own decisions CEO

CH AI NO FC OM M Supervisors and team leaders

AN D

Non-management employees

Stakeholders A stakeholder is anyone who is affected by the performance of the company, while shareholders own one or more shares in a company, which makes each of them a part-owner of the company. How it works Because shareholders part-own the company, they have the right to vote on how it is managed and to receive a share of its proﬁts. All shareholders are stakeholders, since the performance of the company has a direct impact on the value of the shares they own: when the company does well, the share value rises, and when it performs badly, the share value falls.

However, stakeholders can also be non-shareholders— individuals or groups who have an interest in what the company does or whose ﬁnancial situation depends on the company. Some stakeholder groups are interested in a company mainly for its ethical treatment of workers, sustainable approach to the environment, and attitude to society. These are known as environmental, social, and governance (ESG) criteria.

Stakeholders’ areas of interest A few stakeholder groups are concerned only with environmental, social, and governance (ESG) factors, while others, such as shareholders and suppliers, may be more interested in the company’s ﬁnancial performance. Most stakeholder groups have at least some interest in both areas, especially since negative publicity for a company can cause share prices to fall.

Stakeholders with ESG concerns Stakeholders have no direct involvement, but believe that companies have a responsibility to the communities they operate in, to respect the environment, human rights, and animal welfare.

$892 million

the average drop in market value triggered by negative news about a company’s human rights record

Nongovernmental organizations ❯ Contribution to enviromental and social causes ❯ Legal compliance

Community ❯ Impact on local inhabitants ❯ Concern for broader social welfare

HOW COMPANIES WORK Who’s who

$ Stakeholders with economic and ESG concerns Stakeholders use ESG—a recognized part of policy and reporting for most companies—to evaluate corporate behavior and to determine future ﬁnancial performance. Concerns range from $ proﬁts to ethics.

60 61

Government

Shareholders

Customers

❯ Tax payments ❯ Legal compliance

❯ Ability to pay dividend ❯ Increase in share value

❯ Quality product ❯ Good value ❯ Customer service

$ $

$ Trade unions

Suppliers

Employees

Lenders

❯ Treatment of workers ❯ Fair pay, beneﬁts, and working conditions

❯ Ability to pay debt ❯ Enough liquidity

❯ Pay and beneﬁts ❯ Longevity of the company ❯ Employment prospects

❯ Ability to repay loans ❯ Integrity of management ❯ Financial strengths of the company

STAKEHOLDERS

Stakeholders in action Compared with other stakeholders, shareholders have the most interest in the ﬁnancial performance of a company. They are also forced to take an interest in how seriously the company takes its corporate

social responsibility (CSR), whether or not they are socially and environmentally conscious themselves. Several high-proﬁle cases have shown how stakeholder reaction has caused a signiﬁcant decline in share prices. By using

social media, stakeholders can generate a storm of public disapproval, leading to angry consumers and nervous investors.

$60

How stakeholders affect share value In April 2010, an offshore oil rig owned by British Petroleum (BP) exploded in the Gulf of Mexico. BP attempted to alleviate stakeholder concerns, but stakeholders responded negatively, starting their own social media campaigns to shame the company. Sixty-six days after the oil spill, BP’s share value on the New York Stock Exchange had dropped by 52 percent.

$30 $0 BP shares trading at

$60.57

on April 20, 2010

News breaks that spill is worse than BP claims.

Stakeholder social media campaign intensiﬁes.

News media report on the stakeholder backlash.

$60 Bill

$69

$30

BILLION

$0 US government criticizes BP and sends company a $69 billion bill for cleanup.

Obama administration advises it could take legal action to stop BP paying from dividends to shareholders.

Share price drops 7 percent in London trading.

HOW COMPANIES WORK Who’s who

75%

62 63

the increase in the number of publicly traded companies* reporting on ESG * in the Bloomberg database for the period 2008–2011

BANG! BANG!

# Oil rig explodes, killing 11 employees and spewing millions of gallons of oil into the Gulf of Mexico.

BP starts social media campaign on Twitter— initially to minimize the impact of the spill.

News media report on the event.

Stakeholders of the BP oil spill ❯ Inhabitants along the affected coastline ❯ Local ﬁshermen ❯ Oil spill cleanup workers ❯ Environmental activists ❯ BP employees

❯ BP shareholders ❯ Gasoline buyers ❯ Tourists and tourist businesses ❯ Media ❯ Government ❯ General public

Stakeholders use social media to voice anger and concern over perceived lack of responsibility by BP. Conservationists warn of wildlife devastation. Celebrities offer to help in the cleanup. Stakeholders call for more disclosure from BP.

$60

$30 $0

Five of BP’s top 10 shareholders sell off stock.

By June 25, BP’s share price has dropped by more than half; over 34 billion shares have been bought and sold.

BP shares trading at

$23.91

on June 25, 2010

Business cultures Every organization has a particular workplace environment, consciously or unconsciously shaped by the personalities, values, and behavior of the people leading it and working in it. How it works The organizational culture of every business is different, reﬂecting the ethos of the company, its workplace habits, and the image the company projects. It is also tied to the type of work that has to be done. In a high-stakes ﬁnancial trading company, the pace and pressure of the work makes the

atmosphere of the corporate environment crackle, whereas in a company relying on creativity for its products, the mood is likely to be more relaxed. The type of incentives offered to management and employees may also affect the workplace, resulting in either a competitive or a collaborative culture, or a mix of both.

NEED TO KNOW ❯ Control systems Used by managers to set standards and measure performance ❯ Leverage Power to inﬂuence a person or situation ❯ Paradigm Value system of goals, mission, and beliefs

Types of corporate cultures Management experts have tried to explain how organizational cultures work. Charles Handy, a former professor at the London Business School, describes them in terms of four major types: power, task, role, and person.

Role culture

Power culture

Where a company is based on the structural support of specialized roles. Each role is crucial and will persist even if the person occupying it leaves. Procedures and systems are strictly followed, as in a government department.

Driven by a powerful individual at the center of the organization, who is relied on for decision-making and the company’s successes. Those closest to the center have most inﬂuence. Typical of a family-owned business.

SYSTEMS

RULES

PROCEDURES

JOB DESCRIPTIONS

DECISIONS MADE

bureaucratic / controlling

POWER

HOW COMPANIES WORK Who’s who

86%

WHAT SHAPES CORPORATE CULTURE? Many factors reinforce a culture. To bring about change, the workforce needs to be inspired by different motivations, values, and types of role models. Organization size Big business, or small company

Leaders Their personality and behavior

Company structure Strict hierarchy, or power shared among many people

Symbols Titles, dress codes, interior aesthetic

Founding values Includes origination myths and stories

Control systems Rewards, incentives, performance assessment

64 65

of senior managers in global organizations agree that organizational culture is critical to success

Person culture

Project-oriented work where a project’s completion is the motivating force. Relies on teamwork and individuals’ expertise, but results are more important than personal objectives. Found in technology companies, for example.

Company power and inﬂuence is shared among individuals who work semi-autonomously. Individuals count for more than the company, which is made up of people with similar specialist training, such as in an architects’ practice.

Task culture

NE RT

IP RSH

TASK

entrepreneurial / flexible

Corporate structure A company’s structure—the way in which it is organized—can have a major impact on the way it performs. There are several models of corporate structure typically used in the business world, and they continue to evolve. The ﬁrst consideration is whether power should be centralized at the top, with decisionmaking in the hands of a few key senior employees, or decentralized, with more power in the hands of staff, and with fewer people to go through for approval.

Choosing a structure Most start-ups have a centralized structure. More complex structures either evolve or are designed as the company grows, depending on the nature and size of the business, the complexity of the work, any requirement for instant expertise, and the geographical location of parts of the business.

Centralized

Functional

Divisional

Matrix

Power rests in the hands of a few people, with a long chain of command. ❯ Power at the top ❯ Rigid ❯ Conventional ❯ Inﬂexible ❯ Slow response to change

Good for strict control and formal relationships, as in the military. See pp.68–69.

Suits companies with many global ofﬁces or product lines. See pp.70–71.

Good for large corporations with complex projects in different locations. See pp.76–77.

CEO COORDINATES

CEO COORDINATES AND EACH DIVISION RESPONSIBLE FOR GENERATING PROFIT

DIVISIONAL AND FUNCTIONAL MANAGERS COORDINATE

HOW COMPANIES WORK Corporate structure

78%

of groups reach solutions to simple tasks faster in centralized structures

100%

of groups reach solutions to complex tasks faster in decentralized structures

66 67

WARNING When change is needed Signs that a structure is not working include low morale and high staff turnover, no new products being developed, and proﬁt suddenly accelerating or decelerating. Tools to amend poor structure include: ❯ Business process reengineering (BPR) Analyzing and redesigning the workﬂow within a company. ❯ Altering the reporting line In a traditional solid-line reporting relationship, one line manager oversees goals and performance. It can be beneﬁcial to switch to the weaker chain of a dotted-line reporting relationship, in which a manager sets some but not all the objectives.

Network

Team-based

Decentralized

Suits creative and technology companies in which everyone is online. See pp.72–73.

For companies that rely on innovation and are customer focused. See pp.74–75.

Power is spread through the company, and staff make their own decisions. ❯ Power shared ❯ Organic ❯ Experimental ❯ Flexible ❯ Fast response to change

CORE COMPANY COLLABORATES WITH VIRTUAL COMMUNITY

STAFF SELFCOORDINATE

Functional structure The classic way to organize a company is by dividing it into departments that reﬂect the main functions of the business, each headed by a director or manager. How it works The chain of command is straightforward. The business typically consists of a chief executive ofﬁcer (CEO) or president at the top, with the various specialist departments or divisions, such as marketing and ﬁnance, aligned below. Each department operates as an independent unit, with its own budget, and reports directly to the CEO, who takes responsibility for the operation of all the departments. A functional structure is the most common type of organization.

Typical departmental hierarchy The departments operate independently, with the managers reporting to the CEO or president, who has overall command. The sales and marketing department usually takes responsibility for managing product lines.

WARNING Dangers of silo mentality Silo mentality describes a scenario in which each department has a different, closed view of its role within the overall scheme and information does not get shared.

2 for 1

1 Sales and marketing decides to launch a special online two-for-one offer.

2 Finance is not briefed and processes the order for one item only.

Production/ operations manager

Research and development manager

Finance manager

Deciding what to sell

3 Operations is not briefed and sends customers one item instead of two.

4 Customer services is not briefed and is unprepared for calls from angry shoppers.

The marketing department is closest to the market and is best able to analyze which product lines may do well. The sales and marketing manager can suggest what new products the company could make.

PRODUCT A

HOW COMPANIES WORK Corporate structure

41% CEO

of UK companies say the structure of their organization is a barrier to improving customer experience

68 69

FUNCTIONAL: PROS AND CONS Pros ❯ Allows for the development of specialization and expertise ❯ Enables efﬁcient use of resources and potential economies of scale ❯ Offers obvious career path for employees in each department ❯ Simple, efﬁcient structure for manufacturers producing a limited range of goods for sale

Cons ❯ Formal lines of communication; stiﬂes innovation and creativity ❯ Departments fail to coordinate efﬁciently with one another ❯ Response time on problems and queries between different departments slow ❯ Many decisions referred up to the top, creating a backlog

Sales and marketing manager

PRODUCT B

Information technology manager

PRODUCT C

Human resources manager

Customer services manager

PRODUCT D

NEED TO KNOW ❯ Line relationship Chain of command down the structure ❯ Reporting structure Who reports to whom ❯ Silo Pejorative term for a department that works in isolation: a vertical, closed structure like a grain silo

Divisional structure Some companies arrange their staff into divisions devoted to a speciﬁc product or market. Each division is a self-sufﬁcient team employing the personnel for the various functions within it. How it works Under the overall control of a CEO or president, several divisions work alongside one another to design, research, produce, and sell a particular product, or to service a speciﬁc market. Each division runs its own specialized functions, such as operations and production, sales and marketing, and ﬁnance. A company may arrange its divisions according to the types of product it makes, the regions in which it operates, or the customers to whom it sells. Large companies may adopt hybrid structures—by product and geography, for example.

DIVISIONAL: PROS AND CONS Pros ❯ If one division fails, there is no threat to the rest of the business ❯ Can respond quickly to changes in the market ❯ Focused on customer needs ❯ Performance of each division clearly measurable

Division by geography For businesses with products that need to be adapted to local markets, an organization can be structured according to each of the regional markets it serves. These may be domestic or international. Print technology and services company Xerox has successfully adopted this structure (see case study, right).

North America The company’s main market

Division by product Businesses selling different types of products may pick a structure by which each division handles one category. Fast-food chain McDonald’s has been organized by product division.

CEO

Cons ❯ Duplicating resources—for example, each division employing ﬁnance personnel ❯ Lack of expertise-sharing between divisions ❯ Career path for staff restricted ❯ Heightened sense of competition among divisions

FAST-FOOD PRODUCTS

RESTAURANT SUPPLIES

Burgers and fries

Tableware

BEVERAGES

Unbranded drinks mixes

HOW COMPANIES WORK Corporate structure

70 71

CASE STUDY

CEO

Europe The second-largest region for sales

Developing markets All other markets

Global services

Printer technology and services company Xerox has restructured several times to align the business with the main markets that buy its products. In 1992, Xerox’s highproﬁle change from a functional to a new divisional structure, with nine self-contained divisions each serving a particular customer type, hit the headlines. This also allowed the company to focus on its core business—digital publishing, color copying, and printing. Dividing the company by market location is another strategy Xerox has used successfully. In 2006, each division was organized once again, geographically, to ensure that those making the decisions were closest to the customers in each market.

Additional division consulting across regions

Division by customer type Businesses with distinct customer markets may be organized by customer division. For example, the ﬁnancial institution Bank of America Merrill Lynch caters to individuals, small businesses, and corporate and institutional clients.

CEO

CONSUMER

BUSINESS

INSTITUTIONAL

Typically the original market

Products adapted or favorably priced

Large-scale provision to a single client

the increase in Xerox’s share value when it announced its move from a functional to a divisional structure in 1992

Matrix structure Unlike a conventional company hierarchy organized either by function or division, a matrix combines the two approaches so that staff work in both functional and divisional units, and report to two bosses. How it works A business that uses a matrix setup often begins with the more traditional functional structure. As the business develops, it may make sense to overlay a divisional structure to meet changes in business conditions—for example, if a company is managing several large projects for a client or expands globally and is selling its products in several regions. A matrix grid may start out as temporary—perhaps formed to manage short-term projects—and become permanent. The two chains of command in a matrix create the grid. Staff report along a vertical line to a functional manager, such as the marketing director, and along a horizontal line to the project manager of a speciﬁc business line, brand, project, or region.

FOUR BIG MATRIX ORGANIZATIONS Each of the following companies has been cited as a model of success for making the matrix structure work: ❯ Procter & Gamble (P&G) To help it innovate and respond faster to the market, the consumer-product company is segmented into baby and family care, global beauty, health and grooming, and global fabric and home care. ❯ IBM Because it needs to control many global processes, the matrix at the technology and consulting corporation is structured vertically by divisions such as sales and distribution, ﬁnance and marketing, and software, and horizontally by country and region. ❯ Cisco In 2001, the IT company reorganized to enable committees to make decisions across several different functions and divisions. The idea was to stimulate ideas throughout the organization and quickly implement solutions to problems. ❯ Starbucks The coffee-shop chain is arranged by product on one axis of the matrix and business function on the other to ensure that quality and innovation meet customers’ expectations and anticipate their desires.

Matrix structure In this case study, an oil-exploration and production company has several oilreﬁning projects to manage. The matrix guardian oversees the matrix and makes sure it works efﬁciently.

Engineering director

Matrix guardian

Project manager

Drilling team

Arctic drilling

Project manager

Oil-extraction team

Malaysia oil wells

Project manager New Zealand natural gas ﬁelds

Liqueﬁed natural gas team

HOW COMPANIES WORK Corporate structure

72 73

90%

CEO

of FTSE 50 companies had adopted a matrix structure by 2013 Operations director

Marketing director

Financial director

Undersea production team

Marketing team

Finance team

NEED TO KNOW ❯ Project management professional (PMP®) Qualiﬁcation for project managers offered by global Project Management Institute ❯ Matrix guardian Senior professional appointed to oversee the matrix and make sure it works efﬁciently ❯ Mature matrix Matrix structure in which functional and divisional bosses have equal power

MATRIX: PROS AND CONS Site-supervision team

Sales team

Finance team

Pros ❯ Faster decision-making ❯ Potential for improved productivity ❯ Flexible use of staff

Cons

Line operations team

Marketing and PR team

Finance team

❯ Expensive to set up and run ❯ Possible confusion as to the reporting line ❯ More potential for interpersonal conﬂict as team goals may conﬂict

Network structure Also called a virtual organization or virtual corporation, a network structure is centered around a streamlined company, with digital connections linking it to external, independent businesses. How it works The company at the center of the structure is stripped back to basic functions that are essential to the type of business being operated—research and development, for example, in the case of a technology company. All other functions are outsourced to external specialists.

NEED TO KNOW ❯ Agile business Buzzword to describe a networked organization; the opposite of a traditional bureaucracy ❯ Decentralized Organization with a wide span of control and often an upward ﬂow of ideas

The various parties can be scattered around the globe and are connected by the internet. Together, they provide all the services needed for the network to function as one entity. This type of business structure is based on the idea of the social media network, and so is known as a network enterprise.

Network structure in practice Network Screen is a small ﬁlm production company based in Los Angeles, CA, operating from a studio space with two employees—a producer and an assistant. For each project, the producer connects with outsourced talent around the world and everyone collaborates to create the ﬁnished ﬁlm. The producer contracts and pays these external suppliers.

VARIATION: MODULAR STRUCTURE In a business with a modular structure, parts of a single product are outsourced (it is functions or processes, not products, that are outsourced in a network structure). A modular structure is especially suitable for organizations producing appliances, computers, cars, and mechanical consumer goods. Toyota is an example of a company with a modular structure, managing hundreds of external suppliers to produce its ﬁnished vehicles.

Pros

Cons

❯ Potential for round-the-clock work because of global locations ❯ Can source the best expertise wherever it is in the world ❯ Low overheads because there are minimal staff in the core company ❯ Flexible and highly creative environment

❯ Extreme reliance on technology— network errors can stop effective performance of the business ❯ Potential for misunderstandings because there is little face-to-face communication ❯ Difﬁcult to ﬁnd common time across time zones for virtual meetings

27%

of networked organizations report higher proﬁt margins than their competitors

HOW COMPANIES WORK Corporate structure

74 75

Post-production effects in Copenhagen, Denmark

+ X

$ $

rk Scr o e tw Film production company, Los Angeles, CA

Cinematographer in London, UK

Film editing in Osaka, Japan

Accounting and ﬁnance in Boston, MA

Location scout in Istanbul, Turkey

Set design in Sydney, Australia

Team-based structure As its name implies, a team-based organization (TBO) is made up entirely of teams. Managers and staff from different departments join to form teams handling speciﬁc projects, in the short or long term. How it works In a TBO, teams reach decisions through brainstorming and mutual agreement among team members, rather than a senior management member issuing orders from the top down the chain of command as in a traditional organizational structure. Communication is less formal in TBOs, often carried out on social media such as blogs and forums and using software for networking such as Groupware.

One step beyond the team-based structure is a holacracy (see box, right), an unconventional type of organization in which there are no managers, and even the CEO relinquishes power, allowing employees to self-govern through regular committee meetings, which they organize themselves.

NEED TO KNOW ❯ Cascading Successful passing of information or objectives down through the workforce ❯ Lateral structure Decentralized structure in which departments work to a common goal ❯ Flat lattice Structure with no chains of command, in which workers choose to follow leaders

Team-based hierarchy While TBOs still have a CEO, little other hierarchy exists. Team leaders are part of the team rather than in a chain of command. At its best, a teambased model fosters a culture of trust, so individuals take pride in their work and responsibility for carrying out tasks well and on time and budget.

Team leader

CEO

Team leader

Team A

Team B

HOW COMPANIES WORK Corporate structure

HOLACRACY—BREAKING BOUNDARIES Staff are grouped into teams that set their own roles and goals and choose their own leaders. The idea is that if power and responsibility are shared, employees will give their very best. In 2014, the Las Vegas–based online clothing retailer Zappos adopted the model for its 1,500 staff. Holacracy is a trademarked term used by the company that invented this speciﬁc management system. It follows the same principle as a ﬂat lattice, but takes the idea one step further by presenting a comprehensive management structure with clear processes for internal operations and governance.

TRADITIONAL HIERARCHY

Decisions handed down from top

HOLACRACY—A STRUCTURE OF SELF-MANAGED TEAMS

Decisionmaking by committee

76 77

200– 300%

the productivity increase at US sausage-maker Johnsonville Foods, from 1982 to 1990, by moving to a teambased structure TEAM-BASED: PROS AND CONS Pros ❯ Quick decision-making and rapid response to problems and challenges ❯ Reduced overheads because there is no heavy management structure ❯ Open communication because there is no fear of management reaction

Team leader

Team C

Cons

❯ If staff lack expertise, decisions may be ﬂawed ❯ Limited sharing between teams may affect business performance ❯ Decisions by consensus harder to reach

Human resources The human resources (HR) department is responsible for all policies and processes relating to the people employed by a business. To help the business achieve its goals, HR has to make sure that it employs the right people with the right skills, treats them consistently and fairly, and has a supporting framework to drive and deliver the required level of performance.

Business goals

HR framework The starting point for any decision in an organization is its business goals. HR supports the delivery of these goals by ensuring that there is a stafﬁng strategy to support the business plan. Typically, an HR framework sets out a people strategy including the competencies of the people who best suit the organization. This is then implemented in a range of areas, from recruitment and selection to learning and development. HR professionals work closely with business leaders and line managers to design and implement HR systems that back up strategic business goals.

Business goals are the driver for every business decision, and HR polices support them.

SELECTION AND RETENTION See pp.82–83.

SUCCESSION AND TALENT PLANNING See pp.82–83.

Values and culture Organization design

PERFORMANCE MANAGEMENT See pp.84–85.

HR helps to determine principles, conduct, and how tasks are done in a business.

HR formulates the structure and formal reporting relationships that deﬁne a company’s shape.

People and performance

HR is responsible for employees’ welfare and their contribution to business goals.

LEARNING AND DEVELOPMENT See pp.82–83.

HOW COMPANIES WORK Human resources

3.2 billion

people were in recorded employment globally in 2014

REWARDS AND BENEFITS See pp.86–87.

EMPLOYEE ENGAGEMENT See pp.92–93.

78 79

ESSENTIAL PEOPLE SKILLS As well as recruiting effectively and ensuring that employees deliver, HR plays a role in nurturing essential people skills across the organization.

Relating to others ❯ Some people are natural leaders, but most leaders can beneﬁt from objective thinking about the leadership strategy they wish to follow. See pp.88–89. ❯ Even in ﬂattened, team-based hierarchies, team leaders need to develop leadership skills to guide and support their teams. See pp.90–91. ❯ Despite the revolution in technology, people remain vital to organizations, as skills and knowledge are central to success. As a result, HR has an expanding role. One example is Google, which calls its HR function People Operations (POPS) and treats its staff as a valuable asset, offering a range of attractive perks to “ﬁnd them, grow them, and keep them.” See pp.92–93.

Managing projects ❯ Project management is an essential skill for managers at all levels, whether they are running regular day-to-day activities or special projects. See pp.94–95.

Negotiating ❯ The ability to negotiate successfully is an essential skill. Awareness of strategies and styles is key to success. See pp.96–97.

The human resources cycle From the moment a company starts the process of recruiting an employee to the time that person leaves the company, the individual is in a cycle that is managed by the human resources (HR) department. How it works People are a signiﬁcant cost to any organization—and of great value. Many CEOs talk about staff as their most important asset, and US industrialist Henry Ford famously said: “You can take my factories, burn up my buildings, but give me my people and I’ll build the

NEED TO KNOW

business right back again.” The HR department is there to ensure that the right people are in the right roles so that the company can deliver the business strategy and maintain its competitive edge. The complexity of the business inﬂuences the stages in the HR cycle, but the basic elements are the same.

National employment laws Employment practice is regulated by a raft of laws— for example, in the US federal Equal Employment Opportunity laws prohibit any discrimination on the grounds of sex, race, disability, age, sexual orientation, or religion at any stage of the employment cycle.

A business identiﬁes the need to ﬁll a role, and attracts applicants. CVs are assessed and interviews held to ﬁnd the best candidate.

Recruit

Contract

Employ

Once terms are agreed and a contract signed, the candidate becomes the company’s employee.

“Hire people smarter than you and get out of their way.” Howard Schultz

HOW COMPANIES WORK Human resources

80 81

$ Reward

An induction program explains the new role and introduces the team. HR gives a brieﬁng on pay, tax, and beneﬁts such as leave, insurance, and pensions.

The company sets targets and helps individuals to improve performance so they contribute to business results and get the most out of their job.

Develop

The company helps its employee to move into a new role, which may be in another business it owns…

Manage performance

The business has processes to help people improve their skills, competencies, and knowledge, through formal or informal learning, both on and off the job.

Transition

Exit

…or to leave the company, which may be through resignation, redundancy, or retirement.

Recruitment and selection Placing the right person in the right job is vital for the success of the organization—this is the process of recruitment and selection. Technology is changing traditional hiring pathways. How it works The human resources function manages the process. Increasingly, line managers are involved as well because the tools are often accessible via company intranet. Recruitment starts with the company identifying a vacancy— the need for someone to do a job, and pulling together information about the exact nature of the role. Aspects to consider include the job’s purpose, tasks required, and the outputs or deliverables of the job holder, as well as how the role

94%

of recruiters in the US used, or planned to use, social media for recruiting in 2013

ﬁts into the organization’s structure. This information forms the basis of a job description and person speciﬁcation. The search can then begin. The company’s own website, recruitment agencies, commercial job boards, and advertisements in the press are traditional ways of attracting the attention of people outside the organization. Internetbased routes are now common too. Today, application forms are often directly submitted online, triggering automatic responses and sorting of candidate details.

STAYING PUT People tend to stay in a job during a recession. Nine million workers were hired in the second quarter of 2009 (mid-recession) in the US, down from 12.8 million in the last quarter of 2007 (pre-recession), a fall of about 30 percent. According to the Bureau of Labor Statistics, 80 percent of this decline came from a fall in “churn”, when workers in developed economies change jobs, rather than a dip in job creation.

Job description and person speciﬁcation Clear written statement of the role, including job title, purpose, duties, responsibilities, scope, and reporting structure, as well as competencies and qualities required. It is used in the recruitment process to provide a clear guide for both applicants and interviewers.

Person speciﬁcation Summarizes the necessary or desired criteria for candidate selection, including required skills and/or competencies for the role, experience, and educational qualiﬁcations.

HOW COMPANIES WORK Human resources

82 83

Personal recommendation

Internal search Looking at internal resources ﬁrst creates opportunities for career development and progression, improving employee engagement and retention.

Some companies encourage existing employees to introduce friends as candidates.

External search Increasingly, companies and candidates use professional networking sites such as LinkedIn and social media such as Facebook or Twitter. External candidates diversify the workforce but cost more to attract.

NEED TO KNOW

Applications The curriculum vitae (CV) or résumé is the essential document, often with a cover letter. Companies may use an application form instead.

❯ Psychometric tests Often used as an initial screening method, these aim to assess attributes such as intelligence, aptitude, and type of personality, using verbal and non-verbal reasoning tests and behavior questionnaires.

CONTRACT Selection

Appointment

After HR has drawn up a shortlist, candidates are assessed by individual faceto-face interviews, group assesssment, and psychometric testing.

Companies may ask for references and/or request a medical examination for the chosen candidate. The employment offer is a legally binding contract that sets out the terms and conditions of the job.

Evaluating staff For a business to achieve its goals, it needs to have a process that measures the contribution and performance of each individual against those goals.

How it works The way in which tasks are done is becoming as important as what tasks are done, as organizations recognize the importance of creating the right culture to enable workers’ performance. For any company, effective evaluation of the performance of employees should be strategic and is aimed at ensuring the maximum productivity of individuals, teams, and the organization as a whole.

Individual goals Set personal goals to align with business strategy

❯ Business goals drive tasks and activity. ❯ Culture enables teams and individuals to deliver. ❯ HR policies give clear benchmarks.

Traditional performancemanagement cycle Performance management is an ongoing, continuous process. Some companies are now moving away from traditional performance management to “crowdsourcing” as a way for managers to collect, evaluate, and share information on employee performance. WINNER!

A WIN-WIN SITUATION Evaluating performance is good for both the business and the individual.

Business ❯ Aligns individual goals with company goals. ❯ Offers consistent approach, with benchmarks. ❯ Continuously enables improvement. ❯ Fosters the right behaviors and relationships.

Individual ❯ Understands what is expected of them. ❯ Has the skills to deliver on these expectations. ❯ Is supported to ﬁll any gaps in capability. ❯ Is given feedback and allowed to discuss goals.

Rewards Promotions and pay raises in line with performance

HOW COMPANIES WORK Human resources

84 85

NEED TO KNOW

❯ Balanced scorecard Framework to measure performance against strategic goals, devised by Kaplan and Norton ❯ Competencies Deﬁned behaviors and attributes that individuals must have to perform effectively at work ❯ Performance appraisal Process via which individual employee and their manager can discuss performance and development

Discussion Ongoing communication on standards of work and behavior to improve working relationships

360-degree feedback

Coaching Feedback on performance to help individuals work efﬁciently

Gives a rounded picture with better information about working relationships

Customer

Appraisal Formal feedback from the line manager, with an opportunity for individuals to contribute

Direct reports

Manager

INPUT FROM COLLEAGUES

Colleagues

Motivation and rewards People work for money, but they are also motivated by other factors such as doing a good job and being valued. Non-ﬁnancial rewards drive day-to-day motivation more strongly than pay and beneﬁts. How it works In the past, tangible pay and beneﬁts were the key motivational tools for employees. These ﬁnancial rewards are termed extrinsic because they are

external to the actual work and others control the amount, distribution, and timing. Employers now recognize that while extrinsic incentives are clearly important, intrinsic (psychological) rewards are crucial.

Understanding motivation in the workplace Happy staff work well, and job satisfaction comes from subtle feel-good factors as much as a paycheck. Employees who enjoy their work tend to stay—job satisfaction and turnover move in opposite directions.

Extrinsic Policies implemented by the company:

Financial rewards ❯ Base pay ❯ Bonus ❯ Incentives

Beneﬁts ❯ Pension contributions ❯ Paid holidays/vacation ❯ Health care

Individual motivation Employees get psychological beneﬁts from doing meaningful work and performing it well. Only one in eight workers—about 180 million employees in 142 countries studied— are committed to their jobs and make a positive contribution to their organization.

HOW COMPANIES WORK Human resources

MOTIVATION EXTRINSIC You are told to do something.

the percentage of employees who are fully committed to their jobs

WHY PEOPLE DO TASKS

Only this creates positive motivation

Do this task and get a bonus. Do this task or get in trouble.

I want to do this task to make a difference. I don’t want to do this task – it is pointless.

INTRINSIC You choose to do something.

13%

86 87

DEMOTIVATION

Fostering intrinsic rewards Businesses that are successful engender trust and have employees who are passionate about what they do. All these factors contribute:

Intrinsic Feelings that an individual has: ❯ Purpose A sense of

being able to accomplish something of value ❯ Choice Clear ownership and feeling responsible for outcome ❯ Progress As an individual,

feeling and seeing evidence of moving things forward ❯ Competence Pride and satisfaction in own work

Purpose for organization and individual ❯ Clear vision for organization ❯ Understanding of where individual ﬁts in to achieve that purpose ❯ Clear goals and expectations for individual

Recognition ❯ Continuous feedback ❯ Ongoing engagement ❯ Non-cash rewards such as praise

Career development ❯ Progression and promotion ❯ Mentoring and coaching ❯ Learning opportunities

Culture ❯ Strong teamwork and consistent behaviors ❯ Open communication ❯ Sharing of knowledge and information

INCREASING MOTIVATION

Leadership strategy and styles Top-down leadership, in which managers give orders, is not always the best way to get results. A number of different leadership styles have been identiﬁed by business experts. How it works Every leader is an individual with his or her own approach. However, over the years, management gurus have identiﬁed key leadership styles that can be used to achieve different results, depending on the environment. Many frameworks are based on the ideas of psychologist Kurt Lewin, who developed his theories in the 1930s with three major styles: autocratic, democratic, and laissez-faire (non-interference).

In 2007, for example, business authors Eric Flamholtz and Yvonne Randle developed a leadership matrix based on Lewin’s theories, which shows the best style to use in any given situation, ranging from autocratic (one all-powerful leader) to consensus (decisions reached by general agreement. Truly inspirational leaders encourage people to believe in themselves so that they achieve results beyond even their own expectations.

“Outstanding leaders go out of their way to boost the selfesteem of their personnel.” Sam Walton

TRANSFORMATIONAL LEADERSHIP While different styles can suit different situations, transformational leadership, in which leaders and their followers raise one another to higher levels of integrity and motivation, was identiﬁed by guru James McGregor Burns as the most effective. This has been developed by others, including industrial psychologist Bernard Bass, who listed the qualities of a transformational leader.

Sets clear goals

Stirs the emotions of people

Encourages others

Has high expectations Is a model of integrity and fairness

Provides support and recognition

Inspires people to reach for the improbable

Gets people to look beyond their self-interest

HOW COMPANIES WORK Human resources

88 89

When to use which leadership style A three-year study of 3,000 managers led psychologist Daniel Goleman to uncover six distinctive styles of leadership. Each style has a signiﬁcant impact on how

people feel about their work. The most effective leaders master a number of styles and use them appropriately according to the situation.

Style

When to use

Drawbacks

Afﬁliative

“People come before task.” Focuses on creating emotional bonds within a team and a sense of belonging within an organization.

Use in times of stress, when teammates need to recover from trauma, or when the team needs to rebuild trust.

Praise and nurturing can foster mediocre performance and lack of direction.

Coaching

“Try this.” Helps people ﬁnd their strengths and weaknesses, linking these to career aspirations and action.

Use to help teammates build lasting personal strengths that make them more successful.

Coaching is ineffective when teammates are deﬁant and/or unwilling to change or learn, or if a leader lacks ability.

Commanding/ coercive

“Do what I tell you.” Demands immediate compliance, without discussion or negotiation.

Only use in times of crisis or to control a problem employee when all else fails.

Insistence should only be used when essential; it can alienate people, stiﬂe inventiveness, and create a tense atmosphere.

Democratic

“What do you think?” Goal is to build consensus through participation.

Use when it is necessary for the team to buy into or have ownership of, a decision, plan, or goal.

This is not for use in crisis or when teammates are not well enough informed to be able to offer suitable guidance to the leader.

Pacesetting

“Do as I do, now.” Expects and models excellence, creating challenging and exciting goals for the team.

Only use when the team is already motivated and competent, and when fast results are necessary.

Style can overwhelm some team members and adversely affect employee commitment; it may stiﬂe creativity and innovation.

Visionary/ authoritative

“Come with me.” Mobilizes the team toward a common vision and goal, leaving the means up to the individual.

Use when the team needs a new vision because circumstances have changed, or when explicit guidance is not required.

This is not effective when a leader is working with a team of experts or better-informed group.

Leadership for team building Just as generals have to get the best from their troops, so business leaders must make the most of their teams. The key is ensuring that individuals work together to achieve a common goal. How it works From statesmen such as former British prime minster Winston Churchill to former General Electric CEO Jack Welch, great leaders know that to achieve a long-term goal, they must not only use their own capabilities but also maximize the combined strength of other people.

How leaders inspire their teams Academic Carl Larson and organizational effectiveness expert Frank LaFasto conducted a three-year study of more than 75 diverse teams. They identiﬁed six characteristics of leadership that steer a team toward optimum results.

They have a passion that sweeps people along with them; they learn from mistakes and are prepared to alter their course to meet changing circumstances. Much academic work has been done to study the traits and strategies of such leaders.

Focusing on goal ❯ Deﬁnes goal in clear and inspirational way ❯ Helps each team member see how they contribute to goal ❯ Does not play politics

Encouraging collaboration

“Leadership is the art of getting someone else to do something you want done because he wants to do it.” Dwight D. Eisenhower

❯ Allows open discussions ❯ Demands and rewards collaboration ❯ Involves and engages people

Building conﬁdence ❯ Accentuates the positive ❯ Shows trust by assigning responsibility ❯ Says “thank you”

HOW COMPANIES WORK Human resources

BUILDING AN EFFECTIVE TEAM In their book The Wisdom of Teams (1993), Jon Katzenbach and Douglas Smith make a distinction between teams and ordinary groups of people who work together. They deﬁne a team as “a small number of people with complementary skills who are committed to a common purpose, set of performance goals, and approach for which they hold themselves mutually accountable.” They found that leaders who manage to build successful teams tend to:

❯ Select members for skill and potential, not personality. ❯ Focus on a few immediate tasks and goals at the beginning, to help the team to bond. ❯ Set boundaries and behavioral norms. ❯ Stimulate the team regularly with new information, encouraging open discussions and active problem-solving. ❯ Ensure that the team spends lots of time together, both in and outside of work.

90 91

“Don’t ﬁnd fault – ﬁnd a remedy” Henry Ford, American industrialist

Providing know-how ❯ Knows own area ❯ Gets expert help for other areas ❯ Shares context with team

Setting priorities ❯ Demonstrates focus; avoids ambiguity ❯ Is clear about what must and must not happen ❯ Is prepared to change course if priorities switch

Managing performance ❯ Sets clear objectives ❯ Gives constructive feedback; confronts and resolves performance issues ❯ Aligns incentives with team goals

1 2 3

Employee relations and communications Thriving organizations recognize the importance of harnessing people’s ideas and energy to provide a competitive edge, while managers are eager to gain, retain, and build employee commitment and engagement. How it works

leaders no longer send only one-way messages but harness a variety of interactive media, such as videoand tele-conferencing. Individuals and teams can use customized business social media, such as Yammer, to share ideas and knowledge, but may still choose to meet in formal settings such as councils and forums.

Employee relations and communications are, either managed by human resources (HR) or as a function in their own right, are increasingly sophisticated. Rather than just relying on face-to-face talks and word of mouth, successful ﬁrms use added communication tools to help people understand the business goals and the individual’s contribution to results. In particular,

Commitment

Communication in practice In this example, a company is establishing weekly employee forums to facilitate communication and build trust throughout the business. To strengthen employee awarenees, engagement, and commitment to the idea, various media are used, from email to webinars and discussion. Managers focus ever more on collaboration rather than just imparting information.

Engagement and involvement

In many countries, employee communications used to focus on structured industrial relations, managed by HR. Employee relations are now based more on trust and building strong relationships. Many ﬁrms create formal works councils or employee forums. At their best, employee forums: ❯ Allow representatives from across the business to share and generate ideas for improving performance. ❯ Encourage discussions on vision, changes, and plans for business. ❯ Recognize the value of employees.

DEGREE OF COMMITMENT

EMPLOYEE FORUMS

Awareness and understanding CONTACT An email is sent to all employees with a short video informing them an employee forum is to be set up. TIME

HOW COMPANIES WORK Human resources

CASE STUDY John Lewis The UK-based John Lewis chain of department stores is famous for its unique employee-owned structure, in which every worker is a partner in the business. It has a number of employee communication policies: ❯ Gazette Employees can send letters directly to management through the weekly gazette. Managers publish their responses in the gazette for all to read.

❯ Partnership council Made up of 80 elected partners from across the business, the council meets four times a year. The chairman and directors report to the council, which can remove the chairman. ❯ Branch forums Elected by employees at each branch, these forums work with management to inﬂuence the running of their store and select local charities to support.

ESTABLISH PRACTICE A company-wide awayday illustrates to employees how the forums have changed working practices.

92 93

$316 million

the amount paid in staff bonuses by John Lewis in 2013

REINFORCE AND INTERNALIZE Regular face-toface updates show employees how forums have made a difference.

STIMULATE POSITIVE PERCEPTION An inspirational seminar illustrates the beneﬁts of the new forums. ADOPT AND SHARE Employees attend forums and then share their opinions on Twitter and Yammer so they feel involved and collaborate with managers.

AID UNDERSTANDING Resources placed on the company intranet detail how employee forums will work.

CREATE AWARENESS The purpose of employee forums is explained at a company-wide video conference.

Project management Besides day-to-day activities, a business may have projects that are one-time, temporary, speciﬁc pieces of work. Projects need to be managed to deliver on time, within budget, and to speciﬁcations. How it works The process of project management takes a complex project from start to ﬁnish. It requires a different set of knowledge, experience, and skills from a mainstream operation because the goals set up have to be achieved within deﬁned limitations. These constraints include scope, time, quality, and budget. A project team might include people from different organizations, diverse disciplines, and multiple locations. Successful project management

involves not only overseeing the people working towards the particular objective, but also managing the risks, schedule, relationships, individual and team input, range of stakeholders with vested interests in the project, and ﬁnancial resources. Effective project management is increasingly viewed as a strategic competence (see p.85) for any business because it enables the introduction of new products, new methods, and new technology.

NEED TO KNOW Project management tools There are many different project management tools, particularly for software development. One tool is PRINCE2®, a process-based approach to project management within a clear framework. The emphasis is on dividing the project into manageable and controllable stages with a deﬁned structure for the project management team.

Steps in project management There are many workable project management systems, using various deﬁnitions for the key stages, all of which are encompassed in ﬁve main elements.

Initiation

Planning

Execution

❯ Project charter, including business case, objective, scope, budget, deliverables, and schedule ❯ Roles and responsibilities ❯ Resource allocation

❯ Detailed plan of work ❯ Critical path analysis ❯ Risks

❯ Coordinating people and resources ❯ Quality assurance ❯ Communication to team and stakeholders

HOW COMPANIES WORK Human resources

94 95

HURDLES AND HOW TO OVERCOME THEM Every project comes up against challenges. These are some of the common ones, and the ways that effective management can keep the project on track.

Project management

Options

Project is not on schedule, or running short of time

❯ Map out timeline of work and critical paths using tools and techniques. ❯ Review remaining work and identify risks, barriers, and mitigating strategies.

❯ Negotiate scope, budget, and resources. ❯ Inform other teams and see if any changes can be factored in.

Unclear vision or lack of clarity

❯ Review project charter and revisit vision and objective. ❯ Involve team so everyone understands direction of work and avoids stalling.

❯ Seek clarity from sponsors and/or senior management.

Scope creep (project changes once under way)

❯ Manage requests for change against business case and project objective.

❯ Communicate to identify why change is important and how to incorporate, or ﬁnd alternative.

Obstacle

97% Monitoring and control

Closure

❯ Measuring effort and progress ❯ Managing and mitigating risk ❯ People management

❯ Finalizing all activities ❯ Communication ❯ Learning—project review

of managers* believe project management is critical to success *surveyed from 34 different countries

Negotiating strategy Skillful negotiation is vital in business when two or more sides have different viewpoints and each party wants to press for their own advantage. The ideal outcome is a compromise that resolves conﬂict. How it works Like many aspects of business, negotiation is a process to ﬁnd a mutually acceptable solution. Before any discussion, each party must work to understand the other’s interests and decide on strategy; otherwise

talks can end in stalemate, bad feeling, and loss of business. Being able to negotiate is vital to build strong working relationships, deliver a sustainable, well-considered solution (rather than a short-term ﬁx), and avoid future conﬂicts.

Reaching agreement Any strategy, from a wage negotiation between a trade union and employer to a sales negotiation between a customer and a supplier, depends on the relationship between the two parties. Good negotiation should leave each party feeling satisﬁed with the outcome of the discussion and ready to do business again.

Prepare and plan ❯ Set objectives and ideal outcome (and assess those of other party). ❯ Rank and value issues and think of possible concessions. ❯ Consider ideal agenda and meeting place. Rehearse.

Deﬁne ground rules

Propose, clarify, and justify

Bargain to solve problems

❯ Agree on logistics— location, room setup, agenda, schedule, number of negotiators. ❯ Deﬁne etiquette, such as no cell phones, one person speaks at a time, formal breaks. ❯ Agree on how information is to be presented and recorded.

❯ Ensure both sides have equal opportunity to put forward their case. ❯ Clarify any points of disagreement. ❯ Focus discussion on understanding rather than resolving.

❯ Offer alternative proposals and concessions. ❯ Discuss what is acceptable to each side. ❯ Aim to ﬁnd win-win solutions.

HOW COMPANIES WORK Human resources

65%

96 97

BODY LANGUAGE IN DIFFERENT CULTURES

of face-to-face communication is through non-verbal signals

Agree, close, and implement ❯ Conclude with an agreement that is mutually acceptable. ❯ Clearly articulate and note agreement and concessions. ❯ Formalize agreement in writing and follow up.

With international negotiations, it can be hard to read body language signals, particularly since the meaning of gestures can vary. Eye contact Chinese people avoid direct eye contact to show respect while American people see lack of eye contact as a sign of shiftiness. Facial expressions When emotions are high in the US, it is acceptable to frown, even to swear, but not to cry. Japanese people might smile or laugh, but never frown or cry. Head movements In much of Europe and the US, people nod to mean yes and shake their head to mean no. But in some parts of the world, such as in Bulgaria, it is the opposite way round. Gestures Western cultures use a hand extended towards a person to indicate “Come here”. Chinese people would see this gesture as offensive. Posture In the US, being casual is valued; people might slouch when standing or sitting. In some European countries, such as Germany, a slouching posture is considered rude. Formality is also valued in Japan, particularly the ability to sit upright and still.

HOW FINANCE WORKS Financial reporting ❯ Financial accounting Management accounting ❯ Measuring performance ❯ Raising ﬁnancing

$ $

Financial reporting Financial reports are everywhere: a bill at a restaurant is a ﬁnancial report, as are sales receipts and bank statements. In business, however, ﬁnancial reporting refers to the ﬁnancial statements that make up a company’s annual report and accounts. Compiled by accountants, they provide investors and lenders with information to assess a company’s proﬁtability, and enable company managers, government, tax authorities, and other stakeholders to evaluate the business.

Types of ﬁnancial reports Financial reports take many forms and can contain a vast amount of information about a company’s ﬁnances, work, core business values, performance, employees, and its compliance with local, logistical, domestic, and international laws. The most important ﬁnancial report, or statement, is usually the annual report— essentially a collection of many other, smaller reports—which sums up how the business has performed in the last year. There is a multitude of laws, regulations, and guidelines governing what should be put into this report.

THE ACCOUNTING CYCLE The eight steps of the accounting cycle are used by nearly all accountants. The cycle helps by standardizing processes and makes sure that accounting jobs are performed correctly and in the same way and order for every activity. See pp.102–103.

The annual report Financial statements usually appear in a company’s annual report and sum up its ﬁnancial activities in a standardized way for different audiences to interpret quickly and clearly. These statements take diverse forms, and being able to deconstruct them is a vital skill for accountants and businesspeople, making it simple to see how well a business is performing and why.

$50 billion

the amount hidden via loans diguised as sales by Lehman Brothers in 2008 $

HOW FINANCE WORKS Financial reporting

100 101

TYPES OF ACCOUNTING There are seven widely recognized types of accounting:

❯ Financial Drawn up by accountants; used by investors, creditors, and management. See pp.110–129.

❯ Forensic Engages in disputes and litigation, and in criminal investigations of fraud. See pp.152–153.

❯ Management Used by managers to control cash ﬂow and budgets, and forecast sales. See pp.130–143.

❯ Project Deals with a particular project; a useful aid for project management.

❯ Governmental Also called public ﬁnance accounting; used by public sector for noncommercial accounting.

❯ Social and environmental Shows how a company makes a positive difference to the community and environment.

❯ Tax Dictates exact rules that companies and individuals must follow when preparing and submitting tax returns.

Fi n

c n a

atements t s ial

❯ What’s in an annual report? A full record of company performance according to various criteria, as well as accounts. See pp.104–105. ❯ What are the statements? The main one is ﬁnancial; others include sustainability, directors’ pay, and charitable donations. See pp.106–107. ❯ Who reads which statements? Sections are relevant to banks, shareholders, government, auditors, staff, and media. See pp.108–109. ❯ What do the notes mean? Main statements are annotated in detail. See pp.104–109. ❯ What are the rules? Accounting principles regulate ﬁnancial reports. See pp.112–113. ❯ Which are the most important ﬁnancial statements? Proﬁt-and-loss statements, balance sheets, and cash-ﬂow statements contain key facts. See pp.114–121.

The accounting cycle The accounting cycle is a step-by-step process bookkeepers use to record, organize, and classify a company’s ﬁnancial transactions. It helps to keep all accounting uniform and eliminate mistakes. How it works The cycle works as an aid to organize workﬂow into a cyclical chain of steps that are designed to reﬂect the way assets, money, and debts have moved in and out of a business. It progresses through eight different steps, in the same order each time, and restarts as soon as it has ﬁnished. The cycle can be based on

any length of time—this is known as an accounting period—and usually lasts a month, a quarter, or a year. Accounts which deal with revenues and expenses return to zero at the end of each ﬁnancial year, while accounts showing assets, liabilities, and capital carry over from year to year.

The eight-step cycle The processes shown here are repeated in the same way for every accounting period. All businesses go through different phases, and the accounting cycle works by reﬂecting that. The ﬁnancial statement, which is prepared toward the end of each cycle, is helpful in showing how strongly the business has performed during each period of time.

BOOKKEEPING AND ACCOUNTING ❯ Internal controls A method of deploying, measuring, and monitoring a business’s resources. This helps prevent fraud and keep track of the value of assets. ❯ Double-entry bookkeeping The process of recording all transactions twice—as a debit and as a credit. If a company buys a chair for $100, its debit account increases by $100 and its credit account decreases by $100. ❯ Bad debts Debts that cannot be or are unlikely to be recovered, so are useless to the creditor (lender), who writes them off as an expense.

Transactions Any type of ﬁnancial transaction, from buying or selling an asset to paying off a debt, can start the accounting cycle.

new cycle

6,000 15,000 21,000

Closing the books

Financial statements

A closing entry based on adjusted journal entries is taken, the books are closed, and the cycle restarts.

The corrected balances are then used to prepare the company’s ﬁnancial statements.

HOW FINANCE WORKS Financial reporting

102 103

NEED TO KNOW

Journal entries

Posting

Accountants then analyze the transaction and note it in the relevant journal—a book or an electronic record.

Journal entries are then transferred to the general ledger—a large book or electronic record logging all the company’s accounts.

13%

more accountants will be required in the US by 2022

❯ Debits Expenses—dividends, assets, and losses. In double-entry accounting, debits appear on the left-hand side of the account ❯ Credits Gains—income, revenue, owners’ equity, and liabilities. In double-entry accounting, credits appear on the right-hand side ❯ Chart of accounts List giving the names of all of a company’s accounts, used to organize records ❯ Audit trail Full history of a transaction, allowing auditors to trace it from its source, through the general ledger, and note any adjustments made

Trial balance

A list of all the company’s accounts is prepared at the end of the accounting period, usually a year, quarter, or month.

10,000 55 230 21,000

Worksheet

Adjusting journal entries Once the accounts are balanced, any adjustments are noted in journals at the end of the accounting period.

Often, trial balance calculations don’t accurately balance the books (see pp.116–117). In such cases, changes are made on a worksheet.

Financial statements The formal records of a business’s ﬁnancial activities are presented as ﬁnancial statements. Most jurisdictions require accurate information by law, and ﬁnancial directors and auditors are liable for its contents. How it works Financial statements summarize a company’s commercial activities clearly and succinctly, with details of the business’s performance and changes to its ﬁnancial position. They are aimed at several parties,

so they need to be detailed but also comprehensible to the general public. The statements are usually presented together in the form of an annual report, with in-depth accounts and footnotes to give detail. Legal requirements vary, but accounts must be exact.

What’s in an annual report

r custo Ou O

rastruc inf

re tu

A brief overview summarizes the key areas of ﬁnance for the company, including overall performance, turnover, operating costs, capital investment, depreciation, interest charges, taxation, and dividends. (See also pp.114–121.)

mploye re

munity om

ﬁnance ur

This section underlines a company’s social ethos, in particular its community involvement. Different types of companies may focus on different values.

Cha i

ers and c

nvironm re

t en

ion

It is common for the chairman to write an introduction focusing on the positives and explaining any negative parts of an annual report for the beneﬁt of shareholders.

Ou r

introdu

r’s

The contents page shows where to ﬁnd the big three statements—the balance sheet, cash-ﬂow statement, and proﬁt-and-loss statement—and softer information such as stories about staff and opinions of other stakeholders. The annual report provides an opportunity to impress shareholders and lenders as well as fulﬁll legal reporting obligations. It will contain all, or most, of the following.

These pages contain much of the company’s information on its environmental protocols, most of which are industryspeciﬁc. See also pp.122–123.

A section on employees details areas such as staff development and training, health and safety, and key statistics on staff satisfaction.

The infrastructure pages of an annual report are a good place to supply more detail about the company’s ﬁxed assets and explain why the company is an attractive investment for investors

HOW FINANCE WORKS Financial reporting

CONSOLIDATED FINANCIAL STATEMENTS

NEED TO KNOW

Independ

Note

Our perf

Environ Bo a

o the acc st

nts ou

The board of directors, governance report, and statement of directors’ responsibilities sections indicate who is leading the company, showcases their credentials and roles, and reveals their pay.

t audito en report

rs to

of direc rd

tors’ rep

r’s

nting ou

CO2

The environmental accounting section contains ﬁgures that pertain to the environment, often those stipulated by law—for example, greenhouse gas emissions.

❯ Subsidiary One company that is controlled by another, usually a holding company ❯ Holding company A company set up to buy shares of other companies, then control them ❯ Globalization The process of businesses developing such large multinational presences that they transcend international borders

t or

icators nd

ntal ac c me

Performance indicators are common across all industries. They measure areas such as customer satisfaction and the quality of goods or services provided by the company.

Di r

In an era of globalization, large corporations are now commonly made up of multiple companies. Companies owned by a parent company are known as subsidiaries, and continue to maintain their own accounting records, but the parent company produces a consolidated ﬁnancial statement, which shows the ﬁnancial operations of both companies. Depending on the jurisdiction’s reporting requirements, however, if a company owns a minority stake in a second company, then the latter will not be included in the former’s consolidated ﬁnancial statement.

mance i or

104 105

In the directors’ report, members of the board of directors give their professional opinions on how the business has performed over the last year.

Auditors are independent and check the accuracy of companies’ accounts. This helps to eliminate mistakes and track fraud.

Notes to the accounts are a key part of ﬁnancial statements. They provide extra detail, insight, and explanation of the barebones ﬁgures supplied in earlier pages of the report.

FINANCIAL STATEMENTS

Deconstructing a financial statement The proﬁt and loss account shows revenues, costs, and expenses— how much money the business makes—over an accounting period. The balance sheet shows what a business is worth at the time it is published, and is relevant to investors as it reveals assets, liabilities, and shareholders’ equity—all useful for gauging business health. The cash-ﬂow statement shows the movement of cash within a business—its liquidity. However, along with the big three ﬁnancial statements, an annual review contains a wealth of information about a company’s performance, of interest to its stakeholder groups. It is often the notes that bring statements to life.

TAXES The percentage of business taxes taken by governments varies from country to country but the generic types remain similar:

Case study: the details Financial statements are presented as part of the annual report, which also publishes case studies, quotations, statistics, and proﬁles of customers, suppliers, employees, and directors. The notes, often running to 20 pages or so, contain tables and text that ﬂesh out the ﬁnancial information. The following examples are taken from the 2013 annual review of UK utility company Wessex Water.

❯ Direct taxes are levied directly on proﬁts or income and include income taxes, inheritance taxes, and taxes relating to sales or purchase of property and other capital assets. ❯ Indirect taxes are paid on goods or services, such as sales taxes. Indirect taxes are often targeted to reduce consumption of harmful goods, a factor relevant to companies working in the alcohol and tobacco industries. ❯ Green taxes are increasingly common and are often indirect. They are generally used as a way of prohibitively increasing the price of goods or services harmful to the environment, such as air travel, landﬁll sites, or fuel, to diminish their use. ❯ Corporation tax is only paid by companies, not by sole proprietors or partnerships. It is levied as a percentage of the company’s total proﬁt.

Sustainable investment Wessex Water’s investment in sustainability includes mandatory expenditure and extra discretionary expenditure (at the time of the review, £1 = $1.58). 2013 £m

2012 £m

CUSTOMERS AND COMMUNITIES

ENVIRONMENT

EMPLOYEES

INFRASTRUCTURE

139

116

TOTAL

273

225

Our ﬁnance

This section contains the headline ﬁnancial ﬁgures of the business, such as proﬁts, taxes paid, assets owned, liabilities, and dividends paid out, as well as some more detailed explanation of the ﬁgures.

HOW FINANCE WORKS Financial reporting

106 107

BOARD OF DIRECTORS

NEED TO KNOW ❯ Monopoly Situation in which there is just one supplier of a particular product or service; without government control, a company with a monopoly could make prices high and quality low, as consumers would have no alternative ❯ Oligopoly Industries that have a small number of suppliers. The competition is not as intense as in the free market, so governments often impose regulations on companies to ensure quality and fair prices ❯ Remuneration Money paid for work or a service provided— the ﬁnancial term for pay; may include bonuses or share options

Much of what might be considered personal information about directors of public companies is in the public domain. It is usually a legal obligation to disclose: ❯ Names of executive directors ❯ Names of non-executive directors, and whether they are independent or shareholders ❯ Shareholding ❯ Board attendance record

❯ Dates of directors’ terms of ofﬁce ❯ Remuneration, including bonus, share options, pension plans, and beneﬁts ❯ Notice period ❯ Termination payment ❯ Potential conﬂicts of interest

Charitable donations Companies vaunt their philanthropy in the annual report, detailing how much they have given away and how it has helped. They may support charities relevant to the nature of their business or let employees vote on recipients.

Customer satisfaction

96%

Wessex Water utility’s customer satisfaction score

Overall, this section shows how the company works with customers to improve service and support. In monopoly and oligopoly industries, customer satisfaction is particularly important, as governments often set high targets. Wessex Water’s annual review shows a customer satisfaction rating of 96 percent.

FINANCIAL STATEMENTS

Financial statements for users The many ﬁnancial statements included in the annual report are a gold mine of information for those who know how to read them. They provide headline proﬁt ﬁgures, explanations of issues from directors, detailed ﬁnancial data, and information about companies’

operations and policies. For this reason, ﬁnancial statements are useful to a wide range of stakeholders, from the company’s employees, customers, and shareholders to potential investors, governments, tax authorities, journalists, credit-rating agencies, banks, and the general public.

Who reads what Different stakeholders are interested in different parts of the annual review. Customers of a service provider, for instance, may look at the section on customers and community while potential lenders go to the ﬁnancial statements..

REHOLDER S

Stakeholder

PL EM

OYEE

DITORS AU

Important parts ❯ Proﬁt-and-loss account ❯ Balance sheet ❯ Dividends

❯ Our employees ❯ Governance report ❯ Performance indicators

❯ The whole statement ❯ Independent auditor’s report (written by the auditor)

Why? ❯ To see how much money the company is making ❯ To assess the long-term strength of the company ❯ To see how much will be paid out to them

❯ To see any training programs or employee beneﬁts being praised that may be available to them ❯ To see how much executive and non-executive directors are paid ❯ To see how well the company is performing, and if it can improve ❯ To assess whether or not the accounts are error-free ❯ To ensure that the company has complied with Generally Accepted Accounting Principles (GAAP). See pp.112–113.

HOW FINANCE WORKS Financial reporting

108 109

STATISTICS MADE EASY Impressive statistics are often scattered through an annual report. These examples are from UK utility Wessex Water:

6% post-tax return on capital

❯ This percentage is estimated by dividing income after tax by the amount of investment. It is useful for showing shareholders the kind of returns they can expect on their investments. ❯ For most industries, gearing is a company’s debt compared to its equity. In the water industry, it compares a company’s net debt to its regulatory capital value (the value of the business that earns a return on investment). Gearing is expressed as a percentage. See pp.174–175.

64% gearing

❯ Credit ratings assess the likelihood that loans will be repaid. A3 and A- fall at the bottom of “strong capacity to meet ﬁnancial commitments,” while BBB+ is at the top of the adequate range. The major ratings companies in the US are Moody’s, Standard and Poor’s, and Fitch.

A3/A-/BBB+ credit rating

T/ EN

TA X A UT

T NSTI UTION LI

U JO

RNALIST

Important parts

Why important?

❯ Taxation ❯ Independent auditor’s report ❯ Environment section and environmentrelated notes

❯ To check that the ﬁgures are correct and the correct amount of tax has been paid ❯ To check the audit, and that they are satisﬁed with the accounts ❯ To check that environmental laws have been adhered to

❯ Balance sheet

ANKS S/B

FINANC IA

RITIES HO

GOVERN

Stakeholder

❯ Chairman’s introduction ❯ Accounts and notes

❯ To see the company’s assets and liabilities, and assess its strength ❯ To decide whether or not it is wise to lend to the company

❯ To ﬁnd elements to quote ❯ To see how strongly the company has performed ❯ To analyze why a company has been performing well or poorly, and investigate if they suspect fraud

Financial accounting A company’s ﬁnancial accounts classify, quantify, and record its transactions. They are extremely useful for people outside the business, such as creditors and potential investors, as well as those currently involved with making investment decisions. For this reason, the accounts should be concise and clearly present the timing and certainty of future cash ﬂows, so that people looking at the company can decide whether or not to invest in, lend money to, or do business with it.

Key elements The proﬁt-and-loss account, balance sheet, and cashﬂow statements are the most important ﬁnancial statements in an annual review, supplemented by the report’s notes. To understand these statements, a knowledge of accounting principles, depreciation, amortization, and depletion is vital. Accountants also need to understand the legal requirements that the statements must satisfy and how environmental laws can affect a business and its accounts.

Accounting standards

Proﬁt-and-loss statement

Generally accepted principles standardize practice worldwide to ensure accuracy and prevent fraud. See pp.112–113. ❯ International standards simplify account reporting. ❯ Companies must meet environmental accounting rules and regulations. See pp.122–123.

Shows how much money a company is making and is especially useful for potential investors and stakeholders. See pp.114–115. ❯ Outlines revenues and gains minus expenses and losses or operating costs. ❯ Informs a company if a proﬁt warning is needed.

$ $

Balance sheet Gives a snapshot of how much a business is worth at a certain time and is a good indication of its long-term health. See pp.116–119. ❯ Balances company’s assets against its equity and liabilities. ❯ Lists different types of assets, including tangible ﬁxed assets and current assets.

HOW FINANCE WORKS Financial accounting

$74 billion

the total value lost by shareholders in the 2001 Enron accounting scandal

Cash-ﬂow statement

Environmental accounting

Reveals a company’s liquidity by tracking the ﬂow of cash— money or short-term investments—in and out of the company. See pp.120–121. ❯ Shows if a company can sustain itself, grow, and pay debts. ❯ Details cash ﬂow from operating, investing, and ﬁnancing activities.

Accounts for myriad environmental rules and regulations that oblige companies to mitigate the impact of business activities. See pp.122–123. ❯ Showcases green credentials in ﬁnancial statements. ❯ Reveals compliance with environmental, social, and governance criteria.

110 111

AUDITING The accounts of public companies are given unbiased scrutiny by external accountants to check that they are accurate and clear. This is a legal requirement in most countries, designed to ensure market conﬁdence in the business world and transparency in corporate ﬁnance. A company may also have an internal audit process, which means that its accounts are checked before being submitted to an external auditor.

Depreciation Accounts for the decrease in value over time of tangible ﬁxed assets in order to spread the cost of assets over their economic life. See pp.124–127. ❯ Can be calculated using a number of different methods. ❯ Tangible ﬁxed assets include buildings, plant, and machinery.

Amortization and depletion Account for the decrease in value over time of a range of intangible assets, loans, and natural resources. See pp.128–129. ❯ Intangible assets include patents, trademarks, logos and copyright. ❯ Natural resources include minerals and forests.

International accounting standards With increasing globalization, international accounting standards, assumptions, and principles that help to make accounting easier across borders are essential for preparing ﬁnancial statements. Accounting standards

Pros and cons

Purpose

Example

Standard

ECONOMIC ENTITY ASSUMPTION

MONETARY UNIT ASSUMPTION

GOING CONCERN ASSUMPTION

TIME PERIOD ASSUMPTION

FULL DISCLOSURE PRINCIPLE

Transactions by businesses owned by one group or individual are kept separate from transactions made by other companies owned by that group or individual.

International economic activity is expressed in monetary terms, with all units assumed to be quantiﬁable, constant and not affected by inﬂation or deﬂation.

The ﬁnancial activities of a business will carry on indeﬁnitely.

Different operations of a business can be divided into arbitrary time periods.

All information, past, present, or future, which could affect ﬁnancial performance must be disclosed, usually in the notes of ﬁnancial statements.

If a group owns two companies, one manufacturing televisions and the other retailing cell phones, the ﬁnancial statements for each company are separate.

Current manufacture of baseball bats is compared ﬁnancially to manufacture that was carried out 30 years ago, without taking inﬂation into account.

Oil reserves will never run out; gold in a gold mine will last forever; a manufacturer will not go out of business.

Sales of toothbrushes can be measured daily, monthly, quarterly, and so on (when in reality they are constant, or subject to variations that are not predictable).

If a coconut importer knows that a hurricane has damaged next year’s coconut crop, it must mention this in its ﬁnancial statement.

Helps the group of companies and investors compare ﬁnancial statements of each company with its competitors.

Shows as much of the company as possible in ﬁnancial statements, as everything a business owns can be quantiﬁed.

Offers a model for businesses to look at the long-term future of their operations.

Makes ﬁnancial reporting easier.

Provides full information for shareholders and potential investors.

It is hard to measure monetary value of, for example, the fastest worker at the baseballbat production plant.

It is not applicable to companies approaching liquidation, as it assumes that any assets are worth their original value.

The more often economic activity is measured, the easier it is to identify trends.

Companies may try to “bury” information likely to put off investors or lower the share price in the notes.

Largely beneﬁcial Companies that operate in the same group but in different countries must prove standard market rates used for intra-company trading.

It is hard to compare across time because of inﬂation/deﬂation.

Measuring activity often means more work, and such data may multiply errors.

Not all countries are equipped to root out transgressors.

HOW FINANCE WORKS Financial accounting

How it works International Financial Reporting Standards (IFRS) are the most widely accepted standards for accounting, and they are used in more than 110 countries. Originally introduced to harmonize accounting across Europe, they have with time spread around the world. IFRS are not to be

HISTORICAL COST PRINCIPLE

MATCHING PRINCIPLE

112 113

confused with International Accounting Standards (IAS), which were in use from 1973 to 2001. Generally Accepted Accounting Principles (GAAP), which are known colloquially as accounting standards or standard accounting practice, are country-speciﬁc guidelines for recording and reporting accounts. They differ from one jurisdiction to another.

REVENUE RECOGNITION PRINCIPLE

CONSERVATISM

PRINCIPLE OF MATERIALITY

Assets and liabilities are valued at their buying price (in countries with high inﬂation or hyperinﬂation, other principles, such as fair value, are used).

The time period in which a business’s expenses and revenue ﬁgures are collected always concurs.

Revenue should be recorded at the moment when: a) goods or services are exchanged; b) assets can be converted to cash; c) it is earned—not when it is received.

If there are alternatives for reporting on an item, accountants should choose to report the lower amount of income or asset gain.

Accountants may make a professional decision to go against any one of the other principles.

If a company bought a factory 50 years ago for $100,000, that will be its stated value today, even though its market value now is far higher.

A grocery store measures costs incurred and revenues gained over the same time period, because when sales are high, costs are also likely to be high, due to the need to buy more stock.

A toy-maker takes an order for 500 toys in July, delivers it in September, and is paid for it in December. The revenue is recorded in September, when the goods were exchanged.

If a company is involved in a lawsuit, it must report the potential losses rather than the potential gains, in the notes of the ﬁnancial statement.

An oil reﬁnery buys a $100 whiteboard, which could last 10 years. Under the matching principle, it should be billed for $10 each year, but the accountant enters it as a one-time cost.

Ensures uniformity and prevents the overvaluation of assets, which was a feature of the 1929 Wall Street Crash.

Avoids different time scales, which could present a distorted picture and erratic ﬁnancial results—for example, with high revenues from one period and high costs in another.

Matches the time period that work was undertaken to when the payment was received, as with the matching principle.

Prevents companies from overestimating money they will make in the future, then running into debt if it does not materialize.

Saves time for small, almost insigniﬁcant transactions when there is no risk of it being applied misleadingly.

Assets, especially property, acquired a long time ago are invariably represented as being worth less than their current real value.

Helps to present accounts in a representative manner.

Revenue may not always be received. If there are doubts about a recipient’s ability to pay, the company can make an allowance for doubtful accounts.

Requires a degree of objectivity from accountants: if this objectivity is absent, ﬁnancial reports can be misleading.

Saves time on accountancy. Makes information easier to read—for example, ﬁgures can be rounded to the nearest dollar, thousand, or even million dollars.

Profit-and-loss statement A proﬁt-and-loss statement is a ﬁnancial statement that shows all revenues, costs, and expenses during an accounting period. It is also known as an income statement, or an income and expense statement. How it works The purpose of the proﬁt-and-loss statement is to show the proﬁtability of a business during a given period. Along with the cash-ﬂow statement and the balance sheet, it is the most important ﬁnancial statement a business produces, as it shows investors how

proﬁtable the company is. The statement usually works by showing revenues and gains, less expenses and losses from business activities, as well as the sale and purchase of assets. Businesses that are sole proprietorships or partnerships are generally not required to submit proﬁt-and-loss statements.

How to read a proﬁt-and-loss statement Proﬁt-and-loss statements commonly illustrate the ﬁnancial performance of a business over a particular month, quarter, or year. The key pieces of information are the ﬁgures for turnover (or revenue) and operating proﬁt. If proﬁts are going to be lower than expected, the company may put out a proﬁt warning in advance of releasing the statement.

Case study: proﬁt-and-loss statement This statement taken from the 2013 annual review of Wessex Water, a UK utility company, shows it was making a healthy proﬁt (at the time, the exchange rate was £1 = $1.58). Year 2013 £m

Year 2012 £m

Turnover Operating costs

492.1 (268.1)

467.5 (248.5)

Proﬁt earned from the business’s core operations after expenses have been taken off, but before taxes have been deducted; it does not include money made on investments

Operating proﬁt Interest payable and similar charges Interest receivable Other ﬁnance costs

224.0 (86.9) 2.9 (1.5)

219.0 (81.7) 1.2 (1.0)

Proﬁt before tax after all income and expenses have been taken into account, excluding extraordinary payments

Proﬁt on ordinary activities before taxation Taxation on proﬁt on ordinary activities

138.5 (30.6)

137.5 (44.3)

Proﬁt attributable to shareholders

107.9

93.2

Amount of money taken by the business over a certain time; in this case, there was a 5.3 percent increase in turnover from the previous year

Level of proﬁt that can be paid out in dividends to the company’s shareholders.

Figures in parentheses represent negative numbers.

HOW FINANCE WORKS Financial accounting

114 115

TYPICAL EXPENSES Payroll

Ofﬁce supplies

Salaries and wages paid to staff, temporary contractors, and indirect labor

Stationery such as pens, paper, and ﬁling systems, ofﬁce printers, furniture, lighting

Utilities

Legal fees and professional services

Water, electricity, and gas; postage and shipping; transportation

Accounting and legal fees, payable to accountants, auditors, and legal advisers

Insurance

Interest on loans

Insurance on ﬁxed assets and personal liability insurance for employees

Phone/internet bills

% $

Interest paid on money borrowed, which counts as a business expense

Tax

Cost of telephone, broadband internet, and mobile devices used by employees

Varying among jurisdictions, this may include payroll tax and corporation tax

Advertising

Entertainment

Sales and marketing of the company and its products

Legitimate costs of business entertaining, subject to certain criteria being met

Case study: operating costs This table breaks down the company’s operating costs in more detail. It is important to read any notes regarding depreciation and ordinary and extraordinary costs and gains.

Manpower costs including basic pay and pensions, overtime payments, staff training, and maternity leave Term given to the gradual decline in an asset’s value, caused by factors such as wear and tear and market conditions. Decrease in value over time of intangible assets or loans

Year 2013 £m Manpower costs Materials and consumables Other operational costs Depreciation Amortization of grants and contributions Loss/(gain) on disposals of ﬁxed assets

Proﬁt or loss on the sale of ﬁxed assets Leasing costs for buildings and equipment Research and development carried out to improve the reliability and effectiveness of services

Operating leases for plant and machinery Research and development Directors’ remuneration Fees paid to the auditor

Directors’ remuneration including base salaries and beneﬁts, pensions, car and health beneﬁts, share options, and bonuses

Figures in parentheses represent negative numbers.

Year 2012 £m

51.7 29.1 67.6 120.3 (0.8) 0.2 268.1

45.3 26.7 63.8 114.0 (0.8) (0.5) 248.5

1.5 0.1 2.1 0.2

1.2 0.1 1.8 0.2

Balance sheet A balance sheet is a ﬁnancial statement that shows what a business is worth at a speciﬁc point in time. Its primary purpose is to show assets, liabilities, and equity (capital), rather than ﬁnancial results. How it works The balance sheet essentially shows what the company owns, what it owes, and how much is invested in it. It is based on the accounting formula, sometimes called the balance-sheet equation, which is the basis of double-entry bookkeeping. This shows the

relationship between assets, liabilities, and owners’ capital— what the company owns (assets) is purchased either through debt (liability) or investment (capital). The equation always balances, as everything a company owns has to have been bought with its owner’s funds or through borrowing.

NEED TO KNOW ❯ Deferred income Income a company receives for goods or services that have not yet been delivered or provided. Until income is received it is recorded on a balance sheet as a liability.

The balance-sheet equation As the name suggests, the balance sheet must always balance. This is because everything the business owns (its assets) must be offset against the equivalent capital (or equity) and liabilities (debt).

Company has no liabilities For example, a young business may have assets of $1,000. It currently has no liabilities so its capital is equal to its assets—that is, it is the amount of equity the owners or shareholders have invested in the business. Using the accounting formula, the equation would look like this:

ASSETS

LIABILITY

CAPITAL

$1,000

ASSETS

LIABILITY

CAPITAL

$1,000

$400

$600

Company incurs $400 in liabilities After spending $400 on, for example, an illuminated sign for the storefront, the owner incurs $400 in liabilities and so the formula changes. However, since the sign is worth $400, and the owner has $600 remaining, the equation remains balanced—as it always does.

HOW FINANCE WORKS Financial accounting

116 117

Case study: balance sheet This example from Wessex Water, a UK public utility company, shows how a balance sheet works in practice (at the time, the exchange rate was £1 = $1.58).

Fixed assets (or non-current assets) are not easily converted into cash and usually last longer than one year. They are either tangible, such as land, or intangible, such as a logo Current assets are assets that last one year or less, and can be easily converted into cash. Cash, cash equivalents, and inventory are the most common current assets Creditors are the individuals or organizations to which the company owes money. Here, the money must be repaid in the current ﬁnancial year Net current assets equals current assets after money due to creditors has been deducted Total assets less current liabilities is the sum of ﬁxed and net current assets minus liabilities due within the current ﬁnancial year Liabilities due in more than one year are amounts due to creditors, which are deducted from total ﬁxed and net current assets Net assets are what is left once liabilities have been deducted from the company’s ﬁxed and net current assets to give the overall net assets Shareholders’ funds, or owner’s equity, is the remaining capital; this money can be reinvested into the business or paid out as an annual dividend

ASSETS, LIABILITIES, AND CAPITAL

Fixed assets Tangible assets Investments

Year 2013 Year 2012 £m £m

2,167.1 –

2,069.2 –

7.0 162.6 181.0

6.3 153.9 211.0

350.6 (198.8)

371.2 (171.7)

151.8

199.5

Total assets less current liabilities

2,318.9

2,268.7

Creditors—amounts falling due after more than one year Provisions for liabilities and charges Retirement beneﬁt obligations Deferred income

(1,891.5)

(1,811.9)

(114.9) (93.1) (17.2)

(115.3) (83.0) (17.9)

202.2

240.6

81.3 120.9

81.3 159.3

202.2

240.6

Current assets Stock and work in progress Debtors Cash in the bank and in hand

Creditors—amounts falling due within one year Net current assets

Net assets Capital and reserves Called-up equity share capital Proﬁt-and-loss account Shareholders’ funds

SYMBOLS FOR DEBITS AND CREDITS Accountants use a number of different terms and symbols to indicate debits and credits. Some use “Dr” for debits and “Cr” for credits, others use “+” for debits and “–” for credits. On this balance sheet, parentheses are used to show credits (negative numbers).

BALANCE SHEET

Understanding the notes The balance sheet is a useful indication of the health of a business, and it is important that investors know how to analyze it. It can be read in two ways—“at a glance,” as on the previous page, where general information is summarized, or in depth, with more detailed information about each element. Provided

after the summary, the detailed section of the balance sheet explains the speciﬁc ﬁnancial workings of the business in a number of notes. It shows exactly where money has been gained or lost, in ﬁgures, and it often includes a written commentary about potential developments that may affect the company, such as court cases, stafﬁng, or availability of resources.

Balance-sheet notes Investors may want to know more about the ﬁgures in the summary section, so additional notes and tables give detailed breakdowns of the ﬁgures (at the time, the exchange rate was £1 = $1.58).

Case study: tangible ﬁxed assets This table presents details of Wessex Water’s tangible ﬁxed assets (long-term assets that cannot easily be converted into cash).

Tangible ﬁxed assets include land and machinery Additions are new tangible ﬁxed assets the business has acquired this year

Disposals are any tangible ﬁxed assets the business has disposed of or sold this year Total value of the company’s ﬁxed assets is listed by category and in total Depreciation is the decrease in value of assets over time Value of depreciation of assets is listed by category and in total Net book value of an asset is its initial cost minus all its depreciation to date Combined value of the company’s tangible ﬁxed assets in each category, and also in total, is listed

INFRASTRUCTURE ASSETS

PLANT, MACHINERY, AND VEHICLES

OTHER ASSETS

£m

LAND AND BUILDINGS

Cost As of April 1, 2012 Additions Transfers on commissioning Disposals Grants and contributions As of March 31, 2013

676.3 9.5

1,229.7 67.8

1,204.6 49.1

105.0 2.3

13.7 (0.2) – 699.3

11.2 (5.0) 1,303.7

42.2 (13.1) – 1,282.8

2.8 (0.5) – 109.6

Depreciation As of April 1, 2012 Charge for the period Disposals As of March 31, 2013

211.3 13.7 (0.1) 224.9

435.5 43.2 – 478.7

558.8 56.8 (11.5) 604.1

34.0 6.6 (0.5) 40.1

Net book value As of March 31, 2013

474.4

825.0

678.7

69.5

As of April 1, 2012

465.0

794.2

645.8

71.0

HOW FINANCE WORKS Financial accounting

118 119

Case study: debtors $

Debtors are individuals or entities that owe the business money. Wessex Water has four categories of debtor.

Individuals or entities that sell assets to third parties on credit, receiving payment at a later date

Prepayments for services that will be received in the future, which the business has already been paid for, and accrued income that is expected in the future

= PAYMENTS ON ACCOUNT AND ASSETS IN COURSE OF CONSTRUCTION

TOTAL

£m

93.2 96.2

3,308.8 224.9

(69.9) – – 119.5

– (13.8) (5.0) 3,514.9

Trade debtors Owed by group companies Prepayments and accrued income Other debtors

2013 £m 48.9 31.8 70.3

2012 £m 48.1 35.0 62.1

11.6 162.6

8.7 153.9

Case study: creditors $

Creditors are individuals or entities that the business owes money to. They are in credit of Wessex Water.

Money owed to the bank Individuals or entities that are owed money for supplying raw materials or components

Money owed to related companies that are owned by the same group

– – – –

1,239.6 120.3 (12.1) 1,347.8

Payment to shareholders

119.5

2,167.1

Any notes relating to creditors

93.2

2,069.2

Tax and employee beneﬁt payments

Bank overdraft Inter-company loan Obligations under ﬁnance leases Trade creditors Amounts owed to subsidiary company Amounts owed to other group companies Amounts owed to associate company Dividend Other creditors Corporation tax Taxation and social security Accruals and deferred income

2013 £m

2012 £m

21.8 7.0

18.6 1.3 6.3

4.3 18.9

3.1 14.2

0.6

0.7

0.2

23.3 2.4 16.7 1.9 101.2 198.8

21.7 2.0 9.2 1.7 92.8 171.7

The inter company loan was due to a fellow subsidiary company SC Technology GmbH and has been repaid.

Cash-flow statement The cash-ﬂow statement shows the movement of cash during the last accounting period. It is important because it reveals a company’s liquidity—whether or not it has more money coming in than going out.

How to read a cash-ﬂow statement The statement of cash ﬂows, to give it its ofﬁcial title, answers the key question of whether a business is making enough money to sustain itself and provide surplus capital to grow in the future, pay any debts, and give out dividends. Figures in parentheses are negative numbers.

Case study: cash-ﬂow statement By analyzing this water utility’s statement, which includes a comparison to the previous year, decisionmakers can base future plans on past cash ﬂows (at the time, the exchange rate was £1 = $1.58). Year to Year to March 31, March 31, 2013 2012 £m £m

Using proﬁt before tax as a starting point, non-cash income and expenses are deducted to reach net cash inﬂow from operating activities

Net cash inﬂow from operating activities

334.6

303.2

Returns on investments and servicing of ﬁnance

(80.0)

(79.2)

Taxation is the sum of all taxes paid and tax credits received

Taxation

(21.8)

(31.5)

Capital expenditure and ﬁnancial investment is, here, the sum of the sale of tangible assets plus connection charges, grants, and deferred income

Capital expenditure and ﬁnancial investment

(215.4)

(149.7)

Dividends paid

(129.6)

(129.4)

Cash outﬂow before ﬁnancial investment Financing

(112.2) 79.0

(86.6) 222.2

(33.2)

135.6

Reconciliation of cash movement to the movement in net debt (Decrease)/increase in cash—above (33.2) Movement in loans and leases (79.0)

135.6 (222.2)

Returns on investment in this case is total interest received minus total interest paid, as well as interest paid on ﬁnance lease rentals

Dividends are sums of money paid to shareholders, typically each year This is the sum of all the ﬁgures above Financing describes how much money the company has made or lost from loans, ﬁnance leases, and bonds

This is the change from last year’s ﬁgures to this year’s, and the total of the two ﬁgures above A utility company can afford to operate with more debt than companies with a less stable base

(Decrease)/increase in cash

Movement in net debt Opening net debt

(112.2) (1,626.1)

(86.6) (1,539.5)

Closing net debt

(1,738.3)

(1,626.1)

HOW FINANCE WORKS Financial accounting

How it works The cash-ﬂow statement is often more useful for investors assessing a business’s health than other key statements, because it shows how the core activities

120 121

are performing. The proﬁt-and-loss statement, for example, obscures this by adding in non-cash factors such as depreciation. Similarly, the balance sheet is more concerned with assets than liquidity.

Three types of cash ﬂow Cash refers to actual money as well as cash equivalents including cash in the bank; bank lines of credit, and short-term, highly liquid investments for which there is little risk of a change in value. Cash does not include interest, depreciation, or bad debts (debts written off).

Cash ﬂow from operating activities The bulk of cash ﬂow usually comes from operations, and is worked out with a formula. The change in working capital (current assets minus current liabilities) can be a negative ﬁgure.

REVENUE – COST OF SALES

– TAXES

DEPRECIATION

ANY CHANGE IN WORKING CAPITAL

CASH FLOW FROM OPERATING ACTIVITIES

Cash ﬂow from operating activities in practice In this example, a juice company sells $100 worth of orange juice after spending $20 on oranges. It pays 25 percent of its $80 earnings in tax. Its juicing machine incurs a depreciation

$100

WORTH OF ORANGE JUICE

–

AND SPENDS

$20

I OF T PA ITS YS E IN ARN TA IN X GS

25 %

A JUICE COMPANY SELLS

expense of $20 over the period (a positive adjustment on the orginal outlay for the machine). There is no change in working capital (short-term assets to cover short-term debt).

ITS JUICING MACHINE INCURS A DEPRECIATION EXPENSE OF

$20

OVER THE PERIOD

NO CHANGE IN WORKING CAPITAL

ON ORANGES

Cash ﬂow from investing activities Buying or selling assets or investments is in this category. This ﬁgure is usually a cash outﬂow (negative ﬁgure) due to buying more than selling, but can be positive if there are signiﬁcant sales.

Cash ﬂow from ﬁnancing activities This includes buying or selling stock or debt and paying out dividends. Money made from selling something is called cash inﬂow; money lost through paying out is cash outﬂow.

= $80 CASH FLOW FROM OPERATING ACTIVITIES

Total cash ﬂow

Adding all three cash ﬂows gives the total. Separating out the three types shows decisionmakers the health of core activities as opposed to ﬁnancing and investing, which bear little relation to day-to-day operations.

Environmental accounting Environmental regulations force companies to consider the impact of their activities and to adopt corporate social responsibility (CSR) as they grapple with legislation, climate change, and public opinion. How it works Globally, there are reams of different environment acts spread across multiple jurisdictions that affect the companies operating within their borders in different ways. Areas protected by environment acts include the atmosphere, fresh water, the marine environment, nature conservation, nuclear safety, and noise pollution. International acts are usually ratiﬁed by each country individually before taking effect there. An example of a common global means of reducing greenhouse gas emissions is emissions trading (“cap and trade”), by which companies must buy a permit for each ton of CO2 they emit over a certain level. Those emitting under the agreed level can sell their permits to other companies.

Environmental credentials Most companies include a section on environmental accounting in their ﬁnancial statement. Some details are required by law, but the statement also gives an opportunity to showcase environmental credentials to stakeholders.

Society ❯ Programs and practices that assess and manage the impact of operations on communities ❯ Fines and sanctions for noncompliance with regulations

CASE STUDY Cleaning up rivers Wessex Water’s impressive record on pollution is mentioned several times in its statement, including in the chairman’s introduction. This prominence shows that the company believes acting in an environmentally conscious manner is important to its investors. The company illustrates several areas where it has acted with others to positively affect the environment: ❯ Work with the charity Surfers Against Sewage, which campaigns for clean seawater ❯ Its river strategy: collaborating with pressure groups and organizations to reduce pollutants and the impact of habitat alteration, and so increase the numbers of aquatic plants, invertebrates, and ﬁsh in local rivers ❯ Improving water quality at swimming beaches in the region, in compliance with mandatory standards

Product responsibility ❯ Life-cycle stages in which the health-and-safety impact of products and services are assessed for improvement ❯ Adherence to laws, standards, and voluntary codes relating to marketing communications

HOW FINANCE WORKS Financial accounting

122 123

GREENHOUSE GAS EMISSIONS In some countries, companies are required by law to provide details of their greenhouse gas emissions. This is usually presented as a table in the environmental accounting section of the annual report. It includes direct and indirect emissions—by the company itself and by third parties—of gas, diesel, and other fuels; sulfur oxides and nitrous oxides; methane; and other ozonedepleting substances. In this table, from the Wessex Water utility company, emissions are shown as ktCO2 equivalents.

Appointed business

Direct fuel use

Grid electricity

Third parties

Total 2012–13

Total 2011–12

Gas, diesel, other fuels

Grid electricity

115

107

Transportation

Methane

Nitrous oxide

Exported renewable

(3)

(4)

TOTAL (net emissions)

112

169

161

Economic ❯ Financial implications, risks, and opportunities for the organization’s activities due to climate change ❯ Financial assistance received from the government

Environmental ❯ Direct and indirect energy consumption ❯ Waste by type and disposal method ❯ Water withdrawal by source; discharge by destination and quality ❯ Fines and sanctions for noncompliance with regulations

Human rights ❯ Investment agreements that include human rights clauses or that have undergone human rights screening ❯ Suppliers and contractors that have undergone screening on human rights; actions taken to address any issues

Labor practices ❯ Workforce by employment type, contract, and region ❯ Average hours of training per year, per employee by employee category ❯ Ratio of basic salary of men to women by employment category

Depreciation When a company buys an asset, its cost can be deducted from income for accounting and tax purposes. Depreciation allows the company to spread the cost, by calculating the asset’s decline in value over time. How it works If a business buys a long-lived asset, such as a building, factory equipment, or computer, to help it earn income, this expenditure can be offset as a cost against income earned. However, not all this income will be generated in the year of purchase and, over time, the asset will age and become less beneﬁcial to the business, until it becomes outdated or unusable. Accountants do two things to turn the declining value into a tax advantage. Firstly, they work out how much the asset’s value decreases over a period of time—

typically a year. Secondly, they match that loss in value to the amount of income earned in that period, so depreciation becomes a deduction from taxable income. There are several different ways to calculate depreciation. The method a company uses may depend on the kind of business, the type of asset, tax rules, or personal preference. In the United States, per IRS guidelines, companies must use MACRS (Modiﬁed Accelerated Cost Recovery System), a combination of straight-line and double declining balance methods (see below and p.126).

Calculating depreciation

NEED TO KNOW ❯ Fixed/tangible assets Items that enable a business to operate but are not a part of trade; assets lasting a year or more qualify for depreciation ❯ Useful/economic life Length of time an asset is ﬁt for its purpose and has monetary value ❯ Salvage/scrap/residual value Worth of an asset once it has outlived its useful life—often set by the tax authority ❯ Book value An asset’s worth on paper at any point between its initial purchase and salvage

VALUE ($)

The straight-line method is the simplest way of working out depreciation and can be applied to most assets. Depreciation is calculated along a timeline, with value loss spread evenly over the asset’s economic life. Scrap value is deducted from purchase value and the remainder is split into equal portions over time.

0 ,00 $21

$25,000 $20,000 $15,000 $10,000

PURCHASE – VALUE

SCRAP VALUE

USEFUL ECONOMIC LIFE (YEARS)

ANNUAL DEPRECIATION ($)

$5,000 $

Example A landscaping business buys a new van for $25,000. The IRS sets its scrap value at $5,000 after ﬁve years of use.

$25,000 – $5,000 5

= $4,000

Year 1 After a year, the van’s value has depreciated by $4,000 (its purchase value minus its scrap value, divided by its useful economic life). Its value is now $21,000.

HOW FINANCE WORKS Financial accounting

124 125

TYPICAL LIFE OF FIXED ASSETS Tax authorities often specify the typical useful (economic) life of a particular asset. This helps to standardize depreciation, and to eliminate uncertainty about value and the number of years over which an asset can be depreciated.

OFFICE FURNITURE 6 years

RACEHORSES 2 years

ROADS 15 years

5 COMPUTERS 3 years

Time (years)

60%

the value the average car loses after three years

15 BOATS 20 years

FRUITBEARING TREES 10 years

0 ,00 $17 0 ,00 $13

000 $9, 000 $5,

Year 2 After the second year, the value has depreciated by another $4,000. The van will lose an equal amount of value each year for the next three years of its useful economic life.

Year 3 At the end of the third year, the van has depreciated by another $4,000, and its book value is $13,000, although its actual value may be more or less.

Year 4 The van has depreciated by $4,000, to $9,000, at the end of four years of life.

5 TIME (YEARS)

Year 5 By the end of year ﬁve, the van is valued at only $5,000— its scrap value.

DEPRECIATION

Applying depreciation When calculating depreciation, there are a number of different factors to consider. For instance, a business needs to be able to predict the number of years an asset will last. Helpfully, tax authorities in most countries issue guidelines to accountants and businesses with estimates of the useful economic life of many common business assets. Companies may also wonder which of the many methods of calculating depreciation to use for a given asset. Each method reﬂects a different pattern of depreciation, with some being more suitable for particular

categories of assets. For example, the “accelerated” methods that chart rapid depreciation at the beginning of an asset’s life are more suitable for technology, while the “activity” methods that link depreciation to actual hours of use or number of units produced are best suited to transport and production lines. Again, tax authorities in most countries offer guidelines on which method to use. Although it is technically possible for a company to use two different methods for their own accounting and for tax purposes, this is best avoided.

WARNING Misusing depreciation ❯ The wrong method A company must choose a method that is permissible for an asset type ❯ Frontloading Opting for an accelerated method can result in a taxable gain if an asset is sold early, for more than its book value ❯ Claiming beyond useful life Depreciation cannot be claimed after an asset’s useful life ❯ Ignoring depreciation If a company fails to claim depreciation, it has to report a gain from the sale, despite the loss on deduction

Other depreciation methods There are many different methods of calculating depreciation. Some are favored by particular tax codes, while others are speciﬁcally applicable to certain industries and types of assets, and their patterns of value loss.

Double declining balance method A method used to claim more depreciation in the ﬁrst years after purchase, which is useful for assets that lose most of their value early on. It reduces a company’s net income in the early years of an asset’s life, but generates initial tax savings.

(

PURCHASE VALUE – SCRAP VALUE USEFUL ECONOMIC LIFE (YEARS)

)

ANNUAL X 2 = DEPRECIATION (%)

When to use it This accelerated method can be used for any asset that loses value early on, such as computers or a delivery truck.

Sum of the years’ digits method (SYD) Depreciation is calculated by dividing each year of the asset’s life by the sum of the total years to give a percentage of the depreciable value. If the asset’s useful life is 5 years, then the sum of the years as digits is 15 (5 + 4 + 3 + 2 + 1). In year 1, it loses 33 percent (5 ÷ 15), in year 2, 27 percent (4 ÷ 15), and so on.

(PURCHASE VALUE – SCRAP VALUE) ANNUAL X = DEPRECIATION REMAINING USEFUL LIFE (%) SUM OF THE YEARS’ DIGITS

(

)

When to use it This is another accelerated method that can also be used for vehicles that lose most of their value early on.

HOW FINANCE WORKS Financial accounting

126 127

DEPRECIATION ON THE BALANCE SHEET A company’s accounts have to list all assets held by the company, including all ﬁxed assets such as property and equipment. The accumulated depreciation of these ﬁxed assets over the year is deducted from their value at the start of the year to give the year-end total. Without a depreciation ﬁgure, the accounts would give a false reﬂection of the ﬁnances of the business. The assets would appear as their original cost value and that might well exceed their current value. Fixed assets are shown distinct from current assets Depreciation of ﬁxed assets is deducted

Total assets are calculated after depreciation has been deducted Previous year’s total assets can be compared

COMPANY NAME

BALANCE SHEET

Assets Current assets: Cash Investments Inventories Accounts receivable Prepaid expenses Other Total current assets

2013 17,467.00 4,853.00 1,056.00 2,165.00 3,000.00 860.00 29,401.00

2014 8,023.00 3,367.00 2,138.00 3,600.00 3,000.00 976.00 21,104.00

Fixed assets: Property and equipment Building/site improvements Equity and other investments Less accumulated depreciation Total ﬁxed assets

2013 64,553.00 4,780.00 3,789.00 5,625.00 67,497.00

2014 58,219.00 2,679.00 4,587.00 4,171.00 61,314.00

2013 1,577.00 1,577.00

2014 1,650.00 1,650.00

98,475.00

84,068.00

Other assets: Goodwill Total other assets Total assets

Units of production method When a company uses an asset to produce quantiﬁable units, such as pages printed by a photocopier, it can claim depreciation with this method, which calculates depreciation according to the number of units an asset produces in a year.

(PURCHASE VALUE – SCRAP VALUE) X DEPRECIATION UNITS PRODUCED PER YEAR = (PER UNIT) LIFETIME PRODUCTION

(

)

When to use it This method is typically used by factories to calculate depreciation on machines that produce units of goods.

Hours of service method The asset’s decline in value is measured according to the number of actual hours it is in use. To calculate depreciation using this method, the company measures the hours of use per year as a percentage of the estimated total lifetime hours. It is particularly useful for transportation industries.

(PURCHASE VALUE – SCRAP VALUE) X DEPRECIATION = HOURS USED PER YEAR (PER HOUR)

(

LIFETIME HOURS

)

When to use it This method may be used to match an airplane’s ﬂying hours with the revenue generated from those hours.

Amortization and depletion Similar concepts to depreciation, amortization and depletion are used by accountants to show how intangible assets and natural resources respectively are used up. How it works

asset on the balance sheet and an expense on the income statement. In lending, amortization can also mean the paying off of debts over time. Depletion shows the exhaustion of natural resources such as coal mines, forests, or natural gas.

Amortization is how the cost of purchasing an intangible asset, such as copyright of an artwork, is spread over a period of time, usually its useful lifetime. It is shown as a reduction in the value of the intangible

Amortization in practice There are two types of amortization, one for spreading the cost of an intangible asset, the other for loan repayment. Both are calculated in similar ways, but loan repayments are worked out as a percentage.

Intangible assets In this example, a VALUE ($) company buys an $20,000 intangible asset— a patent for a new, revolutionary type $16,000 of tennis racket—for $20,000. The patent $12,000 will be useful for 10 years, so its cost is $8,000 recorded as a $2,000 amortization (expense) each year rather than as $4,000 a one-time cost. Unlike tangible assets, a patent does not have a salvage 0 value (see p.124).

INITIAL COST

YEARLY AMORTIZATION

$2,000

USEFUL LIFE $20,000 10 YEARS

Loan percentage If a company has an outstanding loan worth $150,000, and pays off $3,000 of this loan each year, then $3,000 of the loan has been amortized. It can also be said that 2 percent of the loan has been amortized, as it will take 50 years to repay the loan at this rate.

COST OF LOAN YEARLY REPAYMENT 150,000 3,000

9 10 TIME (YEARS)

YEARS TO REPAY 100 50 100

= %

= 2%

HOW FINANCE WORKS Financial accounting

GOODWILL

128 129

NEED TO KNOW

In business, goodwill describes an intangible asset based on a company’s reputation, including loyal customers and suppliers, brand name, and public proﬁle. Goodwill arises when one company buys another for more than its book value (total assets minus total liabilities). For example, if Company A buys Company B for $10 million but the

❯ Intangible assets Nonphysical assets, such as patents, trademarks, brand recognition, and copyright; their valuation is sometimes subjective ❯ Patent A license granted by a government or authority giving the owner exclusive rights for making or owning an invention

total sum of its assets and liabilities is $9 million, the goodwill is worth $1 million. According to International Financial Reporting Standards since 2001, goodwill does not amortize, so it does not appear as amortization in ﬁnancial statements. However, if the value of goodwill falls (through negative publicity, for example) it can be recorded as an impairment.

How to calculate depletion Like amortization, depletion is calculated using the straight-line method (see pp.124–125) unless there is a particular reason to use another method.

60,000

6,000

MI $2.8 LLI ON

30,000

MI $3.7 LLI ON

MI $4.6 LLI ON

MI $5.5 LLI ON

40,000

DEPLETION UNITS = EXPENSE EXTRACTED

20,000

$900,000

10,000

MI $1 LL IO N

10,000,000 – 1,000,000

MI $6.4 LLI ON

50,000

TOTAL UNITS

MI $1.9 LLI ON

COST – SALVAGE VALUE

MI $7.3 LLI ON

M $8.2 ILL IO N

60,000

M $9.1 ILL IO N

NUMBER OF TREES

M $10 ILL IO N

In this example, a logging company buys a forest with an estimated 60,000 trees for $10 million. The original salvage value is $1.5 million, but the company spends $500,000 on road building in the forest, bringing it down to $1 million. The company cuts down 6,000 trees during each accounting period.

0 1

10 TIME (YEARS)

Management accounting For a company’s management to anticipate proﬁt and loss, plan cash ﬂow, and set effective goals for the business, the coming year’s incomings and outgoings need to be set out in detail. Unlike ﬁnancial accounting, which is primarily for external users such as investors, lenders, or regulators, management or cost accounting takes place within a business to project expected sales revenue and expenses, so that the business can decide how to best use its available resources.

Department budgets Managers estimate what funds will be needed for expected outgoings. See pp.136–137.

Management accounting process

Purchase orders (POs) POs tell the ﬁnance department exactly how much money to reserve for payment.

Planning is done for the ﬁnancial (ﬁscal) year that lies ahead—this is also called the accounting year and is made up of 12 consecutive months. Start and end dates differ from country to country.

Timesheets Staff employed on an hourly or daily basis ﬁll in timesheets; these help managers to calculate overall staff costs. See pp.140–141.

Invoices Invoices submitted by contractors and suppliers have to be matched against purchase orders and paid out. See pp.134–135.

Goods received Employees log receipt of merchandise, describing what the goods or services are and the quantity received.

Management Managers create budgets and document business costs to monitor business performance, and plan for the short and medium term. The information they collate sheds light on the ﬁnancial implications of ongoing projects.

Information is passed to ﬁnance department

HOW FINANCE WORKS Management accounting

80%

130 131

COST ACCOUNTING PRINCIPLES

of accountants and ﬁnancial professionals in the US are employed within a business or organization

The Chartered Institute of Management Accounting (CIMA) in the UK and the American Institute of Certiﬁed Public Accountants (AICPA), with members in 177 countries, have established Global Management Accounting Principles. ❯ Communication provides insight that is inﬂuential Facilitate good decision-making through discussion. ❯ Information is relevant Source best material. ❯ Stewardship builds trust Protect ﬁnancial and nonﬁnancial assets, reputation, and value of organization. ❯ Impact on value is analyzed Develop models to demonstrate outcomes in different scenarios.

Cost of production report (CPR)

CPR shows all of the costs that can be charged to a particular department. See pp.140–143.

Budget reports Reports help management to determine the accuracy of budgets and analyze business performance. See pp.136–137.

Cash-ﬂow statement

This shows how well the business will be able to meet its ﬁnancial obligations and generate cash in the future. See pp.120–121.

Balance sheet Financial analysis is passed to managers

The balance sheet estimates the value of assets and inventory held, so that management can reduce it if necessary. See pp.116–117.

Proﬁt-and-loss statement Also called an income statement, the P&L statement tells management how much money the business made or lost over a particular time period. See pp.114–115.

Finance department Accountants in the ﬁnance department (or contracted from outside the business) receive information about the costs from managers. They then use these to generate reports and statements for the managers, who use this information to make decisions for the next ﬁnancial year.

Cash flow The money coming in and going out of a business is its cash ﬂow; the balance of inﬂow and outﬂow is key to survival. Inﬂows arise from ﬁnancing, operations, and investment, while outﬂows are expenses.

Sales revenue Cash for goods and services sold ❯ Revenue generated by core operations ❯ Basis of proﬁt—does not have to be repaid, unlike loans or capital ❯ Company must be able to turn revenue into cash (get paid) to maintain cash ﬂow ❯ Also known as cash ﬂow from operating activities

“Cash comes in, cash goes out, but the tank should never be empty.”

Capital Investment and lump sums ❯ Main source of cash inﬂow for start-ups ❯ Additional cash injection after initial start-up or at key stages in a company’s growth ❯ Revenue from ﬂotation of private companies (going public) and shares issued by public companies ❯ Also known as cash ﬂow from investing activities

CASH IN

CASH OUT

Ca sh in han d

Salaries and wages

Overheads

Loan repayments

Payments to employees

Payment of bills

❯ Money paid to employees who are directly involved in the creation of goods or provision of services ❯ Salaries paid to staff as a ﬁxed amount monthly or weekly (based on an annual rate) ❯ Wages paid to contractors for hours, days, or weeks worked

❯ Day-to-day running costs ❯ Rental cost of commercial property; utility bills—water, electricity, gas, telephone, and internet; ofﬁce supplies and stationery ❯ Salaries and wages of employees not directly involved in creating goods and services (known as indirect labor)

Debt servicing and shareholder proﬁt ❯ Interest on long-term loans for asset purchases and on shortterm loans for working capital ❯ Repayments on capital loans ❯ Commission paid to factoring companies ❯ Cash distribution to shareholders via share repurchases and dividend payments

HOW FINANCE WORKS Management accounting

How it works Cash ﬂow is the movement of cash in and out of a business over a set period of time. Cash ﬂows in from sales of goods and services, loans, capital investment,

132 133

and other sources. Cash ﬂows out to pay employees, rent and utilities, suppliers, and interest on loans. Timing is key—having enough cash coming in to pay bills on time keeps the company solvent.

Other revenue Grants, donations, and windfalls

Loans Bank loans and overdrafts CASH IN

$ $

CASH IN

❯ Working capital loans to meet shortfalls, with anticipated inﬂows as collateral ❯ Advances on sales invoices from factoring companies ❯ Short-term overdrafts ❯ Also known as cash ﬂow from ﬁnancing activities

❯ Grants from government or other institutions, usually one-time sums for research and development ❯ Donations and gifts (applicable to nonproﬁt organizations) ❯ Sales of assets and investments ❯ Repayment of loans made to other organizations ❯ Tax refunds

$ CASH OUT

k toc or s Suppliers

Tax

Equipment

Payments for materials and services

Payments to tax authorities

Purchase of ﬁxed assets

❯ Corporation tax based on annual ﬁnancial statements ❯ Payroll tax paid by employers on behalf of employees ❯ Sales tax on goods or services ❯ Varies from country to country, depending on tax law

❯ Cost of buildings and equipment, such as computers and phones, ofﬁce furniture, vehicles, plant, and machinery ❯ Offset by depreciation (see pp.124–127)

❯ Cost of raw materials needed to manufacture goods for sale ❯ Cost of stock, imported or local ❯ Fees for services such as consulting or advertising to generate revenue ❯ Payments to contractors involved in goods and services creation

CASH FLOW

Cash-flow management The handling of cash ﬂow determines the survival of any business. Equally important is a company’s ability to convert its earnings into cash, which is known as liquidity. No matter how proﬁtable a business is, it may become insolvent if it cannot pay its bills on time. New businesses may become victims of their own success and fail through “insolvency by overtrading” if, for example, they spend too much on expansion before payments start coming in and run out of cash to pay debts and liabilities. In order to

manage cash ﬂow, it is essential for companies to forecast cash inﬂows and outﬂows. Sales predictions and cash conversion rates are important. A schedule of when payments are due from customers, and when a business has to pay its own wages, bills, suppliers, debts, and other costs, can help to predict shortfalls. If cash ﬂow is mismanaged, a business may have to pay out before receiving payment, leading to cash shortages. Some businesses, such as supermarkets, receive stock on credit but are paid in cash, generating a cash surplus.

WARNING Top ﬁve cash-ﬂow problems ❯ Slow payment of invoices ❯ Credit terms on sales invoices set at 60 or 120 days, while credit terms on outgoings are 30 days ❯ Decline in sales due to change in economic climate or competition, or product becoming outmoded ❯ Underpriced product, especially in start-ups trying to compete ❯ Excessive outlay on payroll and overheads; buying rather than renting assets

Positive and negative cash ﬂow

CASH IN CASH IN

$ CASH IN HAND INCREASES

$ CASH IN HAND STABLE

CASH OUT

Positive cash ﬂow

Stable cash ﬂow

Cash ﬂowing into the business is greater than cash ﬂowing out. Cash in the tank—stock—increases. A business in this position is thriving.

Cash ﬂows into the business at the same rate as it ﬂows out. Cash stock remains stable—a sign that a business is healthy.

CASH OUT

HOW FINANCE WORKS Management accounting

NEED TO KNOW ❯ Factoring Transaction in which a business passes its invoices a third party (factor), which collects payment from the customer for a commission ❯ Accounts payable Payments a business has to make to others ❯ Accounts receivable Payments a business is due to receive ❯ Aging schedule A table charting accounts payable and accounts receivable according to their dates ❯ Cash-ﬂow gap Interval between payments made and received

Cash conversion Successful businesses convert their product or service into cash inﬂows before their bills are due. To make the conversion process more efﬁcient, a business may speed up: ❯ Customer purchase ordering ❯ Order fulﬁllment and shipping ❯ Customer invoicing ❯ Accounts receivable collection period ❯ Payment and deposit

134 135

80%

of small business start-ups across the world fail because of poor cash-ﬂow management HANDLING THE FLOW Managing a surplus

CASH IN

❯ Move excess cash into a bank account where it will earn interest, or make proﬁtable investments. ❯ Use cash to upgrade equipment to improve production efﬁciency. ❯ Expand the business by taking on new staff, developing products, or buying other companies. ❯ Pay creditors early to improve credit credentials, or pay down debt before it is due.

NO CASH IN/OUT

CASH IN HAND DECREASES

CASH DRIES UP CASH OUT

Negative cash ﬂow

Managing a shortage NO CASH IN/OUT

Less cash is ﬂowing into the business than is ﬂowing out. Over time, the stock of cash will decrease and the business will face difﬁculties.

Bankruptcy If cash ﬂowing out continues to exceed cash ﬂowing in, cash stock levels will drop so low that the business becomes insolvent—it has no assets left to continue trading.

❯ Increase sales by lowering prices, or proﬁt margins by raising them. ❯ Issue invoices promptly and pursue overdue payments. ❯ Ask suppliers to extend credit. ❯ Offer discounts on sales invoices in return for faster payment. ❯ Use an overdraft or short-term loan to pay off pressing expenses. ❯ Continue to forecast cash ﬂow and plan to avert future problems.

Budgets Setting the budget for a business involves planning the income and expenditure for the accounting year. This is usually broken down into months so that planned budget and actual ﬁgures can be compared. How it works Every business needs to budget for anticipated revenue and operating costs within the ﬁnancial year. Unlike capital budgeting, in which senior management allocates what will be spent on speciﬁc projects or assets, revenue budgeting focuses on the overall projections for money coming in and money going out for each month of the coming ﬁnancial, or accounting, year. Accountants compile operating budgets from

each manager in the business, along with expected cash-ﬂow projections for the business, to create a master budget. The master budget can also include ﬁgures for any ﬁnancing that the company is expected to need over the coming year. As the year progresses, the projected budget and the actual money coming in and going out are monitored on a daily, weekly, or monthly basis, so that any deviations from the original budget can be identiﬁed, and, if necessary, remedied.

Setting and controlling budgets Budget-setting is a process that takes place between the department managers, senior management, and ﬁnance department in a company to establish and control the cost of each department or project.

of companies worldwide made accurate budget forecasts, from 2004 to 2007

Consultation

Prepare the budget

Senior management sets out the company’s objectives to the departmental managers. Each manager is then responsible for working out the budget required by their individual department, in order to meet those objectives for the coming year.

The budget is usually based on the accounting year, but broken down into shorter periods. Departmental managers submit their budgets to senior management for approval. These may cover areas such as operating costs (salaries and supplies) and administration (ofﬁce expenses).

HOW FINANCE WORKS Management accounting

INCREMENTAL AND ZERO-BASED There are two main approaches to setting budgets: Incremental budget The budget for the year ahead is based on the previous year’s budget. This budget takes into account any changes, such as inﬂation, which could have an impact on the new calculations. The downside is that previous inaccuracies may be carried forward.

Zero-base budget The coming year’s budget starts afresh, with no reference to previous years. This means that each item entered into the budget is carefully scrutinized and has to be justiﬁed by the department managers. This method makes it easier to see the full cost of all planned changes.

136 137

NEED TO KNOW ❯ Planning, Programming, and Budgeting Systems (PPBS) A budgeting system used in public service organizations such as city councils and hospitals ❯ Virement An amount saved under one cost heading in a budget is transferred to another cost heading to compensate for overspend ❯ Budget slack Deliberately underestimating sales or overestimating expenses in a budget

$ $

Master budget

Measure performance

Take action

Once approved, the budgets from each department are combined into a master budget for the year, which includes: a budgeted proﬁt-and-loss account, a projected balance sheet, and a budgeted cash-ﬂow statement that typically shows a month-bymonth breakdown.

After each month (or equivalent time period set in the budget), the actual ﬁgures realized by the company are compared with the original budget projections. Variations are examined closely to work out whether they are signiﬁcantly different from the ﬁgure in the original budget.

If necessary, the budget is revised to take into account any unforeseen and continued expenditure, or any savings that were not anticipated. If income is less than expected, action may be taken to alter departmental processes or campaigns in order to reach the targets set in the budget.

Assets and inventory A company’s possessions, or assets, are divided into two categories: ﬁxed (or long-term) assets and current (or short-term) assets. Current assets consist of cash in the bank and inventory. How it works Fixed assets are items that enable a business to operate. They tend to be long-term holdings and cannot be easily converted into cash. Fixed assets can be categorized as either tangible or intangible: tangible assets are material objects, while intangible assets have no physical form.

Current assets are held for the short term and used mainly for trading. The most important category in terms of generating revenue is current assets. The key component of these is inventory. Inventory can be ﬁnished goods ready for sale, but it can also be the raw materials that will be used for producing the goods.

NEED TO KNOW ❯ Asset valuation A method of assessing the value of a company’s holdings. Asset valuations may take place prior to a merger or the sale of the business, or for insurance purposes

Assets and inventory in practice The partial balance sheets below show the current assets of a branch of Super Sports Inc., a sportswear and sports accessories company. These assets include cash in the bank and inventory held by the company. The inventory in this case consists of all the items in the shop that are ready for sale.

Super Sports Inc.

May 31

June 15

Assets

Cash at bank Inventories

12,000 22,000

Cash at bank Inventories

54,000 0

Total assets

34,000

Total assets

54,000

Balance sheet as of May 31

Balance sheet as of June 15

The “Assets” section of the balance sheet shows that the company holds $22,000 worth of inventory (or goods) at this point in time, as well as $12,000 cash in the bank.

Two weeks later, the company sells all of its inventory for $42,000 and receives payment for this sale on the same day. This means that total assets have risen by $20,000—the proﬁt made on the sale of the inventory—and increases the amount of cash in the bank by $42,000.

138 139

HOW FINANCE WORKS Management accounting

TYPES OF INVENTORY Inventory can include three types of stock, depending on the kind of business being carried out: raw materials, unﬁnished goods, and ﬁnished goods. See pp.316–317.

Raw materials

Work in progress

Finished goods

Materials and components scheduled for use in making a product. For example, a chocolate factory will have: ❯ Ingredients in the form of sugar, cocoa mass, cocoa butter, additives, ﬂavorings, and perhaps milk or nuts. ❯ Foil, plastic, and paper for the wrappers and packaging

Materials and components that have begun their transformation into ﬁnished goods; these may be referred to as “unﬁnished goods.” For instance, a graphic designer will have: ❯ Layouts and designs that are being developed and are awaiting client approval

The stock of completed products, or goods ready for sale to customers. A bookstore, for example, will have: ❯ Hardback and paperback books of various genres and formats supplied by publishing houses ❯ Gift items such as greeting cards and notebooks

Types of ﬁxed assets Super Sports Inc. owns a range of tangible and intangible ﬁxed assets. Compared to tangible ﬁxed assets, the worth of intangible ﬁxed assets can sometimes be harder to evaluate.

Store displays and back ofﬁce furniture

Computers for administrative work

TO O

Trucks and branded company cars

D MACH AN I

Y ER

Retail outlets plus company headquarters

VEHICLES

TER EQUIPM PU

CO M

RNITURE FU

T EN

ND PROP E DA N

Tangible ﬁxed assets

Warehouse and distribution equipment

DEMARK

BRANDS CO

Own brands, including value and luxury ranges

R SOFT

Internet portal for online sales

T AND RO GH Y RI

S TIE AL

Legally protected words and symbols

TE PU

Brands and designs, creative innovation

COP Y

A TR

UAL PR OP ECT LL

INT E

Intangible ﬁxed assets

Licensing revenue streams

Costs Costs are the direct or indirect expenses that a business incurs in order to carry out activities that earn revenue, such as manufacturing goods or providing a service. How it works There are two main ways of classifying costs: direct, or variable, costs, which increase as more goods and services are sold, and indirect costs, which contribute to the overall running of the business and can either vary with the level of production or stay ﬁxed. There are three main costs that businesses need to account for. The ﬁrst is labor—wages paid to people employed to carry out a particular task. Labor can be regarded as direct or variable, or as a ﬁxed cost or overhead. The second is the raw materials used in production and other materials used in service industries—these costs are variable. The third is expenses, which are other costs incurred in the course of the business’s activities.

Variable costs The head chef orders the ingredients that will be required each day. For peak evenings the cost of the food order is higher; for quieter nights, the food order is lower.

Fixed costs

Fixed and variable costs One way of looking at costs is to split them into two categories: ﬁxed costs, which do not change with the level of business activity, and variable costs, which do change with the level of business activity. This helps accountants to determine how changes in business activity (for example, cutting or increasing production) will affect costs. In reality, some ﬁxed costs will increase once business activity reaches a certain level—these are called stepped ﬁxed costs.

LARGE FOOD ORDER

RENT AND INSURANCE COSTS

LAUNDRY SERVICES STAFF SALARIES

CLEANING BILL

A restaurant rents premises to cater for 40 diners. The ﬁxed costs are the same whether the restaurant serves 30 or 40 diners a night.

HOW FINANCE WORKS Management accounting

140 141

NEED TO KNOW ❯ Break-even point (BEP) The point at which total sales revenue is equal to total costs ❯ Questionable costs Costs that can be treated as ﬁxed or variable ❯ Sunk costs Costs incurred in the past that cannot be recovered ❯ Prospective costs Costs that may be incurred in the future depending on which business decisions are made PEAK EVENINGS

QUIETER EVENINGS

SMALL FOOD ORDER

Stepped fixed costs

40%

of business owners say that payroll is their greatest expense

HIGHER RENT AND INSURANCE COSTS

EXTRA LAUNDRY SERVICES HIGHER STAFF COSTS

HIGHER CLEANING BILL

The restaurant becomes popular, so the owner rents the premises next door to serve an additional 40 diners a night. The costs that were ﬁxed at a certain level have now doubled.

Product costing and pricing Knowing the full cost of creating each product that a business sells is vital because it helps a company price its products appropriately and assess the performance of the business. How it works Both direct and indirect costs contribute to the production cost of a product, whether it is a manufactured good or a service being provided. In order to

calculate the cost of a product, it is treated as one unit of production. The direct and indirect costs involved in creating that single unit are then assessed and added together to create the full cost.

38%

the average total of US business costs that can be accounted for by indirect costs

Full cost pricing Direct costs can be measured in terms of how materials and labor are used to produce each unit. Indirect costs (overheads) are harder to assess but also need to be factored in so that the full cost of each product can be calculated. Managers and accountants must apportion indirect costs to reﬂect their contribution to the cost of creating a single product. Once this is ascertained, the full cost of that product can be determined. In general terms, the price is worked out by adding the direct and indirect costs of production with a proﬁt margin that gives an appropriate selling price.

NEED TO KNOW ❯ Absorption costing Allocation of all production costs to product ❯ Differential costing Difference between the cost of two options ❯ Incremental (marginal) costing The change in total costs incurred when one additional unit is made ❯ Throughput costing An analysis of the impact that one extra unit of production will have on sales ❯ Cost-plus pricing Product price is based on direct and indirect costs, plus markup percentage

Direct costs

Share of indirect costs

❯ Materials ❯ Direct labor ❯ Direct expenses ❯ All used exclusively to create a product or service for sale

❯ Production and service overheads ❯ Administrative and management overheads ❯ Sales and distribution overheads

HOW FINANCE WORKS Management accounting

142 143

OTHER COSTING METHODS

There are several different approaches to costing and pricing depending on the industry, the type and size of the business, and the method of production.

JOB COSTING Used for a customized order made to a client’s speciﬁcations—for example, a printing company that prints brochures for a client

BATCH COSTING Used when a batch of identical products is made—for example, an electrical goods company manufacturing television sets

CONTRACT COSTING Used for a large one-time job, often the result of a tender process (when a company bids for work) and carried out at the client’s site—for example, a construction company building homes in a new residential development

$ SERVICE COSTING Used when the product being sold is a standard service offered to customers—for example, a nail salon offering an express manicure and pedicure within a set period of time and for a ﬁxed price

PROCESS COSTING Used for an ongoing job that often involves several manufacturing processes, making it difﬁcult to isolate individual unit costs—for example, an oil reﬁnery which processes crude oil into diesel oil

Selling price

❯ Must be able to generate proﬁt for the company ❯ Must be in line with how the product has been marketed ME ❯ Must be HO Y E R pitched XU R SAL U L realistically so FO that customers will buy

❯ Low: in order to gain market share, or to match competitors ❯ Cost-based: recover direct and indirect costs and proﬁt margin that the market will accept ❯ Service-based: ﬂexible since no manufacturing or distribution cost

Proﬁt margin

Measuring performance There are two main ways of measuring a company’s performance: ﬁnancial and non-ﬁnancial. To assess ﬁnancial performance, a company calculates ﬁnancial ratios. To assess other areas of the business, a company examines its key performance indicators (KPIs), which help management and staff evaluate performance and how it can improve. KPIs also enable interested outsiders, such as investors, lenders, or analysts, to decide whether to invest in the business.

Financial and nonﬁnancial categories Any company that publishes a ﬁnancial report will be required to set out key ﬁgures on the revenue generated and the expenses incurred during the course of its activities. These ﬁgures can be compared using mathematical calculations called ﬁnancial ratios. However, ﬁnancial ratios alone may not give an accurate vision of the company’s future prospects. Non-ﬁnancial ratios, or key performance indicators, do not measure ﬁnancial Tracking and forecasting performance, but they do reveal other important Financial and non-ﬁnancial measures can be characteristics of a company used to forecast company performance and that will ultimately affect its track fraud. See pp.152–153. proﬁtability, such as customer loyalty and research and development (R and D) productivity.

Comp any

HOW FINANCE WORKS Measuring performance

144 145

TREND ANALYSIS USING PERFORMANCE MEASUREMENTS A comparison of either ﬁnancial CURRENT ratios or KPIs RATIO between companies 0.9 in the same industry and across time 0.8 is often used to 0.7 track a company’s 0.6 performance. 0.5 Current ratios are calculated by 0.4 dividing current 0.3 assets by current 0.2 liabilities: the higher the ratio, 0.1 the more liquidity a company has. 1

CURRENT RATIO COMPARISON OVER TIME Fast-food chain A is shown to be a consistently better performer over time, and so has the most solid ﬁnancial standing of the three companies.

l ia nc res na u Fi eas m ❯ Used by investors and lenders to gauge ﬁnancial health of an organization: if it’s likely to survive economic slump, and what prospects it has for future growth ❯ Standard set of ratios used by the ﬁnancial industry ❯ Calculated based on ﬁgures provided in ﬁnancial reports See pp.148–149.

FAST FOOD CHAIN C FAST FOOD CHAIN B

n- cial s o N an ure ﬁn e a s $ m

$ Financial ratios

FAST FOOD CHAIN A

Key performance indicators ❯ Used internally and by investors, as they appear in ﬁnancial statement ❯ May be calculated daily or even more frequently for internal use ❯ Companies can set diverse KPIs to reﬂect future goals ❯ Unique to each company See pp.146–147.

YEAR

THE BIGGER PICTURE Some professional services companies, such as multinational PwC, undertake quarterly surveys, interviewing senior executives to ﬁnd out how optimistic they are about their sector and the wider economy. Such surveys help companies measure their own performance objectively.

69%

of multinationals link performance measures to future ﬁnancial results

Key performance indicators (KPIs) Key performance indicators (KPIs), or key success indicators (KSIs), are based on a company’s goals and vary depending on the company and industry. KPIs are usually stated in a company’s annual report. How it works KPIs are the non-ﬁnancial measures of a company’s performance—they do not have a monetary value but they do contribute to the company’s proﬁtability. Any company department can adopt KPIs to gauge its performance. A KPI for an accounts department might be the percentage of overdue invoices, as this will help

determine the department’s efﬁciency. This is an example of a lagging indicator—it is an outcome and therefore easy to measure, but not straightforward to inﬂuence. Companies also look for leading indicators, which are focused on inputs and easier to change. A leading KPI for the accounts department might be the percentage of purchase orders raised in advance.

Corporate KPIs KPIs can be set up as dashboards on computers so that they can be checked frequently. These dashboards show examples of KPIs speciﬁc to departments in a company. Having set their KPIs, the departments are subject to managerial review, which could result in action if KPIs are sub-standard.

d market ing es an Sal

Net promoter score (NPS—how many customers would recommend company); customer retention rate; customer lifetime value (total amount of money generated by one customer)

Accounts

Number of retrospectively raised purchase orders; ﬁnance report error rate (measures the quality of report); average cycle time of workﬂow; number of duplicate payments

tomer service Cus

Number of customer complaints; customer satisfaction (measured over time); average email response time; number of products sold compared to total sales calls made

HOW FINANCE WORKS Measuring performance

31%

146 147

BALANCED SCORECARD SYSTEM ❯ Learning and growth Employee training and corporate culture ❯ Business processes Includes speciﬁc measurements for monitoring daily performance ❯ Customer perspective Customer satisfaction ❯ Financial perspective Traditional ﬁnancial data

This strategic system offers a different way of monitoring a company’s performance. It was proposed by Robert Kaplan and David Norton at the Harvard Business School in the 1990s, and Harvard Business Review has cited it as one of the most inﬂuential business ideas of the last 75 years; it is estimated that over 50 percent of large companies in the US, Europe, and Asia use the approach. The Balanced Scorecard consists of four ways to view an organization’s performance:

of companies use a computer dashboard to monitor KPI measurements

Operations

Economic value of an employee’s skill set; employee satisfaction levels; revenue per employee; rate of employee turnover

nt and sustain me ab n ro ili vi

an resource s Hum

Project cost (difference between budgeted cost and actual cost of work); time taken to get a product to market; optimally running operations

Waste recycling rate; size of carbon footprint; size of water footprint (amount of water usage); energy consumption

Financial ratios Lenders, investors, analysts, internal management, and other interested parties calculate ﬁnancial ratios to decipher what ﬁnancial statements are really saying about the state of a business. How it works Financial ratios are used to assess the ﬁnancial standing of a business and identify any problem areas that might affect its future prospects. The process involves comparing two related items in the ﬁnancial statement, such as net sales to net worth or net income to net sales, and using those ratios to measure the relative performance of the company. There are many different ratios to choose from, depending on the

Top ﬁnancial ratios These are some of the ratios most commonly used by people involved with assessing businesses. They are best considered comparatively and in the context of the economic climate. The ratios are for analyzing established companies, usually public ones with shares traded on the stock exchange—start-ups and small-tomedium enterprises generally do not have a full enough range of ﬁgures to provide any kind of reliable guide.

$$$ x

6 1 0

2 .

+ –

purpose—for example, whether the purpose is to measure the company’s ability to provide a good return to shareholders, its capacity to handle debt, or the efﬁciency with which it operates. The ratios can also be used to compare a business with its competitors or in comparison to speciﬁc benchmarks within the company to determine how consistent its ﬁnancial results are.

Proﬁtability ratios

Efﬁciency ratios

These are used to see how effective a company is at generating proﬁt. Proﬁtability ratios may mirror investment valuation ratios. One example is the operating proﬁt margin ratio. A high ratio is good, as it indicates that a high proportion of revenue (gross income) converted into operating income (proﬁt minus costs).

These show how efﬁciently the company uses its assets and resources to maximize proﬁts. An example is the sales revenue to capital employed ratio, which indicates a company’s ability to generate sales revenue by utilizing its assets. Similar ratios can examine how quickly the company settles its bills and invoices.

OPERATING OPERATING INCOME = PROFIT MARGIN REVENUE

SALES NET SALES REVENUE TO = CAPITAL CAPITAL EMPLOYED EMPLOYED RATIO

Other proﬁtability ratios

Other efﬁciency ratios

❯ Return on equity (ROE) is measured as net income after tax / shareholders’ equity. The higher the ratio, the greater the proﬁtability, but not if a company is relying too heavily on borrowing. ❯ EBITDA to sales ratio is measured as EBITDA (earnings before interest, taxes, depreciation, and amortization) / revenue. It gauges the proﬁtability of core business operations. The higher the margin, the greater the proﬁts.

❯ Accounts receivable turnover ratio is measured as net credit sales / average accounts receivable. It shows how efﬁciently a company turns sales into cash. The higher the ratio, the more frequently money is collected. ❯ Inventory turnover ratio is measured as the cost of goods sold / average inventory. It shows how efﬁciently a company manages its inventory level. A low ratio usually equates to poor sales.

HOW FINANCE WORKS Measuring performance

WARNING Investors beware Ratio analysis must be used over time—at least four years—to understand how a company has reached its current position, not just what the position is. For instance, if debt has suddenly gone up, it could be because the company is branching out into new areas of potential proﬁt, or to limit the damage of a poor past decision.

10–14%

the minimum return on investment (ROI) needed to fund a company’s future

Liquidity ratios

Solvency ratios

This group of ratios reveals whether or not a company has enough cash or equivalent assets to meet its debt repayments. An example is the working capital ratio (also a measure of efﬁciency), which indicates whether a company has enough short-term assets to cover its short-term debt.

While liquidity ratios look at a company’s short-term ability to meet loan repayments, solvency ratios indicate the likelihood of a company being able to continue indeﬁnitely with enough cash or current assets to pay its debts in the long run. An example is the debt to equity ratio.

WORKING CAPITAL

CURRENT ASSETS CURRENT LIABILITIES

148 149

TOTAL SHAREHOLDERS’ DEBT TO EQUITY EQUITY = RATIO TOTAL ASSETS

Investment valuation ratios Thes ratios are typically used by investors to gauge the returns they are likely to get if they buy shares in a company. An example is the dividend payout ratio. It indicates how well earnings support the dividend payments—more mature companies tend to have a higher payout ratio.

DIVIDEND PAYOUT RATIO

YEARLY DIVIDEND = PER SHARE EARNINGS PER SHARE

Other liquidity ratios

Other solvency ratios

Other investment valuation ratios

❯ Cash ratio is measured as total cash (and equivalents) / current liabilities. It shows whether a company’s shortterm assets could repay its debts. A high ratio is seen as favorable. ❯ Quick ratio (acid-test ratio) is measured as current assets minus inventories / current liabilities. It shows how easily a company can repay shortterm debt from cash. The higher the ratio, the more easily it can pay.

❯ Interest coverage ratio is measured

❯ Net proﬁt margin ratio is measured as proﬁt after tax / revenue. Another measure of a company’s proﬁtability, it is also useful for comparing a company with competitors. The higher the ratio, the more proﬁtable the company. ❯ Price to earnings ratio is measured as market value per share / earnings per share. It indicates the value of the company’s share price. A high ratio demonstrates good growth potential.

as EBIT (earnings before interest and tax) / interest expense. It indicates how easily a company can pay the interest on its debts. The higher the ratio, the more easily they can pay. ❯ Debt ratio is measured as total liabilities / total assets. It indicates the percentage of the company’s assets that are ﬁnanced by debt. A low ratio is considered favorable.

Forecasting Predicting future business performance is necessary to estimate probable sales, income, costs, and proﬁtability and thus gain investment and maintain conﬁdence in the company. How it works Forecasting success or failure relies on historical data—ﬁnancial statements, ﬁnancial ratios, and Key Performance Indicators—that reﬂect business

operation and can be tracked over time. The tracked and monitored data can provide an early warning system for potential problems. For small businesses and start-ups, accurate forecasts provide a basis for

Forecasting with Z-score models Realizing that traditional ﬁnancial ratios, such as the ratio of costs to revenue, created only a partial picture of a business’s ﬁnancial performance, Altman devised a set formula that combined four or ﬁve key ratios to give a Z score. The model has proven 90 percent accurate in predicting business failure over one year, and 80 percent accurate over two years.

Corporate success Efﬁciently run companies with a healthy balance between assets and liabilities, and proﬁt and debt inspire conﬁdence in investors.

Working capital / total assets A measure of liquidity: the more working capital in a company, the more it is able to pay its bills.

Market value of equity / book value of total liabilities A measure of the market conﬁdence in the company: a ratio of less than one means the ﬁrm is worth less than it owes—it is insolvent.

Retained earnings / total assets A measure of leverage: a high ratio indicates proﬁts are funding growth; a low ratio indicates growth is ﬁnanced by debt.

Earnings before interest and taxes / total assets A measure of return on assets: it gauges operating income generated by assets.

Sales / total assets A measure of efﬁciency: the sales generated by the assets.

SS Success Finding the Z score Each of the above ratios is multiplied by a speciﬁc value, to give them weighting; results are added together to give Z score. ❯ A score of 0.2 or lower means the company is highly likely to fail. ❯ A score of 0.3 or higher means the company is unlikely to fail.

HOW FINANCE WORKS Measuring performance

raising external ﬁnancing, while for larger companies, this information provides an indication of ﬁnancial strength for investors and markets. Predictions may range from conjectured costs and revenue to complex ﬁnancial models. One of the most frequently used predictive models for forecasting business success is the Z-score model, devised by Edward Altman, a New York University ﬁnance professor, in 1968.

Signs of corporate failure There are many signs that a company is doing badly and perhaps sliding into insolvency. These signs make investors nervous, which is likely to lower share price if they start selling their shareholding. However, most companies that fail are in proﬁt, but run out of cash.

NEED TO KNOW ❯ Ohlson O score Alternative to Z score for predicting failure ❯ Overtrading When a company’s sales grow faster than its ﬁnance

❯ Undertrading When a company trades at low levels compared to its ﬁnance levels ❯ Zeta analysis Secondgeneration Z-score model

20%

the predicted proﬁtability increase from 2013 to 2017 for organizations using performance measurement to make business forecasts Selling assets s to pay of f debt

SS F ailu re

Cuts to employee beneﬁts

Repea te divide d nd cut to shar s eholde rs Bankruptcy occurs if the company cannot pay its debts

d continue w, seen in holdings o ﬂ h s a Low c in cash f decline e years pattern o t over consecutiv e e ce sh on balan

150 151

High borrowing, high interest paym ents, and dwindling reve nue

Top management resigning and taking jobs elsewhere

ility, seen in Low proﬁtab nslide in proﬁt consistent dow from loss statements on proﬁt-andars consecutive ye

Tracking fraud For keen observers of ﬁnancial statements, warning signs that indicate fraudulent business activities may be detected in overly optimistic statements and evasive attitudes of senior management. How it works Public companies are required to have their annual ﬁnancial statements audited (checked) by an independent auditor. It is typically during this process that any ﬁnancial shenanigans— creative accounting tricks used to manipulate the ﬁgures and improve the performance of a company in its ﬁnancial statements—and outright fraudulent activity is

uncovered. It is the auditor’s job to ensure that business records and statements are accurate and have been honestly reported. Auditors carry out a systematic examination of the company’s records and may identify any irregularities that may indicate fraud. If evidence of fraud is found, the next step is to involve forensic accountants and criminal investigators, who may prosecute the perpetrators.

Red ﬂags indicating fraud Auditors may be alerted to fraud by a number of recognized warning signs or “red ﬂags”; these may be either directly to do with the behavior of the CEO or other top executives, or in the form of irregularities within the ﬁnancial statements.

89%

of US corporate fraud cases in 2010 typically involved the company’s CEO or CFO

NEED TO KNOW ❯ Asset stripping Selling off the assets of a company for a proﬁt to raise funds, often resulting in the closure of the business ❯ Tunneling A particular type of fraud in which assets and funds are illicitly transferred to management or shareholders

Suspicious ﬁgures on ﬁnancial statements ❯ Cash ﬂows that are negative for three quarters, then suddenly and dramatically become positive ❯ Sudden increase in gross margin, at odds with industry average and company’s previous performance pattern ❯ Large sales to companies with dubious track records

❯ Sales recorded before they have been made ❯ Made-up, nonexistent sources of revenue ❯ Expenses moved from one company to another, or classiﬁed as assets ❯ Ongoing, long-term growth of earnings per share ❯ High payments to executives compared to base salary

How to detect fraud Procedures should be in place to hold accountable anyone who handles expenses. When these fall short, internal and external auditors need to take more drastic measures.

Applying ratio analysis to reveal key long-term trends (see pp.148–149)

HOW FINANCE WORKS Measuring performance

152 153

LINE-UP: TOP FIVE NOTORIOUS FRAUDS Some of the worst frauds stem from the most prestigious companies. Enron was one of the top seven US companies, while JPMorgan Chase & Co. was the largest American bank when measured by assets.

SECURITIES EXCHANGE CO. In 1919, Charles Ponzi began a pyramid scheme in Boston, selling postal reply coupons. He pledged investors 50 percent return within 45 days, which he paid from new investors’ funds.

BARINGS BANK The UK merchant bank collapsed in 1995 after unauthorized trading by employee Nick Leeson racked up losses of $1.3 billion. He had been allowed to bypass internal audits.

ENRON Energy company Enron declared bankruptcy in 2001 although it had never shown a loss in its ﬁnancial statements. External auditors were accused of failing to properly review accounts.

WORLDCOM US communications company WorldCom declared bankruptcy in 2002 after it improperly accounted for $3.8 billion in expenses. Auditors Arthur Andersen were held liable for not noticing.

JPMORGAN CHASE & CO. For 10 years from 2002, the company approved thousands of home loans to ineligible recipients. The employee who blew the whistle was awarded $64 million.

CEO behavior

Technicalities

❯ Evasive behavior by executives over important ﬁnancial details ❯ Attempts by CEO to steer auditors away from certain documents

❯ Late entry of sales or earnings adjustments ❯ Missing approvals or signatures ❯ Photocopied documents presented in place of originals

Setting up conﬁdential hotline for current and past employees or others with knowledge of the company

Using element of surprise, such as undertaking an aggressive internal audit without prior warning

Conducting a surprise cash count to determine whether current cash ﬂow matches statements

Data mining with auditing software to detect any mismatch between past patterns and current statements

Raising financing When a company needs additional funds, it can use either internal or external sources, or both, depending on whether it seeks large amounts of funding for long-term growth, such as an expansion, or smaller amounts for short-term expenses, such as to cover operating costs. In addition, the number of external sources available depends on whether the business is well established or whether it is relatively new and without much of a track record.

Sources of ﬁnancing and capital When considering the prospect of raising ﬁnancing, the ﬁnancial directors will ﬁrst evaluate the ﬁnancial health of the company. They will then decide what proportion of the company will be funded by equity (the company’s own reserves of cash and money raised from issuing shares) and what proportion will be funded by borrowing money from an outside source, such as a bank, so that the company takes on debt.

59%

of US ﬁnancial managers say ﬁnancial ﬂexibility is the most important factor in deciding how much debt the company takes on

Debt and loans

FUNDS IN THE FORM OF A LOAN FROM AN OUTSIDE SOURCE

INTEREST PAYMENTS

Institutional lenders Money loaned by large ﬁnancial bodies, such as banks. See pp.158–159.

HOW FINANCE WORKS Raising ﬁnancing

154 155

EVALUATING CAPITAL STRUCTURE When investors consider buying shares in a company, they look at its capital structure to assess the future prospects of the business. The capital structure refers to the percentage of a company’s ﬁnances made up of funds from shares and earnings, called equity, and the percentage made up from borrowed funds, or debt. When evaluating capital structure, investors consider the following: ❯ As a general rule, companies with more equity than debt are considered less risky to invest in because their assets outweigh their liabilities. So a company with signiﬁcantly more equity than debt has a low debt-to-equity ratio and is generally seen to be a low-risk investment.

❯ A company with signiﬁcantly more debt than equity has a high debt-to-equity ratio and is more risky as an investment. ❯ Debt is not always bad. If interest rates are low a company could take on more debt to fund expansion, as long as the revenue it makes from the borrowed funds is greater than the interest payable. So although this company may be more risky, it may also have greater potential for growth—this is known as “gearing.” See pp.174–175..

$ $

Equity FUNDS FROM SHARE ISSUES AND RETAINED PROFIT

Proﬁt from business activities

Shareholders’ stake in company

Proceeds of the core business. See pp.156–157.

Payment received for shares in the company. See pp.164–169.

DIVIDENDS—PAID ONLY WHEN A COMPANY MAKES ENOUGH PROFIT

Company

Bonds Investor lenders FUNDS FROM BONDS BOUGHT

INTEREST AND CAPITAL SUM ON MATURITY

Payments made by bondholders. See pp.170–173.

Internal financing Most companies prefer to secure funding from their own internal resources, rather than either take on debt through borrowing or give up a stake in the company by issuing shares, both of which cost more. How it works When a business needs funds, or capital, to pay for expansion or investment in order to maintain its current operations, it is faced with two choices: either ﬁnd the money from outside sources, or ﬁnd the money from within the organization itself. Since there are costs attached to bringing in funds from external sources, such as interest that has to be paid on a bank loan, the business managers must weigh up the opportunity cost of using its own funds—the proﬁt it could earn by investing those funds—against the cost of ﬁnancing.

Raising internal ﬁnancing Whether a company’s need for additional funds is long- or short-term, steps can be taken to increase the level of funds within the company.

Short-term ﬁnancing For businesses wishing to raise funds without recourse to external sources, there are three main strategies they can implement to maximize the amount of cash available for day-to-day operations and capital expenditure.

THE RECENCY BIAS When a company receives timely payments for its invoices, this helps maintain its levels of funds. Interestingly, invoices issued right after completion of work tend to get paid sooner than those invoices that are sent later. A theory called recency bias explains this phenomenon: the brain prioritizes recent events over those that occurred longer ago.

Tighten credit control Actions include chasing debtors so that invoices are paid on time; ensuring new customers are creditworthy by conducting strict credit checks; and setting a 30-day payment term.

10 8 DAYS IT TAKES CLIENT 6 TO PAY 4

Delay payment

1 2 WEEKS IT TAKES TO SEND INVOICE

Large suppliers may offer a discount for early payment, but they may also allow a company longer terms for payment, boosting cash levels in the short term.

HOW FINANCE WORKS Raising ﬁnancing

156 157

USING PROFITS TO FUND EXPANSION

Company

A company seeking to grow may choose to fund the expansion with its proﬁts. This option offers both advantages and disadvantages.

Pros

Long-term ﬁnancing For a business needing long-term ﬁnancial help, its own resources should act as the primary support.

Reduce inventory

❯ The use of proﬁts means that no interest payment has to be made, unlike on money that is borrowed ❯ Existing owners and directors are able to retain full control over the business, rather than sharing it with new investors ❯ The company is able to keep a low debt proﬁle, which will appeal to future investors and lenders

Cons

It is expensive for a business to retain a large inventory of unsold goods. Cutting the inventory back reduces storage costs, the cost of production, and replacement of goods that go out of date or become obsolete.

Retained proﬁts A portion of proﬁts may be pumped back into the business.

ﬁ al

nancing for usiness eb th

li Tota ntern

A company may also decide to sell assets to raise cash.

❯ Proﬁts can take time to build up sufﬁciently to fund expansion ❯ Withholding dividends may upset some shareholders who prefer to receive the proﬁt as dividends ❯ Lost opportunity to earn funds from investing proﬁt rather than spending it

the average number of days it takes a limited company in the UK to pay a 30-day invoice

External financing When business growth or unforeseen expenses cannot be met using internal sources of ﬁnancing, such as retained proﬁt, organizations must rely on ﬁnding funds from lenders or investors. How it works External ﬁnancial support comes in various forms, including bank loans and issuing shares. The available sources of outside ﬁnancing depend on the amount a company requires, and whether the money is needed to resolve a short-term issue, such as cash ﬂow, or for the long-term growth of the business. While short-term ﬁnancing is easier to secure, ﬁnding larger sums for an

Raising external ﬁnancing Generating funds from external sources can be a challenge, especially when securing investors. However, revenue does not necessarily need to take the form of a loan. There are a number of strategies that can be implemented through working with external parties in order to provide a company with good working capital.

80%

of external corporate ﬁnancing is provided by domestic banks

expansion is more challenging. A company that is either already listed on a stock exchange or is preparing to enlist will be able to raise the capital through the sale of shares. However, an unlisted company may struggle to raise a comparable amount. A company with a large amount of debt will also ﬁnd it hard to raise funds, since lenders or investors will see the business as risky.

NEED TO KNOW ❯ Term loan A bank debt repaid over a set period of time ❯ Loan note A form promising payment to the holder at an agreed future date ❯ Eurobond A bond issued in a currency other than the currency of the country in which it is issued

Short-term ﬁnancing A range of ﬁnancial agreements that help provide a company with immediate funds can be made with outside parties as a way of raising cash short-term.

Bank line of credit $

Borrow from business checking account up to an agreed limit, with interest typically at a high rate.

Debt factoring

Sell unpaid invoices to an external source for an agreed amount in order to receive immediate payment minus a commission fee.

Invoice discounting Borrow money against sales invoices customers are yet to pay (again, often at a disadvantageous rate).

HOW FINANCE WORKS Raising ﬁnancing

158 159

DEBT FACTORING PROCESS To get money immediately, a company sells unpaid invoices (accounts receivable) to a third party, known as a “factor.” The factor advances the company a major portion of the amount, retains the rest until the account is paid, then charges a fee.

$ Company negotiates an agreement in which its unpaid receivables (invoices) are sold at a discount to a “factor.”

Company sends invoices out to customers, and copies these to the factor. Customer now owes payment to factor.

Company

Factor pays company an agreed percentage of the invoices (typically 80–90 percent) within a few days of receipt.

Customer pays factor the invoice amount after 30 days (or more if terms of payment are longer).

Factor pays remaining invoice amount to company, minus a fee (usually 2–5 percent of the invoice amount).

Long-term ﬁnancing Putting effective measures in place to provide ongoing revenue is essential for a company’s long-term growth.

Shares Raise capital by issuing shares to ﬁnance growth. The company then retains less proﬁt, as it pays dividends to shareholders, who also beneﬁt from any capital gains in the company’s value (see pp.164–165).

Borrowing Secure long-term loans from banks and other ﬁnancial institutions, usually on better terms than a bank line of credit.

ancing fo ﬁn r l a

usiness eb th

al exte Tot rn

Finance leases Sell expensive assets such as computers to ﬁnance companies to release capital, and then lease them back.

Rent-to-own agreements

$ $ $

Pay for expensive assets, such as vehicles, in installments. Overall cost may be higher, but capital is not tied up.

Going public When a company changes from private to public, it offers shares for sale to members of the public. This process is known as going public and enables the company to raise money for growth. How it works

Ways to list on a stock exchange

Intr od

There are three primary ways to take a company public, each of which has different associated costs. The type of public offering that a company chooses will be determined by its size and how much capital it needs to raise.

Plac in

The process by which an organization goes public (also known as ﬂotation) marks the end of its life as a private company, after which it is no longer owned by a small number of shareholders or company members. A company may choose to go public when it needs capital to ﬁnance growth. Going public usually happens over several months; the company makes legal and ﬁnancial preparations before the ﬁnal stage, when it releases company shares for sale, either to selected investors or to the general public, or to a combination of both. Each share represents a “stake” in the company, and the money that the company receives from the sale of shares becomes capital, or wealth, which it now owns.

tion uc

A company joins a new stock exchange without raising capital, but by trading its existing shares. To do this, over 25 percent of the shares must already be in public hands (on other stock exchanges) and no one shareholder can own a majority of shares.

Select groups of institutional investors are invited to buy shares. This involves fewer costs than undertaking a full public share offering (see below) but the amount of capital that can potentially be raised is limited since there are fewer shareholders.

❯ Underestimation If the initial valuation of shares by the underwriters is too cautious, then the company will fail to realize the true value of its stock ❯ Overestimation If underwriters overestimate the value of shares newly on the market (new issue), it may ﬂop due to lack of demand ❯ Volatility Share prices in the ﬁrst few days of an IPO may ﬂuctuate dramatically due to political or economic events

tial public of Ini

WARNING g (IPO) rin e f

Institutional and private investors are invited to subscribe to or buy from the ﬁrst round of shares that the company issues. This is the most expensive way to go public, but allows for a company to raise large amounts of capital.

HOW FINANCE WORKS Raising ﬁnancing

20%

160 161

the typical minimum annual growth potential of public companies in the US TEN LARGEST IPOS IN HISTORY

Stock exchange A ﬁnancial market in which company securities (stocks and shares) are bought and sold according to current market rates. See pp.170–171.

INITIAL PUBLIC OFFERING (IPO)

When a well-known private company undertakes an IPO, there is ﬁerce competition between investors to buy its shares, and record-breaking activity can ensue. This graph shows the largest IPOs until 2014, based on proceeds from shares sold on the ﬁrst day they went public.

Alibaba Group 2014, New York Stock Exchange (Chinese e-commerce group) Agricultural Bank of China 2010, Shanghai Stock Exchange (Chinese bank)

$19.2BN

NTT Group 1998, Tokyo Stock Exchange (Japanese telecoms group)

$18.4BN

Visa 2008, New York Stock Exchange (American ﬁnancial services corp.)

$17.9BN

Enel SpA 1999, New York and Milan stock exchanges (Italian utility company)

$16.58BN

Facebook 2012, New York Stock Exchange (American social networking site)

$16BN

General Motors 2010, New York Stock Exchange (American car manufacturer)

$15.8BN Deutsche Telekom AG 1996, Frankfurt, New York, and Tokyo stock exchanges (German telecoms company)

$12.48BN

$11.1BN

$10.65BN

$25BN

Bank of China 2006, Hong Kong Stock Exchange (Chinese bank) OAO Rosneft 2006, Moscow and London stock exchanges (Russian oil company)

$10 BILLION (BN)

$20 BILLION (BN) VALUE (USD)

GOING PUBLIC

A closer look at IPOs An Initial Public Offering (IPO) is the ﬁrst time that shares in the company are offered for public sale. It is the most common way for a private company to go public if it needs a large injection of capital to fund major expansion. There are other reasons for going public—for example if a government wants to privatize a state-owned company, such as a national railroad, or if the members of a large family-owned enterprise want to sell their stake.

WORLD’S TOP 10 STOCK EXCHANGES The largest exchanges manage shares belonging to some of the world’s most lucrative businesses and, as a result, substantial sums of money ﬂow through them. The following

exchanges are listed in order of the size of market capitalization—in other words, by the total monetary value of shares issued by the companies listed on each exchange.

1. 2. 3. 4. 5.

6. 7. 8. 9. 10.

New York Stock Exchange NASDAQ OMX, New York Tokyo Stock Exchange Euronext (Pan-European) London Stock Exchange

Shanghai Stock Exchange Hong Kong Stock Exchange Toronto Stock Exchange Deutsche Borse SIX Swiss Exchange

The IPO process Before a company can issue shares, it has to be listed on a stock exchange where trading (the buying and selling of shares) can take place. The company must then fulﬁll the criteria necessary to secure investors. This process is lengthy, subject to strict ﬁnancial regulations, and is extremely expensive to undertake. Only once all stages of the process are complete can the share offering be ofﬁcially declared on a stock exchange.

1 Meet the qualiﬁcations The speciﬁc requirements are set by the stock exchange where the company plans to list. Listing conditions vary between exchanges, but typically demand:

Pretax earnings above a certain level

File a prospectus This document contains information about the offering, the business, and its ﬁnancial history, and proposed plans. Details are still subject to change.

Three years of audited ﬁnancial statements Ability to pay the annual listing fee

Appoint underwriters These ﬁnancial professionals will be responsible for buying and selling the shares to the public.

HOW FINANCE WORKS Raising ﬁnancing

$16.6 trillion

NEED TO KNOW ❯ Large cap Listed company with market capitalization of more than $10 billion ❯ Mid cap Listed company with market capitalization of between $2 billion and $10 billion ❯ Small cap Listed company with market capitalization of between $250 million and $2 billion

the total market capitalization of companies listed on the New York Stock Exchange*

* as of October 2014

162 163

6 Promote the share offering Company representatives, as well as the underwriters, visit national and international destinations to pitch to potential investors.

$ $

Sell on the stock market

5 Set the ﬁnal offer price After ascertaining market conditions and the anticipated demand, the company decides the price and the number of shares to issue. It is then ready to launch the offering.

The IPO is ofﬁcially declared a few days after potential investors receive the ﬁnal prospectus. The declaration is made on a set day after the exchange has closed, and the shares are available for trading the following day.

Shares and dividends When a company goes public, it sells shares to investors, who become part-owners in return for capital investment. The number and type of shares bought by each investor determines the size of their ownership. How it works Before ﬂoating on a stock exchange, a company undergoes a valuation process to set the initial price of its shares. This process involves the directors, prospective investors, and an investment bank, which is appointed to assess the company’s value. Together, they reach a decision on the most ﬁnancially viable price for the shares that will

be offered on the exchange. Upon going public, a company issues ordinary shares to investors as the basic unit of ownership, commonly referred to as a stake in the business. A company may also issue shares privately, rather than publicly to investors via the stock exchange, to retain greater management control.

y shares n a p m Co

A share of the pie Ordinary shares, issued by all companies when they go public, are the most common type of shares. There are also other share types, which give the company more ﬂexibility to control rights available to different shareholder groups. Most shares are sold on the stock exchange, but non-voting and management shares are issued directly to holders. Different types of shares entitle the holder to different rights.

Management shares Issued (usually given not sold) to owners and members of company management, who have: ✓Extra voting rights, so control of company stays in the same hands

Non-voting shares Issued to employees, who: ✓Receive a part of remuneration in the form of dividends ✗ Have no voting rights ✗ Receive no invitation to attend annual meeting

Iss ue d

dir ec t

HOW FINANCE WORKS Raising ﬁnancing

Common stock Shareholders: ✓Share in the company dividends ✓Share in the company’s assets ✓Have right to attend AGM ✓Have right to vote on important company matters such as appointment of directors ✓Receive the company’s annual report and ﬁnancial statements

s via ld So

e chang k ex toc

Preferred stock Shareholders: ✓Receive ﬁxed dividend, paid ahead of any dividends paid out to ordinary shareholders ✓Take priority in receiving a share of any assets left after debts are paid if company is insolvent ✗ Have fewer, if any, voting rights

Deferred stock ✓Shareholders receive company dividends and share of assets, but only after all other shareholders

164 165

NEED TO KNOW ❯ Flipping Buying and quickly reselling IPOs for a large proﬁt ❯ Redeemable shares Shares that may be later bought back by the issuing company for a cash sum

698%

the increase in share price of IPO VA Linux Systems in one day on the New York Stock Exchange, in 1999 RAISING MORE SHARE CAPITAL After the initial sale of shares, when a company goes from private to public, the business can raise additional funds by issuing more shares. There are three main ways to do this: ❯ Rights issue entitles existing shareholders to buy additional shares from the company within a set time frame, before they are offered to other buyers. ❯ Public issue is a process by which the company issues a new allotment of shares to sell to the public on the stock market. ❯ Private placement is a practice by which the company sells its shares (or other securities) directly to private investors, usually large institutions, bypassing the stock exchange all together.

SHARES AND DIVIDENDS

Establishing share value The forces of supply and demand set the price of shares. Companies issue only a limited number of shares to the public, which can then be bought and sold on the stock exchange. Demand for those shares is determined by whether investors think the company has good future economic prospects. If investors believe that the company is primed for substantial growth, they will want to buy shares in it, which consequently drives up the share price.

25%

SPLITTING SHARES

the drop in share value over four days during the Wall Street Crash of 1929

A company occasionally carries out a “share split” to its existing shares. This increases the total number of shares, although the combined value of shares stays the same. A share split allows a company to lower the price of its shares to bring them in line with the price of competitor shares. The share split is usually a two-for-one or three-for-one increase, whereby the shareholder sees the number of their shares double or triple.

Rising value of shares VALUE

Financial market observers believe (INDEX that the emphasis on optimizing the POINT) value of shares for shareholders began 4,000 in 1976, when the idea of maximizing proﬁt for shareholders became a priority. Since then, the market has 3,500 experienced a general upward trend with occasional deep dips. The graph tracks the average value of all shares 3,000 on London’s FTSE from 1964 to 2013.

198 7

OC MO TOBE ND R 19 AY CR : BLAC AS H K

2,500

NEED TO KNOW ❯ Bear market Market that has seen decline of 20 percent over a period of 2 months or more ❯ Bull market Market where share prices are rising and investor conﬁdence is high ❯ Market correction Short-term decline in share prices to adjust for an overvaluation

2,000

1,500

197 2

–19 74

STO CR CK M AS H ARK ET

1,000

6 LUE 197 IMIZINLGDER OVASED X O P MA AREH PRO SH EORY TH

500

0 1970

1980

HOW FINANCE WORKS Raising ﬁnancing

SHARE PRICE TOO HIGH A company listed on the stock exchange has seen its share price increase so that its shares now cost more than its competitors’. The high price puts off investors.

19 9

SHARES SPLIT The company decides on a share split. It halves the price of each existing $3 share, so each share is now worth $1.50.

HE DO IGHT T-C OF OM TH BO E OM

1,000 2,000

0 $1.5

A CR UGU ED ST IT : G CR LO UN BA CH L

$1.5 0

SHARE CERTIFICATES ISSUED It issues new share certiﬁcates to holders, doubling shares held: a shareholder with 1,000 shares at $3 each now has 2,000 at $1.50 each. Total worth is still $3,000.

SHARE VALUE ALIGNED The value of shares is now similar to that of competitors. The price encourages new investors to make a purchase.

20 10

F DE EBR BT UA CR RY IS : EU IS R OZ ON E

1997

TCO M

BU ST

2001

9/11 ATTA TERRORI ST IN N CK EW Y ORK

–2

JULY: A FINAN SIAN CIAL C RISIS

1990

2000

166 167

2010

YEAR

SHARES AND DIVIDENDS

What is a dividend?

pay out dividends. In a good economic climate, they win twice—the dividend provides income and the capital value of the shareholding increases. However, there is always a risk that the value of shares will go down, and companies only pay dividends if they have made a proﬁt. Paying dividends is a good way for a company to attract investors. It is essentially a reward for putting money into a company so that it can fund its existing output and develop and expand the business.

Shareholders in a company are usually entitled to a payment of cash from its proﬁts. The company pays a dividend sum on every share it has issued, but it is up to the company’s board to decide how much proﬁt to reinvest and pay out. Investors may look at a company’s rate of dividend payout, along with its capital growth, to gauge its ﬁnancial health and decide whether to invest in it. Investors who rely on shares for income are likely to invest in companies that reliably

NEED TO KNOW ❯ Dividend yield ratio Measure of how much a company pays out in dividends relative to the price of each share ❯ Dividend per share Sum paid on each share after retained proﬁts have been calculated ❯ Dividend payout ratio Percentage of a company’s net income that is paid out in the form of dividends

How it works Shareholders usually receive a dividend if the company in which they hold shares has retained enough proﬁt in that ﬁnancial year to make the payment. The decision to make a payment is made by the board of directors. The dividend might be paid every quarter (four times a year), or in two parts—an interim dividend may be made partway through the year, with the ﬁnal dividend paid just after the end of the ﬁnancial year.

Announcing retained proﬁts

Making the decision for dividends

At the end of the ﬁnancial year, the company announces its retained proﬁts: the sum it intends to keep for reinvesting or paying off debts rather than pay out as dividends.

The board of directors makes a decision on whether there is enough to warrant a dividend payment, and if so, how much. It records details of each payment in dividend vouchers.

$ $

HOW FINANCE WORKS Raising ﬁnancing

168 169

INTEREST RATES AND DIVIDENDS When interest rates are low, shares with high dividend payouts become extremely attractive to investors because they provide a better return than investments that yield an interest payment. This economic climate encourages companies to pay out top-rate dividends and so attract as many investors as possible, which in turn increases the share value. Conversely, when interest rates are rising, investors may prefer to put their money into ﬁxed-income assets, which will pay high rates as a result of the hike without the risk attached to buying shares.

$ $ $ Keeping funds for growth The company keeps some of its proﬁt to put back into the business. It needs to strike a balance between pleasing investors and expanding its operation.

HIGH INTEREST RATES

Investors are attracted to pay into ﬁxed-income assets, such as deposit accounts.

Investors are attracted to buy shares as dividends give a good return for their money.

LOW INTEREST RATES

1602

the year the Dutch East India Company became the ﬁrst company to issue stocks and bonds Paying taxes

$ Making the payment Most dividends are cash dividends. Sometimes companies distribute stock dividends, issuing more shares instead of cash to shareholders.

Shareholders must declare dividends on their tax return and pay taxes on them.

The capital market The capital market is a global ﬁnancial marketplace for trading long-term securities—bonds with a maturity of at least a year, and shares. It is where governments and businesses can raise funds and investors make money. How it works There are two types of product sold on the capital market: shares (equity) and bonds (debt investments). Shares and bonds are sold ﬁrst on the primary market, where they are originally issued, and later traded on the secondary market. The capital market is crucial to a functioning economy, because it channels funds

to users of capital, such as businesses and government, and capital is what enables goods and services to be produced. The original issuers of the shares and bonds do not gain from trading activity in the secondary market, which is purely for investors. However, share value and bond trading levels reﬂect conﬁdence in a company or institution, reinforcing its ﬁnancial position.

The structure

tal mark i p et

The capital market encompasses the debt capital market, where bonds are sold, and the stock exchange, where shares are sold. Both have a primary and a secondary market.

Primary market

The market issues new bonds and shares, with investment banks overseeing the trading. It is also known as the new issue market (NIM).

GOVERNMENTS SELL BONDS

COMPANIES SELL BONDS AND SHARES

SHARES Sold on stock exchange (equity capital market)

BONDS Sold on debt capital market (bond market)

INVESTORS

HOW FINANCE WORKS Raising ﬁnancing

WHAT IS A BOND? A bond is a debt security that a company issues to investors. By buying bonds, an investor is effectively loaning money to the issuers, who in return agree to pay interest to the investor. A bond has a set term of maturity (a limited number of years of validity) and until that

time the interest is paid to the investor annually. When the bond matures, the issuer repays the original sum of the loan to the investor. Companies or governments issue bonds to raise money that can then be put back into the business or used to fund government.

170 171

$100 trillion

the estimated value of global debt markets

Bonds or shares: pros and cons

Bonds (debt investments)

Secondary market Investors buy bonds and shares from other investors, not from issuing companies. The cash proceeds go to an investor, not to the underlying company or entity.

✓Sellers are contractually obliged to pay interest ✓Bonds are less risky: debt capital markets are less volatile than stock exchanges; if the issuing company has trouble, bondholders are paid before other expenses and before compensation to shareholders ✗ Buyers of bonds have no stake in the company ✗ Buyers cannot access principal sum until bonds mature

Shares (equity)

BONDS

Individual investors buy and sell shares and bonds previously issued on the primary market

✓Buyers of shares gain a stake in the company ✓Sellers of shares have to pay dividends, although these can be reduced or suspended if the company feels it is necessary ✗ Shares are more risky: changes in company proﬁts and in the economy as a whole can cause share prices to rise and fall; if the company fails, the shares become worthless

THE CAPITAL MARKET

How do bonds work? Bondholders effectively buy a slice of a larger loan with each bond, for which they receive interest, along with the original sum on maturity. Issuing, buying, and selling bonds takes place in the debt capital market. The marketplace has several functions: it offers bonds and other types of loans to investors; it operates as a ﬁxedincome market, because the issuer is required to pay regular interest; and it enables companies and governments to raise long-term funds. Overall, the debt capital market is much larger than the stock exchange (equity capital market), where shares are bought

and sold. It attracts investors because bonds provide more protection from risk than shares. There are various types of bonds, some safer than others—the risk lies in whether the issuer will be able to pay the interest and repay the principal sum on maturity. A secured bond is backed by an asset, such as property; an unsecured bond is not and so carries more risk. Both bonds and shares may be referred to as securities. The term describes the share or bond itself, and the certiﬁcate of ownership or creditorship that gives the holder the right to receive a dividend, in the case of shares, or interest payments, in the case of bonds.

NEED TO KNOW ❯ Debt instrument Ofﬁcial term for bond or other long-term debt ❯ Convertible bond Bond that can be converted into shares of the issuing company, or cash ❯ Warrant Security that allows the holder to buy stock in a company at a ﬁxed price for a certain period of time ❯ Callable bond Bond that gives the issuer the right to redeem it before maturity ❯ Non-callable bond Bond that cannot be redeemed or sold back to the issuer before maturity but continues to provide interest

Investing in the debt capital market A company wants to raise $100 million to ﬁnance growth but does not wish to issue further shares. Instead, it raises the money by issuing bonds on the debt capital market.

BOND $100

$100 10 YEARS 7%

interest

Company issues bonds

Investors buy bonds

The company issues 1 million bonds at $100 each. Each bond effectively acts as a loan between the investor and the company.

Each bond has a set maturity date of 10 years and a 7 percent interest rate, with a face value of $100. During the 10 years, the company can use the money as capital.

HOW FINANCE WORKS Raising ﬁnancing

172 173

TYPES OF BONDS Government bonds

Corporate bonds

GOVERNMENT BONDS

SECURED BONDS

re d cu

UNSECURED BONDS

re d cu

Unsecured

Government bonds are the safest type of bond since governments in developed capitalist economies are unlikely to default on interest payments on the loan or on the principal sum.

Secured bonds are secured by the assets of a company, making them a less risky investment than shares. Examples include equipment, trust certiﬁcates, and mortgage bonds.

Unsecured bonds are not backed by pledged collateral and are a riskier investment—if the company fails, investors are paid only after secured bonds have been paid out. Because they are more risky, investors expect a higher return (interest) on their investment.

INTEREST PAID (%)

100 90 80

$70

over 10 years

60 50

10 YEARS

40 30 20 10 0

4 5

7 8 9 10 YEARS

$100

$7 Investors receive annual interest

Mature bond is repaid

Each year, the company pays an investor $7 (7 percent of $100) for each bond bought, in return for using the principal sum as capital to fund its business. After 10 years, the investor has received a total of $70 interest per bond.

Once the bond reaches its date of maturity, in this case 10 years, the original sum of money, $100, is repaid to the investor. So the investor receives a total of $170, including interest, over the full term, in return for the original $100 investment.

Gearing ratio and financial risk Capital gearing is the balance between the capital a company owns and its funding by short- or long-term loans. Investors and lenders use it to assess risk. How it works Most businesses operate on some form of gearing (also called ﬁnancial leverage). They partly fund their operations by borrowing money, via loans and bonds, on the condition that they make regular repayments of a ﬁxed amount to the lender. If the level of gearing is high (in other words, the business has taken on large debt), some investors will be concerned about its ability to repay and see this as an insolvency risk. However, if the amount of operating proﬁt is more than enough to repay interest, high gearing can provide better returns to shareholders. The optimum level of gearing for a company also depends on how risky its business sector is, how heavily geared its competitors are, and what stage of its life cycle it is at.

Low gearing

Equity ﬁnance (shares) Pros

Company has less debt

❯ Does not have to be repaid ❯ Shareholders absorb loss ❯ Good for start-ups, which may take a while to become proﬁtable ❯ Angel investors share expertise ❯ Low gearing seen as a measure of ﬁnancial strength ❯ Low risk attracts more investors and boosts credit rating

Company has more equity Low proportion of debt to equity, also described as a low degree of ﬁnancial leverage. Equity comes from: ❯ Reserves (retained proﬁts) ❯ Share capital

Cons ❯ Shared ownership, so company has limited control of decisions ❯ Shared proﬁt in return for investors risking their funds ❯ Legal obligation to act in the interests of shareholders ❯ Heavy administrative load ❯ Complex to set up

Gearing ratio calculation

Low gearing

Analysts and potential investors assess the ﬁnancial risk of a company with this calculation, presented as a percentage.

A software company is going public. Its ratio of 21.2 percent tells investors that it has relatively low gearing and is well positioned to weather economic downturns.

LONG-TERM DEBT SHARE CAPITAL + RESERVES + LONG-TERM DEBT

× 100

$1.2 MILLION $2 MILLION + $2.455 MILLION + $1.2 MILLION

100

21.2%

HOW FINANCE WORKS Raising ﬁnancing

Debt ﬁnance (loans) Pros

High gearing Company has more debt High proportion of debt to equity, also described as a high degree of ﬁnancial leverage. Typical examples of debt are: ❯ Loans ❯ Bonds

Company has less equity

❯ If the company makes a proﬁt, it can reap a larger proportion ❯ Paying interest is tax deductible ❯ Does not dilute ownership ❯ Company retains control of decisions ❯ Repayment is a known amount that can be planned for ❯ Quicker and simpler to set up ❯ Small business loans at favorable rates may be available to start-ups

❯ Interest cover ratio An alternative method of calculating gearing—operating proﬁt divided by interest payable ❯ Overleveraged A situation in which a business has too much debt to meet interest payments on loans ❯ Deleverage Immediate payment of any existing debt in order to reduce gearing

❯ Loan must be repaid ❯ Interest must be paid, even if operating proﬁt shrinks ❯ Debt may be secured on ﬁxed assets of company ❯ Unpaid lender can seize assets and force bankruptcy ❯ Lenders ﬁrst to be paid in the event of insolvency ❯ High gearing considered a measure of ﬁnancial weakness ❯ High risk may put off investors and adversely affect credit rating

25%

A water utility is the only water provider in the area, with several million customers. The ratio of 64 percent is acceptable for a utility company with a regional monopoly and a good reputation.

$82 MILLION + $120 MILLION + $360 MILLION

NEED TO KNOW

Cons

High gearing

$360 MILLION

174 175

100

64%

the ratio at or below which a company is traditionally said to have low gearing

HOW SALES AND MARKETING WORKS Marketing mix ❯ Marketing approaches Outbound marketing ❯ Inbound marketing Business development ❯ Information management

Marketing mix The successful marketing of a product depends on the consideration of four key elements—the product itself, its price, how it is promoted, and where it is sold. This combination is called the marketing mix, and it is used as a tool for planning product launches and campaigns. Before focusing on the marketing mix, marketers need to deﬁne the target market for their product by determining which groups of customers are most likely to purchase it.

The 4Ps and 4Cs of the marketing mix First proposed in 1960, the classic marketing mix tool contains the 4Ps: product, price, promotion, and place. In the 1990s, these were recast as the 4Cs, which emphasized the customeroriented dimension of the tool.

Commodity

Product

❯ Has the product been speciﬁcally engineered and designed to meet and exceed customer expectations?

❯ Is the product the right design, size, and color to appeal to customers? ❯ What are its unique features? How does it compare with competitors?

Communication

Promotion

The 7Ps of the marketing mix Some marketers use a more detailed model of the marketing mix, which has three additional elements. ❯ Product See pp.180–183. ❯ Price See pp.186–187. ❯ Place See pp.188–189. ❯ Promotion See pp.190–191. ❯ People Does the business employ the right people to deliver optimum service to customers? ❯ Process Are effective systems in place for handling orders and dealing with customer questions and complaints? ❯ Physical environment Does the design and layout of the business premises appeal to customers?

❯ What is the most meaningful way to get marketing messages to customers and provide them with useful information?

❯ What combination of marketing and media channels will be most effective? ❯ When is the best time to run promotions?

HOW SALES AND MARKETING WORKS Marketing mix

“Product, promotion, and place create value. But price harvests value.”

Price ❯ What is the value of the product to prospective customers? ❯ What is the usual price point for this type of product?

178 179

DEFINING THE MARKET In order to establish a marketing strategy for the product they are introducing to the marketplace, businesses have to deﬁne the customers they aim to sell to by researching and segmenting the market.

Market research

Market segmentation

See pp.192–193.

See pp.194–195.

❯ Identiﬁes gaps in the market for the launch of new products ❯ Measures customer reactions to new offers and campaign messages

❯ Breaks down the market into smaller customer groups with similar needs ❯ Allows more focused campaigns with a greater chance of success

Cost ❯ How much will the product cost the customer, and will it be seen to represent a good buy?

The 7Cs of the marketing mix

Place ❯ Where should the product be sold—stores, online, or catalogs? ❯ Where do competitors sell, and is there a way to stand out in the same place?

Convenience ❯ How easy is it for busy customers to ﬁnd and buy the product?

This model offers a customerfocused variation of the 7Ps, adding three more elements to the 4Cs. ❯ Commodity ❯ Cost ❯ Convenience (or Channel) ❯ Communication ❯ Corporation How do company structure, stakeholders, and other competitors affect marketing? ❯ Consumer What are the customer’s needs and wants? Is the product safe? What product information is available? ❯ Circumstances Can the business deal with external factors, such as laws, weather, economy, culture?

Product The goods and services a company sells are its product. A product can be deﬁned in terms of features, design, size, packaging, service type, return policies, and warranties, together intended to meet the customer’s needs. How it works

Marketers identify the goods and services they sell in three or ﬁve product levels, with the beneﬁt at the core. The marketer’s job is to translate and communicate each product level as an offer to the consumer.

Consumers can be said to buy beneﬁts rather than products. For the marketer, the product itself is that beneﬁt to the consumer, as packaged and presented.

Total product concept: three product levels From a marketer’s perspective, a product is more than the end commodity bought by a customer. It is a total product concept with several layers of beneﬁt, and these must be conveyed to the consumer.

Core product Product’s basic function and its core beneﬁt to consumer

Actual product

iti a on ge al d 3 esign •

llm ent

s’ fre e service

•

6m on th

in sta

Takes rider from A to B

•

Additional beneﬁts, such as delivery and credit, warranty, after-sales service

d ec ra o-f riendly • t n yi pa free delivery •

Augmented product

s high-tech tire

Packaging, brand name, quality level, design, and additional features that set it apart from rival products

s • 2-year

y nt a r war

HOW SALES AND MARKETING WORKS Marketing mix

42%

180 181

NEED TO KNOW ❯ Personal branding Promoting oneself as a product with a distinct brand personality ❯ Fast-moving consumer goods (FMCGs) Sold quickly and at relatively low unit cost, such as food and household products

of new product launches can be expected to fail

Variation: ﬁve product levels This variation on the total product concept is more detailed. It introduces two more levels by breaking down the actual product level into a generic and an expected product, and also includes an extra level of beneﬁt—the potential product. Core product Product’s core beneﬁt to consumer

Generic product Basic functional beneﬁts

Expected product Additional desirable beneﬁts

kes

t io

e m

a br

•c n o lo now r cho s io au ell-k i w c e • l li to o lo c nc k to lt-i prevent thef t • bui

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•

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te r

s ig

ligh

•b ls • 3 gears

h 2w

Augmented product Extra features and beneﬁts

Takes rider from A to B

Potential product Future, improved version

Product positioning A vital step in the process of deciding how to market a product is deﬁning how it is distinct from the competition—what is unique about it and what are the qualities that make it better than rival products. How it works

of the product or brand, and clarify how it is different from similar types of products offered by competitors. They also need to identify the criteria that customers are most likely to use when choosing a particular product or brand. With this information the marketers can then create a product positioning matrix or map.

Before a company launches a product, the marketing department has to decide how to position it in the marketplace compared to competitors’ products. To determine the positioning of a product, marketers must deﬁne the most important features and values

Product positioning maps

HIGH QUALITY

Marketers commonly create a perceptual “map,” using a product’s two most important attributes, presented as variables on an x and y axis, to work out where to position it. Attributes may include price, quality, status, features, safety, and reliability. Once the map is labeled, existing products are placed on it to reveal the best position or gap for the proposed launch.

LOW PRICE

❯ Value positioning A product plotted on the map so that it has an attractive price while delivering good functional qualities. ❯ Quality positioning A product that is located on the map on the basis of its perceived quality or superiority. ❯ Demographic positioning A product mapped according to its appeal to a speciﬁc population segment, such as consumers with a particular occupation. ❯ Competitive positioning A product that is very similar to those of competitors, relying on correct pricing to ﬁnd a viable position in the marketplace.

Competitor brand Competitor brand

Competitor brand

Gap in the market

Competitor brand

Brand’s current position

LOW QUALITY

Product positioning template The map shows how marketers position competing products in the marketplace according to the price/quality variables (the most commonly used) to identify a gap for the new product.

HIGH PRICE

FOUR POSITIONING STRATEGIES

Competitor brand Competitor brand

Ideal brand position

HOW SALES AND MARKETING WORKS Marketing mix

182 183

s gg

bacon and

i ro

ssa

An expensive breakfast food ideal for busy professionals in a hurry.

A breakfast dish aimed at those with ample leisure time and money.

EXPENSIVE

ereal dc l o

With a slow cook time, pancakes occupy a niche gap in the market.

e al cer

SLOW

es cak n a

QUICK

Centrally positioned, cereal is the most popular breakfast food.

reakfas nt b t a t s

Students make the ideal target market for instant breakfast products.

Older people and children provide strong demand for hot cereals.

INEXPENSIVE

Breakfast positioning map The positioning of the various breakfast foods has been determined by the speed at which the food is prepared, measured from slowest to fastest, and the price of each food type, from the least expensive to the most expensive.

“Positioning is not what you do to a product. (It) is what you do to the mind of the prospect.” Al Ries and Jack Trout

Product life cycle Every successful product launched on the market experiences growth followed by decline. To maximize proﬁtability, business managers must recognize and manage each stage of the product’s life span. How it works There are typically six identiﬁable stages in a product life cycle, with the product’s rate of growth measured by time and revenue. Most businesses have more than one product on the market at any time, and strategic manipulation of the portfolio of products at their

different stages in the cycle is crucial to maintaining business growth. The life of older products may be prolonged by extension strategies, but if they are no longer grabbing new market share, the business must consider launching new products in order to continue generating revenue.

Growth Sales increase and the cost per customer falls as proﬁts rise. There are more customers—and more competitors.

Saturation Sales peak and the cost per customer is at its lowest. Proﬁts are now high and competition is intense.

Launch Business outlay is high due to product development costs and marketing budget. There is no return on investment.

Decline

Introduction Sales are typically low and cost per customer is high as the market takes time to accept the new product.

SALES

TIME

Proﬁts fall as sales fall and the customer base contracts. The cost per customer remains low. Marketing spend is now kept at a minimum.

HOW SALES AND MARKETING WORK Marketing mix

LAGGARDS

❯ Extension strategy Revival of a product by rebranding, or repackaging, repricing it, or ﬁnding new markets ❯ Portfolio analysis Each of a company’s products measured by growth rate and market share to determine marketing spend ❯ Product life cycle management (PLM) Tracking of product data from inception to withdrawal

LATE MAJORITY

Marketers identify ﬁve distinct customer types according to how quickly they pick up on a new product. EARLY MAJORITY

NEED TO KNOW

EARLY ADOPTERS

the length of time a product can be labelled as “new”

Diffusion of innovation (consumer uptake) %

INNOVATORS

6 months

184 185

PORTFOLIO ANALYSIS 34%

Rising stars

34%

Products with a high market share in a high-growth market; they require a big marketing spend to keep them growing.

Withdrawal The product is phased out as sales stall or continue to fall. The business introduces a replacement product before the old one is withdrawn.

Cash cows Products with a high market share in a low-growth market; they generate money to support rising stars.

16% 13.5%

Problem children Products with a low market share in a high-growth market; they need a big marketing spend.

Dogs

2.5%

Products with low market share and low growth; they may stay in portfolio to keep customers happy.

Price Price is a crucial variable of the marketing mix: it generates revenue, while product, promotion, and place yield costs. Pricing may also be the marketer’s most potent tool because even minor tweaks affect returns. How it works To set the price of a product, marketers adopt a pricing strategy based not only on the actual cost of production but also on the perceived attractiveness of the product to consumers. If consumers think a product has a high value, they will be prepared to pay more for it, but if they believe the value

of the product is low they will look for the cheapest price among competing products. A business must also take into account the price charged by rival organizations, particularly in competitive markets. Setting a price above that charged by competitors can only work if the product is superior to others.

Pricing strategies

Pricing matrix: price vs. quality A product’s quality affects its price tag— the higher the quality, the more money consumers will pay for it—but marketers use strategies that play on the interaction between price and perceived quality.

Economy ❯ High prevalence Manufacture a product that is very similar to others in the same category. ❯ Low price Undercut competitors’ pricing and gain a larger share of the market. ❯ Minimal marketing Keep the marketing and branding spend as low as possible.

Skimming

High price

increase in price is worth more than a 5% increase in market share

❯ Price, value, and cost Price refers to the amount a product sells for; value refers to the product’s actual worth; cost is the amount that has been spent to manufacture the product

Low quality Low price

A number of different strategies can be used to determine the price of a product. Cost-plus pricing is a retail markup used by many companies to ensure a proﬁt is made. For example, adding a markup of 50 percent to a product that costs $2 to make means that every unit will sell for $3, generating a $1 proﬁt.

NEED TO KNOW

❯ High launch price Charge more than usual in the short term while a product is seen as unique. ❯ Correct timing Set a higher price when the business has a temporary advantage in the marketplace, before competing products appear. ❯ Price adjustment Reduce the price once competitors enter the market, or to draw more customers.

$$$$

HOW SALES AND MARKETING WORKS Marketing mix

186 187

PRICING MARKUP COMPARISON

400%

DESSERT WINE 200–250% of cost

BEER 250–300% of cost

CARAFE OF WINE 250–300% of cost

Market penetration ❯ Low price Charge the lowest price possible in order to lure customers away from competitors. ❯ Price adjustment Increase the price to a normal level once the product has a loyal following. ❯ Pricing ﬂexibility Reassess pricing; initial high-volume sales lower cost of production, allowing price tweaks.

$$$$

OTHER LIQUOR 400–500% of cost

200%

High quality

COCKTAIL 350–400% of cost

GLASS OF WINE 300–400% of cost

300%

COST (100%)

Different industries adopt different approaches to markups. A markup of two to ﬁve times the cost is typically applied to drinks served in bars and restaurants. The highest markup is usually applied to the second-cheapest bottle of wine on the wine list, as people tend to avoid the cheapest item.

Premium ❯ High price Charge as much as the market will pay for an item. ❯ Unique value Apply premium prices to products that have no comparable substitute, such as famous brand-name goods. ❯ High production cost Charge a premium price because a product is customized and offers no savings through volume manufacturing.

Other pricing strategies

Psychological pricing Manipulate a customer’s emotions, appealing to their thrifty side or desire for prestige.

Bundle pricing

$$$$ $

Offer several products for an overall price, providing better value than buying separately.

Geographic pricing Charge different prices for the same product in different locations.

Non-pricing strategies Avoid adjusting the price to attract sales, promoting superiority of product instead.

Place Knowing where customers shop, where a product is sold, and how efﬁciently goods can be delivered to the consumer—called “place” in marketing terms—is essential to sales success. How it works Whether a company sells goods or services, customers must be able to ﬁnd and buy those products as easily as possible. Businesses have to decide on the best sales outlet and sales channel to get their products to customers in a way that beneﬁts both parties.

A sales outlet is the place where a product is sold, suchas stores, catalogs, or e-commerce sites. Sales channels are the merchants, agents, and distributors who take a product from the seller and bring it to the consumer.

Main distribution channels A product reaches the marketplace through one of four main types of distribution channels. The most suitable distribution channel is usually dictated by where customers prefer to buy the product.

70.5%

of device sales by 2017 are forecast to be smartphones Selling direct to consumers Product is sold directly by the producer, online, or through a mail-order catalog, and delivered to customer without intermediary.

Selling through retailers Goods are delivered by producer directly to retail outlets; retailer adds a markup onto the price they pay to producer.

Selling through wholesalers and retailers Products are distributed in two stages: by producer to wholesaler and then wholesaler to retailer.

Selling through an agent Producer A producer chooses the distribution channel, or a combination of channels, that will maximize the number of customers it can reach while keeping costs as low as possible.

Products are distributed in three stages: from producer to agent, from agent to wholesaler, and then on to retailer.

HOW SALES AND MARKETING WORKS Marketing mix

PROS AND CONS OF USING INTERMEDIARIES

188 189

NEED TO KNOW

Pros

Cons

❯ Allows wider market coverage so producer can reach more customers, especially those in distant areas. ❯ Minimizes distribution cost for producer as intermediaries are responsible for this service. ❯ Provides producer with specialized knowledge of customer buying habits, as well as delivery logistics.

❯ Raises difﬁculty of making direct communication with customers to learn about their preferences. ❯ Increases the risk of slow, inefﬁcient delivery, especially if several intermediaries are involved. ❯ Takes away control over how products are handled and displayed at point of sale.

❯ Channel margin The cost intermediary adds to producer’s selling price, which is added to price paid by customer ❯ Push strategy Method in which producer promotes products to wholesalers, wholesalers to retailers, and retailers to customer ❯ Pull strategy Use of advertising and promotion to sell to customer

Example E-commerce site selling vitamins; they are sent to customer by mail or delivery service. Consumer

Example Electronics company distributes its television sets to a chain of retail stores. Retailer

Consumer

Example Farmer sells apples to wholesaler, who sells them on to supermarkets. Wholesaler

Retailer

Consumer

Example Chocolatier in France uses import agent in Japan to sell its products to wholesalers and on to retailers.

Agent

Wholesaler

Retailer

Consumer

Promotion Promotion is necessary for generating interest in and sales of a product or service. A complex and expensive part of the marketing mix, it involves communicating to customers and inﬂuencers such as peer groups. How it works The primary purpose of promotion is to boost sales by attracting new customers, while enticing existing ones to try out something new. Most companies use a number of communication activities to inform and remind their target audience of a product’s beneﬁts (see pp.196–231). One of the long-term beneﬁts of communicating with customers is that it helps to build brand loyalty.

Personal selling Co nsu mer bee

Interact with customers face to face and tailor sales messages to their needs.

NEED TO KNOW ❯ Integrated Marketing Communication (IMC) Promotion of the same brand message across all media channels ❯ MarCom (Marketing Communication) Full range of promotional activities used to reach out to the market

25%

the percentage of digital promotion budgets spent on mobile advertising in 2013

Customer service Provides customers with information about the product; offers updates and special deals.

Below the line (BTL) Describes promotional activities a business carries out in-house, such as direct mail or telemarketing, to reach customers directly.

HOW SALES AND MARKETING WORKS Marketing mix

Advertising

190 191

Direct marketing

Run ad campaigns through media channels most likely to reach target market, and stick to budget appropriate for the product.

Send product offers and information directly to the potential consumer, via mail or email.

Interactive marketing Build long-term relationships with customers using twoway communication, especially online.

Sales promotion Entice customer with offers, free samples, gifts, competitions, packaging, and point-of-sale displays.

Above the line (ATL) Refers to online and ofﬂine advertising a business pays for to target customers.

Public relations Generate positive interest in the company by sponsoring events and charities, or pitching news content to media.

Market research Asking customers what they think about a product is a vital part of the decision-making process for marketers. Research offers insights into how a product might perform and lowers the risk of marketing campaigns. How it works Market research is used during product development and then to monitor customer satisfaction and competitor activity. Researchers draw on existing data, observations, and their own research. New research is broken down into quantitative (numberbased) research—closed (multiple choice) questions

asked of a large group of people—and qualitative (in-depth) research—into how a consumer uses and feels about a potential new product. The marketing department’s research budget is usually split between the two types of surveys. Quantitative research is often used when developing a new product, followed by qualitative research to help reﬁne the product.

“Research + Intuition = Decision” Primary data collection New research to answer speciﬁc question

Observations

Quantitative surveys

Qualitative surveys

❯ Researchers may watch from a distance as customer interacts with product, or identify themselves and talk to customer. ❯ They observe customer using equipment such as eye tracking analysis and checkout scanners. ❯ They study credit card records or computer history to observe past consumer behavior.

❯ Researchers question many people for a broad view (numerical data). ❯ They carry out online surveys to obtain a quick result from a large sample.

❯ Researchers probe small groups or individuals for in-depth view. ❯ They conduct focus group discussions.

HOW SALES AND MARKETING WORKS Marketing mix

192 193

CASE STUDY

Coca-Cola launch

Marketer reaches a decision DATA RETURNED

DATA REQUESTED

Marketer has a question

In 1985, Coca-Cola launched a new kind of cola. The launch followed two years of taste tests, costing $4 million, to reﬁne the product. However, the drink failed and had to be withdrawn in the face of overwhelming disapproval from the public. In the marketing postmortem, analysts concluded that the company’s researchers had failed to ask customers a very important question: “Do you want a new Coke?”

Secondary data collection Published material on a subject

Agency Carries out original research and organizes research data into meaningful results

32%

the projected increase in the hiring of market research analysts in the US by 2022

Internal sources

External sources

❯ Web usage data (for example browser logs and online sales records) ❯ Customer proﬁles with buying history and demographic data ❯ Accounting records, such as statements and balance sheets ❯ Original data from past market research reports

❯ Industry reports by trade bodies, institutions, and private research companies ❯ Reports by broadcast, print, and internet media ❯ Academic papers, university think tank reports, and research library holdings ❯ Government surveys, reports, and statistics

Market segmentation In order to make decisions about who to sell their product to, marketers try to identify distinct groups of consumers with similar wants and habits who together form a “segment” of the market. How it works Marketing departments use a strategy of market segmentation to ﬁnd the potential customers who are most likely to buy a particular product, thereby increasing the chances of a successful product launch. They divide a broad group of consumers into subgroups based on many factors, including age, lifestyle preferences, location, family structure, household income, and occupation. This process

narrows down a potentially huge market into segments, allowing marketers to identify the ones more inclined to buy a given product. For example, after applying this strategy, a company trying to launch premium-price organic baby food realizes that instead of marketing to all women who have young children, it should aim its product at working mothers with children under six months, above-average incomes, and an interest in healthy eating.

Behavioral

NEED TO KNOW ❯ Baby Boomers Section of population born between 1946 and 1964 ❯ Generation X People born between 1966 and 1980 ❯ Millennials Section of population born between 1980 and the early 2000s

Deﬁning market groups To establish different consumer groups, marketers create ﬁve segments and focus on each individually. Besides identifying groups by geography and demographics, marketers also explore psychology to ascertain how consumers behave, so that they gain a better idea of which products might appeal to which consumer groups. See also pp.258–261.

“Market segmentation is a natural result of the vast differences among people.” Donald Norman

Focuses on behavioral patterns when it comes to shopping. Understanding this helps marketers adapt campaigns to target speciﬁc groups. Potential focus areas include: ❯ Brand loyalty ❯ Regularity of purchases ❯ Credit card usage ❯ Typical expenditure ❯ On- or ofﬂine shopping ❯ Heavy product user

194 195 Sociographic

Psychographic

Identiﬁes individuals’ connections on social media, or membership of political and other groups, helping marketers learn about consumers’ passions and interests. Potential focus areas include: ❯ Group memberships ❯ Number of friends on social media

Focuses on consumer’s interests, values, and opinions to help marketers develop relevant messages and ﬁnd the right media channels to target a segment. Potential focus areas include: ❯ Risk taker ❯ Charitable ❯ High achiever ❯ A tendency towards expensive tastes ❯ A preference for email contact

Geographic

Demographic Uses basic consumer data, such as gender or age, to accurately categorize needs and target products appropriately. Potential focus areas include: ❯ Income ❯ Nationality ❯ Family size and age ❯ Ethnic background ❯ Occupation ❯ Religion

Concentrates on a customer’s place of residence, so that any product launched is made relevant to their environment. Potential focus areas include: ❯ Post code ❯ Continent ❯ City ❯ Neighbourhood ❯ Population density ❯ Climate

Marketing approaches Every product launch requires strategic planning to make sure messages about a new product reach the right types of consumers, are communicated through the most effective combination of channels, and have the most relevant content and style. Once marketers have researched the market and deﬁned their target audience, they face several key decisions on how to make their approach.

Types of approaches Whom to target and how to go about it are crucial to success. Marketers may use several complementary approaches to different groups of potential consumers.

Rather than sending the same message via different media, they usually adjust the tone and style of the marketing pitch to suit the channel as well as the target consumer.

Niche marketing “I only have eyes for you.”

The big choice The ﬁrst decision is whether to go for a narrow, specialized market or to appeal to as large an audience as possible. See pp.198–199.

Mass marketing “I love you all.”

HOW SALES AND MARKETING WORKS Marketing approaches

196 197

85%

of all purchasing decisons in the US are made or inﬂuenced by women

Traditional channel allied with a dominating style. “Let me tell you,” it blares. See pp.200–201.

Engagement marketing “Come dance with me.” It entices the customer to collude in product sales. See pp.204–205. Sensory marketing “Wake up and smell the roses.” It seduces the customer with sights, sounds, and smells. See pp.206–207.

Digital channel allied with a soft approach. “Let me woo you,” it whispers. See pp.202–203.

Relationship marketing “Let’s be friends.” It builds a rapport with its audience of consumers. See pp.208–209.

How to tell the customer

Making a move

Marketers often get the best of both worlds by using traditional and online channels in varying styles.

Turning the buying transaction into an experience the consumer enjoys can help sell a product.

Niche vs. mass marketing Two fundamental choices traditionally face marketers: whether to try to sell a product with broad appeal to as many people as possible, or to focus on selling a tailored product to a deﬁned group. How it works Both niche and mass marketing strategies offer businesses the potential to make a high return on investment. A niche approach generally works on the basis of lowvolume sales at a premium price to a speciﬁc group of consumers, while a mass approach tends to use heavy promotion to a wider audience and aims to achieve high-volume sales. In reality, businesses tend to mix up both approaches, launching a niche product and then expanding it to a mass market. Marketers also

use internet channels to promote the same product to different groups of customers within a mass audience.

20%

of sales can make up to 80% of proﬁt

NEED TO KNOW Long-tail marketing

POPULARITY

Coined by Wired magazine editor Chris Anderson, the term “long-tail marketing” takes its name from a demand curve (see below) depicting products with low demand or sales volume—niche products—that continue to sell and make proﬁt over time. Head Popular products with high demand and sales volume Withdraw The point at which retailers typically stop selling a product

Long tail Products with low demand that sell steadily

PRODUCTS

HOW SALES AND MARKETING WORKS Marketing approaches

198 199

Niche market Who and how ❯ Business targets a select group of consumers with speciﬁc need and wants. ❯ Customers often prepared to pay a premium price for an uncommon product. ❯ Sales volume of niche product low, so does not beneﬁt from production economies of scale (manufacturing large quantities to decrease the unit cost of production).

HYBRID APPROACHES Using social media to identify and reach more than one target market, marketers have developed hybrid approaches that are more ﬂexible than conventional niche or massmarket positioning of products.

Mass market An unfocused strategy that aims at the broadest customer base.

Large segment

Mass market

Channels marketing resources to one large segment of the mass market.

Who and how

Adjacent segment

❯ Business targeting a large group of consumers with generalized wants and needs. ❯ Requires high marketing spend to promote products, which must be widely distributed. ❯ Marketplace often crowded with other competitors selling a similar product.

Once large segment is fully penetrated, product expands into related segment.

Multi segment Markets to several segments at once, with a customized strategy for each.

Small segment Markets to a small segment with few competitors, if resources are limited.

Niche segment Focuses marketing resources on a speciﬁc group of customers.

Mass customization Customizes a strategy for each sub-segment within the mass market.

Traditional marketing Before the digital age, marketers relied exclusively on non-digital channels, such as TV, radio, and print media, as well as direct mail, events, and cold-calling, to convey their message to the consumer. How it works Traditional marketing encompasses a number of tried-and-tested ways of building a brand and pushing a product to sell more. It remains a key facet of marketing. Nowadays, however, most businesses use a mix of traditional and digital marketing methods. One of the advantages of traditional marketing is that companies have face-to-face contact with customers through person-to-person selling, special events, and event sponsorship.

Events Staging sports activities, themed displays, parades, or exhibits to promote a product, cause, or brand.

TV Promoting sales through TV ads, program sponsorship, or product placement.

Traditional marketing process Small and large businesses use a range of conventional marketing channels, and often integrate them with digital marketing strategies.

Direct mail Mailing catalogs or circulars to a targeted list of consumers, often promoting special offers on products.

Face-to-face

Telemarketing

Approaching customers directly to create brand awareness or persuade them to buy a product.

Calling potential customers who have an identiﬁable need for a product with a sales pitch.

HOW SALES AND MARKETING WORKS Marketing approaches

200 201

Product samples Offering free samples of a product to customers, giving them the opportunity to try it before making a purchase —an effective way to launch new products and build a customer base.

Billboards Renting large outdoor advertising spaces to market products. Cost depends on the size of space, its visibility, and the amount of trafﬁc that passes the location.

Radio Using commercial slots on radio to promote products either locally or nationally, depending on the station’s reach.

25%

Newspapers and magazines Buying space in print media to run advertisements, or creating advertorials to market products or services.

Traditional marketing Digital marketing 75%

25% Brochures and ﬂyers

Networking

Promoting through mailing or locally hand-distributing printed materials to promote businesses.

Interacting with other people at special events to develop professional contacts.

of US companies surveyed in 2012 valued traditional marketing while 75% valued digital marketing

Digital marketing Using the internet, marketers can connect directly and instantly with current and potential customers to build brand recognition, collect data, and encourage word-of-mouth recommendations. How it works

m Consu

Customer blogs about the gym

Q to ks lin site og b Bl we

gy to n e ke on ta h i s ll p d e ce co on u ko

t to er m ct

to TV ADS AIRED DURING TENNIS TOURNAMENT

POSTER IN GYM ADVERTISING FREE WI-FI

Customer takes coupon to gym

or w QR code is scanned with cell phone

PRINTED AD WITH TRIAL COUPON

ee fr sa e le s i t du e b he w s c on

nal marke o i t tin di a g r

er POSTER WITH QR CODE FOR TRIAL

Directs viewer to

c u Di s t re om c t er s to

CUSTOMERS VISIT THE GYM

A new health club is launched using a tradigital approach to marketing. TV ads are aired with a call to action to visit the gym’s website and schedule a free workout with a ﬁtness trainer. Print ads feature a coupon or a QR (quick response) code to scan and present at the health club for a free trial. At the club, members get free Wi-Fi access. The Wi-Fi landing page has a link to the gym’s free app. The club may also use pop-up ads, podcasts, email, and text messaging to attract or retain members.

xperien ce

Tradigital in practice

e er

s Cu

Unlike traditional ofﬂine marketing, digital marketing gives a business direct, two-way communication with customers. Digital marketing employs some conventional approaches, such as “pop-up” or “banner” ads on web pages, but it also relies heavily on the power of social media for raising awareness of a product or brand. This makes it harder to measure return on investment. Digital marketing is often used in conjunction with traditional marketing techniques, a hybrid known as “tradigital” marketing.

HOW SALES AND MARKETING WORKS Marketing approaches

% SHARE OF GLOBAL AD SPEND BY MEDIUM

Digi tal ma rk et i

FREE APP

202 203

The internet is the fastest-growing channel for global ad spending, while TV continues to dominate the current spend. 1%

6% 7%

Directs Wi-Fi user to

n ve gi i a is e d ck l m ba c i a e d so Fe i a v

2012 $

40%

19% 18%

D I LAN ING PA I-F GE W

Feedback is given via social media

1% 6%

Directs Wi-Fi user to

7% Wi-Fi landing page links to a workout clip on video sharing site

7% 2015

40%

16%

ti se al c ar u s ch to f o me rt r h e do g y es m aw eb

en Po t

GYM WEBSITE

Cu up s t o n e f o me w r e r si s l e m gn t t a il s er

23% KEY TV internet newspapers magazines

23%

radio billboards movie theaters

the percentage of the global e-commerce market forecast to be held by China by 2016

Engagement marketing By involving customers directly in the development of a brand, marketers hope to build a strong two-way relationship with customers and win long-term loyalty. How it works Engagement marketing harnesses several online and ofﬂine strategies to draw a customer’s interest and get them talking about products and services. This contrasts with the more traditional style of marketing in which a brand concept and product proposal are presented to the customer as ﬁxed, to be either accepted or rejected. Engagement marketing, on the other hand, encourages customer input so that they feel closer to the brand. The goal is to lure potential customers to the website with an initial experience, and then work hard to keep them there.

Start with a “wow” experience Provide interesting, informative, or entertaining content to draw potential customers to a web page.

Sale Once customer makes purchase, follow up with after-sale call, full of feel-good reinforcement.

$ $ $

PURCHASE

NEED TO KNOW ❯ “Sticky” customers Consumers who are loyal to a company and return to make more purchases ❯ Decision simplicity Ease with which consumers can ﬁnd trustworthy information about a product ❯ Churn rate Percentage of customers that cut ties with the company in any given time period ❯ WOM Word-of-mouth marketing, which relies on satisﬁed customers recommending products to others

New prospects Offer incentives to existing customers for recommending product or sharing content.

Social visibility COMMENTS AND SHARES

Post interesting and relevant content on social media, and encourage dialogue.

HOW SALES AND MARKETING WORKS Marketing approaches

204 205

71%

of UK business leaders believe that customer experience is the next corporate battleground Entice to stay in touch ATTRACT

Offer incentives to visitors when they sign up for email updates and newsletters.

@ Virtual engagement Design every aspect of a website to maintain visitor interest so people return for new content.

IN-STORE PROMOTION

SOCIAL MEDIA

Events Use previous customer feedback to decide on best content for publicity events.

Actual engagement Encourage customers in the real world to use product, meet and speak with sales staff, and interact with other customers.

Sensory marketing Sensory marketing targets multiple senses to sway purchasing decisions. Based on research showing how the brain responds to sensory input, this type of marketing acts covertly on the customer. How it works Sensory marketing is most obviously used by the food and drinks industries, but its use extends to diverse products and services: computers designed with tactile materials, hotels scented to relax customers, and even ﬁreworks displays featuring edible confetti. Typical channels for sensory marketing include ﬁeld marketing (in-store events, samples, and person-to-person sales), direct mail, and product delivery. For online businesses, however, ﬁnding a way to use it remains a challenge.

Sight Technology is making advances with this, the most stimulated sense in marketing, by using optical illusions, digital effects, 3-D, and 360-degree photography.

Touch

Smell

Marketers use 2-D and 3-D textural print techniques for promotional materials and packaging, as well as to sell products with tactile appeal.

Customers are willing to pay more for a product sold in an environment that is scented appealingly.

81%

of consumers born from 1980 to 2000 value experience over material items

Taste Taste sensations can be enhanced or subtly altered by combining them with touch, sight, and especially the closely linked sense of smell.

HOW SALES AND MARKETING WORKS Marketing approaches

206 207

Attitude, memory, behavior, and mood

NEED TO KNOW ❯ Sensory testing Assessment of products by panel members with exceptional sensory perception ❯ Haptic technology Invention that simulates touch through vibrations on computers ❯ 3-D marketing An immersive form of consumer marketing

The sensory input results in a short- or longterm effect on attitude, memory, behavior, and mood. This can be inﬂuenced by the intensity of sensory data and by using it to stimulate more than one sense at the same time.

Perception The brain receives stimuli from one or more senses.

Emotion

Cognition

Sensory stimuli tap into the store of emotional memories, as both are processed by the same area of the brain.

After processing sensory stimuli, the brain embeds memory, regulates emotion, and makes decisions.

Hearing Sound is more effective than sight in triggering the brain areas that process emotions.

Relationship marketing The strategy of relationship marketing is to develop and manage a trusting, long-term association with customers and other markets that have links with the company. How it works Relationship marketing aims to replicate the type of interaction that village stores once had with their customers, offering a high level of personalized service to win them over for a lifetime. While small, local businesses naturally work this way, large

corporations have now changed their focus from making the sale to relationships, and from short-term reward to long-term gain. The marketer can extend the network beyond the engaged customer to include employees, suppliers, and others.

Supplier markets Building a relationship of collaboration with suppliers makes good commercial sense.

Six markets model Relationship marketing has established a strategy for communicating with the customer. This strategy deﬁnes six markets—not just traditional customer markets—where companies should direct their marketing efforts.

CASE STUDY Starbucks The strategy of coffee-shop chain Starbucks exempliﬁes effective relationship marketing. Centered on core customer and internal markets, it also involves suppliers, referrals, and recruitment (employee) markets. Marketing to customers ❯ Social media ❯ Business crowdsourcing ❯ Familiarity with customers ❯ Loyalty program ❯ Reward card app ❯ Mobile payments

Marketing internally ❯ Barista training ❯ Tech development opportunities Marketing via referrals ❯ Word of mouth ❯ Social media shares Marketing to employees ❯ Stock options ❯ Medical insurance ❯ Partnership Marketing to suppliers ❯ Fairtrade programs ❯ Quality control

Inﬂuence markets To maintain good public relations, the company works with regulators and consumer or environmental groups.

HOW SALES AND MARKETING WORKS Marketing approaches

Referral markets Customers can be word-ofmouth advocates for a company. Related businesses may also refer trade.

208 209

“Ignore the human element of marketing at your own peril.” Bob Garﬁeld

Internal markets

Customer markets The main marketing focus is on customers, but activities are based more on building long-term customer relationships than on acquiring new customers.

A company’s employees are its internal customers, working together to represent its goals, mission, and strategy.

NEED TO KNOW

Recruitment markets To attract the best employees, a company may market itself by offering incentives to staff.

❯ Key account management (KAM) System that coordinates departments in a businessto-business (B2B) company to serve big clients ❯ Frequency marketing Promotion aimed at increasing repeat sales by rewarding customers for repeat purchases ❯ Direct response (DR) Marketing that invites consumers to respond directly to the advertiser, by mail, telephone, or email ❯ Transaction marketing Strategy that aims to persuade customers to make additional one-time purchases at the point of sale

Outbound marketing Also called interruption marketing, outbound marketing involves a marketer pushing a message to consumers. With this type of marketing, businesses typically reach out to a wide audience by paying for advertisements on various media channels. Although the audience may have no interest in the advertisement, outbound strategy relies on delivering a high-impact message and generating a response by creating familiarity through repetition.

Outbound marketing process Outbound marketing takes a traditional approach to grabbing consumers’ attention, but may use both non-digital and digital media platforms. There are two stages to the outbound process. First, the company broadcasts a message to an audience and tries to convert them into customers; second, it analyzes the results to identify the channels and campaigns that have generated the most sales.

Broadcast

Convert

Marketers select a media channel with proven reach to the target audience, then communicate the message about brand or product to that audience.

Marketers link ofﬂine outbound campaigns with digital channels as part of an overall strategy to persuade potential customers to respond.

Broadcast channels

Means of conversion

❯ Ads on prime time TV to ﬁnd widest possible audience—ideal for raising brand awareness. ❯ Direct mail sent to a general audience using mailing lists, or to existing customers who have previously bought by mail order. See pp.212–213. ❯ Print advertisements in special interest, hobby, or trade magazines with proven circulation to ﬁnd a deﬁned target market. ❯ Presence at trade events for increasing corporate visibility and to reach a business audience.

❯ Radio advertisement that repeats easy-to-recall phone number to elicit immediate action. ❯ Direct mail that makes highimpact call for customer response; includes postage-paid reply form and customer service contacts. ❯ Online advertisement that has prominent position on web page and clear click-through point that invites customers to click, ﬁnd out more about product, and buy. ❯ Flyer distributed door to door that includes an appealing introductory offer on the product for a limited period of time.

HOW SALES AND MARKETING WORKS Outbound marketing

210 211

32%

of UK brands cut outbound marketing spend in favour of spending more on content marketing, in 2013

TYPES OF OUTBOUND MARKETING Ofﬂine ❯ Cold calling Campaign can be more effective if conducted at the right time of day to suit target audience; message should be scripted carefully and delivered in a genuine tone. See pp.218–219. ❯ TV commercials Although many consumers now switch off TV advertisements, they are familiar with and open to this type of media, and repetition gets the message across. See pp.212–213. ❯ Radio This medium is the world’s most popular mass communication channel with a global reach, and is ideal for outbound messages aimed at an international market. See pp.212–213. ❯ Guerrilla marketing The use of a creative and unconventional approach in high-trafﬁc public places can be a cost-effective way to raise brand awareness. This is a form of engagement marketing. See pp.204–205.

Analyze Marketers monitor the progress of outbound campaign and adjust the mix of media or other paid-for channels, then measure campaign results.

Actions ❯ Run control and test streams to compare the success of different media or campaign strategies. ❯ Examine click-through-rate analytics, which look at how many customers have clicked through to ﬁnd out about or buy product, to determine online ad success. ❯ Measure direct mail response rates, including breakdown of different mailing lists or target demographics. ❯ Analyze sales by outbound spend to establish which channels offer the best return on marketing investment (ROMI).

Online ❯ Social media The types of advertising on social media sites are increasing and include sponsored posts, promoted pins, and direct forms, such as banner ads. See pp.228–229. ❯ Mobile technology Advertising that is tailored for mobile devices takes the form of text and images, or both, to offer special deals to users; promotions are also made via apps. See pp.214–215. ❯ Social lead targeting This strategy taps into individual proﬁles from social media and tailors messages, which are sent via online networks, such as Twitter and LinkedIn. ❯ Search engine optimization (SEO) keywords Paying for popular SEO keywords relevant to a brand can improve exposure by raising them in internet search engine listings pages. See pp.230–231.

Traditional offline advertising Ofﬂine advertising uses traditional media channels, such as magazines, TV, radio, and billboards, to market a product or service. Although online advertising is growing fast, globally most advertising is still ofﬂine. How it works The common criteria for both online and ofﬂine advertising is that businesses pay for ads that are intended to catch a consumer’s attention with a brand or product message. Businesses calculate the success of their advertisement by looking at the return on investment (ROI) for every ad dollar spent. And to maximize the ROI, they must make sure they choose the right channel for their target audience.

Marketers choose different channels according to the target market deﬁned for the product or service being advertised. The choice may also be based on the ROI that a company has previously experienced for that channel. However, tracking the response rate of ofﬂine advertising is more difﬁcult and less accurate than tracking online advertising (see pp.214–215).

83%

of all advertising in India in 2013 was via television or print; digital comprised just 6.5% of the total

OFFLINE ADVERTISING AND RETURN ON INVESTMENT (ROI) 44.3%

One of the most important set of ﬁgures for a marketing department is return on investment (ROI) for advertising spend, which indicates the success of its campaigns. Data compiled by the Radio Advertising Bureau, UK, in 2013 showed that TV and radio boasted the best ROI.

KEY Share of overall ofﬂine ad budget Average return on investment per $ spent

18.1% 11.7% $14.15

$12.53 5.8%

$9.44 $3.25 TELEVISION

PRESS

OUTDOOR

RADIO

HOW SALES AND MARKETING WORKS Outbound marketing

Ofﬂine advertising channels Television

Radio

Newspapers S N EW

Magazines

Direct mail

Billboards

Movies

Pros

Cons

Offers local, national, and global reach; mix of sound and vision creates high-impact message

Expensive; ad repetition may cause viewer fatigue; viewers likely to skip ads on recorded shows

Inexpensive; quick and easy production process; most stations play to speciﬁc demographic

Competition for prime “commute” slots; radio on as background noise renders ad ineffective

Fast publication process; themed newspaper sections allow for more targeted advertising

Ads compete for attention with other material on page; usually black and white, and text only

May remain in circulation for months; niche trade and special-interest titles allow focused advertising

Real circulation ﬁgures hard to source; securing ad slot requires planning months in advance

Cost-effective; delivered straight to people’s homes and ofﬁces; targets speciﬁc markets

May be perceived as junk mail and instantly thrown away; response rate usually low

High reach makes channel cost-effective; advertiser’s message visible 24 hours a day

Heavy competition for prime sites; format limits message length and complexity

Potential to impress with sophisticated, creative production; it has captive audience members

Audience numbers limited; members may choose to enter theater after ads are shown

212 213

NEED TO KNOW ❯ Television rating point (TVR) Indicates percentage of target viewers in program audience ❯ Cost per thousand (CPT) Figure used to measure outlay to reach a thousand people via any channel ❯ Advertising to sales ratio (A/S) Method of measuring money spent on advertising and sales generated ❯ Share of voice Percentage of total activity claimed by one advertiser for a product sector

58%

of marketers’ ad budget globally was spent on TV advertising in 2010, although 86% of people skip television ads

Online advertising Marketers are increasingly advertising online to push marketing messages to consumers. Online channels include display and mobile technologies, email, search engines, and social media marketing. How it works When marketers advertise on the internet, they have to choose both the form of the ad and a location that has an audience matching their target market. There are several advertising channels, but the two most often used are display advertising and search advertising. Display advertising includes banners with text and images, which appear on websites known to be used frequently by target consumers, such as news, social media, or video content sites. Search advertising is a method of placing ads in the web pages that appear in the results of search

engine queries. While display advertising is likely to get more views overall, search advertising has a better chance of reaching the target audience. Other forms of digital advertising include mobile advertising, which embeds advertisements in mobile content viewed on smartphones and tablets, or sends text messages; email, which delivers ad copy directly to an email address; and social media advertising, which a company uses to promote products via its social media proﬁle. A major advantage of online over ofﬂine advertising is that response rates can be tracked effectively.

210%

the growth rate of mobile advertising in China, between 2013 and 2014

RESPONSES TO DIGITAL ADVERTISING OVERLOAD 70%

66%

65%

60%

Consumers who feel bombarded by digital promotions from a brand are likely to be put off. Here is a sample of how consumers would respond if they felt a brand’s promotions were too frequent.

KEY US UK

50% 40%

32% 28%

30%

27% 20%

20%

11% 10% 0%

Would unsubscribe from a brand’s promotions

Would respond negatively to future brand messages

Would stop using the brand’s product or service

10%

Would protest on social media sites

HOW SALES AND MARKETING WORKS Outbound marketing

Online advertising channels Pros

Cons

Display advertising

Attention-grabbing; if ad is clicked on, success can be tracked with pay-perclick system

Hard to target consumer precisely; internet users suffer ad fatigue and ignore advertisements

Search advertising

Good for targeting consumers, as search user keywords are matched to advertiser keywords (see pp.230–231)

Potentially expensive if using premium keywords; can take time to see results

xxxx

214 215

NEED TO KNOW ❯ Clickstream User activity proﬁle that summarizes what an individual has clicked on ❯ Behavioral targeting Process whereby websites capture data from landing page visitors and use it to improve ad effectiveness ❯ Interstitials Ads that precede the content page a user expects to land on, or appear right after it

CASE STUDY Mobile

@ Social media

Cheaper to develop content for mobiles than for computers; easy to track ad effectiveness

Different screen sizes and systems can distort ad layout; user may feel annoyed by interruption

Offers opportunity to reach millions of potential customers, especially with bulk emailing (see pp.216–217)

Recipient may delete email without reading it, and is more likely to do so if feeling bombarded

Easy to target speciﬁc audience; offers chance of ad going viral and achieving many views (see pp.228–229)

Continual posts and updates can easily distract user’s attention away from placed ad

46%

of e-commerce sales in 2014 came from the Asia–Paciﬁc region

Click fraud and botnets With pay-per-click (PPC) advertising, a business pays a website for every click made on one of its ads, but click fraud has become a serious issue. Fraudsters set up a website and sell PPC advertising, then inﬁltrate the computers of unsuspecting users with a computer virus known as a “botnet” to generate fake trafﬁc to the website. Advertisers on the site end up paying the fraudsters for the large number of clicks received. In 2013, one London company uncovered a botnet that was generating nine billion fake clicks per month.

Direct mail By targeting a large number of potential customers via mail or email, marketers hope to convert some into actual customers. This is achieved through the timing, design, and wording of the message. How it works Direct mail is one of the oldest forms of marketing. It works on the basis of sending a product offer to a large group of consumers in the knowledge that at least some will take up the offer and become customers. Direct mail relies on lists of names and addresses, which could be a company’s existing clients or a list bought from a specialist agency. Almost any business, from a small

company to a corporation, may use direct mail to sell. Typical companies that sell through direct mail include mail-order companies, ﬁnancial institutions, and nonproﬁt organizations seeking donations. The percentage of people who respond to direct mail, take up the offer, make a purchase, and become customers—a category known as the conversion rate—is extremely low, but nevertheless proves to be proﬁtable.

NEED TO KNOW ❯ Cleaning Correcting name and address details on mailing lists ❯ Lettershop Company that specializes in printing and mailing out letters and catalogs ❯ Merge/purge Software system that pulls together different mailing lists, searches for duplicates, and makes corrections

Direct mail and email—A/B testing A/B testing compares the effectiveness of two versions of a marketing email or direct mail copy. The two versions are sent to different groups of potential customers, and the response to each is measured.

Group A

APPROACH A

WEEKDAY MAILING See response from email hit on Monday

Responds with two clicks on the company’s website

@ Acquire names

Send mail

Set size of sample and split in half

3.42%

APPROACH B

WEEKEND MAILING See response from email hit on Saturday

was the average response rate to direct-mail marketing in the US in 2010

Group B Responds with 20 clicks on the company’s website

216 217

HOW SALES AND MARKETING WORKS Outbound marketing

HOW TO SEND DIRECT MAIL 1

5 A B

Acquire names

Prepare directmail copy

Send letters or emails

Work out response rate

Evaluate effectiveness

Buy in mailing lists or trade with other companies.

Write offer/response instructions; include prepaid envelope.

Send mail (staggered dispatch controls ﬂow of response).

Calculate responses as percentage of mail sent out.

Assess performance of campaign compared to others.

A B

Data analysis

Evaluate effectiveness

Comparison of results shows that Saturday time slot is more effective

Full email blast reveals that approach B yields the best response

Campaign B Send emails to remainder of the group on Saturday

Telemarketing Businesses use telemarketing to initiate direct contact with existing and potential customers. Customers can also contact the company directly. Telemarketing offers businesses a way to retain and acquire customers. How it works Telemarketing works in two directions: inbound and outbound. A customer making a call to a business (with a question or complaint, for example) is referred to as an inbound call. It gives the business a chance to retain a customer who may be dissatisﬁed with a product or service, or to win over a new customer contacting the company for the ﬁrst time. When a business

makes an outbound call, it is to sell additional products or services to an existing customer, or to entice a new customer to make a purchase. Telemarketing sales can be monitored in orders per hour; for example, agent A may make 140 calls per hour and generate $400. A more effective measure is revenue per call—if agent B makes 60 calls per hour but $450 worth of sales, the conversion rate per call is higher for agent B than agent A.

60%

of all call centre staff in France and India have college degrees

Outbound and inbound telemarketing process Telemarketers usually refer to a list of telephone numbers retrieved from a database to contact new or existing customers. Call center agents have access to product information to help them deal with questions and complaints.

Customer inquiry The customer may have a question about service or billing.

INBOUND Customer telephones call center

Call center Agents in the call center receive inbound calls and make outbound calls.

WARM OUTBOUND Call made to promote new products/offers to existing customer

COLD OUTBOUND Call made to establish ﬁrst-time contact with prospective customer

HOW SALES AND MARKETING WORKS Outbound marketing

TOP FIVE CALL CENTER LOCATIONS

NEED TO KNOW

The Philippines is the top call center location for US ﬁrms, followed by India. This is because of the high number of Filipinos who have a US education and knowledge of American culture.

Ireland

Poland China India

218 219

Philippines

❯ After-call work (ACW) Tasks the agent has to complete after making a call, such as processing sales forms ❯ Average handling time (AHT) Typical length of calls made to customers ❯ Automatic call distributor (ACD) Computerized telephone system that connects each call to the correct agent ❯ Average speed of answer (ASA) Measure of the time it takes to answer inbound calls

A B

Evaluate effectiveness Telemarketers constantly evaluate the effectiveness of calls.

Customer The person who decides whether to buy a product.

Agent A

Agent B

May adopt a particular sales strategy or have a personal approach.

May use a different communication or selling technique.

Outcome AGENT A AGENT B

Gatekeeper The person who answers the call and decides to pass it on.

At the conclusion of a marketing drive, telemarketers appraise strategies and styles to help them decide on future campaigns.

Inbound marketing Inbound marketing lures customers by offering them appealing content, and engaging with them. The approach pulls customers into a relationship with a brand rather than “pushing” them into making a purchase, which is how advertising works. Inbound marketing is also known as permission marketing as potential customers are giving a business permission to communicate with them. In other words, they are actively interacting with the company or brand.

Inbound marketing process Content forms the core of inbound marketing. It includes text, images, and video that consumers seek out online, especially on social media sites, or in person at events, such as trade fairs, and share with their network of friends, family, and colleagues. Potential customers respond to inbound marketing because the business or brand is offering interesting and relevant information, entertainment, or content with emotional value. Businesses expect this interaction to culminate in a sale, or create brand recognition that leads to a sale.

Top types of content marketing 1. 2. 3. 4. 5. 6. 7.

Blogs How-to guides Images Infographics Videos Testimonials/reviews Case studies

8. Internet memes 9. Email newsletters 10. E-books 11. Podcasts 12. Twitter chat 13. Newsjacking (giving content to news media)

Exploration Publish and actively promote content; use search engine optimization (SEO) to attract consumers online

NEED TO KNOW ❯ Top of funnel marketing (TOFU) Offers content to grab the initial attention of potential customer ❯ Middle of funnel marketing MOFU Offers more detail and encourages participation ❯ Bottom of funnel marketing (BOFU) Attempts to win a sale with low pricing, offers, or via customer recommendations

Decision-making Ensure that content captivates potential customers or solves problems for them; encourage two-way communication

Purchase Entice interested site visitors to become customers; make shopping online an easy and positive experience

Advocacy Provide excellent customer service; spur customers to make recommendations and share on social media

HOW SALES AND MARKETING WORKS Inbound marketing

220 221

41%

of marketers surveyed in 2013 believed inbound marketing produced measurable return on investment (ROI)

INBOUND MARKETING STRATEGIES Ofﬂine ❯ Optimize retail space Provide a well-designed physical environment that will both draw customers in and encourage them to come back. ❯ Engage media Generate press releases to gain media coverage. Focus on topics of real interest, especially ones that can be backed up by statistics and research. ❯ Interact face to face Conduct events in stores that provide a new experience/beneﬁt to customers; rent a stand at a trade event and offer key information.

@ Search engines, social media networks, web publishers, and third-party blogs

Company website, blog, podcast, community, and interactive tools

E-commerce process, product, price, discount, and promotion

Customer championing of product or service

Online ❯ Post blogs Update company blog with appealing content to attract visitors. See pp.224–225. ❯ Create podcasts Produce content relevant to customers searching for information; engage experts to add value. See pp.226–227. ❯ Produce other content Post articles, photos, and videos on social media sites; target inﬂuential users to encourage viral sharing. See pp.228–229. ❯ Apply search engine optimization (SEO) Fill search engine listings with key phrases that answer speciﬁc questions; add inbound links from popular sites. See pp.230–231.

Outbound vs. inbound marketing Outbound marketing interrupts consumers to promote a product or brand, but inbound marketing needs consumers’ permission—they have to seek out information that leads to the marketing message. How it works Before the rise of the internet and the phenomenon of social media, most marketing strategies were outbound. In other words, marketers pushed messages at consumers by interrupting them with advertisements or direct mail. The same principle applies to outbound marketing that appears on the internet, with pop-up ads

interrupting the content the consumer wishes to access. However, because consumers from all over the world now use the internet to search for information and entertainment, marketers have adopted inbound strategies instead, providing content that draws the consumer to the brand or product, rather than pushing marketing messages at them.

NEED TO KNOW ❯ Push or interruption-based Alternative marketing terms used to describe outbound marketing ❯ Pull or permission-based Alternative marketing terms used to describe inbound marketing

Pros and cons

Marketers interrupt consumers with hundreds of outbound marketing messages every day, but they also use subtle inbound marketing tactics to attract consumers. Each strategy has its advantages and drawbacks.

ound tb

Pros

Cons

❯ Campaign results can be forecast and measured ❯ Marketing material is easier to create ❯ Campaigns can be tightly controlled

❯ Customer conversion rates are low ❯ Marketing campaigns are expensive to create ❯ Effects of campaign are often short-lived

nd ou

Pros

Cons

❯ More likely to draw customers with long-term interest in the brand ❯ Non-intrusive approach preferred by customers ❯ Cost-effective compared with outbound campaigns

❯ Response from market may take longer ❯ New content must be generated regularly to keep customer interested ❯ Campaign results can be difﬁcult to measure

ADVERTISING

Inb

COMPANY

BLOGGING

HOW SALES AND MARKETING WORKS Inbound marketing

60%

AVERAGE COST PER LEAD OF INBOUND VS. OUTBOUND MARKETING A report compiled by HubSpot in 2012 $3 per 4 6 discovered that le a d companies with inbound-dominant marketing strategies reported a 61 percent lower average cost per lead. The study highlighted the cost-effectiveness of social media, SEO, and email marketing.

61% OUTBOUND MARKETING

222 223

lower cost per lead 5 $13 ad e l r pe

INBOUND MARKETING

of marketers have added inbound marketing to their existing outbound strategies

2012

TRADE SHOWS

TELEMARKETING

PAID SEARCH

DIRECT MAIL

$ Integration of channels By coordinating the message on all channels, businesses can optimize the impact of a marketing campaign.

PODCASTING

SEO

WEBSITE

SOCIAL MEDIA

Blogging Businesses post information articles on web logs, or blogs, as a way to attract consumers to their websites. They may blog on their own website or rely on independent bloggers to achieve this goal. How it works Unlike a conventional website, a blog is a site that consists purely of informational posts or entries that appear in chronological order, starting with the most recent. Blogs ﬁrst started appearing in the mid-1990s, when new web tools made it possible for non-experts

to publish material online. This type of web content has since become one of the most common sources of information and opinion on the internet. Although it was once only individuals who published blogs, many are now commissioned or professionally edited and produced by the company’s marketing department.

Blogging process Marketers may use SEO tools (see pp.230–231) to gain insight into what’s being talked about online, which helps them to determine the most suitable topics for blogs. Many companies have the in-house talent to create blog content.

Post Publish blog entry on internet using web software or specialized corporate blogging platforms.

Select key word or question Determine key word, phrase, or question that appeals to the target audience.

Create content Base content on key word/ question, and ensure that it gives readers valuable insight into the chosen topic.

KEY WORD

Add links Cite industry experts and research reports; add photos or videos, and provide links to the original sources.

RISE OF BLOGGING: THE FIRST 20 YEARS First blog (links.net) appears

1994

1995

Term “weblog” is coined

1996

1997

Open Diary blog launches

1998

1999

Boing Boing tech blog launches

2000

Blogads (ads on blog) founded

2001

2002

HOW SALES AND MARKETING WORKS Inbound marketing

85.2%

NEED TO KNOW ❯ Disclosure Statement of whether blog is sponsored, or if reviewed products are given to blogger or were independently bought ❯ Splog Spam blog containing fake articles designed to increase the search engine rankings of speciﬁc websites

of internet users in Brazil visited blog sites in 2011

Submit blog to syndication sites and share with social media networks, such as Facebook, Twitter, Instagram.

Track and measure Monitor key blog statistics, such as the number of unique visitors and the number that sign up for RSS feed and email.

Google launches AdSense

2003

2004

“Blog” is word of the year

2005

2006

Top ﬁve statistics to track

Three blogging mistakes

❯ Number of visitors Potential customers visiting blog and their route in—via links or direct entry ❯ Bounce rate Share of visitors who leave site within 10 seconds ❯ Pages per visit Number of pages viewed by visitor ❯ Conversions Proportion of visitors who subscribe to blog ❯ Keywords Common words visitors use to ﬁnd blog site

❯ Obsession with SEO Although SEO is important, focus should be on publishing quality content ❯ Omitting facts Posts should offer factual information, not just opinion or repackaged content ❯ Lack of legibility Poorly designed blogs with unclear typography will discourage customers from reading content

Microblog Tumblr launches

Weblogs Inc. sold for $25m

2007

G VITAL STAT N I IS GG

CS TI

BL O

Syndicate/share

224 225

2008

AOL buys HuffPo blog and news website

Bloggers’ code of conduct proposed

2009

2010

2011

Blogging turns 20

Over 75m WordPress blogs

2012

2013

2014

BLOGGING

Podcasting/vidcasting Businesses may post audio or video ﬁles on the internet to attract and engage website users; the goal is to convert ﬁrst-time users into subscribers. Once consumers

engage with podcasts or vidcasts, companies try to sell products either through advertising on the podcast or the podcast download page, or by sponsoring the podcast or vidcast to create brand reinforcement.

Podcasting/vidcasting process In order to get commercial results from a podcast or vidcast, a company needs to create and publish interesting and informative content.

NEED TO KNOW ❯ Vodcast Alternative term for vidcast (both short for videoon-demand broadcasts) ❯ Rich site summary (RSS) Format used for frequently updating text, audio, and video content online ❯ Mobcast Podcast that is created and published on a cell phone

Capture content Decide on topic, and create an outline, then ﬁlm video for vidcasts or record audio material for podcasts.

Process content Edit video footage or audio track for background noise, mistakes, repetitions; test and edit further, if necessary.

Select correct format Save podcasts in MP3 format; save video in small-screen format; compress ﬁle size for optimal download speed.

Publish content Embed and publish content on new post. Use app to generate feed address; submit to iTunes or other platform.

Tracking Count number of subscribers; use web feed services to access user location, level of interaction, and other statistics.

1 billion+

users subscribe to Apple’s podcast app

HOW SALES AND MARKETING WORKS Inbound marketing

226 227

BUSINESS BLOGGING AND PODCASTING ETHICS Independent online reviewers often collaborate with businesses, which is beneﬁcial to both. However, business promotion on blogs/podcasts is not regulated like advertising, and ethical boundaries can become blurred.

Blog /podcast reviews include products such as apparel, hotels and restaurants, and technology. YES

Other content

Business gives free sample of product or service to blogger/podcaster for testing and reviewing.

Business provides support to reviewer through paid content and advertisements.

Business provides support to reviewer by offering further free products and services.

YES

Reviewer writes consumer report.

YES

Possible conﬂict of interest

Reviewer tries to be neutral.

Blog/podcast helps generate revenue for both parties. NO

Reviewer site builds own reputation and has its own agenda.

KEY Business potentially inﬂuences blogger Blogger operates independently of business

Blog generates revenue for blogger/business

YES

Reviewer site depends on revenue that business provides.

Social media marketing By posting content on social media, marketers try to attract website trafﬁc and draw attention to their products and services. Occasionally, interest in the posted content can multiply rapidly across these channels. How it works Social media marketers are responsible for generating engaging content. Typically, the content provides entertainment or offers useful information that social media users actively look for. If the content is

compelling enough it will attract followers, who will share it with their audiences. As the content continues to be shared, liked, and commented upon, it will eventually get picked up by Google and other search engines, helping to generate more interest.

Social media marketing in practice The makers of a new health supplement for repairing sun-damaged skin generate video content showing the dramatic results of the product, and launch it across two social media channels. Video footage, an image, or a story that is spread quickly and widely via the internet is said to have gone “viral.” 360 YouTube users share the content.

CONVERTING SEEKERS TO JOINERS The goal of content marketers is to convert “seekers,” who have arrived on a website, blog, or social media page, into “joiners,” who subscribe and allow two-way communication. Stage 1 Marketers post content, such as a video, article, or special offer, to draw consumers (seekers and joiners). Stage 2 They rely on “ampliﬁers”—social media users who share content with their friends—to spread their post to a wider audience. Stage 3 They monitor response rates from seekers, joiners, and ampliﬁers, and audit their posts.

One major beauty blogger links to YouTube post.

12 smaller blogs follow the link and post about it.

Blog followers see the post and blog and visit the link.

Content is posted on YouTube as “new anti-aging skin care.”

HOW SALES AND MARKETING WORKS Inbound marketing

Content created

37%

of businesses in Germany used social media in 2013 Content is tweeted to 460 followers of the company.

# #

228 229

NEED TO KNOW ❯ Social graph Internet graph that maps connections between user groups, such as Facebook friends ❯ Social media optimization (SMO) Use of online communities to maximize social media coverage of product or event ❯ Social media monitoring Process of tracking the number of mentions a brand or company receives on social media sites

Content is retweeted to 750 other followers.

Content is posted on Facebook by one Twitter user.

Each social media mention of the content moves the company’s website higher up the listings of search engine results.

Content is shared among 520 Facebook friends.

Search engine optimization (SEO) SEO is a process marketers use to acquire trafﬁc from search results on search engine sites. SEO software tools are available to help the user create web pages that will appear at the top of search engine listings. How it works Companies that have a web presence must ensure that their website has a high ranking on search engine listings. To achieve this, they frequently use SEO tools to monitor where their website appears when keywords are searched for, and take steps to keep it moving up the search results page. Some of the important measures marketers take include

coming up with the right keywords, linking to other websites, and generating content that includes frequently searched keywords or phrases, so that their website remains relevant to a wide variety of search queries. Search engines offer pay-per-click, a service that places a company’s listing at the top of a search results page. Every click generates a fee payable to the search engine.

92%

of all Google trafﬁc goes to entries on the ﬁrst page of results

SEO process These tools can be used regularly in a continuous attempt to move a website higher up the listings.

Keyword selection Use a combination of intuition and analysis to choose words.

Keyword research Use SEO tools to research the most popular keywords.

❯ Brainstorm keywords ❯ Find words in top engines ❯ Test trafﬁc using words

❯ Think of key phrases ❯ Avoid overused words ❯ Try variations of a word

Competition analysis Check competitors’ rankings to ascertain how to rise above them.

❯ See ranking with SEO tool ❯ View rival web links ❯ Find top-ranked domain

HOW SALES AND MARKETING WORKS Inbound marketing

NEED TO KNOW ❯ Robot.txt Text ﬁle that stops web crawler software, such as Googlebot, from crawling certain web pages ❯ Search algorithm Step-by-step calculation that looks for clues to decide on search rankings ❯ Metadata Information that describes stored data – data about data ❯ Cloaking Technique for improving SEO by making some web content invisible ❯ Panda and Penguin Two updates to how Google calculates its website rankings, preventing unfair rankings from SEO tools

230 231

SEO TIPS Avoid single words because multiple-word phrases rank higher.

Monitor search statistics using Google Keyword Tool, for example.

Add blog to offer content that search engines will pick up.

Prioritize good content and update it regularly with keywords.

Use reputable sites with relevant content to link back to your site.

Give headings keywords that relate to content on page.

Reporting and tracking Use tools to track trafﬁc and report on website ranking.

❯ Focus on quality of visits

Link-building Add links from related websites to point back to own site.

❯ Check server reports ❯ Tally sales from searches

❯ Link to high-proﬁle sites ❯ Contribute to forums ❯ Ask partners to link

Keyword revision Monitor search results from current keyword selection and make adjustments.

❯ Make sure terms aren’t broad SEO spider Software that crawls the internet, adding content to search engine databases

❯ Avoid specialized words ❯ Alter word order

Business development The overall goal of sales and marketing teams is to generate customer contact and convert it into revenue. This is the core of business development, and it involves a continual process of drawing in potential customers, enticing them to purchase, and keeping them engaged. During this process, marketers and sales people use a range of strategies and channels to attract customers and to earn their long-term commitment to a brand and product.

Collaborative process Marketing departments generate brand identity while sales teams do the selling. Working together, they aim to take potential customers on a journey from brand awareness to repeat sales, communicating the message through various channels.

Build brand awareness

Generate leads Use a combination of inbound and outbound marketing strategies to entice potential customers to seek out the brand or product. See pp.236-237.

Target customer groups with content and/or ad campaigns to inform them about the brand and its values. This will lay the foundation for a long-term relationship. See pp.234-235.

Public relations Advertising

Face-to-face communication

Live events Social media

Convert leads into sales Once potential customers are interested, entice them to buy with targeted messages, offers, and well-designed e-commerce sites. See pp.238-239.

Email blasts

Telemarketing

HOW SALES AND MARKETING WORKS Business development

15%

BUSINESS DEVELOPMENT STRATEGIES

Databases

Develop intellectual capital

Track marketing spend on each channel and analyze results to gauge return on marketing investment (ROMI). See pp.242-243.

Nurture talent and foster creativity in order to optimize ongoing marketing efforts. See pp.244-245.

Special offers and updates

Return on investment (ROI)

Trafﬁcdriving to website

Innovation

Review effectiveness

Know-how

Follow up sales with efﬁcient delivery, excellent customer service, and personal contact to reinforce positive customer relationships. See pp.240-241.

Analytics tools

Retain customers

Call center

Business development is reliant on growth. Sales and marketing teams can increase long-term proﬁtability by building up a customer base and then trying to retain it. There are several ways to ensure that the customer base remains buoyant. ❯ Chart customer journey from before to after sale ❯ Think of ways to reduce cost of sale and increase customer satisfaction ❯ Integrate sales processes with marketing to gain and retain customers; think about ideal customer ❯ Monitor and evaluate these processes regularly

REVENUE

of companies have specialized business development staff who are not involved in sales

Loyalty programs

232 233

Branding and rebranding A brand is deﬁned by the characteristics that mark a particular product. Branding is used to communicate a product’s qualities to a consumer, and create a lasting bond between supplier and customer. How it works When a supplier develops a brand, it creates a deﬁned set of values, expressed in product imagery, colors, logo, slogan, jingles, promotional imagery, and association with high-proﬁle individuals or characters. The brand

works for both the supplier and the customer, aiming to eliminate uncertainty and risk and to convey key attributes. Social media helps to promote brands—for example, 29 percent of Facebook users follow a brand and 58 percent have “liked” a brand.

The branding cycle There are typical stages to branding a product. In order to rebrand (redevelop) a product, the supplier starts over at the beginning.

Choose brand personality

Develop the concept Marketer focuses on positioning (where brand sits among competition in terms of function and look) and building a consistent and clear personality.

Sincere Down to earth, honest, kind, thoughtful

Bold Carefree, spirited, youthful

Rugged Tough, strong, outdoorsy, masculine

Sophisticated Exclusive, romantic, elegant

Competent Reliable, intelligent, authentic, successful

HOW SALES AND MARKETING WORKS Business development

234 235

Apply marketing mix

NEED TO KNOW Product

Promotion

Price

❯ Brand equity Power of a well-respected brand to generate more sales than the competition ❯ Brandwidth Measure of the effectiveness with which a brand connects across a wide range of consumers ❯ Brand architecture Overarching plan to develop one or more brands and create a hierarchy

Place

Apply promotion mix Brand name

Tagline

Psychological needs Make brand alluring

Design and packaging

Audiovisual elements

Physical needs Assert product’s usefulness

Buying power Use brand values to optimize sales

The consumer

Is it time for a rebrand to make product more appealing?

nd Bra au

t di

Research

Audit passed

Rebrand

REDEVELOPMENT: RETURN TO THE BEGINNING OF THE PROCESS

Lead generation For a business to grow, one of its basic goals is to acquire new customers. Lead generation is the strategy it uses to locate, target, and nurture leads (potential customers). How it works The purpose of generating leads is to ﬁnd consumers who may need or want to buy the product a business is selling. Sales teams do not want to waste resources on people who have no interest in the product in the ﬁrst place, so the process of lead generation helps to deﬁne and capture the potential customers who seem most

inclined to become actual customers—known as high-quality leads. To generate leads, marketing and sales departments typically collaborate on a campaign, ofﬂine or online, designed to identify and recruit promising customer prospects. Acquiring contact information is the ﬁrst part of the process. Converting leads into sales is the next step (see pp.238–239).

Lead-generation process Generating leads is a multi-step process that involves sales, marketing, and customer service teams working together to plan, design, produce, test, and reﬁne a campaign.

Produce campaign

Plan the approach Set goals and parameters, including expected return on investment (ROI) and number and quality of leads. REVIEW OBJECTIVES Check that they are realistic; compare with previous efforts. AUDIT Assess current lead generation.

PLANNING Ensure that sales, marketing, and customer service are working together.

RESEARCH Ascertain which media and customer touchpoints are most effective.

BIG IDEA Devise a compelling message to engage and entice leads.

Create and deliver materials for each medium involved in the campaign. SEO/PPC Integrate search engine optimization (SEO) efforts and pay-per-click spend (see pp.230–231).

TRADE SHOW Invite potential leads to visit the company’s stand and meet face to face.

SYSTEMATIZE Integrate customer relationship management (CRM) software to manage the leads.

Identify target customer

Design campaign

Deﬁne the characteristics of the customer the business is aiming to capture in as much detail as possible.

Craft a multi-channel message to entice the lead to opt in and give contact information.

EMAIL BLASTS Include a beneﬁt for the recipient and a call to action (see pp.216–217).

TELEMARKETING Review key message and call script with customer service team. ADVERTISING Generate broad interest with ads on selected media.

HOW SALES AND MARKETING WORKS Business development

TOP FIVE STRATEGIES FOR LEAD GENERATION ❯ Create content such as a viral video or a newsworthy business report that takes leads to a sign-up page. ❯ Use both online and ofﬂine channels, as most customers will respond to just one channel. ❯ Trace the customer touchpoint— the point at which a customer comes into contact with the

product—before, during, and after purchase. Touchpoints may range from online reviews to billing. ❯ Tailor the call to action to the channel, such as inviting trade show visitors to enter a competition. ❯ Design effective opt-in web forms to capture data, such as asking customers to sign up for updates.

QUALIFIED LEADS Determine percentage of initial contacts with purchase capability.

236 237

NEED TO KNOW ❯ Owned media Channel owned by a business, such as a website, blog, or social media proﬁle ❯ Attention, interest, desire, action (AIDA) Model for effective marketing messages ❯ Cost per lead (CPL) Amount it costs the company to acquire one potential customer

ANALYZE PERFORMANCE Identify adjustments needed to keep campaign on track.

Reﬁne RESPONSE RATES Tally how many leads have been generated so far.

ONLINE CONVERSION RATES Calculate percentage of web visitors converted to leads.

Fine-tune the ﬁltering process to ensure that leads being generated are high quality and likely to buy.

B2B LEAD GENERATION Measure Track and measure the response from the various campaign activities to gauge effectiveness.

Most businesses selling to other businesses (B2B) identify lead generation as one of their most important digital marketing priorities. But which tactics do they ﬁnd most effective?

10%

Traditional advertising (radio, TV, print)

Social media

2% Other

17% Online marketing (web content, SEO)

Test campaign Monitor the initial hours and days of the campaign and make any corrections that are needed.

27% Live events (trade shows, webinars)

% of B2B companies that say each tactic is most effective at generating leads

39% Outbound marketing (direct sales, telemarketing)

Lead conversion The process of turning a customer’s interest into a sale is called lead conversion. The task requires not only a sales pitch to promote the product or service, but also an approach tailored to the customer. How it works Sales and marketing departments are responsible for generating sales income for a company. The ﬁrst step is to locate or identify potential customers—lead generation. The second step is to make contact with those potential customers and entice or persuade them to buy—lead conversion. A sales pitch is used to convert leads into customers. However, nowadays the stereotypical spiel delivered by an overzealous salesperson has been largely replaced by more sophisticated tactics, such as live chat on shopping websites, which inform customers and invite them to participate in a dialogue, rather than simply pestering them.

Raw lead Potential customer— perhaps a website visitor, or a suitable person who can be approached by cold-calling

Prospect One step away from becoming a customer, prospects need a ﬁnal enticement to convince them to buy the product.

Pitch Reinforce product’s value to prospect; offer payment options; highlight customer satisfaction policy.

Pitch Suggest keeping in touch with updates, offers, product add-ons, or discounts.

NEED TO KNOW ❯ Lead scoring System used to measure the readiness of leads for conversion ❯ Sales pipeline Visual tracking of the number of leads, suspects, and prospects at each stage in order to monitor sales process ❯ Lead nurturing Informal contact with a lead designed to gradually win them over as a customer ❯ Cost per touch Measurement of the cost of sales labor each time a lead is “touched” (contacted)

Pitch Find precise needs of suspect; show product’s qualities and unique values to counter objections.

Customer Raw lead has committed to buy; focus is now on retaining the customer and enticing them to make repeat purchases.

3.3%

the average lead conversion rate via online e-commerce in 2012

HOW SALES AND MARKETING WORKS Business development

238 239

Online lead conversion Pitch Involve raw lead in website experience or conversation; identify need for product; show beneﬁts.

A strategy is required for steering website visitors through every step of the lead-converting process. It is often presented as a funnel. Once visitors have arrived at a website, they are enticed to click on a “call to action” (CTA) button, which takes them farther into the funnel.

Visitors to website 3,000

Suspect Raw leads show their interest by remaining on website or by not ending phone conversation with cold-caller.

Leads click on call to action 600

Leads interact with company 150 Leads qualiﬁed by company 50 Sales closed 10

Inactive Prospect isn’t ready to buy immediately, but shows enough interest to suggest they might buy in the future.

THREE CLASSIC SALES PITCHES High concept Catchy introduction that captures the vision or key idea of a product or business; intended to grab attention and interest

Elevator Short summary (under a minute long) that explains the why, what, and how of a business or product

Dead lead Lead will not convert, but may be worth trying to revive in future.

20-minute deck Presentation that explains the product or business in detail; how it can serve the need a prospective customer may have

Customer retention Existing customers help businesses generate the majority of proﬁt and growth through making additional sales and referrals, and so retaining these customers is a high priority for marketers.

Identify satisﬁed customers

Introduce retention improvement strategy

Monitor and measure by analyzing

Customer referral Measure the number of referrals an individual customer generates.

Track how many customers repeat purchase or buy more products.

Measure customer retention level

Loyalty Pinpoint customers who are active in the brand’s loyalty program.

Early warning systems Anticipate any problems and alert customers in advance.

Recovery programs Apologize for any mistakes and make amends to woo dissatisﬁed customers back.

Assess rate of customer complaints and recommendations.

EXISTING CUSTOMERS

EXITING CUSTOMERS

Customer feedback surveys

Identify the dissatisﬁed Defection Find out why certain customers have left and which competitor they have gone to.

Complaint analysis Examine written customer complaints and call-center records.

Listen to customers and identify people at risk of defecting.

Loyalty programs

Attrition rate Calculate the number of customers retained (existing), lost (exiting), or gained in a given period.

Reward customers with improved incentives for staying loyal.

Boost customer service

–

Customer satisfaction

Offer employees incentives to build customer relations.

Revenue targets Measure revenue targets against cost of customer retention efforts.

HOW SALES AND MARKETING WORKS Business development

How it works There are two stages to the process of customer retention: measuring the current rate of retention, and applying strategies to manage and improve it.

Practices include identifying the most valuable customers and nurturing relationships with them. The least valuable or most costly customers may be dropped if they show little development potential.

TOP FIVE REASONS FOR LOSING A CUSTOMER Senses indifference from provider

Upsell and cross-sell leads Identify customers who may buy larger products, or related items.

1-2

3-4

7-8

5-6

Dissatisﬁed with product or service

Calculate savings made in marketing spend by retaining existing customers.

3-4

5-6

❯ Customer lifetime value (CLV) Measure of the amount customer will contribute to company revenue in the long term ❯ Customer retention rate (CRR) The number of customers retained over a given period, expressed as a percentage ❯ Customer acquisition cost (CAC) The amount company spends to gain a customer; also called cost of customer acquisition (COCA)

Net promoter score ®

Customer retention savings

1-2

NEED TO KNOW

Unhappy with price

9-10

Use management tool to gauge how likely a customer is to recommend company to others.

240 241

Lured by competition

Natural attrition (death, relocation)

reduction in customer defection rate can increase proﬁts by 25–125% $

Return on marketing investment (ROMI) Many organizations gauge the effectiveness of the amount they spend on marketing campaigns by measuring the return they make on marketing investment, which is commonly known as ROMI. How it works A subset of ROI (return on investment), ROMI is one of the key calculations businesses use to work out the effectiveness of the money they spend on marketing. ROMI is measured by comparing the revenue gained against the investment made in marketing, and is used to assess online campaigns, in particular. This calculation, however, only reﬂects the direct impact of marketing investment on a business’s revenue and fails to take into account other gains,

such as the word-of-mouth effect on social media, which is more difﬁcult to quantify than the more clear-cut response received from advertising or direct mail. As a result, many digital marketers now factor lag time or brand awareness into their ROMI calculations in order to quantify less tangible beneﬁts and target future campaigns more effectively.

NEED TO KNOW ❯ 4P3C1E framework Method that uses several variables to calculate effectiveness of marketing campaign ❯ Success metrics Use of standard measure (metric) to help manage marketing process and to assess its performance

ROMI in practice The diagram shows how a commercial air-conditioning company might use ROMI to measure the performance of a marketing campaign. The company spends $2,100 on a direct-mail promotion, which it aims at ofﬁces in three major cities to generate sales leads and secure new contracts. The direct-mail brochure contains a contact form offering a 10 percent discount to new clients who respond to the promotion within a speciﬁed period of time.

@ Marketing sends 4,000 direct mails

TOTAL REVENUE MARKETING BUDGET

= ROMI

120 leads respond to offer

HOW SALES AND MARKETING WORKS Business development

of chief marketing ofﬁcers believe ROI will become the leading measure of success during 2011–2016

LONG-TERM BENEFITS OF MARKETING INVESTMENT Some aspects of marketing investment are difﬁcult to measure immediately. The beneﬁts of providing excellent customer service, for example, or investing in research to help marketers retain customers, may not be evident right away but will reap long-term proﬁts. MARKETING INVESTMENTS

$ Cost of market investment

63%

242 243

Run marketing campaigns IMPROVED CUSTOMER VALUE AND SATISFACTION

Increased customer attraction

Increased customer retention

INCREASED CUSTOMER LIFETIME VALUES AND CUSTOMER LOYALTY RETURN ON MARKETING INVESTMENT

Results

14 qualiﬁed leads (who are a good ﬁt for the product) become sales opportunities

3 of these become customers

Total new customers = 3 Average customer spend = $6,500 (after 10% discount deducted from average $7,222 total spend) Revenue from marketing = $19,500 (3 x $6,500) Campaign spend = $2,100 + $2,167 (3 x $722) cost to company of promotional discount = $4,267 total ROMI = $4.57 per customer / per $ spent on campaign

$19,500 $4,267

$4.57

Intellectual capital The knowledge within a company that is used to improve business performance is known as its intellectual capital.

P TO

TALENT

No. 1

How it works H

Every business has capital, NT AN I ELLEC T UM which refers to the physical, tangible assets that appear on the balance sheet of its ﬁnancial statements. A business also has intellectual capital—the knowledge and skills inside the company. This collective knowhow is hard to quantify and measure, but it is essential to a company’s ability to generate revenue. For instance, management must provide training and a handover period for new staff so that human capital does not go down when people leave the company, taking their expertise with them. Management academics have identiﬁed three main kinds of intellectual capital: human, structural, and customer.

Difﬁculty

Human capital

IE N

VO L U

AC TIC AL E

Difﬁculty

NAL LINK S TE R

Customer capital Goodwill developed between a company and its customers, reﬂected in customer loyalty to the business and its products. This relational capital can be extended to suppliers, but is very hard to quantify.

T L

RE L ATIO NS H

ELATIONS TR HI

MA R

NEED TO KNOW ❯ Strategic capital A company’s knowledge of its market and the business model needed for success ❯ Intellectual property Creations or inventions that are legally recognized as belonging to a particular entity or individual on a balance sheet ❯ Intangible capital All knowledge assets belonging to a business or organization; can be audited under various systems (see far right)

The combined talents of the staff and executives employed by the business. It includes skills and abilities, drive, creativity, and innovativeness, all of which can be quite hard to measure.

HOW SALES AND MARKETING WORKS Business development

RN TE IN

ORG A

ONAL RO ATI UT IZ ES IN

AL LINK

MEASURING INTELLECTUAL CAPITAL Various different methods have been developed to quantify and measure a company’s intellectual capital.

8am 9am

Watson Wyatt index

10am

A survey conducted every two years in public companies to assess the value of human capital and HR practices.

Difﬁculty

Structural capital The support structures developed and held by the company, including its own software, databases and other information systems, patents, copyrights, and trademarks. Structural capital is non-physical, so it can be hard to assess.

244 245

IN N

OVATI O N

Intellectual capital monitor Matrix that measures the past effects, present power, and future potential of the intellectual capital in a company.

FIVA

“The only irreplaceable capital an organization possesses is the knowledge and ability of its people.” Andrew Carnegie

Framework of intangible value areas (FIVA): an eight-step system used to calculate the worth of a company’s intellectual capital.

Knowledge capital scorecard Method developed by New York University professor Baruch Lev to rate a company’s intellectual capital and assess its contribution to a company’s success.

Information management Monitoring the marketplace and making sense of the vast quantities of data available has become a priority for businesses; the data is crucial for digital marketing, which is taking on increasingly sophisticated forms. Most businesses have a system in place for managing information—and the most successful ones use data not only to monitor day-to-day performance at every level, but to predict future outcomes and plan accordingly.

Internal

Outside the business, data ﬂows in from production, supply chain, sales outlets, partners, and customers.

Within the business itself, data feeds into the marketing and IT teams from operations, ﬁnance, and human resources.

oduction Pr

External

Executives

Analysis

Forecast

pply chai Su

n Marketing and IT

DATA DATA

les outle Sa

DATA

The marketing and IT departments are at the center of information management. They are responsible for collecting and analyzing data, and then reporting their ﬁndings to executives. See pp.252–253.

DATA DATA

HOW SALES AND MARKETING WORKS Information management

246 247

TRANSFORMING DATA INTO DECISIONS

of organizations employ a chief digital ofﬁcer

With relevant data easily accessible (see pp.262–263) a business can identify its strengths and weaknesses in order to improve its processes and operations, as well as its customer relationships (see pp.264–265).

LEGAL COMPLIANCE

Le g

system

Finance

Operations

Source raw data Gather customer data. See pp.254–255 and pp.258–261.

Store information Store data via data warehousing. See pp.256–257.

Gain insight Examine data using business analytics. See pp.250–251.

Access knowledge Retrieve data with business intelligence tool. See pp.248–249.

The legal system ensures the use of data adheres to privacy and other laws. See pp.266–267.

$ $

Pa r

ers tn

Human Resources

Cu s

mers to

Make decisions Plan and budget for future outcome

Business intelligence Business intelligence (BI) is an umbrella term referring to the variety of software applications companies use to access and analyze the massive amounts of raw data they have at their ﬁngertips. How it works BI relies on software programs and computerized systems for collecting and integrating data in order that a business can report on its activities, both past and present. The tools allow staff to pull relevant data

from the company database. The marketer then views the information on a computer screen using a data visualization tool known as a dashboard, which can also be used for real-time monitoring of business operations.

Business intelligence process BI tools allow retrieval of speciﬁc relevant data by specifying the terms of the intelligence they need (such as real-time sales compared to previous year’s sales).

Collect source data Company gathers raw data via several operation systems.

SUPPLY CHAIN MANAGEMENT (SCM) Data from SCM sources

ENTERPRISE RESOURCE PLANNING (ERP) Manages company data

WEB LOGS Data relating to activity on corporate or e-commerce sites

TRANSACTIONAL DATABASE Data of current commercial transactions

CUSTOMER RELATIONSHIP MANAGEMENT (CRM) Data from CRM sources

EXTERNAL DATABASE Information gathered from sources outside the company

Extract, transform, load: ETL process ETL system pulls raw data from the source, formats it, and loads it for use.

NEED TO KNOW ❯ Star schema Simplest format of online analytical processing (OLAP) in data warehouse ❯ Data quality (DQ) Condition of company’s master data, which should be complete and accurate ❯ Slice and dice Process in which large amounts of data are broken down to help analysis

Store data Business uses data warehousing to integrate and bank data in a readily accessible form.

ETL SYSTEM Migrates raw data to data warehouse

DATA WAREHOUSE Flexible access to data

Translates data codes

Data from across organization

Transposes data columns and rows Splits and separates information

Creates data archives

Data from outside organization

Current data

Historical data

HOW SALES AND MARKETING WORKS Information management

14%

the increase in sales per employee if data usability is improved by 10%

Retrieve and analyze Staff can fetch data to answer speciﬁc questions about what is happening in the company.

248 249

Digital dashboard Displays regularly updated business results using customized graphics.

TRACKING EMAIL CAMPAIGN This dashboard tracks the percentage of people who open an email, click on a website, and make a purchase on different days of the week. 50% DAYS

YES NO

Mon Tue Wed Thu Fri Sat Sun Mon Tue Wed Thu Fri Sat Sun Mon Tue Wed Thu Fri Sat Sun

OPENS

CLICKS

PURCHASES

SPREADSHEETS Form primary BI tool to display data (basic or advanced) OLAP CUBES Online analytical processing cubes enable 3-D analysis of three variables on spreadsheet DATA MINING Allows the sifting of data to ﬁnd patterns and relationships REPORTING TOOLS Help users develop and produce reports

Actual sales: $4,700,000 Expected sales: $8,125,000 TRACKING SALES This dashboard shows the sales a company actually makes as a percentage of expected sales.

40% 20%

58% 60% 80%

100%

Business analytics More cutting-edge than business intelligence (BI), business analytics (BA) allows advanced statistical analysis of data, which is used to help make future business decisions. How it works BA takes a scientiﬁc approach to interpreting information. Businesses use BA’s advanced software tools to analyze information about past or current trends and behavior to predict a future scenario. Unlike business intelligence or predictive analytics

that analyze current and past data, BA allows businesses to forecast with a high degree of conﬁdence. BA can be applied on a macro level to get a broad view of future business performance and on a micro level to assess, for example, the likelihood of individuals in niche markets making purchases.

Predictive modeling Software program that predicts patterns of behavior and the likelihood of speciﬁc sets of customers, or even individuals, making a purchase.

Business analytics process A skilled analyst interprets the raw data using BA tools. The results inﬂuence the business actions that will be taken in the future.

BUSINESS INTELLIGENCE AND BUSINESS ANALYTICS The example of a 5 percent sales dip shows how BI and BA can be used to examine and understand the situation.

Business intelligence ❯ Type of data investigation Results reveal past and current event in the business. ❯ Questions answered What has happened in the business in the past and what is happening currently? ❯ Tools used Reporting, dashboards, scorecards, online analytical processing (OLAP)

Business analytics ❯ Type of data investigation Examines past event in the business, and applies the patterns discovered to a future scenario. ❯ Questions answered Why did it happen? Will it happen again? What can we do to stop it from happening again? ❯ Tools used Statistical analysis, data mining, pattern matching, predictive modeling

93%

of IT executives in Brazil say that their business could be improved by using big data analytics or intelligence

HOW SALES AND MARKETING WORKS Information management

250 251

Data visualization

DATA USEFULNESS

Formulation of graphs depicting the results of data analysis; graphs may rank data, group common attributes, and compare relationships.

Some data is more useful than other data; value is determined by the extent to which marketers can use it to make conﬁdent forecasts. Methods of interpreting data are increasingly sophisticated.

Pattern matching

Predictive analytics Program that conducts advanced analysis of data to forecast future outcome

Process of trawling through large quantities of data to ﬁnd patterns between variables, which can be applied to other sets of data.

Monitoring Data mining Use of computerized processes and software programs to ﬁnd relevant patterns in large sets of data.

Process that uses software to show what is currently happening in a business, providing real-time results to help key operations make decisions

Statistical analysis Software that organizes and investigates every piece of relevant data and interprets it to show trends and patterns

Ou t

Raw data

Analysis

This includes company records (past and current customer data and transaction histories) and external data (economic, trade, and industry reports).

Software tools are used to process and study raw data. Analysts interpret results and make forecasts that help future business decisions.

Reporting Method that draws on historical data to provide a general overview, revealing, for example, how the business performed in a given year

Marketing and IT The rise of digital marketing strategies means that marketers are working more closely with IT specialists to develop the best ways of launching and managing online publicity campaigns.

Convergence of marketing and IT Communicating with customers online has become a vital part of many businesses. As a result, marketing relies so much on IT that in some companies marketing teams spend more money on technology than their IT departments do.

Areas of overlap Digital marketing ➤

➤

Developing a technology program for publicity campaigns

Real-time transactions ➤ Installing a system for recording and tracking online sales as they happen

➤

Data analytics

Using advanced tools to gather and analyze data for developing future marketing strategy

➤

Mobile technology ➤

Understanding and keeping up to date with advances in mobile applications and e-commerce potential

Data storage ➤ Building infrastructure and software for storing and retrieving sales, campaign, and customer history

➤

Must grasp technology required to execute and track online campaigns.

➤

Marketer

Big data ➤

Locating key statistics from vast amounts of online information to improve marketing

Social media ➤

Developing the best methods for increasing online trafﬁc via social media channels

Tracking ➤ Following a customer through the online engagement and sales process

HOW SALES AND MARKETING WORKS Information management

How it works Marketers need to know how to use technology to increase revenue. At the same time, chief information ofﬁcers (CIOs) are adapting to changes in external

technology. This has led to an increasing overlap between the marketing and IT departments, and to the emergence of a new hybrid professional role—the marketing technologist (see below).

78% IT person Must ﬁnd or develop software tools to implement and manage online campaigns.

252 253

NEED TO KNOW

of marketing executives believe that digital strategies will transform marketing by 2020

❯ MarTech Annual business conference that focuses on overlap of marketing strategy and technology ❯ Actionable metrics Measurement of campaign results which enable businesses to make informed decisions ❯ Vanity metrics Measurements of campaign results that appear positive but are not meaningful ❯ Growth hacking Low-cost online marketing techniques, such as using social media to improve sales

RISE OF THE MARKETING TECHNOLOGIST Online marketers rely on software to monitor and analyze campaigns, generate content, and extract data. The job of the marketing technologist, who has knowledge of both marketing and IT, requires a broad knowledge base. WEBSITE ARCHITECTURE SOFTWARE PROGRAMMING

DATA AND ANALYTICS

IT OPERATIONS

MARKETING SOFTWARE

SOCIAL AND MOBILE PLATFORMS

CONTENT MARKETING AND SEO

Collecting consumer data Capturing key data is a priority for any business seeking to understand the marketplace. However, the task requires the use of innovative strategies to circumvent consumer sensitivity about privacy issues. How it works There are a number of methods companies use to collect customer data. When there is contact between a customer and the company, marketers can use the opportunity to gather as much information as possible. This might happen at the point of sale in a store or online, where marketers are able to observe customer behavior. Marketers may also choose to solicit information directly by asking their customers to ﬁll in registration forms and conducting telemarketing calls or customer surveys.

Collecting data to create consumer proﬁle Digital marketing and e-commerce have accelerated the rate at which customer information is gathered. Some methods require the customer’s input, such as questionnaires that appear online. Others, such as website tracking, are possible without the need to contact the customer.

Surveys Gather customer feedback via email, text, or mail, and face-to-face questionnaires.

Observations Study customer’s behavior while they shop in a store or online.

WARNING Data collection errors ❯ Barraging Using a customer’s data to bombard them with information on products viewed or sites visited ❯ Overlooking technical ﬂaws Failing to integrate apps properly, leading to inconsistency (and errors) in collecting customer data ❯ Using only automated systems Neglecting the opportunity to strengthen relationships with customers by communicating with them personally

Customer research Conduct research on existing customers or on those who ﬁt the customer proﬁle.

Contact center Monitor customer calls and store data on preferences and purchase history.

HOW SALES AND MARKETING WORKS Information management

Social media View customer’s proﬁle information on social media.

58%

of marketers could link data to an individual customer by 2012

254 255

TECHNOLOGY AT THE CHECKOUT In this technological age, businesses have the means to learn about their customers without bombarding them with questions. Retailers, for example, typically use three methods in stores to capture information about the customer.

Loyalty program

loyalty card

loy

a lt y

c ar

A company may collect information by inviting customers to register for a loyalty program that offers an incentive. A loyalty program also helps track customer preferences.

Website trackers Track website visitor’s movement around a site and see what attracts interest.

Competitions

Point of sale software Computer software programs that track a customer’s purchases are available, allowing marketers to tailor offers to their spending habits.

Use competitions to collect information, from opinions to demographic data.

Mobile technology

Transactions Ask questions at checkout—in the store, online, or on the phone.

The use of smartphones enables marketers to compile data, for example the frequency of customer visits and the amount of time they spend in the store.

Data warehousing The process of data warehousing involves information from a company’s internal system, such as invoices and sales logs, as well as data from outside sources, being ﬁled away in an electronic vault. How it works The data warehouse is a repository that holds the company’s sales and operational history, as well as relevant economic and trade information from other sources. The data goes through three stages before it is stored in the warehouse, which makes it usable for analytical purposes. Once stored, the data may be accessed by all areas of a company—from accounts and operations to sales and marketing.

The data is often used to assess beliefs and intuitions about the business. For example, the marketing manager of a power tools company might presume that 25–35-year-old men are more likely to purchase their products than women in the same age bracket. The manager would test this belief by analyzing sales data and customer records accessed from the data warehouse.

50%

of companies surveyed in 2011 were not sure their data warehouses were future-proof

Warehousing process The data stored is regularly updated. When the business requires information from the warehouse, it is transformed into an accessible format and analyzed using software tools.

Tapping data sources The information a company collects includes online transaction processing (OLTP) data, historical data, and data from external sources.

OLTP Includes transactions such as sales and refunds recorded via OLTP

Staging data The ELT process converts raw data into a usable format.

HISTORICAL DATA Repository of past sales information

EXTERNAL DATA Includes government statistics on business

USABLE FORMAT EXTRACT, LOAD, TRANSFORM (ELT)

USABLE FORMAT

HOW SALES AND MARKETING WORKS Information management

256 257

WHO USES THE DATA WAREHOUSE? The key departments of a company can access the data warehouse to ﬁnd out how they are performing. The method in which the data is formatted and stored makes it possible for them to seek answers to questions relevant to them. Typical questions various departments might ask include:

FINANCE “What was proﬁt margin on product sold in a region?”

$ MARKETING “How did online ad compare to poster ad campaign?” SALES “What are average sales of product by region?”

HUMAN RESOURCES “How much have we spent on contract staff this year?”

Storing data The data is stored in three sections: metadata, summary data, and raw data.

Accessing data METADATA Information relating to the data itself

SUMMARY DATA Business activity information

RAW DATA The original form of the information

Using software, the data can be analyzed and retrieved in three ways: via online analytical processing (OLAP), reporting tools, and data mining. OLAP Accesses data to answer speciﬁc questions REPORTING TOOLS Presents data as tables or graphs

DATA MINING Finds detailed patterns in data for analysis

Customer profiling Marketers can create detailed portraits of customers using internal company data on their purchase habits, preferences, and lifestyle, and cite external data sources to learn about attitudes and social trends. How it works In order to best understand their audience, marketing departments deﬁne their ideal customer by developing a customer proﬁle. They build this proﬁle by gathering information about the kind of person who usually buys the type of product they wish to introduce to

the marketplace. The information they look at includes basic data about a person, such as gender, age, occupation, and salary, as well as more detailed ideas concerning the person’s typical spending habits, such as the places where they like to shop and the amount they tend to spend.

Segmentation model By constructing a segmentation model, layered with a number of variables (different levels of information) about consumers, marketers can gradually build up a clear picture of their ideal target customer—in this case, for a travel company.

Geographic variables

Lives in New York City metropolitan area

Wants to get in shape while on vacation

Takes two or more getaway trips per year with family

❯ Personality Outspoken; likes to stand out from the crowd ❯ Attitude Positive outlook and enjoys the good things in life ❯ Ethic Works hard and believes in contributing to social causes

Demographic variables

Woman, age 35 to 54, with household income of $85,000+

Shares with 125 friends on social media

Psychographic view

Sociographic variables Psychographic variables Behavioral variables

HOW SALES AND MARKETING WORKS Information management

75%

Behavioral view ❯ Shopping location Prefers to shop in smaller stores ❯ Purchasing habits Buys in bulk to save money, responds to discounts ❯ Degree of loyalty Faithful to a brand, but open to better offers

258 259

Sociographic view ❯ Social media Actively shares interests with connections ❯ Community Inﬂuential member who socializes and contributes to neighborhood ❯ Groups and clubs Member of bird-watching and hiking groups

of marketers say personalization could have a signiﬁcant effect on customer retention

Geographic view

Customer profile dimensions

❯ Continent North America ❯ City Booming metropolis with work and social opportunities ❯ Climate Varies from below freezing in winter to hot and humid in summer

What does the ideal customer look like? Where do they live? What do they spend their money on?

Demographic view ❯ Age group 35–54 (helps gauge family priorities and income) ❯ Status Married (children affect spending choices) ❯ Occupation and salary Teacher, $65,000

CUSTOMER PROFILING

Creating a customer proﬁle By constructing a proﬁle of an existing customer using data from within the company, marketers have a clearer view of the buying patterns and habits of an individual. They can then make projections about the long-term value of that individual as a customer.

WEBSITE DATA How often do they visit the site? Which web pages do they look at?

WWW

SOCIAL DATA Which social media networks are they connected to? Do they share links?

TRANSACTION DATA How much have they spent, how often, and on which products?

CRM DATA What’s their contact history with call centers? How have they responded to campaigns?

LOYALTY DATA How loyal are they to the company? Do they use the company loyalty program?

MAIL DATA What email contact has there been? What has the response rate to emailed content been?

@ $

POINT OF SALE What observations have sales staff made from interacting with customer?

Customer profile

HOW SALES AND MARKETING WORKS Information management

“Once you understand customer behavior, everything else falls into place.” Thomas G. Stemberg

Assessing customer proﬁle Good customer

Bad customer

❯ Returns frequently to make repeat purchases ❯ Responds to marketing and in-store promotions ❯ Shares favorite products on social media networks ❯ Signs up for newsletters and special offers

❯ Bombards call center with complaints ❯ Frequently returns products for full refund ❯ Never joins loyalty programs or signs up for newsletters ❯ Spends less money than the cost of courting them

260 261

SEGMENTATION SYSTEMS Once marketers have gathered data and identiﬁed their ideal customer proﬁle, they can compare their customer to a number of commonly used systems of segmenting, or characterizing, consumers. In the US, there are many systems, but one of those most well-known is that of the Nielsen company, which uses more than 60 segments that have names like “Boomtown singles” and “Up-and-comers.” In the UK, customers may be compared to the simple system of socioeconomic class: A Managerial and professional B

Middle management

C1 Clerical and junior management C2 Skilled manual workers D

Working class

Non-working and low-paid workers

NEED TO KNOW Three ways to use a customer proﬁle

1 2 3

Tailor content to suit customer By sending out personalized messages and experiences, businesses engage customers and build a long-term relationship. Sell more to existing customer Mining customer proﬁles to see their spending habits, likes, and interests enables marketers to make personalized offers. Reward loyal customers Identifying good customers and offering gifts and incentives tailored to their tastes increases customer lifetime value.

❯ Omnichannel customer Consumer who shops using multiple channels, including store visits, mobile apps, and websites ❯ Loyads Customers who are loyal to a provider and champion them, bringing in other customers in the process ❯ 360-view Proﬁle that gives marketer a complete picture of a customer, making it possible to predict their needs and behavior

Big data Business is trying to harness the huge amount of consumer data now available online. This information can be analyzed and used to create detailed proﬁles to target customers more precisely. How it works Big data is the huge amount of digital information transmitted via the internet every day. It is streamed at high speed and in many different formats, from database statistics to video, audio, and email

documents. The challenge for most organizations is to sift through big data to ﬁnd information that has the potential to add value to their business. Software tools are now available that can analyze the masses of external data generated on the internet.

Internally and externally mined big data

Businesses are now able to access data from sources such as mobile communications, social media networks, and commercial transactions, which show the activity of billions of people.

ta source a d al n r e t An ever-expanding amount of data is being generated by outside organizations, which will prove increasingly valuable to businesses.

Big data store

Big data The volume of data is potentially so vast it cannot easily be moved and may overwhelm most organizations.

Social media Data monitors what people are saying about the organization and its products.

Audio Data includes news broadcasts, interviews, call center recordings, and podcasts.

Photos and video Data comprises blogs, images, video recordings from entertainment media, and surveillance.

Public data Information shared outside the company, such as press releases, job descriptions, and marketing materials.

Big data vendor Provides services, systems, and tools enabling companies to store, access, and analyze data. Vendor offers applications to suit individual business needs.

HOW SALES AND MARKETING WORKS Information management

38%

NEED TO KNOW

of marketers had a centralized database for customer data by 2014 Internal data source Internal data sent to the big data vault where it is traced and recorded is drawn from all parts of the organization and forms a uniﬁed database.

Transactions ❯ Spend per customer ❯ Foot trafﬁc in stores ❯ Time spent per visit

Log data ❯ Customer reviews ❯ Customer service ❯ Audio ﬁles of customer service calls, for example

Emails

262 263

❯ Internal communications ❯ Customer contacts ❯ Email campaigns

❯ Apache Hadoop Open-source software library for storing and processing big data ❯ Terabyte One trillion bytes ❯ Petabyte Unit of digital data equivalent to 1,024 terabytes ❯ Exabyte Unit of digital data equivalent to 1,024 petabytes (ﬁve exabytes equates to all words ever spoken by human beings)

INFORMATION OVERLOAD The volume of data typically generated online every second: ❯ Emails 2,314,084 sent ❯ Tweets 7,231 sent ❯ Instagram 1,129 images uploaded ❯ Tumblr 1,362 posts ❯ Skype 1,473 calls ❯ Internet 22,148 GB of trafﬁc ❯ Google 44,490 searches ❯ YouTube 84,841 videos watched ❯ Facebook 30,000 likes; 5 new proﬁles

DATA MANAGEMENT Organizations can choose either ofﬂine or online options to store big data and various software for access and analysis. ❯ Big storage hardware Servers; storage and network equipment capable of supporting many terabytes of data ❯ Software Includes programs for research and analysis, storage and access, and graphic visualization of data ❯ Cloud services Third-party providers that offer storage networks for big data management and access

Customer relationship management (CRM) CRM (customer relationship management) is a computerized system used for managing and coordinating marketing, sales, and customer-support data to maintain good customer relations and improve proﬁtability. How it works CRM is a software tool in the company’s IT system that records all interactions the business has with customers. The information can be used in a number

NEED TO KNOW ❯ Technology-enabled relationship management (TERM) Use of automated processes to manage customer relationships ❯ Enterprise resource planning (ERP) Precursor to CRM ❯ Cloud-based CRM Computerized CRM system that exists in the cloud (online)

of ways: the sales team may use it to ﬁnd new business leads and improve relationships with existing customers, the marketing team may use it to reward loyalty, and customer service may use it to deal with problems.

CRM system The system uses reliable processes that allow companies to connect more efﬁciently with customers and ultimately offer better service, resulting in long-term gains for the company.

Customer Customer data ﬂows into the CRM system through their transactions.

AUTOMATION CRM can use automation as a tool to respond to customers who visit and use a website.

Customer segmentation

Email campaign management

The market can be segmented into groups relevant to the product the company sells.

Different emails are sent automatically to the relevant groups.

sp inte ecial re s ts

ofe

@ Age

on ssi

@ location

e siz ily m a f

age

Location

@ Gender

Family size

@ Profession

Special interests

264 265

HOW SALES AND MARKETING WORKS Information management

871%

Marketing Target groups for special campaigns; monitor and reward loyalty; generate leads

the average return on investment delivered by CRM

Sales Convert new leads; ﬁnd new prospects; cross-sell and upsell opportunities; customize pitches

Customer contact form CRM uses the information to group customers according to their buying behavior.

Price quote The company sends a price quote in response to the customer’s interest in their product.

Customer feedback The company asks questions to glean information about the customer’s views.

E-commerce transaction The customer pays for the product via the internet.

Support ticket An automated ticket allows the customer to track delivery of the product. $ $

Finance Operations Improve efﬁciency of manufacturing, product delivery, ordering, and tracking

Customer service Respond to service issues immediately; manage customer cases; gather feedback

Generate invoices in a timely manner; manage payment process

Compliance In most countries, companies have to adhere to laws and industry regulations that govern how they can sell and market their products. The rules are there to make sure that businesses operate fairly. How it works Governments impose rules on marketers to prevent any unscrupulous, misleading, or unwelcome practices, such as false advertising, the failure to disclose all

terms and conditions, and spam marketing (sending unsolicited emails). The regulatory body is able to investigate any company accused of breaking the rules and impose penalties if it ﬁnds the company guilty.

Marketing regulations To protect the consumer, regulatory bodies produce guidelines instructing companies on how they should market their products.

Business areas subject to regulation

Example of marketing practice

Comparative claims

“Our model is much better than our competitors’ models!”

Endorsements

“I owe my success to their product!”

Special offers

“Buy one, get one free!”

Sweepstakes and contests

“Enter the prize drawing for the chance to win the vacation of a lifetime!”

Telemarketing

“Good evening. Would you like to save money on your energy bills?”

Marketing to children

“Step right up and enter the House of Toys…”

Customer data

“Please ﬁll in the registration form.”

Email marketing

“Today only—24-hour online sale!”

Use of spam

“Congratulations! You have been selected…”

Negative-option billing

“Please uncheck the box if you do not wish to…”

HOW SALES AND MARKETING WORKS Information management

66%

of all email trafﬁc in 2014 was spam

266 267

NEED TO KNOW ❯ CAN-SPAM Act International legal ruling that sets out commercial email requirements and penalties for violation ❯ Phishing Fraudulent sending of emails while pretending to be a genuine entity, to gain the recipient’s bank details, for example

Typical regulations to protect consumer A marketer making a claim that its product is superior to a rival’s must be able to substantiate it with proof. A marketer must be able to prove that a person they have used to endorse a product has used the goods or service they are promoting. A marketer promoting a product with a special offer must set out the terms and conditions in writing. In the UK, use of the word “free” is subject to regulation. All competitions and prize draws must adhere to government guidelines to ensure that they are fair and impartial. Telemarketers must promptly disclose key facts of the proposed sale, including cost and quantity, restrictions and conditions, and refund policy. Marketers must stick to speciﬁc guidelines governing how they advertise and promote products to children. Customer information must be stored, managed, and used in accordance with privacy laws. It is illegal to use contact lists from external sources. Emails must disclose their commercial nature to the recipient. Marketers must refrain from sending bulk unsolicited emails, the most common form of spam, or other types of unrequested messages. Any item offered alongside the main product purchased must be presented as an option to buy, not an item the consumer must take action to refuse.

HOW OPERATIONS AND PRODUCTION WORK Manufacturing and production ❯ Management Product ❯ Control ❯ Supply chain

Manufacturing and production Once a ﬁrm has decided what goods or services to make, its directors have to choose the method of production that best suits consumer demand, the product, and the market, as well as one that will be the most proﬁtable. Companies work in three general areas of industry, which together form a production chain to provide consumers with ﬁnished goods or services.

Production methods Before the Industrial Revolution, products were made by craftsmen. Then factories brought people together to work on machines. Typically, this was job production, with one person making one item. Economist Adam Smith ﬁrst introduced the concept of division of labor, which led to mass production, with car-maker Henry Ford bringing in the moving assembly line at the start of the 20th century. Today, manufacturers can combine the best of all methods, with large-scale production of personalized products. Production typically involves three stages—here, from navy bean to canned beans sold in supermarkets.

Primary production The acquisition and processing of raw materials—in this case, navy beans, as well as tomatoes for the sauce

PRODUCTION IN PRACTICE Native to South America, navy beans are grown either for the immature green pods, eaten fresh as green beans, or for the beans themselves. These are dried and used most commonly in baked beans, a dish that originally came from Boston, MA.

CHOOSING THE BEST METHOD ❯ Job production Items are made individually. See pp.272–273. ❯ Batch production A number of items are all made together at the same time. See pp.274–275. ❯ Flow production Suitable for mass-producing identical items on an assembly line. See pp.276–277.

❯ Mass customization Mass product is customized by buyer. See pp.278–279. ❯ Continuous production 24/7 line of production, for products with consistent demand. See pp.280–281. ❯ Hybrid processes Mixing batch and ﬂow production or combining other processes. See pp.282–283.

HOW OPERATIONS AND PRODUCTION WORK Manufacturing and production

$2.33 trillion

KEY PRODUCTION FACTORS To make products, businesses need several resources

the value of China’s annual manufacturing output in 2011—the largest in the world

❯ Capital Money invested in business, including money spent on production tools, such as equipment, machinery, and buildings ❯ Land Natural resources used to create goods and services—for example, physical land or extractable resources such as minerals, lumber, oil, or gas ❯ Labor People employed in a business to produce the goods and services ❯ Enterprise Entrepreneurs and/or leaders who bring the factors of production together to make the whole process happen

Secondary production

Tertiary production

The manufacture and assembly of raw materials to turn them into a product or service; in this instance, canned beans

Services that support the production and distribution of the baked beans, such as transportation, advertising, warehousing, and insurance

The raw beans are mixed with tomato sauce, sugar, salt, and secret spices. The ingredients are cooked in vast pressure cookers, ensuring consistent texture and a long shelf life, and then sealed in tins.

270 271

The labeled cans are transported to warehouses and from there to supermarkets and other outlets to be sold. Several brands vie for market supremacy of this popular convenience food, using advertising, price, and taste differentiation.

Job production In job production, items are made individually. Each item is one job, which is usually ﬁnished before another is started. This method is typically used for small-scale production or for large one-time projects. How it works Job production is best suited to a business that has to meet speciﬁc customer requirements. Typically, these are unique requests, which an individual or a team handles from start to ﬁnish. Made-tomeasure suits, or custom-made furniture are examples. The scale may be small, and ﬁrms often start with job production because it is

simple and little investment is required. Job production can also be used for complex projects and those involving leading-edge technology, including ﬁlm production, major constructions such as ships for the navy, architect-designed buildings, and structural engineering projects including bridges and tunnels.

SERVICES Job production can also apply to services, such as hairdressing or processing an order for pickup. Airline ﬂights come under the same umbrella—ﬂight attendants tailor their services to passengers’ dietary requirements and special needs for items such as wheelchairs.

Wedding dress production A bride-to-be can choose to buy a dress off the rack (typically made by batch production) or have one specially designed and made for her, which costs signiﬁcantly more.

Bride-to-be at the store

Dressmaker commissioned

Cutting out the dress

The bride cannot ﬁnd the dress of her dreams and opts to pay for a custom garment.

A dressmaker is engaged to design a wedding dress to the bride-to-be’s speciﬁcations.

The dressmaker makes a pattern and cuts one dress from the bride-to-be’s chosen fabric.

HOW OPERATIONS AND PRODUCTION WORK Manufacturing and production

$1,211

JOB PRODUCTION PROS AND CONS Pros

Cons

❯ Products generally of high quality ❯ Great job satisfaction and pride in work followed through from start to ﬁnish ❯ Producer can satisfy individual customer needs ❯ Can make a proﬁt with only a few customers ❯ For small jobs, word-ofmouth recommendations reduce marketing costs

❯ Does not allow for economies of scale, so high production costs ❯ Labor-intensive ❯ Special materials and investment in skills may be required ❯ High price may put off customers, especially in times of recession ❯ Heavy reliance on just a handful of customers

272 273

the average cost of a wedding dress in the US, in 2014 $ $

Sewing the dress

Dress ﬁtting

Completing the dress

The dressmaker focuses on stitching and ﬁnishing the one garment.

After any alterations, the dressmaker is satisﬁed that the dress ﬁts the brideto-be and meets her requirements.

The price is high, but the dress is exactly what the bride-to-be wants. Now the dressmaker can start on another dress.

Batch production When a number of the same items are made together, it is called batch production. One batch ﬁnishes each stage of the production process before the next batch starts, using the same equipment and steps. How it works Batch production allows a ﬁrm to make a quantity of items in one production run. Factory equipment is geared up in terms of scale and special tools that can be changed for each batch. For example, equipment is set up to make 200 size 8 dresses in red fabric and then adjusted to produce 400 size 10 dresses in blue fabric. Quantities can vary from as

few as four identical items for a local supplier to thousands for a department store, and batches can be made as often as required. Batch production is common in the food, clothing, footwear, paints, adhesive, and pharmaceutical ingredients industries. Each batch must be traceable, with clear date stamping, in order to comply with laws and standards.

Bread by the batch Bread is commonly made in batches. A baker might make 100 white rolls, then 50 large brown loaves.

Mix bulk ingredients Ingredients for the batch of white rolls are mixed to form a dough.

Divide dough After machine-mixing, the bulk dough is divided into small pans.

Proof dough The dough is left to rise (proof) in pans.

Batch 1 Adjust for second batch The equipment is recalibrated to make 50 large brown loaves. Bulk ingredients for the batch of brown bread are mixed to form a dough.

Batch 2

Divide dough After machine-mixing, the bulk dough is divided into large pans.

Proof dough The dough is left to rise (proof) in pans.

HOW OPERATIONS AND PRODUCTION WORK Manufacturing and production

12 million

274 275

BATCH PRODUCTION PROS AND CONS

loaves of bread were sold every day in the UK, in 2014

Pros

Cons

❯ Economies of scale: low unit costs, as large number is made ❯ Customer offered choice of, for example, size, weight, and ﬂavor ❯ Output and productivity increases with use of specialty/ dedicated machinery

❯ Repetitive work, so workers may be less motivated ❯ Costly because may require storage of raw materials, work in progress, and ﬁnished items (see p.139) ❯ Requires detailed planning and scheduling

Bag up to complete All the rolls ﬁnish the production process together.

Bake rolls

De-pan and cool rolls

The whole batch is baked at the same time at the same temperature.

The rolls are removed from their pans.

Slice and bag loaves The loaves are sliced and packed for sale.

Bake loaves Baking time is longer than for Batch 1, as the units are larger.

De-pan and cool bread The large brown loaves are removed from their pans.

Flow production The purpose of ﬂow (mass) production is to produce a large number of identical, standardized items. This usually happens on a moving line, which can be interrupted when the product is changed. How it works Flow production typically involves large factories equipped with conveyor belts and expensive machinery, the assembly of individual components, which may be bought in from other companies, and the automation of tasks. Car manufacturing is an

example where elements of the car are put together along a line; robot arms may install wheels and workers may perform specialized jobs. Signiﬁcant output is possible with even a small number of workers. Newspaper printers, oil reﬁneries, and chemical plants also use ﬂow production.

The production line In ﬂow production, the item being made, such as a car, moves on a conveyor belt through different stages until completion. Components to build the car may have been outsourced or produced in another of the company’s factories. They are all ready to be used along the line.

Chassis assembly

Wheel assembly

Engine assembly

Main body assembly

Windshield assembly

PARTS ASSEMBLY

Electrical assembly

CAR ASSEMBLY

HOW OPERATIONS AND PRODUCTION WORK Manufacturing and production

FLOW PRODUCTION PROS AND CONS Pros

Cons

❯ Economies of scale: can produce large number of goods cheaply ❯ Unskilled labor keeps costs low ❯ Materials bought in large quantities, so low cost

❯ Expensive machinery requires signiﬁcant investment ❯ Repetitive work means workers may be less motivated ❯ Reliant on equipment: if line breaks, production is halted

Gear box assembly

Radiator assembly

276 277

60 million cars are produced globally each year

Seat assembly

Ready for customer Door assembly

Finishing

Inspection

When customer demand is high, car companies may run their production lines continuously.

Mass customization Sophisticated technology and manufacturing developments allow mass products to be personalized. The low unit costs of mass production combine with the marketing opportunities of custom-made. How it works Mass customization offers new opportunities for the manufacturing and service industries. Social media, online technology, 3-D modeling tools, e-commerce software, and ﬂexible production systems and processes are allowing customers to conﬁgure products to match their own tastes and needs. Industries such as footwear (particularly athletic shoes), clothing, cars, jewelry, and

computers already allow consumers to customize their purchases. The price is generally higher than for standardized goods. Revolutionary new technologies are expected to further extend customization, allowing individuals to, for example, scan their body contours and use augmented reality to design and order unique clothing.

FOOD MIXES The generation raised on social media expects to personalize every aspect of their lives, and food and drink is set to be a growth area for mass customization. Websites allow consumers to make their own cereal mixes, which is especially useful for those with allergies, and to create their own blends of tea and coffee.

Customers design own products Mass customization has enormous potential to change consumerism. For example, consumers can buy shoes designed to their own speciﬁcation via the internet. This is a high-status commodity among certain groups.

Lace color Shoe color

Laces Tools

Name

The customer decides On the company’s website, a drop-down menu, with options including style, shape, size, color, and laces, allows consumers to design their own pair of shoes.

Sends order to factory The ﬁrm holds no ﬁnished stock but manufactures to order from a range of parts, getting paid by the customer before production.

HOW OPERATIONS AND PRODUCTION WORK Manufacturing and production

$10 million

the total value of customized sweets sold by Mars by 2007, including coloured M&M’s

278 279

FOUR TYPES OF MASS CUSTOMIZATION In his book Mass Customization: The New Frontier in Business Competition, B. Joseph Pine II outlines four distinct types: ❯ Collaborative customization Work with individual customer to develop speciﬁc product to suit their needs. Technology ﬁrm Dell, for example, assembles computers to customer’s speciﬁcation. ❯ Adaptive customization Produce standardized products that are customizable by end-user. For instance, US company Lutron produces a lighting system that lets customers choose own setting from programmed settings.

❯ Transparent customization Provide unique products to individuals without overtly stating items are customized: the Ritz-Carlton hotel group keeps a database of preferences for pillows and newspapers to personalize a guest’s stay. ❯ Cosmetic customization Make a standardized product but market it differently: Hertz distinguishes its standard rental car from its #1 Club Gold program.

Shoes shipped to customer The customer receives a differentiated product and has the psychological beneﬁt of personal design—at a price. s lace ned d sole ﬁt r e t Pat hione arrow Cus 7.5, n Size

Continuous production During continuous production, a product is made 24 hours a day, seven days a week. The production line runs continuously to cope with demand, and staff work around the clock in shifts. How it works With ﬂow or mass production, the line is stopped to change products or models. Continuous production uses the same concept, but it runs throughout the year so output is nonstop. This method is used for identical commodities with high, consistent demand, including paper, cardboard, packaging, laundry detergent,

electronic components, and oil products. As with mass production, processes are automated, stafﬁng levels are kept to a minimum, and quality control is essential. There is high competition in industries using continuous production. Margins may be low, but demand is often relatively stable, encouraging investment in capital equipment.

The paper trail Paper is used throughout the world, and factories operate 365 days a year to satisfy constant demand. Lumber is the raw material for papermaking. Once the lumber has been debarked, chipped, and pulped, the ﬁbers are washed and dyed. At the end of its life cycle, some paper is recycled.

Wood

Papermaking

Lumber is a renewable resource and logs are stockpiled. Trucks make constant deliveries to processors for pulping.

In this continuous process, automated machinery runs 24 hours a day, 365 days a year.

Paper recycling Recycled paper is an important resource for the paper industry.

HEADBOX Fiber and water are fed onto a moving wire mesh.

WIRE SECTION Some of the water is sucked away to leave wet ﬁbers that form paper.

280 281

HOW OPERATIONS AND PRODUCTION WORK Manufacturing and production

S IE

AND CHEM I

PRODUCT I

OD S PR UCTI

R PE

OIL

L PLANTS

GAS

REFIN ER

TRICIT Y LEC A

trees are cut down every year to make paper

Continuous production is used for undifferentiated commodities required in large and constant amounts.

ENER GY

4 billion

TYPICAL USES

DRYING The paper is dried off.

PRESS SECTION More water is squeezed out of the wet sheets.

COATING AND CALENDERING The paper is coated, compressed, and smoothed.

FINISHING AND SUPPLY The ﬁnished paper is constantly supplied to printers, packers, and newspapers.

Hybrid processes Manufacturing ﬁrms may adapt existing processes or combine two production methods for optimal performance, particularly if they make a wide range of products. How it works There are many examples of hybrid processes. One is linked batch ﬂow production, where only two or three pieces of equipment are required and a batch ﬂows from one process to another. This is common in the chemicals and pharmaceuticals industries. For instance, a company may make headache medication and a hay fever remedy in tablet,

Combining methods On the classic assembly line, each worker is skilled at producing one type or part of an item. At the other end of the scale, one person completes all stages, creating the ﬁnished product from beginning to end. Cell manufacturing combines ﬂow production with job production to create autonomous units. A number of workers are dedicated to production, or part-production, of a set of goods.

capsule, and liquid form, and in varying doses; each batch ﬂows through a series of steps, depending on composition and form, from bulk processing to packaging. Another example is cell manufacturing, which combines job production with ﬂow (mass) production.

NEED TO KNOW ❯ Increments Small steps of gradual improvement over a period of time, rather than breakthrough or transformational change ❯ Hybridization Replacing several separate processes with one single hybrid process

Flow production One process is handled by one or more workers and that job is completed before the product or part moves on to the next workstation. Worker 1 uses only one set of tools for the process, before the product moves on to Worker 2, and so on down the line. (See pp.276–277.) INPUT

WORKER 1

WORKER 2

PRODUCTION LINE

WORKER 3

WORKER 4

OUTPUT

282 283

HOW OPERATIONS AND PRODUCTION WORK Manufacturing and production

HYBRID PROCESSES FOR INNOVATION By combining manufacturing processes, companies can create products with new and original qualities. For instance, a food company that makes bread and french fries may speed up production of the fries by baking them in the bread oven ﬁrst. This has the unintended but beneﬁcial consequence of making the fries healthier. A new product is created, which may now be marketed as a new proposition to a different set of consumers.

dough

bread

lighter fries potatoes french fries

Job production

Cell manufacturing

One worker creates a one-of-a-kind product, such as a custom kitchen, from start to ﬁnish. This way of working can be more rewarding for the worker, who uses a range of skills, but it tends to be costly for the customer. See pp.272–273.

Combining the best of ﬂow and job production, here a group of products or parts is produced in separate small units (cells) made up of a number of workers in the factory. Workers are trained to produce all the items in the set. Dissimilar items can be produced without slowing the production line. The idea is to improve performance by giving each cell a degree of autonomy. INPUT

CELL 1

CELL 2

WORKER PRODUCTION LINE

CELL 3

CELL 4

OUTPUT

Management Every manager in a business, particularly in manufacturing, has to ensure that all resources—from materials to equipment and staff— are used efﬁciently, while keeping the customer continually in mind. Managers make key decisions to lay down procedures and set standards and then work continuously to improve processes to ensure that the company remains proﬁtable.

Which approach? How people and processes are organized in making and delivering the product to the customer is critical if a company is to survive ﬁerce competition and rapidly shifting consumer demands in a global market. In making decisions about how a business can meet its goals, managers may combine a number of approaches as many are interlinked and achieve similar outcomes.

Agile production How can we be more responsive to shifts in customer demand? See pp.296–297.

MANAGER OR LEADER? Management and leadership are not the same, but are closely linked: ❯ Managers plan, organize, and coordinate; leaders also galvanize and motivate. ❯ Managers organize workers to maximize efﬁciency; leaders also nurture skills and develop talent. ❯ Managers focus on the bottom line; leaders also look to the horizon. ❯ Managers tell people what to do; leaders also ask questions. ❯ Managers make sure workers are doing everything that needs to be done; leaders also inspire workers to want to do more than needs to be done. The following classic distinction has been attributed to two different business leaders and writers, Peter Drucker and Warren Bennis: management is doing things right; leadership is doing the right things.

Time-based management How can we use time effectively? See pp.294–295.

No. 1

country for innovation in 2014: South Korea

HOW OPERATIONS AND PRODUCTION WORK Management

Economies and diseconomies of scale

Kaizen

What scale of operation is best for us? See pp.286–287.

How can we drive continuous improvements? See pp.298–299.

Lean production

INNOVATE FOCUS ON VALUE

INVOLVE EMPLOYEES

How do we minimize resources to reduce costs? See pp.288–289.

STRATEGIC ALLIANCES WITH SUPPLIERS

UNINTERRUPTED WORKFLOW

MINIMIZE WASTE

CUSTOMERS AT THE HEART OF WHAT WE DO

Total quality management How do we improve customer satisfaction? See pp.292–293.

Just-in-time How can we meet customer demand and minimize stock? See pp.290–291.

284 285

Economies and diseconomies of scale Economies of scale are one of the advantages of large-scale production and result in a lower unit cost of each item produced. However, costs can also go up as the operation grows, resulting in diseconomies of scale. How it works Economies of scale is a simple concept: the more items produced or handled, the cheaper the average (unit) cost, as efﬁciencies and ﬁxed costs are shared across all items. This gives a business a competitive advantage.

Supermarkets, for example, buy food in bulk at low unit costs, which they pass on to consumers. However, diseconomies of scale may occur when the operation grows because of high administration costs, wastage from lack of control, or lack of employee productivity.

Economies of scale While it may be inefﬁcient for a small dairy to supply milk to a supermarket, it is cost-effective for a large dairy operation producing thousands of bottles. If a delivery is too large, though, wastage can creep in due to associated costs.

AVERAGE COST AND REVENUE

SUPERMARKET

DELIVERY OF 100 BOTTLES

1 VEHICLE

Average cost high

DELIVERY OF 10,000 BOTTLES

Average cost low

Few economies of scale $

Economies

HOW OPERATIONS AND PRODUCTION WORK Management

NETWORK ECONOMY Online networks, such as eBay and Facebook, rarely stray into diseconomies of scale. They can deliver economies of scale even at an international level: the cost of adding one more user to a network is almost zero. However, the resulting beneﬁts may be huge, because each new user in the network can interact or trade with other members of the network.

286 287

150 million

the number of eBay users worldwide in 2014

2+ VEHICLES = MORE DRIVERS AND FUEL AND POTENTIAL WASTAGE

SUPERMARKET

DELIVERY OF MORE THAN 10,000 BOTTLES

Average cost goes up

1 VEHICLE (LARGER, BUT ONLY ONE DRIVER AND SAME FUEL COSTS)

of scale

SUPERMARKET

Diseconomies of scale OUTPUT

Lean production The goal of lean production is to reduce the resources used to supply goods and services to consumers. By cutting down human effort, materials, space, capital, and time, lean production cuts costs. How it works

Optimizing the ﬂow of products and services through value streams—sequences of activity that ﬂow horizontally across technologies, assets, and functions to customers—allows the business to respond more quickly to consumer demand. Efﬁciency also makes it simpler and more accurate to manage information.

NEED TO KNOW ❯ Kanban cards Toyota’s demanddriven scheduling triggers ❯ Value-stream mapping The process of analyzing how the product gets from start to ﬁnish now and the design of an improved ﬂow for the future

Waste

Items produced surplus to customer demand

Unproductive time spent waiting for material, information, equipment, tools

Lean solution

Waiting

Waste

Lean solution

Manufacture based upon a pull system, producing products as customers order them

All resources provided on a just-in-time ( JIT) basis—not too early, not too late (see pp.290–291)

Waste

Extra, unwanted stock held in inventory

Consumes materials and uses up labor; results in customer complaints

Lean solution Kanban cards used to indicate material order points: how much, from where, and to where

Defects

Lean production is about getting rid of waste, sometimes called non-valueadded activities. Car manufacturer Toyota has identiﬁed eight areas of waste and a lean approach to counter these.

Excess inventory

Case study: how Toyota eliminates waste

Overproduction

The focus in lean production is on efﬁciency to maximize value for the customer, but without affecting quality. Lean seeks to eliminate all activities that do not add value to the production process, including holding inventory (stock), repairing faults, and unnecessary movement of people and products around a manufacturing plant.

Lean solution Total quality management (see pp.292–293) used to improve all areas

HOW OPERATIONS AND PRODUCTION WORK Management

BENEFITS OF LEAN PRODUCTION According to a US National Institute of Standards and Technology survey, 40 ﬁrms implementing lean production reported these beneﬁts:

Amount of space required reduced by 75% Quality improved by 80%

BENEFIT

10 million

the number of cars Toyota expected to sell in 2014

Work-in-process inventory reduced by 80% Productivity increased by 50% Lead time (taking product from start to ﬁnish) reduced by 90%

Lean solution Material shipped directly from the vendor to the assembly line

Waste Unproﬁtable stages in the production or reworking of a product

Lean solution Map the value stream to identify non-value-added steps in the process; get it right the ﬁrst time

Waste

Poor workﬂow, poor layout, and inconsistent working methods

Underutilization of employees’ mental, creative, and physical skills and abilities

Lean solution Workplace Organization, a systematic method for standardizing the workplace

Underused people

Transportation in stages Excess motion

Superﬂuous stages in the transportation process

Non-value-added processing

PERCENTAGE

Waste

288 289

Lean solution Work cells replace assembly line; better use of labor and employee involvement and communication

Just-in-time The system of production in which an actual order is the trigger for an item to be manufactured is called just-in-time. It enables a ﬁrm to produce only the items required, in the right amount, at the right time. How it works Also called demand-pull production, just-in-time means that stock levels of raw materials, components, work in progress, and ﬁnished goods are kept as low as possible, reducing costs. The system requires detailed planning, scheduling, and ﬂow of resources throughout the production process, now assisted by sophisticated productionscheduling software. Supplies have to be delivered directly to the production line when they are needed, requiring strong relationships and interconnected systems with suppliers. The beneﬁts of reduced inventory are balanced against the cost

of frequent deliveries and loss of purchasing economies of scale (discounts for bulk buying). The system dates back to 1953, the year Toyota brought in just-in-time manufacturing. The phrase is sometimes used in a more general sense today to mean eliminating waste of resources.

NEW STOCK IS DELIVERED TO STORE TO REFILL SHELVES

JUST-IN-TIME PROS AND CONS Pros ❯ Lower stock so less storage space and less working capital needed ❯ Demand-pull avoids obsolete, out-of-date stock ❯ Staff spend less time checking and moving items

Cons ❯ No room for error—for instance, if there are any faults in the stock delivered, the whole day’s production is halted ❯ Operation is reliant on suppliers ❯ No cushion for sudden upsurge in demand

SYSTEM TRIGGERS DELIVERY FROM SUPPLIER WHEN MINIMUM STOCK LEVEL REACHED

HOW OPERATIONS AND PRODUCTION WORK Management

$62 billion

CUSTOMER SELECTS ITEM FROM SHELF

Just-in-time in retail To reduce stock levels, many supermarkets now use just-in-time deliveries, relying on computer data systems. In manufacturing, systems are often based on Kanban cards— dockets for withdrawing and ordering items at each workstation of the production process.

2 3

COMPUTER SYSTEM SIGNALS WAREHOUSE

290 291

the value of Dell computers sold in 2012

CASHIER SCANS BARCODE

CASE STUDY Dell’s just-in-time computers Computer produced when customer orders it: ❯ Customer’s individual speciﬁcation is sent straight to factory ﬂoor. ❯ Just in time manufacturing sees deliveries of supplier parts arriving at one side of the factory and unloaded directly into bins to build customer order. ❯ Inventory and costs are reduced.

Total quality management Success though customer satisfaction is the ethos of total quality management (TQM). Everything a company does is relevant, and the focus is on managing and improving processes rather than outcomes. How it works Companies use TQM to create a customer-focused organization that involves all employees in continuous improvement. It is a strategic and systematic approach that puts quality at the heart of the organization’s activities and culture. Customers determine the level of quality, measured through their

satisfaction. The organization is viewed as a series of horizontal processes that take inputs from suppliers through to the outputs that are delivered to the customer. Recording and measuring performance data is critical, as is effective communication to maintain momentum.

WHAT TQM MEANS ❯ Total Involves everyone and all activities in the company ❯ Quality Conformity to meeting customer requirements ❯ Management Quality can and must be managed

Case study: The Walt Disney Company Manufacturing companies, in which the focus is on meeting or exceeding customer expectations by making products within certain speciﬁcations, are often used as TQM examples. TQM can also be applied in service industries, of which Disney is a very good example.

“TQM is a philosophy for managing an organization to meet stakeholder needs without compromising ethical values.” Chartered Quality Institute

The Walt Disney Company Disney’s goal is to maximize long-term shareholder value, and part of this involves delivering a magical customer experience at its theme parks.

Involve everyone in quality Founder Walt Disney ﬁrmly believed in quality and saw it as everyone’s job, something that could not be delegated.

Focus on the customer Disney incorporated the TQM concept of quality into its approach to customer service. Its visitors are seen as guests and treated as VIPs and individuals.

Perfect processes Walt Disney viewed the theme parks as factories producing delight. He built quality by designing processes and repeating them.

HOW OPERATIONS AND PRODUCTION WORK Management

12,000 Disneyland “cast members” are employed to make guests happy Employees

Exceptional service

Disney calls its employees “cast members.” They are trained in every aspect of delivery, including posture, gestures, facial expressions, and tone of voice.

Cast members (employees) are focused on delighting the customer—their sole job is to make visitors happy.

Suppliers

Continuous improvement

Disney collaborates with suppliers—for example, it has partnerships with McDonald’s and Coca-Cola—to ensure consistent quality.

“When does the Three O’Clock Parade start?” Cast members are trained to answer this common question by responding with the time the parade will be passing a particular point in the park.

292 293

NEED TO KNOW ❯ American customer satisfaction index (ACSI) Cross-industry benchmarks for customer satisfaction in the US; NCSI is the UK equivalent ❯ Net Promoter Score (NPS®) Metric for company performance from the perspective of customers, who are divided into promoters, passives, and detractors

Walt Disney saw the theme parks as an incomplete product; today, improvements come from the bottom up.

Shared purpose

Integrated systems

Walt Disney started by deﬁning a company culture based entirely on creating a genuine shared purpose that people would be proud to support.

Technology supports the experience: for example, the volume of ambient music is the same in all theme parks, delivered through thousands of perfectly placed speakers.

Time-based management The general approach that recognizes the importance and value of time and seeks to reduce the level of unproductive time in an organization is called time-based management. How it works The fast pace of competition means a business that can manage time efﬁciently will enjoy a signiﬁcant competitive advantage. This applies to new product development, faster response times to meet changing market and customer needs, and reduced waste. For a business to operate a time-based management system,

Case study: managing time in Ford Electronics

Before

INVENTORY $200 MILLION

PRODUCTION CYCLE 15 DAYS

INVENTORY $100 MILLION

After

Between 1988 and 1994, Ford Motor Company’s electronics division implemented a number of change programs. One that used time-based management had a sustained and dramatic impact on the company’s performance. A senior leader led the program with visits to the factory, where the focus was on the length of the production cycle and adding value at every stage. The factory worked with suppliers to improve shipment, reliability, and quality of raw materials used.

its people have to be multi-skilled and able to move swiftly between different tasks; its machinery has to be ﬂexible so that production runs can be changed at short notice; and there has to be a culture of mutual trust between workers and managers. Time-based management is a key aspect of lean production.

Change created new focus on measuring and improving speed of operation. PRODUCTION CYCLE 1 DAY

HOW OPERATIONS AND PRODUCTION WORK Management

70%

PART OF PROJECT MANAGEMENT

of companies use formal projectmanagement methodologies

Time-based management is a critical part of project management. Timing aids include: ❯ Tools such as Gantt charts show the project schedule as a bar chart, making it easy to plot and monitor daily progress and targets. ❯ Project management systems PRINCE2 (PRojects IN Controlled Environments) and similar methods help to structure projects step by step in logical, organized ways.

❯ Methodologies such as Agile help project managers working in software development respond to the unpredictable; they are often implemented via the Scrum framework, in which one person takes charge of constant reprioritizing. Based on the premise that software cannot be built up like a product on an assembly line, as it would be out of date before it was released, every area of development is constantly reappraised.

Measuring by the unit Measuring the units produced per person had created an environment where supervisors focused on daily production requirements and keeping staff busy.

$ NEW FACTORY EVERY YEAR

2 1 3 POOR STAFF MOTIVATION

LESS COMPETITIVE

Measuring by cycle Simply measuring performance in a different way—over a shorter production cycle—allowed people to see new opportunities.

2 STAFF MOTIVATED

294 295

Regularly ﬁnding extra ﬂoor space was a necessity due to high inventory. PROFIT LESS THAN $100 MILLION

$ NEW FACTORY EVERY 2–3 YEARS

1 3

MORE COMPETITIVE

PROFIT $400 MILLION

Reduction in inventory meant ﬂoor space was no longer required so fewer new facilities were needed.

Agile production Speed and agility are the key competitive advantages of agile production: the focus is on rapid response to the customer, enabling the business to take advantage of short windows of opportunity. How it works

The goal of agile production is to stay ahead of the competition. Often incorporating concepts of lean production (see pp.288–289), agile has an extra dimension: meeting customer demand rapidly and effectively. It relies on ﬂexible and collaborative workers, who can deliver swiftly and effectively. The company has to be able to change or increase production quickly. Design of products might incorporate modular concepts, allowing for customization, and strong relationships with suppliers are essential.

Rapid response Company setup allows it to respond quickly and effectively to customer and market demands

tomer s u Customer demand is trigger to start production

Product reaches consumer

Continuous innovation Constant search for new and better ways to deliver for customer

Agile manufacturing The organization has to create a position from which it can alter course as nimbly and swiftly as a cheetah. It needs to be able to retool facilities quickly, modify agreements with suppliers, and continually introduce new ideas and improvements.

Integrated technology Effective information systems, often linked to suppliers

HOW OPERATIONS AND PRODUCTION WORK Management

296 297

Modular products

LOCAL EDGE

Independently created parts used in different/ customized products

Agile production is typically adopted by companies in extremely competitive environments with high labor costs, such as North America, where local manufacturing can provide a competitive advantage: ❯ Proximity to customers allows feedback and response. ❯ Small variations in performance and delivery can make a huge difference in customer satisfaction, company reputation, and ﬁnancial results. ❯ Unprecedented levels of speed and personalization cannot be matched by offshore competitors.

Knowledge culture Capturing experience, learning from mistakes

3 months

the time it took Wikispeed to develop a revolutionary new car in 2012 Transportation system Systems, facilities, infrastructure to speed product to customer

Flexible workforce Self-organizing, adaptable teams

Strategic partnerships Supplier collaboration rather than contract negotiation

Kaizen Started in Japan, kaizen is a system of continuous improvement that involves all employees. From senior managers to people on the shop ﬂoor, everyone is encouraged to suggest improvements day to day. How it works standards and then looking for ways to continually improve those standards. It is supported by a framework of training, communication, and supervision, and results in improved efﬁciency, productivity, quality, lead time, and customer loyalty.

Kaizen events are implemented through a cycle of activity, known as plan, do, check, act. Central to kaizen are quality, ongoing effort, involvement of every employee as part of their daily work, willingness to change, and communication.

BETTER AND BETTER Kaizen was created in Japan after World War II. It comes from the Japanese words kai, which means “change” or “to correct,” and zen, which means “good.” Companies such as Toyota and Canon have seen signiﬁcant improvements by involving their employees in recommendations for change.

KAI

ZEN

Innov

Creating good change

e at Quality

Innovate—ﬁnd and implement better ways to meet requirements and increase productivity.

suggestions per employee were implemented at Toyota in 1983

Effort

Gaug e

The kaizen philosophy is “to do it better, make it better, improve it even if it isn’t broken, because if we don’t, we can’t compete with those who do.” Kaizen is rarely about ideas for major change but has more to do with ongoing, systematic, incremental improvement. A relentless attempt to eliminate unnecessary activities, delay, or waste (muda), Kaizen starts with setting high

Gauge measurements against required standards. CHANGE

GOOD

HOW OPERATIONS AND PRODUCTION WORK Management

298 299

The ﬁve steps of workplace organization, known as 5S, are the foundations for continuous improvement in kaizen.

ndardi a t

FIVE FOUNDATIONS

Seiri (Sort) Standardize operation and activities; make each improvement standard practice, enshrined in the ﬁve foundations, or 5S.

Seiton (Streamline)

Willingness to change

Retrieve ordered items swiftly and easily to create efﬁcient workﬂow.

Communication

Seiso (Shine)

ea sure

People involvement

Keep only essential items in the work area. Remove and store all unnecessary items.

Measure the operation—for example, the length of the production cycle and amount of in-process inventory.

Keep the workspace clean, because cleanliness leads to efﬁciency.

Seiketsu (Standardize) Keep consistent work practices, tools, and workstations, and make roles clear.

Shitsuke (Sustain) The four cornerstones above become the standard way to operate all the time.

Product The items that ﬁrms sell to satisfy a consumer need and to make a proﬁt for the business are broadly termed product, whether they are something tangible like toothpaste or an intangible service such as an insurance policy. In a typical life cycle, a product is developed and launched, and a few customers take it up. The domino effect causes wider distribution. Growth eases as the market becomes saturated, and sales ﬂatten and decline until the product is no longer viable.

Product evolution From start to ﬁnish, every product, such as a tube of toothpaste, goes through a process of testing, innovation, and quality control to ensure that it will make the biggest impact on release and throughout its life span. Successful companies understand the limited life span of products and thus invest in the early stages to maximize growth later on.

“A lot of times, people don’t know what they want until you show it to them.” Steve Jobs

New product idea A company decides to release a tube of toothpaste with a new ﬂavor. Its viability is evaluated and potential competition researched. The new toothpaste also requires other qualities, such as whitening and enamel protection, to capture its segment of the market. See pp.304–305.

Testing and development A focus group is assembled to taste the new ﬂavor, along with some variations. Their preferences and comments are noted, and the toothpaste is developed into a usable product. See pp.302–303.

HOW OPERATIONS AND PRODUCTION WORK Product

$3.6 trillion

300 301

PRODUCT LIFE SPAN

the value of goods traded between EU member states in 2013

Home entertainment offers different products to consumers. These are four examples of products at different stages in their life cycle (see pp.184–185): ❯ Introduction 3-D televisions—only recently available for the home ❯ Growth Blu-ray players—steady increase in sales because of enhanced viewing experience ❯ Maturity DVD players—challenged by more sophisticated technology ❯ Decline Video recorders—cheaper and more modern viewing formats now available

Process

D 1

2 3 Product

Packaging and design

Quality management

Product-process matrix

The toothpaste tube is given a bright, clean, and attractive look. Design considerations include functionality, expense of materials, and an appeal to current trends. See pp.306–307.

A period of quality control begins, in which standards of safety and comfort are thoroughly checked. It is far cheaper to correct defects in the design phase than later in production. See pp.308–309.

Using a product-process matrix, the company identiﬁes the correct production method for the toothpaste. Because the company makes only a few products, each at a high volume, it decides to use assembly-line production See pp.310–311.

New product development Companies cannot stand still. In today’s ﬁercely competitive marketplace, they have to budget for research into new ideas and identify new products to bring to market simply to stay in business. How it works New product development is a process with a number of critical stages to ensure that a business focuses its investment on products that will sell and, above all, make a proﬁt. It starts with an idea, possibly to improve and relaunch an existing product. Some companies run sessions to

encourage creativity and generate a pool of ideas, a few of which can be explored. They might work with potential customers and also with suppliers, if part of the manufacturing process is to be outsourced, to reﬁne and develop ideas before ﬁnally bringing the product to market.

TRENDING CLAIMS New products are inﬂuenced by trends, reﬂected in the claims on packaging and in advertising. The top claims on new food products in the US from 2000 to 2010, for example, were “natural,” “organic,” “single serving,” and “fresh.”

The development process The nature of the idea and the size of the company affects each stage and how long the product takes to reach the market, but the process is generally the same.

enerati g o a n

Ideas can come from anywhere: customers may express a need or employees may make suggestions.

Screen ideas Criteria help identify products that ﬁt business strategy, will be easy to make, and will be proﬁtable to produce.

HOW OPERATIONS AND PRODUCTION WORK Product

302 303

Test concept Feedback from consumers, using focus groups, interviews, or online evaluation, ensures that an idea is worth pursuing.

Analyze market Analysis of opportunity, inﬂuenced by predicted growth and trends, helps build a picture of potential sales.

Test market Product is tested on section of market, perhaps a selected geographic area with good representation of target audience.

Develop products

Features are conﬁrmed, actual product designed—taking account of test-concept stage—and prototype developed.

Launch

Companies ensure distribution and tell customers about new product, through social media or advertising, to kick-start sales.

250,000 new products are launched globally each year

Innovation and invention Innovating is more than just having a bright idea—it is the way inventions and ideas reach commercial success. It is the lifeblood of any company, because keeping ahead of the game is essential for survival. How it works Innovation needs a culture that encourages people to be inventive and explore ideas. It also requires processes that can take initial ideas and develop them. Successful businesses such as the 3M, Apple, and

Google technology companies know how to do this. Innovation is not small, incremental changes, but transformational ones, such as solving an existing problem in a radically different way, or identifying an unknown problem and inventing a solution.

From idea to product Innovation is stimulated by many triggers. The idea then requires people to be working in a conducive environment to ensure that it is implemented and makes a difference.

Innovation triggers

Ef ﬁ ci

Cross -t

umer nee ns

m collabo ea

tion ra

es su

Env ir

ed ag

blem/cris ro

mental i s on

ity encour iv

Idea

ng vi

cy/cost sa en

Crea t

technolo

Shifts in society, such as leaps in IT and growing concerns about climate change, as well as internal company developments, create new needs.

HOW OPERATIONS AND PRODUCTION WORK Product

“Genius is one per cent inspiration, and ninetynine per cent perspiration.”

DIFFERENT TYPES OF INNOVATION Sustaining innovation Signiﬁcantly improving existing products, typically through technology—for example, more pixels in cameras, smaller and more powerful laptops Sustainable or eco-innovation New product that has minimal impact on the environment Frugal innovation Low-cost product for emerging mass market

304 305

Breakthrough innovation Product or service that simultaneously shifts a market and has signiﬁcant outcomes for the world at large, such as the Fairtrade initiative Disruptive innovation Displaces established competitors or changes the norm—for instance, the internet or iPads

Thomas Edison

Intellectual property (IP) is the expression of an idea. IP might be a design, an invention, or another type of intellectual creation, and it can be protected by law—for example, with a patent.

Individuals and teams need the time and mental space to think originally.

The culture and processes of the company have to be favorable for testing the viability of ideas.

t Impac

Flat m a

List

rrectly m co

gement st na

cture ru

-term vie ng

missio

sured ea

ls ve re allow e ilu

r lea

ng at all le ni

Action

Brainstorm

Product

Design Any product has to be well designed to succeed. Excellent designs for everyday items—from the Anglepoise lamp to reﬂective road signs—have shaped our modern world.

CU S

H RC

O GY OL

BR AINS

T NEW ECH

RESE

How it works The starting point for design is an idea for a product that fulﬁlls a need, whether it is a specialty item or something in day-to-day use. The designer has to think of ways in which a product can serve its purpose and meet other criteria, including aesthetics, cost, durability, and environmental considerations. The design may be integral to the product, such as Apple’s rectangular devices with rounded corners, for which it obtained a design patent. Some designs are iconic, such as the Coca-Cola bottle. Yet design is more than just shape. As well as functionality, it includes materials and color, and extends from the products to their packaging.

ME R S TO

MING OR

IDE AS

Explore concept From scribbles on a piece of paper, to computer-generated image technology, it may help to visualize options.

Product-design process Designs for mass-produced items, such as furniture, lighting, domestic appliances, and communications technology, take a lot of hard work. The process of creating a functional design that looks good has several steps.

CONSIDERATIONS FOR DESIGN SUCCESS ❯ Functional Serves a purpose ❯ Aesthetic Enjoyable to use ❯ Innovative Different and new, possibly using innovative technology ❯ Easy to use Understandable and with useful features ❯ Simple Unobtrusive, subtle ❯ Long-lasting Sustainable, not too fashion-sensitive ❯ Environmentally friendly Minimizes resources and pollution

Redesign Next year, the product may need revamping.

End product The design of the ﬁnal version that goes on sale may look very different from the initial concept.

HOW OPERATIONS AND PRODUCTION WORK Product

306 307

Develop concept

Make prototype

The design can be broken into components, such as functional requirements and production options, and each evaluated independently.

This might be a single item or a series of prototypes, to test and reﬁne the functionality.

10–18%

Feedback Now is the time to ﬁnd out what people think of the product and how it could be improved. (EX TERNA L

Design decisions

MARKET I

INTERNA G( L

)

Before full-scale production begins, all decisions have to be made and paperwork, such as intellectual property rights, ﬁnalized.

MANUFA C

)

CUSTOM E

of the budget for bringing a new product to market is spent on design

RING

Quality management For businesses, quality is not a vague term but a philosophy of meeting or going beyond consumer expectations. Excellent quality management can give a company a key competitive edge. How it works Many consumers might ﬁnd it hard to deﬁne quality, because it can be subjective, but they know it when they see it. However, companies need to deﬁne and measure it. They know that to build a good reputation and thrive, they have to exceed customers’ expectations in terms of quality for both products and

services. To do this, they have a number of standards or key performance indicators (KPIs) for the manufacturing process, and continually measure themselves against these. Quality does not apply just to the product or service itself; it ripples out to the associated people and processes, and across the organizational environment.

Cost of quality COST OF DEFECT

Quality management is essential to ensure that any defects are nipped in the bud, the earlier the better, and deﬁnitely before they become apparent to the consumer.

During production, quality management involves testing, evaluating, and inspecting quality. Defective items may be scrapped. Quality management at the product-design stage is low-cost and integral to the process because it prevents issues farther down the line.

CUSTOMER FIRST Before the 1970s, quality was seen as something to be inspected and corrected. Then US businesses began to lose out to Japanese companies—for example, Toyota and Honda were able to produce cars at lower cost and with a much higher quality. The difference was that quality had a strategic meaning for Japanese ﬁrms—they made the customer their priority and were the ﬁrst companies to deﬁne quality as meeting or exceeding customer expectations.

PRODUCT DESIGN

PRODUCTION

HOW OPERATIONS AND PRODUCTION WORK Product

$3.6 million the annual saving Singapore supermarket NTUC FairPrice made by implementing ISO quality standards, 1999–2009

308 309

NEED TO KNOW ❯ ISO 9000 Set of international quality standards and certiﬁcation demonstrating that companies have met standards speciﬁed ❯ Malcolm Baldrige National Quality Award Annual award given to US companies that demonstrate quality excellence and establish best-practice standards in industry ❯ Deming Prize Japanese award given to companies to recognize efforts in quality improvement

WHAT MAKES QUALITY? Manufacturing industry ❯ Conformity to speciﬁcations/standards ❯ Performance ❯ Reliability ❯ Functionality/features ❯ Durability ❯ Serviceability

Service industry Once the product is with the customer, a defect is expensive. Financial cost includes returns, repairs, and recalls, but the impact on the company’s reputation may be even more damaging.

LOCATION OF DEFECT

PRODUCT WITH CUSTOMER

❯ Getting the desired result ❯ Consistency ❯ Responsiveness to customer needs ❯ Courtesy/friendliness ❯ Promptness ❯ Psychological factors, such as good atmosphere

Product-process matrix A product-process matrix is a tool that can help a business to identify the best way to make a product, based on volume and the level of customization.

NOT VIABLE

How it works

EVOLVING PROCESS The product-process matrix was ﬁrst introduced by Harvard academics Robert H. Hayes and Steven C. Wheelwright in the Harvard Business Review in 1979. Since then, some companies have worked out the apparent contradiction of how to customize high-volume products (mass customization). Nevertheless, the product-process matrix remains relevant in many industries.

Choosing the best method A business, or business unit in a large company, occupies a particular region in the matrix. Different processes suit different products, depending on the stage of their life cycle and the scale of the business.

Product

Products pass through different stages and so does the production process. Businesses typically start with low volume and are highly ﬂexible but not very cost-efﬁcient. A print shop or dressmaker is an example of a company positioned in the bottom left-hand corner of the product-process matrix, where each job is unique and job production is most effective. Production stages then progress through increasing standardization and mechanization to full automation. Companies in the top right-hand corner have high-volume products and a small range so continuous ﬂow production is the best option.

Low volume Low standardization; unique, one-off products

5 Dressmaker

China accounts for one-ﬁfth of global manufacturing

HOW OPERATIONS AND PRODUCTION WORK Product

310 311

Process Sugar reﬁnery Mass production Continuous ﬂow; nonstop process (see pp.280–281)

Car assembly RARELY VIABLE An assembly line is not normally a suitable process for making multiple products at low or medium volume.

Assembly line Connected line ﬂow; process repeated for each product (see pp.276–277)

Low–medium volume Some standardization; multiple products

Bakery

High volume Standardization; products manufactured in large quantities

Batch production Disconnected line ﬂow; similar process adjusted for each batch (see pp.274–275)

Job production Jumbled ﬂow; complex, unique process design for each order (see pp.272–273)

Very high volume High standardization; single commodity product

RARELY VIABLE Batch production is not normally a suitable process for making standardized products at high volume.

NOT VIABLE

Control Essential in any type of organization, control is fundamental when the primary goal is to generate proﬁts. Control needs to cover costs, resources, and quality of the product or service to ensure that the operation runs smoothly. As well as crossing departments, control has to run from top to bottom, with directors formulating strategy while managers allocate resources, people, materials, and equipment and oversee the work of individuals and teams.

The chain of control It is simplest to think of a business as an end-to-end chain. Leaders have to make decisions on business goals, strategy, and policies at the start of the chain. This is critical for control along the chain. If there is no clear direction from the start, problems become exacerbated as they travel

farther along the line. Controls are put in place all the way along the chain to ensure that the organization is working toward its goals, that it meets the desired standards, and that individuals and teams are clear about what is involved in speciﬁc tasks.

Control in practice: strategic control ABC Cake Company’s goal is to be the top-selling cupcake business. Its directors determine the quantity and quality of cupcakes the company needs to sell and whether to invest in a new factory. They also set the scale of investment and estimate when it will begin to yield returns, and how long it will take for the project to repay its full cost (payback period).

FUNCTIONS ALONG THE CHAIN While directors work on strategic investment, policy, and process control, management may use tools such as Six Sigma to perfect operational control. See pp.320–321.

Investment relies on cash ﬂowing back into the business from the cupcake sales, balanced by the cost of production.

Policies on, say, maintaining the optimum level of inventory are supported along the chain by ﬁnance, HR, and IT.

ABC CAKES

Management control The management team ensures that everyone meets their targets, talks with other links in the chain, and works seamlessly to be a top-selling cupcake business.

Processes are in place to control costs, with continual reviews of the most efﬁcient use of resources.

Procurement purchases raw materials from companies that meet its stringent standards.

HOW OPERATIONS AND PRODUCTION WORK Control

312 313

LEGALLY IMPOSED CONTROL

130:1

the average ratio of CEO to employee pay of FTSE 100 companies in 2014—compared with a ratio of 47:1 in 1998

Many industries are subject to external controls as well as their own: ❯ Financial institutions National and international regulatory controls ❯ Advertising industry National regulation to protect public interest ❯ Health and social care National laws to protect vulnerable members of the public ❯ Manufacturing National regulations on health and safety

“Drive thy business or it will drive thee.” Benjamin Franklin

ABC CAKES

Task control Metrics and key performance indicators are set for each task. They control, for example, how long it takes to ice and decorate a batch of cupcakes.

KE CO ABC CA

Goods received checks on-time delivery and that all inputs are consistently of the right quality. See pp.318–319.

Stock control uses sophisticated systems to ensure the optimum level of inventory. See pp.316–317.

Production has metrics for the quantity and quality of the cupcakes. See pp.314–315.

Marketing benchmarks the price and reviews the promotion of the product against competition. See pp.332–333.

MPANY

Sales works toward detailed targets. See pp.314–315.

Managing capacity In terms of production, capacity means how much work can be achieved in a given time. Ideally, a business matches its capacity to customer demand, using its resources with maximum efﬁciency. How it works Every business has to consider how much capacity it needs for its operation, and how to manage this capacity both day-to-day and in the future. Management has to choose a priority: whether to deliver excellent customer service by having extra capacity, and thus price its products or services high; or to manage its resources efﬁciently for a better return on investment, at the risk of disappointing customers

if and when demand goes beyond capacity. Businesses may offer consumers incentives to help manage capacity—for instance, cheaper late-morning train fares encourage passengers to travel after rush hour, easing overcrowding on trains that are full to capacity in the early morning. Likewise, many hotel chains do not charge a ﬁxed price for rooms, pricing them according to demand to maintain capacity.

Capacity decisions The fundamental decision is whether to compromise on demand or capacity—whether to put customers or the streamlining of operational costs ﬁrst.

Customer focus Manage capacity— raise prices

Increase demand

Customers are happy to have a product immediately but must pay a higher price to cover the cost of holding excess stock.

To use up stock, pricing policies increase demand by encouraging customers to buy fast—for example, offering on-site deals for older car models.

The company, in this case a car dealer, keeps more cars in stock than required so it can always satisfy customer demand.

SALE

HOW OPERATIONS AND PRODUCTION WORK Control

HOW CAPACITY AFFECTS A COMPANY Capacity management is critical to ensure, for example, that a manufacturing operation has the right level of resources to work to a production schedule. It affects many areas of the business, as all are interlinked and cost the company money: ❯ Factory or ofﬁce size ❯ What and how much equipment is needed

❯ Stafﬁng levels ❯ Use of labor—for example, shift work ❯ Which materials to use, how much/how often to order ❯ Inventory (stock) levels ❯ Production scheduling ❯ Speed and ease of processes ❯ Type of information technology used

Resource focus The company uses resources as efﬁciently as possible. Wastage is kept to a minimum, but satisfying demand is hard because work is at full capacity and output cannot rise.

314 315

NEED TO KNOW ❯ Potential capacity The capacity that can be made available long-term, a factor that affects investment decisions and business growth ❯ Immediate capacity The maximum potential capacity available in the short term ❯ Effective capacity The total capacity that is realistically achievable when all resources are being used optimally

90 million

the number of iPhone 6 units made by one manufacturer to meet demand in 2014

Manage capacity—keep stock low It produces stock according to demand and holds low inventory to minimize unnecessary spending and storage costs.

Demand not satisﬁed Company is unable to meet surges in demand; customers may have to wait while production catches up, and business may be lost to competitors.

Inventory Companies have to manage inventory (stock) to meet customer demand, even if they trade online and have no physical storefront. Successful inventory management is a complex process. How it works Stock may include ﬁnished goods, work in progress, and raw materials. Getting the right level is a balance between having enough to meet customer demand and having too much, which is costly in terms of ﬁnished goods, storage space, and warehouse staff. Stock may also lose value if it perishes or become unsalable because of changes in fashion or obsolete technology.

Effective inventory management involves systems and programs for sales forecasts, production targets, and actual inventory status, plus the physical tracking and handling of the different items. Bar codes and radio-frequency identiﬁcation (RFID) tags have revolutionized inventory management, making it much easier to monitor stock levels.

Inventory management Successful inventory management is a ﬁne balance between satisﬁed customers and minimizing the risk of holding too much stock. In this example, the clothing company is managing the supply of T-shirts for a range of sites and for direct delivery to customers.

Make sales forecasts

Order from suppliers

Production

The company sets production targets based on prediction of demand.

Decisions on the level of raw materials to hold are based on lead times and reliability of suppliers.

The quality of raw materials and ﬁnished goods is checked at every stage of production.

Smaller storage Firm may use smaller facilities to hold buffer stock—for example, to meet seasonal demand.

HOW OPERATIONS AND PRODUCTION WORK Control

316 317

NEED TO KNOW ❯ First in, ﬁrst out (FIFO) Oldest inventory items sold ﬁrst (or recorded as sold for accounting purposes rather than physically moving goods) ❯ Last in, ﬁrst out (LIFO) Most recently produced items sold ﬁrst (or recorded as sold) ❯ Stock-keeping unit (SKU) A distinct item that has its own stock code ❯ RFID tag A chip that enables remote tracking of an item by radio sensors

142,000 different items were handled by Walmart Supercenters in any one store in 2005

Main warehouse Company may have one main warehouse or a number of warehouses as hubs for smaller storage facilities.

Delivery to customers Efﬁcient and timely delivery is part of the overall customer experience, especially as online shopping grows. Stock is checked in by scanning bar codes or RFID tags.

Customer returns Returns are checked out by scanning bar codes or RFID tags. Batch number and other data can be monitored.

Quality control There is a series of processes to ensure that a business maintains a prescribed level of quality in its products or services. Quality control is particularly important in industries where safety is an issue. How it works Businesses measure and manage the quality of their output against national legal standards and/or internal standards. For example, the manufacturing industry sets its own standards. Checking takes place against these and any national standards at various points along the production process, such as when raw materials arrive in the factory, during production, and before shipment of ﬁnished goods to the customer.

Quality control relies on a predetermined percentage of products for inspection, agreed corrective action, and remedial efforts to minimize future defects. Industries in which safety is paramount, including food, clothing, pharmaceuticals, construction, and car, train, and aircraft manufacture, are subject to extremely strict standards of quality control. Some are there to protect workers—for instance, if they are handling chemicals—while others safeguard the consumer.

The bread and butter of quality control Hygiene and safety are essential in the food industry, as in this example of quality control in a factory making prepacked sandwiches. Samples are tested all along the line. Any lapses in quality are not only a dangerous health hazard but would also be extremely damaging to the company’s reputation.

Delivery to factory

Assembly line

Before assembly, weight, chemicals, bacteria, taste, and interaction of individual ingredients are tested.

During assembly, weight, temperature, hygiene, and visual appearance are assessed.

HOW OPERATIONS AND PRODUCTION WORK Control

318 319

THE CONSTRUCTION INDUSTRY Standard safety procedures are mandatory in developed countries, including site organization with suitable work gear, limited access, materials storage, and trafﬁc ﬂow; working at heights using appropriate ladders and scaffolds; and avoidance of slips and trips with awareness of obstacles, trailing cables, and uneven or wet surfaces.

Packaging station Samples are tested to check that sealing is accurate, labels are correctly applied, and overall presentation is good.

$4.4 billion

the value of the prepacked sandwich market in the UK

Storage

Transportation

The temperature is checked for accuracy and safety, and samples are tested for taste, texture, and contamination by foreign objects.

The temperature in the vehicles and their delivery time are checked to ensure product freshness.

Six Sigma Used in organizations to strive for near-perfect products and services, Six Sigma is a disciplined, data-driven approach for eliminating defects in any process. How it works The idea is that measuring the number of defects in any process makes it possible to systematically work out how to eliminate them and get as close to zero defects as possible. Individuals are trained to become experts in the different methods, creating a cadre of black belts, green belts, and champions.

Every Six Sigma project is carefully documented, follows a deﬁned sequence of steps, and has quantiﬁed value targets, such as increasing customer satisfaction or reducing costs. To achieve Six Sigma quality, a manufacturing process must have 99.99966 percent of output free of defects (3.4 defective parts per million).

SIX SIGMA ROLES Six Sigma professionals are experts at improving processes. They drive the implementation of change.

5 Control Perform before-andafter analysis; monitor systems; document results; work out recommendations for next steps.

Master black belt Trains and coaches black belts and green belts; works at highest level, developing key measures and the strategic direction

4 Improve

Black belt Leads problem-solving projects; coaches project teams, assigning roles and responsibilities; trains green belts Green belt Leads green-belt projects; helps with data collection and analysis for black-belt projects

Champions Translate the company’s vision, mission, and goals to create an organizational deployment (OD) plan and identify individual projects Executives Provide overall alignment by establishing strategic focus of the Six Sigma program within the context of the organization’s culture and its vision of what the customer sees and feels

Implement improvements and so address the root causes of major problems.

$320 million

the sum saved by General Electric with Six Sigma in 1997

HOW OPERATIONS AND PRODUCTION WORK Control

CHAMPIONS

Deﬁne Deﬁne the project’s purpose and scope; identify processes that need improvement; determine customer needs and beneﬁts.

Striving for perfection The DMAIC methodology (standing for Deﬁne, Measure, Analyze, Improve, Control) is an integral part of Six Sigma. It is used for improving existing business processes that are falling below targets and where step-by-step improvements can be made.

320 321

Mobile-phone maker Motorola used Six Sigma quality as a goal for its manufacturing operations; CEO and chairman Jack Welch made it central to his business strategy at General Electric in the 1990s; tech company Dell has used a form of Six Sigma since 2000 and is now the model for many other businesses.

Measure Use data on current processes as a baseline; pinpoint problem locations and occurrences; identify potential areas for improvement.

Analyze Identify root causes of problems and check them against data; determine precise improvements that need to be made.

²³ of Fortune 500 US organizations were running Six Sigma initiatives by the late 1990s, with the goal of improving quality and reducing costs

Supply chain Along the journey from raw material to ﬁnished item in the hands of a consumer, every business needs an efﬁcient supply chain. Supply chain management involves different organizations, people, activities, and resources to take, for example, grains of corn from a ﬁeld to a ﬁnished box of cornﬂakes on the consumer’s breakfast table. The company may outsource parts of the chain to other ﬁrms. It may also send some activities, typically administrative functions, offshore.

Supply chain management The traditional supply chain takes raw materials and resources through to a ﬁnished product for the consumer. The company has to manage costs and ensure standards, being particularly careful that it does not harm people or

the environment along the way, from fair wages for labor at the source to recyclable packaging after consumption. Supply chain is big business—in the US, 4.2 million people are employed in warehousing and transport alone.

Raw materials and resources

Supplier and processor

Manufacturer

Whether from a ﬁeld or a mine, raw materials start somewhere.

The raw materials are processed, often near their source.

Organizations bring resources together to manufacture goods, often near the customer.

HOW OPERATIONS AND PRODUCTION WORK Supply chain

$688 billion

322 323

EXTENDING THE CHAIN

the cost of supply chain transportation in the US, in 2009

❯ Adding value Companies may try to add value along the chain, rather than just seeing it as a way to transport a product from A to B. See pp.324–325. ❯ Delegating functions To save money and use specialized expertise, the business can outsource activities and/or have them done by local companies or a branch of its own company offshore. See pp.326–329. ❯ Returning goods Part of the supply chain involves an efﬁcient system for dealing with goods returned by the consumer. See pp.330–331. ❯ Competitive edge At every stage, the company compares its performance with its competitors to see how it can improve. See pp.332–333. ❯ Ethics and the environment Taking responsibility for avoiding pollution and protecting workers’ rights is part of the package. See pp.334–335.

Distribution

Retailer

Consumer

Finished goods are transported to storage depots or retailers.

The store displays the products for maximum appeal to the consumer.

The consumer enjoys the ﬁnished product, and ideally recycles the packaging.

Value chain Rather than looking at the supply chain as merely a series of activities, organizations are increasingly looking at how value is created by each stage of the process. Lowering costs or raising performance are key. How it works

Porter’s value chain Primary activities work directly to create or deliver a product or service, while support activities help to improve their efﬁciency. To apply the value chain, a company has to identify each activity and either lower its cost or differentiate it from its competitors to add value in the customer’s eye.

CASE STUDY

PRIMARY ACTIVITIES Each department must cooperate and provide necessary information between value-chain activities to make a proﬁt.

Harvard Business School professor Michael Porter ﬁrst introduced the concept of a value chain in his book Competitive Advantage. Most organizations have dozens—possibly hundreds—of activities along the supply chain in the process of converting raw materials (inputs) to products or services (outputs). These can be classiﬁed generally as either primary or support activities that all businesses must undertake. The idea

of the value chain is that how activities are organized and carried out determines a company’s costs and thus its margin (proﬁt). Each link of the chain must communicate to other departments clearly and promptly. For example, marketing and sales must make accurate sales forecasts and pass them on in time for procurement to buy the correct type and quantity of raw materials, who in turn must connect with inbound logistics so they can organize receipt of goods.

Inbound logistics

Operations

Involves relationships with suppliers, including all activities to receive, store, and allocate inputs

Activities required to transform inputs into outputs

Pizza Hut’s greatest asset is breaking down complex pizza-making into simple steps unskilled chefs can do. ❯ Inbound logistics Vast global purchase orders for ingredients ❯ Operations Target countries with a liking for Italian food, on a franchise model with local staff ❯ Outbound logistics In-house meals and home delivery service ❯ Marketing Differentiate from other pizza chains ❯ Service Delicious, convenient pizzas at a fair price

SUPPORT ACTIVITIES Although not directly involved in outputs, these support primary activities, improving their efﬁciency and successful function.

Pizza Hut’s value chain

Company infrastructure

Human resource management

Technology development

Procurement

HOW OPERATIONS AND PRODUCTION WORK Supply chain

ONLINE VALUE CHAIN More than a quarter of the world’s population uses the internet for everyday activities, from shopping and banking to sharing photos and watching TV. To handle this volume, a complex value chain delivers internet services, made up of global and local ﬁrms with assets as diverse as content rights, communications and IT infrastructure, proprietary software, and global brands.

$1.93 trillion

the internet value chain revenue in the US, in 2008

Outbound logistics

Marketing and sales

Service

Activities required to collect, store, and distribute the output

Activities that inform buyers, encourage purchase, and facilitate transaction

Activities to keep product working effectively for buyer after it is received

Functions such as accounting, legal, ﬁnance, planning, public affairs, and quality assurance

People activities: recruiting, hiring, training, developing, compensating, and terminating

Equipment, hardware, software, procedures, and technical knowledge used in transformation of inputs into outputs

Acquisition of inputs (raw materials) for the company

324 325

PROFIT MARGIN Proﬁt equals the customer’s willingness to pay more than the sum of all the activities in the value chain.

Outsourcing Firms may choose to pay outside suppliers to do work rather than complete the tasks internally. Handing over part or all of production or a service to a third party increases ﬂexibility. How it works

COMPANIES SURVEYED (%)

Outsourcing grew in the 1980s because ﬁrms looked to save costs by contracting peripheral business activities to third parties. But outsourcing today is no longer just about cost savings. It is a strategic tool that is increasingly important in the global economy in the 21st century. Firms may choose outsourcing for elements of the production process, for support

100

functions such as accounting, or because they do not have the specialized knowledge or skills within the organization. Outsourcing may be to a ﬁrm in the same country or it may be to an organization in another country. Rapid expansion of logistics networks and information technology has made it easier to outsource, thus accelerating the growth of outsourcing over the last decade.

Top reasons for outsourcing Growth and success for many businesses is underpinned by outsourcing, as a number of ﬁrms ask: why do it ourselves, if another ﬁrm can do it faster, better, or cheaper? Organizations recognize that using external capabilities, capacities, knowledge, and skills opens opportunities. Some ﬁrms now focus only on their core business; in a global survey, this was cited as one of the top reasons for outsourcing.

36% Lower costs

Focus on core business

External provider often beneﬁts from economies of scale

Firm can identify and prioritize its primary activity

36% 13% Improve quality External organization paid for delivering a quality product or service

HOW OPERATIONS AND PRODUCTION WORK Supply chain

90%

NEED TO KNOW ❯ Outsourcing Subcontracting work to another company or buying in components for a product rather than manufacturing them ❯ Offshoring Practice of moving a company’s operating base to a foreign country where labor costs are cheaper

326 327

❯ Network structure Tasks or operations are performed by another company—which may be in the same country, a neighboring country, or overseas—within a network structure of organizations

of ﬁrms worldwide say outsourcing is crucial to growth strategies

EXAMPLES OF BUSINESS TASKS THAT CAN BE OUTSOURCED Outsourcing certain tasks within a business enables focus to remain on core business activities, which helps generate growth as well as income. Some tasks are better suited to outsourcing than others due to factors including expertise, how time consuming a task is, and how much face-to-face time it requires. IT operations, for example, can be highly expensive, requiring expert knowledge and can easily be managed remotely. Human resources, however, is more employee focussed, so better suited to in-house.

Accounting

Computer/ IT support

Manufacturing

Research and development

Tax preparation

CORE BUSINESS

Customer support

Engineering

Healthcare services

Legal services Payroll

Web design

Logistics

10% Increase speed to market External expertise often brings shorter lead times

4% Encourage innovation Frees up internal capability and buys in knowledge and ideas

1% Save capital Frees up capital to invest in areas for growth REASON

Offshoring Moving jobs outside the country where a company is based is called offshoring. Either the company employs people overseas to perform some functions, or work is outsourced to a third party overseas. How it works Offshoring grew in the 1980s as Western companies with high labor costs realized they could make signiﬁcant savings by manufacturing in countries with lower wages. Information technology (IT) services followed, enabled by the internet and global communications. However, companies are now rethinking this strategy, driven by factors including

the need to be close to customers, consumer dislike of overseas call centers, high unemployment in Western countries after the 2008 ﬁnancial crisis, global wage equalization, and growing transportation costs. Some ﬁrms are now nearshoring—for instance, US ﬁrms placing operations in Canada—or reshoring, bringing activities back to their home country.

Case study: global expertise Offshoring started in India and today it still leads the way. The country’s IT and business processing outsourcing export industries employ more than 2.2 million people and are worth more than $100 billion. Other regions have different areas of expertise—for example, Eastern Europe specializes in IT services.

CANADA

Examples of offshoring KEY

Technology

Technical support

Financial services

Design

Back-ofﬁce functions

Software

Insurance

Call centers

Banking

MEXICO

BRAZIL

Engineering Manufacturing CHILE

Research and development

Business processes

Customer support

HOW OPERATIONS AND PRODUCTION WORK Supply chain

328 329

INDIA: OFFSHORING WORLD LEADER ESTONIA

POLAND IRELAND

UKRAINE CZECH REPUBLIC ROMANIA

The Americas and Europe are India’s largest customers and account for 60 percent and 31 percent, respectively, of India’s IT and business processing exports. Services include ﬁnancial services (41 percent), high-tech/telecom (20 percent), manufacturing (17 percent) and retail (8 percent).

RUSSIA

CHINA

UNITED ARAB EMIRATES $

PHILIPPINES

INDIA GHANA MALAYSIA $

SINGAPORE SOUTH AFRICA INDONESIA $

Reverse supply chain Supply chain takes a product to a customer. Reverse supply chain is the series of activities it takes to retrieve an unwanted or used product from a customer and dispose of it, recycle, or resell it. How it works Companies have to focus on more than simply bringing a product to a customer. Now an efﬁcient reverse supply chain is essential to satisfy consumers, especially for the growing number of online retailers. Manufacturers, too, in industries from carpets to computers, may need reverse supply to recycle

products to meet environmental regulations. For example, companies have to manage products that are returned from consumers for a refund; products that do not sell and are returned to producers from retailers; or products near the end of their life, where disposal may be subject to environmental legislation.

Retrieve

Reverse logistics The cost to companies of reverse supply is enormous. For example, in the US, statistics from the Reverse Logistics Association suggest that the annual volume of consumer returns is estimated to cost $150–200 billion. This represents about 0.7 percent of gross national product (GNP) and 6 percent of the US’s total annual retail sales of $3.5 trillion.

Companies may have processes in place to collect used or unwanted items, whether from the customer or a retailer.

CUSTOMER RETURNS US retailers Sears and JCPenney were the ﬁrst stores to allow consumers to return goods with no penalty. This pioneering move in the late 19th century encouraged people to shop with them and helped build a loyal following. British retailer Marks & Spencer at one time had the most lenient returns policy in the retail word—until 2005 they had no time limit on returns, as long as the customer could produce a receipt. $

Please return within 28 days

Eventual recycling or reconditioning may be considered at the start of design and manufacturing decisions.

Manage disposal

HOW OPERATIONS AND PRODUCTION WORK Supply chain

NEED TO KNOW ❯ Electronic waste (e-waste) Electrical or electronic devices that are unwanted, do not work, or are obsolete ❯ Warehousing Administrative and physical functions necessary for storage of goods, either for selling or retrieval

32%

of an item’s original product value could be reclaimed as a result of a well-managed reverse logistics system

Transport

Customers expect items to be transported back to the seller in a straightforward system, in person or by a delivery service.

Items and components are sorted and separated, ready for reselling, recycling, or disposal.

Sort

330 331

Receive

Effective inventory management is critical to ensure that inbound items are recorded so the company can keep track of returns.

Items are carefully checked on return. If they are to be resold, they must be in pristine condition.

Inspect

Benchmarking Businesses use benchmarking to improve efﬁciency by comparing their performance with that of other organizations. The goal is to identify and learn from best practices within or outside the industry. How it works To improve results, a business may look outside the organization, industry, or country to explore others’ levels of performance and identify how they achieve it. Benchmark areas include unit cost, customer ratings, and pay and beneﬁts. The evaluation takes into

account a range of factors, including training, technology platforms, and manufacturing equipment. For example, Formula 1 is often used as a benchmark for teamwork as pit-stop crews have perfected the changing of four tires in less than seven seconds.

The process of benchmarking

Identify need to benchmark

cia l ing ild bu

Com pa n

There are several stages to benchmarking performance before a company can start to see cost savings and increased efﬁciency. commer ns a

Compare to competition The company gathers information on others’ energy systems and costs.

Monitor value It measures how much its energy costs have gone down and how well the new lighting system works.

eplaces l igh ny r a p ti m

energy an ors t dm i on saved ey on

Compa ny m

In this example, a company wants to improve its energy efﬁciency.

HOW OPERATIONS AND PRODUCTION WORK Supply chain

49%

SOCIAL MEDIA MAKES IT EASY

of companies across 44 countries used performance benchmarking in 2008

Compe tito r’

erg en

y use

ut e so

C02 C02

nergy au dit o

building

Company ca rr

It sees that a comparable company has a much lower carbon footprint.

wn fo

It changes its lighting system to the one used by the most energy-efﬁcient company in its survey.

Analyze differences or gaps

cient ef ﬁ yrg

is more ding l en i u e sb

imilar build in at s s g ok

s’

Compan yl o

It is now easier than ever before for organizations to gather data about their competitors. Social media can provide data on customer preferences, brands, and campaigns of other organizations. Analytical tools are available to simplify benchmarking across many different channels.

Implement changes

332 333

Identify changes required It examines its own energy use to see how it could improve.

Corporate social responsibility Businesses today must aim not only to do no harm to the environment, people, or communities, but also to show commitment to building a better society. This is termed corporate social responsibility (CSR). How it works For a business, CSR goes further than aiming to be compliant with national or international regulations, managing risks, or corporate philanthropy—it has to be an integral part of every aspect of operations, helping to create a sustainable business. A company still has to be competitive and proﬁtable, but must avoid making decisions merely for shortterm gain. Instead, it has to consider the future impact on society, the environment, and a wide range of stakeholders. Companies now report annually on how they have met their CSR and are benchmarked and ranked against competitors.

Community Housing; healthcare; infrastructure; partnering with local institutions; local supplier initiatives; education; training; local employment

97%

of UK FTSE 100 companies reported on CSR in 2011

Environment Company’s carbon footprint, including recycling; water and waste management; energy use; transportation

HOW OPERATIONS AND PRODUCTION WORK Supply chain

334 335

Workforce Workplace safety, health, and well-being; diversity; equal opportunities; learning and development; ethical policies and practices

Suppliers Fair trade, supply-chain ethics, and sustainability (including use of child labor); code of conduct; transportation policies

CSR stakeholders A number of different business areas have to be considered in assessing a company’s CSR, from how it affects people working in and for the company to wider environmental and community implications.

Operations Ethical trading including marketing practices and pricing; managing customers; ﬁnancial reporting; policies; values

CASE STUDY Fairtrade International Many consumers expect the companies they buy their latte from to uphold ethical practices. A US campaign in 2000 pressurized Starbucks to serve Fairtrade coffee. The public wanted to understand the coffee giant’s supply chain as there was concern for the livelihoods of coffee farmers, many of whom are indigenous people. Fairtrade International ensures that coffee farmers receive a fair price for their crop, plus a premium that is invested in improving farming practices. Coffee was one of the ﬁrst products to carry the Fairtrade Mark.

How companies work Businesses in the US are registered in the state in which they are domiciled. Most states and the federal government recognize four business structures: sole proprietorship; partnership; corporation; and nonproﬁt corporation. Sole proprietorship An individual (or married couple) may register their business as a sole proprietorship if they plan to conduct operations on their own. This is the simplest form of business structure. The owner is entitled to all revenues and proﬁts, while maintaining personal responsibility for all debts and liabilities. Income from sole proprietorships is taxed as individual income.

Partnerships Partnerships are business entities formed by two or more individuals. The most basic form is the general partnership. Partners in a general partnership contribute an agreed-upon share of money, skill, and labor to the enterprise, in exchange for a proportionate share of the proﬁts. Liabilities are thusly divided as well. A limited partnership includes general partners and limited partners (also known as silent partners) who share in the proﬁts but whose losses are generally limited to the size of their initial investment. Similar to a general partnership, a limited liability partnership indemniﬁes one partner from claims arising from other partners’ negligence. Lawyers and doctors frequently operate under this structure.

equity is shared by a limited group of stock owners. A publicly held corporation makes shares available to the public through a stock exchange or through over-the-counter markets.

Nonprofit corporation A nonproﬁt corporation engages in activities meant to further the public good, such as works in charitable, scientiﬁc, educational, or artistic ﬁelds. Such organizations, most frequently registered with the Internal Revenue Service (IRS) through form 501(c)(3), are generally tax-exempt at the federal and state level. They may in fact make proﬁts and pay competitive salaries, but are prohibited from engaging in political activities.

In Canada Businesses in Canada can also be sole proprietorships, partnerships, or corporations. They can also be run as cooperatives, a business that it is owned and controlled by its members. Co-ops are often used by agricultural enterprises. Canadian companies must register in the province or territory in which they are domiciled.

Corporation

Reporting requirements

The federal government and states recognize corporations as business entities that are separate and apart from employees and shareholders in terms of income and liabilities. This structure protects management and workers in the case of litigation or other claims, but is more complex and subject to greater regulation than a partnership. Such entities must be registered through articles of incorporation. A corporation may be privately held, in which case

Businesses in the US are subject to a range of ﬁnancial reporting requirements and regulations, depending on structure. Owners of sole proprietorships include income on their individual returns ﬁled annually with the IRS. Corporations must also report income to the IRS, but are subject to additional requirements. Privately held corporations must, at a minimum, ﬁle charter documents, including name and address, with the Secretary of State in the state in which they are

US-SPECIFIC INFORMATION How companies work

headquartered. Publicly traded corporations are subject to considerably greater disclosure requirements. They must ﬁle with the Securities and Exchange Commission quarterly (10-Q) and annual (10-K) reports detailing revenue, income, proﬁts, and losses. They must also ﬁle interim reports (8-K) disclosing signiﬁcant events, such as an acquisition or divestiture, as well as reports (Form 4) that disclose signiﬁcant buying and selling of shares by company insiders.

Company law The US Constitution vests in individual states the power to regulate commerce and administer and oversee companies that operate within their borders. States maintain a Department of State or equivalent (such as Massachusetts’ Secretary of the Commonwealth) that act as registrar for commercial endeavors. Departments of State maintain publicly searchable databases of all registered companies, hold administrative hearings, and can take enforcement actions.

Taxation The IRS collects taxes from businesses on behalf of both the federal and state governments. At the time of printing, the federal tax rate on corporations ranged from 15 percent to 35 percent. Tax rates vary widely among states, and six states impose no corporate income tax at all. The federal government and states do not collect Value Added Taxes (VAT) from businesses, but many states impose sales tax on consumers that businesses collect at the point of sale. Several states have no sales tax. Sales taxes can also vary depending on the item purchased. For example, in New York state, groceries are tax-free, while takeout meals are taxed at the prevailing rate of 4 percent. New York City also applies an additional sales tax of 4.5 percent to most items. Other municipalities around the country are also free to establish their own sales tax rates.

336 337

ORGANIZATIONS AND RESOURCES The Small Business Administration website has information on the corporate structures permitted under US law. https://www.sba.gov

Taxation The Internal Revenue Service provides a number of online services for business owners, including when and where to ﬁle tax returns and how to obtain tax credits. http://www.irs.gov/Businesses

Startups BusinessUSA is a central repository where entrepreneurs can access a range of services. Its website provides information on funding, taxation, hiring, growth strategies, and more. It also offers advice tailored to speciﬁc groups, such as women, veterans, and minorities. http://business.usa.gov The US Department of the Treasury also offers advice and services for would-be proprietors. In addition, it operates the Small Business Lending Fund, which secures loans made to business owners by private banks. http://www.treasury.gov

Registering intellectual property The main arbiter for determining whether a product or business method is worthy of exclusivity is the United States Patent and Trademark Ofﬁce. http://www.uspto.gov

Immigration All employees must be authorized to work in the US through citizenship or some form of visa. US Citizenship and Immigration Services, part of the Department of Homeland Security, determines visa eligibility and enforces immigration rules.

In Canada The Canada Business Network offers information about starting and operating a business. http://www.canadabusiness.ca/eng/page/2853/ http://www.entreprisescanada.ca/fra/page/2853/

How finance works For publicly traded companies, the Securities Exchange Act of 1934 is the framework for ﬁnancial accounting and reporting. The Securities and Exchange Commission (SEC) enforces the Act. The SEC has established reporting requirements for companies whose shares trade on public exchanges such as the New York Stock Exchange, the NASDAQ Stock Market, and the NYSE Market LLC. Privately held companies are subject to fewer requirements.

Tax reporting Both private and public companies must ﬁle tax returns to the Internal Revenue Service on an annual basis. The due date varies based on the ﬁler’s status. Sole proprietorships follow the same schedule as individuals and must ﬁle by April 15 or request an extension. Partnerships must ﬁle by the 15th day of the fourth month after the end of their ﬁscal year. Public companies must ﬁle by the 15th of the third month.

Reporting standards Companies must log and report ﬁnancial transactions to the SEC according to Generally Accepted Accounting Standards (GAAP) as established by the Financial Accounting Standards Board, a private, nonproﬁt organization. Due to the increasingly global nature of business, there is a movement to adopt International Financial Reporting Standards (IFRS). In the aftermath of several events in recent years, including the bursting of the so-called dot-com bubble, the increased use of controversial ﬁnancial instruments like mortgage-backed securities (MBS) and collateralized debt obligations (CDO), and the 2007–2008 ﬁnancial crisis, the FASB has adopted a number of new rules aimed at restoring order and clarity in the markets.

Financial disclosure Exchange-listed companies must make their ﬁnancial records publicly available on a quarterly and annual basis, respectively. They must report unscheduled, material events (such as an acquisition or divestiture). Ofﬁcers and insiders must declare signiﬁcant purchases or sales of company stock, and the terms of issuance for corporate notes must be detailed. Regulation Fair Disclosure (Reg FD) stipulates that companies must disseminate ﬁnancial information simultaneously to all investors. The SEC amended Reg FD in 2013 to include disclosures through socialmedia channels such as Twitter and Facebook. Public companies must retain a licensed auditing ﬁrm to verify the veracity of their ﬁnancial records. Under SEC rule 3235-AI74 (2003), auditors must retain client records, including worksheets, ﬁnancial data, meeting minutes, electronic correspondence, and other materials used to form an opinion for seven years.

Accounting periods For sole proprietorships, the reporting period for tax purposes runs simultaneous to the calendar year. Publicly traded companies may set their own ﬁscal years. Public companies must ﬁle a report for each ﬁscal quarter, as well as a report at the end of each ﬁscal year. Reports generally must be released within 45 days after the close of a quarter.

Corporate fraud In addition to its regulatory functions, the SEC, through its Division of Enforcement, is also the US’s chief watchdog when it comes to policing and prosecuting ﬁnancial fraud. The SEC is mainly on the lookout for several types of misconduct: False statements. Corporations must report ﬁnancial information that, to the best of management’s knowledge, is complete and accurate.

US-SPECIFIC INFORMATION How ﬁnance works

Insider trading. Corporate insiders, such as ofﬁcers and executives, can legally buy and sell shares in their companies, but not on the basis of non-public information. For example, a CFO cannot unload shares on the basis of negative ﬁnancial news that has not yet been released. Insiders are also barred from tipping off friends, family, and business associates. Ponzi schemes. This is the practice whereby a money manager distributes returns to existing investors from funds acquired from new investors. These schemes generally collapse once a fund runs out of fresh capital. The most infamous Ponzi scheme to date was that orchestrated by fund manager Bernard Madoff, starting in the 1990s and continuing until his arrest in 2008. Pump and dumps. A “pump and dump” occurs when a brokerage acquires a large amount of stock, spreads false news meant to increase the stock’s value, then quickly sells its position before the fraud is uncovered. Front running. This occurs when a brokerage acquires a block of shares in a particular company before executing a large, pending buy order from a client. The client’s order, if large enough, will increase the value of the stock, allowing the ﬁrm to proﬁt from its foreknowledge of the transaction.

In Canada The Toronto Stock Exchange is Canada’s largest and most commonly used stock market. It is overseen by the Ontario Securities Commission. Stock markets also operate in Vancouver and Montreal. Businesses operating in Canada must ﬁle tax returns to the Canada Revenue Agency. Forms may be ﬁled through the mail or electronically. Unlike the US, the federal government in Canada imposes a value-added tax known as the Goods and Services Tax (GST). The current rate is 5 percent. The tax is levied on manufacturers and producers throughout the chain of production. In some cases, companies can claim tax credits for VAT already paid. In some provinces, the GST is included in the Harmonized Sales Tax (HST).

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ORGANIZATIONS AND RESOURCES Financial reporting The Securities and Exchange Commission provides information on ﬁnancial reporting requirements for publicly listed companies. http://www.sec.gov The Financial Accounting Standards Board website features educational webcasts and seminars for ﬁnance and accounting professionals. http://www.fasb.org The Association of Chartered Accountants in the United States offers online training videos, while the CFA Institute maintains a glossary of ﬁnance and investment terms. http://www.acaus.org http://www.cfainstitute.org

Corporate fraud Those who wish to report corporate fraud may approach the SEC directly through its Ofﬁce of the Whistleblower. http://www.sec.gov/whistleblower Similarly, the Internal Revenue Service maintains an ofﬁce through which the public can anonymously report suspected corporate tax cheats. http://www.irs.gov

In Canada The Canada Revenue Agency website has information on the GST and other taxation issues. http://www.cra-arc.gc.ca The Ontario Securities Commission offers a number of online resources for companies considering a listing on the Toronto Stock Exchange. http://www.osc.gov.on.ca

How sales and marketing works Advertising and marketing in the United States are regulated at both federal and state level. The Federal Trade Commission (FTC) sets national policies and enforces relevant laws passed by Congress. The First Amendment to the US Constitution restricts the government’s ability to limit or inhibit public speech or communication. However, courts over the years have ruled that commercial speech is subject to less protection than noncommercial speech. The Federal Trade Commission (FTC) was established in 1914 through the Federal Trade Commission Act. Much of the FTC’s work involves enforcing truth-in-advertising regulations, a legislative rubric that requires ads to be truthful, not misleading, and backed by scientiﬁc data if appropriate. In a case of suspected false advertising, the FTC can sue the perpetrator in federal court to obtain a cease-anddesist order, freeze assets, and obtain recompense for victims. A bill pending in Congress at the time of writing, the Truth In Advertising Act of 2014, would prevent marketers from using digital tools such as Adobe Photoshop to alter the appearance of models’ bodies and faces in ads. The FTC also enforces legislation aimed at electronic marketing communications, such as email campaigns and telemarketing. For example, the Commission can ﬁle suit against agencies suspected of violating the National Do Not Call Registry. Telemarketers are forbidden from calling consumers who have entered their numbers in the registry. Similarly, the FTC enforces the CAN-SPAM Act of 2003, which requires marketers to give consumers a means to opt out of receiving future messages. The Federal Communications Commission (FCC) also has some authority to regulate commercial speech. For instance, the FCC enforces the CALM ACT of 2012, which stipulates that broadcasters and cable companies must air commercials at the same volume as regular programming.

Individual states can set marketing and advertising rules, particularly for highly regulated industries like health care, ﬁnancial services, and real estate. At the state level, the Better Business Bureau accepts and responds to complaints regarding companies doing business within state jurisdictions.

In Canada Freedom of speech and expression in Canada is protected by Section Two of the Canadian Charter of Rights and Freedoms. As is the case in the US, commercial speech is afforded less protection than political or other types of expression. Still, the Charter places numerous limitations on the federal and provincial governments’ ability to abridge marketing and advertising communications. For example, Canada’s Supreme Court in Ford v. Quebec (1988) struck down a Quebec law that required all advertising signs to be in French. Commercial speech in Canada is also governed by the Consumer Packaging and Labelling Act (1985). The law prohibits the use of misleading ads and claims on consumer goods.

Data protection Unlike Europe, with its centralized Data Protection Directive, the US does not have a single, overarching law on data protection. Rather, Congress has passed a series of laws that together form a framework around the safeguarding of consumers’ privacy and information. Many of these rules are directed at particular industries. For example, the Department of Health and Human Services enforces the Health Insurance Portability and Accountability Act of 1996 (HIPAA). The Act dictates the administrative, physical,

US-SPECIFIC INFORMATION How sales and marketing work

and technical safeguards that health care insurers and providers must follow to protect patient records. In ﬁnancial services, the Gramm-Leach-Bliley Act of 1999 stipulates the steps that banks, credit unions, and other ﬁnancial institutions must follow to safeguard customer data. The act is enforced by the FTC. Other industries are also subject to speciﬁc privacy and data protection rules.

Direct marketing Direct marketing agencies are subject to laws enforced by the above-mentioned agencies, but are also supposed to adhere to self-imposed codes of conduct adopted by the Direct Marketing Association. The DMA is a lobby group for the industry that promotes “responsible, data-driven marketing.” The DMA promulgates member policies on a number of issues, including privacy, the environment, e-commerce, and consumer protection.

E-commerce For marketers that conduct campaigns through the internet and social media channels, the Interactive Advertising Bureau (IAB) publishes codes of conduct that members are expected to follow. For example, the IAB expects all members to be transparent about the data and personal information they collect from consumers on the web.

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ORGANIZATIONS AND RESOURCES Advertising The Federal Trade Commission oversees truth-inadvertising laws and regulations and offers resources to advertisers and marketers to help keep them from running afoul of the rules. On its website, the FTC publishes advisory opinions on how changes to laws or court rulings may have an impact on future enforcement decisions. http://www.ftc.gov/policy/advisory-opinions The Bureau of Consumer Protection, an arm of the FTC, operates an online Business Center that advises businesses how to comply with Do Not Call, CAN-SPAM, and other rules. It also offers general guidelines on advertising and marketing basics, marketing to children, health claims, and “Made in the USA” claims. http://business.ftc.gov/advertising-and-marketing

Data protection Various federal agencies can provide information on rules, regulations, and methods concerning the protection of consumer data and privacy, depending on the industry. The Department of Health & Human Services publishes an online FAQ for complying with HIPAA. It also posts guidelines for covered entities and their business partners and associates. http://www.hhs.gov For marketers and advertisers who work within the ﬁnancial services industry, the SEC has a web page devoted to the topic of protecting consumers’ ﬁnancial data and personally identiﬁable information (PII). http://www.sec.gov/about/privacy/secprivacyofﬁce.htm

In Canada Canada’s Competition Bureau maintains a website that provides in-depth information on the Consumer Packaging and Labelling Act, as well as on other relevant legislation. http://www.competitionbureau.gc.ca

How operations and production work In the US, practices concerning corporate governance, responsibility, ﬁduciary obligations, and social responsibility are broadly governed by the Sarbanes-Oxley Act, passed by Congress in 2002. Also known as the Public Company Accounting Reform and Investor Protection Act, the Sarbanes-Oxley Act of 2002 (SOX) was passed by Congress in the wake of several high-proﬁle corporate accounting scandals— most notably at Tyco International, WorldCom, Enron, and Enron’s auditor, Arthur Andersen. SOX established the Public Company Accounting Oversight Board (PCAOB), which regulates auditing of corporate ﬁnancial statements. It prohibits auditing ﬁrms from operating consulting businesses and stipulates that a company may not engage an auditor if certain members of senior management worked for that company within the prior year. SOX requires Chief Executive Ofﬁcers and Chief Financial Ofﬁcers to sign and attest to the veracity of their company’s ﬁnancial statements. Board audit committees must have at least one independent director. In addition to government oversight, the auditing profession has stepped up self-regulation in the wake of the ﬁnancial scandals. The American Institute of Certiﬁed Public Accountants (AICPA) has in recent years issued several key Statements on Auditing Standards (SAS). SAS 70 sets audit standards for the services industry, SAS 85 requires auditors to obtain written representations from management, and SAS 99 sets out steps to be taken to detect material misstatement and accounting fraud.

In Canada Businesses in Canada are governed by the Competition Act. The Act prohibits misleading advertising and marketing practices, and requires truthful statements concerning warranties, guarantees, and prices. It enables wronged parties to sue defendants for fraud in civil court, usually at the provincial level.

Standards and quality control In the US, numerous independent standards organizations play a role in ensuring adherence to standards and quality control in various industries, including manufacturing, services, and health care. Many of these standards are promulgated by the International Organization for Standardization (ISO), a nongovernmental organization based in Geneva, Switzerland. ISO 9000 sets out eight principles for achieving quality control and operational consistency. ISO 9001 establishes formal processes that companies must adhere to, including the establishment of formal quality-control committees, to achieve the designation. ISO 3100 stipulates procedures for controlling and managing risk, while ISO 22,000 concerns food safety. There are other, privately sponsored qualitycontrol initiatives in which many large US companies participate. Beyond ISO, one of the most widely adhered to is the Six Sigma program, which was developed by Motorola and widely deployed by General Electric under former CEO Jack Welch. Six Sigma seeks to build processes aimed at removing defects from the manufacturing process.

Health, safety, and the environment Companies operating in the US are expected to operate in a socially responsible manner that attempts to minimize environmental impact while protecting worker health and safety. The federal Environmental Protection Agency (EPA) has broad authority to interpret, apply, and enforce federal laws concerning environmental impact. The EPA regulates greenhouse gas emissions, estuarial runoff, and wetlands protection, among other things.

US-SPECIFIC INFORMATION How operations and production work

To maintain worker safety, corporations and even small, privately held companies must adhere to standards set by the Occupational Safety & Health Administration (OSHA). OSHA regulations require a workplace that keeps workers safe from everything from slips and falls to major industrial hazards like exposure to toxic chemicals. OSHA has the power to halt production at job sites deemed unsafe. Food production and processing are further subject to health and safety standards set by the Food and Drug Administration (FDA) and the US Department of Agriculture’s Food Safety and Inspection Service.

Liabilities, warranties, and guarantees Companies that sell goods and services in the United States must adhere to various consumer protection laws that are generally promulgated and enforced at the state level. For example, New York State maintains a Division of Consumer Protection, California has its Department of Consumer Affairs, and the Texas Attorney General maintains a Consumer Protection unit. These organizations enforce laws concerning the terms and conditions under which goods and services are sold to the public. New York State, for instance, requires stores to post their refund policies in open view, maintain transparent rebate policies, and limit restrictive provisions on gift card redemption.

Intellectual property law and patent protection Intellectual property laws in the US are upheld and enforced mainly through the United States Patent and Trademark Ofﬁce (USPTO) and the US Copyright Ofﬁce. The USPTO adjudicates the validity of patent claims and awards patents on new designs of products, services, and business methods. The USPTO also evaluates trademark claims. The Copyright Ofﬁce registers claims and issues certiﬁcates for copyrights on literary, artistic, and design works, such as a corporate logo.

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ORGANIZATIONS AND RESOURCES Compliance and corporate responsibility The Securities and Exchange Commission enforces Sarbanes-Oxley compliance. http://www.sec.gov

Standards and quality control ISO’s site provides full information on all of the standards overseen by the organization. http://www.iso.org

Health, safety, and the environment OSHA’s website offers information on new regulations, compliance tips, and enforcement actions. https://www.osha.gov The EPA has online tools for checking compliance with federal environmental regulations. http://www.epa.gov Information on food safety laws and practices can be obtained from the FDA’s site. http://www.fda.gov

Liability, warranties, and guarantees In the US, consumer protection generally falls to the state level. Individual state websites provide information on regulations concerning public sale of goods and services.

Intellectual property law The USPTO is the main resource for all information concerning the ﬁling of patent applications. http://www.uspto.gov The US Copyright Ofﬁce website includes information about the copyright process and fees. http://copyright.gov

In Canada Information on corporate law and operations in Canada can be obtained from the federal government’s Competition Bureau. http://www.competitionbureau.gc.ca http://www.bureaudelaconcurrence.gc.ca

Index Page numbers in bold type indicate main entries. 3-D marketing 207 3M 304 4P3C1E framework (marketing) 242 5S (workplace organization) 299 7-Eleven 23 360-degree feedback 85 360-view customer proﬁle 261

A A/B testing (mail marketing) 216 absorption costing 142 accounting see ﬁnancial accounting acid-test ratio 149 acquisition of company 31, 41 ACSI (American customer satisfaction index) 293 actionable metrics 253 ACW (after-call work) 219 adaptive customization 279 advertising advertising to sales ratio (A/S) 213 ATL (above the line) 191 BTL (below the line) 190 online 214–15 traditional ofﬂine 212–13 agents, selling through 188–89 agile business 74 agile production 296–97 aging schedule 135 Agricultural Bank of China 161 AHT (average handling time) 219 AIDA (Attention, Interest, Desire, Action) 237 Alibaba Group 161 Amazon 26 amortization and depletion 128–29 annual report 100, 104–05, 106, 109 Apache Hadoop software 263 Apple 20, 304, 306, 315 appraisal see staff evaluation

ASA (average speed of answer) 219 asset stripping 152 assets and inventory 138–39 audit trail 103 auditing 103, 111, 114–15 automatic call distributor (ACD) 219

B B2B lead generation 237 Baby Boomers 194 back-up plan 33 balance day adjustment 103 balance sheets 116–19 analysis 118–19 current assets 138 equation 116 balanced scorecard 85, 147 Bank of China 161 bank line of credit 34, 133, 158–59 Barings Bank 153 batch costing 143 batch production 274–75 bear market 166 behavioral targeting 215 benchmarking 326–27 big data 262–63 billboard marketing 201, 213 blogging 224–27, 228–29 board of directors 52–55 board members, choosing 19 disclosures 107 body language in different cultures 97 BOFU (bottom of funnel marketing) 220 bonds 170–73 book value 124, 150 bookkeeping 102–03 Boots 49 bootstrapping 14 botnet virus 215 BP (British Petroleum) 62–63 branding and rebranding 234–35 brand loyalty 240, 259 personal 181

break-even point (BEP) 141 breakthrough innovation 305 brochures and ﬂyers 201, 210 budgets 136–37 bull market 166 bundle pricing 187 Burger King 23 burn rate 30 business accelerators and incubators 38–39 business analytics 250–51 business angels 35, 36–37 business cultures 64–65 business development 232–45 business goals 78–79 business intelligence software 248–49 business launch 27 business ownership 12–25 business plans 32–33 business process reengineering (BPR) 67 business-format franchise 23 buying and selling businesses 40–49

C call center locations, top ﬁve 219 call to action (CTA) 239 callable bond 172 CAN-SPAM Act 267 Canon 298 capacity management 314–15 capital investment and lump sums 132 capital markets and securities 170–73 capital and reserves 117 capital structure evaluation 155 cascading 76 cash conversion 135 cash cows 185 cash ﬂow 132–35 corporate failure signs 151 and fraud 152, 153 gap 135

HOW BUSINESS WORKS Index

management 134–35 statement 120–21 see also cost accounting; ﬁnancial accounting CEO (chief executive ofﬁcer) 53, 54, 55, 56, 57 chamber of commerce 25 channel margin 189 charitable donations 107 charity 25 chart of accounts 103 checkout technology 255 children’s marketing 266–67 Chrysler 59 churn rate 204 Cisco 72 cleaning (direct mail) 216 clickstream 215 cloaking 231 cloud services 263, 264 Coach 44 Coca-Cola 193, 293, 306 cold calling 211, 218 collaborative customization 279 communication, art of 92, 178 company hierarchy 56–59 company shares 164–65 comparative claims regulation 266–67 competitive product positioning 182 competitor analysis 33 compliance regulation 266–67 conglomerate 46 conservatism 113 consolidated ﬁnancial statements 105 construction industry safety procedures 319 consumer see customer content marketing 220–21 continuous production 280–81 contract costing 143 control, chain of 312–21 control systems 64 cooperatives 24 corporate bonds 173 corporate failure signs 151 corporate social responsibility (CSR) 334–35 environmental accounting 122–23 corporate structure 66–77

corporate success 150 corporation tax 106 corporations 16–17 cosmetic customization 279 cost accounting 130–43 see also cash ﬂow; ﬁnancial accounting cost per lead (CPL) 237 cost per thousand (CPT) 213 cost per touch (lead conversion) 238 cost-plus pricing 142 costs, ﬁxed vs. variable 140–41 costs and pricing strategy 33 credit and creditors 36, 109, 117, 119, 156 CRM (customer relationship management) 264–265 C-suite 54 crowdfunding 34, 35, 36 current assets 117 current ratio 149 customer acquisition cost (CAC) 241 behavior 194–95, 258, 259 capital 244 churn rate 204 complaints 240 consumer data collection 254–55 customer relationship management (CRM) 264–65 customer returns 330–31 data regulation 266–67 decision simplicity 204 expectations, and quality 308 feedback surveys 107, 240–41, 265 lifetime value (CLV) 243 loyalty programs 240–41, 255, 260, 261 personalized product design 278–79 proﬁling 258–61 retention 240–41 segmentation 264 selling direct to 188–89 service 146, 190, 265 “sticky” customers 204 uptake 185

344 345

D data data to decisions transformation 247 mining 153, 249, 251, 257 quality (DQ) 248 visualization 251 warehousing 256–57 debt bad 102 bonds as debt investments 171–72 and business failures 14 capital structure evaluation 155 cash-ﬂow reconciliation 120 corporate failure signs 151 debtor categories 119 factoring 158–59 gearing ratio 174–75 loan interest 115 loan note 158 loan percentage payment and amortization 128 ratio 149 repayments 132, 133 utility company affordability 120 decentralization 67, 74 decision simplicity (consumers) 204 defect measurement 320–21 defensive merger 43 deferred income 114 deferred ordinary shares 165 delayed payment 156 deleverage 175 Dell 279, 291, 321 demand-pull production 290–91 Deming Prize 309 departmental hierarchy 68–69 depletion and amortization 128–29 depreciation 124–27 calculation 115, 118, 126–27 Deutsche Telekom AG 161 Dia 23 differential costing 142 digital asset management (DAM) 253 digital dashboard 249 digital marketing 202–03 direct costs 142 direct mail marketing 216–17

INDEX

direct response (DR) marketing 209 direct taxes 106 directors 18, 19, 50, 53, 55, 115 disbursement quota 25 disclosure (blogging) 225 disruptive innovation 305 diversiﬁcation 42 divestitures 44–45 dividends see shares and dividends divisional structure 66, 70–71 doing business as (DBA) 16 donations 133 double-entry bookkeeping 102, 131 due diligence 41, 43 Dunkin’ Donuts 23

E earnout 48 EBITDA to sales ratio 148 eco-innovation 305 economic entity assumption 112 economic life 124 economies of scale 286–87 mergers see mergers economy pricing 186 effective capacity 315 efﬁciency 148, 150, 326–27 electronic waste (e-waste) 331 ELT (extract, load, transform) 256 email direct mail marketing 216–17 regulation 266–67 employee relations 92–93 employment laws 80 endorsement regulation 266–67 Enel SpA 161 engagement marketing 204–05 Enron 153 enterprise portal 30 environmental accounting 122–23 environmental concerns, KPIs 147 environmental, social and gorporate criteria (ESG) 60–61 equipment purchase 133 equity 149, 150, 155, 171, 174 ERP (enterprise resource planning) 264 Eurobond 158 events marketing 200, 205, 210

exabyte 263 expansion funding 157 Expedia 44 expenses 115, 140, 152 extension strategy 185 external ﬁnancing 158–59 extrinsic motivation 86

F face-to-face marketing 200, 205, 221, 260 Facebook 161, 287 factoring 34, 135, 159 factors of production 271 fair trade 335 fast-moving consumer goods (FMCGs) 181 ﬁnance leases 159 ﬁnancing sources 154–75 ﬁnancial accounting 110–29 accounting cycle 102–03 accounts payable and receivable 135, 148 accounts receivable turnover ratio 148 conventions 31 international standards 112–13 KPIs 146 see also cash ﬂow; cost accounting ﬁnancial forecasts 33 ﬁnancial management 100–09 ﬁnancial performance measurement 144–53 ﬁnancial ratios 148–49 ﬁnancial report types 100 ﬁnancial reporting 100–29 ﬁnancial risk and gearing ratio 174–75 ﬁnancial statements 104–09 deconstructing 106–07 fraud, tracking 152–53 for users 108–09 ﬁnished goods inventory 139 ﬁrst in, ﬁrst out (FIFO) 317 FIVA (framework of intangible value areas) 245 ﬁxed/tangible assets 117–19, 124, 125, 133, 138–39, 153

ﬂat lattice structure 76 ﬂipping 165 ﬂow production 276–77 ﬂyers 201, 210 Ford 294–95 forecasting 150–51 forensic accounting see fraud, tracking franchise disclosure documents (FDD) 22 franchises 22–23 fraternal organization 24 fraud, tracking 152–53 frequency marketing 209 frugal innovation 305 full cost pricing 142 full disclosure principle 112 functional structure 68–69 funding 154–63 external ﬁnancing 158–59 ﬂotation 160–63 internal ﬁnancing 156–57 start-ups 34–37

G GAAP (Generally Accepted Accounting Principles) 113 gearing ratio and ﬁnancial risk 174–75 Generation X and Generation Y 194 General Electric (GE) 60, 320, 321 general ledger 103 General Motors (GM) 59, 161 geographic pricing 187 globalization 20, 105 Global Management Accounting Principle (GMAP) 134 GNC 23 going concern assumption 112, 131 going public 160–63 goodwill 129 Google 26, 79, 304 government bonds 173 governmental accounting 101 grants 35, 133 green taxes 106 greenhouse gas emissions 123

HOW BUSINESS WORKS Index

H haptic technology 207 Hearst Corporation 18 Hertz 279 Hewlett Packard (HP) 15 hire-purchase agreements 159 historic cost principle 113, 131 holding company 105 Honda 308 horizontal integration 46–47 human capital 244 human resources 78–97 cycle 80–81 KPIs 147 human rights, and environment 123 hybrid processes 282–83

I IBM 72 IKEA 18 immediate capacity 315 inbound marketing 220–31 income and expense statement 114–15 incremental budget 137 increments 282 incubators 38–39 indirect costs 142 indirect taxes 106 inﬂuence markets 208 information management 246–67 infrastructure assets 118–19 initial public offering (IPO) 160–63 innovation and invention 304–05 intangible assets amortization and depletion 128–29 inventory 139 intangible capital 244 integrated marketing communication 190 integration, vertical vs. horizontal 46–47 mergers and acquisitions 42–43 intellectual capital 244–45 interactive marketing 191 interest cover ratio 175

interest rates and dividends 169 intermediaries, selling through 188–89 internal ﬁnancing 156–57 internal markets 209 internal start-ups 26 international accounting standards 112–13 internet marketing 202–03 interstitials (advertising) 215 inventory 316–17 inventory and assets 138–39 inventory reduction 157 inventory turnover ratio 148 investment returns 120, 121 investors 35 ﬁnancial ratios warning 149 invoice discounting 158–59 ISO 9000 309 IT and marketing 252–53

J JCPenney 330 job costing 143 job production 272–73 John Lewis 93 Johnsonville Foods 77 JPMorgan Chase & Co. 153 just-in-time production 290–91

K kaizen improvement system 298–99 Kanban cards 288, 291 key account management (KAM) 209 key performance indicators (KPIs) 146–47 KFC 23 knowledge capital scorecard 245

L labor costs 140 labor practices, and environment 123 large cap listed company 163

346 347

last in, ﬁrst out (LIFO) 317 lateral integration 47 lateral structure 76 lead conversion 238–39 lead generation 236–37 lead nurturing 238 lead scoring 238 leadership strategy and styles 88–89 leadership for team building 90–91 leadership/management differences 284 lean production 288–89 lean start-up 28 leasing costs 115 legally imposed control 313 LEGO 18 Lehman Brothers 100 letter of intent 45 leverage 64 limited companies 16–17 line position 58 line relationship 69 LinkedIn 83 liquidity ratios 149 listed company 163 loans see debt long-tail marketing 198 long-term ﬁnancing 157–59 loyads 261 loyalty programs 240–41, 255, 260, 261 Lutron 279

M MACRS (Modiﬁed Accelerated Cost Recovery System) 124 McDonald’s 20, 23, 70, 292 magazine marketing 201, 213 management 284–99 management, and fraud 153 management accounting 130–31 management buy-ins and buy-outs 48–49 management shares 164 management/cost accounting 130–43 management/leadership differences 284 managing capacity 314–15 manpower costs 115 manufacturing franchise 22

INDEX

manufacturing and production 270–83 MarCom (marketing communication) 190 mark-up comparison 187 market correction 166 market extension 46 market penetration pricing 187 market research 192–93 market segmentation 194–95 market share 42 market value of equity 150 marketing approaches 196–209 marketing and IT 252–53 marketing mix 178–95 marketing regulations 266–67 marketing technologist 253 Marks & Spencer 330 Mars 18, 279 MarTech conference 253 mass customization 278–79 mass marketing 198–99 matching principle 113 materiality principle 113 matrix guardian 77 matrix structure 72–73 media engagement 221 members (shareholders) 16 merge/purge software 216 mergers and acquisitions 42–43 integration, vertical vs. horizontal 46–47 Merrill Lynch 70 metadata 231 microfranchising 22 micropreneur 30 mid cap listed company 163 millennials 194 mobcast 226 mobile technology 215, 255 Model Business Corporation Act 54 MOFU (middle of funnel marketing) 220 Mondelez 44 monetary unit assumption 112 monopoly 47, 107 motivation and rewards 86–87 Motorola 321 movie advertising 213 multinationals 20–21 mutual organization 24–25

naming a company 13, 28 national employment laws 80 negative-option billing 266–67 negotiating strategy 96–97 net assets 117, 118 net proﬁt margin ratio 149 Net Promoter Score (NPS®) 293 network structure 74–75 networking 83, 201 new product development 302–03 newspaper marketing 201, 213 niche marketing 198–99 Nike 20–21 nongovernmental organization (NGO) 25 nonproﬁt organizations 24–25 NTT Group 161 NTUC FairPrice 309

Pacman strategy 43 Panda and Penguin (Google) 231 paradigm 64 partnerships 14–15 patent 129 patent trolls 26 pattern matching (data) 251 pay-per-click (PPC) advertising 215 peer-to-peer (P2P) lending 34 Pemsel test 25 performance management 81 performance measurement 144–47 and budgets 137 perpetual bond 172 person culture 65 personal branding 181 personal selling 190 personal warranty 48 petabyte 263 philanthropic sector 25 phishing 267 Pizza Hut 23, 324 place and distribution channels 188–89 planning, programming, and budgeting systems (PPBS) 137 platform corporation 21 podcasting/vidcasting 226–27 point of sale software 255 Ponzi/pyramid scheme 153 portfolio analysis 185 potential capacity 315 power culture 64 predictive analytics 250, 251 preference shares 165 premium pricing 187 price and pricing strategies 186–87 price to earnings ratio 149 primary market 170 private companies 18–19 private foundation 24 private corporation 17 private placing shares 165 process costing 143 Procter & Gamble (P&G) 72 product costing 142–43

O OAO Rosneft 161 offshoring 328–29 Ohlson O score 151 OLAP (online analytical processing) cubes 249, 257 oligopoly 107 OLTP tool (online transaction processing) 256 omni-channel customer 261 online advertising 211, 214–15, 260 online lead conversion 239 online value chain 325 operating proﬁt 114–15 operations 33, 121, 147 ordinary shares 165 outbound marketing 210–19 outbound vs. inbound marketing 222–23 outsourcing 326–27 overheads 132 overleveraged 175 overtime pay 51 overtrading 151 owned media 237

HOW BUSINESS WORKS Index

design 306–07 environmental responsibility 122 evolution 300–11 extension 46 franchise 22 levels 180–81 life cycle 184–85 positioning 182–83 product-process matrix 310–11 promotion 190–91 samples 201 professional corporation (PC) 16 proﬁt, corporate failure signs 151 proﬁt-and-loss statement 114–15 proﬁt margin 143 proﬁt maximization 60 proﬁtability ratios 148 proﬁts, retained 157, 168 project accounting 101 project management 94–95 professional (PMP) 73 time-based management 294–95 tools 94, 295 promotion of product 190–91 property management 17 prospective costs 141 psychological pricing 187 public companies 18–19 public issue shares 165 public limited company (plc) 16 public relations 191 push/pull strategy 189, 220, 222 PwC 18, 145

raw materials costs 140 raw materials inventory 139 Recency Bias theory 156 recession, employment turnover 82 recruitment and selection 82–83 red ﬂags indicating fraud 152 referral markets 209 relationship marketing 208–09 remuneration 107 reporting line, altering 67 reporting structure 18, 19, 69 research and development costs 115 residual value 124 retail space optimization 221 retailers, selling through 188–89 retained earnings 150 retained proﬁts 157 return on equity (ROE) ratio 148 return on marketing investment (ROMI) 242–43 revenue recognition principle 113 reverse merger 45 reverse supply chain 330–31 rewards and motivation 86–87 rights issue shares 165 Ritz-Carlton hotel group 279 robot.txt 231 ROI (return on investment) 242 Rolex 18 RSS (rich site summary) 226

salaries and wages 115, 132, 152 sales and fraud 152, 153 KPIs 146 pipeline 238 pitch 239 promotion 191, 205 revenue 132 tracking 249 sales tax 106 salvage/scrap/residual value 124 search algorithm 231 search engine optimization (SEO) 230–31 Sears 330

quality control 318–19 quality management 308–09 total quality management 292–93 quality product positioning 182 questionable costs 141

R radio marketing 201, 210, 213 raising money see funding raw data 251

348 349

secondary market 171 secondary stock offering 19 securities and capital markets 170–73 Securities Exchange Co 153 selling and buying businesses 40–41 selling price 143 sensory marketing 206–07 sensory testing 207 service costing 143 service jobs 272 share capital, raising 165 share split 166–67 share of voice (advertising) 213 shareholders 60–63 divestitures 45 and ﬁnancial statements 108 funds 117 liability 16, 17 and management 18, 19 shares and dividends corporate failure signs 151 dividends 168–69 share capital, raising 165 share ﬂotation 160–63 share value 62, 71, 120, 121, 159 share value, establishing 166–67 types 164–65 short-term ﬁnancing 156–59 shortage management 135 silo mentality 68, 69 single-member company (SMC) 17 Six Sigma control 320–21 skimming pricing 186 slice and dice data 248 small cap listed company 163 small and medium-sized enterprises (SMEs) 38 social economic scale 261 social enterprise 25 social graph 229 social lead targeting 211 social media marketing 228–29 and benchmarking 327 big data 262 and branding 234 see also blogging social media monitoring 229 sole proprietors 14–15 solvency ratios 149

INDEX

spam use regulation 266–67 span of control 58 special offers regulation 266–67 spinoffs 44, 45 splog 225 spreadsheets 249 staff evaluation 84–85 performance–management cycle 64 staff position 58 stakeholders 60–63 and corporate social responsibility (CSR) 335 and ﬁnancial statements 108–09 and share value 62 Standard Oil 15 star schema data 248 Starbucks 72, 208, 335 start-up pivot 28 start-ups 26–39 concept development 28–29 funding 34–37 incubators see business accelerators and incubators types 30–31 statistics 109, 251 “sticky” customers 204 stock exchange listing 160–61, 162 stock exchanges, world’s top 162 stock-keeping unit (SKU) 317 straight-line method of depreciation 124–25 strategic capital 244 structural capital 245 subsidiary company 105 Subway 23 success metrics (marketing) 242 sunk costs 141 super angels 35 supplier markets 208 suppliers’ payments 133 supply chain 322–35 surplus management 135 sustainability, KPIs 147 sustainable investment 106 swap ratio 43 sweepstakes and contests regulation 266–67 SWOT analysis 33 synergy 47

tangible/ﬁxed assets 117–19, 124, 125, 133, 138–39, 153 task culture 65 tax accounting 114–15, 120 tax payments 106, 109, 115, 119, 120, 133, 169 team-based structure 76–77 team-building leadership 90–91 technology, mass customization 278–79 telemarketing 218–19 regulation 266–67 terabyte 263 TERM (technology-enabled relationship management) 264 term loan 34, 158 ticker symbols 19 time-based management 294–95 TOFU (top of funnel marketing) 220 total quality management 292–93 quality management 308–09 Toyota 288–89, 290, 298, 308 tracking stock 45 trade event marketing 200, 205, 210 traditional marketing 200–02 traditional ofﬂine advertising 212–13 transaction marketing 209 transnational corporation 21 transparent customization 279 trending product claims 302 trial balance 103 tunneling 152 turnover 114–15 TV marketing 200, 210, 213 TVR (television rating point) 213

valuation of company 18, 19 value 186 Value Added Tax (VAT) 106 value chain 324–25 value product positioning 182 value-stream mapping 288 vanity metrics 253 venture capitalists (VCs) 35, 37 vidcasting 226–27 Virgin 15 virtual business incubator 39 Visa 161

U undertrading 151 underwriters 162 unquoted/unlisted company 19 useful/economic life 124 USP (unique selling point) 33 utility company, debt affordability 120

W wages and salaries 107, 132 Walt Disney 292–93 warehousing 331 warrant 172 waste elimination 288–89 Watson Wyatt index 245 Wessex Water 107, 109, 114–15, 117–19, 122–23 wholesalers, selling through 188–89 who’s who 50–65 Wikispeed 287 windfalls 133 WIP (work in progress) 317 WOM (word-of-mouth) marketing 204 working capital/total assets 150 WorldCom 153 Wyndham Hotel Group 23

X Xerox 70, 71

Z Z-score models, forecasting with 150 Zappos 77 zero-based budget 137 Zeta analysis 151

HOW BUSINESS WORKS Acknowledgments

350 351

Acknowledgments Dorling Kindersley would like to thank Douglas Bell and Debra Wolter for editorial assistance; Margaret McCormack for the index; and Nicola Gary, Vaibhav Rastogi, and Riti Sodhi for design assistance.

Credits DK would like to thank Wessex Water for their kind permission to reproduce sections of their 2013 annual report and accounts on pp.100–123; the Radio Advertising Bureau for permission to reproduce the graph on p.212; and Upstream/YouGov for permission to reproduce the graph on p.214. Sources of statistics and quotes: p.13: Roach, B., “Corporate Power in a Global Economy,” Global Development and Environment Institute, Tufts University, 2007; p.15: www.brusselsnetwork.be/ eu-news-m/563-smes-contribution-to-adynamic-europe.html; p.16: UK government business population estimates 2013; p.18: Biery, M.E., “4 Things You Don’t Know About Private Companies,” forbes.com, May 26, 2013; p.19: www.nyse.com/ why-nyse; p.24: The Nonproﬁt Almanac, 2012; p.26: Kauffman Index of Entrepreneurial Activity; p.27: France Digitale; p.29: Harvard Business School; p.30: IBISWorld; p.32: Panel Study of Entrepreneurial Dynamics, University of Michigan, 2008; p.35: Entrepreneurs Index report, 2013; p.39: National Business Incubation Association; p.41: Mergermarket M&A Trends Report, 2013; p.43: Humber, Y., “Japan Mergers Fall to Nine-Year Low as Yen Volatility Surges,” bloomberg.com, July 8, 2013; p.45: Hashem, N., “Demerger Study: Analysing the value of demergers through share price performance,” Deloitte & Touche, March 2002; p.47: Grant Thornton International Business Report, 2014; p.49: Craven, N., “KKR Agrees to Buy Alliance Boots, Beating Guy Hands,” bloomberg.com, April 24, 2007; p.51: “Employee attitudes and the recession,” Chartered Institute of Personnel and Development, 2009; p.53: Huang, S., “Zombie Boards: Board Tenure and Firm Performance,” INSEAD—Finance;

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ACKNOWLEDGMENTS

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Walmart; p.319: British Sandwich Association; p.320: “How Jack Welch Runs GE,” businessweek.com, 1998; p.321: De Feo, J., Barnard, W., Juran Institute’s Six Sigma Breakthrough and Beyond: Quality Performance Breakthrough Methods, Tata McGraw-Hill Publishing, 2003; p.323: Council of Supply Chain Management Professionals; p.325: A .T. Kearney, Internet Value Chain Economics report 2010; p.327: Corbett, M. F., The Outsourcing Revolution, Dearborn, 2004; p.331: “The Hidden Value in Reverse Logistics,” Deloitte, January 2014; p.333: Global Benchmarking Network, “Global Survey on Business Improvement and Benchmarking,” 2010; p.334: Pilot, S., “Companies are embracing corporate responsibility in their annual reports,” The Guardian, September 29, 2011.

A GRAPHIC GUIDE TO BUSINESS SUCCESS$ $A GRAPHIC GUIDE TO BUSINESS SUCCESSContents Senior editorGeorgina PalffyProject art editorSaffron StockerEditorsDesignersUS senior editor US editor Managing editorsAnna Fischel, Alison Sturgeon, Suhel Ahmed, Hannah Bowen, Joanna Edwards, Alex Beeden Natalie Clay, Stephen Bere, Phil Gamble, Vanessa Hamilton, Jemma WestingStephanie Farrow, Gareth JonesBusiness ownership12Sole proprietorships and partnerships Corporations Private and public companies Multinationals Franchises Not-for-proﬁt14 16 18 20 22 24Sophia MTTStart-ups26Ben Marcus, Nikoleta ParasakiStart-ups from concept to launch Types of start-up Business plans Raising money Business accelerators and incubators28 30 32 34 38Buying and selling business40Mergers and acquisitions Divestitures Vertical vs. horizontal integration Management buy-ins and buy-outs42 44 46 48Who’s who50Board of directors Company hierarchy Stakeholders Business cultures52 56 60 64PublisherLiz WheelerDeputy art directorKaren SelfPublishing directorJonathan MetcalfJacket assistant Jacket design manager Pre-production producers Producer10Christine Heilman Lee GrifﬁthsSenior jacket designerHOW COMPANIES WORKMargaret ParrishSenior managing art editorArt directorIntroductionPhil Ormerod Mark Cavanagh Claire GellChristine NiFirst American edition 2015 Published in the United States by DK Publishing, 345 Hudson Street New York, New York 10014 A Penguin Random House Company 15 16 17 18 19 10 9 8 7 6 5 4 3 2 1 001—196402—Mar/2015 Copyright © 2015 Dorling Kindersley Limited All rights reserved. Without limiting the rights under copyright reserved above, no part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form, or by any means (electronic, mechanical, photocopying, recording, or otherwise), without the prior written permission of both the copyright owner and the above publisher of this book. Published in Great Britain by Dorling Kindersley Limited A catalog record for this book is available from the Library of Congress. ISBN: 978-1-4654-2979-7 DK books are available at special discounts when purchased in bulk for sales promotions, premiums, fund-raising, or educational use. For details, contact: DK Publishing Special Markets, 345 Hudson Street, New York, New York 10014 or [email protected] Printed in ChinaA WORLD OF IDEAS: SEE ALL THERE IS TO KNOW www.dk.comHOW FINANCE WORKS98Financial reporting100The accounting cycle Financial statements102 104Financial accounting110 112 114 116 120 122 124 128Corporate structure66Functional structure Divisional structure Matrix structure Network structure Team-based structure68 70 72 74 76International accounting standards Proﬁt-and-loss statement Balance sheet Cash-ﬂow statement Environmental accounting Depreciation Amortization and depletionHuman resources78Management accounting130The human resources cycle Recruitment and selection Evaluating staff Motivation and rewards Leadership strategy and styles Leadership for team building Employee relations and communications Project management Negotiating strategy80 82 84 86 88 90Cash ﬂow Budgets Assets and inventory Costs Product costing and pricing132 136 138 140 142Measuring performance144Key performance indicators (KPIs) Financial ratios Forecasting Tracking fraud146 148 150 152Raising ﬁnancing154Internal ﬁnancing External ﬁnancing Going public Shares and dividends The capital market Gearing ratio and ﬁnancial risk156 158 160 164 170 17492 94 96HOW SALES AND MARKETING WORKS176Marketing mix178Inbound marketing220Product Product positioning Product life cycle Price Place Promotion Market research Market segmentation180 182 184 186 188 190 192 194Outbound vs. inbound marketing Blogging Social media marketing Search engine optimization (SEO)222 224 228 230Business development232Marketing approaches196234 236 238 240Niche vs. mass marketing Traditional marketing Digital marketing Engagement marketing Sensory marketing Relationship marketing198 200 202 204 206 208Branding and rebranding Lead generation Lead conversion Customer retention Return on marketing investment (ROMI) Intellectual capital242 244Information management246Outbound marketing210Traditional ofﬂine advertising Online advertising Direct mail Telemarketing212 214 216 218Business intelligence Business analytics Marketing and IT Collecting consumer data Data warehousing Customer proﬁling Big data Customer relationship management (CRM) Compliance248 250 252 254 256 258 262 264 266HOW OPERATIONS AND PRODUCTION WORK268Resources Index Acknowledgments336 344 351Manufacturing and production 270 Job production Batch production Flow production Mass customization Continuous production Hybrid processes272 274 276 278 280 282Management284Economies and diseconomies of scale Lean production Just-in-time Total quality management Time-based management Agile production Kaizen286 288 290 292 294 296 298Product300New product development Innovation and invention Design Quality management Product-process matrix302 304 306 308 310Control312Managing capacity Inventory Quality control Six Sigma314 316 318 320Supply chain322Value chain Outsourcing Offshoring Reverse supply chain Benchmarking Corporate social responsibility324 326 328 330 332 334Contributors Dr. Julian Sims (consultant editor) entered academia after a successful career in industry in the US and UK. He is a lecturer in the Department of Management at Birkbeck, University of London, UK; a Chartered Accountant (CPA Aus); and a Chartered Information Technology Practitioner (CITP). His work is widely published in academic journals. Philippa Anderson is a business writer and communications consultant, who has advised multinationals including 3M, Anglo American, and Coca-Cola. She collaborated with Lord Browne, former CEO of BP, on his memoir, Beyond Business, and was a contributor to DK´s The Business Book. Alexandra Black studied business communications before writing for ﬁnancial newspaper group Nikkei Inc. in Japan. While in Tokyo, she was an editor at the Risk Analysis division of investment bank JP Morgan. Now based in Cambridge, UK, she covers subjects as varied as business, technology, and fashion. She was a contributor to DK’s The Business Book. Joe Stanley-Smith is a reporter at the International Tax Review in London, UK, where he specializes in indirect tax and tax disputes. He graduated in journalism with a business specialty from Kingston University, UK, and has previously worked in social media and local news. Paul McDougall (US/Canada writer) is Deputy Technology Editor for the International Business Times. He has written for Scientiﬁc American, InformationWeek, SHAPE magazine, and others. A native of Toronto, Canada, he currently resides in New York City.$ $HOW BUSINESS WORKS Introduction8 9Introduction The term “business” refers to an organization or commercial enterprise engaged in producing and trading goods and services for money. We can trace the origins of business to the very foundations of human society. When Homo sapiens evolved, mankind left behind the nomadic hunter-gatherer lifestyle to become farmers. This allowed for specialization of work, where individuals would become skilled at speciﬁc tasks to serve a particular community need. Over time, this enabled more complex goods and services to be produced and traded, in order to provide for all members of society. Thus, human society has been engaging in “business” for thousands of years. Today the world of business is inescapable—businesses are no longer just local providers of goods and services, but extend to vast corporate enterprises operating on a global scale. For governments to function and economies to ﬂourish, a successful and thriving business sector is essential. Whether businesses are small or large, public or private, for-proﬁt or nonproﬁt, they each play a key role in supporting the global economy, and together they form the backbone of the modern world. Business underpins every aspect of the world we live in today, and understanding how it works is the key to understanding society. This book explains the complex world of business in a simple and graphic way. It examines every aspect of how a business works, including forming a company, raising capital, product development and marketing, management strategies, tracking revenue, ﬁnancial reporting, and legal, social, and environmental responsibilities. Through visual explanations as well as real-life examples to make even the most complex concept immediately accessible, How Business Works offers a clear understanding of what business is all about and how business, in its many forms, shapes modern society.HOW COMPANIES WORK Business ownership ❯ Start-ups Buying and selling business ❯ Who’s who Corporate structure ❯ Human resourcesBusiness ownership Every type of business has to choose an ownership structure. Although there are variations globally, most countries offer similar types of legal entities, from a singleperson private enterprise to a massive organization trading on a stock exchange. There are three key considerations: how big the venture is expected to grow; the complexity of ﬁnancial recording, management, and reporting that the proprietor is willing to take on; and the amount of liability the owner is willing to accept.Public companies Private companies Small and simple ❯ A sole proprietorship or partnership is simple to set up and requires little capital. ❯ One or more owners conduct business as a legal entity. ❯ Owners are personally liable for business debts. See pp.14–15.❯ More complex to set up and run, a private company is a legal entity separate from its owner or owners. ❯ The company structure means the owners are not usually personally liable for business debts. ❯ Private companies are owned by shareholders, who are often the company’s managers. See pp.16–19.❯ Companies that go public are large businesses, and they have many legal and ﬁnancial reporting obligations. ❯ The general public and other institutions can buy shares in public companies. ❯ The public company structure is good for a major capital injection, allowing the business to expand. See pp.16–19.HOW COMPANIES WORK Business ownership7%12 13NAMING A COMPANYof global economic activity is accounted for by the world’s 100 largest companiesDoDon’t❯ Use a domain suggestion tool to search for available internet domain names and work back from there. ❯ Be descriptive so potential customers instantly grasp the nature of the business. ❯ Say the name out loud—it may come across differently from the written word. The goal is that people can search and ﬁnd it, especially online, just from hearing it. ❯ Keep it short and simple and avoid puns.❯ Include your name—if the venture fails, your name will be associated with it. ❯ Ape competition, because if your name is unique, you have a better chance of topping search-engine results. If your name is similar to that of competitors, customers can’t distinguish. ❯ Spend time thinking of a name until your product and brand is ﬁnalized. Get the product right ﬁrst and the name will follow naturally.Multinationals ❯ For both growth and ﬂexibility, multinationals have operations in various countries. ❯ Multinationals can save money by setting up operations in countries where costs are cheaper. ❯ Foreign branches can adapt to the local market and also ﬁnd new markets. See pp.20–21.Franchises ❯ In this model, a business (the franchisor) authorizes a franchisee to set up a branch under its name, in return for a fee. ❯ The franchisor needs less capital than it otherwise would to develop a business. ❯ The franchisee takes on a known, successful business model and name, so minimizing risk. See pp.22–23.Nonproﬁt sector ❯ Common nonproﬁt organizations include charities and trade associations. ❯ Their organizational structure is similar to that of a company. ❯ They may generate substantial sums of money, but plow it back into beneﬁcial causes rather than distributing proﬁts. See pp.24–25.Sole proprietorships and partnerships The simplest business structures are those formed by one person as a sole proprietor, or by two or more people as a partnership, for commercial activity. Many cost little to set up and some are easy to run. How it works Many businesses start out as the most basic unit—either a sole proprietor or a partnership. A sole proprietor is an individual who is the only owner of the business. This structure is easy to set up and there are no extra taxes to pay, unlike with a company. Instead, the sole proprietor ﬁles a personal tax return. There is risk attached, though. A sole proprietor has unlimited liability, so if the business fails, the owner must personally pay debts. Partnerships have more than one owner, and each can be held liable for the whole debt of the business in case of failure.Pros and cons Both sole proprietorships and partnership structures are excellent for anyone starting out or running a small business—as long as the business stays out of debt: owners are personally liable for business debts.NEED TO KNOWUnlimited liability: business debts paid personallyTax-efﬁcient way to be self-employedWorking alone requires only simple administration and relatively few start-up costs.Simple registration processLittle capital neededEasy to move from sole proprietor to company statusSchedule C ﬁled with IRS Form 1040Sole proprietorship❯ Firm Collective term for individuals in a partnership ❯ Limited liability partnership (LLP) Partners not personally accountable for business debtsTrade under own name or chosen business nameKeep all business proﬁts after paying tax on themHOW COMPANIES WORK Business ownershipFROM INDIVIDUAL TO MULTINATIONAL Sole proprietorships and partnerships may grow into global names. ❯ Richard Branson Sole proprietorship that expanded into Virgin empire ❯ Steve Jobs and Steve Wozniak Partnership that created Apple brand ❯ Bill Hewlett and David Packard Partners who founded HP technology ❯ John D. Rockefeller, William Rockefeller, Henry Flagler, Jabez A. Bostwick, Samuel Andrews, Stephen Harkness Partnership that grew into Standard Oil corporation66%of EU private sector jobs are in small or mediumsize enterprisesWHEN TO MO COMPANY STVE TO ATUSIf the need fo r ca increases (and pital potential debts grow), forming a company m ay be beneﬁcial. Se e pp.16–17.Proﬁt and control of the business sharedAllows for specialization by each partner If partner leaves, new partnership neededEach partner pays tax on own portion of proﬁtLike sole proprietors, partners ﬁle only personal tax returns and are liable for business debts.Option to set up a limited liability partnership$ $Furnish Schedule K-1 (IRS Form 1065) to partnersPartnership14 15More partners mean more capital and expansionNew partners bring new business skillsCorporations A corporation is a business entity considered distinct from its employees and shareholders. The primary purpose of forming a corporation is for shareholders to avoid personal liability. How it works A corporate structure protects management and workers in the case of litigation or other claims. It is, however, a more complex structure and subject to greater regulation than the simpler business entities of sole proprietorships and partnerships. A corporation is owned by one or more stockholders, and is managed by a board of directors and run by the company’s ofﬁcers, who are appointed by the board of directors. The company retains any proﬁt made and maydistribute it to the stockholders in the form of dividends. Corporate and securities laws regulate the sale of shares. Legally, the stockholders cannot be held liable for the company’s actions and debts.Types of incorporation Anyone who operates a business may incorporate by registering articles of incorporation. General incorporation (C Corporation) is the most common structure. An S Corporation, created through IRS tax election, provides limited liability; it is favored by small businesses because it combines the advantages of sole proprietorship, partnership, and the corporate forms of business structure. Nonproﬁts can also incorporate.Publicly traded company A publicly traded company is usually a large business—such as a technology company— with stock traded on a stock exchange, such as NASDAQ.NEED TO KNOW ❯ Stockholder An individual, group, or organization that owns shares in a company ❯ Doing business as (DBA) Operational rather than company name ❯ Professional corporation (PC) Corporate form used for primarily for doctors, lawyers, and similar professional service providersPublic characteristics ❯ Issues securities through an Initial Public Offering (IPO) ❯ Can sell future equity stakes ❯ Has greater access to ﬁnancing ❯ Must meet reporting requirements set out by Securities and Exchange Commission (SEC) ❯ Reduced control for initial ownersHOW COMPANIES WORK Business ownership16 17LIMITED LIABILITY COMPANIES IN THE USCorporation Corporations operate as legally and ﬁnancially independent entities. They may be publicly traded or privately held.A limited liability company (LLC) is a hybrid between a corporation and a partnership. The upside of an LLC is that it offers many of the advantages of a corporation, but is cheaper to create and maintain. Taxation rules vary, depending on the Articles of Organization of the LLC. Laws also differ from state to state. A limited liability company is an “LLC,” not an “Inc.” or “Corp.”CANADIAN COMPANIESPrivately held company56.5%of UK limited companies have employees; the remaining 43.5% are single-member companies (SMCs)In a privately held company, a limited group of private stock owners controls the company. These companies do not offer shares to the general public on stock exchanges.Businesses in Canada can be sole proprietorships, partnerships, or corporations. A business can also be run as a cooperative, a business that is owned and controlled by its members. Canadian companies must register in the province or territory in which they are domiciled.Private characteristics ❯ May issue stock and have shareholders. Shares, however, do not trade on public exchanges ❯ Management is not required to ﬁle disclosure statements with the SEC ❯ Dependant on private fundingPrivate and public companies While the owner-shareholders of a private company may buy and sell their shares privately (usually with director approval), any investor in the ﬁnancial market can trade the shares of a public company. How it works Although most of the world’s companies are set up as private, public companies are seen as more prestigious and proﬁtable. For business ventures requiring large amounts of capital, a public company offers greater opportunity for raising funds, since shares can be sold to public investors to generate cash. Private companies must rely on private investors or use the capital investment of their owners. Public companies are subject to more stringent legal controls than private ones, and are expected to disclose ﬁnancial details.27 million the number of companies in the US, fewer than 1% of which are publicDifferences between private and public companies Private company directors have to weigh up the potential capital increase of ﬂoating on the stock exchange against the legal red tape aimed at protecting public shareholders.Private Directors Usually control all of the shares.Reporting In the US, no disclosure is required outside the company; in the UK, it is mandatory to ﬁle accounts at Companies House.Shareholders and managementFAMOUS PRIVATE COMPANIESShareholders are often actively involved in management so decisions can be made quickly.❯ Mars Confectionery and pet food; third-largest private US company ❯ Rolex Swiss-based English company making status-symbol watches ❯ LEGO® Danish company producing household-name toy bricks ❯ Hearst Corporation Mass-media multinational based in New York City ❯ IKEA Swedish retailer registered in Netherlands selling ﬂat-pack furniture ❯ PwC Largest professional services networkFinancing Company must rely on private investment, which is often harder to attract because there are fewer ﬁnancial details available.Valuation Value of the company is more likely to ﬂuctuate; it is more difﬁcult to assess because there are fewer available ﬁnancial details.Size Number of shareholders is limited, usually to fewer than 2,000.HOW COMPANIES WORK Business ownership$55 billionthe amount raised on 141 IPOs at the NYSE in 201318 19GOING PUBLIC There are legal requirements at each stage of converting a company from private to public, such as voting in a board of directors and deciding on a new name.Choose board members Usually at least three directors to allow future board decisions to be made with only two members present (representing a majority)Inform staffPublicMust notify in writing anyone with an interest (including employees and proposed board members) that company intends to go publicVote for conversion Board meeting held to vote in favor of changing company’s Articles of Incorporation (specifying private or public company)Directors Not necessarily shareholders.Reporting Companies have a legal obligation to disclose accounts and submit regular ﬁnancial reports.Shareholders and management Clear boundary is drawn between the role of shareholders and management; may lead to a conﬂict of interest.Register company Documents setting out board resolutions sent to Secretary of State, who issues certiﬁcate declaring the company is publicMake public announcement Press releases issued, events for business held, and emails sent to inform contacts of changeFinancing Can tap ﬁnancial markets to raise capital by selling stock or bonds.Valuation Value of the company is easier to assess, from the trading price of shares and ﬁnancial statements.Size Number of shareholders is unlimited.NEED TO KNOW ❯ Unquoted/unlisted company Another term for a private company ❯ Initial public offering (IPO) Stock-market launch ❯ Secondary stock offering Second-round sale of shares to raise more capital ❯ Ticker symbols Unique code assigned to publicly traded companies and used by stock exchangesMultinationals A multinational corporation has business operations in more than one country. It usually starts as a national company and sets up subsidiary (branch) companies abroad for production and sales. How it works Multinationals have several goals: to increase revenue by ﬁnding new markets; to streamline operations and production by taking advantage of global locations with lower labor and/or transport costs; and to adaptto local cultural/market differences. A company may achieve such goals by outsourcing (using external suppliers) or offshoring (relocating functions). Companies may also insource (move operations in-house) to rightsource (ﬁnd a good balance).Case study: mapping a multinational Sportswear company Nike has successfully spread around the globe from its corporate base in the US. It has manufacturing functions where technical expertise maximizes efﬁciency and keeps costs down; distribution hubs in strategic locations; marketing and retail departments in countries where it is establishing local markets; and call centers where they are cost-effective.United Kingdom London One of many country HQs in major European cities, the London ofﬁce serves the UK market. Nike also has a product creation center in Italy. Regional HQ Management and core admin functions Marketing UK campaigns and merchandisingUnited States Beaverton, OregonGLOBAL VS. MULTINATIONAL A global company has facilities in different countries but operates as a single corporate culture with common processes. A multinational has facilities in different countries but each functions as its own entity, adapting locally, with little communication between geographic divisions.Senior management are located at the company’s corporate base, or “campus”, its center for decisionmaking on global strategy, design, and marketing, and core functions.Global hellohola!Apple is an example of a global company—the product is essentially the same except for a language change.World HQ Management, ﬁnance, legal, IT, and admin Global marketing Branding and marketing R and D Sport research lab and design facilitiesMultinational McDonald’s is a multinational—the product changes to suit the market. For example, it serves a shrimp burger in Japan and chicken rice porridge in Malaysia.Retail Online sales and stores across North AmericaMemphis, Tennessee Distribution Hi-tech hub in location with good linksHOW COMPANIES WORK Business ownershipThe Netherlands20 21NEED TO KNOWHilversum Based in a central location, a European headquarters supports operations across Western, Central, and Eastern Europe, and is close to the company’s European distribution center in Belgium.❯ Transnational corporation Similar to a multinational but does not identify itself with any particular parent nation❯ Platform corporation Multinationals that do not manufacture, but outsource products they have designedEuropean HQ Management, ﬁnance, legal, IT, and adminChinaDesign HQ for global soccer apparel businessThe company’s second-largest and fastest-growing market, China is also a major manufacturing base due to local expertise and low production costs.Retail Online sales and stores across EuropeShanghaiChinese HQ Operations and core support functionsManufacturing Sportswear factories and innovation hubsMarketing Campaigns for the Chinese marketRetail Continually expanding retail network for sports brandJapan Tokyo Most manufacturing is based in the Asia-Paciﬁc region, beneﬁting from expertise and lower wages. Regional ofﬁces in 13 countries also support production and retail.Regional HQ Core operations and marketing Manufacturing Sites in several countriesBrazilIndiaSão PauloBangaloreOperations, marketing, and distribution for the Central and South American market are based in Brazil, with ofﬁces and retail outlets in all major countries.Call centers draw on a supply of English-speakers on lower wages.Central and South American HQ Operational centerDistribution Hub for retail stores across the continentCustomer support Complaints and returnsFranchises The franchise is a business model in which an independent entity—the franchisee—is entitled to set up a branch of an established brand. There are advantages for both parties. How it works Rather than developing an original business idea, the franchisee pays for the right to represent an existing, successful brand in a particular location. The size of a franchise can vary from a single unit—one outlet only— to an area development in which the franchisee takes on the option to represent the brand through several branches in a city or region. The franchisor candevelop the business with modest capital outlay while the franchisee takes on a proven business model and brand name, so everyone reaps the beneﬁts.NEED TO KNOW“I put the hamburger on the assembly line.”❯ Franchise disclosure documents (FDD) Preagreement information ❯ Microfranchising Support and training for small-scale businesses in the developing world ❯ International Franchise Association (IFA) The oldest and largest franchise organizationRay Kroc, founder of McDonald’sThree types of franchise The franchisor’s level of control varies from managing the contracts for the entire supply chain to input on every detail down to the last French fry. In a product franchise, the franchisor lends its trademark and brand but not an entire business system.Manufacturing franchiseProduct franchise This is a supplier-dealer relationship in which the franchisee sells the franchisor’s products. Examples include cars, gasoline, and tires.A company that manufactures a speciﬁc range of products grants retailers the right to distribute its products and use its brand name and trademark. For example, a soft-drink makers sell syrups to the franchisee, who then bottles the drink.HOW COMPANIES WORK Business ownershipTOP 1022 23CASE STUDYFastest-growing franchises worldwideBusiness-format franchise: fast-food outlets1. Subway fast-food sandwich outlets 2. McDonald’s fast-food outlets 3. KFC fast-food outlets 4. Burger King fast-food outlets 5. 7-Eleven convenience stores 6. Pizza Hut restaurants 7. GNC health and beauty products 8. Wyndham Hotel Group hotels 9. Dunkin’ Donuts bakery/coffee shops 10. Dia grocery storesThe business-format franchise, in which a franchisee takes on a whole blueprint for running a business as well as the product itself, was pioneered in the US in the late 1940s. Fast-food outlets were a new concept at the time and were generating great demand. To increase the rate of expansion, these original fast-food entrepreneurs developed a franchise system under which the franchisee was contractually obliged to run the outlet according to strict guidelines.A limited and uniform menu was the key to the success of these franchises. The consistency of the menu, service, and surroundings helped to establish a strong brand identity, since customers were assured that the product and experience would be the same anywhere in the country. McDonald’s is the most successful example, collecting an estimated 11.5 percent royalty fee from its 31,000 franchises worldwide.Business-format franchiseThe most common type, this has high input from the franchisor including brand name and trademark, training, store identity, marketing plan, and company culture. The franchisee buys supplies from the franchisor and pays fees and royalties. Fast-food outlets are typical business-format franchises.Not-for-profit Some organizations are run not for the beneﬁt of shareholders, but for the beneﬁt of their members or an external community or charity. Unlike conventional businesses, proﬁt is not the goal. How it works Organizations that do not intend to generate proﬁt for their shareholders, are self-governing, and committed to a common cause come under the broad umbrella of not-primarily-for proﬁt, not-for-proﬁt, and nonproﬁt entities. On this spectrum, cooperatives may disburse proﬁts to members, but charities are strictly nonproﬁt. Although their goals differ, not-for-proﬁts have a similar type of company status and structure to businesses.The not-for-proﬁt universe There are many forms of not-for-proﬁt organization (NPO). Joel L. Fleishman, Professor of Public Policy and Law at Duke University, has characterized the not-for-proﬁt sector as a universe that embraces all NPOs, whatever their mission.Private foundation Similar to a charity but funded by one source, not the public; generates revenue from investments; makes grants to other charitable bodies9.2%of all wages and salaries paid in the US come from the not-for-proﬁt sectorCooperative Owned by members; can beneﬁt from proﬁt; clear ethos of pursuing common economic, social, or cultural goals; one member, one voteFraternal organization Based on common interests or beliefs such as social or academic interest or a benevolent cause; Freemasons and college fraternities are both examplesTHRIVING SECTOR Despite being NPOs, many cooperatives and mutuals have a sizable annual turnover (gross revenue transacted). ❯ Japan Zen Noh cooperative: $53 billion ❯ France Crédit Agricole Group of cooperatives and mutuals: $32 billion❯ US Nationwide Mutual Assurance: $23 billion ❯ Germany Edeka Zentrale AG cooperative: $16 billion ❯ UK Co-operative Group: $16 billion ❯ Spain Mondragon cooperative: $14 billionHOW COMPANIES WORK Business ownershipNOT-FOR-PROFIT STRUCTURENEED TO KNOW ❯ Philanthropic sector Alternative umbrella term for the not-for-proﬁt sector or universe ❯ 501(c) corporation An IRSrecognized nonproﬁt; one of several types of nonproﬁts, organized for purposes speciﬁcally designated in the Internal Revenue Code24 25❯ Associated charity An organization related to a main charity that takes on a particular aspect of the charity’s work ❯ Payouts 5 percent of assets that private foundations must pay out each year; no such requirements exist for public charitiesNongovernmental organization (NGO) Funded by government or by international donor agencies such as the World Health Organization (WHO); operate independentlyChairman coordinates work of the directors.Board of directors are usually unpaid; may also be called the board of trustees. Committees formed by board members carry out speciﬁc tasks such as fundraising. Administration staff often include a proportion of voluntary workers.Mutual Raises funds from members (usually customers); often takes the form of ﬁnancial institutions; proﬁts reinvested in the mutual or to sustain or grow the organization Chamber of commerce Chambers from various regions gather to promote trade, investment, and cooperation; usually funded by subscriptions from local businessesSocial enterprise May sell goods or services to fund community projects; any surplus revenue reinvested in the enterprise for the communityCharity Must be registered as a charity; tax exempt; all resources must be devoted to the charity’s stated charitable activities; may be organized as a trust, corporation, or associationStart-ups A start-up is a new business in the early stages of development and operation, during which an entrepreneur or founding group comes up with an idea for a product or service, researches it, develops a business plan, raises funds, and launches with the goal of rapid growth. Registering intellectual property (IP)—a unique creation, not just an idea—to protect it is an important stage of the start-up process. Protection includes trademarks, patents, and copyright.The early days Before a company is fully developed, with a working business model, it is known as a start-up. The start-up evolves from an entrepreneur, or group of entrepreneurs, with an idea or invention. It can take a few years to turn the initial concept or prototype into a viable, proﬁtable venture, so the start-up founder tries to attract support and ﬁnancial backing to achieve rapid growth. During this phase, which can take anything from a few months to several years, the business changes quickly.NEED TO KNOW ❯ Internal start-ups Start-ups that originate from inside a large organization ❯ Patent trolls Companies or individuals who buy up the patents of failed start-ups and attempt to collect licensing fees from potential infringers of the patent476,000new businesses are started every month in the USINTELLECTUAL PROPERTY (IP) VALUE The term ”start-up” became commonplace during the dot.com boom of the late 1990s, when thousands of entrepreneurs with web-based products and services found funding, many on the strength of their intellectual property alone. Giants Google and Amazon both started up at that time. Since then, technology businesses have become one of the most talked-about start-up types. Their value is often based 100 percent on intellectual property.™ ® ©HOW COMPANIES WORK Start-ups26 27big idea The Consider the IP ❯ Register IP ❯ Find a name ❯ Buy a domain ❯ Research marketChoose a start-up type? ❯ With a social conscience? ❯ Primed to grow big? ❯ To ﬁt lifestyle?Launch ❯ Win? Lose? ❯ Research indicates that, in most Western countries, 80–90 percent of start-ups fail.Prepare to launch ❯ Plan a marketing campaign ❯ Run a test launch and reﬁne message and offerSee pp.196–197.See pp.30–31.Make a business plan ❯ Explain how the business will make money ❯ Describe the unique aspects of the business ❯ Set out how much money the business will need and how much it will makeFind funding ❯ Invest savings ❯ Ask friends and family ❯ Take out a bank loan ❯ Seek venture capital ❯ Try crowdfundingSee pp.34–37.See pp.32–33.Seek help ❯ Join a business accelerator❯ Enter a business incubator ❯ Go it alone ❯ Find an investorSee pp.38–39.40%the sales growth achieved by online start-ups in France, in 2011–2012Start-ups from concept to launch A new business can be described as a start-up in the early phases of its launch, when an entrepreneur comes up with the idea for a product or service, and develops the concept into something that will sell. How it works The idea is just the start. Next comes the process of expanding the concept into a viable business. Specialized help may be needed in some areas—hiring a website and logo designer, for example, and an accountant to advise on the best structure and ﬁnancial setup. What the business and product or service are called can make orbreak the start-up, so it is worth spending some time doing online research to make sure no one else is using an intended name, especially in a negative context. Location is another consideration with signiﬁcant cost implications. It may be possible to create a virtual ofﬁce and work from home. Finding premises is an extra stage, but the goal at start-up is to keep costs low.Come up with a good ideaSTARTDevelop a product, or an idea for a product.Set up an online presenceNEED TO KNOW ❯ Lean start-up Method of learning fast and discarding what does not work to keep start-up costs down ❯ Start-up pivot Quickly changing direction or correcting mistakes based on customer feedback or technology changesRegister IP For an invention or innovation, register your intellectual property (IP).Decide on a name Check to determine whether your proposed name is available; check that the domain name is available; search online for competitors with similar names.Register the domain name and set up web hosting.Create a lookMake a websiteDesign a logo and visual identity for the business.Build a website. Research search engine optimization (SEO) words to use on it (see pp.230–231).HOW COMPANIES WORK Start-ups75%START-UP STRUCTURE BusinessProsConsSole proprietorshipLow cost, easy to set up, minimum of ﬁnancial reportingMay be seen to lack credibility; challenge to raise capitalPartnershipMore input, more potential to raise fundingHarder to dissolve in case of failure; partners liable for debtsLimited companyLow risk of personal liability; tax beneﬁts; dividends can supplement wagesMore ﬁnancial reporting necessary; more paperworkLimited liability partnershipPersonal liability of partners is limited to the amount they invest in the businessMust ﬁle annual accounts; can be dissolved once a partner leavesDecide structureStudy your proposed target market and potential competitors, and evaluate the viability of the idea.Choose a business structure that suits your initial needs, but also allows ﬂexibility for growth.Devise a plan Draw up a plan (see pp.32–33), including your goals, mission statement, and key ﬁnancial information.Consider a business incubator if the business requires large-scale support.of all US start-ups failed between 2004 and 2010Research marketObtain backing funds28 29Set up ﬁnancesStart marketingInclude an accounting and cash-ﬂow system, sales tax if applicable, and bank account.Plan a marketing campaign. Run a test and make any reﬁnements to the message or strategy.LAUNCHTypes of start-up Entrepreneurs go into businesses for many reasons. Some start-up decisions are based on personal ethos and conviction, while others are founded ﬁrmly on the desire to make money. How it works Not all start-ups ﬁt the same mold. Although they often follow a similar process in their initial evolution, they are as varied in type as the personalities behind them. Startups can broadly be divided intothose that are aimed from the outset to be large ventures within a corporate environment, and those intended to work on a more personal scale to suit the lives and passions of individuals.Lifestyle Motivation Working is a passionNEED TO KNOW ❯ Enterprise portal Dedicated website providing content for staff, usually intended for larger companies ❯ Micropreneur Entrepreneur who keeps their business small so they can control and manage it alone ❯ Burn rate How fast the start-up’s initial cash balance is going down, month by monthcial start-ups o S Motivation Making a difference Example Ex-athlete starts ﬁtness coaching business173%the projected revenue increase over three years for mobile gaming start-upsType of funding Self, friends, peers, bank loanExample Malaria blood-test kit for smartphoneType of funding Community, charity, government, donationHOW COMPANIES WORK Start-upsi iatInitall business SmInnovatingon at i orven a large c or p Motivationt hi wi0101010011 0100010101le startup alab c S Motivation Readiness to growExample PC manufacturer starts a separate business providing cloud data storageExample Phone app developerType of funding Internal company fundingType of funding Crowdfunding, angel fundingMotivation Feeding the familyon uisiti target q s Ac Motivation Example Small-town grocery store30 31Intent to sell the business on from the beginningType of funding Self, family, bank loan Example Biotech laboratoryType of funding Outside investmentBusiness plans Writing a business plan is one of the most important steps in developing a start-up. The plan sets out the new business’s goals, market analysis, and projected income and proﬁt. How it works Before a start-up entrepreneur can write a business plan, they need to have done enough research to identify a clear opportunity in the market for the product or service, and to deﬁne how the proposedKey elements Preparing a business plan can take several weeks, and it is worth doing thoroughly. It is a vital document for securing funding, so the ﬁnancial forecast must be both realistic and accurate. If showing it to others, pare the executive summary down to two pages, write it in plain English, and explain any technical terms.Start-ups in the US are2.5xmore likely to go into business if they have a written plannew business will be uniquely positioned to capture that market, given the services or products offered. An outline of existing ﬁnances and an accurate projection of sales and proﬁt are essential components, especially if seeking external funding.Executive summary Fill in this section last, bearing in mind that it may be the only part a busy person reads: ❯ Business summary Company structure, name, product or service, and customer proﬁle ❯ Business goals Three objectives over one, three, and ﬁve years ❯ Financial summary Expected sales and costs, and funding ❯ Elevator pitch Two-minute talk to sell your idea to a customerProducts and servicesBusiness background Provide details of each person in the business: ❯ Experience Relevant work carried out to date ❯ Qualiﬁcations Credentials, such as diploma in horticulture for a gardening service ❯ Training Past and future, including business skills such as assertivenessThe marketDescribe what the business is going to sell: ❯ Product or service With a picture if product is new ❯ Range If more than one, such as garden design and maintenance ❯ How it is different What makes the product or service stand out from the crowd?Set out speciﬁc details of your potential market: ❯ Typical customer Businesses or individuals and their proﬁle; local, national, or international ❯ Market research What the local market is for similar products or servicesMarketing strategy Choose about three of these methods: ❯ Word of mouth ❯ Advertising❯ Business literature ❯ Direct marketing ❯ Social media ❯ WebsiteHOW COMPANIES WORK Start-upsTOP FIVE REASONS TO WRITE A PLAN ❯ The process Working through each element ensures nothing is forgotten. ❯ Costing The only way to ﬁnd out whether the business is viable is to work out details of costs and sales. ❯ Funding A good business plan improves chances of getting a loan.NEED TO KNOW❯ Areas of expertise Making a business plan clariﬁes where outside help is needed—for instance, in bookkeeping or marketing. ❯ Getting to know the competition Conducting market research is the best way to give a business an edge.Competitor analysis Show how the business idea compares with the competition: ❯ Table of competitors Who and where they are, what they sell and for how much, how good they are ❯ SWOT analysis Including how to remedy any weaknesses and combat known threats, such as a garden center opening nearby ❯ USP Unique selling point of the product or service See Need to Know box, above.Costs and pricing strategy Work out how much the product or service costs and its sale price: ❯ Cost How much each unit or batch costs to make and deliver ❯ Price How much each unit or batch will sell for ❯ Proﬁt margin The difference between cost and price per unit❯ SWOT analysis Stands for Strengths, Weaknesses, Opportunities, and Threats ❯ Unique selling point (USP) The feature that makes a product different from the competitionOperations and logistics Describe from start to ﬁnish how the business will run day to day: ❯ Supply and delivery How the goods or service will get from A to B ❯ Equipment Details of transportation, ofﬁce items, and premises ❯ Payment, legal, and insurance How customers will pay and how that translates into salaries; compliance with the lawFinancial forecasts Predict sales and costs over the year, allowing for seasonal ﬂuctuation, such as spring demand for lawn services: ❯ Sales calculations For each month, the expected number of sales ❯ Costs calculations The costs of the predicted sales each month ❯ Cash-ﬂow forecast The money coming in and out of the business See How Finance Works, pp.98–175.Back-up plan Make a Plan B in case something goes unexpectedly wrong: ❯ Short-term changes Cutting costs or boosting sales immediately32 33❯ Longer-term changes Shifts such as working online, not on premises ❯ Closure Lessons learned and skills acquired if the business closesRaising money Almost every new enterprise needs funding to get it going, and to keep aﬂoat until it turns a proﬁt. Financial help is at hand from a variety of sources, suitable at different stages of start-up growth. How it works Capital for new enterprises comes from two main sources: lenders and investors. Lenders, such as banks, provide debt capital in the form of a loan that is returned with interest. Investors, such as business angels and venturecapitalists (VCs), provide equity capital in the form of a share in the business that may include a proportionate share of control and rewards. Both types of funding can be corporate—from a company—or more quirky and alternative, such as crowdfunding.LendersTypes of start-up fundingDebt capital most often takes the form of loans paid back with interest.Corporate, traditional, and substantial funding comes largely from banks and VCs, while smaller sums come from more personal sources.Term loan Paid back regularly over a set period of timeBank overdraft or credit card Interest charged monthly if balance not paid in fullFactoring/invoice discounting Unpaid invoices sold at a discount to a company that collects them for commission❯ Bank Offers either personal or business loans ❯ Government Offers low-interest start-up loans ❯ Credit union Cooperative that gives members low-interest loans ❯ Peer-to-peer (P2P) lending Unsecured personal loans ❯ Friends and family May give interest-free loans❯ Bank or credit company Financial organization that makes loans to commercial ventures❯ Factors and discounters Companies that offer advance on unpaid invoices, for a proﬁtNEED TO KNOW$ $❯ P2P lending Loans made between individuals over internet ❯ Crowdfunding Debt or equity raised via internet platformsp fund u rtg inStaHOW COMPANIES WORK Start-ups5–10% of small and medium-sized enterprises in the UK need no start-up fundingInvestorsGrantsEquity capital is paid to the start-up in return for a share of the business.Financial awards and prizes are provided by public bodies.Founders, friends, family (FFF) May buy shares in the company rather than lending moneyCrowdfunding Large number of supporters, each contributing a small amount of money, usually onlineBusiness angels Investors who give favorable terms because their focus is on the company’s success rather than proﬁtVenture capitalists (VCs) Companies that provide capital for new businesses in the hope of making a proﬁt34 35Local, national, global Funded by a local authority, government initiative, or international charitySUPER ANGELS ❯ What they are Serious investors in technology start-ups. Facebook was funded by super angels, some of whom are now famous in their own right. ❯ Who they are Former Silicon Valley professionals who invest their personal money in new ventures. ❯ How they differ from ordinary angels and venture capitalists (VCs) Funding level straddles the two, often reaching millions of dollars as what started out as a hobby becomes a profession. ❯ Pros and cons Super-angel investing acts like a magnet to other investors, but individual super angels can rarely provide the full funding of a VC.RAISING MONEYSince the start of the economic downturn that started in 2008, several innovative and more personal types of funding, such as crowdfunding and peer-to-peer (P2P) lending, have evolved and blossomed on the internet. All involve the principle of raising small amounts of money from large numbers of individuals who pool their resources to provide the loan or equity needed.The key to successful funding is to choose the right type of ﬁnance at each stage of a company’s early growth. Start-ups usually begin modestly, with self-funding and help from friends, family, and anyone else who is prepared to take a high risk. Crowdfunders and business angels are amateurs willing the entrepreneur to succeed, while venture capitalists become interested when the level of risk goes down and they can expect a healthy proﬁt in return for injecting substantial funds. Public markets such as stock exchanges may step in as sales soar and success looks probable. At all stages, investors will conduct credit analyis to asses a company’s ability to repay its debt.CapacityCollateralThe borrower’s ability to repay the loan is shown by the business plan.The borrower is often expected to pledge an asset that can be sold to pay off the loan if funds are too low to pay the monthly interest or repay the capital at the end of the term.Capital The borrower’s net worth is assessed to check that assets exceed debts.Character The lender usually looks for a borrower with a good credit history.iends, fam , fr s r(FFF) ilyLife cycle of investmentCREDIT ANALYSIS CRITERIA FOR LENDINGFoun deAlternative modelsConditions The lender is swayed by the current economic climate as well as by the sum requested.funde owd rs CrRISKENT STM E V INREVENUETIMEIdeaSeedHOW COMPANIES WORK Start-ups36 37Start-up ﬁnance of small and medium-sized enterprises (SMEs) The chart shows sources of start-up ﬁnance of SMEs over a three-year period in the UK, taken from a 2004 survey by Warwick Business School. Most funding comes from individual savings, and least from equity (shares), a type of investment associated more with larger companies.66% 12.5% 10%5%Home mortgage5%No funds used$ 1.5%Bank loant enurecapita lis tsss ang el sine u s BFriends and familyPersonal savingsEquity investmentmarke blic ts u PSALESEarlyMidLateBusiness accelerators and incubators Starting a new venture can be a long process. Business (also called venture) accelerators and incubators are specialized organizations devoted to developing and supporting start-ups. How it works Business accelerators and incubators provide expertise and connections in the formative stages of a business in return for a percentage of ownership. They are two separate types of services. Business accelerators are short-term programs that offer wide-rangingsupport including mentorship, business advice, and connections to potential sources of ﬁnancing. Business incubators, on the other hand, provide a supportive environment in which ﬂedgling start-ups can develop, with technical assistance, working space, and networking opportunities.Business accelerators Suited to start-ups that have limited ﬁnancing, accelerators offer short–term (one to three months) boot camps. Clients include web and software developers.Help with bank loans, funds and guarantees programsIntroduction to potential partners Access to mentors and advisory boardsAccounting and ﬁnancial services adviceNetworkingSeed capitalLinks to potential investorsStart-up pays accelerator % of equity in the business.In return, accelerator provides help and services.Marketing adviceManagement of intellectual propertyHOW COMPANIES WORK Start-ups38 39Business incubators Start-up pays incubator % of equity in the business. It may also pay rent to share part of the incubator’s work space. In return, it receives a range of beneﬁts.Often sponsored by nonproﬁt organizations, incubators tend to be longer term (one to ﬁve years) and cater for a variety of clients, many science-based.Start-up introduced to incubatorNEED TO KNOWSupport and educationMentorshipSpecialized facilities such as science laboratoriesOfﬁce space to work fromInteraction with other start-upsSeed money to get started❯ Incubator networks Collaboration of incubation centers, research facilities, and science parks ❯ Virtual business incubator Online hothouse for start-ups33months the average time US start-ups spent in an incubator, during 1999–2002Buying and selling business Both private and public companies regularly change hands—they are bought, sold, and restructured to reﬂect changing business conditions. These deals all come under the umbrella term of mergers and acquisitions (M and A). Acquisition ﬁnancing is usually needed to pay for the purchase of another company, often in the form of a loan or venture capital.How to acquire a companyTaA company is typically acquired in one of two ways—either by a management team or by another company. When a company is buying, the result can be a merger, in which two companies join forces, an acquisition (outright purchase), or a divestiture, in which part of a company is hived off and sold. Management team purchases are often funded by private equity.Management team acquiringFOR SALEPrivate equity ﬁrms look for companies to buy and then sell their shares when proﬁts have maximized. They fund the management team. See pp.48–49.Buy-outDivestitureThe existing management team buys out the company they work for.Part of company is split off to form new company; may become acquisition target. See pp.44–45.Buy-in An external management team buys into the company.pany m o tc e rgHOW COMPANIES WORK Buying and selling business$311.5 millionthe average size of M and A deals, globally, in 201340 41SIZING UP M AND A’S Measuring a big deal The corporate world categorizes acquisition deals according to the capitalization size (the value of the company’s shares).Small Under $500 millionMid-market $500 million to $2 billionLarge $2 billion to $10 billion $Megadeal Above $10 billionAnother company acquiringDue diligenceCompanies may want to expand by joining with another business.Before any company sale, the potential buyers see a detailed report prepared by lawyers, covering key aspects of the target business. ❯ Financial Identiﬁes problem areas that could affect the future value of the company.Merger The company combines with another company. See pp.42–43.❯ Legal Gauges possible legal risks attached to corporate status, assets, securities, intellectual property, and employee reshufﬂing.Acquisition Horizontal The company buys another company that makes similar products. Vertical The company buys another company that makes different products. See pp.46–47.❯ Commercial Includes industry trends, market environment, the company’s capabilities, and the competition. ❯ Environmental Uncovers potential liabilities such as land or water contamination and estimates remediation costs.Mergers and acquisitions Two of the quickest ways to accelerate expansion are for a business to buy out another—an acquisition—or to amalgamate with another business in a merger. How it works Mergers and acquisitions (M and A) is a general term used to describe the ways in which companies are bought, sold, and recombined. In the case of either a merger or an acquisition, two separate legal entities are uniﬁed into a single legal entity. While a merger combines two companies ona reasonably equal footing to create a new company, which will make both parties better off, an acquisition is usually a purchase of a smaller company by a larger one. This beneﬁts the company making the purchase but may not necessarily beneﬁt the target company. M and A can be friendly or hostile—agreed to or imposed.REASONS TO PURSUE M AND A ❯ Improved economies of scale Wider operations streamline production and sales. ❯ Bigger market share Combining the existing markets expands share of the total market. ❯ Diversiﬁcation A different product lineup gives the chance to cross-sell or create more efﬁcient operations if the products are complementary.Company A manufactures luxury cars in the US.Mergermerges withAcquisitionA Company A produces movies.takes overB Company B creates animations.Company B manufactures luxury cars in Italy.HOW COMPANIES WORK Buying and selling businessFRIENDLY AND HOSTILE❯ The target company’s board of directors and management agree to be bought out. ❯ The acquiring company makes an offer of cash or stock to the target company’s board and management. ❯ The stock or cash offer is set at a premium level. ❯ Because the offer is above actual market level, shareholders usually agree to it.NEED TO KNOW❯ The acquiring company bypasses management and goes straight to the target company’s shareholders. ❯ The target company’s management ﬁght the deal. ❯ The buying company convinces shareholders to vote out the management (a proxy ﬁght) or it makes an offer to shareholders to buy shares at an above-market price (a tender offer).❯ Pacman strategy The target company tries to take over the very company attempting the hostile buyout ❯ Swap ratio An exchange rate between the value of the shares of two companies when merging ❯ Defensive merger Undertaken to anticipate a merger or takeover attempt that threatens a company ❯ Economies of scale Beneﬁt to company of M and A expansion$112 billionNew company A + B now has an expanded market spanning Europe and North America.A+B42 43Expanded company A now has in-house expertise for producing animated ﬁlms.the record annual spend by Japanese companies on overseas mergers and acquisitions, in 2012Divestitures While a merger results in a bigger company, a divestiture reduces the size of a business by breaking it down into smaller components or divisions, which are then sold off or dissolved. How it worksof view, those which have promise but are not yet proﬁtable. The process of restructuring by divestiture is designed to free the company of divisions with low return, to reduce debt and ﬁnancing requirements, and to give the shareholders a stronger return. The market price of the parent company’s shares often bounces back strongly and its spin-off companies may thrive too.The typical scenario for a divestiture is a company that is struggling to pay off debt it has taken on to expand into new areas of business that are not yet proﬁtable. To save the rest of the company from the burden of debt, management decides to start a divestiture. Generally, the goal is to shed the least proﬁtable areas of operation, or from the potential buyer’s pointSUCCESSFUL SPIN-OFFS Mondelez The spin-off of Kraft Foods owns snack foods Oreos, Ritz, and Trident. Coach Sara Lee food’s spin-off makes luxury leatherware. Expedia Media company IAC hived off online travel to Expedia.Divestiture in practice Smith Industries Inc. is one example of an industrial paint conglomerate that has grown rapidly over the past ﬁve years, due to an increase in proﬁts from its expanding sales in China. It diversiﬁed into agricultural chemicals, textiles, and biotechnology, and set up a separate division for each. Share prices fell in response to poor ﬁnancial performance.Making a decisionAnnouncing the saleFaced with a downturn in business, the company divests the newer business areas that have not yet shown strong returns despite positive signs of growth.Smith Industries Inc. now announces the sale of its three remaining divisions: agricultural chemicals, textiles, and biotechnology.INDUSTRIAL PAINTTEXTILESSmith Industries Inc.AGRICULTURAL CHEMICALSINDUSTRIAL PAINTSmith Industries Inc. FOR SALEFOR SALEFOR SALEAGRICULTURAL CHEMICALSTEXTILESBIOTECHNOLOGYBIOTECHNOLOGYHOW COMPANIES WORK Buying and selling businessNEED TO KNOW ❯ Spin-off New company formed as the result of a divestiture; also called a hive-off ❯ Tracking stock Special type of shares issued by a parent company for the division or subsidiary they will sell; tracking stock is tied to the performance of the speciﬁc division rather than the company as a whole; also known as targeted stock ❯ Letter of intent Letter stating serious intention to do business, often concerning M and A❯ Reverse merger Not to be confused with a divestiture, this is a quick and cheap method for a private company to go public by buying a shell stock— a public company that is no longer operating because it went bankrupt or was simply closed. ❯ Demerger Term commonly used in the UK for divestiture44 4552%the potential rise in a parent company’s share price following a divestitureThe shareholders beneﬁt Shareholders in the original company also receive the same percentage holding in shares from the three new companies.One company becomes four The three divisions are sold off to separate investors and become three separate companies. Shares for each are sold on the stock market. The parent company is reduced to its core business. Its share price rebounds.Smith Industries Inc.INDUSTRIAL PAINTWest Inc.Jones Inc.Brown Inc.AGRICULTURAL CHEMICALSTEXTILESBIOTECHNOLOGYVertical vs. horizontal integration Companies that want to expand through a merger or acquisition may decide on a strategy of either horizontal or vertical integration, combining businesses involved in similar or dissimilar activities. How it works Companies can choose from several strategies when they merge or are part of an acquisition. Two of the most common are horizontal and vertical integration. Horizontal deals are always done between competitors that produce similar types of products, such as cars or mobile phones, and often share—or compete for—the same suppliers and clients. As a result ofmerger or acquisition, the newly formed company can make cost savings in production, distribution, sales, and marketing. Vertical deals are usually between businesses involved in the same industry but at different stages—for example, a computer maker and a component manufacturer. These deals can be upstream (toward the market) or downstream (in the direction of operations and production).NEED TO KNOW ❯ Lateral integration Another term for horizontal integration ❯ Horizontal monopoly When a company controls the market after buying up the competition ❯ Synergy The potential of merged companies to be more successful as a single entityIntegration models in practice In these hypothetical examples, a cluster of printers, publishers, and bookstores merge or acquire each other in horizontal or vertical deals that aim to strengthen their market position, take advantage of economies of scale, and exploit synergy.Horizontal integration Two publishing companies, both involved in the process of book creation but with different areas of specialization, agree to a merger deal to gain a larger market share.PUBLISHER ABPUBLISHER APublisher A, a general publisher, acquires specialized academic Publisher B to strengthen its textbook division.PUBLISHER BHOW COMPANIES WORK Buying and selling businessONLINE BOOKSTORE AForward (upstream)PUBLISHER/ONLINE BOOKSTORE A Publisher A buys Online bookstore A to improve brand presence and provide direct sales.Vertical integration A publisher acquires two related businesses— a printer and an online bookstore—so that it can have greater control over production of its books and their route to market.46 4731%of businesses worldwide planned to expand through a merger or acquisition in the three years from 2014 MERGER AND ACQUISITION TYPESPUBLISHER AConglomerate Combining two companies with nothing in common: for example, in 1985, tobacco-producer Philip Morris purchased General Foods, a new line of business unconnected to legal wrangles around smoking.Market extension Backward (downstream)PUBLISHER/ PRINTER A Publisher A buys Printer A to improve print capacity and production costs and provide warehouse space.Combining two companies that sell the same products but in different markets: for example, in 1996, the Union Paciﬁc Railroad Company acquired the Southern Paciﬁc Rail Corporation to link railroads in adjacent US regions.Product extensionPRINTER ACombining two companies that sell different but related products in the same market: for example, in 2014, Microsoft bought Nokia’s mobile-phone unit to address ﬂagging PC sales and its weakness in the mobile device market.Management buy-ins and buy-outs A company’s ownership may undergo a change, which can be driven either externally, known as a management buy-in, or internally, known as a management buy-out. How it works In a management buy-in (MBI), a group of managers or investors from outside the company raises the funds to buy a majority stake in the company and then takes over its management. This type of action occurs when a company appears to be either undervalued or underperforming. In a typical management buy-out (MBO), thecompany’s existing management team purchases all or part of the company they work for. Despite the name, MBOs are not restricted to managers, and they can include employees from any level of the organization who wish to make the transition from employee to owner.NEED TO KNOW ❯ Earnout A percentage of the purchase price paid to the sellers after acquisition if the business has performed as expected ❯ Leveraged buy-out Acquisition of a company using equity and borrowed money, with company as collateral for loanBuy-in Some companies, such as investment banks or venture capitalists, can make sizable proﬁts by purchasing undervalued businesses and transforming them. Company+ An outside management team or investment group sees that a company is undervalued.$ They raise funds to buy a majority shareholding.Company= They ﬁre and replace the previous management team.They overhaul the business to improve performance and realize its true value.HOW COMPANIES WORK Buying and selling businessBUY-IN MANAGEMENT BUY-OUT (BIMBO) In this type of transaction, the existing management of a company stages a buy-out, but additional external management is brought in by ﬁnancers to strengthen the company’s leadership and to provide expertise in particular areas that might be lacking in the original team. CompanyCompany+ Existing management members buy company= Outside management members brought inNew management team48 49$22.2 billion Europe’s biggest ever leveraged buy-out—of chemist chain Alliance Boots in 2007Buy-out A buy-out allows a large company to sell off a part of the business it no longer wants or helps a small business owner to retire or move on. CompanyCompany+ The management team sees an opportunity to take ownership when their corporate division is put up for sale.They raise funds via bank loans, private investors, their own capital, or a loan from the seller.Company= They buy the business.The management team—which now owns the company— streamlines the business to make it more proﬁtable.Who’s who Determining a company’s hierarchy—including how many layers of power it has, and how many staff to appoint at each level—is one of the biggest challenges of modern management. In family-run businesses, positions are usually ﬁlled by family members who answer to the head of the family. The emergence of public companies has meant that company ownership is separated from management, so that shareholder interests are prioritized.Who’s who in an organization Stakeholders and shareholders Stakeholders are anyone with a vested interest in the company. Shareholders are stakeholders who have bought stock in the company. See pp.60–63.Board of directorsC-suite executivesThe board of directors makes sure the company is run proﬁtably to provide returns to shareholders. The board votes in a chairman, who is sometimes also the chief executive ofﬁcer (CEO). See pp.52–55.The top level operates the company day to day and sets strategy. All titles of top management begin with a “C” for chief. Senior managers are headed by the CEO. See pp.56–59.HOW COMPANIES WORK Who’s who46%50 51STRUCTURAL WHYS AND WHEREFORESof UK employees believe what senior managers tell them about what is happening in their organizationOvertime pay Managerial staff who are not paid for overtime hold exempt positions. Non-exempt positions usually belong to non-managerial staff who are paid by the hour and qualify for overtime pay.Who bosses whom When one manager has formal authority (decisionmaking power) over another, it is called vertical specialization. Horizontal specialization means several managers have equal authority.Mid-level managementJunior managementDivision and department heads are usually called directors or managers. Jobs at this level are often the ﬁrst to go when a company downsizes or restructures. See pp.56–59.Supervisors, managers, or team leaders directly manage groups of employees carrying out speciﬁc tasks. Examples include a head nurse or foreman. See pp.56–59 and pp.74–75.Non-management employees The lowest ranks of the organization: skilled and unskilled workers carry out core tasks needed for the company to operate. See pp.56–59 and pp.74–75.Board of directors Public companies are required by law to appoint a board of directors to provide oversight.Board of directors The board of directors of a publicly listed company sits between the company and its shareholders.How it works All companies must have at least one director. If a company goes public and issues shares, it is legally required to have a board of directors. The board is made up of experienced business advisers who provide independent oversight of the company for shareholders and are mandated by law to govern the company responsibly. Board members may come from within the company or be independent outsiders, and should cover a range of expertise— such as legal, ﬁnancial and marketing— or have specialized industry knowledge. Networkers are also highly prized for their ability to build connections with inﬂuential ﬁgures in the corporate and governmental spheres. From within their ranks, the board elects a chairman, vice-chairman, secretary, and treasurer.REPORTS TOSecretary Appointed by The boardResponsible for ❯ Publicly representing the company’s policies and leading board meetingsTreasurer Appointed by EVALUATESThe boardShareholders Any person or institution that has bought shares in a publicly listed company is a shareholder. The board works for the shareholders, who effectively own the company.Responsible for ❯ Presenting yearly accounts ❯ Leading audit committeeHOW COMPANIES WORK Who’s who52 53The average company board in the US hasChairman Appointed by The boardResponsible for9.2❯ Publicly representing the company’s policies ❯ Leading the board, conducting board meetings ❯ Determining the composition of the board ❯ Mentoring and monitoring the CEO or managing director (MD) ❯ Communicating with shareholdersdirectorsCompany Responsible for day-to-day production, sales and marketing operations, and ﬁnance. The company reports to the board via its chief executive ofﬁcer (CEO), who executes the board’s decisions.Vice-chairman Appointed by The boardResponsible forDirectors Appointed byEVALUATESCEO REPORTS TO❯ Standing in for chairman ❯ Undertaking special projects for chairman ❯ Assisting chairman in balancing experience, personality, and age of directors on boardAppointed by The boardResponsible for ❯ Performance of the company ❯ Implementing board strategy ❯ Leading senior management ❯ Reporting back to chairman and boardThe boardResponsible for ❯ Determining strategy ❯ Monitoring achievement of implemented policies ❯ Appointing managers ❯ Accounting for company’s activities to shareholders and other stakeholdersREPORTS TOEVALUATESManagement Managers pass the CEO’s decisions down to employees.BOARD OF DIRECTORSBalancing the board The board has three clear areas of responsibility: developing business strategy, advising the company, and overseeing how the ﬁrm is run. Selecting the right mix of directors to fulﬁll these functions is crucial. Board members may come from inside or outside the company. Those who work for the company (executive or internal directors) have more expertise in running the business, but independent members (non-executive or external directors) are better placed to offer perspective, scrutinize the actionsof company executives, and call them to account. When potential conﬂicts of interest arise between management and shareholders, independent directors can weigh decision-making in favor of acting in the company’s best interests. The ideal balance is a hot topic in corporate governance. In US companies, CEO and chairman roles have traditionally been combined, but following a spate of corporate scandals, the roles are now more often vested in two individuals. In Europe, keeping the roles separate has long been seen as best practice.NEED TO KNOW ❯ NEDs Non-executive directors, also known as independent, external, or outside directors ❯ Executive directors Board members who also work for the company—not to be confused with the term executive director when used as a title for the CEO ❯ Model Business Corporation Act Developed by the American Bar Association, this model is used as the basis for corporate governance in the USBoard structure variations Independent board of directorsCEO as chairmanThe board sits between shareholders and company. The CEO is the main channel of communication between board and company, while the chairman is the principal conduit between shareholders and board. This structure gives the board most independence.A setup in which the company’s CEO serves as the board’s chairman. While this offers less independent scrutiny of ﬁnances, strategy, performance, and pay, it avoids duplication of roles. This setup is found in US corporations and in many small- and medium-sized companies in other countries.ShareholdersShareholdersBoard of directorsBoard of directorsChairman and CEOCEOManagement and employeesKeyShareholdersManagement and employeesChairmanTreasurerSecretaryHOW COMPANIES WORK Who’s whoPROS AND CONS OF CEO AS CHAIRMAN ProsCons❯ Strong, central leadership Decisions hold fewer conﬂicts. ❯ Efﬁciency CEO/chairman can implement board decisions swiftly. ❯ Expertise CEO has company and industry knowledge (a CEO may become chairman after retirement). ❯ Balance of power Established hierarchy between CEO/chairman and other directors reduces risk of conﬂict on the board.❯ Lack of transparency Conﬂicts of interest/corruption are more likely. ❯ Reduced objectivity Board headed by CEO is unable to monitor CEO’s work objectively. ❯ Higher remuneration Combined role generally commands higher pay than two separate individuals. ❯ Mentoring Chairman who is also CEO cannot offer independent mentoring and support for the role.54 5544%of S&P 500-listed companies had distinct CEO and chairman roles in 2012—up from 21% in 2001Senior management as directorsTwo-tier boardA structure in which senior managers also sit on the board. The chief ﬁnancial ofﬁcer (CFO) is appointed board treasurer and the chief operations ofﬁcer (COO) is vice-chairman. In some countries (Germany, for example), employees must be included on the board by law.An arrangement that is made up of separate supervisory and executive boards. The supervisory board is composed of outside directors, led by a chairman. The executive board comprises senior managers, including the CEO. The two boards always meet separately.ShareholdersShareholdersSupervisory boardBoard of directorsChairman and CEOExecutive boardTreasurer and CFOVice-chairman and COOManagement and employeesVice-chairmanCEO and board memberEmployee and board memberManagement and employeesOther directorsCEOManagement and employeesCompany hierarchy Almost every organization has a structured arrangement of levels for members, from the board of directors at the top to junior employees at the bottom. There is a trend toward reducing the number of levels. How it works There are ﬁve levels in the conventional corporate structure with a line of authority from top to bottom. The chief executive ofﬁcer (CEO) is the highest-ranking person in the company, reporting to the board of directors and sometimes also sitting on the board. Reporting to the CEO are a number of highlevel executives, known as C-levelC-LEVEL VARIATIONS The range of C-level positions varies for each company. In addition to the three top posts, there may be: CAO Chief Administrative Ofﬁcer CIO Chief Information Ofﬁcer CTO Chief Technology Ofﬁcer CPO Chief Product/Production Ofﬁcer, responsible for overseeing product development and production CMO Chief Marketing Ofﬁcer, responsible for marketing strategy and business development C-level positions are evolving, adapting to market conditions and business priorities. New roles are emerging while some traditional roles are disappearing. The role of COO, for example, is less popular in modern organizations. Some of the new roles include: CPO Chief Privacy Ofﬁcer CSO Chief Sustainability Ofﬁcer CDO Chief Digital Ofﬁcer CKO Chief Knowledge Ofﬁcer CCO Chief Customer Ofﬁcerexecutives—their job titles begin with a “C” and end with an “O.” Below the C-level is management, in tiers that differ from company to company, with employees forming the bottom level. As well as skilled and unskilled employees, there may be staff on ﬁxed-term contracts, taken on for the duration of a project or for a set length of time, and casual temporary workers.51%of CIOs and CTOs say they are pioneering new digital approaches within their businessC-suite executives These are the most senior jobs in the company, with the CEO at the top, the COO and CFO traditionally on the next level down, and other C-positions below that. In many companies, the C-level positions have equal authority and all report directly to the CEO.Mid-level management Responsible for overseeing speciﬁc functions in the organization, the most senior managers at this level head up different departments or divisions. These managers are often called directors (not to be confused with the board of directors) or, in the US, vice-presidents. The exact job titles, and the number of midlevel managers, vary depending on the company.Junior management and other employees Team leaders, such as supervisors and assistant managers, implement management plans. They also coordinate teams of skilled and unskilled workers in, for example, production, customer service, and sales to carry out the core tasks needed for the company to function efﬁciently and proﬁtably.HOW COMPANIES WORK Who’s whoCHIEF OPERATING OFFICER (COO) Responsible for day-to-day operations; reports to CEO and acts as second in command15%CHIEF EXECUTIVE OFFICER (CEO) Decides on corporate policy and strategyCHIEF FINANCIAL OFFICER (CFO) Manages company’s ﬁnancial risk; reports to CEOthe average salary rise for a C-level executive reporting to the CEO, in the US between 1986 and 2006FINANCE MANAGER Puts CFO’s plans or directions into action, instructing junior managersMARKETING MANAGER Directs marketing department day to dayOPERATIONS MANAGER Oversees operations division; may also direct production departmentR AND D MANAGER Heads up research and development (R and D) of new productsSUPERVISORS AND TEAM LEADERSNON-MANAGEMENT EMPLOYEES56 57COMPANY HIERARCHYFlattening hierarchies The trend in management over the past few decades has been to eliminate layers from company hierarchies, which means they are becoming ﬂatter—in other words, there are not as many levels to go through in order to reach the top. One example is the role of chief operating ofﬁcer (COO), which has been disappearing in recent years. Between 2000 and 2012, there was a 10 percent decline in the number of Fortune 500 (an annual list of the top US corporations compiled by Fortune magazine) companies with COOs. Only 38 percent of the500 have a COO position now. CEOs have also eliminated layers of middle management, and in the US there was a 300 percent increase between 1986 and 2003 in the number of division heads reporting directly to the CEO. Sometimes companies decide restructure the other way round instead —from ﬂat to tall—by eliminating a number of senior management posts and replacing them with a greater number of junior supervisory roles.NEED TO KNOW ❯ Span of control Number of employees reporting to a manager or other senior level; the greater the span of control, the more workers reporting to an individual above ❯ Line position Job role with responsibility for achieving the goals of the organization ❯ Staff position Job role providing expertise to assist someone in a line positionTall vs. ﬂat hierarchies There are pros and cons for both types of hierarchy, and each company has to ﬁnd the number of levels, and positions within each level, that suits the nature of its CEO business.Supervisors and team leadersNon-management employeesThe traditional model is suitable for a formal chain of command as, for example, in the army. ❯ Several layers from top to bottom ❯ Fewer employees reporting to each manager; close supervision possible ❯ More room for career advancement because there are many levels to rise throughD AN MM CO OF AIN CHMid-level managementTall hierarchyHOW COMPANIES WORK Who’s whoCASE STUDY Restructuring the big three US car manufacturers The economic crisis of 2008 caused the big three American car-making companies—General Motors (GM), Ford, and Chrysler—to rethink their corporate structures. Market share had fallen and the three companies needed to shed employees and ﬁnd ways to cut production. All three took similar action to reorganize the company hierarchy, removing some managerial roles from the mid-management level and installing more team leadersat a lower level in the organization to create a ﬂatter, less top-heavy company hierarchy. ❯ Before restructuring Thirty technicians reported to one production supervisor. ❯ After restructuring Seventy-ﬁve technicians now reported to one production supervisor, through 18 newly created team leader positions.58 5925%the decline in the levels of hierarchy between division heads and CEOs in the US, from 1986 to 2003Flat hierarchy This looser model is more ﬂexible and suitable for companies that foster creativity. ❯ Only a few layers so mid- and low-level management are merged ❯ Large number of employees reporting to each manager; close supervision not possible ❯ More freedom for employees to make their own decisions CEOCH AI NO FC OM M Supervisors and team leadersAN DNon-management employeesStakeholders A stakeholder is anyone who is affected by the performance of the company, while shareholders own one or more shares in a company, which makes each of them a part-owner of the company. How it works Because shareholders part-own the company, they have the right to vote on how it is managed and to receive a share of its proﬁts. All shareholders are stakeholders, since the performance of the company has a direct impact on the value of the shares they own: when the company does well, the share value rises, and when it performs badly, the share value falls.However, stakeholders can also be non-shareholders— individuals or groups who have an interest in what the company does or whose ﬁnancial situation depends on the company. Some stakeholder groups are interested in a company mainly for its ethical treatment of workers, sustainable approach to the environment, and attitude to society. These are known as environmental, social, and governance (ESG) criteria.Stakeholders’ areas of interest A few stakeholder groups are concerned only with environmental, social, and governance (ESG) factors, while others, such as shareholders and suppliers, may be more interested in the company’s ﬁnancial performance. Most stakeholder groups have at least some interest in both areas, especially since negative publicity for a company can cause share prices to fall.Stakeholders with ESG concerns Stakeholders have no direct involvement, but believe that companies have a responsibility to the communities they operate in, to respect the environment, human rights, and animal welfare.$892 millionthe average drop in market value triggered by negative news about a company’s human rights recordNongovernmental organizations ❯ Contribution to enviromental and social causes ❯ Legal complianceCommunity ❯ Impact on local inhabitants ❯ Concern for broader social welfareHOW COMPANIES WORK Who’s who$ Stakeholders with economic and ESG concerns Stakeholders use ESG—a recognized part of policy and reporting for most companies—to evaluate corporate behavior and to determine future ﬁnancial performance. Concerns range from $ proﬁts to ethics.60 61GovernmentShareholdersCustomers❯ Tax payments ❯ Legal compliance❯ Ability to pay dividend ❯ Increase in share value❯ Quality product ❯ Good value ❯ Customer service$ $$ Trade unionsSuppliersEmployeesLenders❯ Treatment of workers ❯ Fair pay, beneﬁts, and working conditions❯ Ability to pay debt ❯ Enough liquidity❯ Pay and beneﬁts ❯ Longevity of the company ❯ Employment prospects❯ Ability to repay loans ❯ Integrity of management ❯ Financial strengths of the companySTAKEHOLDERSStakeholders in action Compared with other stakeholders, shareholders have the most interest in the ﬁnancial performance of a company. They are also forced to take an interest in how seriously the company takes its corporatesocial responsibility (CSR), whether or not they are socially and environmentally conscious themselves. Several high-proﬁle cases have shown how stakeholder reaction has caused a signiﬁcant decline in share prices. By usingsocial media, stakeholders can generate a storm of public disapproval, leading to angry consumers and nervous investors.$60How stakeholders affect share value In April 2010, an offshore oil rig owned by British Petroleum (BP) exploded in the Gulf of Mexico. BP attempted to alleviate stakeholder concerns, but stakeholders responded negatively, starting their own social media campaigns to shame the company. Sixty-six days after the oil spill, BP’s share value on the New York Stock Exchange had dropped by 52 percent.$30 $0 BP shares trading at$60.57on April 20, 2010News breaks that spill is worse than BP claims.Stakeholder social media campaign intensiﬁes.News media report on the stakeholder backlash.$60 Bill$69$30BILLION$0 US government criticizes BP and sends company a $69 billion bill for cleanup.Obama administration advises it could take legal action to stop BP paying from dividends to shareholders.Share price drops 7 percent in London trading.HOW COMPANIES WORK Who’s who75%62 63the increase in the number of publicly traded companies* reporting on ESG * in the Bloomberg database for the period 2008–2011BANG! BANG!# Oil rig explodes, killing 11 employees and spewing millions of gallons of oil into the Gulf of Mexico.BP starts social media campaign on Twitter— initially to minimize the impact of the spill.News media report on the event.Stakeholders of the BP oil spill ❯ Inhabitants along the affected coastline ❯ Local ﬁshermen ❯ Oil spill cleanup workers ❯ Environmental activists ❯ BP employees❯ BP shareholders ❯ Gasoline buyers ❯ Tourists and tourist businesses ❯ Media ❯ Government ❯ General publicStakeholders use social media to voice anger and concern over perceived lack of responsibility by BP. Conservationists warn of wildlife devastation. Celebrities offer to help in the cleanup. Stakeholders call for more disclosure from BP.$60$$$30 $0Five of BP’s top 10 shareholders sell off stock.By June 25, BP’s share price has dropped by more than half; over 34 billion shares have been bought and sold.BP shares trading at$23.91on June 25, 2010Business cultures Every organization has a particular workplace environment, consciously or unconsciously shaped by the personalities, values, and behavior of the people leading it and working in it. How it works The organizational culture of every business is different, reﬂecting the ethos of the company, its workplace habits, and the image the company projects. It is also tied to the type of work that has to be done. In a high-stakes ﬁnancial trading company, the pace and pressure of the work makes theatmosphere of the corporate environment crackle, whereas in a company relying on creativity for its products, the mood is likely to be more relaxed. The type of incentives offered to management and employees may also affect the workplace, resulting in either a competitive or a collaborative culture, or a mix of both.NEED TO KNOW ❯ Control systems Used by managers to set standards and measure performance ❯ Leverage Power to inﬂuence a person or situation ❯ Paradigm Value system of goals, mission, and beliefsTypes of corporate cultures Management experts have tried to explain how organizational cultures work. Charles Handy, a former professor at the London Business School, describes them in terms of four major types: power, task, role, and person.Role culturePower cultureWhere a company is based on the structural support of specialized roles. Each role is crucial and will persist even if the person occupying it leaves. Procedures and systems are strictly followed, as in a government department.Driven by a powerful individual at the center of the organization, who is relied on for decision-making and the company’s successes. Those closest to the center have most inﬂuence. Typical of a family-owned business.SYSTEMSRULESPROCEDURESJOB DESCRIPTIONSDECISIONS MADEbureaucratic / controllingPOWERHOW COMPANIES WORK Who’s who86%WHAT SHAPES CORPORATE CULTURE? Many factors reinforce a culture. To bring about change, the workforce needs to be inspired by different motivations, values, and types of role models. Organization size Big business, or small companyLeaders Their personality and behaviorCompany structure Strict hierarchy, or power shared among many peopleSymbols Titles, dress codes, interior aestheticFounding values Includes origination myths and storiesControl systems Rewards, incentives, performance assessment64 65of senior managers in global organizations agree that organizational culture is critical to successPerson cultureProject-oriented work where a project’s completion is the motivating force. Relies on teamwork and individuals’ expertise, but results are more important than personal objectives. Found in technology companies, for example.Company power and inﬂuence is shared among individuals who work semi-autonomously. Individuals count for more than the company, which is made up of people with similar specialist training, such as in an architects’ practice.PATask cultureNE RTIP RSHTASKTASKTASKentrepreneurial / flexibleCorporate structure A company’s structure—the way in which it is organized—can have a major impact on the way it performs. There are several models of corporate structure typically used in the business world, and they continue to evolve. The ﬁrst consideration is whether power should be centralized at the top, with decisionmaking in the hands of a few key senior employees, or decentralized, with more power in the hands of staff, and with fewer people to go through for approval.Choosing a structure Most start-ups have a centralized structure. More complex structures either evolve or are designed as the company grows, depending on the nature and size of the business, the complexity of the work, any requirement for instant expertise, and the geographical location of parts of the business.CentralizedFunctionalDivisionalMatrixPower rests in the hands of a few people, with a long chain of command. ❯ Power at the top ❯ Rigid ❯ Conventional ❯ Inﬂexible ❯ Slow response to changeGood for strict control and formal relationships, as in the military. See pp.68–69.Suits companies with many global ofﬁces or product lines. See pp.70–71.Good for large corporations with complex projects in different locations. See pp.76–77.CEO COORDINATESCEO COORDINATES AND EACH DIVISION RESPONSIBLE FOR GENERATING PROFITDIVISIONAL AND FUNCTIONAL MANAGERS COORDINATEHOW COMPANIES WORK Corporate structure78%of groups reach solutions to simple tasks faster in centralized structures100%of groups reach solutions to complex tasks faster in decentralized structures66 67WARNING When change is needed Signs that a structure is not working include low morale and high staff turnover, no new products being developed, and proﬁt suddenly accelerating or decelerating. Tools to amend poor structure include: ❯ Business process reengineering (BPR) Analyzing and redesigning the workﬂow within a company. ❯ Altering the reporting line In a traditional solid-line reporting relationship, one line manager oversees goals and performance. It can be beneﬁcial to switch to the weaker chain of a dotted-line reporting relationship, in which a manager sets some but not all the objectives.NetworkTeam-basedDecentralizedSuits creative and technology companies in which everyone is online. See pp.72–73.For companies that rely on innovation and are customer focused. See pp.74–75.Power is spread through the company, and staff make their own decisions. ❯ Power shared ❯ Organic ❯ Experimental ❯ Flexible ❯ Fast response to changeCORE COMPANY COLLABORATES WITH VIRTUAL COMMUNITYSTAFF SELFCOORDINATEFunctional structure The classic way to organize a company is by dividing it into departments that reﬂect the main functions of the business, each headed by a director or manager. How it works The chain of command is straightforward. The business typically consists of a chief executive ofﬁcer (CEO) or president at the top, with the various specialist departments or divisions, such as marketing and ﬁnance, aligned below. Each department operates as an independent unit, with its own budget, and reports directly to the CEO, who takes responsibility for the operation of all the departments. A functional structure is the most common type of organization.Typical departmental hierarchy The departments operate independently, with the managers reporting to the CEO or president, who has overall command. The sales and marketing department usually takes responsibility for managing product lines.WARNING Dangers of silo mentality Silo mentality describes a scenario in which each department has a different, closed view of its role within the overall scheme and information does not get shared.2 for 11 Sales and marketing decides to launch a special online two-for-one offer.2 Finance is not briefed and processes the order for one item only.Production/ operations managerResearch and development managerFinance managerDeciding what to sell3 Operations is not briefed and sends customers one item instead of two.4 Customer services is not briefed and is unprepared for calls from angry shoppers.The marketing department is closest to the market and is best able to analyze which product lines may do well. The sales and marketing manager can suggest what new products the company could make.PRODUCT AHOW COMPANIES WORK Corporate structure41% CEOof UK companies say the structure of their organization is a barrier to improving customer experience68 69FUNCTIONAL: PROS AND CONS Pros ❯ Allows for the development of specialization and expertise ❯ Enables efﬁcient use of resources and potential economies of scale ❯ Offers obvious career path for employees in each department ❯ Simple, efﬁcient structure for manufacturers producing a limited range of goods for saleCons ❯ Formal lines of communication; stiﬂes innovation and creativity ❯ Departments fail to coordinate efﬁciently with one another ❯ Response time on problems and queries between different departments slow ❯ Many decisions referred up to the top, creating a backlogSales and marketing managerPRODUCT BInformation technology managerPRODUCT CHuman resources managerCustomer services managerPRODUCT DNEED TO KNOW ❯ Line relationship Chain of command down the structure ❯ Reporting structure Who reports to whom ❯ Silo Pejorative term for a department that works in isolation: a vertical, closed structure like a grain siloDivisional structure Some companies arrange their staff into divisions devoted to a speciﬁc product or market. Each division is a self-sufﬁcient team employing the personnel for the various functions within it. How it works Under the overall control of a CEO or president, several divisions work alongside one another to design, research, produce, and sell a particular product, or to service a speciﬁc market. Each division runs its own specialized functions, such as operations and production, sales and marketing, and ﬁnance. A company may arrange its divisions according to the types of product it makes, the regions in which it operates, or the customers to whom it sells. Large companies may adopt hybrid structures—by product and geography, for example.DIVISIONAL: PROS AND CONS Pros ❯ If one division fails, there is no threat to the rest of the business ❯ Can respond quickly to changes in the market ❯ Focused on customer needs ❯ Performance of each division clearly measurableDivision by geography For businesses with products that need to be adapted to local markets, an organization can be structured according to each of the regional markets it serves. These may be domestic or international. Print technology and services company Xerox has successfully adopted this structure (see case study, right).North America The company’s main marketDivision by product Businesses selling different types of products may pick a structure by which each division handles one category. Fast-food chain McDonald’s has been organized by product division.CEOCons ❯ Duplicating resources—for example, each division employing ﬁnance personnel ❯ Lack of expertise-sharing between divisions ❯ Career path for staff restricted ❯ Heightened sense of competition among divisionsFAST-FOOD PRODUCTSRESTAURANT SUPPLIESBurgers and friesTablewareBEVERAGESUnbranded drinks mixesHOW COMPANIES WORK Corporate structure70 71CASE STUDYCEOEurope The second-largest region for salesDeveloping markets All other marketsGlobal servicesPrinter technology and services company Xerox has restructured several times to align the business with the main markets that buy its products. In 1992, Xerox’s highproﬁle change from a functional to a new divisional structure, with nine self-contained divisions each serving a particular customer type, hit the headlines. This also allowed the company to focus on its core business—digital publishing, color copying, and printing. Dividing the company by market location is another strategy Xerox has used successfully. In 2006, each division was organized once again, geographically, to ensure that those making the decisions were closest to the customers in each market.Additional division consulting across regionsDivision by customer type Businesses with distinct customer markets may be organized by customer division. For example, the ﬁnancial institution Bank of America Merrill Lynch caters to individuals, small businesses, and corporate and institutional clients.7%CEOCONSUMERBUSINESSINSTITUTIONALTypically the original marketProducts adapted or favorably pricedLarge-scale provision to a single clientthe increase in Xerox’s share value when it announced its move from a functional to a divisional structure in 1992Matrix structure Unlike a conventional company hierarchy organized either by function or division, a matrix combines the two approaches so that staff work in both functional and divisional units, and report to two bosses. How it works A business that uses a matrix setup often begins with the more traditional functional structure. As the business develops, it may make sense to overlay a divisional structure to meet changes in business conditions—for example, if a company is managing several large projects for a client or expands globally and is selling its products in several regions. A matrix grid may start out as temporary—perhaps formed to manage short-term projects—and become permanent. The two chains of command in a matrix create the grid. Staff report along a vertical line to a functional manager, such as the marketing director, and along a horizontal line to the project manager of a speciﬁc business line, brand, project, or region.FOUR BIG MATRIX ORGANIZATIONS Each of the following companies has been cited as a model of success for making the matrix structure work: ❯ Procter & Gamble (P&G) To help it innovate and respond faster to the market, the consumer-product company is segmented into baby and family care, global beauty, health and grooming, and global fabric and home care. ❯ IBM Because it needs to control many global processes, the matrix at the technology and consulting corporation is structured vertically by divisions such as sales and distribution, ﬁnance and marketing, and software, and horizontally by country and region. ❯ Cisco In 2001, the IT company reorganized to enable committees to make decisions across several different functions and divisions. The idea was to stimulate ideas throughout the organization and quickly implement solutions to problems. ❯ Starbucks The coffee-shop chain is arranged by product on one axis of the matrix and business function on the other to ensure that quality and innovation meet customers’ expectations and anticipate their desires.Matrix structure In this case study, an oil-exploration and production company has several oilreﬁning projects to manage. The matrix guardian oversees the matrix and makes sure it works efﬁciently.Engineering directorMatrix guardianProject managerDrilling teamArctic drillingProject managerOil-extraction teamMalaysia oil wellsProject manager New Zealand natural gas ﬁeldsLiqueﬁed natural gas teamHOW COMPANIES WORK Corporate structure72 7390%CEOof FTSE 50 companies had adopted a matrix structure by 2013 Operations directorMarketing directorFinancial directorUndersea production teamMarketing teamFinance teamNEED TO KNOW ❯ Project management professional (PMP®) Qualiﬁcation for project managers offered by global Project Management Institute ❯ Matrix guardian Senior professional appointed to oversee the matrix and make sure it works efﬁciently ❯ Mature matrix Matrix structure in which functional and divisional bosses have equal powerMATRIX: PROS AND CONS Site-supervision teamSales teamFinance teamPros ❯ Faster decision-making ❯ Potential for improved productivity ❯ Flexible use of staffConsLine operations teamMarketing and PR teamFinance team❯ Expensive to set up and run ❯ Possible confusion as to the reporting line ❯ More potential for interpersonal conﬂict as team goals may conﬂictNetwork structure Also called a virtual organization or virtual corporation, a network structure is centered around a streamlined company, with digital connections linking it to external, independent businesses. How it works The company at the center of the structure is stripped back to basic functions that are essential to the type of business being operated—research and development, for example, in the case of a technology company. All other functions are outsourced to external specialists.NEED TO KNOW ❯ Agile business Buzzword to describe a networked organization; the opposite of a traditional bureaucracy ❯ Decentralized Organization with a wide span of control and often an upward ﬂow of ideasThe various parties can be scattered around the globe and are connected by the internet. Together, they provide all the services needed for the network to function as one entity. This type of business structure is based on the idea of the social media network, and so is known as a network enterprise.Network structure in practice Network Screen is a small ﬁlm production company based in Los Angeles, CA, operating from a studio space with two employees—a producer and an assistant. For each project, the producer connects with outsourced talent around the world and everyone collaborates to create the ﬁnished ﬁlm. The producer contracts and pays these external suppliers.VARIATION: MODULAR STRUCTURE In a business with a modular structure, parts of a single product are outsourced (it is functions or processes, not products, that are outsourced in a network structure). A modular structure is especially suitable for organizations producing appliances, computers, cars, and mechanical consumer goods. Toyota is an example of a company with a modular structure, managing hundreds of external suppliers to produce its ﬁnished vehicles.ProsCons❯ Potential for round-the-clock work because of global locations ❯ Can source the best expertise wherever it is in the world ❯ Low overheads because there are minimal staff in the core company ❯ Flexible and highly creative environment❯ Extreme reliance on technology— network errors can stop effective performance of the business ❯ Potential for misunderstandings because there is little face-to-face communication ❯ Difﬁcult to ﬁnd common time across time zones for virtual meetings27%of networked organizations report higher proﬁt margins than their competitorsHOW COMPANIES WORK Corporate structure74 75Post-production effects in Copenhagen, Denmark10+ X$ $rk Scr o e tw Film production company, Los Angeles, CAenNeCinematographer in London, UKFilm editing in Osaka, JapanAccounting and ﬁnance in Boston, MALocation scout in Istanbul, TurkeySet design in Sydney, AustraliaTeam-based structure As its name implies, a team-based organization (TBO) is made up entirely of teams. Managers and staff from different departments join to form teams handling speciﬁc projects, in the short or long term. How it works In a TBO, teams reach decisions through brainstorming and mutual agreement among team members, rather than a senior management member issuing orders from the top down the chain of command as in a traditional organizational structure. Communication is less formal in TBOs, often carried out on social media such as blogs and forums and using software for networking such as Groupware.One step beyond the team-based structure is a holacracy (see box, right), an unconventional type of organization in which there are no managers, and even the CEO relinquishes power, allowing employees to self-govern through regular committee meetings, which they organize themselves.NEED TO KNOW ❯ Cascading Successful passing of information or objectives down through the workforce ❯ Lateral structure Decentralized structure in which departments work to a common goal ❯ Flat lattice Structure with no chains of command, in which workers choose to follow leadersTeam-based hierarchy While TBOs still have a CEO, little other hierarchy exists. Team leaders are part of the team rather than in a chain of command. At its best, a teambased model fosters a culture of trust, so individuals take pride in their work and responsibility for carrying out tasks well and on time and budget.Team leaderCEOTeam leaderTeam ATeam BHOW COMPANIES WORK Corporate structureHOLACRACY—BREAKING BOUNDARIES Staff are grouped into teams that set their own roles and goals and choose their own leaders. The idea is that if power and responsibility are shared, employees will give their very best. In 2014, the Las Vegas–based online clothing retailer Zappos adopted the model for its 1,500 staff. Holacracy is a trademarked term used by the company that invented this speciﬁc management system. It follows the same principle as a ﬂat lattice, but takes the idea one step further by presenting a comprehensive management structure with clear processes for internal operations and governance.TRADITIONAL HIERARCHYDecisions handed down from topHOLACRACY—A STRUCTURE OF SELF-MANAGED TEAMSDecisionmaking by committee76 77200– 300%the productivity increase at US sausage-maker Johnsonville Foods, from 1982 to 1990, by moving to a teambased structure TEAM-BASED: PROS AND CONS Pros ❯ Quick decision-making and rapid response to problems and challenges ❯ Reduced overheads because there is no heavy management structure ❯ Open communication because there is no fear of management reactionTeam leaderTeam CCons❯ If staff lack expertise, decisions may be ﬂawed ❯ Limited sharing between teams may affect business performance ❯ Decisions by consensus harder to reachHuman resources The human resources (HR) department is responsible for all policies and processes relating to the people employed by a business. To help the business achieve its goals, HR has to make sure that it employs the right people with the right skills, treats them consistently and fairly, and has a supporting framework to drive and deliver the required level of performance.Business goalsHR framework The starting point for any decision in an organization is its business goals. HR supports the delivery of these goals by ensuring that there is a stafﬁng strategy to support the business plan. Typically, an HR framework sets out a people strategy including the competencies of the people who best suit the organization. This is then implemented in a range of areas, from recruitment and selection to learning and development. HR professionals work closely with business leaders and line managers to design and implement HR systems that back up strategic business goals.Business goals are the driver for every business decision, and HR polices support them.SELECTION AND RETENTION See pp.82–83.SUCCESSION AND TALENT PLANNING See pp.82–83.Values and culture Organization designPERFORMANCE MANAGEMENT See pp.84–85.HR helps to determine principles, conduct, and how tasks are done in a business.HR formulates the structure and formal reporting relationships that deﬁne a company’s shape.People and performanceHR is responsible for employees’ welfare and their contribution to business goals.LEARNING AND DEVELOPMENT See pp.82–83.HOW COMPANIES WORK Human resources3.2 billionpeople were in recorded employment globally in 2014REWARDS AND BENEFITS See pp.86–87.EMPLOYEE ENGAGEMENT See pp.92–93.78 79ESSENTIAL PEOPLE SKILLS As well as recruiting effectively and ensuring that employees deliver, HR plays a role in nurturing essential people skills across the organization.Relating to others ❯ Some people are natural leaders, but most leaders can beneﬁt from objective thinking about the leadership strategy they wish to follow. See pp.88–89. ❯ Even in ﬂattened, team-based hierarchies, team leaders need to develop leadership skills to guide and support their teams. See pp.90–91. ❯ Despite the revolution in technology, people remain vital to organizations, as skills and knowledge are central to success. As a result, HR has an expanding role. One example is Google, which calls its HR function People Operations (POPS) and treats its staff as a valuable asset, offering a range of attractive perks to “ﬁnd them, grow them, and keep them.” See pp.92–93.Managing projects ❯ Project management is an essential skill for managers at all levels, whether they are running regular day-to-day activities or special projects. See pp.94–95.Negotiating ❯ The ability to negotiate successfully is an essential skill. Awareness of strategies and styles is key to success. See pp.96–97.The human resources cycle From the moment a company starts the process of recruiting an employee to the time that person leaves the company, the individual is in a cycle that is managed by the human resources (HR) department. How it works People are a signiﬁcant cost to any organization—and of great value. Many CEOs talk about staff as their most important asset, and US industrialist Henry Ford famously said: “You can take my factories, burn up my buildings, but give me my people and I’ll build theNEED TO KNOWbusiness right back again.” The HR department is there to ensure that the right people are in the right roles so that the company can deliver the business strategy and maintain its competitive edge. The complexity of the business inﬂuences the stages in the HR cycle, but the basic elements are the same.CVNational employment laws Employment practice is regulated by a raft of laws— for example, in the US federal Equal Employment Opportunity laws prohibit any discrimination on the grounds of sex, race, disability, age, sexual orientation, or religion at any stage of the employment cycle.A business identiﬁes the need to ﬁll a role, and attracts applicants. CVs are assessed and interviews held to ﬁnd the best candidate.RecruitContractEmployOnce terms are agreed and a contract signed, the candidate becomes the company’s employee.“Hire people smarter than you and get out of their way.” Howard SchultzHOW COMPANIES WORK Human resources80 81$ RewardAn induction program explains the new role and introduces the team. HR gives a brieﬁng on pay, tax, and beneﬁts such as leave, insurance, and pensions.The company sets targets and helps individuals to improve performance so they contribute to business results and get the most out of their job.DevelopThe company helps its employee to move into a new role, which may be in another business it owns…Manage performanceThe business has processes to help people improve their skills, competencies, and knowledge, through formal or informal learning, both on and off the job.TransitionExit…or to leave the company, which may be through resignation, redundancy, or retirement.Recruitment and selection Placing the right person in the right job is vital for the success of the organization—this is the process of recruitment and selection. Technology is changing traditional hiring pathways. How it works The human resources function manages the process. Increasingly, line managers are involved as well because the tools are often accessible via company intranet. Recruitment starts with the company identifying a vacancy— the need for someone to do a job, and pulling together information about the exact nature of the role. Aspects to consider include the job’s purpose, tasks required, and the outputs or deliverables of the job holder, as well as how the role94%of recruiters in the US used, or planned to use, social media for recruiting in 2013ﬁts into the organization’s structure. This information forms the basis of a job description and person speciﬁcation. The search can then begin. The company’s own website, recruitment agencies, commercial job boards, and advertisements in the press are traditional ways of attracting the attention of people outside the organization. Internetbased routes are now common too. Today, application forms are often directly submitted online, triggering automatic responses and sorting of candidate details.STAYING PUT People tend to stay in a job during a recession. Nine million workers were hired in the second quarter of 2009 (mid-recession) in the US, down from 12.8 million in the last quarter of 2007 (pre-recession), a fall of about 30 percent. According to the Bureau of Labor Statistics, 80 percent of this decline came from a fall in “churn”, when workers in developed economies change jobs, rather than a dip in job creation.Job description and person speciﬁcation Clear written statement of the role, including job title, purpose, duties, responsibilities, scope, and reporting structure, as well as competencies and qualities required. It is used in the recruitment process to provide a clear guide for both applicants and interviewers.Person speciﬁcation Summarizes the necessary or desired criteria for candidate selection, including required skills and/or competencies for the role, experience, and educational qualiﬁcations.HOW COMPANIES WORK Human resources82 83Personal recommendationInternal search Looking at internal resources ﬁrst creates opportunities for career development and progression, improving employee engagement and retention.Some companies encourage existing employees to introduce friends as candidates.External search Increasingly, companies and candidates use professional networking sites such as LinkedIn and social media such as Facebook or Twitter. External candidates diversify the workforce but cost more to attract.NEED TO KNOWApplications The curriculum vitae (CV) or résumé is the essential document, often with a cover letter. Companies may use an application form instead.❯ Psychometric tests Often used as an initial screening method, these aim to assess attributes such as intelligence, aptitude, and type of personality, using verbal and non-verbal reasoning tests and behavior questionnaires.CONTRACT SelectionAppointmentAfter HR has drawn up a shortlist, candidates are assessed by individual faceto-face interviews, group assesssment, and psychometric testing.Companies may ask for references and/or request a medical examination for the chosen candidate. The employment offer is a legally binding contract that sets out the terms and conditions of the job.Evaluating staff For a business to achieve its goals, it needs to have a process that measures the contribution and performance of each individual against those goals.How it works The way in which tasks are done is becoming as important as what tasks are done, as organizations recognize the importance of creating the right culture to enable workers’ performance. For any company, effective evaluation of the performance of employees should be strategic and is aimed at ensuring the maximum productivity of individuals, teams, and the organization as a whole.Individual goals Set personal goals to align with business strategy❯ Business goals drive tasks and activity. ❯ Culture enables teams and individuals to deliver. ❯ HR policies give clear benchmarks.Traditional performancemanagement cycle Performance management is an ongoing, continuous process. Some companies are now moving away from traditional performance management to “crowdsourcing” as a way for managers to collect, evaluate, and share information on employee performance. WINNER!A WIN-WIN SITUATION Evaluating performance is good for both the business and the individual.Business ❯ Aligns individual goals with company goals. ❯ Offers consistent approach, with benchmarks. ❯ Continuously enables improvement. ❯ Fosters the right behaviors and relationships.Individual ❯ Understands what is expected of them. ❯ Has the skills to deliver on these expectations. ❯ Is supported to ﬁll any gaps in capability. ❯ Is given feedback and allowed to discuss goals.Rewards Promotions and pay raises in line with performanceHOW COMPANIES WORK Human resources84 85NEED TO KNOW❯ Balanced scorecard Framework to measure performance against strategic goals, devised by Kaplan and Norton ❯ Competencies Deﬁned behaviors and attributes that individuals must have to perform effectively at work ❯ Performance appraisal Process via which individual employee and their manager can discuss performance and developmentDiscussion Ongoing communication on standards of work and behavior to improve working relationships360-degree feedbackCoaching Feedback on performance to help individuals work efﬁcientlyGives a rounded picture with better information about working relationshipsCustomerAppraisal Formal feedback from the line manager, with an opportunity for individuals to contributeDirect reportsManagerINPUT FROM COLLEAGUESColleaguesMotivation and rewards People work for money, but they are also motivated by other factors such as doing a good job and being valued. Non-ﬁnancial rewards drive day-to-day motivation more strongly than pay and beneﬁts. How it works In the past, tangible pay and beneﬁts were the key motivational tools for employees. These ﬁnancial rewards are termed extrinsic because they areexternal to the actual work and others control the amount, distribution, and timing. Employers now recognize that while extrinsic incentives are clearly important, intrinsic (psychological) rewards are crucial.Understanding motivation in the workplace Happy staff work well, and job satisfaction comes from subtle feel-good factors as much as a paycheck. Employees who enjoy their work tend to stay—job satisfaction and turnover move in opposite directions.Extrinsic Policies implemented by the company:Financial rewards ❯ Base pay ❯ Bonus ❯ IncentivesBeneﬁts ❯ Pension contributions ❯ Paid holidays/vacation ❯ Health careIndividual motivation Employees get psychological beneﬁts from doing meaningful work and performing it well. Only one in eight workers—about 180 million employees in 142 countries studied— are committed to their jobs and make a positive contribution to their organization.HOW COMPANIES WORK Human resourcesMOTIVATION EXTRINSIC You are told to do something.the percentage of employees who are fully committed to their jobsWHY PEOPLE DO TASKSOnly this creates positive motivationDo this task and get a bonus. Do this task or get in trouble.I want to do this task to make a difference. I don’t want to do this task – it is pointless.INTRINSIC You choose to do something.13%86 87DEMOTIVATIONFostering intrinsic rewards Businesses that are successful engender trust and have employees who are passionate about what they do. All these factors contribute:Intrinsic Feelings that an individual has: ❯ Purpose A sense ofbeing able to accomplish something of value ❯ Choice Clear ownership and feeling responsible for outcome ❯ Progress As an individual,feeling and seeing evidence of moving things forward ❯ Competence Pride and satisfaction in own workPurpose for organization and individual ❯ Clear vision for organization ❯ Understanding of where individual ﬁts in to achieve that purpose ❯ Clear goals and expectations for individualRecognition ❯ Continuous feedback ❯ Ongoing engagement ❯ Non-cash rewards such as praiseCareer development ❯ Progression and promotion ❯ Mentoring and coaching ❯ Learning opportunitiesCulture ❯ Strong teamwork and consistent behaviors ❯ Open communication ❯ Sharing of knowledge and informationINCREASING MOTIVATIONLeadership strategy and styles Top-down leadership, in which managers give orders, is not always the best way to get results. A number of different leadership styles have been identiﬁed by business experts. How it works Every leader is an individual with his or her own approach. However, over the years, management gurus have identiﬁed key leadership styles that can be used to achieve different results, depending on the environment. Many frameworks are based on the ideas of psychologist Kurt Lewin, who developed his theories in the 1930s with three major styles: autocratic, democratic, and laissez-faire (non-interference).In 2007, for example, business authors Eric Flamholtz and Yvonne Randle developed a leadership matrix based on Lewin’s theories, which shows the best style to use in any given situation, ranging from autocratic (one all-powerful leader) to consensus (decisions reached by general agreement. Truly inspirational leaders encourage people to believe in themselves so that they achieve results beyond even their own expectations.“Outstanding leaders go out of their way to boost the selfesteem of their personnel.” Sam WaltonTRANSFORMATIONAL LEADERSHIP While different styles can suit different situations, transformational leadership, in which leaders and their followers raise one another to higher levels of integrity and motivation, was identiﬁed by guru James McGregor Burns as the most effective. This has been developed by others, including industrial psychologist Bernard Bass, who listed the qualities of a transformational leader.Sets clear goalsStirs the emotions of peopleEncourages othersHas high expectations Is a model of integrity and fairnessProvides support and recognitionInspires people to reach for the improbableGets people to look beyond their self-interestHOW COMPANIES WORK Human resources88 89When to use which leadership style A three-year study of 3,000 managers led psychologist Daniel Goleman to uncover six distinctive styles of leadership. Each style has a signiﬁcant impact on howpeople feel about their work. The most effective leaders master a number of styles and use them appropriately according to the situation.StyleWhen to useDrawbacksAfﬁliative“People come before task.” Focuses on creating emotional bonds within a team and a sense of belonging within an organization.Use in times of stress, when teammates need to recover from trauma, or when the team needs to rebuild trust.Praise and nurturing can foster mediocre performance and lack of direction.Coaching“Try this.” Helps people ﬁnd their strengths and weaknesses, linking these to career aspirations and action.Use to help teammates build lasting personal strengths that make them more successful.Coaching is ineffective when teammates are deﬁant and/or unwilling to change or learn, or if a leader lacks ability.Commanding/ coercive“Do what I tell you.” Demands immediate compliance, without discussion or negotiation.Only use in times of crisis or to control a problem employee when all else fails.Insistence should only be used when essential; it can alienate people, stiﬂe inventiveness, and create a tense atmosphere.Democratic“What do you think?” Goal is to build consensus through participation.Use when it is necessary for the team to buy into or have ownership of, a decision, plan, or goal.This is not for use in crisis or when teammates are not well enough informed to be able to offer suitable guidance to the leader.Pacesetting“Do as I do, now.” Expects and models excellence, creating challenging and exciting goals for the team.Only use when the team is already motivated and competent, and when fast results are necessary.Style can overwhelm some team members and adversely affect employee commitment; it may stiﬂe creativity and innovation.Visionary/ authoritative“Come with me.” Mobilizes the team toward a common vision and goal, leaving the means up to the individual.Use when the team needs a new vision because circumstances have changed, or when explicit guidance is not required.This is not effective when a leader is working with a team of experts or better-informed group.Leadership for team building Just as generals have to get the best from their troops, so business leaders must make the most of their teams. The key is ensuring that individuals work together to achieve a common goal. How it works From statesmen such as former British prime minster Winston Churchill to former General Electric CEO Jack Welch, great leaders know that to achieve a long-term goal, they must not only use their own capabilities but also maximize the combined strength of other people.How leaders inspire their teams Academic Carl Larson and organizational effectiveness expert Frank LaFasto conducted a three-year study of more than 75 diverse teams. They identiﬁed six characteristics of leadership that steer a team toward optimum results.They have a passion that sweeps people along with them; they learn from mistakes and are prepared to alter their course to meet changing circumstances. Much academic work has been done to study the traits and strategies of such leaders.Focusing on goal ❯ Deﬁnes goal in clear and inspirational way ❯ Helps each team member see how they contribute to goal ❯ Does not play politicsEncouraging collaboration“Leadership is the art of getting someone else to do something you want done because he wants to do it.” Dwight D. Eisenhower❯ Allows open discussions ❯ Demands and rewards collaboration ❯ Involves and engages peopleBuilding conﬁdence ❯ Accentuates the positive ❯ Shows trust by assigning responsibility ❯ Says “thank you”HOW COMPANIES WORK Human resourcesBUILDING AN EFFECTIVE TEAM In their book The Wisdom of Teams (1993), Jon Katzenbach and Douglas Smith make a distinction between teams and ordinary groups of people who work together. They deﬁne a team as “a small number of people with complementary skills who are committed to a common purpose, set of performance goals, and approach for which they hold themselves mutually accountable.” They found that leaders who manage to build successful teams tend to:❯ Select members for skill and potential, not personality. ❯ Focus on a few immediate tasks and goals at the beginning, to help the team to bond. ❯ Set boundaries and behavioral norms. ❯ Stimulate the team regularly with new information, encouraging open discussions and active problem-solving. ❯ Ensure that the team spends lots of time together, both in and outside of work.90 91“Don’t ﬁnd fault – ﬁnd a remedy” Henry Ford, American industrialistProviding know-how ❯ Knows own area ❯ Gets expert help for other areas ❯ Shares context with teamSetting priorities ❯ Demonstrates focus; avoids ambiguity ❯ Is clear about what must and must not happen ❯ Is prepared to change course if priorities switchManaging performance ❯ Sets clear objectives ❯ Gives constructive feedback; confronts and resolves performance issues ❯ Aligns incentives with team goals1 2 3Employee relations and communications Thriving organizations recognize the importance of harnessing people’s ideas and energy to provide a competitive edge, while managers are eager to gain, retain, and build employee commitment and engagement. How it worksleaders no longer send only one-way messages but harness a variety of interactive media, such as videoand tele-conferencing. Individuals and teams can use customized business social media, such as Yammer, to share ideas and knowledge, but may still choose to meet in formal settings such as councils and forums.Employee relations and communications are, either managed by human resources (HR) or as a function in their own right, are increasingly sophisticated. Rather than just relying on face-to-face talks and word of mouth, successful ﬁrms use added communication tools to help people understand the business goals and the individual’s contribution to results. In particular,CommitmentCommunication in practice In this example, a company is establishing weekly employee forums to facilitate communication and build trust throughout the business. To strengthen employee awarenees, engagement, and commitment to the idea, various media are used, from email to webinars and discussion. Managers focus ever more on collaboration rather than just imparting information.Engagement and involvementIn many countries, employee communications used to focus on structured industrial relations, managed by HR. Employee relations are now based more on trust and building strong relationships. Many ﬁrms create formal works councils or employee forums. At their best, employee forums: ❯ Allow representatives from across the business to share and generate ideas for improving performance. ❯ Encourage discussions on vision, changes, and plans for business. ❯ Recognize the value of employees.DEGREE OF COMMITMENTEMPLOYEE FORUMSAwareness and understanding CONTACT An email is sent to all employees with a short video informing them an employee forum is to be set up. TIMEHOW COMPANIES WORK Human resourcesCASE STUDY John Lewis The UK-based John Lewis chain of department stores is famous for its unique employee-owned structure, in which every worker is a partner in the business. It has a number of employee communication policies: ❯ Gazette Employees can send letters directly to management through the weekly gazette. Managers publish their responses in the gazette for all to read.❯ Partnership council Made up of 80 elected partners from across the business, the council meets four times a year. The chairman and directors report to the council, which can remove the chairman. ❯ Branch forums Elected by employees at each branch, these forums work with management to inﬂuence the running of their store and select local charities to support.ESTABLISH PRACTICE A company-wide awayday illustrates to employees how the forums have changed working practices.92 93$316 millionthe amount paid in staff bonuses by John Lewis in 2013REINFORCE AND INTERNALIZE Regular face-toface updates show employees how forums have made a difference.STIMULATE POSITIVE PERCEPTION An inspirational seminar illustrates the beneﬁts of the new forums. ADOPT AND SHARE Employees attend forums and then share their opinions on Twitter and Yammer so they feel involved and collaborate with managers.AID UNDERSTANDING Resources placed on the company intranet detail how employee forums will work.CREATE AWARENESS The purpose of employee forums is explained at a company-wide video conference.Project management Besides day-to-day activities, a business may have projects that are one-time, temporary, speciﬁc pieces of work. Projects need to be managed to deliver on time, within budget, and to speciﬁcations. How it works The process of project management takes a complex project from start to ﬁnish. It requires a different set of knowledge, experience, and skills from a mainstream operation because the goals set up have to be achieved within deﬁned limitations. These constraints include scope, time, quality, and budget. A project team might include people from different organizations, diverse disciplines, and multiple locations. Successful project managementinvolves not only overseeing the people working towards the particular objective, but also managing the risks, schedule, relationships, individual and team input, range of stakeholders with vested interests in the project, and ﬁnancial resources. Effective project management is increasingly viewed as a strategic competence (see p.85) for any business because it enables the introduction of new products, new methods, and new technology.NEED TO KNOW Project management tools There are many different project management tools, particularly for software development. One tool is PRINCE2®, a process-based approach to project management within a clear framework. The emphasis is on dividing the project into manageable and controllable stages with a deﬁned structure for the project management team.Steps in project management There are many workable project management systems, using various deﬁnitions for the key stages, all of which are encompassed in ﬁve main elements.InitiationPlanningExecution❯ Project charter, including business case, objective, scope, budget, deliverables, and schedule ❯ Roles and responsibilities ❯ Resource allocation❯ Detailed plan of work ❯ Critical path analysis ❯ Risks❯ Coordinating people and resources ❯ Quality assurance ❯ Communication to team and stakeholdersHOW COMPANIES WORK Human resources94 95HURDLES AND HOW TO OVERCOME THEM Every project comes up against challenges. These are some of the common ones, and the ways that effective management can keep the project on track.Project managementOptionsProject is not on schedule, or running short of time❯ Map out timeline of work and critical paths using tools and techniques. ❯ Review remaining work and identify risks, barriers, and mitigating strategies.❯ Negotiate scope, budget, and resources. ❯ Inform other teams and see if any changes can be factored in.Unclear vision or lack of clarity❯ Review project charter and revisit vision and objective. ❯ Involve team so everyone understands direction of work and avoids stalling.❯ Seek clarity from sponsors and/or senior management.Scope creep (project changes once under way)❯ Manage requests for change against business case and project objective.❯ Communicate to identify why change is important and how to incorporate, or ﬁnd alternative.Obstacle97% Monitoring and controlClosure❯ Measuring effort and progress ❯ Managing and mitigating risk ❯ People management❯ Finalizing all activities ❯ Communication ❯ Learning—project reviewof managers* believe project management is critical to success *surveyed from 34 different countriesNegotiating strategy Skillful negotiation is vital in business when two or more sides have different viewpoints and each party wants to press for their own advantage. The ideal outcome is a compromise that resolves conﬂict. How it works Like many aspects of business, negotiation is a process to ﬁnd a mutually acceptable solution. Before any discussion, each party must work to understand the other’s interests and decide on strategy; otherwisetalks can end in stalemate, bad feeling, and loss of business. Being able to negotiate is vital to build strong working relationships, deliver a sustainable, well-considered solution (rather than a short-term ﬁx), and avoid future conﬂicts.Reaching agreement Any strategy, from a wage negotiation between a trade union and employer to a sales negotiation between a customer and a supplier, depends on the relationship between the two parties. Good negotiation should leave each party feeling satisﬁed with the outcome of the discussion and ready to do business again.Prepare and plan ❯ Set objectives and ideal outcome (and assess those of other party). ❯ Rank and value issues and think of possible concessions. ❯ Consider ideal agenda and meeting place. Rehearse.Deﬁne ground rulesPropose, clarify, and justifyBargain to solve problems❯ Agree on logistics— location, room setup, agenda, schedule, number of negotiators. ❯ Deﬁne etiquette, such as no cell phones, one person speaks at a time, formal breaks. ❯ Agree on how information is to be presented and recorded.❯ Ensure both sides have equal opportunity to put forward their case. ❯ Clarify any points of disagreement. ❯ Focus discussion on understanding rather than resolving.❯ Offer alternative proposals and concessions. ❯ Discuss what is acceptable to each side. ❯ Aim to ﬁnd win-win solutions.HOW COMPANIES WORK Human resources65%96 97BODY LANGUAGE IN DIFFERENT CULTURESof face-to-face communication is through non-verbal signalsAgree, close, and implement ❯ Conclude with an agreement that is mutually acceptable. ❯ Clearly articulate and note agreement and concessions. ❯ Formalize agreement in writing and follow up.With international negotiations, it can be hard to read body language signals, particularly since the meaning of gestures can vary. Eye contact Chinese people avoid direct eye contact to show respect while American people see lack of eye contact as a sign of shiftiness. Facial expressions When emotions are high in the US, it is acceptable to frown, even to swear, but not to cry. Japanese people might smile or laugh, but never frown or cry. Head movements In much of Europe and the US, people nod to mean yes and shake their head to mean no. But in some parts of the world, such as in Bulgaria, it is the opposite way round. Gestures Western cultures use a hand extended towards a person to indicate “Come here”. Chinese people would see this gesture as offensive. Posture In the US, being casual is valued; people might slouch when standing or sitting. In some European countries, such as Germany, a slouching posture is considered rude. Formality is also valued in Japan, particularly the ability to sit upright and still.HOW FINANCE WORKS Financial reporting ❯ Financial accounting Management accounting ❯ Measuring performance ❯ Raising ﬁnancing$ $Financial reporting Financial reports are everywhere: a bill at a restaurant is a ﬁnancial report, as are sales receipts and bank statements. In business, however, ﬁnancial reporting refers to the ﬁnancial statements that make up a company’s annual report and accounts. Compiled by accountants, they provide investors and lenders with information to assess a company’s proﬁtability, and enable company managers, government, tax authorities, and other stakeholders to evaluate the business.Types of ﬁnancial reports Financial reports take many forms and can contain a vast amount of information about a company’s ﬁnances, work, core business values, performance, employees, and its compliance with local, logistical, domestic, and international laws. The most important ﬁnancial report, or statement, is usually the annual report— essentially a collection of many other, smaller reports—which sums up how the business has performed in the last year. There is a multitude of laws, regulations, and guidelines governing what should be put into this report.THE ACCOUNTING CYCLE The eight steps of the accounting cycle are used by nearly all accountants. The cycle helps by standardizing processes and makes sure that accounting jobs are performed correctly and in the same way and order for every activity. See pp.102–103.The annual report Financial statements usually appear in a company’s annual report and sum up its ﬁnancial activities in a standardized way for different audiences to interpret quickly and clearly. These statements take diverse forms, and being able to deconstruct them is a vital skill for accountants and businesspeople, making it simple to see how well a business is performing and why.$50 billionthe amount hidden via loans diguised as sales by Lehman Brothers in 2008 $HOW FINANCE WORKS Financial reporting100 101TYPES OF ACCOUNTING There are seven widely recognized types of accounting:❯ Financial Drawn up by accountants; used by investors, creditors, and management. See pp.110–129.❯ Forensic Engages in disputes and litigation, and in criminal investigations of fraud. See pp.152–153.❯ Management Used by managers to control cash ﬂow and budgets, and forecast sales. See pp.130–143.❯ Project Deals with a particular project; a useful aid for project management.❯ Governmental Also called public ﬁnance accounting; used by public sector for noncommercial accounting.❯ Social and environmental Shows how a company makes a positive difference to the community and environment.❯ Tax Dictates exact rules that companies and individuals must follow when preparing and submitting tax returns.Fi nc n aatements t s ial❯ What’s in an annual report? A full record of company performance according to various criteria, as well as accounts. See pp.104–105. ❯ What are the statements? The main one is ﬁnancial; others include sustainability, directors’ pay, and charitable donations. See pp.106–107. ❯ Who reads which statements? Sections are relevant to banks, shareholders, government, auditors, staff, and media. See pp.108–109. ❯ What do the notes mean? Main statements are annotated in detail. See pp.104–109. ❯ What are the rules? Accounting principles regulate ﬁnancial reports. See pp.112–113. ❯ Which are the most important ﬁnancial statements? Proﬁt-and-loss statements, balance sheets, and cash-ﬂow statements contain key facts. See pp.114–121.The accounting cycle The accounting cycle is a step-by-step process bookkeepers use to record, organize, and classify a company’s ﬁnancial transactions. It helps to keep all accounting uniform and eliminate mistakes. How it works The cycle works as an aid to organize workﬂow into a cyclical chain of steps that are designed to reﬂect the way assets, money, and debts have moved in and out of a business. It progresses through eight different steps, in the same order each time, and restarts as soon as it has ﬁnished. The cycle can be based onany length of time—this is known as an accounting period—and usually lasts a month, a quarter, or a year. Accounts which deal with revenues and expenses return to zero at the end of each ﬁnancial year, while accounts showing assets, liabilities, and capital carry over from year to year.The eight-step cycle The processes shown here are repeated in the same way for every accounting period. All businesses go through different phases, and the accounting cycle works by reﬂecting that. The ﬁnancial statement, which is prepared toward the end of each cycle, is helpful in showing how strongly the business has performed during each period of time.BOOKKEEPING AND ACCOUNTING ❯ Internal controls A method of deploying, measuring, and monitoring a business’s resources. This helps prevent fraud and keep track of the value of assets. ❯ Double-entry bookkeeping The process of recording all transactions twice—as a debit and as a credit. If a company buys a chair for $100, its debit account increases by $100 and its credit account decreases by $100. ❯ Bad debts Debts that cannot be or are unlikely to be recovered, so are useless to the creditor (lender), who writes them off as an expense.Transactions Any type of ﬁnancial transaction, from buying or selling an asset to paying off a debt, can start the accounting cycle.new cycle6,000 15,000 21,000Closing the booksFinancial statementsA closing entry based on adjusted journal entries is taken, the books are closed, and the cycle restarts.The corrected balances are then used to prepare the company’s ﬁnancial statements.HOW FINANCE WORKS Financial reporting102 103NEED TO KNOWJournal entriesPostingAccountants then analyze the transaction and note it in the relevant journal—a book or an electronic record.Journal entries are then transferred to the general ledger—a large book or electronic record logging all the company’s accounts.13%more accountants will be required in the US by 2022❯ Debits Expenses—dividends, assets, and losses. In double-entry accounting, debits appear on the left-hand side of the account ❯ Credits Gains—income, revenue, owners’ equity, and liabilities. In double-entry accounting, credits appear on the right-hand side ❯ Chart of accounts List giving the names of all of a company’s accounts, used to organize records ❯ Audit trail Full history of a transaction, allowing auditors to trace it from its source, through the general ledger, and note any adjustments madeTrial balanceA list of all the company’s accounts is prepared at the end of the accounting period, usually a year, quarter, or month.10,000 55 230 21,000WorksheetAdjusting journal entries Once the accounts are balanced, any adjustments are noted in journals at the end of the accounting period.Often, trial balance calculations don’t accurately balance the books (see pp.116–117). In such cases, changes are made on a worksheet.Financial statements The formal records of a business’s ﬁnancial activities are presented as ﬁnancial statements. Most jurisdictions require accurate information by law, and ﬁnancial directors and auditors are liable for its contents. How it works Financial statements summarize a company’s commercial activities clearly and succinctly, with details of the business’s performance and changes to its ﬁnancial position. They are aimed at several parties,so they need to be detailed but also comprehensible to the general public. The statements are usually presented together in the form of an annual report, with in-depth accounts and footnotes to give detail. Legal requirements vary, but accounts must be exact.What’s in an annual reportr custo Ou Orastruc infre tuA brief overview summarizes the key areas of ﬁnance for the company, including overall performance, turnover, operating costs, capital investment, depreciation, interest charges, taxation, and dividends. (See also pp.114–121.)mploye reesmunity omﬁnance urThis section underlines a company’s social ethos, in particular its community involvement. Different types of companies may focus on different values.OuCha iers and cnvironm ret enionIt is common for the chairman to write an introduction focusing on the positives and explaining any negative parts of an annual report for the beneﬁt of shareholders.Ou rintroductr’sOuThe contents page shows where to ﬁnd the big three statements—the balance sheet, cash-ﬂow statement, and proﬁt-and-loss statement—and softer information such as stories about staff and opinions of other stakeholders. The annual report provides an opportunity to impress shareholders and lenders as well as fulﬁll legal reporting obligations. It will contain all, or most, of the following.These pages contain much of the company’s information on its environmental protocols, most of which are industryspeciﬁc. See also pp.122–123.A section on employees details areas such as staff development and training, health and safety, and key statistics on staff satisfaction.The infrastructure pages of an annual report are a good place to supply more detail about the company’s ﬁxed assets and explain why the company is an attractive investment for investorsHOW FINANCE WORKS Financial reportingCONSOLIDATED FINANCIAL STATEMENTSNEED TO KNOWIndependNoteOur perfEnviron Bo ao the acc stnts ouThe board of directors, governance report, and statement of directors’ responsibilities sections indicate who is leading the company, showcases their credentials and roles, and reveals their pay.t audito en reportrs toof direc rdtors’ repr’snting ouCO2The environmental accounting section contains ﬁgures that pertain to the environment, often those stipulated by law—for example, greenhouse gas emissions.ec❯ Subsidiary One company that is controlled by another, usually a holding company ❯ Holding company A company set up to buy shares of other companies, then control them ❯ Globalization The process of businesses developing such large multinational presences that they transcend international borderst oricators ndntal ac c mePerformance indicators are common across all industries. They measure areas such as customer satisfaction and the quality of goods or services provided by the company.Di rIn an era of globalization, large corporations are now commonly made up of multiple companies. Companies owned by a parent company are known as subsidiaries, and continue to maintain their own accounting records, but the parent company produces a consolidated ﬁnancial statement, which shows the ﬁnancial operations of both companies. Depending on the jurisdiction’s reporting requirements, however, if a company owns a minority stake in a second company, then the latter will not be included in the former’s consolidated ﬁnancial statement.mance i or104 105In the directors’ report, members of the board of directors give their professional opinions on how the business has performed over the last year.Auditors are independent and check the accuracy of companies’ accounts. This helps to eliminate mistakes and track fraud.Notes to the accounts are a key part of ﬁnancial statements. They provide extra detail, insight, and explanation of the barebones ﬁgures supplied in earlier pages of the report.FINANCIAL STATEMENTSDeconstructing a financial statement The proﬁt and loss account shows revenues, costs, and expenses— how much money the business makes—over an accounting period. The balance sheet shows what a business is worth at the time it is published, and is relevant to investors as it reveals assets, liabilities, and shareholders’ equity—all useful for gauging business health. The cash-ﬂow statement shows the movement of cash within a business—its liquidity. However, along with the big three ﬁnancial statements, an annual review contains a wealth of information about a company’s performance, of interest to its stakeholder groups. It is often the notes that bring statements to life.TAXES The percentage of business taxes taken by governments varies from country to country but the generic types remain similar:Case study: the details Financial statements are presented as part of the annual report, which also publishes case studies, quotations, statistics, and proﬁles of customers, suppliers, employees, and directors. The notes, often running to 20 pages or so, contain tables and text that ﬂesh out the ﬁnancial information. The following examples are taken from the 2013 annual review of UK utility company Wessex Water.❯ Direct taxes are levied directly on proﬁts or income and include income taxes, inheritance taxes, and taxes relating to sales or purchase of property and other capital assets. ❯ Indirect taxes are paid on goods or services, such as sales taxes. Indirect taxes are often targeted to reduce consumption of harmful goods, a factor relevant to companies working in the alcohol and tobacco industries. ❯ Green taxes are increasingly common and are often indirect. They are generally used as a way of prohibitively increasing the price of goods or services harmful to the environment, such as air travel, landﬁll sites, or fuel, to diminish their use. ❯ Corporation tax is only paid by companies, not by sole proprietors or partnerships. It is levied as a percentage of the company’s total proﬁt.Sustainable investment Wessex Water’s investment in sustainability includes mandatory expenditure and extra discretionary expenditure (at the time of the review, £1 = $1.58). 2013 £m2012 £mCUSTOMERS AND COMMUNITIES5538ENVIRONMENT3025EMPLOYEES4946INFRASTRUCTURE139116TOTAL273225Our ﬁnanceThis section contains the headline ﬁnancial ﬁgures of the business, such as proﬁts, taxes paid, assets owned, liabilities, and dividends paid out, as well as some more detailed explanation of the ﬁgures.HOW FINANCE WORKS Financial reporting106 107BOARD OF DIRECTORSNEED TO KNOW ❯ Monopoly Situation in which there is just one supplier of a particular product or service; without government control, a company with a monopoly could make prices high and quality low, as consumers would have no alternative ❯ Oligopoly Industries that have a small number of suppliers. The competition is not as intense as in the free market, so governments often impose regulations on companies to ensure quality and fair prices ❯ Remuneration Money paid for work or a service provided— the ﬁnancial term for pay; may include bonuses or share optionsMuch of what might be considered personal information about directors of public companies is in the public domain. It is usually a legal obligation to disclose: ❯ Names of executive directors ❯ Names of non-executive directors, and whether they are independent or shareholders ❯ Shareholding ❯ Board attendance record❯ Dates of directors’ terms of ofﬁce ❯ Remuneration, including bonus, share options, pension plans, and beneﬁts ❯ Notice period ❯ Termination payment ❯ Potential conﬂicts of interestCharitable donations Companies vaunt their philanthropy in the annual report, detailing how much they have given away and how it has helped. They may support charities relevant to the nature of their business or let employees vote on recipients.Customer satisfaction96%Wessex Water utility’s customer satisfaction scoreOverall, this section shows how the company works with customers to improve service and support. In monopoly and oligopoly industries, customer satisfaction is particularly important, as governments often set high targets. Wessex Water’s annual review shows a customer satisfaction rating of 96 percent.FINANCIAL STATEMENTSFinancial statements for users The many ﬁnancial statements included in the annual report are a gold mine of information for those who know how to read them. They provide headline proﬁt ﬁgures, explanations of issues from directors, detailed ﬁnancial data, and information about companies’operations and policies. For this reason, ﬁnancial statements are useful to a wide range of stakeholders, from the company’s employees, customers, and shareholders to potential investors, governments, tax authorities, journalists, credit-rating agencies, banks, and the general public.Who reads what Different stakeholders are interested in different parts of the annual review. Customers of a service provider, for instance, may look at the section on customers and community while potential lenders go to the ﬁnancial statements..HAREHOLDER SStakeholderPL EMOYEEDITORS AUImportant parts ❯ Proﬁt-and-loss account ❯ Balance sheet ❯ Dividends❯ Our employees ❯ Governance report ❯ Performance indicators❯ The whole statement ❯ Independent auditor’s report (written by the auditor)Why? ❯ To see how much money the company is making ❯ To assess the long-term strength of the company ❯ To see how much will be paid out to them❯ To see any training programs or employee beneﬁts being praised that may be available to them ❯ To see how much executive and non-executive directors are paid ❯ To see how well the company is performing, and if it can improve ❯ To assess whether or not the accounts are error-free ❯ To ensure that the company has complied with Generally Accepted Accounting Principles (GAAP). See pp.112–113.HOW FINANCE WORKS Financial reporting108 109STATISTICS MADE EASY Impressive statistics are often scattered through an annual report. These examples are from UK utility Wessex Water:6% post-tax return on capital❯ This percentage is estimated by dividing income after tax by the amount of investment. It is useful for showing shareholders the kind of returns they can expect on their investments. ❯ For most industries, gearing is a company’s debt compared to its equity. In the water industry, it compares a company’s net debt to its regulatory capital value (the value of the business that earns a return on investment). Gearing is expressed as a percentage. See pp.174–175.64% gearing❯ Credit ratings assess the likelihood that loans will be repaid. A3 and A- fall at the bottom of “strong capacity to meet ﬁnancial commitments,” while BBB+ is at the top of the adequate range. The major ratings companies in the US are Moody’s, Standard and Poor’s, and Fitch.A3/A-/BBB+ credit ratingT/ ENTA X A UTT NSTI UTION LIU JORNALISTImportant partsWhy important?❯ Taxation ❯ Independent auditor’s report ❯ Environment section and environmentrelated notes❯ To check that the ﬁgures are correct and the correct amount of tax has been paid ❯ To check the audit, and that they are satisﬁed with the accounts ❯ To check that environmental laws have been adhered to❯ Balance sheetANKS S/BFINANC IARITIES HOGOVERNStakeholder❯ Chairman’s introduction ❯ Accounts and notes❯ To see the company’s assets and liabilities, and assess its strength ❯ To decide whether or not it is wise to lend to the company❯ To ﬁnd elements to quote ❯ To see how strongly the company has performed ❯ To analyze why a company has been performing well or poorly, and investigate if they suspect fraudFinancial accounting A company’s ﬁnancial accounts classify, quantify, and record its transactions. They are extremely useful for people outside the business, such as creditors and potential investors, as well as those currently involved with making investment decisions. For this reason, the accounts should be concise and clearly present the timing and certainty of future cash ﬂows, so that people looking at the company can decide whether or not to invest in, lend money to, or do business with it.Key elements The proﬁt-and-loss account, balance sheet, and cashﬂow statements are the most important ﬁnancial statements in an annual review, supplemented by the report’s notes. To understand these statements, a knowledge of accounting principles, depreciation, amortization, and depletion is vital. Accountants also need to understand the legal requirements that the statements must satisfy and how environmental laws can affect a business and its accounts.Accounting standardsProﬁt-and-loss statementGenerally accepted principles standardize practice worldwide to ensure accuracy and prevent fraud. See pp.112–113. ❯ International standards simplify account reporting. ❯ Companies must meet environmental accounting rules and regulations. See pp.122–123.Shows how much money a company is making and is especially useful for potential investors and stakeholders. See pp.114–115. ❯ Outlines revenues and gains minus expenses and losses or operating costs. ❯ Informs a company if a proﬁt warning is needed.$ $Balance sheet Gives a snapshot of how much a business is worth at a certain time and is a good indication of its long-term health. See pp.116–119. ❯ Balances company’s assets against its equity and liabilities. ❯ Lists different types of assets, including tangible ﬁxed assets and current assets.HOW FINANCE WORKS Financial accounting$74 billionthe total value lost by shareholders in the 2001 Enron accounting scandalCash-ﬂow statementEnvironmental accountingReveals a company’s liquidity by tracking the ﬂow of cash— money or short-term investments—in and out of the company. See pp.120–121. ❯ Shows if a company can sustain itself, grow, and pay debts. ❯ Details cash ﬂow from operating, investing, and ﬁnancing activities.Accounts for myriad environmental rules and regulations that oblige companies to mitigate the impact of business activities. See pp.122–123. ❯ Showcases green credentials in ﬁnancial statements. ❯ Reveals compliance with environmental, social, and governance criteria.110 111AUDITING The accounts of public companies are given unbiased scrutiny by external accountants to check that they are accurate and clear. This is a legal requirement in most countries, designed to ensure market conﬁdence in the business world and transparency in corporate ﬁnance. A company may also have an internal audit process, which means that its accounts are checked before being submitted to an external auditor.Depreciation Accounts for the decrease in value over time of tangible ﬁxed assets in order to spread the cost of assets over their economic life. See pp.124–127. ❯ Can be calculated using a number of different methods. ❯ Tangible ﬁxed assets include buildings, plant, and machinery.Amortization and depletion Account for the decrease in value over time of a range of intangible assets, loans, and natural resources. See pp.128–129. ❯ Intangible assets include patents, trademarks, logos and copyright. ❯ Natural resources include minerals and forests.International accounting standards With increasing globalization, international accounting standards, assumptions, and principles that help to make accounting easier across borders are essential for preparing ﬁnancial statements. Accounting standardsPros and consPurposeExampleStandardECONOMIC ENTITY ASSUMPTIONMONETARY UNIT ASSUMPTIONGOING CONCERN ASSUMPTIONTIME PERIOD ASSUMPTIONFULL DISCLOSURE PRINCIPLETransactions by businesses owned by one group or individual are kept separate from transactions made by other companies owned by that group or individual.International economic activity is expressed in monetary terms, with all units assumed to be quantiﬁable, constant and not affected by inﬂation or deﬂation.The ﬁnancial activities of a business will carry on indeﬁnitely.Different operations of a business can be divided into arbitrary time periods.All information, past, present, or future, which could affect ﬁnancial performance must be disclosed, usually in the notes of ﬁnancial statements.If a group owns two companies, one manufacturing televisions and the other retailing cell phones, the ﬁnancial statements for each company are separate.Current manufacture of baseball bats is compared ﬁnancially to manufacture that was carried out 30 years ago, without taking inﬂation into account.Oil reserves will never run out; gold in a gold mine will last forever; a manufacturer will not go out of business.Sales of toothbrushes can be measured daily, monthly, quarterly, and so on (when in reality they are constant, or subject to variations that are not predictable).If a coconut importer knows that a hurricane has damaged next year’s coconut crop, it must mention this in its ﬁnancial statement.Helps the group of companies and investors compare ﬁnancial statements of each company with its competitors.Shows as much of the company as possible in ﬁnancial statements, as everything a business owns can be quantiﬁed.Offers a model for businesses to look at the long-term future of their operations.Makes ﬁnancial reporting easier.Provides full information for shareholders and potential investors.It is hard to measure monetary value of, for example, the fastest worker at the baseballbat production plant.It is not applicable to companies approaching liquidation, as it assumes that any assets are worth their original value.The more often economic activity is measured, the easier it is to identify trends.Companies may try to “bury” information likely to put off investors or lower the share price in the notes.Largely beneﬁcial Companies that operate in the same group but in different countries must prove standard market rates used for intra-company trading.It is hard to compare across time because of inﬂation/deﬂation.Measuring activity often means more work, and such data may multiply errors.Not all countries are equipped to root out transgressors.HOW FINANCE WORKS Financial accountingHow it works International Financial Reporting Standards (IFRS) are the most widely accepted standards for accounting, and they are used in more than 110 countries. Originally introduced to harmonize accounting across Europe, they have with time spread around the world. IFRS are not to beHISTORICAL COST PRINCIPLEMATCHING PRINCIPLE112 113confused with International Accounting Standards (IAS), which were in use from 1973 to 2001. Generally Accepted Accounting Principles (GAAP), which are known colloquially as accounting standards or standard accounting practice, are country-speciﬁc guidelines for recording and reporting accounts. They differ from one jurisdiction to another.REVENUE RECOGNITION PRINCIPLECONSERVATISMPRINCIPLE OF MATERIALITYAssets and liabilities are valued at their buying price (in countries with high inﬂation or hyperinﬂation, other principles, such as fair value, are used).The time period in which a business’s expenses and revenue ﬁgures are collected always concurs.Revenue should be recorded at the moment when: a) goods or services are exchanged; b) assets can be converted to cash; c) it is earned—not when it is received.If there are alternatives for reporting on an item, accountants should choose to report the lower amount of income or asset gain.Accountants may make a professional decision to go against any one of the other principles.If a company bought a factory 50 years ago for $100,000, that will be its stated value today, even though its market value now is far higher.A grocery store measures costs incurred and revenues gained over the same time period, because when sales are high, costs are also likely to be high, due to the need to buy more stock.A toy-maker takes an order for 500 toys in July, delivers it in September, and is paid for it in December. The revenue is recorded in September, when the goods were exchanged.If a company is involved in a lawsuit, it must report the potential losses rather than the potential gains, in the notes of the ﬁnancial statement.An oil reﬁnery buys a $100 whiteboard, which could last 10 years. Under the matching principle, it should be billed for $10 each year, but the accountant enters it as a one-time cost.Ensures uniformity and prevents the overvaluation of assets, which was a feature of the 1929 Wall Street Crash.Avoids different time scales, which could present a distorted picture and erratic ﬁnancial results—for example, with high revenues from one period and high costs in another.Matches the time period that work was undertaken to when the payment was received, as with the matching principle.Prevents companies from overestimating money they will make in the future, then running into debt if it does not materialize.Saves time for small, almost insigniﬁcant transactions when there is no risk of it being applied misleadingly.Assets, especially property, acquired a long time ago are invariably represented as being worth less than their current real value.Helps to present accounts in a representative manner.Revenue may not always be received. If there are doubts about a recipient’s ability to pay, the company can make an allowance for doubtful accounts.Requires a degree of objectivity from accountants: if this objectivity is absent, ﬁnancial reports can be misleading.Saves time on accountancy. Makes information easier to read—for example, ﬁgures can be rounded to the nearest dollar, thousand, or even million dollars.Profit-and-loss statement A proﬁt-and-loss statement is a ﬁnancial statement that shows all revenues, costs, and expenses during an accounting period. It is also known as an income statement, or an income and expense statement. How it works The purpose of the proﬁt-and-loss statement is to show the proﬁtability of a business during a given period. Along with the cash-ﬂow statement and the balance sheet, it is the most important ﬁnancial statement a business produces, as it shows investors howproﬁtable the company is. The statement usually works by showing revenues and gains, less expenses and losses from business activities, as well as the sale and purchase of assets. Businesses that are sole proprietorships or partnerships are generally not required to submit proﬁt-and-loss statements.How to read a proﬁt-and-loss statement Proﬁt-and-loss statements commonly illustrate the ﬁnancial performance of a business over a particular month, quarter, or year. The key pieces of information are the ﬁgures for turnover (or revenue) and operating proﬁt. If proﬁts are going to be lower than expected, the company may put out a proﬁt warning in advance of releasing the statement.Case study: proﬁt-and-loss statement This statement taken from the 2013 annual review of Wessex Water, a UK utility company, shows it was making a healthy proﬁt (at the time, the exchange rate was £1 = $1.58). Year 2013 £mYear 2012 £mTurnover Operating costs492.1 (268.1)467.5 (248.5)Proﬁt earned from the business’s core operations after expenses have been taken off, but before taxes have been deducted; it does not include money made on investmentsOperating proﬁt Interest payable and similar charges Interest receivable Other ﬁnance costs224.0 (86.9) 2.9 (1.5)219.0 (81.7) 1.2 (1.0)Proﬁt before tax after all income and expenses have been taken into account, excluding extraordinary paymentsProﬁt on ordinary activities before taxation Taxation on proﬁt on ordinary activities138.5 (30.6)137.5 (44.3)Proﬁt attributable to shareholders107.993.2Amount of money taken by the business over a certain time; in this case, there was a 5.3 percent increase in turnover from the previous yearLevel of proﬁt that can be paid out in dividends to the company’s shareholders.Figures in parentheses represent negative numbers.HOW FINANCE WORKS Financial accounting114 115TYPICAL EXPENSES PayrollOfﬁce suppliesSalaries and wages paid to staff, temporary contractors, and indirect laborStationery such as pens, paper, and ﬁling systems, ofﬁce printers, furniture, lightingUtilitiesLegal fees and professional servicesWater, electricity, and gas; postage and shipping; transportationAccounting and legal fees, payable to accountants, auditors, and legal advisersInsuranceInterest on loansInsurance on ﬁxed assets and personal liability insurance for employeesPhone/internet bills% $Interest paid on money borrowed, which counts as a business expenseTaxCost of telephone, broadband internet, and mobile devices used by employeesVarying among jurisdictions, this may include payroll tax and corporation taxAdvertisingEntertainmentSales and marketing of the company and its productsLegitimate costs of business entertaining, subject to certain criteria being metCase study: operating costs This table breaks down the company’s operating costs in more detail. It is important to read any notes regarding depreciation and ordinary and extraordinary costs and gains.Manpower costs including basic pay and pensions, overtime payments, staff training, and maternity leave Term given to the gradual decline in an asset’s value, caused by factors such as wear and tear and market conditions. Decrease in value over time of intangible assets or loansYear 2013 £m Manpower costs Materials and consumables Other operational costs Depreciation Amortization of grants and contributions Loss/(gain) on disposals of ﬁxed assetsProﬁt or loss on the sale of ﬁxed assets Leasing costs for buildings and equipment Research and development carried out to improve the reliability and effectiveness of servicesOperating leases for plant and machinery Research and development Directors’ remuneration Fees paid to the auditorDirectors’ remuneration including base salaries and beneﬁts, pensions, car and health beneﬁts, share options, and bonusesFigures in parentheses represent negative numbers.Year 2012 £m51.7 29.1 67.6 120.3 (0.8) 0.2 268.145.3 26.7 63.8 114.0 (0.8) (0.5) 248.51.5 0.1 2.1 0.21.2 0.1 1.8 0.2Balance sheet A balance sheet is a ﬁnancial statement that shows what a business is worth at a speciﬁc point in time. Its primary purpose is to show assets, liabilities, and equity (capital), rather than ﬁnancial results. How it works The balance sheet essentially shows what the company owns, what it owes, and how much is invested in it. It is based on the accounting formula, sometimes called the balance-sheet equation, which is the basis of double-entry bookkeeping. This shows therelationship between assets, liabilities, and owners’ capital— what the company owns (assets) is purchased either through debt (liability) or investment (capital). The equation always balances, as everything a company owns has to have been bought with its owner’s funds or through borrowing.NEED TO KNOW ❯ Deferred income Income a company receives for goods or services that have not yet been delivered or provided. Until income is received it is recorded on a balance sheet as a liability.The balance-sheet equation As the name suggests, the balance sheet must always balance. This is because everything the business owns (its assets) must be offset against the equivalent capital (or equity) and liabilities (debt).Company has no liabilities For example, a young business may have assets of $1,000. It currently has no liabilities so its capital is equal to its assets—that is, it is the amount of equity the owners or shareholders have invested in the business. Using the accounting formula, the equation would look like this:ASSETSLIABILITYCAPITAL$1,000$0$1,000ASSETSLIABILITYCAPITAL$1,000$400$600Company incurs $400 in liabilities After spending $400 on, for example, an illuminated sign for the storefront, the owner incurs $400 in liabilities and so the formula changes. However, since the sign is worth $400, and the owner has $600 remaining, the equation remains balanced—as it always does.HOW FINANCE WORKS Financial accounting116 117Case study: balance sheet This example from Wessex Water, a UK public utility company, shows how a balance sheet works in practice (at the time, the exchange rate was £1 = $1.58).Fixed assets (or non-current assets) are not easily converted into cash and usually last longer than one year. They are either tangible, such as land, or intangible, such as a logo Current assets are assets that last one year or less, and can be easily converted into cash. Cash, cash equivalents, and inventory are the most common current assets Creditors are the individuals or organizations to which the company owes money. Here, the money must be repaid in the current ﬁnancial year Net current assets equals current assets after money due to creditors has been deducted Total assets less current liabilities is the sum of ﬁxed and net current assets minus liabilities due within the current ﬁnancial year Liabilities due in more than one year are amounts due to creditors, which are deducted from total ﬁxed and net current assets Net assets are what is left once liabilities have been deducted from the company’s ﬁxed and net current assets to give the overall net assets Shareholders’ funds, or owner’s equity, is the remaining capital; this money can be reinvested into the business or paid out as an annual dividendASSETS, LIABILITIES, AND CAPITALFixed assets Tangible assets InvestmentsYear 2013 Year 2012 £m £m2,167.1 –2,069.2 –7.0 162.6 181.06.3 153.9 211.0350.6 (198.8)371.2 (171.7)151.8199.5Total assets less current liabilities2,318.92,268.7Creditors—amounts falling due after more than one year Provisions for liabilities and charges Retirement beneﬁt obligations Deferred income(1,891.5)(1,811.9)(114.9) (93.1) (17.2)(115.3) (83.0) (17.9)202.2240.681.3 120.981.3 159.3202.2240.6Current assets Stock and work in progress Debtors Cash in the bank and in handCreditors—amounts falling due within one year Net current assetsNet assets Capital and reserves Called-up equity share capital Proﬁt-and-loss account Shareholders’ fundsSYMBOLS FOR DEBITS AND CREDITS Accountants use a number of different terms and symbols to indicate debits and credits. Some use “Dr” for debits and “Cr” for credits, others use “+” for debits and “–” for credits. On this balance sheet, parentheses are used to show credits (negative numbers).BALANCE SHEETUnderstanding the notes The balance sheet is a useful indication of the health of a business, and it is important that investors know how to analyze it. It can be read in two ways—“at a glance,” as on the previous page, where general information is summarized, or in depth, with more detailed information about each element. Providedafter the summary, the detailed section of the balance sheet explains the speciﬁc ﬁnancial workings of the business in a number of notes. It shows exactly where money has been gained or lost, in ﬁgures, and it often includes a written commentary about potential developments that may affect the company, such as court cases, stafﬁng, or availability of resources.Balance-sheet notes Investors may want to know more about the ﬁgures in the summary section, so additional notes and tables give detailed breakdowns of the ﬁgures (at the time, the exchange rate was £1 = $1.58).Case study: tangible ﬁxed assets This table presents details of Wessex Water’s tangible ﬁxed assets (long-term assets that cannot easily be converted into cash).Tangible ﬁxed assets include land and machinery Additions are new tangible ﬁxed assets the business has acquired this yearDisposals are any tangible ﬁxed assets the business has disposed of or sold this year Total value of the company’s ﬁxed assets is listed by category and in total Depreciation is the decrease in value of assets over time Value of depreciation of assets is listed by category and in total Net book value of an asset is its initial cost minus all its depreciation to date Combined value of the company’s tangible ﬁxed assets in each category, and also in total, is listedINFRASTRUCTURE ASSETSPLANT, MACHINERY, AND VEHICLESOTHER ASSETS£m£m£m£mLAND AND BUILDINGSCost As of April 1, 2012 Additions Transfers on commissioning Disposals Grants and contributions As of March 31, 2013676.3 9.51,229.7 67.81,204.6 49.1105.0 2.313.7 (0.2) – 699.311.2 (5.0) 1,303.742.2 (13.1) – 1,282.82.8 (0.5) – 109.6Depreciation As of April 1, 2012 Charge for the period Disposals As of March 31, 2013211.3 13.7 (0.1) 224.9435.5 43.2 – 478.7558.8 56.8 (11.5) 604.134.0 6.6 (0.5) 40.1Net book value As of March 31, 2013474.4825.0678.769.5As of April 1, 2012465.0794.2645.871.0HOW FINANCE WORKS Financial accounting118 119Case study: debtors $Debtors are individuals or entities that owe the business money. Wessex Water has four categories of debtor.Individuals or entities that sell assets to third parties on credit, receiving payment at a later datePrepayments for services that will be received in the future, which the business has already been paid for, and accrued income that is expected in the future= PAYMENTS ON ACCOUNT AND ASSETS IN COURSE OF CONSTRUCTIONTOTAL£m£m93.2 96.23,308.8 224.9(69.9) – – 119.5– (13.8) (5.0) 3,514.9Trade debtors Owed by group companies Prepayments and accrued income Other debtors2013 £m 48.9 31.8 70.32012 £m 48.1 35.0 62.111.6 162.68.7 153.9Case study: creditors $Creditors are individuals or entities that the business owes money to. They are in credit of Wessex Water.Money owed to the bank Individuals or entities that are owed money for supplying raw materials or componentsMoney owed to related companies that are owned by the same group– – – –1,239.6 120.3 (12.1) 1,347.8Payment to shareholders119.52,167.1Any notes relating to creditors93.22,069.2Tax and employee beneﬁt paymentsBank overdraft Inter-company loan Obligations under ﬁnance leases Trade creditors Amounts owed to subsidiary company Amounts owed to other group companies Amounts owed to associate company Dividend Other creditors Corporation tax Taxation and social security Accruals and deferred income2013 £m2012 £m21.8 7.018.6 1.3 6.34.3 18.93.1 14.20.60.60.70.223.3 2.4 16.7 1.9 101.2 198.821.7 2.0 9.2 1.7 92.8 171.7The inter company loan was due to a fellow subsidiary company SC Technology GmbH and has been repaid.Cash-flow statement The cash-ﬂow statement shows the movement of cash during the last accounting period. It is important because it reveals a company’s liquidity—whether or not it has more money coming in than going out.How to read a cash-ﬂow statement The statement of cash ﬂows, to give it its ofﬁcial title, answers the key question of whether a business is making enough money to sustain itself and provide surplus capital to grow in the future, pay any debts, and give out dividends. Figures in parentheses are negative numbers.Case study: cash-ﬂow statement By analyzing this water utility’s statement, which includes a comparison to the previous year, decisionmakers can base future plans on past cash ﬂows (at the time, the exchange rate was £1 = $1.58). Year to Year to March 31, March 31, 2013 2012 £m £mUsing proﬁt before tax as a starting point, non-cash income and expenses are deducted to reach net cash inﬂow from operating activitiesNet cash inﬂow from operating activities334.6303.2Returns on investments and servicing of ﬁnance(80.0)(79.2)Taxation is the sum of all taxes paid and tax credits receivedTaxation(21.8)(31.5)Capital expenditure and ﬁnancial investment is, here, the sum of the sale of tangible assets plus connection charges, grants, and deferred incomeCapital expenditure and ﬁnancial investment(215.4)(149.7)Dividends paid(129.6)(129.4)Cash outﬂow before ﬁnancial investment Financing(112.2) 79.0(86.6) 222.2(33.2)135.6Reconciliation of cash movement to the movement in net debt (Decrease)/increase in cash—above (33.2) Movement in loans and leases (79.0)135.6 (222.2)Returns on investment in this case is total interest received minus total interest paid, as well as interest paid on ﬁnance lease rentalsDividends are sums of money paid to shareholders, typically each year This is the sum of all the ﬁgures above Financing describes how much money the company has made or lost from loans, ﬁnance leases, and bondsThis is the change from last year’s ﬁgures to this year’s, and the total of the two ﬁgures above A utility company can afford to operate with more debt than companies with a less stable base(Decrease)/increase in cashMovement in net debt Opening net debt(112.2) (1,626.1)(86.6) (1,539.5)Closing net debt(1,738.3)(1,626.1)HOW FINANCE WORKS Financial accountingHow it works The cash-ﬂow statement is often more useful for investors assessing a business’s health than other key statements, because it shows how the core activities120 121are performing. The proﬁt-and-loss statement, for example, obscures this by adding in non-cash factors such as depreciation. Similarly, the balance sheet is more concerned with assets than liquidity.Three types of cash ﬂow Cash refers to actual money as well as cash equivalents including cash in the bank; bank lines of credit, and short-term, highly liquid investments for which there is little risk of a change in value. Cash does not include interest, depreciation, or bad debts (debts written off).Cash ﬂow from operating activities The bulk of cash ﬂow usually comes from operations, and is worked out with a formula. The change in working capital (current assets minus current liabilities) can be a negative ﬁgure.REVENUE – COST OF SALES– TAXESDEPRECIATIONANY CHANGE IN WORKING CAPITALCASH FLOW FROM OPERATING ACTIVITIESCash ﬂow from operating activities in practice In this example, a juice company sells $100 worth of orange juice after spending $20 on oranges. It pays 25 percent of its $80 earnings in tax. Its juicing machine incurs a depreciation$100WORTH OF ORANGE JUICEAND SPENDS$20I OF T PA ITS YS E IN ARN TA IN X GS25 %A JUICE COMPANY SELLSexpense of $20 over the period (a positive adjustment on the orginal outlay for the machine). There is no change in working capital (short-term assets to cover short-term debt).ITS JUICING MACHINE INCURS A DEPRECIATION EXPENSE OF$20OVER THE PERIODNO CHANGE IN WORKING CAPITAL$0ON ORANGESCash ﬂow from investing activities Buying or selling assets or investments is in this category. This ﬁgure is usually a cash outﬂow (negative ﬁgure) due to buying more than selling, but can be positive if there are signiﬁcant sales.Cash ﬂow from ﬁnancing activities This includes buying or selling stock or debt and paying out dividends. Money made from selling something is called cash inﬂow; money lost through paying out is cash outﬂow.= $80 CASH FLOW FROM OPERATING ACTIVITIESTotal cash ﬂowAdding all three cash ﬂows gives the total. Separating out the three types shows decisionmakers the health of core activities as opposed to ﬁnancing and investing, which bear little relation to day-to-day operations.Environmental accounting Environmental regulations force companies to consider the impact of their activities and to adopt corporate social responsibility (CSR) as they grapple with legislation, climate change, and public opinion. How it works Globally, there are reams of different environment acts spread across multiple jurisdictions that affect the companies operating within their borders in different ways. Areas protected by environment acts include the atmosphere, fresh water, the marine environment, nature conservation, nuclear safety, and noise pollution. International acts are usually ratiﬁed by each country individually before taking effect there. An example of a common global means of reducing greenhouse gas emissions is emissions trading (“cap and trade”), by which companies must buy a permit for each ton of CO2 they emit over a certain level. Those emitting under the agreed level can sell their permits to other companies.Environmental credentials Most companies include a section on environmental accounting in their ﬁnancial statement. Some details are required by law, but the statement also gives an opportunity to showcase environmental credentials to stakeholders.Society ❯ Programs and practices that assess and manage the impact of operations on communities ❯ Fines and sanctions for noncompliance with regulationsCASE STUDY Cleaning up rivers Wessex Water’s impressive record on pollution is mentioned several times in its statement, including in the chairman’s introduction. This prominence shows that the company believes acting in an environmentally conscious manner is important to its investors. The company illustrates several areas where it has acted with others to positively affect the environment: ❯ Work with the charity Surfers Against Sewage, which campaigns for clean seawater ❯ Its river strategy: collaborating with pressure groups and organizations to reduce pollutants and the impact of habitat alteration, and so increase the numbers of aquatic plants, invertebrates, and ﬁsh in local rivers ❯ Improving water quality at swimming beaches in the region, in compliance with mandatory standardsProduct responsibility ❯ Life-cycle stages in which the health-and-safety impact of products and services are assessed for improvement ❯ Adherence to laws, standards, and voluntary codes relating to marketing communicationsHOW FINANCE WORKS Financial accounting122 123GREENHOUSE GAS EMISSIONS In some countries, companies are required by law to provide details of their greenhouse gas emissions. This is usually presented as a table in the environmental accounting section of the annual report. It includes direct and indirect emissions—by the company itself and by third parties—of gas, diesel, and other fuels; sulfur oxides and nitrous oxides; methane; and other ozonedepleting substances. In this table, from the Wessex Water utility company, emissions are shown as ktCO2 equivalents.Appointed businessDirect fuel useGrid electricityThird partiesTotal 2012–13Total 2011–12Gas, diesel, other fuels10Grid electricity115115107Transportation1111Methane172020Nitrous oxide101719Exported renewable(3)(3)(4)TOTAL (net emissions)4211214169161Economic ❯ Financial implications, risks, and opportunities for the organization’s activities due to climate change ❯ Financial assistance received from the governmentEnvironmental ❯ Direct and indirect energy consumption ❯ Waste by type and disposal method ❯ Water withdrawal by source; discharge by destination and quality ❯ Fines and sanctions for noncompliance with regulationsHuman rights ❯ Investment agreements that include human rights clauses or that have undergone human rights screening ❯ Suppliers and contractors that have undergone screening on human rights; actions taken to address any issuesLabor practices ❯ Workforce by employment type, contract, and region ❯ Average hours of training per year, per employee by employee category ❯ Ratio of basic salary of men to women by employment categoryDepreciation When a company buys an asset, its cost can be deducted from income for accounting and tax purposes. Depreciation allows the company to spread the cost, by calculating the asset’s decline in value over time. How it works If a business buys a long-lived asset, such as a building, factory equipment, or computer, to help it earn income, this expenditure can be offset as a cost against income earned. However, not all this income will be generated in the year of purchase and, over time, the asset will age and become less beneﬁcial to the business, until it becomes outdated or unusable. Accountants do two things to turn the declining value into a tax advantage. Firstly, they work out how much the asset’s value decreases over a period of time—typically a year. Secondly, they match that loss in value to the amount of income earned in that period, so depreciation becomes a deduction from taxable income. There are several different ways to calculate depreciation. The method a company uses may depend on the kind of business, the type of asset, tax rules, or personal preference. In the United States, per IRS guidelines, companies must use MACRS (Modiﬁed Accelerated Cost Recovery System), a combination of straight-line and double declining balance methods (see below and p.126).Calculating depreciationNEED TO KNOW ❯ Fixed/tangible assets Items that enable a business to operate but are not a part of trade; assets lasting a year or more qualify for depreciation ❯ Useful/economic life Length of time an asset is ﬁt for its purpose and has monetary value ❯ Salvage/scrap/residual value Worth of an asset once it has outlived its useful life—often set by the tax authority ❯ Book value An asset’s worth on paper at any point between its initial purchase and salvageVALUE ($)The straight-line method is the simplest way of working out depreciation and can be applied to most assets. Depreciation is calculated along a timeline, with value loss spread evenly over the asset’s economic life. Scrap value is deducted from purchase value and the remainder is split into equal portions over time.0 ,00 $21$25,000 $20,000 $15,000 $10,000PURCHASE – VALUESCRAP VALUEUSEFUL ECONOMIC LIFE (YEARS)ANNUAL DEPRECIATION ($)$5,000 $Example A landscaping business buys a new van for $25,000. The IRS sets its scrap value at $5,000 after ﬁve years of use.$25,000 – $5,000 5= $4,000Year 1 After a year, the van’s value has depreciated by $4,000 (its purchase value minus its scrap value, divided by its useful economic life). Its value is now $21,000.HOW FINANCE WORKS Financial accounting124 125TYPICAL LIFE OF FIXED ASSETS Tax authorities often specify the typical useful (economic) life of a particular asset. This helps to standardize depreciation, and to eliminate uncertainty about value and the number of years over which an asset can be depreciated.OFFICE FURNITURE 6 yearsRACEHORSES 2 yearsROADS 15 years105 COMPUTERS 3 years20Time (years)60%the value the average car loses after three years15 BOATS 20 yearsFRUITBEARING TREES 10 years0 ,00 $17 0 ,00 $13000 $9, 000 $5,Year 2 After the second year, the value has depreciated by another $4,000. The van will lose an equal amount of value each year for the next three years of its useful economic life.Year 3 At the end of the third year, the van has depreciated by another $4,000, and its book value is $13,000, although its actual value may be more or less.Year 4 The van has depreciated by $4,000, to $9,000, at the end of four years of life.5 TIME (YEARS)Year 5 By the end of year ﬁve, the van is valued at only $5,000— its scrap value.DEPRECIATIONApplying depreciation When calculating depreciation, there are a number of different factors to consider. For instance, a business needs to be able to predict the number of years an asset will last. Helpfully, tax authorities in most countries issue guidelines to accountants and businesses with estimates of the useful economic life of many common business assets. Companies may also wonder which of the many methods of calculating depreciation to use for a given asset. Each method reﬂects a different pattern of depreciation, with some being more suitable for particularcategories of assets. For example, the “accelerated” methods that chart rapid depreciation at the beginning of an asset’s life are more suitable for technology, while the “activity” methods that link depreciation to actual hours of use or number of units produced are best suited to transport and production lines. Again, tax authorities in most countries offer guidelines on which method to use. Although it is technically possible for a company to use two different methods for their own accounting and for tax purposes, this is best avoided.WARNING Misusing depreciation ❯ The wrong method A company must choose a method that is permissible for an asset type ❯ Frontloading Opting for an accelerated method can result in a taxable gain if an asset is sold early, for more than its book value ❯ Claiming beyond useful life Depreciation cannot be claimed after an asset’s useful life ❯ Ignoring depreciation If a company fails to claim depreciation, it has to report a gain from the sale, despite the loss on deductionOther depreciation methods There are many different methods of calculating depreciation. Some are favored by particular tax codes, while others are speciﬁcally applicable to certain industries and types of assets, and their patterns of value loss.Double declining balance method A method used to claim more depreciation in the ﬁrst years after purchase, which is useful for assets that lose most of their value early on. It reduces a company’s net income in the early years of an asset’s life, but generates initial tax savings.PURCHASE VALUE – SCRAP VALUE USEFUL ECONOMIC LIFE (YEARS)ANNUAL X 2 = DEPRECIATION (%)When to use it This accelerated method can be used for any asset that loses value early on, such as computers or a delivery truck.Sum of the years’ digits method (SYD) Depreciation is calculated by dividing each year of the asset’s life by the sum of the total years to give a percentage of the depreciable value. If the asset’s useful life is 5 years, then the sum of the years as digits is 15 (5 + 4 + 3 + 2 + 1). In year 1, it loses 33 percent (5 ÷ 15), in year 2, 27 percent (4 ÷ 15), and so on.(PURCHASE VALUE – SCRAP VALUE) ANNUAL X = DEPRECIATION REMAINING USEFUL LIFE (%) SUM OF THE YEARS’ DIGITSWhen to use it This is another accelerated method that can also be used for vehicles that lose most of their value early on.HOW FINANCE WORKS Financial accounting126 127DEPRECIATION ON THE BALANCE SHEET A company’s accounts have to list all assets held by the company, including all ﬁxed assets such as property and equipment. The accumulated depreciation of these ﬁxed assets over the year is deducted from their value at the start of the year to give the year-end total. Without a depreciation ﬁgure, the accounts would give a false reﬂection of the ﬁnances of the business. The assets would appear as their original cost value and that might well exceed their current value. Fixed assets are shown distinct from current assets Depreciation of ﬁxed assets is deductedTotal assets are calculated after depreciation has been deducted Previous year’s total assets can be comparedCOMPANY NAMEBALANCE SHEETAssets Current assets: Cash Investments Inventories Accounts receivable Prepaid expenses Other Total current assets2013 17,467.00 4,853.00 1,056.00 2,165.00 3,000.00 860.00 29,401.002014 8,023.00 3,367.00 2,138.00 3,600.00 3,000.00 976.00 21,104.00Fixed assets: Property and equipment Building/site improvements Equity and other investments Less accumulated depreciation Total ﬁxed assets2013 64,553.00 4,780.00 3,789.00 5,625.00 67,497.002014 58,219.00 2,679.00 4,587.00 4,171.00 61,314.002013 1,577.00 1,577.002014 1,650.00 1,650.0098,475.0084,068.00Other assets: Goodwill Total other assets Total assetsUnits of production method When a company uses an asset to produce quantiﬁable units, such as pages printed by a photocopier, it can claim depreciation with this method, which calculates depreciation according to the number of units an asset produces in a year.(PURCHASE VALUE – SCRAP VALUE) X DEPRECIATION UNITS PRODUCED PER YEAR = (PER UNIT) LIFETIME PRODUCTIONWhen to use it This method is typically used by factories to calculate depreciation on machines that produce units of goods.Hours of service method The asset’s decline in value is measured according to the number of actual hours it is in use. To calculate depreciation using this method, the company measures the hours of use per year as a percentage of the estimated total lifetime hours. It is particularly useful for transportation industries.(PURCHASE VALUE – SCRAP VALUE) X DEPRECIATION = HOURS USED PER YEAR (PER HOUR)LIFETIME HOURSWhen to use it This method may be used to match an airplane’s ﬂying hours with the revenue generated from those hours.Amortization and depletion Similar concepts to depreciation, amortization and depletion are used by accountants to show how intangible assets and natural resources respectively are used up. How it worksasset on the balance sheet and an expense on the income statement. In lending, amortization can also mean the paying off of debts over time. Depletion shows the exhaustion of natural resources such as coal mines, forests, or natural gas.Amortization is how the cost of purchasing an intangible asset, such as copyright of an artwork, is spread over a period of time, usually its useful lifetime. It is shown as a reduction in the value of the intangibleAmortization in practice There are two types of amortization, one for spreading the cost of an intangible asset, the other for loan repayment. Both are calculated in similar ways, but loan repayments are worked out as a percentage.Intangible assets In this example, a VALUE ($) company buys an $20,000 intangible asset— a patent for a new, revolutionary type $16,000 of tennis racket—for $20,000. The patent $12,000 will be useful for 10 years, so its cost is $8,000 recorded as a $2,000 amortization (expense) each year rather than as $4,000 a one-time cost. Unlike tangible assets, a patent does not have a salvage 0 value (see p.124).INITIAL COSTYEARLY AMORTIZATION$2,000USEFUL LIFE $20,000 10 YEARSLoan percentage If a company has an outstanding loan worth $150,000, and pays off $3,000 of this loan each year, then $3,000 of the loan has been amortized. It can also be said that 2 percent of the loan has been amortized, as it will take 50 years to repay the loan at this rate.COST OF LOAN YEARLY REPAYMENT 150,000 3,0009 10 TIME (YEARS)YEARS TO REPAY 100 50 100= %= 2%HOW FINANCE WORKS Financial accountingGOODWILL128 129NEED TO KNOWIn business, goodwill describes an intangible asset based on a company’s reputation, including loyal customers and suppliers, brand name, and public proﬁle. Goodwill arises when one company buys another for more than its book value (total assets minus total liabilities). For example, if Company A buys Company B for $10 million but the❯ Intangible assets Nonphysical assets, such as patents, trademarks, brand recognition, and copyright; their valuation is sometimes subjective ❯ Patent A license granted by a government or authority giving the owner exclusive rights for making or owning an inventiontotal sum of its assets and liabilities is $9 million, the goodwill is worth $1 million. According to International Financial Reporting Standards since 2001, goodwill does not amortize, so it does not appear as amortization in ﬁnancial statements. However, if the value of goodwill falls (through negative publicity, for example) it can be recorded as an impairment.How to calculate depletion Like amortization, depletion is calculated using the straight-line method (see pp.124–125) unless there is a particular reason to use another method.60,0006,000MI $2.8 LLI ON30,000MI $3.7 LLI ONMI $4.6 LLI ONMI $5.5 LLI ON40,000DEPLETION UNITS = EXPENSE EXTRACTED20,000$900,00010,000MI $1 LL IO N10,000,000 – 1,000,000MI $6.4 LLI ON50,000TOTAL UNITSMI $1.9 LLI ONCOST – SALVAGE VALUEMI $7.3 LLI ONM $8.2 ILL IO N60,000M $9.1 ILL IO NNUMBER OF TREESM $10 ILL IO NIn this example, a logging company buys a forest with an estimated 60,000 trees for $10 million. The original salvage value is $1.5 million, but the company spends $500,000 on road building in the forest, bringing it down to $1 million. The company cuts down 6,000 trees during each accounting period.0 110 TIME (YEARS)Management accounting For a company’s management to anticipate proﬁt and loss, plan cash ﬂow, and set effective goals for the business, the coming year’s incomings and outgoings need to be set out in detail. Unlike ﬁnancial accounting, which is primarily for external users such as investors, lenders, or regulators, management or cost accounting takes place within a business to project expected sales revenue and expenses, so that the business can decide how to best use its available resources.Department budgets Managers estimate what funds will be needed for expected outgoings. See pp.136–137.Management accounting processPurchase orders (POs) POs tell the ﬁnance department exactly how much money to reserve for payment.Planning is done for the ﬁnancial (ﬁscal) year that lies ahead—this is also called the accounting year and is made up of 12 consecutive months. Start and end dates differ from country to country.Timesheets Staff employed on an hourly or daily basis ﬁll in timesheets; these help managers to calculate overall staff costs. See pp.140–141.Invoices Invoices submitted by contractors and suppliers have to be matched against purchase orders and paid out. See pp.134–135.Goods received Employees log receipt of merchandise, describing what the goods or services are and the quantity received.Management Managers create budgets and document business costs to monitor business performance, and plan for the short and medium term. The information they collate sheds light on the ﬁnancial implications of ongoing projects.Information is passed to ﬁnance departmentHOW FINANCE WORKS Management accounting80%130 131COST ACCOUNTING PRINCIPLESof accountants and ﬁnancial professionals in the US are employed within a business or organizationThe Chartered Institute of Management Accounting (CIMA) in the UK and the American Institute of Certiﬁed Public Accountants (AICPA), with members in 177 countries, have established Global Management Accounting Principles. ❯ Communication provides insight that is inﬂuential Facilitate good decision-making through discussion. ❯ Information is relevant Source best material. ❯ Stewardship builds trust Protect ﬁnancial and nonﬁnancial assets, reputation, and value of organization. ❯ Impact on value is analyzed Develop models to demonstrate outcomes in different scenarios.Cost of production report (CPR)CPR shows all of the costs that can be charged to a particular department. See pp.140–143.Budget reports Reports help management to determine the accuracy of budgets and analyze business performance. See pp.136–137.Cash-ﬂow statementThis shows how well the business will be able to meet its ﬁnancial obligations and generate cash in the future. See pp.120–121.Balance sheet Financial analysis is passed to managersThe balance sheet estimates the value of assets and inventory held, so that management can reduce it if necessary. See pp.116–117.Proﬁt-and-loss statement Also called an income statement, the P&L statement tells management how much money the business made or lost over a particular time period. See pp.114–115.Finance department Accountants in the ﬁnance department (or contracted from outside the business) receive information about the costs from managers. They then use these to generate reports and statements for the managers, who use this information to make decisions for the next ﬁnancial year.Cash flow The money coming in and going out of a business is its cash ﬂow; the balance of inﬂow and outﬂow is key to survival. Inﬂows arise from ﬁnancing, operations, and investment, while outﬂows are expenses.Sales revenue Cash for goods and services sold ❯ Revenue generated by core operations ❯ Basis of proﬁt—does not have to be repaid, unlike loans or capital ❯ Company must be able to turn revenue into cash (get paid) to maintain cash ﬂow ❯ Also known as cash ﬂow from operating activities“Cash comes in, cash goes out, but the tank should never be empty.”Capital Investment and lump sums ❯ Main source of cash inﬂow for start-ups ❯ Additional cash injection after initial start-up or at key stages in a company’s growth ❯ Revenue from ﬂotation of private companies (going public) and shares issued by public companies ❯ Also known as cash ﬂow from investing activitiesCASH INCASH INCASH OUTCa sh in han dSalaries and wagesOverheadsLoan repaymentsPayments to employeesPayment of bills❯ Money paid to employees who are directly involved in the creation of goods or provision of services ❯ Salaries paid to staff as a ﬁxed amount monthly or weekly (based on an annual rate) ❯ Wages paid to contractors for hours, days, or weeks worked❯ Day-to-day running costs ❯ Rental cost of commercial property; utility bills—water, electricity, gas, telephone, and internet; ofﬁce supplies and stationery ❯ Salaries and wages of employees not directly involved in creating goods and services (known as indirect labor)Debt servicing and shareholder proﬁt ❯ Interest on long-term loans for asset purchases and on shortterm loans for working capital ❯ Repayments on capital loans ❯ Commission paid to factoring companies ❯ Cash distribution to shareholders via share repurchases and dividend paymentsHOW FINANCE WORKS Management accountingHow it works Cash ﬂow is the movement of cash in and out of a business over a set period of time. Cash ﬂows in from sales of goods and services, loans, capital investment,132 133and other sources. Cash ﬂows out to pay employees, rent and utilities, suppliers, and interest on loans. Timing is key—having enough cash coming in to pay bills on time keeps the company solvent.Other revenue Grants, donations, and windfallsLoans Bank loans and overdrafts CASH IN$ $CASH IN❯ Working capital loans to meet shortfalls, with anticipated inﬂows as collateral ❯ Advances on sales invoices from factoring companies ❯ Short-term overdrafts ❯ Also known as cash ﬂow from ﬁnancing activities❯ Grants from government or other institutions, usually one-time sums for research and development ❯ Donations and gifts (applicable to nonproﬁt organizations) ❯ Sales of assets and investments ❯ Repayment of loans made to other organizations ❯ Tax refunds$ CASH OUTk toc or s SuppliersTaxEquipmentPayments for materials and servicesPayments to tax authoritiesPurchase of ﬁxed assets❯ Corporation tax based on annual ﬁnancial statements ❯ Payroll tax paid by employers on behalf of employees ❯ Sales tax on goods or services ❯ Varies from country to country, depending on tax law❯ Cost of buildings and equipment, such as computers and phones, ofﬁce furniture, vehicles, plant, and machinery ❯ Offset by depreciation (see pp.124–127)❯ Cost of raw materials needed to manufacture goods for sale ❯ Cost of stock, imported or local ❯ Fees for services such as consulting or advertising to generate revenue ❯ Payments to contractors involved in goods and services creationCASH FLOWCash-flow management The handling of cash ﬂow determines the survival of any business. Equally important is a company’s ability to convert its earnings into cash, which is known as liquidity. No matter how proﬁtable a business is, it may become insolvent if it cannot pay its bills on time. New businesses may become victims of their own success and fail through “insolvency by overtrading” if, for example, they spend too much on expansion before payments start coming in and run out of cash to pay debts and liabilities. In order tomanage cash ﬂow, it is essential for companies to forecast cash inﬂows and outﬂows. Sales predictions and cash conversion rates are important. A schedule of when payments are due from customers, and when a business has to pay its own wages, bills, suppliers, debts, and other costs, can help to predict shortfalls. If cash ﬂow is mismanaged, a business may have to pay out before receiving payment, leading to cash shortages. Some businesses, such as supermarkets, receive stock on credit but are paid in cash, generating a cash surplus.WARNING Top ﬁve cash-ﬂow problems ❯ Slow payment of invoices ❯ Credit terms on sales invoices set at 60 or 120 days, while credit terms on outgoings are 30 days ❯ Decline in sales due to change in economic climate or competition, or product becoming outmoded ❯ Underpriced product, especially in start-ups trying to compete ❯ Excessive outlay on payroll and overheads; buying rather than renting assetsPositive and negative cash ﬂowCASH IN CASH IN$ CASH IN HAND INCREASES$ CASH IN HAND STABLECASH OUTPositive cash ﬂowStable cash ﬂowCash ﬂowing into the business is greater than cash ﬂowing out. Cash in the tank—stock—increases. A business in this position is thriving.Cash ﬂows into the business at the same rate as it ﬂows out. Cash stock remains stable—a sign that a business is healthy.CASH OUTHOW FINANCE WORKS Management accountingNEED TO KNOW ❯ Factoring Transaction in which a business passes its invoices a third party (factor), which collects payment from the customer for a commission ❯ Accounts payable Payments a business has to make to others ❯ Accounts receivable Payments a business is due to receive ❯ Aging schedule A table charting accounts payable and accounts receivable according to their dates ❯ Cash-ﬂow gap Interval between payments made and receivedCash conversion Successful businesses convert their product or service into cash inﬂows before their bills are due. To make the conversion process more efﬁcient, a business may speed up: ❯ Customer purchase ordering ❯ Order fulﬁllment and shipping ❯ Customer invoicing ❯ Accounts receivable collection period ❯ Payment and deposit134 13580%of small business start-ups across the world fail because of poor cash-ﬂow management HANDLING THE FLOW Managing a surplusCASH IN❯ Move excess cash into a bank account where it will earn interest, or make proﬁtable investments. ❯ Use cash to upgrade equipment to improve production efﬁciency. ❯ Expand the business by taking on new staff, developing products, or buying other companies. ❯ Pay creditors early to improve credit credentials, or pay down debt before it is due.NO CASH IN/OUTCASH IN HAND DECREASESCASH DRIES UP CASH OUTNegative cash ﬂowManaging a shortage NO CASH IN/OUTLess cash is ﬂowing into the business than is ﬂowing out. Over time, the stock of cash will decrease and the business will face difﬁculties.Bankruptcy If cash ﬂowing out continues to exceed cash ﬂowing in, cash stock levels will drop so low that the business becomes insolvent—it has no assets left to continue trading.❯ Increase sales by lowering prices, or proﬁt margins by raising them. ❯ Issue invoices promptly and pursue overdue payments. ❯ Ask suppliers to extend credit. ❯ Offer discounts on sales invoices in return for faster payment. ❯ Use an overdraft or short-term loan to pay off pressing expenses. ❯ Continue to forecast cash ﬂow and plan to avert future problems.Budgets Setting the budget for a business involves planning the income and expenditure for the accounting year. This is usually broken down into months so that planned budget and actual ﬁgures can be compared. How it works Every business needs to budget for anticipated revenue and operating costs within the ﬁnancial year. Unlike capital budgeting, in which senior management allocates what will be spent on speciﬁc projects or assets, revenue budgeting focuses on the overall projections for money coming in and money going out for each month of the coming ﬁnancial, or accounting, year. Accountants compile operating budgets fromeach manager in the business, along with expected cash-ﬂow projections for the business, to create a master budget. The master budget can also include ﬁgures for any ﬁnancing that the company is expected to need over the coming year. As the year progresses, the projected budget and the actual money coming in and going out are monitored on a daily, weekly, or monthly basis, so that any deviations from the original budget can be identiﬁed, and, if necessary, remedied.Setting and controlling budgets Budget-setting is a process that takes place between the department managers, senior management, and ﬁnance department in a company to establish and control the cost of each department or project.1%of companies worldwide made accurate budget forecasts, from 2004 to 2007ConsultationPrepare the budgetSenior management sets out the company’s objectives to the departmental managers. Each manager is then responsible for working out the budget required by their individual department, in order to meet those objectives for the coming year.The budget is usually based on the accounting year, but broken down into shorter periods. Departmental managers submit their budgets to senior management for approval. These may cover areas such as operating costs (salaries and supplies) and administration (ofﬁce expenses).HOW FINANCE WORKS Management accountingINCREMENTAL AND ZERO-BASED There are two main approaches to setting budgets: Incremental budget The budget for the year ahead is based on the previous year’s budget. This budget takes into account any changes, such as inﬂation, which could have an impact on the new calculations. The downside is that previous inaccuracies may be carried forward.Zero-base budget The coming year’s budget starts afresh, with no reference to previous years. This means that each item entered into the budget is carefully scrutinized and has to be justiﬁed by the department managers. This method makes it easier to see the full cost of all planned changes.136 137NEED TO KNOW ❯ Planning, Programming, and Budgeting Systems (PPBS) A budgeting system used in public service organizations such as city councils and hospitals ❯ Virement An amount saved under one cost heading in a budget is transferred to another cost heading to compensate for overspend ❯ Budget slack Deliberately underestimating sales or overestimating expenses in a budget$ $Master budgetMeasure performanceTake actionOnce approved, the budgets from each department are combined into a master budget for the year, which includes: a budgeted proﬁt-and-loss account, a projected balance sheet, and a budgeted cash-ﬂow statement that typically shows a month-bymonth breakdown.After each month (or equivalent time period set in the budget), the actual ﬁgures realized by the company are compared with the original budget projections. Variations are examined closely to work out whether they are signiﬁcantly different from the ﬁgure in the original budget.If necessary, the budget is revised to take into account any unforeseen and continued expenditure, or any savings that were not anticipated. If income is less than expected, action may be taken to alter departmental processes or campaigns in order to reach the targets set in the budget.Assets and inventory A company’s possessions, or assets, are divided into two categories: ﬁxed (or long-term) assets and current (or short-term) assets. Current assets consist of cash in the bank and inventory. How it works Fixed assets are items that enable a business to operate. They tend to be long-term holdings and cannot be easily converted into cash. Fixed assets can be categorized as either tangible or intangible: tangible assets are material objects, while intangible assets have no physical form.Current assets are held for the short term and used mainly for trading. The most important category in terms of generating revenue is current assets. The key component of these is inventory. Inventory can be ﬁnished goods ready for sale, but it can also be the raw materials that will be used for producing the goods.NEED TO KNOW ❯ Asset valuation A method of assessing the value of a company’s holdings. Asset valuations may take place prior to a merger or the sale of the business, or for insurance purposesAssets and inventory in practice The partial balance sheets below show the current assets of a branch of Super Sports Inc., a sportswear and sports accessories company. These assets include cash in the bank and inventory held by the company. The inventory in this case consists of all the items in the shop that are ready for sale.Super Sports Inc.Super Sports Inc.May 31June 15AssetsAssetsCash at bank Inventories12,000 22,000Cash at bank Inventories54,000 0Total assets34,000Total assets54,000Balance sheet as of May 31Balance sheet as of June 15The “Assets” section of the balance sheet shows that the company holds $22,000 worth of inventory (or goods) at this point in time, as well as $12,000 cash in the bank.Two weeks later, the company sells all of its inventory for $42,000 and receives payment for this sale on the same day. This means that total assets have risen by $20,000—the proﬁt made on the sale of the inventory—and increases the amount of cash in the bank by $42,000.138 139HOW FINANCE WORKS Management accountingTYPES OF INVENTORY Inventory can include three types of stock, depending on the kind of business being carried out: raw materials, unﬁnished goods, and ﬁnished goods. See pp.316–317.Raw materialsWork in progressFinished goodsMaterials and components scheduled for use in making a product. For example, a chocolate factory will have: ❯ Ingredients in the form of sugar, cocoa mass, cocoa butter, additives, ﬂavorings, and perhaps milk or nuts. ❯ Foil, plastic, and paper for the wrappers and packagingMaterials and components that have begun their transformation into ﬁnished goods; these may be referred to as “unﬁnished goods.” For instance, a graphic designer will have: ❯ Layouts and designs that are being developed and are awaiting client approvalThe stock of completed products, or goods ready for sale to customers. A bookstore, for example, will have: ❯ Hardback and paperback books of various genres and formats supplied by publishing houses ❯ Gift items such as greeting cards and notebooksTypes of ﬁxed assets Super Sports Inc. owns a range of tangible and intangible ﬁxed assets. Compared to tangible ﬁxed assets, the worth of intangible ﬁxed assets can sometimes be harder to evaluate.Store displays and back ofﬁce furnitureComputers for administrative workTO OTrucks and branded company carsLSD MACH AN IY ERRetail outlets plus company headquartersVEHICLESTER EQUIPM PUCO MRNITURE FUT ENND PROP E DA NRTLATangible ﬁxed assetsWarehouse and distribution equipmentDEMARKBRANDS COOwn brands, including value and luxury rangesR SOFTInternet portal for online salesT AND RO GH Y RIS TIE ALLegally protected words and symbolsTE PUTYBrands and designs, creative innovationCOP YA TRARUAL PR OP ECT LLERINT EIntangible ﬁxed assetsLicensing revenue streamsCosts Costs are the direct or indirect expenses that a business incurs in order to carry out activities that earn revenue, such as manufacturing goods or providing a service. How it works There are two main ways of classifying costs: direct, or variable, costs, which increase as more goods and services are sold, and indirect costs, which contribute to the overall running of the business and can either vary with the level of production or stay ﬁxed. There are three main costs that businesses need to account for. The ﬁrst is labor—wages paid to people employed to carry out a particular task. Labor can be regarded as direct or variable, or as a ﬁxed cost or overhead. The second is the raw materials used in production and other materials used in service industries—these costs are variable. The third is expenses, which are other costs incurred in the course of the business’s activities.Variable costs The head chef orders the ingredients that will be required each day. For peak evenings the cost of the food order is higher; for quieter nights, the food order is lower.Fixed costsFixed and variable costs One way of looking at costs is to split them into two categories: ﬁxed costs, which do not change with the level of business activity, and variable costs, which do change with the level of business activity. This helps accountants to determine how changes in business activity (for example, cutting or increasing production) will affect costs. In reality, some ﬁxed costs will increase once business activity reaches a certain level—these are called stepped ﬁxed costs.LARGE FOOD ORDERRENT AND INSURANCE COSTSLAUNDRY SERVICES STAFF SALARIESCLEANING BILLA restaurant rents premises to cater for 40 diners. The ﬁxed costs are the same whether the restaurant serves 30 or 40 diners a night.HOW FINANCE WORKS Management accounting140 141NEED TO KNOW ❯ Break-even point (BEP) The point at which total sales revenue is equal to total costs ❯ Questionable costs Costs that can be treated as ﬁxed or variable ❯ Sunk costs Costs incurred in the past that cannot be recovered ❯ Prospective costs Costs that may be incurred in the future depending on which business decisions are made PEAK EVENINGSQUIETER EVENINGSSMALL FOOD ORDERStepped fixed costs40%of business owners say that payroll is their greatest expenseHIGHER RENT AND INSURANCE COSTSEXTRA LAUNDRY SERVICES HIGHER STAFF COSTSHIGHER CLEANING BILLThe restaurant becomes popular, so the owner rents the premises next door to serve an additional 40 diners a night. The costs that were ﬁxed at a certain level have now doubled.Product costing and pricing Knowing the full cost of creating each product that a business sells is vital because it helps a company price its products appropriately and assess the performance of the business. How it works Both direct and indirect costs contribute to the production cost of a product, whether it is a manufactured good or a service being provided. In order tocalculate the cost of a product, it is treated as one unit of production. The direct and indirect costs involved in creating that single unit are then assessed and added together to create the full cost.38%the average total of US business costs that can be accounted for by indirect costsFull cost pricing Direct costs can be measured in terms of how materials and labor are used to produce each unit. Indirect costs (overheads) are harder to assess but also need to be factored in so that the full cost of each product can be calculated. Managers and accountants must apportion indirect costs to reﬂect their contribution to the cost of creating a single product. Once this is ascertained, the full cost of that product can be determined. In general terms, the price is worked out by adding the direct and indirect costs of production with a proﬁt margin that gives an appropriate selling price.NEED TO KNOW ❯ Absorption costing Allocation of all production costs to product ❯ Differential costing Difference between the cost of two options ❯ Incremental (marginal) costing The change in total costs incurred when one additional unit is made ❯ Throughput costing An analysis of the impact that one extra unit of production will have on sales ❯ Cost-plus pricing Product price is based on direct and indirect costs, plus markup percentageDirect costsShare of indirect costs❯ Materials ❯ Direct labor ❯ Direct expenses ❯ All used exclusively to create a product or service for sale❯ Production and service overheads ❯ Administrative and management overheads ❯ Sales and distribution overheadsHOW FINANCE WORKS Management accounting142 143OTHER COSTING METHODSThere are several different approaches to costing and pricing depending on the industry, the type and size of the business, and the method of production.JOB COSTING Used for a customized order made to a client’s speciﬁcations—for example, a printing company that prints brochures for a clientBATCH COSTING Used when a batch of identical products is made—for example, an electrical goods company manufacturing television setsCONTRACT COSTING Used for a large one-time job, often the result of a tender process (when a company bids for work) and carried out at the client’s site—for example, a construction company building homes in a new residential development$ SERVICE COSTING Used when the product being sold is a standard service offered to customers—for example, a nail salon offering an express manicure and pedicure within a set period of time and for a ﬁxed pricePROCESS COSTING Used for an ongoing job that often involves several manufacturing processes, making it difﬁcult to isolate individual unit costs—for example, an oil reﬁnery which processes crude oil into diesel oilSelling price❯ Must be able to generate proﬁt for the company ❯ Must be in line with how the product has been marketed ME ❯ Must be HO Y E R pitched XU R SAL U L realistically so FO that customers will buy❯ Low: in order to gain market share, or to match competitors ❯ Cost-based: recover direct and indirect costs and proﬁt margin that the market will accept ❯ Service-based: ﬂexible since no manufacturing or distribution costProﬁt marginMeasuring performance There are two main ways of measuring a company’s performance: ﬁnancial and non-ﬁnancial. To assess ﬁnancial performance, a company calculates ﬁnancial ratios. To assess other areas of the business, a company examines its key performance indicators (KPIs), which help management and staff evaluate performance and how it can improve. KPIs also enable interested outsiders, such as investors, lenders, or analysts, to decide whether to invest in the business.Financial and nonﬁnancial categories Any company that publishes a ﬁnancial report will be required to set out key ﬁgures on the revenue generated and the expenses incurred during the course of its activities. These ﬁgures can be compared using mathematical calculations called ﬁnancial ratios. However, ﬁnancial ratios alone may not give an accurate vision of the company’s future prospects. Non-ﬁnancial ratios, or key performance indicators, do not measure ﬁnancial Tracking and forecasting performance, but they do reveal other important Financial and non-ﬁnancial measures can be characteristics of a company used to forecast company performance and that will ultimately affect its track fraud. See pp.152–153. proﬁtability, such as customer loyalty and research and development (R and D) productivity.Comp anyHOW FINANCE WORKS Measuring performance144 145TREND ANALYSIS USING PERFORMANCE MEASUREMENTS A comparison of either ﬁnancial CURRENT ratios or KPIs RATIO between companies 0.9 in the same industry and across time 0.8 is often used to 0.7 track a company’s 0.6 performance. 0.5 Current ratios are calculated by 0.4 dividing current 0.3 assets by current 0.2 liabilities: the higher the ratio, 0.1 the more liquidity a company has. 1CURRENT RATIO COMPARISON OVER TIME Fast-food chain A is shown to be a consistently better performer over time, and so has the most solid ﬁnancial standing of the three companies.l ia nc res na u Fi eas m ❯ Used by investors and lenders to gauge ﬁnancial health of an organization: if it’s likely to survive economic slump, and what prospects it has for future growth ❯ Standard set of ratios used by the ﬁnancial industry ❯ Calculated based on ﬁgures provided in ﬁnancial reports See pp.148–149.FAST FOOD CHAIN C FAST FOOD CHAIN Bn- cial s o N an ure ﬁn e a s $ m$ Financial ratiosFAST FOOD CHAIN AKey performance indicators ❯ Used internally and by investors, as they appear in ﬁnancial statement ❯ May be calculated daily or even more frequently for internal use ❯ Companies can set diverse KPIs to reﬂect future goals ❯ Unique to each company See pp.146–147.YEARTHE BIGGER PICTURE Some professional services companies, such as multinational PwC, undertake quarterly surveys, interviewing senior executives to ﬁnd out how optimistic they are about their sector and the wider economy. Such surveys help companies measure their own performance objectively.69%of multinationals link performance measures to future ﬁnancial resultsKey performance indicators (KPIs) Key performance indicators (KPIs), or key success indicators (KSIs), are based on a company’s goals and vary depending on the company and industry. KPIs are usually stated in a company’s annual report. How it works KPIs are the non-ﬁnancial measures of a company’s performance—they do not have a monetary value but they do contribute to the company’s proﬁtability. Any company department can adopt KPIs to gauge its performance. A KPI for an accounts department might be the percentage of overdue invoices, as this will helpdetermine the department’s efﬁciency. This is an example of a lagging indicator—it is an outcome and therefore easy to measure, but not straightforward to inﬂuence. Companies also look for leading indicators, which are focused on inputs and easier to change. A leading KPI for the accounts department might be the percentage of purchase orders raised in advance.Corporate KPIs KPIs can be set up as dashboards on computers so that they can be checked frequently. These dashboards show examples of KPIs speciﬁc to departments in a company. Having set their KPIs, the departments are subject to managerial review, which could result in action if KPIs are sub-standard.d market ing es an SalNet promoter score (NPS—how many customers would recommend company); customer retention rate; customer lifetime value (total amount of money generated by one customer)AccountsNumber of retrospectively raised purchase orders; ﬁnance report error rate (measures the quality of report); average cycle time of workﬂow; number of duplicate paymentstomer service CusNumber of customer complaints; customer satisfaction (measured over time); average email response time; number of products sold compared to total sales calls madeHOW FINANCE WORKS Measuring performance31%146 147BALANCED SCORECARD SYSTEM ❯ Learning and growth Employee training and corporate culture ❯ Business processes Includes speciﬁc measurements for monitoring daily performance ❯ Customer perspective Customer satisfaction ❯ Financial perspective Traditional ﬁnancial dataThis strategic system offers a different way of monitoring a company’s performance. It was proposed by Robert Kaplan and David Norton at the Harvard Business School in the 1990s, and Harvard Business Review has cited it as one of the most inﬂuential business ideas of the last 75 years; it is estimated that over 50 percent of large companies in the US, Europe, and Asia use the approach. The Balanced Scorecard consists of four ways to view an organization’s performance:of companies use a computer dashboard to monitor KPI measurementsOperationsEconomic value of an employee’s skill set; employee satisfaction levels; revenue per employee; rate of employee turnovernt and sustain me ab n ro ili vityEnan resource s HumProject cost (difference between budgeted cost and actual cost of work); time taken to get a product to market; optimally running operationsWaste recycling rate; size of carbon footprint; size of water footprint (amount of water usage); energy consumptionFinancial ratios Lenders, investors, analysts, internal management, and other interested parties calculate ﬁnancial ratios to decipher what ﬁnancial statements are really saying about the state of a business. How it works Financial ratios are used to assess the ﬁnancial standing of a business and identify any problem areas that might affect its future prospects. The process involves comparing two related items in the ﬁnancial statement, such as net sales to net worth or net income to net sales, and using those ratios to measure the relative performance of the company. There are many different ratios to choose from, depending on theTop ﬁnancial ratios These are some of the ratios most commonly used by people involved with assessing businesses. They are best considered comparatively and in the context of the economic climate. The ratios are for analyzing established companies, usually public ones with shares traded on the stock exchange—start-ups and small-tomedium enterprises generally do not have a full enough range of ﬁgures to provide any kind of reliable guide.$$$ x6 1 02 .+ –purpose—for example, whether the purpose is to measure the company’s ability to provide a good return to shareholders, its capacity to handle debt, or the efﬁciency with which it operates. The ratios can also be used to compare a business with its competitors or in comparison to speciﬁc benchmarks within the company to determine how consistent its ﬁnancial results are.Proﬁtability ratiosEfﬁciency ratiosThese are used to see how effective a company is at generating proﬁt. Proﬁtability ratios may mirror investment valuation ratios. One example is the operating proﬁt margin ratio. A high ratio is good, as it indicates that a high proportion of revenue (gross income) converted into operating income (proﬁt minus costs).These show how efﬁciently the company uses its assets and resources to maximize proﬁts. An example is the sales revenue to capital employed ratio, which indicates a company’s ability to generate sales revenue by utilizing its assets. Similar ratios can examine how quickly the company settles its bills and invoices.OPERATING OPERATING INCOME = PROFIT MARGIN REVENUESALES NET SALES REVENUE TO = CAPITAL CAPITAL EMPLOYED EMPLOYED RATIOOther proﬁtability ratiosOther efﬁciency ratios❯ Return on equity (ROE) is measured as net income after tax / shareholders’ equity. The higher the ratio, the greater the proﬁtability, but not if a company is relying too heavily on borrowing. ❯ EBITDA to sales ratio is measured as EBITDA (earnings before interest, taxes, depreciation, and amortization) / revenue. It gauges the proﬁtability of core business operations. The higher the margin, the greater the proﬁts.❯ Accounts receivable turnover ratio is measured as net credit sales / average accounts receivable. It shows how efﬁciently a company turns sales into cash. The higher the ratio, the more frequently money is collected. ❯ Inventory turnover ratio is measured as the cost of goods sold / average inventory. It shows how efﬁciently a company manages its inventory level. A low ratio usually equates to poor sales.HOW FINANCE WORKS Measuring performanceWARNING Investors beware Ratio analysis must be used over time—at least four years—to understand how a company has reached its current position, not just what the position is. For instance, if debt has suddenly gone up, it could be because the company is branching out into new areas of potential proﬁt, or to limit the damage of a poor past decision.10–14%the minimum return on investment (ROI) needed to fund a company’s futureLiquidity ratiosSolvency ratiosThis group of ratios reveals whether or not a company has enough cash or equivalent assets to meet its debt repayments. An example is the working capital ratio (also a measure of efﬁciency), which indicates whether a company has enough short-term assets to cover its short-term debt.While liquidity ratios look at a company’s short-term ability to meet loan repayments, solvency ratios indicate the likelihood of a company being able to continue indeﬁnitely with enough cash or current assets to pay its debts in the long run. An example is the debt to equity ratio.WORKING CAPITALCURRENT ASSETS CURRENT LIABILITIES148 149TOTAL SHAREHOLDERS’ DEBT TO EQUITY EQUITY = RATIO TOTAL ASSETSInvestment valuation ratios Thes ratios are typically used by investors to gauge the returns they are likely to get if they buy shares in a company. An example is the dividend payout ratio. It indicates how well earnings support the dividend payments—more mature companies tend to have a higher payout ratio.DIVIDEND PAYOUT RATIOYEARLY DIVIDEND = PER SHARE EARNINGS PER SHAREOther liquidity ratiosOther solvency ratiosOther investment valuation ratios❯ Cash ratio is measured as total cash (and equivalents) / current liabilities. It shows whether a company’s shortterm assets could repay its debts. A high ratio is seen as favorable. ❯ Quick ratio (acid-test ratio) is measured as current assets minus inventories / current liabilities. It shows how easily a company can repay shortterm debt from cash. The higher the ratio, the more easily it can pay.❯ Interest coverage ratio is measured❯ Net proﬁt margin ratio is measured as proﬁt after tax / revenue. Another measure of a company’s proﬁtability, it is also useful for comparing a company with competitors. The higher the ratio, the more proﬁtable the company. ❯ Price to earnings ratio is measured as market value per share / earnings per share. It indicates the value of the company’s share price. A high ratio demonstrates good growth potential.as EBIT (earnings before interest and tax) / interest expense. It indicates how easily a company can pay the interest on its debts. The higher the ratio, the more easily they can pay. ❯ Debt ratio is measured as total liabilities / total assets. It indicates the percentage of the company’s assets that are ﬁnanced by debt. A low ratio is considered favorable.Forecasting Predicting future business performance is necessary to estimate probable sales, income, costs, and proﬁtability and thus gain investment and maintain conﬁdence in the company. How it works Forecasting success or failure relies on historical data—ﬁnancial statements, ﬁnancial ratios, and Key Performance Indicators—that reﬂect businessoperation and can be tracked over time. The tracked and monitored data can provide an early warning system for potential problems. For small businesses and start-ups, accurate forecasts provide a basis forForecasting with Z-score models Realizing that traditional ﬁnancial ratios, such as the ratio of costs to revenue, created only a partial picture of a business’s ﬁnancial performance, Altman devised a set formula that combined four or ﬁve key ratios to give a Z score. The model has proven 90 percent accurate in predicting business failure over one year, and 80 percent accurate over two years.Corporate success Efﬁciently run companies with a healthy balance between assets and liabilities, and proﬁt and debt inspire conﬁdence in investors.Working capital / total assets A measure of liquidity: the more working capital in a company, the more it is able to pay its bills.Market value of equity / book value of total liabilities A measure of the market conﬁdence in the company: a ratio of less than one means the ﬁrm is worth less than it owes—it is insolvent.Retained earnings / total assets A measure of leverage: a high ratio indicates proﬁts are funding growth; a low ratio indicates growth is ﬁnanced by debt.Earnings before interest and taxes / total assets A measure of return on assets: it gauges operating income generated by assets.Sales / total assets A measure of efﬁciency: the sales generated by the assets.SS Success Finding the Z score Each of the above ratios is multiplied by a speciﬁc value, to give them weighting; results are added together to give Z score. ❯ A score of 0.2 or lower means the company is highly likely to fail. ❯ A score of 0.3 or higher means the company is unlikely to fail.HOW FINANCE WORKS Measuring performanceraising external ﬁnancing, while for larger companies, this information provides an indication of ﬁnancial strength for investors and markets. Predictions may range from conjectured costs and revenue to complex ﬁnancial models. One of the most frequently used predictive models for forecasting business success is the Z-score model, devised by Edward Altman, a New York University ﬁnance professor, in 1968.Signs of corporate failure There are many signs that a company is doing badly and perhaps sliding into insolvency. These signs make investors nervous, which is likely to lower share price if they start selling their shareholding. However, most companies that fail are in proﬁt, but run out of cash.NEED TO KNOW ❯ Ohlson O score Alternative to Z score for predicting failure ❯ Overtrading When a company’s sales grow faster than its ﬁnance❯ Undertrading When a company trades at low levels compared to its ﬁnance levels ❯ Zeta analysis Secondgeneration Z-score model20%the predicted proﬁtability increase from 2013 to 2017 for organizations using performance measurement to make business forecasts Selling assets s to pay of f debtSS F ailu reCuts to employee beneﬁtsRepea te divide d nd cut to shar s eholde rs Bankruptcy occurs if the company cannot pay its debtsd continue w, seen in holdings o ﬂ h s a Low c in cash f decline e years pattern o t over consecutiv e e ce sh on balan150 151High borrowing, high interest paym ents, and dwindling reve nueTop management resigning and taking jobs elsewhereility, seen in Low proﬁtab nslide in proﬁt consistent dow from loss statements on proﬁt-andars consecutive yeTracking fraud For keen observers of ﬁnancial statements, warning signs that indicate fraudulent business activities may be detected in overly optimistic statements and evasive attitudes of senior management. How it works Public companies are required to have their annual ﬁnancial statements audited (checked) by an independent auditor. It is typically during this process that any ﬁnancial shenanigans— creative accounting tricks used to manipulate the ﬁgures and improve the performance of a company in its ﬁnancial statements—and outright fraudulent activity isuncovered. It is the auditor’s job to ensure that business records and statements are accurate and have been honestly reported. Auditors carry out a systematic examination of the company’s records and may identify any irregularities that may indicate fraud. If evidence of fraud is found, the next step is to involve forensic accountants and criminal investigators, who may prosecute the perpetrators.Red ﬂags indicating fraud Auditors may be alerted to fraud by a number of recognized warning signs or “red ﬂags”; these may be either directly to do with the behavior of the CEO or other top executives, or in the form of irregularities within the ﬁnancial statements.89%of US corporate fraud cases in 2010 typically involved the company’s CEO or CFONEED TO KNOW ❯ Asset stripping Selling off the assets of a company for a proﬁt to raise funds, often resulting in the closure of the business ❯ Tunneling A particular type of fraud in which assets and funds are illicitly transferred to management or shareholdersSuspicious ﬁgures on ﬁnancial statements ❯ Cash ﬂows that are negative for three quarters, then suddenly and dramatically become positive ❯ Sudden increase in gross margin, at odds with industry average and company’s previous performance pattern ❯ Large sales to companies with dubious track records❯ Sales recorded before they have been made ❯ Made-up, nonexistent sources of revenue ❯ Expenses moved from one company to another, or classiﬁed as assets ❯ Ongoing, long-term growth of earnings per share ❯ High payments to executives compared to base salaryHow to detect fraud Procedures should be in place to hold accountable anyone who handles expenses. When these fall short, internal and external auditors need to take more drastic measures.Applying ratio analysis to reveal key long-term trends (see pp.148–149)HOW FINANCE WORKS Measuring performance152 153LINE-UP: TOP FIVE NOTORIOUS FRAUDS Some of the worst frauds stem from the most prestigious companies. Enron was one of the top seven US companies, while JPMorgan Chase & Co. was the largest American bank when measured by assets.SECURITIES EXCHANGE CO. In 1919, Charles Ponzi began a pyramid scheme in Boston, selling postal reply coupons. He pledged investors 50 percent return within 45 days, which he paid from new investors’ funds.BARINGS BANK The UK merchant bank collapsed in 1995 after unauthorized trading by employee Nick Leeson racked up losses of $1.3 billion. He had been allowed to bypass internal audits.ENRON Energy company Enron declared bankruptcy in 2001 although it had never shown a loss in its ﬁnancial statements. External auditors were accused of failing to properly review accounts.WORLDCOM US communications company WorldCom declared bankruptcy in 2002 after it improperly accounted for $3.8 billion in expenses. Auditors Arthur Andersen were held liable for not noticing.JPMORGAN CHASE & CO. For 10 years from 2002, the company approved thousands of home loans to ineligible recipients. The employee who blew the whistle was awarded $64 million.CEO behaviorTechnicalities❯ Evasive behavior by executives over important ﬁnancial details ❯ Attempts by CEO to steer auditors away from certain documents❯ Late entry of sales or earnings adjustments ❯ Missing approvals or signatures ❯ Photocopied documents presented in place of originalsSetting up conﬁdential hotline for current and past employees or others with knowledge of the companyUsing element of surprise, such as undertaking an aggressive internal audit without prior warningConducting a surprise cash count to determine whether current cash ﬂow matches statementsData mining with auditing software to detect any mismatch between past patterns and current statementsRaising financing When a company needs additional funds, it can use either internal or external sources, or both, depending on whether it seeks large amounts of funding for long-term growth, such as an expansion, or smaller amounts for short-term expenses, such as to cover operating costs. In addition, the number of external sources available depends on whether the business is well established or whether it is relatively new and without much of a track record.Sources of ﬁnancing and capital When considering the prospect of raising ﬁnancing, the ﬁnancial directors will ﬁrst evaluate the ﬁnancial health of the company. They will then decide what proportion of the company will be funded by equity (the company’s own reserves of cash and money raised from issuing shares) and what proportion will be funded by borrowing money from an outside source, such as a bank, so that the company takes on debt.59%of US ﬁnancial managers say ﬁnancial ﬂexibility is the most important factor in deciding how much debt the company takes onDebt and loansFUNDS IN THE FORM OF A LOAN FROM AN OUTSIDE SOURCEINTEREST PAYMENTSInstitutional lenders Money loaned by large ﬁnancial bodies, such as banks. See pp.158–159.HOW FINANCE WORKS Raising ﬁnancing154 155EVALUATING CAPITAL STRUCTURE When investors consider buying shares in a company, they look at its capital structure to assess the future prospects of the business. The capital structure refers to the percentage of a company’s ﬁnances made up of funds from shares and earnings, called equity, and the percentage made up from borrowed funds, or debt. When evaluating capital structure, investors consider the following: ❯ As a general rule, companies with more equity than debt are considered less risky to invest in because their assets outweigh their liabilities. So a company with signiﬁcantly more equity than debt has a low debt-to-equity ratio and is generally seen to be a low-risk investment.❯ A company with signiﬁcantly more debt than equity has a high debt-to-equity ratio and is more risky as an investment. ❯ Debt is not always bad. If interest rates are low a company could take on more debt to fund expansion, as long as the revenue it makes from the borrowed funds is greater than the interest payable. So although this company may be more risky, it may also have greater potential for growth—this is known as “gearing.” See pp.174–175..$ $Equity FUNDS FROM SHARE ISSUES AND RETAINED PROFITProﬁt from business activitiesShareholders’ stake in companyProceeds of the core business. See pp.156–157.Payment received for shares in the company. See pp.164–169.DIVIDENDS—PAID ONLY WHEN A COMPANY MAKES ENOUGH PROFITCompanyBonds Investor lenders FUNDS FROM BONDS BOUGHTINTEREST AND CAPITAL SUM ON MATURITYPayments made by bondholders. See pp.170–173.Internal financing Most companies prefer to secure funding from their own internal resources, rather than either take on debt through borrowing or give up a stake in the company by issuing shares, both of which cost more. How it works When a business needs funds, or capital, to pay for expansion or investment in order to maintain its current operations, it is faced with two choices: either ﬁnd the money from outside sources, or ﬁnd the money from within the organization itself. Since there are costs attached to bringing in funds from external sources, such as interest that has to be paid on a bank loan, the business managers must weigh up the opportunity cost of using its own funds—the proﬁt it could earn by investing those funds—against the cost of ﬁnancing.Raising internal ﬁnancing Whether a company’s need for additional funds is long- or short-term, steps can be taken to increase the level of funds within the company.Short-term ﬁnancing For businesses wishing to raise funds without recourse to external sources, there are three main strategies they can implement to maximize the amount of cash available for day-to-day operations and capital expenditure.THE RECENCY BIAS When a company receives timely payments for its invoices, this helps maintain its levels of funds. Interestingly, invoices issued right after completion of work tend to get paid sooner than those invoices that are sent later. A theory called recency bias explains this phenomenon: the brain prioritizes recent events over those that occurred longer ago.Tighten credit control Actions include chasing debtors so that invoices are paid on time; ensuring new customers are creditworthy by conducting strict credit checks; and setting a 30-day payment term.10 8 DAYS IT TAKES CLIENT 6 TO PAY 4Delay payment1 2 WEEKS IT TAKES TO SEND INVOICELarge suppliers may offer a discount for early payment, but they may also allow a company longer terms for payment, boosting cash levels in the short term.HOW FINANCE WORKS Raising ﬁnancing156 157USING PROFITS TO FUND EXPANSIONCompanyA company seeking to grow may choose to fund the expansion with its proﬁts. This option offers both advantages and disadvantages.ProsLong-term ﬁnancing For a business needing long-term ﬁnancial help, its own resources should act as the primary support.Reduce inventory❯ The use of proﬁts means that no interest payment has to be made, unlike on money that is borrowed ❯ Existing owners and directors are able to retain full control over the business, rather than sharing it with new investors ❯ The company is able to keep a low debt proﬁle, which will appeal to future investors and lendersConsIt is expensive for a business to retain a large inventory of unsold goods. Cutting the inventory back reduces storage costs, the cost of production, and replacement of goods that go out of date or become obsolete.Retained proﬁts A portion of proﬁts may be pumped back into the business.ﬁ alnancing for usiness eb thli Tota nternA company may also decide to sell assets to raise cash.❯ Proﬁts can take time to build up sufﬁciently to fund expansion ❯ Withholding dividends may upset some shareholders who prefer to receive the proﬁt as dividends ❯ Lost opportunity to earn funds from investing proﬁt rather than spending it44the average number of days it takes a limited company in the UK to pay a 30-day invoiceExternal financing When business growth or unforeseen expenses cannot be met using internal sources of ﬁnancing, such as retained proﬁt, organizations must rely on ﬁnding funds from lenders or investors. How it works External ﬁnancial support comes in various forms, including bank loans and issuing shares. The available sources of outside ﬁnancing depend on the amount a company requires, and whether the money is needed to resolve a short-term issue, such as cash ﬂow, or for the long-term growth of the business. While short-term ﬁnancing is easier to secure, ﬁnding larger sums for anRaising external ﬁnancing Generating funds from external sources can be a challenge, especially when securing investors. However, revenue does not necessarily need to take the form of a loan. There are a number of strategies that can be implemented through working with external parties in order to provide a company with good working capital.80%of external corporate ﬁnancing is provided by domestic banksexpansion is more challenging. A company that is either already listed on a stock exchange or is preparing to enlist will be able to raise the capital through the sale of shares. However, an unlisted company may struggle to raise a comparable amount. A company with a large amount of debt will also ﬁnd it hard to raise funds, since lenders or investors will see the business as risky.NEED TO KNOW ❯ Term loan A bank debt repaid over a set period of time ❯ Loan note A form promising payment to the holder at an agreed future date ❯ Eurobond A bond issued in a currency other than the currency of the country in which it is issuedShort-term ﬁnancing A range of ﬁnancial agreements that help provide a company with immediate funds can be made with outside parties as a way of raising cash short-term.Bank line of credit $Borrow from business checking account up to an agreed limit, with interest typically at a high rate.Debt factoringSell unpaid invoices to an external source for an agreed amount in order to receive immediate payment minus a commission fee.Invoice discounting Borrow money against sales invoices customers are yet to pay (again, often at a disadvantageous rate).HOW FINANCE WORKS Raising ﬁnancing158 159DEBT FACTORING PROCESS To get money immediately, a company sells unpaid invoices (accounts receivable) to a third party, known as a “factor.” The factor advances the company a major portion of the amount, retains the rest until the account is paid, then charges a fee.$ Company negotiates an agreement in which its unpaid receivables (invoices) are sold at a discount to a “factor.”Company sends invoices out to customers, and copies these to the factor. Customer now owes payment to factor.CompanyFactor pays company an agreed percentage of the invoices (typically 80–90 percent) within a few days of receipt.Customer pays factor the invoice amount after 30 days (or more if terms of payment are longer).Factor pays remaining invoice amount to company, minus a fee (usually 2–5 percent of the invoice amount).Long-term ﬁnancing Putting effective measures in place to provide ongoing revenue is essential for a company’s long-term growth.Shares Raise capital by issuing shares to ﬁnance growth. The company then retains less proﬁt, as it pays dividends to shareholders, who also beneﬁt from any capital gains in the company’s value (see pp.164–165).Borrowing Secure long-term loans from banks and other ﬁnancial institutions, usually on better terms than a bank line of credit.ancing fo ﬁn r l ausiness eb thal exte Tot rnFinance leases Sell expensive assets such as computers to ﬁnance companies to release capital, and then lease them back.Rent-to-own agreements$ $ $Pay for expensive assets, such as vehicles, in installments. Overall cost may be higher, but capital is not tied up.Going public When a company changes from private to public, it offers shares for sale to members of the public. This process is known as going public and enables the company to raise money for growth. How it worksWays to list on a stock exchangeIntr odThere are three primary ways to take a company public, each of which has different associated costs. The type of public offering that a company chooses will be determined by its size and how much capital it needs to raise.Plac inThe process by which an organization goes public (also known as ﬂotation) marks the end of its life as a private company, after which it is no longer owned by a small number of shareholders or company members. A company may choose to go public when it needs capital to ﬁnance growth. Going public usually happens over several months; the company makes legal and ﬁnancial preparations before the ﬁnal stage, when it releases company shares for sale, either to selected investors or to the general public, or to a combination of both. Each share represents a “stake” in the company, and the money that the company receives from the sale of shares becomes capital, or wealth, which it now owns.tion ucA company joins a new stock exchange without raising capital, but by trading its existing shares. To do this, over 25 percent of the shares must already be in public hands (on other stock exchanges) and no one shareholder can own a majority of shares.Select groups of institutional investors are invited to buy shares. This involves fewer costs than undertaking a full public share offering (see below) but the amount of capital that can potentially be raised is limited since there are fewer shareholders.❯ Underestimation If the initial valuation of shares by the underwriters is too cautious, then the company will fail to realize the true value of its stock ❯ Overestimation If underwriters overestimate the value of shares newly on the market (new issue), it may ﬂop due to lack of demand ❯ Volatility Share prices in the ﬁrst few days of an IPO may ﬂuctuate dramatically due to political or economic eventstial public of IniWARNING g (IPO) rin e fInstitutional and private investors are invited to subscribe to or buy from the ﬁrst round of shares that the company issues. This is the most expensive way to go public, but allows for a company to raise large amounts of capital.HOW FINANCE WORKS Raising ﬁnancing20%160 161the typical minimum annual growth potential of public companies in the US TEN LARGEST IPOS IN HISTORYStock exchange A ﬁnancial market in which company securities (stocks and shares) are bought and sold according to current market rates. See pp.170–171.INITIAL PUBLIC OFFERING (IPO)When a well-known private company undertakes an IPO, there is ﬁerce competition between investors to buy its shares, and record-breaking activity can ensue. This graph shows the largest IPOs until 2014, based on proceeds from shares sold on the ﬁrst day they went public.Alibaba Group 2014, New York Stock Exchange (Chinese e-commerce group) Agricultural Bank of China 2010, Shanghai Stock Exchange (Chinese bank)$19.2BNNTT Group 1998, Tokyo Stock Exchange (Japanese telecoms group)$18.4BNVisa 2008, New York Stock Exchange (American ﬁnancial services corp.)$17.9BNEnel SpA 1999, New York and Milan stock exchanges (Italian utility company)$16.58BNFacebook 2012, New York Stock Exchange (American social networking site)$16BNGeneral Motors 2010, New York Stock Exchange (American car manufacturer)$15.8BN Deutsche Telekom AG 1996, Frankfurt, New York, and Tokyo stock exchanges (German telecoms company)$12.48BN$11.1BN$10.65BN$0$25BNBank of China 2006, Hong Kong Stock Exchange (Chinese bank) OAO Rosneft 2006, Moscow and London stock exchanges (Russian oil company)$10 BILLION (BN)$20 BILLION (BN) VALUE (USD)GOING PUBLICA closer look at IPOs An Initial Public Offering (IPO) is the ﬁrst time that shares in the company are offered for public sale. It is the most common way for a private company to go public if it needs a large injection of capital to fund major expansion. There are other reasons for going public—for example if a government wants to privatize a state-owned company, such as a national railroad, or if the members of a large family-owned enterprise want to sell their stake.WORLD’S TOP 10 STOCK EXCHANGES The largest exchanges manage shares belonging to some of the world’s most lucrative businesses and, as a result, substantial sums of money ﬂow through them. The followingexchanges are listed in order of the size of market capitalization—in other words, by the total monetary value of shares issued by the companies listed on each exchange.1. 2. 3. 4. 5.6. 7. 8. 9. 10.New York Stock Exchange NASDAQ OMX, New York Tokyo Stock Exchange Euronext (Pan-European) London Stock ExchangeShanghai Stock Exchange Hong Kong Stock Exchange Toronto Stock Exchange Deutsche Borse SIX Swiss ExchangeThe IPO process Before a company can issue shares, it has to be listed on a stock exchange where trading (the buying and selling of shares) can take place. The company must then fulﬁll the criteria necessary to secure investors. This process is lengthy, subject to strict ﬁnancial regulations, and is extremely expensive to undertake. Only once all stages of the process are complete can the share offering be ofﬁcially declared on a stock exchange.1 Meet the qualiﬁcations The speciﬁc requirements are set by the stock exchange where the company plans to list. Listing conditions vary between exchanges, but typically demand:Pretax earnings above a certain levelFile a prospectus This document contains information about the offering, the business, and its ﬁnancial history, and proposed plans. Details are still subject to change.Three years of audited ﬁnancial statements Ability to pay the annual listing feeAppoint underwriters These ﬁnancial professionals will be responsible for buying and selling the shares to the public.HOW FINANCE WORKS Raising ﬁnancing$16.6 trillionNEED TO KNOW ❯ Large cap Listed company with market capitalization of more than $10 billion ❯ Mid cap Listed company with market capitalization of between $2 billion and $10 billion ❯ Small cap Listed company with market capitalization of between $250 million and $2 billionthe total market capitalization of companies listed on the New York Stock Exchange** as of October 2014162 1636 Promote the share offering Company representatives, as well as the underwriters, visit national and international destinations to pitch to potential investors.$ $Sell on the stock market5 Set the ﬁnal offer price After ascertaining market conditions and the anticipated demand, the company decides the price and the number of shares to issue. It is then ready to launch the offering.The IPO is ofﬁcially declared a few days after potential investors receive the ﬁnal prospectus. The declaration is made on a set day after the exchange has closed, and the shares are available for trading the following day.Shares and dividends When a company goes public, it sells shares to investors, who become part-owners in return for capital investment. The number and type of shares bought by each investor determines the size of their ownership. How it works Before ﬂoating on a stock exchange, a company undergoes a valuation process to set the initial price of its shares. This process involves the directors, prospective investors, and an investment bank, which is appointed to assess the company’s value. Together, they reach a decision on the most ﬁnancially viable price for the shares that willbe offered on the exchange. Upon going public, a company issues ordinary shares to investors as the basic unit of ownership, commonly referred to as a stake in the business. A company may also issue shares privately, rather than publicly to investors via the stock exchange, to retain greater management control.y shares n a p m CoA share of the pie Ordinary shares, issued by all companies when they go public, are the most common type of shares. There are also other share types, which give the company more ﬂexibility to control rights available to different shareholder groups. Most shares are sold on the stock exchange, but non-voting and management shares are issued directly to holders. Different types of shares entitle the holder to different rights.Management shares Issued (usually given not sold) to owners and members of company management, who have: ✓Extra voting rights, so control of company stays in the same handsNon-voting shares Issued to employees, who: ✓Receive a part of remuneration in the form of dividends ✗ Have no voting rights ✗ Receive no invitation to attend annual meetingIss ue ddir ec tlyHOW FINANCE WORKS Raising ﬁnancingCommon stock Shareholders: ✓Share in the company dividends ✓Share in the company’s assets ✓Have right to attend AGM ✓Have right to vote on important company matters such as appointment of directors ✓Receive the company’s annual report and ﬁnancial statementss via ld Soe chang k ex tocPreferred stock Shareholders: ✓Receive ﬁxed dividend, paid ahead of any dividends paid out to ordinary shareholders ✓Take priority in receiving a share of any assets left after debts are paid if company is insolvent ✗ Have fewer, if any, voting rightsDeferred stock ✓Shareholders receive company dividends and share of assets, but only after all other shareholders164 165NEED TO KNOW ❯ Flipping Buying and quickly reselling IPOs for a large proﬁt ❯ Redeemable shares Shares that may be later bought back by the issuing company for a cash sum698%the increase in share price of IPO VA Linux Systems in one day on the New York Stock Exchange, in 1999 RAISING MORE SHARE CAPITAL After the initial sale of shares, when a company goes from private to public, the business can raise additional funds by issuing more shares. There are three main ways to do this: ❯ Rights issue entitles existing shareholders to buy additional shares from the company within a set time frame, before they are offered to other buyers. ❯ Public issue is a process by which the company issues a new allotment of shares to sell to the public on the stock market. ❯ Private placement is a practice by which the company sells its shares (or other securities) directly to private investors, usually large institutions, bypassing the stock exchange all together.SHARES AND DIVIDENDSEstablishing share value The forces of supply and demand set the price of shares. Companies issue only a limited number of shares to the public, which can then be bought and sold on the stock exchange. Demand for those shares is determined by whether investors think the company has good future economic prospects. If investors believe that the company is primed for substantial growth, they will want to buy shares in it, which consequently drives up the share price.25%SPLITTING SHARESthe drop in share value over four days during the Wall Street Crash of 1929A company occasionally carries out a “share split” to its existing shares. This increases the total number of shares, although the combined value of shares stays the same. A share split allows a company to lower the price of its shares to bring them in line with the price of competitor shares. The share split is usually a two-for-one or three-for-one increase, whereby the shareholder sees the number of their shares double or triple.Rising value of shares VALUEFinancial market observers believe (INDEX that the emphasis on optimizing the POINT) value of shares for shareholders began 4,000 in 1976, when the idea of maximizing proﬁt for shareholders became a priority. Since then, the market has 3,500 experienced a general upward trend with occasional deep dips. The graph tracks the average value of all shares 3,000 on London’s FTSE from 1964 to 2013.198 7OC MO TOBE ND R 19 AY CR : BLAC AS H K2,500NEED TO KNOW ❯ Bear market Market that has seen decline of 20 percent over a period of 2 months or more ❯ Bull market Market where share prices are rising and investor conﬁdence is high ❯ Market correction Short-term decline in share prices to adjust for an overvaluation2,0001,500197 2–19 74STO CR CK M AS H ARK ET1,0006 LUE 197 IMIZINLGDER OVASED X O P MA AREH PRO SH EORY TH5000 19701980HOW FINANCE WORKS Raising ﬁnancing$3SHARE PRICE TOO HIGH A company listed on the stock exchange has seen its share price increase so that its shares now cost more than its competitors’. The high price puts off investors.19 9SHARES SPLIT The company decides on a share split. It halves the price of each existing $3 share, so each share is now worth $1.50.20HE DO IGHT T-C OF OM TH BO E OM1,000 2,0000 $1.507A CR UGU ED ST IT : G CR LO UN BA CH L$1.5 0SHARE CERTIFICATES ISSUED It issues new share certiﬁcates to holders, doubling shares held: a shareholder with 1,000 shares at $3 each now has 2,000 at $1.50 each. Total worth is still $3,000.SHARE VALUE ALIGNED The value of shares is now similar to that of competitors. The price encourages new investors to make a purchase.20 10F DE EBR BT UA CR RY IS : EU IS R OZ ON E1997TCO MBU ST20019/11 ATTA TERRORI ST IN N CK EW Y ORKDO2000–200JULY: A FINAN SIAN CIAL C RISIS19902000166 1672010YEARSHARES AND DIVIDENDSWhat is a dividend?pay out dividends. In a good economic climate, they win twice—the dividend provides income and the capital value of the shareholding increases. However, there is always a risk that the value of shares will go down, and companies only pay dividends if they have made a proﬁt. Paying dividends is a good way for a company to attract investors. It is essentially a reward for putting money into a company so that it can fund its existing output and develop and expand the business.Shareholders in a company are usually entitled to a payment of cash from its proﬁts. The company pays a dividend sum on every share it has issued, but it is up to the company’s board to decide how much proﬁt to reinvest and pay out. Investors may look at a company’s rate of dividend payout, along with its capital growth, to gauge its ﬁnancial health and decide whether to invest in it. Investors who rely on shares for income are likely to invest in companies that reliablyNEED TO KNOW ❯ Dividend yield ratio Measure of how much a company pays out in dividends relative to the price of each share ❯ Dividend per share Sum paid on each share after retained proﬁts have been calculated ❯ Dividend payout ratio Percentage of a company’s net income that is paid out in the form of dividendsHow it works Shareholders usually receive a dividend if the company in which they hold shares has retained enough proﬁt in that ﬁnancial year to make the payment. The decision to make a payment is made by the board of directors. The dividend might be paid every quarter (four times a year), or in two parts—an interim dividend may be made partway through the year, with the ﬁnal dividend paid just after the end of the ﬁnancial year.Announcing retained proﬁtsMaking the decision for dividendsAt the end of the ﬁnancial year, the company announces its retained proﬁts: the sum it intends to keep for reinvesting or paying off debts rather than pay out as dividends.The board of directors makes a decision on whether there is enough to warrant a dividend payment, and if so, how much. It records details of each payment in dividend vouchers.$ $HOW FINANCE WORKS Raising ﬁnancing168 169INTEREST RATES AND DIVIDENDS When interest rates are low, shares with high dividend payouts become extremely attractive to investors because they provide a better return than investments that yield an interest payment. This economic climate encourages companies to pay out top-rate dividends and so attract as many investors as possible, which in turn increases the share value. Conversely, when interest rates are rising, investors may prefer to put their money into ﬁxed-income assets, which will pay high rates as a result of the hike without the risk attached to buying shares.$ $ $ Keeping funds for growth The company keeps some of its proﬁt to put back into the business. It needs to strike a balance between pleasing investors and expanding its operation.HIGH INTEREST RATESInvestors are attracted to pay into ﬁxed-income assets, such as deposit accounts.Investors are attracted to buy shares as dividends give a good return for their money.LOW INTEREST RATES1602the year the Dutch East India Company became the ﬁrst company to issue stocks and bonds Paying taxes$ Making the payment Most dividends are cash dividends. Sometimes companies distribute stock dividends, issuing more shares instead of cash to shareholders.Shareholders must declare dividends on their tax return and pay taxes on them.The capital market The capital market is a global ﬁnancial marketplace for trading long-term securities—bonds with a maturity of at least a year, and shares. It is where governments and businesses can raise funds and investors make money. How it works There are two types of product sold on the capital market: shares (equity) and bonds (debt investments). Shares and bonds are sold ﬁrst on the primary market, where they are originally issued, and later traded on the secondary market. The capital market is crucial to a functioning economy, because it channels fundsto users of capital, such as businesses and government, and capital is what enables goods and services to be produced. The original issuers of the shares and bonds do not gain from trading activity in the secondary market, which is purely for investors. However, share value and bond trading levels reﬂect conﬁdence in a company or institution, reinforcing its ﬁnancial position.The structureCatal mark i p etThe capital market encompasses the debt capital market, where bonds are sold, and the stock exchange, where shares are sold. Both have a primary and a secondary market.Primary marketThe market issues new bonds and shares, with investment banks overseeing the trading. It is also known as the new issue market (NIM).GOVERNMENTS SELL BONDSCOMPANIES SELL BONDS AND SHARESSHARES Sold on stock exchange (equity capital market)BONDS Sold on debt capital market (bond market)INVESTORSHOW FINANCE WORKS Raising ﬁnancingWHAT IS A BOND? A bond is a debt security that a company issues to investors. By buying bonds, an investor is effectively loaning money to the issuers, who in return agree to pay interest to the investor. A bond has a set term of maturity (a limited number of years of validity) and until thattime the interest is paid to the investor annually. When the bond matures, the issuer repays the original sum of the loan to the investor. Companies or governments issue bonds to raise money that can then be put back into the business or used to fund government.170 171$100 trillionthe estimated value of global debt marketsBonds or shares: pros and consBonds (debt investments)Secondary market Investors buy bonds and shares from other investors, not from issuing companies. The cash proceeds go to an investor, not to the underlying company or entity.✓Sellers are contractually obliged to pay interest ✓Bonds are less risky: debt capital markets are less volatile than stock exchanges; if the issuing company has trouble, bondholders are paid before other expenses and before compensation to shareholders ✗ Buyers of bonds have no stake in the company ✗ Buyers cannot access principal sum until bonds matureShares (equity)BONDSSHARESIndividual investors buy and sell shares and bonds previously issued on the primary market✓Buyers of shares gain a stake in the company ✓Sellers of shares have to pay dividends, although these can be reduced or suspended if the company feels it is necessary ✗ Shares are more risky: changes in company proﬁts and in the economy as a whole can cause share prices to rise and fall; if the company fails, the shares become worthlessTHE CAPITAL MARKETHow do bonds work? Bondholders effectively buy a slice of a larger loan with each bond, for which they receive interest, along with the original sum on maturity. Issuing, buying, and selling bonds takes place in the debt capital market. The marketplace has several functions: it offers bonds and other types of loans to investors; it operates as a ﬁxedincome market, because the issuer is required to pay regular interest; and it enables companies and governments to raise long-term funds. Overall, the debt capital market is much larger than the stock exchange (equity capital market), where shares are boughtand sold. It attracts investors because bonds provide more protection from risk than shares. There are various types of bonds, some safer than others—the risk lies in whether the issuer will be able to pay the interest and repay the principal sum on maturity. A secured bond is backed by an asset, such as property; an unsecured bond is not and so carries more risk. Both bonds and shares may be referred to as securities. The term describes the share or bond itself, and the certiﬁcate of ownership or creditorship that gives the holder the right to receive a dividend, in the case of shares, or interest payments, in the case of bonds.NEED TO KNOW ❯ Debt instrument Ofﬁcial term for bond or other long-term debt ❯ Convertible bond Bond that can be converted into shares of the issuing company, or cash ❯ Warrant Security that allows the holder to buy stock in a company at a ﬁxed price for a certain period of time ❯ Callable bond Bond that gives the issuer the right to redeem it before maturity ❯ Non-callable bond Bond that cannot be redeemed or sold back to the issuer before maturity but continues to provide interestInvesting in the debt capital market A company wants to raise $100 million to ﬁnance growth but does not wish to issue further shares. Instead, it raises the money by issuing bonds on the debt capital market.BOND $100BOND $100$100 10 YEARS 7%interestCompany issues bondsInvestors buy bondsThe company issues 1 million bonds at $100 each. Each bond effectively acts as a loan between the investor and the company.Each bond has a set maturity date of 10 years and a 7 percent interest rate, with a face value of $100. During the 10 years, the company can use the money as capital.HOW FINANCE WORKS Raising ﬁnancing172 173TYPES OF BONDS Government bondsCorporate bondsGOVERNMENT BONDSSECURED BONDSSere d cuUNSECURED BONDSSere d cuUnsecuredGovernment bonds are the safest type of bond since governments in developed capitalist economies are unlikely to default on interest payments on the loan or on the principal sum.Secured bonds are secured by the assets of a company, making them a less risky investment than shares. Examples include equipment, trust certiﬁcates, and mortgage bonds.Unsecured bonds are not backed by pledged collateral and are a riskier investment—if the company fails, investors are paid only after secured bonds have been paid out. Because they are more risky, investors expect a higher return (interest) on their investment.INTEREST PAID (%)100 90 80$7070over 10 years60 5010 YEARS40 30 20 10 04 57 8 9 10 YEARS$100$7 Investors receive annual interestMature bond is repaidEach year, the company pays an investor $7 (7 percent of $100) for each bond bought, in return for using the principal sum as capital to fund its business. After 10 years, the investor has received a total of $70 interest per bond.Once the bond reaches its date of maturity, in this case 10 years, the original sum of money, $100, is repaid to the investor. So the investor receives a total of $170, including interest, over the full term, in return for the original $100 investment.Gearing ratio and financial risk Capital gearing is the balance between the capital a company owns and its funding by short- or long-term loans. Investors and lenders use it to assess risk. How it works Most businesses operate on some form of gearing (also called ﬁnancial leverage). They partly fund their operations by borrowing money, via loans and bonds, on the condition that they make regular repayments of a ﬁxed amount to the lender. If the level of gearing is high (in other words, the business has taken on large debt), some investors will be concerned about its ability to repay and see this as an insolvency risk. However, if the amount of operating proﬁt is more than enough to repay interest, high gearing can provide better returns to shareholders. The optimum level of gearing for a company also depends on how risky its business sector is, how heavily geared its competitors are, and what stage of its life cycle it is at.Low gearingEquity ﬁnance (shares) ProsCompany has less debt❯ Does not have to be repaid ❯ Shareholders absorb loss ❯ Good for start-ups, which may take a while to become proﬁtable ❯ Angel investors share expertise ❯ Low gearing seen as a measure of ﬁnancial strength ❯ Low risk attracts more investors and boosts credit ratingCompany has more equity Low proportion of debt to equity, also described as a low degree of ﬁnancial leverage. Equity comes from: ❯ Reserves (retained proﬁts) ❯ Share capitalCons ❯ Shared ownership, so company has limited control of decisions ❯ Shared proﬁt in return for investors risking their funds ❯ Legal obligation to act in the interests of shareholders ❯ Heavy administrative load ❯ Complex to set upGearing ratio calculationLow gearingAnalysts and potential investors assess the ﬁnancial risk of a company with this calculation, presented as a percentage.A software company is going public. Its ratio of 21.2 percent tells investors that it has relatively low gearing and is well positioned to weather economic downturns.LONG-TERM DEBT SHARE CAPITAL + RESERVES + LONG-TERM DEBT× 100$1.2 MILLION $2 MILLION + $2.455 MILLION + $1.2 MILLION10021.2%HOW FINANCE WORKS Raising ﬁnancingDebt ﬁnance (loans) ProsHigh gearing Company has more debt High proportion of debt to equity, also described as a high degree of ﬁnancial leverage. Typical examples of debt are: ❯ Loans ❯ BondsCompany has less equity❯ If the company makes a proﬁt, it can reap a larger proportion ❯ Paying interest is tax deductible ❯ Does not dilute ownership ❯ Company retains control of decisions ❯ Repayment is a known amount that can be planned for ❯ Quicker and simpler to set up ❯ Small business loans at favorable rates may be available to start-ups❯ Interest cover ratio An alternative method of calculating gearing—operating proﬁt divided by interest payable ❯ Overleveraged A situation in which a business has too much debt to meet interest payments on loans ❯ Deleverage Immediate payment of any existing debt in order to reduce gearing❯ Loan must be repaid ❯ Interest must be paid, even if operating proﬁt shrinks ❯ Debt may be secured on ﬁxed assets of company ❯ Unpaid lender can seize assets and force bankruptcy ❯ Lenders ﬁrst to be paid in the event of insolvency ❯ High gearing considered a measure of ﬁnancial weakness ❯ High risk may put off investors and adversely affect credit rating25%A water utility is the only water provider in the area, with several million customers. The ratio of 64 percent is acceptable for a utility company with a regional monopoly and a good reputation.$82 MILLION + $120 MILLION + $360 MILLIONNEED TO KNOWConsHigh gearing$360 MILLION174 17510064%the ratio at or below which a company is traditionally said to have low gearingHOW SALES AND MARKETING WORKS Marketing mix ❯ Marketing approaches Outbound marketing ❯ Inbound marketing Business development ❯ Information managementMarketing mix The successful marketing of a product depends on the consideration of four key elements—the product itself, its price, how it is promoted, and where it is sold. This combination is called the marketing mix, and it is used as a tool for planning product launches and campaigns. Before focusing on the marketing mix, marketers need to deﬁne the target market for their product by determining which groups of customers are most likely to purchase it.The 4Ps and 4Cs of the marketing mix First proposed in 1960, the classic marketing mix tool contains the 4Ps: product, price, promotion, and place. In the 1990s, these were recast as the 4Cs, which emphasized the customeroriented dimension of the tool.CommodityProduct❯ Has the product been speciﬁcally engineered and designed to meet and exceed customer expectations?❯ Is the product the right design, size, and color to appeal to customers? ❯ What are its unique features? How does it compare with competitors?CommunicationPromotionThe 7Ps of the marketing mix Some marketers use a more detailed model of the marketing mix, which has three additional elements. ❯ Product See pp.180–183. ❯ Price See pp.186–187. ❯ Place See pp.188–189. ❯ Promotion See pp.190–191. ❯ People Does the business employ the right people to deliver optimum service to customers? ❯ Process Are effective systems in place for handling orders and dealing with customer questions and complaints? ❯ Physical environment Does the design and layout of the business premises appeal to customers?❯ What is the most meaningful way to get marketing messages to customers and provide them with useful information?❯ What combination of marketing and media channels will be most effective? ❯ When is the best time to run promotions?HOW SALES AND MARKETING WORKS Marketing mix“Product, promotion, and place create value. But price harvests value.”Price ❯ What is the value of the product to prospective customers? ❯ What is the usual price point for this type of product?178 179DEFINING THE MARKET In order to establish a marketing strategy for the product they are introducing to the marketplace, businesses have to deﬁne the customers they aim to sell to by researching and segmenting the market.Market researchMarket segmentationSee pp.192–193.See pp.194–195.❯ Identiﬁes gaps in the market for the launch of new products ❯ Measures customer reactions to new offers and campaign messages❯ Breaks down the market into smaller customer groups with similar needs ❯ Allows more focused campaigns with a greater chance of successCost ❯ How much will the product cost the customer, and will it be seen to represent a good buy?The 7Cs of the marketing mixPlace ❯ Where should the product be sold—stores, online, or catalogs? ❯ Where do competitors sell, and is there a way to stand out in the same place?Convenience ❯ How easy is it for busy customers to ﬁnd and buy the product?This model offers a customerfocused variation of the 7Ps, adding three more elements to the 4Cs. ❯ Commodity ❯ Cost ❯ Convenience (or Channel) ❯ Communication ❯ Corporation How do company structure, stakeholders, and other competitors affect marketing? ❯ Consumer What are the customer’s needs and wants? Is the product safe? What product information is available? ❯ Circumstances Can the business deal with external factors, such as laws, weather, economy, culture?Product The goods and services a company sells are its product. A product can be deﬁned in terms of features, design, size, packaging, service type, return policies, and warranties, together intended to meet the customer’s needs. How it worksMarketers identify the goods and services they sell in three or ﬁve product levels, with the beneﬁt at the core. The marketer’s job is to translate and communicate each product level as an offer to the consumer.Consumers can be said to buy beneﬁts rather than products. For the marketer, the product itself is that beneﬁt to the consumer, as packaged and presented.Total product concept: three product levels From a marketer’s perspective, a product is more than the end commodity bought by a customer. It is a total product concept with several layers of beneﬁt, and these must be conveyed to the consumer.Core product Product’s basic function and its core beneﬁt to consumerActual productrsiti a on ge al d 3 esign •llm ents’ fre e service6m on thin staTakes rider from A to BAdditional beneﬁts, such as delivery and credit, warranty, after-sales serviced ec ra o-f riendly • t n yi pa free delivery •Augmented products high-tech tirePackaging, brand name, quality level, design, and additional features that set it apart from rival productss • 2-yeary nt a r warHOW SALES AND MARKETING WORKS Marketing mix42%180 181NEED TO KNOW ❯ Personal branding Promoting oneself as a product with a distinct brand personality ❯ Fast-moving consumer goods (FMCGs) Sold quickly and at relatively low unit cost, such as food and household productsof new product launches can be expected to failVariation: ﬁve product levels This variation on the total product concept is more detailed. It introduces two more levels by breaking down the actual product level into a generic and an expected product, and also includes an extra level of beneﬁt—the potential product. Core product Product’s core beneﬁt to consumerGeneric product Basic functional beneﬁtsExpected product Additional desirable beneﬁtskesect iorie mota br•c n o lo now r cho s io au ell-k i w c e • l li to o lo c nc k to lt-i prevent thef t • buif rath • re li a b l e • s m o oprdete rs igdyndlighstur•b ls • 3 gearsdeh 2weeAugmented product Extra features and beneﬁtsraTakes rider from A to BPotential product Future, improved versionProduct positioning A vital step in the process of deciding how to market a product is deﬁning how it is distinct from the competition—what is unique about it and what are the qualities that make it better than rival products. How it worksof the product or brand, and clarify how it is different from similar types of products offered by competitors. They also need to identify the criteria that customers are most likely to use when choosing a particular product or brand. With this information the marketers can then create a product positioning matrix or map.Before a company launches a product, the marketing department has to decide how to position it in the marketplace compared to competitors’ products. To determine the positioning of a product, marketers must deﬁne the most important features and valuesProduct positioning mapsHIGH QUALITYMarketers commonly create a perceptual “map,” using a product’s two most important attributes, presented as variables on an x and y axis, to work out where to position it. Attributes may include price, quality, status, features, safety, and reliability. Once the map is labeled, existing products are placed on it to reveal the best position or gap for the proposed launch.LOW PRICE❯ Value positioning A product plotted on the map so that it has an attractive price while delivering good functional qualities. ❯ Quality positioning A product that is located on the map on the basis of its perceived quality or superiority. ❯ Demographic positioning A product mapped according to its appeal to a speciﬁc population segment, such as consumers with a particular occupation. ❯ Competitive positioning A product that is very similar to those of competitors, relying on correct pricing to ﬁnd a viable position in the marketplace.Competitor brand Competitor brandCompetitor brandGap in the marketCompetitor brandBrand’s current positionLOW QUALITYProduct positioning template The map shows how marketers position competing products in the marketplace according to the price/quality variables (the most commonly used) to identify a gap for the new product.HIGH PRICEFOUR POSITIONING STRATEGIESCompetitor brand Competitor brandIdeal brand positionHOW SALES AND MARKETING WORKS Marketing mix182 183s ggbacon andi rossantAn expensive breakfast food ideal for busy professionals in a hurry.A breakfast dish aimed at those with ample leisure time and money.EXPENSIVEereal dc l oWith a slow cook time, pancakes occupy a niche gap in the market.ote al cerInSLOWes cak n aQUICKCentrally positioned, cereal is the most popular breakfast food.reakfas nt b t a t sStudents make the ideal target market for instant breakfast products.Older people and children provide strong demand for hot cereals.INEXPENSIVEBreakfast positioning map The positioning of the various breakfast foods has been determined by the speed at which the food is prepared, measured from slowest to fastest, and the price of each food type, from the least expensive to the most expensive.“Positioning is not what you do to a product. (It) is what you do to the mind of the prospect.” Al Ries and Jack TroutProduct life cycle Every successful product launched on the market experiences growth followed by decline. To maximize proﬁtability, business managers must recognize and manage each stage of the product’s life span. How it works There are typically six identiﬁable stages in a product life cycle, with the product’s rate of growth measured by time and revenue. Most businesses have more than one product on the market at any time, and strategic manipulation of the portfolio of products at theirdifferent stages in the cycle is crucial to maintaining business growth. The life of older products may be prolonged by extension strategies, but if they are no longer grabbing new market share, the business must consider launching new products in order to continue generating revenue.Growth Sales increase and the cost per customer falls as proﬁts rise. There are more customers—and more competitors.Saturation Sales peak and the cost per customer is at its lowest. Proﬁts are now high and competition is intense.Launch Business outlay is high due to product development costs and marketing budget. There is no return on investment.DeclineIntroduction Sales are typically low and cost per customer is high as the market takes time to accept the new product.SALESTIMEProﬁts fall as sales fall and the customer base contracts. The cost per customer remains low. Marketing spend is now kept at a minimum.HOW SALES AND MARKETING WORK Marketing mixLAGGARDS❯ Extension strategy Revival of a product by rebranding, or repackaging, repricing it, or ﬁnding new markets ❯ Portfolio analysis Each of a company’s products measured by growth rate and market share to determine marketing spend ❯ Product life cycle management (PLM) Tracking of product data from inception to withdrawalLATE MAJORITYMarketers identify ﬁve distinct customer types according to how quickly they pick up on a new product. EARLY MAJORITYNEED TO KNOWEARLY ADOPTERSthe length of time a product can be labelled as “new”Diffusion of innovation (consumer uptake) %INNOVATORS6 months184 185PORTFOLIO ANALYSIS 34%Rising stars34%Products with a high market share in a high-growth market; they require a big marketing spend to keep them growing.Withdrawal The product is phased out as sales stall or continue to fall. The business introduces a replacement product before the old one is withdrawn.Cash cows Products with a high market share in a low-growth market; they generate money to support rising stars.16% 13.5%Problem children Products with a low market share in a high-growth market; they need a big marketing spend.Dogs2.5%Products with low market share and low growth; they may stay in portfolio to keep customers happy.Price Price is a crucial variable of the marketing mix: it generates revenue, while product, promotion, and place yield costs. Pricing may also be the marketer’s most potent tool because even minor tweaks affect returns. How it works To set the price of a product, marketers adopt a pricing strategy based not only on the actual cost of production but also on the perceived attractiveness of the product to consumers. If consumers think a product has a high value, they will be prepared to pay more for it, but if they believe the valueof the product is low they will look for the cheapest price among competing products. A business must also take into account the price charged by rival organizations, particularly in competitive markets. Setting a price above that charged by competitors can only work if the product is superior to others.Pricing strategiesPricing matrix: price vs. quality A product’s quality affects its price tag— the higher the quality, the more money consumers will pay for it—but marketers use strategies that play on the interaction between price and perceived quality.Economy ❯ High prevalence Manufacture a product that is very similar to others in the same category. ❯ Low price Undercut competitors’ pricing and gain a larger share of the market. ❯ Minimal marketing Keep the marketing and branding spend as low as possible.SkimmingHigh price5%increase in price is worth more than a 5% increase in market share❯ Price, value, and cost Price refers to the amount a product sells for; value refers to the product’s actual worth; cost is the amount that has been spent to manufacture the productLow quality Low priceA number of different strategies can be used to determine the price of a product. Cost-plus pricing is a retail markup used by many companies to ensure a proﬁt is made. For example, adding a markup of 50 percent to a product that costs $2 to make means that every unit will sell for $3, generating a $1 proﬁt.NEED TO KNOW❯ High launch price Charge more than usual in the short term while a product is seen as unique. ❯ Correct timing Set a higher price when the business has a temporary advantage in the marketplace, before competing products appear. ❯ Price adjustment Reduce the price once competitors enter the market, or to draw more customers.$$$$HOW SALES AND MARKETING WORKS Marketing mix186 187PRICING MARKUP COMPARISON400%DESSERT WINE 200–250% of costBEER 250–300% of costCARAFE OF WINE 250–300% of costMarket penetration ❯ Low price Charge the lowest price possible in order to lure customers away from competitors. ❯ Price adjustment Increase the price to a normal level once the product has a loyal following. ❯ Pricing ﬂexibility Reassess pricing; initial high-volume sales lower cost of production, allowing price tweaks.$$$$OTHER LIQUOR 400–500% of cost200%High qualityCOCKTAIL 350–400% of costGLASS OF WINE 300–400% of cost300%COST (100%)Different industries adopt different approaches to markups. A markup of two to ﬁve times the cost is typically applied to drinks served in bars and restaurants. The highest markup is usually applied to the second-cheapest bottle of wine on the wine list, as people tend to avoid the cheapest item.Premium ❯ High price Charge as much as the market will pay for an item. ❯ Unique value Apply premium prices to products that have no comparable substitute, such as famous brand-name goods. ❯ High production cost Charge a premium price because a product is customized and offers no savings through volume manufacturing.Other pricing strategiesPsychological pricing Manipulate a customer’s emotions, appealing to their thrifty side or desire for prestige.Bundle pricing$$$$ $Offer several products for an overall price, providing better value than buying separately.Geographic pricing Charge different prices for the same product in different locations.Non-pricing strategies Avoid adjusting the price to attract sales, promoting superiority of product instead.Place Knowing where customers shop, where a product is sold, and how efﬁciently goods can be delivered to the consumer—called “place” in marketing terms—is essential to sales success. How it works Whether a company sells goods or services, customers must be able to ﬁnd and buy those products as easily as possible. Businesses have to decide on the best sales outlet and sales channel to get their products to customers in a way that beneﬁts both parties.A sales outlet is the place where a product is sold, suchas stores, catalogs, or e-commerce sites. Sales channels are the merchants, agents, and distributors who take a product from the seller and bring it to the consumer.Main distribution channels A product reaches the marketplace through one of four main types of distribution channels. The most suitable distribution channel is usually dictated by where customers prefer to buy the product.70.5%of device sales by 2017 are forecast to be smartphones Selling direct to consumers Product is sold directly by the producer, online, or through a mail-order catalog, and delivered to customer without intermediary.Selling through retailers Goods are delivered by producer directly to retail outlets; retailer adds a markup onto the price they pay to producer.Selling through wholesalers and retailers Products are distributed in two stages: by producer to wholesaler and then wholesaler to retailer.Selling through an agent Producer A producer chooses the distribution channel, or a combination of channels, that will maximize the number of customers it can reach while keeping costs as low as possible.Products are distributed in three stages: from producer to agent, from agent to wholesaler, and then on to retailer.HOW SALES AND MARKETING WORKS Marketing mixPROS AND CONS OF USING INTERMEDIARIES188 189NEED TO KNOWProsCons❯ Allows wider market coverage so producer can reach more customers, especially those in distant areas. ❯ Minimizes distribution cost for producer as intermediaries are responsible for this service. ❯ Provides producer with specialized knowledge of customer buying habits, as well as delivery logistics.❯ Raises difﬁculty of making direct communication with customers to learn about their preferences. ❯ Increases the risk of slow, inefﬁcient delivery, especially if several intermediaries are involved. ❯ Takes away control over how products are handled and displayed at point of sale.❯ Channel margin The cost intermediary adds to producer’s selling price, which is added to price paid by customer ❯ Push strategy Method in which producer promotes products to wholesalers, wholesalers to retailers, and retailers to customer ❯ Pull strategy Use of advertising and promotion to sell to customerExample E-commerce site selling vitamins; they are sent to customer by mail or delivery service. ConsumerExample Electronics company distributes its television sets to a chain of retail stores. RetailerConsumerExample Farmer sells apples to wholesaler, who sells them on to supermarkets. WholesalerRetailerConsumerExample Chocolatier in France uses import agent in Japan to sell its products to wholesalers and on to retailers.AgentWholesalerRetailerConsumerPromotion Promotion is necessary for generating interest in and sales of a product or service. A complex and expensive part of the marketing mix, it involves communicating to customers and inﬂuencers such as peer groups. How it works The primary purpose of promotion is to boost sales by attracting new customers, while enticing existing ones to try out something new. Most companies use a number of communication activities to inform and remind their target audience of a product’s beneﬁts (see pp.196–231). One of the long-term beneﬁts of communicating with customers is that it helps to build brand loyalty.Personal selling Co nsu mer beeInteract with customers face to face and tailor sales messages to their needs.NEED TO KNOW ❯ Integrated Marketing Communication (IMC) Promotion of the same brand message across all media channels ❯ MarCom (Marketing Communication) Full range of promotional activities used to reach out to the market25%the percentage of digital promotion budgets spent on mobile advertising in 2013Customer service Provides customers with information about the product; offers updates and special deals.Below the line (BTL) Describes promotional activities a business carries out in-house, such as direct mail or telemarketing, to reach customers directly.HOW SALES AND MARKETING WORKS Marketing mixAdvertising190 191Direct marketingRun ad campaigns through media channels most likely to reach target market, and stick to budget appropriate for the product.Send product offers and information directly to the potential consumer, via mail or email.Interactive marketing Build long-term relationships with customers using twoway communication, especially online.Sales promotion Entice customer with offers, free samples, gifts, competitions, packaging, and point-of-sale displays.Above the line (ATL) Refers to online and ofﬂine advertising a business pays for to target customers.Public relations Generate positive interest in the company by sponsoring events and charities, or pitching news content to media.Market research Asking customers what they think about a product is a vital part of the decision-making process for marketers. Research offers insights into how a product might perform and lowers the risk of marketing campaigns. How it works Market research is used during product development and then to monitor customer satisfaction and competitor activity. Researchers draw on existing data, observations, and their own research. New research is broken down into quantitative (numberbased) research—closed (multiple choice) questionsasked of a large group of people—and qualitative (in-depth) research—into how a consumer uses and feels about a potential new product. The marketing department’s research budget is usually split between the two types of surveys. Quantitative research is often used when developing a new product, followed by qualitative research to help reﬁne the product.“Research + Intuition = Decision” Primary data collection New research to answer speciﬁc questionObservationsQuantitative surveysQualitative surveys❯ Researchers may watch from a distance as customer interacts with product, or identify themselves and talk to customer. ❯ They observe customer using equipment such as eye tracking analysis and checkout scanners. ❯ They study credit card records or computer history to observe past consumer behavior.❯ Researchers question many people for a broad view (numerical data). ❯ They carry out online surveys to obtain a quick result from a large sample.❯ Researchers probe small groups or individuals for in-depth view. ❯ They conduct focus group discussions.HOW SALES AND MARKETING WORKS Marketing mix192 193CASE STUDYCoca-Cola launchMarketer reaches a decision DATA RETURNEDDATA REQUESTEDMarketer has a questionIn 1985, Coca-Cola launched a new kind of cola. The launch followed two years of taste tests, costing $4 million, to reﬁne the product. However, the drink failed and had to be withdrawn in the face of overwhelming disapproval from the public. In the marketing postmortem, analysts concluded that the company’s researchers had failed to ask customers a very important question: “Do you want a new Coke?”Secondary data collection Published material on a subjectAgency Carries out original research and organizes research data into meaningful results32%the projected increase in the hiring of market research analysts in the US by 2022Internal sourcesExternal sources❯ Web usage data (for example browser logs and online sales records) ❯ Customer proﬁles with buying history and demographic data ❯ Accounting records, such as statements and balance sheets ❯ Original data from past market research reports❯ Industry reports by trade bodies, institutions, and private research companies ❯ Reports by broadcast, print, and internet media ❯ Academic papers, university think tank reports, and research library holdings ❯ Government surveys, reports, and statisticsMarket segmentation In order to make decisions about who to sell their product to, marketers try to identify distinct groups of consumers with similar wants and habits who together form a “segment” of the market. How it works Marketing departments use a strategy of market segmentation to ﬁnd the potential customers who are most likely to buy a particular product, thereby increasing the chances of a successful product launch. They divide a broad group of consumers into subgroups based on many factors, including age, lifestyle preferences, location, family structure, household income, and occupation. This processnarrows down a potentially huge market into segments, allowing marketers to identify the ones more inclined to buy a given product. For example, after applying this strategy, a company trying to launch premium-price organic baby food realizes that instead of marketing to all women who have young children, it should aim its product at working mothers with children under six months, above-average incomes, and an interest in healthy eating.BehavioralNEED TO KNOW ❯ Baby Boomers Section of population born between 1946 and 1964 ❯ Generation X People born between 1966 and 1980 ❯ Millennials Section of population born between 1980 and the early 2000sDeﬁning market groups To establish different consumer groups, marketers create ﬁve segments and focus on each individually. Besides identifying groups by geography and demographics, marketers also explore psychology to ascertain how consumers behave, so that they gain a better idea of which products might appeal to which consumer groups. See also pp.258–261.“Market segmentation is a natural result of the vast differences among people.” Donald NormanFocuses on behavioral patterns when it comes to shopping. Understanding this helps marketers adapt campaigns to target speciﬁc groups. Potential focus areas include: ❯ Brand loyalty ❯ Regularity of purchases ❯ Credit card usage ❯ Typical expenditure ❯ On- or ofﬂine shopping ❯ Heavy product user194 195 SociographicPsychographicIdentiﬁes individuals’ connections on social media, or membership of political and other groups, helping marketers learn about consumers’ passions and interests. Potential focus areas include: ❯ Group memberships ❯ Number of friends on social mediaFocuses on consumer’s interests, values, and opinions to help marketers develop relevant messages and ﬁnd the right media channels to target a segment. Potential focus areas include: ❯ Risk taker ❯ Charitable ❯ High achiever ❯ A tendency towards expensive tastes ❯ A preference for email contactGeographicDemographic Uses basic consumer data, such as gender or age, to accurately categorize needs and target products appropriately. Potential focus areas include: ❯ Income ❯ Nationality ❯ Family size and age ❯ Ethnic background ❯ Occupation ❯ ReligionConcentrates on a customer’s place of residence, so that any product launched is made relevant to their environment. Potential focus areas include: ❯ Post code ❯ Continent ❯ City ❯ Neighbourhood ❯ Population density ❯ ClimateMarketing approaches Every product launch requires strategic planning to make sure messages about a new product reach the right types of consumers, are communicated through the most effective combination of channels, and have the most relevant content and style. Once marketers have researched the market and deﬁned their target audience, they face several key decisions on how to make their approach.Types of approaches Whom to target and how to go about it are crucial to success. Marketers may use several complementary approaches to different groups of potential consumers.Rather than sending the same message via different media, they usually adjust the tone and style of the marketing pitch to suit the channel as well as the target consumer.Niche marketing “I only have eyes for you.”The big choice The ﬁrst decision is whether to go for a narrow, specialized market or to appeal to as large an audience as possible. See pp.198–199.Mass marketing “I love you all.”HOW SALES AND MARKETING WORKS Marketing approaches196 19785%of all purchasing decisons in the US are made or inﬂuenced by womenTraditional channel allied with a dominating style. “Let me tell you,” it blares. See pp.200–201.Engagement marketing “Come dance with me.” It entices the customer to collude in product sales. See pp.204–205. Sensory marketing “Wake up and smell the roses.” It seduces the customer with sights, sounds, and smells. See pp.206–207.Digital channel allied with a soft approach. “Let me woo you,” it whispers. See pp.202–203.Relationship marketing “Let’s be friends.” It builds a rapport with its audience of consumers. See pp.208–209.How to tell the customerMaking a moveMarketers often get the best of both worlds by using traditional and online channels in varying styles.Turning the buying transaction into an experience the consumer enjoys can help sell a product.Niche vs. mass marketing Two fundamental choices traditionally face marketers: whether to try to sell a product with broad appeal to as many people as possible, or to focus on selling a tailored product to a deﬁned group. How it works Both niche and mass marketing strategies offer businesses the potential to make a high return on investment. A niche approach generally works on the basis of lowvolume sales at a premium price to a speciﬁc group of consumers, while a mass approach tends to use heavy promotion to a wider audience and aims to achieve high-volume sales. In reality, businesses tend to mix up both approaches, launching a niche product and then expanding it to a mass market. Marketers alsouse internet channels to promote the same product to different groups of customers within a mass audience.20%of sales can make up to 80% of proﬁtNEED TO KNOW Long-tail marketingPOPULARITYCoined by Wired magazine editor Chris Anderson, the term “long-tail marketing” takes its name from a demand curve (see below) depicting products with low demand or sales volume—niche products—that continue to sell and make proﬁt over time. Head Popular products with high demand and sales volume Withdraw The point at which retailers typically stop selling a productLong tail Products with low demand that sell steadilyPRODUCTSHOW SALES AND MARKETING WORKS Marketing approaches198 199Niche market Who and how ❯ Business targets a select group of consumers with speciﬁc need and wants. ❯ Customers often prepared to pay a premium price for an uncommon product. ❯ Sales volume of niche product low, so does not beneﬁt from production economies of scale (manufacturing large quantities to decrease the unit cost of production).HYBRID APPROACHES Using social media to identify and reach more than one target market, marketers have developed hybrid approaches that are more ﬂexible than conventional niche or massmarket positioning of products.Mass market An unfocused strategy that aims at the broadest customer base.Large segmentMass marketChannels marketing resources to one large segment of the mass market.Who and howAdjacent segment❯ Business targeting a large group of consumers with generalized wants and needs. ❯ Requires high marketing spend to promote products, which must be widely distributed. ❯ Marketplace often crowded with other competitors selling a similar product.Once large segment is fully penetrated, product expands into related segment.Multi segment Markets to several segments at once, with a customized strategy for each.Small segment Markets to a small segment with few competitors, if resources are limited.Niche segment Focuses marketing resources on a speciﬁc group of customers.Mass customization Customizes a strategy for each sub-segment within the mass market.Traditional marketing Before the digital age, marketers relied exclusively on non-digital channels, such as TV, radio, and print media, as well as direct mail, events, and cold-calling, to convey their message to the consumer. How it works Traditional marketing encompasses a number of tried-and-tested ways of building a brand and pushing a product to sell more. It remains a key facet of marketing. Nowadays, however, most businesses use a mix of traditional and digital marketing methods. One of the advantages of traditional marketing is that companies have face-to-face contact with customers through person-to-person selling, special events, and event sponsorship.Events Staging sports activities, themed displays, parades, or exhibits to promote a product, cause, or brand.TV Promoting sales through TV ads, program sponsorship, or product placement.Traditional marketing process Small and large businesses use a range of conventional marketing channels, and often integrate them with digital marketing strategies.Direct mail Mailing catalogs or circulars to a targeted list of consumers, often promoting special offers on products.Face-to-faceTelemarketingApproaching customers directly to create brand awareness or persuade them to buy a product.Calling potential customers who have an identiﬁable need for a product with a sales pitch.HOW SALES AND MARKETING WORKS Marketing approaches200 201Product samples Offering free samples of a product to customers, giving them the opportunity to try it before making a purchase —an effective way to launch new products and build a customer base.Billboards Renting large outdoor advertising spaces to market products. Cost depends on the size of space, its visibility, and the amount of trafﬁc that passes the location.Radio Using commercial slots on radio to promote products either locally or nationally, depending on the station’s reach.25%Newspapers and magazines Buying space in print media to run advertisements, or creating advertorials to market products or services.Traditional marketing Digital marketing 75%25% Brochures and ﬂyersNetworkingPromoting through mailing or locally hand-distributing printed materials to promote businesses.Interacting with other people at special events to develop professional contacts.of US companies surveyed in 2012 valued traditional marketing while 75% valued digital marketingDigital marketing Using the internet, marketers can connect directly and instantly with current and potential customers to build brand recognition, collect data, and encourage word-of-mouth recommendations. How it worksm ConsuCustomer blogs about the gymQ to ks lin site og b Bl wegy to n e ke on ta h i s ll p d e ce co on u kot to er m ctscusto TV ADS AIRED DURING TENNIS TOURNAMENTrePOSTER IN GYM ADVERTISING FREE WI-FIDiCustomer takes coupon to gymor w QR code is scanned with cell phonePRINTED AD WITH TRIAL COUPONee fr sa e le s i t du e b he w s c onnal marke o i t tin di a g rer POSTER WITH QR CODE FOR TRIALDirects viewer toc u Di s t re om c t er s toCUSTOMERS VISIT THE GYMA new health club is launched using a tradigital approach to marketing. TV ads are aired with a call to action to visit the gym’s website and schedule a free workout with a ﬁtness trainer. Print ads feature a coupon or a QR (quick response) code to scan and present at the health club for a free trial. At the club, members get free Wi-Fi access. The Wi-Fi landing page has a link to the gym’s free app. The club may also use pop-up ads, podcasts, email, and text messaging to attract or retain members.xperien cetoTradigital in practicee ers CuUnlike traditional ofﬂine marketing, digital marketing gives a business direct, two-way communication with customers. Digital marketing employs some conventional approaches, such as “pop-up” or “banner” ads on web pages, but it also relies heavily on the power of social media for raising awareness of a product or brand. This makes it harder to measure return on investment. Digital marketing is often used in conjunction with traditional marketing techniques, a hybrid known as “tradigital” marketing.HOW SALES AND MARKETING WORKS Marketing approaches% SHARE OF GLOBAL AD SPEND BY MEDIUMDigi tal ma rk et iFREE APP202 203The internet is the fastest-growing channel for global ad spending, while TV continues to dominate the current spend. 1%ng6% 7%Directs Wi-Fi user ton ve gi i a is e d ck l m ba c i a e d so Fe i a v9%2012 $40%19% 18%D I LAN ING PA I-F GE WFeedback is given via social media1% 6%Directs Wi-Fi user to7% Wi-Fi landing page links to a workout clip on video sharing site7% 201540%16%ti se al c ar u s ch to f o me rt r h e do g y es m aw eben Po tGYM WEBSITECu up s t o n e f o me w r e r si s l e m gn t t a il s er23% KEY TV internet newspapers magazines23%radio billboards movie theatersthe percentage of the global e-commerce market forecast to be held by China by 2016Engagement marketing By involving customers directly in the development of a brand, marketers hope to build a strong two-way relationship with customers and win long-term loyalty. How it works Engagement marketing harnesses several online and ofﬂine strategies to draw a customer’s interest and get them talking about products and services. This contrasts with the more traditional style of marketing in which a brand concept and product proposal are presented to the customer as ﬁxed, to be either accepted or rejected. Engagement marketing, on the other hand, encourages customer input so that they feel closer to the brand. The goal is to lure potential customers to the website with an initial experience, and then work hard to keep them there.Start with a “wow” experience Provide interesting, informative, or entertaining content to draw potential customers to a web page.Sale Once customer makes purchase, follow up with after-sale call, full of feel-good reinforcement.$ $ $PURCHASENEED TO KNOW ❯ “Sticky” customers Consumers who are loyal to a company and return to make more purchases ❯ Decision simplicity Ease with which consumers can ﬁnd trustworthy information about a product ❯ Churn rate Percentage of customers that cut ties with the company in any given time period ❯ WOM Word-of-mouth marketing, which relies on satisﬁed customers recommending products to othersNew prospects Offer incentives to existing customers for recommending product or sharing content.Social visibility COMMENTS AND SHARESPost interesting and relevant content on social media, and encourage dialogue.HOW SALES AND MARKETING WORKS Marketing approaches204 20571%of UK business leaders believe that customer experience is the next corporate battleground Entice to stay in touch ATTRACTOffer incentives to visitors when they sign up for email updates and newsletters.EMAIL@ Virtual engagement Design every aspect of a website to maintain visitor interest so people return for new content.IN-STORE PROMOTIONSOCIAL MEDIAEvents Use previous customer feedback to decide on best content for publicity events.Actual engagement Encourage customers in the real world to use product, meet and speak with sales staff, and interact with other customers.Sensory marketing Sensory marketing targets multiple senses to sway purchasing decisions. Based on research showing how the brain responds to sensory input, this type of marketing acts covertly on the customer. How it works Sensory marketing is most obviously used by the food and drinks industries, but its use extends to diverse products and services: computers designed with tactile materials, hotels scented to relax customers, and even ﬁreworks displays featuring edible confetti. Typical channels for sensory marketing include ﬁeld marketing (in-store events, samples, and person-to-person sales), direct mail, and product delivery. For online businesses, however, ﬁnding a way to use it remains a challenge.Sight Technology is making advances with this, the most stimulated sense in marketing, by using optical illusions, digital effects, 3-D, and 360-degree photography.TouchSmellMarketers use 2-D and 3-D textural print techniques for promotional materials and packaging, as well as to sell products with tactile appeal.Customers are willing to pay more for a product sold in an environment that is scented appealingly.81%of consumers born from 1980 to 2000 value experience over material itemsTaste Taste sensations can be enhanced or subtly altered by combining them with touch, sight, and especially the closely linked sense of smell.HOW SALES AND MARKETING WORKS Marketing approaches206 207Attitude, memory, behavior, and moodNEED TO KNOW ❯ Sensory testing Assessment of products by panel members with exceptional sensory perception ❯ Haptic technology Invention that simulates touch through vibrations on computers ❯ 3-D marketing An immersive form of consumer marketingThe sensory input results in a short- or longterm effect on attitude, memory, behavior, and mood. This can be inﬂuenced by the intensity of sensory data and by using it to stimulate more than one sense at the same time.Perception The brain receives stimuli from one or more senses.EmotionCognitionSensory stimuli tap into the store of emotional memories, as both are processed by the same area of the brain.After processing sensory stimuli, the brain embeds memory, regulates emotion, and makes decisions.Hearing Sound is more effective than sight in triggering the brain areas that process emotions.Relationship marketing The strategy of relationship marketing is to develop and manage a trusting, long-term association with customers and other markets that have links with the company. How it works Relationship marketing aims to replicate the type of interaction that village stores once had with their customers, offering a high level of personalized service to win them over for a lifetime. While small, local businesses naturally work this way, largecorporations have now changed their focus from making the sale to relationships, and from short-term reward to long-term gain. The marketer can extend the network beyond the engaged customer to include employees, suppliers, and others.Supplier markets Building a relationship of collaboration with suppliers makes good commercial sense.Six markets model Relationship marketing has established a strategy for communicating with the customer. This strategy deﬁnes six markets—not just traditional customer markets—where companies should direct their marketing efforts.CASE STUDY Starbucks The strategy of coffee-shop chain Starbucks exempliﬁes effective relationship marketing. Centered on core customer and internal markets, it also involves suppliers, referrals, and recruitment (employee) markets. Marketing to customers ❯ Social media ❯ Business crowdsourcing ❯ Familiarity with customers ❯ Loyalty program ❯ Reward card app ❯ Mobile paymentsMarketing internally ❯ Barista training ❯ Tech development opportunities Marketing via referrals ❯ Word of mouth ❯ Social media shares Marketing to employees ❯ Stock options ❯ Medical insurance ❯ Partnership Marketing to suppliers ❯ Fairtrade programs ❯ Quality controlInﬂuence markets To maintain good public relations, the company works with regulators and consumer or environmental groups.HOW SALES AND MARKETING WORKS Marketing approachesReferral markets Customers can be word-ofmouth advocates for a company. Related businesses may also refer trade.208 209“Ignore the human element of marketing at your own peril.” Bob GarﬁeldInternal marketsCustomer markets The main marketing focus is on customers, but activities are based more on building long-term customer relationships than on acquiring new customers.A company’s employees are its internal customers, working together to represent its goals, mission, and strategy.NEED TO KNOWCVCVCVRecruitment markets To attract the best employees, a company may market itself by offering incentives to staff.❯ Key account management (KAM) System that coordinates departments in a businessto-business (B2B) company to serve big clients ❯ Frequency marketing Promotion aimed at increasing repeat sales by rewarding customers for repeat purchases ❯ Direct response (DR) Marketing that invites consumers to respond directly to the advertiser, by mail, telephone, or email ❯ Transaction marketing Strategy that aims to persuade customers to make additional one-time purchases at the point of saleOutbound marketing Also called interruption marketing, outbound marketing involves a marketer pushing a message to consumers. With this type of marketing, businesses typically reach out to a wide audience by paying for advertisements on various media channels. Although the audience may have no interest in the advertisement, outbound strategy relies on delivering a high-impact message and generating a response by creating familiarity through repetition.Outbound marketing process Outbound marketing takes a traditional approach to grabbing consumers’ attention, but may use both non-digital and digital media platforms. There are two stages to the outbound process. First, the company broadcasts a message to an audience and tries to convert them into customers; second, it analyzes the results to identify the channels and campaigns that have generated the most sales.BroadcastConvertMarketers select a media channel with proven reach to the target audience, then communicate the message about brand or product to that audience.Marketers link ofﬂine outbound campaigns with digital channels as part of an overall strategy to persuade potential customers to respond.Broadcast channelsMeans of conversion❯ Ads on prime time TV to ﬁnd widest possible audience—ideal for raising brand awareness. ❯ Direct mail sent to a general audience using mailing lists, or to existing customers who have previously bought by mail order. See pp.212–213. ❯ Print advertisements in special interest, hobby, or trade magazines with proven circulation to ﬁnd a deﬁned target market. ❯ Presence at trade events for increasing corporate visibility and to reach a business audience.❯ Radio advertisement that repeats easy-to-recall phone number to elicit immediate action. ❯ Direct mail that makes highimpact call for customer response; includes postage-paid reply form and customer service contacts. ❯ Online advertisement that has prominent position on web page and clear click-through point that invites customers to click, ﬁnd out more about product, and buy. ❯ Flyer distributed door to door that includes an appealing introductory offer on the product for a limited period of time.HOW SALES AND MARKETING WORKS Outbound marketing210 21132%of UK brands cut outbound marketing spend in favour of spending more on content marketing, in 2013TYPES OF OUTBOUND MARKETING Ofﬂine ❯ Cold calling Campaign can be more effective if conducted at the right time of day to suit target audience; message should be scripted carefully and delivered in a genuine tone. See pp.218–219. ❯ TV commercials Although many consumers now switch off TV advertisements, they are familiar with and open to this type of media, and repetition gets the message across. See pp.212–213. ❯ Radio This medium is the world’s most popular mass communication channel with a global reach, and is ideal for outbound messages aimed at an international market. See pp.212–213. ❯ Guerrilla marketing The use of a creative and unconventional approach in high-trafﬁc public places can be a cost-effective way to raise brand awareness. This is a form of engagement marketing. See pp.204–205.Analyze Marketers monitor the progress of outbound campaign and adjust the mix of media or other paid-for channels, then measure campaign results.Actions ❯ Run control and test streams to compare the success of different media or campaign strategies. ❯ Examine click-through-rate analytics, which look at how many customers have clicked through to ﬁnd out about or buy product, to determine online ad success. ❯ Measure direct mail response rates, including breakdown of different mailing lists or target demographics. ❯ Analyze sales by outbound spend to establish which channels offer the best return on marketing investment (ROMI).Online ❯ Social media The types of advertising on social media sites are increasing and include sponsored posts, promoted pins, and direct forms, such as banner ads. See pp.228–229. ❯ Mobile technology Advertising that is tailored for mobile devices takes the form of text and images, or both, to offer special deals to users; promotions are also made via apps. See pp.214–215. ❯ Social lead targeting This strategy taps into individual proﬁles from social media and tailors messages, which are sent via online networks, such as Twitter and LinkedIn. ❯ Search engine optimization (SEO) keywords Paying for popular SEO keywords relevant to a brand can improve exposure by raising them in internet search engine listings pages. See pp.230–231.Traditional offline advertising Ofﬂine advertising uses traditional media channels, such as magazines, TV, radio, and billboards, to market a product or service. Although online advertising is growing fast, globally most advertising is still ofﬂine. How it works The common criteria for both online and ofﬂine advertising is that businesses pay for ads that are intended to catch a consumer’s attention with a brand or product message. Businesses calculate the success of their advertisement by looking at the return on investment (ROI) for every ad dollar spent. And to maximize the ROI, they must make sure they choose the right channel for their target audience.Marketers choose different channels according to the target market deﬁned for the product or service being advertised. The choice may also be based on the ROI that a company has previously experienced for that channel. However, tracking the response rate of ofﬂine advertising is more difﬁcult and less accurate than tracking online advertising (see pp.214–215).83%of all advertising in India in 2013 was via television or print; digital comprised just 6.5% of the totalOFFLINE ADVERTISING AND RETURN ON INVESTMENT (ROI) 44.3%One of the most important set of ﬁgures for a marketing department is return on investment (ROI) for advertising spend, which indicates the success of its campaigns. Data compiled by the Radio Advertising Bureau, UK, in 2013 showed that TV and radio boasted the best ROI.KEY Share of overall ofﬂine ad budget Average return on investment per $ spent18.1% 11.7% $14.15$12.53 5.8%$9.44 $3.25 TELEVISIONPRESSOUTDOORRADIOHOW SALES AND MARKETING WORKS Outbound marketingOfﬂine advertising channels TelevisionRadioNewspapers S N EWMagazinesDirect mailBillboardsMoviesProsConsOffers local, national, and global reach; mix of sound and vision creates high-impact messageExpensive; ad repetition may cause viewer fatigue; viewers likely to skip ads on recorded showsInexpensive; quick and easy production process; most stations play to speciﬁc demographicCompetition for prime “commute” slots; radio on as background noise renders ad ineffectiveFast publication process; themed newspaper sections allow for more targeted advertisingAds compete for attention with other material on page; usually black and white, and text onlyMay remain in circulation for months; niche trade and special-interest titles allow focused advertisingReal circulation ﬁgures hard to source; securing ad slot requires planning months in advanceCost-effective; delivered straight to people’s homes and ofﬁces; targets speciﬁc marketsMay be perceived as junk mail and instantly thrown away; response rate usually lowHigh reach makes channel cost-effective; advertiser’s message visible 24 hours a dayHeavy competition for prime sites; format limits message length and complexityPotential to impress with sophisticated, creative production; it has captive audience membersAudience numbers limited; members may choose to enter theater after ads are shown212 213NEED TO KNOW ❯ Television rating point (TVR) Indicates percentage of target viewers in program audience ❯ Cost per thousand (CPT) Figure used to measure outlay to reach a thousand people via any channel ❯ Advertising to sales ratio (A/S) Method of measuring money spent on advertising and sales generated ❯ Share of voice Percentage of total activity claimed by one advertiser for a product sector58%of marketers’ ad budget globally was spent on TV advertising in 2010, although 86% of people skip television adsOnline advertising Marketers are increasingly advertising online to push marketing messages to consumers. Online channels include display and mobile technologies, email, search engines, and social media marketing. How it works When marketers advertise on the internet, they have to choose both the form of the ad and a location that has an audience matching their target market. There are several advertising channels, but the two most often used are display advertising and search advertising. Display advertising includes banners with text and images, which appear on websites known to be used frequently by target consumers, such as news, social media, or video content sites. Search advertising is a method of placing ads in the web pages that appear in the results of searchengine queries. While display advertising is likely to get more views overall, search advertising has a better chance of reaching the target audience. Other forms of digital advertising include mobile advertising, which embeds advertisements in mobile content viewed on smartphones and tablets, or sends text messages; email, which delivers ad copy directly to an email address; and social media advertising, which a company uses to promote products via its social media proﬁle. A major advantage of online over ofﬂine advertising is that response rates can be tracked effectively.210%the growth rate of mobile advertising in China, between 2013 and 2014RESPONSES TO DIGITAL ADVERTISING OVERLOAD 70%66%65%60%Consumers who feel bombarded by digital promotions from a brand are likely to be put off. Here is a sample of how consumers would respond if they felt a brand’s promotions were too frequent.KEY US UK50% 40%32% 28%30%27% 20%20%11% 10% 0%Would unsubscribe from a brand’s promotionsWould respond negatively to future brand messagesWould stop using the brand’s product or service10%Would protest on social media sitesHOW SALES AND MARKETING WORKS Outbound marketingOnline advertising channels ProsConsDisplay advertisingAttention-grabbing; if ad is clicked on, success can be tracked with pay-perclick systemHard to target consumer precisely; internet users suffer ad fatigue and ignore advertisementsSearch advertisingGood for targeting consumers, as search user keywords are matched to advertiser keywords (see pp.230–231)Potentially expensive if using premium keywords; can take time to see resultsxxxx214 215NEED TO KNOW ❯ Clickstream User activity proﬁle that summarizes what an individual has clicked on ❯ Behavioral targeting Process whereby websites capture data from landing page visitors and use it to improve ad effectiveness ❯ Interstitials Ads that precede the content page a user expects to land on, or appear right after itCASE STUDY MobileEmail@ Social mediaCheaper to develop content for mobiles than for computers; easy to track ad effectivenessDifferent screen sizes and systems can distort ad layout; user may feel annoyed by interruptionOffers opportunity to reach millions of potential customers, especially with bulk emailing (see pp.216–217)Recipient may delete email without reading it, and is more likely to do so if feeling bombardedEasy to target speciﬁc audience; offers chance of ad going viral and achieving many views (see pp.228–229)Continual posts and updates can easily distract user’s attention away from placed ad46%of e-commerce sales in 2014 came from the Asia–Paciﬁc regionClick fraud and botnets With pay-per-click (PPC) advertising, a business pays a website for every click made on one of its ads, but click fraud has become a serious issue. Fraudsters set up a website and sell PPC advertising, then inﬁltrate the computers of unsuspecting users with a computer virus known as a “botnet” to generate fake trafﬁc to the website. Advertisers on the site end up paying the fraudsters for the large number of clicks received. In 2013, one London company uncovered a botnet that was generating nine billion fake clicks per month.Direct mail By targeting a large number of potential customers via mail or email, marketers hope to convert some into actual customers. This is achieved through the timing, design, and wording of the message. How it works Direct mail is one of the oldest forms of marketing. It works on the basis of sending a product offer to a large group of consumers in the knowledge that at least some will take up the offer and become customers. Direct mail relies on lists of names and addresses, which could be a company’s existing clients or a list bought from a specialist agency. Almost any business, from a smallcompany to a corporation, may use direct mail to sell. Typical companies that sell through direct mail include mail-order companies, ﬁnancial institutions, and nonproﬁt organizations seeking donations. The percentage of people who respond to direct mail, take up the offer, make a purchase, and become customers—a category known as the conversion rate—is extremely low, but nevertheless proves to be proﬁtable.NEED TO KNOW ❯ Cleaning Correcting name and address details on mailing lists ❯ Lettershop Company that specializes in printing and mailing out letters and catalogs ❯ Merge/purge Software system that pulls together different mailing lists, searches for duplicates, and makes correctionsDirect mail and email—A/B testing A/B testing compares the effectiveness of two versions of a marketing email or direct mail copy. The two versions are sent to different groups of potential customers, and the response to each is measured.Group AAPPROACH AWEEKDAY MAILING See response from email hit on MondayResponds with two clicks on the company’s website@ Acquire namesSend mailSet size of sample and split in half3.42%APPROACH BWEEKEND MAILING See response from email hit on Saturdaywas the average response rate to direct-mail marketing in the US in 2010Group B Responds with 20 clicks on the company’s website216 217HOW SALES AND MARKETING WORKS Outbound marketingHOW TO SEND DIRECT MAIL 15 A BAcquire namesPrepare directmail copySend letters or emailsWork out response rateEvaluate effectivenessBuy in mailing lists or trade with other companies.Write offer/response instructions; include prepaid envelope.Send mail (staggered dispatch controls ﬂow of response).Calculate responses as percentage of mail sent out.Assess performance of campaign compared to others.A BData analysisEvaluate effectivenessComparison of results shows that Saturday time slot is more effectiveFull email blast reveals that approach B yields the best responseCampaign B Send emails to remainder of the group on SaturdayTelemarketing Businesses use telemarketing to initiate direct contact with existing and potential customers. Customers can also contact the company directly. Telemarketing offers businesses a way to retain and acquire customers. How it works Telemarketing works in two directions: inbound and outbound. A customer making a call to a business (with a question or complaint, for example) is referred to as an inbound call. It gives the business a chance to retain a customer who may be dissatisﬁed with a product or service, or to win over a new customer contacting the company for the ﬁrst time. When a businessmakes an outbound call, it is to sell additional products or services to an existing customer, or to entice a new customer to make a purchase. Telemarketing sales can be monitored in orders per hour; for example, agent A may make 140 calls per hour and generate $400. A more effective measure is revenue per call—if agent B makes 60 calls per hour but $450 worth of sales, the conversion rate per call is higher for agent B than agent A.60%of all call centre staff in France and India have college degreesOutbound and inbound telemarketing process Telemarketers usually refer to a list of telephone numbers retrieved from a database to contact new or existing customers. Call center agents have access to product information to help them deal with questions and complaints.Customer inquiry The customer may have a question about service or billing.INBOUND Customer telephones call centerCall center Agents in the call center receive inbound calls and make outbound calls.WARM OUTBOUND Call made to promote new products/offers to existing customerCOLD OUTBOUND Call made to establish ﬁrst-time contact with prospective customerHOW SALES AND MARKETING WORKS Outbound marketingTOP FIVE CALL CENTER LOCATIONSNEED TO KNOWThe Philippines is the top call center location for US ﬁrms, followed by India. This is because of the high number of Filipinos who have a US education and knowledge of American culture.IrelandPoland China India218 219Philippines❯ After-call work (ACW) Tasks the agent has to complete after making a call, such as processing sales forms ❯ Average handling time (AHT) Typical length of calls made to customers ❯ Automatic call distributor (ACD) Computerized telephone system that connects each call to the correct agent ❯ Average speed of answer (ASA) Measure of the time it takes to answer inbound callsA BEvaluate effectiveness Telemarketers constantly evaluate the effectiveness of calls.Customer The person who decides whether to buy a product.Agent AAgent BMay adopt a particular sales strategy or have a personal approach.May use a different communication or selling technique.Outcome AGENT A AGENT BGatekeeper The person who answers the call and decides to pass it on.At the conclusion of a marketing drive, telemarketers appraise strategies and styles to help them decide on future campaigns.Inbound marketing Inbound marketing lures customers by offering them appealing content, and engaging with them. The approach pulls customers into a relationship with a brand rather than “pushing” them into making a purchase, which is how advertising works. Inbound marketing is also known as permission marketing as potential customers are giving a business permission to communicate with them. In other words, they are actively interacting with the company or brand.Inbound marketing process Content forms the core of inbound marketing. It includes text, images, and video that consumers seek out online, especially on social media sites, or in person at events, such as trade fairs, and share with their network of friends, family, and colleagues. Potential customers respond to inbound marketing because the business or brand is offering interesting and relevant information, entertainment, or content with emotional value. Businesses expect this interaction to culminate in a sale, or create brand recognition that leads to a sale.Top types of content marketing 1. 2. 3. 4. 5. 6. 7.Blogs How-to guides Images Infographics Videos Testimonials/reviews Case studies8. Internet memes 9. Email newsletters 10. E-books 11. Podcasts 12. Twitter chat 13. Newsjacking (giving content to news media)Exploration Publish and actively promote content; use search engine optimization (SEO) to attract consumers onlineNEED TO KNOW ❯ Top of funnel marketing (TOFU) Offers content to grab the initial attention of potential customer ❯ Middle of funnel marketing MOFU Offers more detail and encourages participation ❯ Bottom of funnel marketing (BOFU) Attempts to win a sale with low pricing, offers, or via customer recommendationsDecision-making Ensure that content captivates potential customers or solves problems for them; encourage two-way communicationPurchase Entice interested site visitors to become customers; make shopping online an easy and positive experienceAdvocacy Provide excellent customer service; spur customers to make recommendations and share on social mediaHOW SALES AND MARKETING WORKS Inbound marketing220 22141%of marketers surveyed in 2013 believed inbound marketing produced measurable return on investment (ROI)INBOUND MARKETING STRATEGIES Ofﬂine ❯ Optimize retail space Provide a well-designed physical environment that will both draw customers in and encourage them to come back. ❯ Engage media Generate press releases to gain media coverage. Focus on topics of real interest, especially ones that can be backed up by statistics and research. ❯ Interact face to face Conduct events in stores that provide a new experience/beneﬁt to customers; rent a stand at a trade event and offer key information.@ Search engines, social media networks, web publishers, and third-party blogsCompany website, blog, podcast, community, and interactive toolsE-commerce process, product, price, discount, and promotionCustomer championing of product or serviceOnline ❯ Post blogs Update company blog with appealing content to attract visitors. See pp.224–225. ❯ Create podcasts Produce content relevant to customers searching for information; engage experts to add value. See pp.226–227. ❯ Produce other content Post articles, photos, and videos on social media sites; target inﬂuential users to encourage viral sharing. See pp.228–229. ❯ Apply search engine optimization (SEO) Fill search engine listings with key phrases that answer speciﬁc questions; add inbound links from popular sites. See pp.230–231.Outbound vs. inbound marketing Outbound marketing interrupts consumers to promote a product or brand, but inbound marketing needs consumers’ permission—they have to seek out information that leads to the marketing message. How it works Before the rise of the internet and the phenomenon of social media, most marketing strategies were outbound. In other words, marketers pushed messages at consumers by interrupting them with advertisements or direct mail. The same principle applies to outbound marketing that appears on the internet, with pop-up adsinterrupting the content the consumer wishes to access. However, because consumers from all over the world now use the internet to search for information and entertainment, marketers have adopted inbound strategies instead, providing content that draws the consumer to the brand or product, rather than pushing marketing messages at them.NEED TO KNOW ❯ Push or interruption-based Alternative marketing terms used to describe outbound marketing ❯ Pull or permission-based Alternative marketing terms used to describe inbound marketingPros and consOuMarketers interrupt consumers with hundreds of outbound marketing messages every day, but they also use subtle inbound marketing tactics to attract consumers. Each strategy has its advantages and drawbacks.ound tbProsCons❯ Campaign results can be forecast and measured ❯ Marketing material is easier to create ❯ Campaigns can be tightly controlled❯ Customer conversion rates are low ❯ Marketing campaigns are expensive to create ❯ Effects of campaign are often short-livednd ouProsCons❯ More likely to draw customers with long-term interest in the brand ❯ Non-intrusive approach preferred by customers ❯ Cost-effective compared with outbound campaigns❯ Response from market may take longer ❯ New content must be generated regularly to keep customer interested ❯ Campaign results can be difﬁcult to measureADVERTISINGInbCOMPANYBLOGGINGHOW SALES AND MARKETING WORKS Inbound marketing60%AVERAGE COST PER LEAD OF INBOUND VS. OUTBOUND MARKETING A report compiled by HubSpot in 2012 $3 per 4 6 discovered that le a d companies with inbound-dominant marketing strategies reported a 61 percent lower average cost per lead. The study highlighted the cost-effectiveness of social media, SEO, and email marketing.61% OUTBOUND MARKETING222 223lower cost per lead 5 $13 ad e l r peINBOUND MARKETINGof marketers have added inbound marketing to their existing outbound strategies2012TRADE SHOWSTELEMARKETINGPAID SEARCHDIRECT MAIL$ Integration of channels By coordinating the message on all channels, businesses can optimize the impact of a marketing campaign.PODCASTINGSEOWEBSITESOCIAL MEDIABlogging Businesses post information articles on web logs, or blogs, as a way to attract consumers to their websites. They may blog on their own website or rely on independent bloggers to achieve this goal. How it works Unlike a conventional website, a blog is a site that consists purely of informational posts or entries that appear in chronological order, starting with the most recent. Blogs ﬁrst started appearing in the mid-1990s, when new web tools made it possible for non-expertsto publish material online. This type of web content has since become one of the most common sources of information and opinion on the internet. Although it was once only individuals who published blogs, many are now commissioned or professionally edited and produced by the company’s marketing department.Blogging process Marketers may use SEO tools (see pp.230–231) to gain insight into what’s being talked about online, which helps them to determine the most suitable topics for blogs. Many companies have the in-house talent to create blog content.Post Publish blog entry on internet using web software or specialized corporate blogging platforms.Select key word or question Determine key word, phrase, or question that appeals to the target audience.Create content Base content on key word/ question, and ensure that it gives readers valuable insight into the chosen topic.KEY WORDAdd links Cite industry experts and research reports; add photos or videos, and provide links to the original sources.RISE OF BLOGGING: THE FIRST 20 YEARS First blog (links.net) appears19941995Term “weblog” is coined19961997Open Diary blog launches19981999Boing Boing tech blog launches2000Blogads (ads on blog) founded20012002HOW SALES AND MARKETING WORKS Inbound marketing85.2%NEED TO KNOW ❯ Disclosure Statement of whether blog is sponsored, or if reviewed products are given to blogger or were independently bought ❯ Splog Spam blog containing fake articles designed to increase the search engine rankings of speciﬁc websitesof internet users in Brazil visited blog sites in 2011Submit blog to syndication sites and share with social media networks, such as Facebook, Twitter, Instagram.Track and measure Monitor key blog statistics, such as the number of unique visitors and the number that sign up for RSS feed and email.Google launches AdSense20032004“Blog” is word of the year20052006Top ﬁve statistics to trackThree blogging mistakes❯ Number of visitors Potential customers visiting blog and their route in—via links or direct entry ❯ Bounce rate Share of visitors who leave site within 10 seconds ❯ Pages per visit Number of pages viewed by visitor ❯ Conversions Proportion of visitors who subscribe to blog ❯ Keywords Common words visitors use to ﬁnd blog site❯ Obsession with SEO Although SEO is important, focus should be on publishing quality content ❯ Omitting facts Posts should offer factual information, not just opinion or repackaged content ❯ Lack of legibility Poorly designed blogs with unclear typography will discourage customers from reading contentMicroblog Tumblr launchesWeblogs Inc. sold for $25m2007G VITAL STAT N I IS GGCS TIBL OSyndicate/share224 2252008AOL buys HuffPo blog and news websiteBloggers’ code of conduct proposed200920102011Blogging turns 20Over 75m WordPress blogs201220132014BLOGGINGPodcasting/vidcasting Businesses may post audio or video ﬁles on the internet to attract and engage website users; the goal is to convert ﬁrst-time users into subscribers. Once consumersengage with podcasts or vidcasts, companies try to sell products either through advertising on the podcast or the podcast download page, or by sponsoring the podcast or vidcast to create brand reinforcement.Podcasting/vidcasting process In order to get commercial results from a podcast or vidcast, a company needs to create and publish interesting and informative content.NEED TO KNOW ❯ Vodcast Alternative term for vidcast (both short for videoon-demand broadcasts) ❯ Rich site summary (RSS) Format used for frequently updating text, audio, and video content online ❯ Mobcast Podcast that is created and published on a cell phoneCapture content Decide on topic, and create an outline, then ﬁlm video for vidcasts or record audio material for podcasts.Process content Edit video footage or audio track for background noise, mistakes, repetitions; test and edit further, if necessary.Select correct format Save podcasts in MP3 format; save video in small-screen format; compress ﬁle size for optimal download speed.Publish content Embed and publish content on new post. Use app to generate feed address; submit to iTunes or other platform.Tracking Count number of subscribers; use web feed services to access user location, level of interaction, and other statistics.1 billion+users subscribe to Apple’s podcast appHOW SALES AND MARKETING WORKS Inbound marketing226 227BUSINESS BLOGGING AND PODCASTING ETHICS Independent online reviewers often collaborate with businesses, which is beneﬁcial to both. However, business promotion on blogs/podcasts is not regulated like advertising, and ethical boundaries can become blurred.NOBlog /podcast reviews include products such as apparel, hotels and restaurants, and technology. YESOther contentNOBusiness gives free sample of product or service to blogger/podcaster for testing and reviewing.Business provides support to reviewer through paid content and advertisements.NOBusiness provides support to reviewer by offering further free products and services.YESReviewer writes consumer report.YESYESPossible conﬂict of interestPossible conﬂict of interestNOReviewer tries to be neutral.Blog/podcast helps generate revenue for both parties. NOReviewer site builds own reputation and has its own agenda.KEY Business potentially inﬂuences blogger Blogger operates independently of businessBlog generates revenue for blogger/businessYESReviewer site depends on revenue that business provides.Social media marketing By posting content on social media, marketers try to attract website trafﬁc and draw attention to their products and services. Occasionally, interest in the posted content can multiply rapidly across these channels. How it works Social media marketers are responsible for generating engaging content. Typically, the content provides entertainment or offers useful information that social media users actively look for. If the content iscompelling enough it will attract followers, who will share it with their audiences. As the content continues to be shared, liked, and commented upon, it will eventually get picked up by Google and other search engines, helping to generate more interest.Social media marketing in practice The makers of a new health supplement for repairing sun-damaged skin generate video content showing the dramatic results of the product, and launch it across two social media channels. Video footage, an image, or a story that is spread quickly and widely via the internet is said to have gone “viral.” 360 YouTube users share the content.CONVERTING SEEKERS TO JOINERS The goal of content marketers is to convert “seekers,” who have arrived on a website, blog, or social media page, into “joiners,” who subscribe and allow two-way communication. Stage 1 Marketers post content, such as a video, article, or special offer, to draw consumers (seekers and joiners). Stage 2 They rely on “ampliﬁers”—social media users who share content with their friends—to spread their post to a wider audience. Stage 3 They monitor response rates from seekers, joiners, and ampliﬁers, and audit their posts.One major beauty blogger links to YouTube post.12 smaller blogs follow the link and post about it.Blog followers see the post and blog and visit the link.Content is posted on YouTube as “new anti-aging skin care.”HOW SALES AND MARKETING WORKS Inbound marketingContent created37%of businesses in Germany used social media in 2013 Content is tweeted to 460 followers of the company.# #228 229NEED TO KNOW ❯ Social graph Internet graph that maps connections between user groups, such as Facebook friends ❯ Social media optimization (SMO) Use of online communities to maximize social media coverage of product or event ❯ Social media monitoring Process of tracking the number of mentions a brand or company receives on social media sitesContent is retweeted to 750 other followers.Content is posted on Facebook by one Twitter user.Each social media mention of the content moves the company’s website higher up the listings of search engine results.Content is shared among 520 Facebook friends.Search engine optimization (SEO) SEO is a process marketers use to acquire trafﬁc from search results on search engine sites. SEO software tools are available to help the user create web pages that will appear at the top of search engine listings. How it works Companies that have a web presence must ensure that their website has a high ranking on search engine listings. To achieve this, they frequently use SEO tools to monitor where their website appears when keywords are searched for, and take steps to keep it moving up the search results page. Some of the important measures marketers take includecoming up with the right keywords, linking to other websites, and generating content that includes frequently searched keywords or phrases, so that their website remains relevant to a wide variety of search queries. Search engines offer pay-per-click, a service that places a company’s listing at the top of a search results page. Every click generates a fee payable to the search engine.92%of all Google trafﬁc goes to entries on the ﬁrst page of resultsSEO process These tools can be used regularly in a continuous attempt to move a website higher up the listings.Keyword selection Use a combination of intuition and analysis to choose words.Keyword research Use SEO tools to research the most popular keywords.❯ Brainstorm keywords ❯ Find words in top engines ❯ Test trafﬁc using words❯ Think of key phrases ❯ Avoid overused words ❯ Try variations of a wordCompetition analysis Check competitors’ rankings to ascertain how to rise above them.❯ See ranking with SEO tool ❯ View rival web links ❯ Find top-ranked domainHOW SALES AND MARKETING WORKS Inbound marketingNEED TO KNOW ❯ Robot.txt Text ﬁle that stops web crawler software, such as Googlebot, from crawling certain web pages ❯ Search algorithm Step-by-step calculation that looks for clues to decide on search rankings ❯ Metadata Information that describes stored data – data about data ❯ Cloaking Technique for improving SEO by making some web content invisible ❯ Panda and Penguin Two updates to how Google calculates its website rankings, preventing unfair rankings from SEO tools230 231SEO TIPS Avoid single words because multiple-word phrases rank higher.Monitor search statistics using Google Keyword Tool, for example.Add blog to offer content that search engines will pick up.Prioritize good content and update it regularly with keywords.Use reputable sites with relevant content to link back to your site.Give headings keywords that relate to content on page.Reporting and tracking Use tools to track trafﬁc and report on website ranking.❯ Focus on quality of visitsLink-building Add links from related websites to point back to own site.❯ Check server reports ❯ Tally sales from searches❯ Link to high-proﬁle sites ❯ Contribute to forums ❯ Ask partners to linkKeyword revision Monitor search results from current keyword selection and make adjustments.❯ Make sure terms aren’t broad SEO spider Software that crawls the internet, adding content to search engine databases❯ Avoid specialized words ❯ Alter word orderBusiness development The overall goal of sales and marketing teams is to generate customer contact and convert it into revenue. This is the core of business development, and it involves a continual process of drawing in potential customers, enticing them to purchase, and keeping them engaged. During this process, marketers and sales people use a range of strategies and channels to attract customers and to earn their long-term commitment to a brand and product.Collaborative process Marketing departments generate brand identity while sales teams do the selling. Working together, they aim to take potential customers on a journey from brand awareness to repeat sales, communicating the message through various channels.Build brand awarenessGenerate leads Use a combination of inbound and outbound marketing strategies to entice potential customers to seek out the brand or product. See pp.236-237.Target customer groups with content and/or ad campaigns to inform them about the brand and its values. This will lay the foundation for a long-term relationship. See pp.234-235.Public relations AdvertisingFace-to-face communicationLive events Social mediaConvert leads into sales Once potential customers are interested, entice them to buy with targeted messages, offers, and well-designed e-commerce sites. See pp.238-239.Email blastsTelemarketingHOW SALES AND MARKETING WORKS Business development15%BUSINESS DEVELOPMENT STRATEGIESDatabasesDevelop intellectual capitalTrack marketing spend on each channel and analyze results to gauge return on marketing investment (ROMI). See pp.242-243.Nurture talent and foster creativity in order to optimize ongoing marketing efforts. See pp.244-245.Special offers and updatesReturn on investment (ROI)Trafﬁcdriving to websiteInnovationReview effectivenessKnow-howFollow up sales with efﬁcient delivery, excellent customer service, and personal contact to reinforce positive customer relationships. See pp.240-241.Analytics toolsRetain customersCall centerBusiness development is reliant on growth. Sales and marketing teams can increase long-term proﬁtability by building up a customer base and then trying to retain it. There are several ways to ensure that the customer base remains buoyant. ❯ Chart customer journey from before to after sale ❯ Think of ways to reduce cost of sale and increase customer satisfaction ❯ Integrate sales processes with marketing to gain and retain customers; think about ideal customer ❯ Monitor and evaluate these processes regularlyREVENUEof companies have specialized business development staff who are not involved in salesLoyalty programs232 233Branding and rebranding A brand is deﬁned by the characteristics that mark a particular product. Branding is used to communicate a product’s qualities to a consumer, and create a lasting bond between supplier and customer. How it works When a supplier develops a brand, it creates a deﬁned set of values, expressed in product imagery, colors, logo, slogan, jingles, promotional imagery, and association with high-proﬁle individuals or characters. The brandworks for both the supplier and the customer, aiming to eliminate uncertainty and risk and to convey key attributes. Social media helps to promote brands—for example, 29 percent of Facebook users follow a brand and 58 percent have “liked” a brand.The branding cycle There are typical stages to branding a product. In order to rebrand (redevelop) a product, the supplier starts over at the beginning.Choose brand personalityDevelop the concept Marketer focuses on positioning (where brand sits among competition in terms of function and look) and building a consistent and clear personality.Sincere Down to earth, honest, kind, thoughtfulBold Carefree, spirited, youthfulRugged Tough, strong, outdoorsy, masculineSophisticated Exclusive, romantic, elegantCompetent Reliable, intelligent, authentic, successfulHOW SALES AND MARKETING WORKS Business development234 235Apply marketing mixNEED TO KNOW ProductPromotionPrice❯ Brand equity Power of a well-respected brand to generate more sales than the competition ❯ Brandwidth Measure of the effectiveness with which a brand connects across a wide range of consumers ❯ Brand architecture Overarching plan to develop one or more brands and create a hierarchyPlaceApply promotion mix Brand nameTaglinePsychological needs Make brand alluringDesign and packagingAudiovisual elementsPhysical needs Assert product’s usefulnessBuying power Use brand values to optimize salesThe consumerIs it time for a rebrand to make product more appealing?nd Bra aut diResearchAudit passedRebrandREDEVELOPMENT: RETURN TO THE BEGINNING OF THE PROCESSLead generation For a business to grow, one of its basic goals is to acquire new customers. Lead generation is the strategy it uses to locate, target, and nurture leads (potential customers). How it works The purpose of generating leads is to ﬁnd consumers who may need or want to buy the product a business is selling. Sales teams do not want to waste resources on people who have no interest in the product in the ﬁrst place, so the process of lead generation helps to deﬁne and capture the potential customers who seem mostinclined to become actual customers—known as high-quality leads. To generate leads, marketing and sales departments typically collaborate on a campaign, ofﬂine or online, designed to identify and recruit promising customer prospects. Acquiring contact information is the ﬁrst part of the process. Converting leads into sales is the next step (see pp.238–239).Lead-generation process Generating leads is a multi-step process that involves sales, marketing, and customer service teams working together to plan, design, produce, test, and reﬁne a campaign.Produce campaignPlan the approach Set goals and parameters, including expected return on investment (ROI) and number and quality of leads. REVIEW OBJECTIVES Check that they are realistic; compare with previous efforts. AUDIT Assess current lead generation.PLANNING Ensure that sales, marketing, and customer service are working together.RESEARCH Ascertain which media and customer touchpoints are most effective.BIG IDEA Devise a compelling message to engage and entice leads.Create and deliver materials for each medium involved in the campaign. SEO/PPC Integrate search engine optimization (SEO) efforts and pay-per-click spend (see pp.230–231).TRADE SHOW Invite potential leads to visit the company’s stand and meet face to face.SYSTEMATIZE Integrate customer relationship management (CRM) software to manage the leads.Identify target customerDesign campaignDeﬁne the characteristics of the customer the business is aiming to capture in as much detail as possible.Craft a multi-channel message to entice the lead to opt in and give contact information.EMAIL BLASTS Include a beneﬁt for the recipient and a call to action (see pp.216–217).TELEMARKETING Review key message and call script with customer service team. ADVERTISING Generate broad interest with ads on selected media.HOW SALES AND MARKETING WORKS Business developmentTOP FIVE STRATEGIES FOR LEAD GENERATION ❯ Create content such as a viral video or a newsworthy business report that takes leads to a sign-up page. ❯ Use both online and ofﬂine channels, as most customers will respond to just one channel. ❯ Trace the customer touchpoint— the point at which a customer comes into contact with theproduct—before, during, and after purchase. Touchpoints may range from online reviews to billing. ❯ Tailor the call to action to the channel, such as inviting trade show visitors to enter a competition. ❯ Design effective opt-in web forms to capture data, such as asking customers to sign up for updates.QUALIFIED LEADS Determine percentage of initial contacts with purchase capability.236 237NEED TO KNOW ❯ Owned media Channel owned by a business, such as a website, blog, or social media proﬁle ❯ Attention, interest, desire, action (AIDA) Model for effective marketing messages ❯ Cost per lead (CPL) Amount it costs the company to acquire one potential customerANALYZE PERFORMANCE Identify adjustments needed to keep campaign on track.Reﬁne RESPONSE RATES Tally how many leads have been generated so far.ONLINE CONVERSION RATES Calculate percentage of web visitors converted to leads.Fine-tune the ﬁltering process to ensure that leads being generated are high quality and likely to buy.B2B LEAD GENERATION Measure Track and measure the response from the various campaign activities to gauge effectiveness.Most businesses selling to other businesses (B2B) identify lead generation as one of their most important digital marketing priorities. But which tactics do they ﬁnd most effective?10%5%Traditional advertising (radio, TV, print)Social media2% Other17% Online marketing (web content, SEO)Test campaign Monitor the initial hours and days of the campaign and make any corrections that are needed.27% Live events (trade shows, webinars)% of B2B companies that say each tactic is most effective at generating leads39% Outbound marketing (direct sales, telemarketing)Lead conversion The process of turning a customer’s interest into a sale is called lead conversion. The task requires not only a sales pitch to promote the product or service, but also an approach tailored to the customer. How it works Sales and marketing departments are responsible for generating sales income for a company. The ﬁrst step is to locate or identify potential customers—lead generation. The second step is to make contact with those potential customers and entice or persuade them to buy—lead conversion. A sales pitch is used to convert leads into customers. However, nowadays the stereotypical spiel delivered by an overzealous salesperson has been largely replaced by more sophisticated tactics, such as live chat on shopping websites, which inform customers and invite them to participate in a dialogue, rather than simply pestering them.Raw lead Potential customer— perhaps a website visitor, or a suitable person who can be approached by cold-callingProspect One step away from becoming a customer, prospects need a ﬁnal enticement to convince them to buy the product.Pitch Reinforce product’s value to prospect; offer payment options; highlight customer satisfaction policy.Pitch Suggest keeping in touch with updates, offers, product add-ons, or discounts.NEED TO KNOW ❯ Lead scoring System used to measure the readiness of leads for conversion ❯ Sales pipeline Visual tracking of the number of leads, suspects, and prospects at each stage in order to monitor sales process ❯ Lead nurturing Informal contact with a lead designed to gradually win them over as a customer ❯ Cost per touch Measurement of the cost of sales labor each time a lead is “touched” (contacted)Pitch Find precise needs of suspect; show product’s qualities and unique values to counter objections.Customer Raw lead has committed to buy; focus is now on retaining the customer and enticing them to make repeat purchases.3.3%the average lead conversion rate via online e-commerce in 2012HOW SALES AND MARKETING WORKS Business development238 239Online lead conversion Pitch Involve raw lead in website experience or conversation; identify need for product; show beneﬁts.A strategy is required for steering website visitors through every step of the lead-converting process. It is often presented as a funnel. Once visitors have arrived at a website, they are enticed to click on a “call to action” (CTA) button, which takes them farther into the funnel.Visitors to website 3,000Suspect Raw leads show their interest by remaining on website or by not ending phone conversation with cold-caller.Leads click on call to action 600Leads interact with company 150 Leads qualiﬁed by company 50 Sales closed 10Inactive Prospect isn’t ready to buy immediately, but shows enough interest to suggest they might buy in the future.THREE CLASSIC SALES PITCHES High concept Catchy introduction that captures the vision or key idea of a product or business; intended to grab attention and interestElevator Short summary (under a minute long) that explains the why, what, and how of a business or productDead lead Lead will not convert, but may be worth trying to revive in future.20-minute deck Presentation that explains the product or business in detail; how it can serve the need a prospective customer may haveCustomer retention Existing customers help businesses generate the majority of proﬁt and growth through making additional sales and referrals, and so retaining these customers is a high priority for marketers.Identify satisﬁed customersIntroduce retention improvement strategyMonitor and measure by analyzingCustomer referral Measure the number of referrals an individual customer generates.Track how many customers repeat purchase or buy more products.Measure customer retention levelLoyalty Pinpoint customers who are active in the brand’s loyalty program.Early warning systems Anticipate any problems and alert customers in advance.Recovery programs Apologize for any mistakes and make amends to woo dissatisﬁed customers back.Assess rate of customer complaints and recommendations.EXISTING CUSTOMERSEXITING CUSTOMERSCustomer feedback surveysIdentify the dissatisﬁed Defection Find out why certain customers have left and which competitor they have gone to.Complaint analysis Examine written customer complaints and call-center records.Listen to customers and identify people at risk of defecting.Loyalty programsAttrition rate Calculate the number of customers retained (existing), lost (exiting), or gained in a given period.Reward customers with improved incentives for staying loyal.Boost customer serviceCustomer satisfactionOffer employees incentives to build customer relations.Revenue targets Measure revenue targets against cost of customer retention efforts.HOW SALES AND MARKETING WORKS Business developmentHow it works There are two stages to the process of customer retention: measuring the current rate of retention, and applying strategies to manage and improve it.Practices include identifying the most valuable customers and nurturing relationships with them. The least valuable or most costly customers may be dropped if they show little development potential.TOP FIVE REASONS FOR LOSING A CUSTOMER Senses indifference from providerUpsell and cross-sell leads Identify customers who may buy larger products, or related items.1-23-47-85-6Dissatisﬁed with product or serviceCalculate savings made in marketing spend by retaining existing customers.3-45-6❯ Customer lifetime value (CLV) Measure of the amount customer will contribute to company revenue in the long term ❯ Customer retention rate (CRR) The number of customers retained over a given period, expressed as a percentage ❯ Customer acquisition cost (CAC) The amount company spends to gain a customer; also called cost of customer acquisition (COCA)5%Net promoter score ®Customer retention savings1-2NEED TO KNOWUnhappy with price9-10Use management tool to gauge how likely a customer is to recommend company to others.240 241Lured by competitionNatural attrition (death, relocation)reduction in customer defection rate can increase proﬁts by 25–125% $Return on marketing investment (ROMI) Many organizations gauge the effectiveness of the amount they spend on marketing campaigns by measuring the return they make on marketing investment, which is commonly known as ROMI. How it works A subset of ROI (return on investment), ROMI is one of the key calculations businesses use to work out the effectiveness of the money they spend on marketing. ROMI is measured by comparing the revenue gained against the investment made in marketing, and is used to assess online campaigns, in particular. This calculation, however, only reﬂects the direct impact of marketing investment on a business’s revenue and fails to take into account other gains,such as the word-of-mouth effect on social media, which is more difﬁcult to quantify than the more clear-cut response received from advertising or direct mail. As a result, many digital marketers now factor lag time or brand awareness into their ROMI calculations in order to quantify less tangible beneﬁts and target future campaigns more effectively.NEED TO KNOW ❯ 4P3C1E framework Method that uses several variables to calculate effectiveness of marketing campaign ❯ Success metrics Use of standard measure (metric) to help manage marketing process and to assess its performanceROMI in practice The diagram shows how a commercial air-conditioning company might use ROMI to measure the performance of a marketing campaign. The company spends $2,100 on a direct-mail promotion, which it aims at ofﬁces in three major cities to generate sales leads and secure new contracts. The direct-mail brochure contains a contact form offering a 10 percent discount to new clients who respond to the promotion within a speciﬁed period of time.@ Marketing sends 4,000 direct mailsTOTAL REVENUE MARKETING BUDGET= ROMI120 leads respond to offerHOW SALES AND MARKETING WORKS Business developmentof chief marketing ofﬁcers believe ROI will become the leading measure of success during 2011–2016LONG-TERM BENEFITS OF MARKETING INVESTMENT Some aspects of marketing investment are difﬁcult to measure immediately. The beneﬁts of providing excellent customer service, for example, or investing in research to help marketers retain customers, may not be evident right away but will reap long-term proﬁts. MARKETING INVESTMENTS$ Cost of market investment63%242 243Run marketing campaigns IMPROVED CUSTOMER VALUE AND SATISFACTIONIncreased customer attractionIncreased customer retentionINCREASED CUSTOMER LIFETIME VALUES AND CUSTOMER LOYALTY RETURN ON MARKETING INVESTMENTResults14 qualiﬁed leads (who are a good ﬁt for the product) become sales opportunities3 of these become customersTotal new customers = 3 Average customer spend = $6,500 (after 10% discount deducted from average $7,222 total spend) Revenue from marketing = $19,500 (3 x $6,500) Campaign spend = $2,100 + $2,167 (3 x $722) cost to company of promotional discount = $4,267 total ROMI = $4.57 per customer / per $ spent on campaign$19,500 $4,267$4.57Intellectual capital The knowledge within a company that is used to improve business performance is known as its intellectual capital.P TOTALENTNo. 1How it works HEvery business has capital, NT AN I ELLEC T UM which refers to the physical, tangible assets that appear on the balance sheet of its ﬁnancial statements. A business also has intellectual capital—the knowledge and skills inside the company. This collective knowhow is hard to quantify and measure, but it is essential to a company’s ability to generate revenue. For instance, management must provide training and a handover period for new staff so that human capital does not go down when people leave the company, taking their expertise with them. Management academics have identiﬁed three main kinds of intellectual capital: human, structural, and customer.DifﬁcultyHuman capitalERIE NCEVO L UOFPRAC TIC AL EXPDifﬁcultyEXNAL LINK S TE RCustomer capital Goodwill developed between a company and its customers, reﬂected in customer loyalty to the business and its products. This relational capital can be extended to suppliers, but is very hard to quantify.T LNGSLASHORE L ATIO NS HIPKEELATIONS TR HIPSMA RNEED TO KNOW ❯ Strategic capital A company’s knowledge of its market and the business model needed for success ❯ Intellectual property Creations or inventions that are legally recognized as belonging to a particular entity or individual on a balance sheet ❯ Intangible capital All knowledge assets belonging to a business or organization; can be audited under various systems (see far right)The combined talents of the staff and executives employed by the business. It includes skills and abilities, drive, creativity, and innovativeness, all of which can be quite hard to measure.HOW SALES AND MARKETING WORKS Business developmentRN TE INORG AONAL RO ATI UT IZ ES INAL LINKMEASURING INTELLECTUAL CAPITAL Various different methods have been developed to quantify and measure a company’s intellectual capital.8am 9amWatson Wyatt index10amA survey conducted every two years in public companies to assess the value of human capital and HR practices.DifﬁcultyStructural capital The support structures developed and held by the company, including its own software, databases and other information systems, patents, copyrights, and trademarks. Structural capital is non-physical, so it can be hard to assess.244 245IN NOVATI O NIntellectual capital monitor Matrix that measures the past effects, present power, and future potential of the intellectual capital in a company.FIVA“The only irreplaceable capital an organization possesses is the knowledge and ability of its people.” Andrew CarnegieFramework of intangible value areas (FIVA): an eight-step system used to calculate the worth of a company’s intellectual capital.Knowledge capital scorecard Method developed by New York University professor Baruch Lev to rate a company’s intellectual capital and assess its contribution to a company’s success.Information management Monitoring the marketplace and making sense of the vast quantities of data available has become a priority for businesses; the data is crucial for digital marketing, which is taking on increasingly sophisticated forms. Most businesses have a system in place for managing information—and the most successful ones use data not only to monitor day-to-day performance at every level, but to predict future outcomes and plan accordingly.InternalOutside the business, data ﬂows in from production, supply chain, sales outlets, partners, and customers.Within the business itself, data feeds into the marketing and IT teams from operations, ﬁnance, and human resources.oduction PrExternalExecutivesAnalysisForecastpply chai Sun Marketing and ITDATA DATAles outle SaDATADATADATAThe marketing and IT departments are at the center of information management. They are responsible for collecting and analyzing data, and then reporting their ﬁndings to executives. See pp.252–253.DATA DATAHOW SALES AND MARKETING WORKS Information management7%246 247TRANSFORMING DATA INTO DECISIONSof organizations employ a chief digital ofﬁcerWith relevant data easily accessible (see pp.262–263) a business can identify its strengths and weaknesses in order to improve its processes and operations, as well as its customer relationships (see pp.264–265).LEGAL COMPLIANCELe gsystemFinancealOperationsSource raw data Gather customer data. See pp.254–255 and pp.258–261.Store information Store data via data warehousing. See pp.256–257.Gain insight Examine data using business analytics. See pp.250–251.Access knowledge Retrieve data with business intelligence tool. See pp.248–249.The legal system ensures the use of data adheres to privacy and other laws. See pp.266–267.$ $Pa rers tnHuman ResourcesCu smers toMake decisions Plan and budget for future outcomeBusiness intelligence Business intelligence (BI) is an umbrella term referring to the variety of software applications companies use to access and analyze the massive amounts of raw data they have at their ﬁngertips. How it works BI relies on software programs and computerized systems for collecting and integrating data in order that a business can report on its activities, both past and present. The tools allow staff to pull relevant datafrom the company database. The marketer then views the information on a computer screen using a data visualization tool known as a dashboard, which can also be used for real-time monitoring of business operations.Business intelligence process BI tools allow retrieval of speciﬁc relevant data by specifying the terms of the intelligence they need (such as real-time sales compared to previous year’s sales).Collect source data Company gathers raw data via several operation systems.SUPPLY CHAIN MANAGEMENT (SCM) Data from SCM sourcesENTERPRISE RESOURCE PLANNING (ERP) Manages company dataWEB LOGS Data relating to activity on corporate or e-commerce sitesTRANSACTIONAL DATABASE Data of current commercial transactionsCUSTOMER RELATIONSHIP MANAGEMENT (CRM) Data from CRM sourcesEXTERNAL DATABASE Information gathered from sources outside the companyExtract, transform, load: ETL process ETL system pulls raw data from the source, formats it, and loads it for use.NEED TO KNOW ❯ Star schema Simplest format of online analytical processing (OLAP) in data warehouse ❯ Data quality (DQ) Condition of company’s master data, which should be complete and accurate ❯ Slice and dice Process in which large amounts of data are broken down to help analysisStore data Business uses data warehousing to integrate and bank data in a readily accessible form.ETL SYSTEM Migrates raw data to data warehouseDATA WAREHOUSE Flexible access to dataTranslates data codesData from across organizationTransposes data columns and rows Splits and separates informationCreates data archivesData from outside organizationCurrent dataHistorical dataHOW SALES AND MARKETING WORKS Information management14%the increase in sales per employee if data usability is improved by 10%Retrieve and analyze Staff can fetch data to answer speciﬁc questions about what is happening in the company.248 249Digital dashboard Displays regularly updated business results using customized graphics.TRACKING EMAIL CAMPAIGN This dashboard tracks the percentage of people who open an email, click on a website, and make a purchase on different days of the week. 50% DAYSYES NOMon Tue Wed Thu Fri Sat Sun Mon Tue Wed Thu Fri Sat Sun Mon Tue Wed Thu Fri Sat SunOPENSCLICKSPURCHASESSPREADSHEETS Form primary BI tool to display data (basic or advanced) OLAP CUBES Online analytical processing cubes enable 3-D analysis of three variables on spreadsheet DATA MINING Allows the sifting of data to ﬁnd patterns and relationships REPORTING TOOLS Help users develop and produce reportsActual sales: $4,700,000 Expected sales: $8,125,000 TRACKING SALES This dashboard shows the sales a company actually makes as a percentage of expected sales.40% 20%0%58% 60% 80%100%Business analytics More cutting-edge than business intelligence (BI), business analytics (BA) allows advanced statistical analysis of data, which is used to help make future business decisions. How it works BA takes a scientiﬁc approach to interpreting information. Businesses use BA’s advanced software tools to analyze information about past or current trends and behavior to predict a future scenario. Unlike business intelligence or predictive analyticsthat analyze current and past data, BA allows businesses to forecast with a high degree of conﬁdence. BA can be applied on a macro level to get a broad view of future business performance and on a micro level to assess, for example, the likelihood of individuals in niche markets making purchases.Predictive modeling Software program that predicts patterns of behavior and the likelihood of speciﬁc sets of customers, or even individuals, making a purchase.Business analytics process A skilled analyst interprets the raw data using BA tools. The results inﬂuence the business actions that will be taken in the future.BUSINESS INTELLIGENCE AND BUSINESS ANALYTICS The example of a 5 percent sales dip shows how BI and BA can be used to examine and understand the situation.Business intelligence ❯ Type of data investigation Results reveal past and current event in the business. ❯ Questions answered What has happened in the business in the past and what is happening currently? ❯ Tools used Reporting, dashboards, scorecards, online analytical processing (OLAP)Business analytics ❯ Type of data investigation Examines past event in the business, and applies the patterns discovered to a future scenario. ❯ Questions answered Why did it happen? Will it happen again? What can we do to stop it from happening again? ❯ Tools used Statistical analysis, data mining, pattern matching, predictive modeling93%of IT executives in Brazil say that their business could be improved by using big data analytics or intelligenceHOW SALES AND MARKETING WORKS Information management250 251Data visualizationDATA USEFULNESSFormulation of graphs depicting the results of data analysis; graphs may rank data, group common attributes, and compare relationships.Some data is more useful than other data; value is determined by the extent to which marketers can use it to make conﬁdent forecasts. Methods of interpreting data are increasingly sophisticated.Pattern matchingPredictive analytics Program that conducts advanced analysis of data to forecast future outcomeProcess of trawling through large quantities of data to ﬁnd patterns between variables, which can be applied to other sets of data.Monitoring Data mining Use of computerized processes and software programs to ﬁnd relevant patterns in large sets of data.Process that uses software to show what is currently happening in a business, providing real-time results to help key operations make decisionsStatistical analysis Software that organizes and investigates every piece of relevant data and interprets it to show trends and patternsInOu tRaw dataAnalysisThis includes company records (past and current customer data and transaction histories) and external data (economic, trade, and industry reports).Software tools are used to process and study raw data. Analysts interpret results and make forecasts that help future business decisions.Reporting Method that draws on historical data to provide a general overview, revealing, for example, how the business performed in a given yearMarketing and IT The rise of digital marketing strategies means that marketers are working more closely with IT specialists to develop the best ways of launching and managing online publicity campaigns.Convergence of marketing and IT Communicating with customers online has become a vital part of many businesses. As a result, marketing relies so much on IT that in some companies marketing teams spend more money on technology than their IT departments do.Areas of overlap Digital marketing ➤Developing a technology program for publicity campaignsReal-time transactions ➤ Installing a system for recording and tracking online sales as they happenData analyticsUsing advanced tools to gather and analyze data for developing future marketing strategyMobile technology ➤Understanding and keeping up to date with advances in mobile applications and e-commerce potentialData storage ➤ Building infrastructure and software for storing and retrieving sales, campaign, and customer historyMust grasp technology required to execute and track online campaigns.MarketerBig data ➤Locating key statistics from vast amounts of online information to improve marketingSocial media ➤Developing the best methods for increasing online trafﬁc via social media channelsTracking ➤ Following a customer through the online engagement and sales processHOW SALES AND MARKETING WORKS Information managementHow it works Marketers need to know how to use technology to increase revenue. At the same time, chief information ofﬁcers (CIOs) are adapting to changes in externaltechnology. This has led to an increasing overlap between the marketing and IT departments, and to the emergence of a new hybrid professional role—the marketing technologist (see below).78% IT person Must ﬁnd or develop software tools to implement and manage online campaigns.252 253NEED TO KNOWof marketing executives believe that digital strategies will transform marketing by 2020❯ MarTech Annual business conference that focuses on overlap of marketing strategy and technology ❯ Actionable metrics Measurement of campaign results which enable businesses to make informed decisions ❯ Vanity metrics Measurements of campaign results that appear positive but are not meaningful ❯ Growth hacking Low-cost online marketing techniques, such as using social media to improve salesRISE OF THE MARKETING TECHNOLOGIST Online marketers rely on software to monitor and analyze campaigns, generate content, and extract data. The job of the marketing technologist, who has knowledge of both marketing and IT, requires a broad knowledge base. WEBSITE ARCHITECTURE SOFTWARE PROGRAMMINGDATA AND ANALYTICSIT OPERATIONSMARKETING SOFTWARESOCIAL AND MOBILE PLATFORMSCONTENT MARKETING AND SEOCollecting consumer data Capturing key data is a priority for any business seeking to understand the marketplace. However, the task requires the use of innovative strategies to circumvent consumer sensitivity about privacy issues. How it works There are a number of methods companies use to collect customer data. When there is contact between a customer and the company, marketers can use the opportunity to gather as much information as possible. This might happen at the point of sale in a store or online, where marketers are able to observe customer behavior. Marketers may also choose to solicit information directly by asking their customers to ﬁll in registration forms and conducting telemarketing calls or customer surveys.Collecting data to create consumer proﬁle Digital marketing and e-commerce have accelerated the rate at which customer information is gathered. Some methods require the customer’s input, such as questionnaires that appear online. Others, such as website tracking, are possible without the need to contact the customer.Surveys Gather customer feedback via email, text, or mail, and face-to-face questionnaires.Observations Study customer’s behavior while they shop in a store or online.WARNING Data collection errors ❯ Barraging Using a customer’s data to bombard them with information on products viewed or sites visited ❯ Overlooking technical ﬂaws Failing to integrate apps properly, leading to inconsistency (and errors) in collecting customer data ❯ Using only automated systems Neglecting the opportunity to strengthen relationships with customers by communicating with them personallyCustomer research Conduct research on existing customers or on those who ﬁt the customer proﬁle.Contact center Monitor customer calls and store data on preferences and purchase history.HOW SALES AND MARKETING WORKS Information managementSocial media View customer’s proﬁle information on social media.58%of marketers could link data to an individual customer by 2012254 255TECHNOLOGY AT THE CHECKOUT In this technological age, businesses have the means to learn about their customers without bombarding them with questions. Retailers, for example, typically use three methods in stores to capture information about the customer.Loyalty programloyalty cardloya lt yc arA company may collect information by inviting customers to register for a loyalty program that offers an incentive. A loyalty program also helps track customer preferences.Website trackers Track website visitor’s movement around a site and see what attracts interest.CompetitionsPoint of sale software Computer software programs that track a customer’s purchases are available, allowing marketers to tailor offers to their spending habits.Use competitions to collect information, from opinions to demographic data.Mobile technologyTransactions Ask questions at checkout—in the store, online, or on the phone.The use of smartphones enables marketers to compile data, for example the frequency of customer visits and the amount of time they spend in the store.Data warehousing The process of data warehousing involves information from a company’s internal system, such as invoices and sales logs, as well as data from outside sources, being ﬁled away in an electronic vault. How it works The data warehouse is a repository that holds the company’s sales and operational history, as well as relevant economic and trade information from other sources. The data goes through three stages before it is stored in the warehouse, which makes it usable for analytical purposes. Once stored, the data may be accessed by all areas of a company—from accounts and operations to sales and marketing.The data is often used to assess beliefs and intuitions about the business. For example, the marketing manager of a power tools company might presume that 25–35-year-old men are more likely to purchase their products than women in the same age bracket. The manager would test this belief by analyzing sales data and customer records accessed from the data warehouse.50%of companies surveyed in 2011 were not sure their data warehouses were future-proofWarehousing process The data stored is regularly updated. When the business requires information from the warehouse, it is transformed into an accessible format and analyzed using software tools.Tapping data sources The information a company collects includes online transaction processing (OLTP) data, historical data, and data from external sources.OLTP Includes transactions such as sales and refunds recorded via OLTPStaging data The ELT process converts raw data into a usable format.HISTORICAL DATA Repository of past sales informationEXTERNAL DATA Includes government statistics on businessUSABLE FORMAT EXTRACT, LOAD, TRANSFORM (ELT)USABLE FORMATHOW SALES AND MARKETING WORKS Information management256 257WHO USES THE DATA WAREHOUSE? The key departments of a company can access the data warehouse to ﬁnd out how they are performing. The method in which the data is formatted and stored makes it possible for them to seek answers to questions relevant to them. Typical questions various departments might ask include:FINANCE “What was proﬁt margin on product sold in a region?”$ MARKETING “How did online ad compare to poster ad campaign?” SALES “What are average sales of product by region?”HUMAN RESOURCES “How much have we spent on contract staff this year?”Storing data The data is stored in three sections: metadata, summary data, and raw data.Accessing data METADATA Information relating to the data itselfSUMMARY DATA Business activity informationRAW DATA The original form of the informationUsing software, the data can be analyzed and retrieved in three ways: via online analytical processing (OLAP), reporting tools, and data mining. OLAP Accesses data to answer speciﬁc questions REPORTING TOOLS Presents data as tables or graphsDATA MINING Finds detailed patterns in data for analysisCustomer profiling Marketers can create detailed portraits of customers using internal company data on their purchase habits, preferences, and lifestyle, and cite external data sources to learn about attitudes and social trends. How it works In order to best understand their audience, marketing departments deﬁne their ideal customer by developing a customer proﬁle. They build this proﬁle by gathering information about the kind of person who usually buys the type of product they wish to introduce tothe marketplace. The information they look at includes basic data about a person, such as gender, age, occupation, and salary, as well as more detailed ideas concerning the person’s typical spending habits, such as the places where they like to shop and the amount they tend to spend.Segmentation model By constructing a segmentation model, layered with a number of variables (different levels of information) about consumers, marketers can gradually build up a clear picture of their ideal target customer—in this case, for a travel company.Geographic variablesLives in New York City metropolitan areaWants to get in shape while on vacationTakes two or more getaway trips per year with family❯ Personality Outspoken; likes to stand out from the crowd ❯ Attitude Positive outlook and enjoys the good things in life ❯ Ethic Works hard and believes in contributing to social causesDemographic variablesWoman, age 35 to 54, with household income of $85,000+Shares with 125 friends on social mediaPsychographic viewSociographic variables Psychographic variables Behavioral variablesHOW SALES AND MARKETING WORKS Information management75%Behavioral view ❯ Shopping location Prefers to shop in smaller stores ❯ Purchasing habits Buys in bulk to save money, responds to discounts ❯ Degree of loyalty Faithful to a brand, but open to better offers258 259Sociographic view ❯ Social media Actively shares interests with connections ❯ Community Inﬂuential member who socializes and contributes to neighborhood ❯ Groups and clubs Member of bird-watching and hiking groupsof marketers say personalization could have a signiﬁcant effect on customer retentionGeographic viewCustomer profile dimensions❯ Continent North America ❯ City Booming metropolis with work and social opportunities ❯ Climate Varies from below freezing in winter to hot and humid in summerWhat does the ideal customer look like? Where do they live? What do they spend their money on?Demographic view ❯ Age group 35–54 (helps gauge family priorities and income) ❯ Status Married (children affect spending choices) ❯ Occupation and salary Teacher, $65,000CUSTOMER PROFILINGCreating a customer proﬁle By constructing a proﬁle of an existing customer using data from within the company, marketers have a clearer view of the buying patterns and habits of an individual. They can then make projections about the long-term value of that individual as a customer.WEBSITE DATA How often do they visit the site? Which web pages do they look at?WWWSOCIAL DATA Which social media networks are they connected to? Do they share links?TRANSACTION DATA How much have they spent, how often, and on which products?CRM DATA What’s their contact history with call centers? How have they responded to campaigns?LOYALTY DATA How loyal are they to the company? Do they use the company loyalty program?MAIL DATA What email contact has there been? What has the response rate to emailed content been?@ $POINT OF SALE What observations have sales staff made from interacting with customer?Customer profileHOW SALES AND MARKETING WORKS Information management“Once you understand customer behavior, everything else falls into place.” Thomas G. StembergAssessing customer proﬁle Good customerBad customer❯ Returns frequently to make repeat purchases ❯ Responds to marketing and in-store promotions ❯ Shares favorite products on social media networks ❯ Signs up for newsletters and special offers❯ Bombards call center with complaints ❯ Frequently returns products for full refund ❯ Never joins loyalty programs or signs up for newsletters ❯ Spends less money than the cost of courting them260 261SEGMENTATION SYSTEMS Once marketers have gathered data and identiﬁed their ideal customer proﬁle, they can compare their customer to a number of commonly used systems of segmenting, or characterizing, consumers. In the US, there are many systems, but one of those most well-known is that of the Nielsen company, which uses more than 60 segments that have names like “Boomtown singles” and “Up-and-comers.” In the UK, customers may be compared to the simple system of socioeconomic class: A Managerial and professional BMiddle managementC1 Clerical and junior management C2 Skilled manual workers DWorking classNon-working and low-paid workersNEED TO KNOW Three ways to use a customer proﬁle1 2 3Tailor content to suit customer By sending out personalized messages and experiences, businesses engage customers and build a long-term relationship. Sell more to existing customer Mining customer proﬁles to see their spending habits, likes, and interests enables marketers to make personalized offers. Reward loyal customers Identifying good customers and offering gifts and incentives tailored to their tastes increases customer lifetime value.❯ Omnichannel customer Consumer who shops using multiple channels, including store visits, mobile apps, and websites ❯ Loyads Customers who are loyal to a provider and champion them, bringing in other customers in the process ❯ 360-view Proﬁle that gives marketer a complete picture of a customer, making it possible to predict their needs and behaviorBig data Business is trying to harness the huge amount of consumer data now available online. This information can be analyzed and used to create detailed proﬁles to target customers more precisely. How it works Big data is the huge amount of digital information transmitted via the internet every day. It is streamed at high speed and in many different formats, from database statistics to video, audio, and emaildocuments. The challenge for most organizations is to sift through big data to ﬁnd information that has the potential to add value to their business. Software tools are now available that can analyze the masses of external data generated on the internet.Internally and externally mined big dataExBusinesses are now able to access data from sources such as mobile communications, social media networks, and commercial transactions, which show the activity of billions of people.ta source a d al n r e t An ever-expanding amount of data is being generated by outside organizations, which will prove increasingly valuable to businesses.Big data storeBig data The volume of data is potentially so vast it cannot easily be moved and may overwhelm most organizations.Social media Data monitors what people are saying about the organization and its products.Audio Data includes news broadcasts, interviews, call center recordings, and podcasts.Photos and video Data comprises blogs, images, video recordings from entertainment media, and surveillance.Public data Information shared outside the company, such as press releases, job descriptions, and marketing materials.Big data vendor Provides services, systems, and tools enabling companies to store, access, and analyze data. Vendor offers applications to suit individual business needs.HOW SALES AND MARKETING WORKS Information management38%NEED TO KNOWof marketers had a centralized database for customer data by 2014 Internal data source Internal data sent to the big data vault where it is traced and recorded is drawn from all parts of the organization and forms a uniﬁed database.Transactions ❯ Spend per customer ❯ Foot trafﬁc in stores ❯ Time spent per visitLog data ❯ Customer reviews ❯ Customer service ❯ Audio ﬁles of customer service calls, for exampleEmails262 263❯ Internal communications ❯ Customer contacts ❯ Email campaigns❯ Apache Hadoop Open-source software library for storing and processing big data ❯ Terabyte One trillion bytes ❯ Petabyte Unit of digital data equivalent to 1,024 terabytes ❯ Exabyte Unit of digital data equivalent to 1,024 petabytes (ﬁve exabytes equates to all words ever spoken by human beings)INFORMATION OVERLOAD The volume of data typically generated online every second: ❯ Emails 2,314,084 sent ❯ Tweets 7,231 sent ❯ Instagram 1,129 images uploaded ❯ Tumblr 1,362 posts ❯ Skype 1,473 calls ❯ Internet 22,148 GB of trafﬁc ❯ Google 44,490 searches ❯ YouTube 84,841 videos watched ❯ Facebook 30,000 likes; 5 new proﬁlesDATA MANAGEMENT Organizations can choose either ofﬂine or online options to store big data and various software for access and analysis. ❯ Big storage hardware Servers; storage and network equipment capable of supporting many terabytes of data ❯ Software Includes programs for research and analysis, storage and access, and graphic visualization of data ❯ Cloud services Third-party providers that offer storage networks for big data management and accessCustomer relationship management (CRM) CRM (customer relationship management) is a computerized system used for managing and coordinating marketing, sales, and customer-support data to maintain good customer relations and improve proﬁtability. How it works CRM is a software tool in the company’s IT system that records all interactions the business has with customers. The information can be used in a numberNEED TO KNOW ❯ Technology-enabled relationship management (TERM) Use of automated processes to manage customer relationships ❯ Enterprise resource planning (ERP) Precursor to CRM ❯ Cloud-based CRM Computerized CRM system that exists in the cloud (online)of ways: the sales team may use it to ﬁnd new business leads and improve relationships with existing customers, the marketing team may use it to reward loyalty, and customer service may use it to deal with problems.CRM system The system uses reliable processes that allow companies to connect more efﬁciently with customers and ultimately offer better service, resulting in long-term gains for the company.Customer Customer data ﬂows into the CRM system through their transactions.AUTOMATION CRM can use automation as a tool to respond to customers who visit and use a website.Customer segmentationEmail campaign managementThe market can be segmented into groups relevant to the product the company sells.Different emails are sent automatically to the relevant groups.sp inte ecial re s tsprofegend@ Ageon ssi@ locatione siz ily m a fageLocation@ GenderFamily sizeer@ ProfessionSpecial interests264 265HOW SALES AND MARKETING WORKS Information management871%Marketing Target groups for special campaigns; monitor and reward loyalty; generate leadsthe average return on investment delivered by CRMSales Convert new leads; ﬁnd new prospects; cross-sell and upsell opportunities; customize pitchesCustomer contact form CRM uses the information to group customers according to their buying behavior.Price quote The company sends a price quote in response to the customer’s interest in their product.Customer feedback The company asks questions to glean information about the customer’s views.E-commerce transaction The customer pays for the product via the internet.Support ticket An automated ticket allows the customer to track delivery of the product. $ $Finance Operations Improve efﬁciency of manufacturing, product delivery, ordering, and trackingCustomer service Respond to service issues immediately; manage customer cases; gather feedbackGenerate invoices in a timely manner; manage payment processCompliance In most countries, companies have to adhere to laws and industry regulations that govern how they can sell and market their products. The rules are there to make sure that businesses operate fairly. How it works Governments impose rules on marketers to prevent any unscrupulous, misleading, or unwelcome practices, such as false advertising, the failure to disclose allterms and conditions, and spam marketing (sending unsolicited emails). The regulatory body is able to investigate any company accused of breaking the rules and impose penalties if it ﬁnds the company guilty.Marketing regulations To protect the consumer, regulatory bodies produce guidelines instructing companies on how they should market their products.Business areas subject to regulationExample of marketing practiceComparative claims“Our model is much better than our competitors’ models!”Endorsements“I owe my success to their product!”Special offers“Buy one, get one free!”Sweepstakes and contests“Enter the prize drawing for the chance to win the vacation of a lifetime!”Telemarketing“Good evening. Would you like to save money on your energy bills?”Marketing to children“Step right up and enter the House of Toys…”Customer data“Please ﬁll in the registration form.”Email marketing“Today only—24-hour online sale!”Use of spam“Congratulations! You have been selected…”Negative-option billing“Please uncheck the box if you do not wish to…”HOW SALES AND MARKETING WORKS Information management66%of all email trafﬁc in 2014 was spam266 267NEED TO KNOW ❯ CAN-SPAM Act International legal ruling that sets out commercial email requirements and penalties for violation ❯ Phishing Fraudulent sending of emails while pretending to be a genuine entity, to gain the recipient’s bank details, for exampleTypical regulations to protect consumer A marketer making a claim that its product is superior to a rival’s must be able to substantiate it with proof. A marketer must be able to prove that a person they have used to endorse a product has used the goods or service they are promoting. A marketer promoting a product with a special offer must set out the terms and conditions in writing. In the UK, use of the word “free” is subject to regulation. All competitions and prize draws must adhere to government guidelines to ensure that they are fair and impartial. Telemarketers must promptly disclose key facts of the proposed sale, including cost and quantity, restrictions and conditions, and refund policy. Marketers must stick to speciﬁc guidelines governing how they advertise and promote products to children. Customer information must be stored, managed, and used in accordance with privacy laws. It is illegal to use contact lists from external sources. Emails must disclose their commercial nature to the recipient. Marketers must refrain from sending bulk unsolicited emails, the most common form of spam, or other types of unrequested messages. Any item offered alongside the main product purchased must be presented as an option to buy, not an item the consumer must take action to refuse.HOW OPERATIONS AND PRODUCTION WORK Manufacturing and production ❯ Management Product ❯ Control ❯ Supply chainManufacturing and production Once a ﬁrm has decided what goods or services to make, its directors have to choose the method of production that best suits consumer demand, the product, and the market, as well as one that will be the most proﬁtable. Companies work in three general areas of industry, which together form a production chain to provide consumers with ﬁnished goods or services.Production methods Before the Industrial Revolution, products were made by craftsmen. Then factories brought people together to work on machines. Typically, this was job production, with one person making one item. Economist Adam Smith ﬁrst introduced the concept of division of labor, which led to mass production, with car-maker Henry Ford bringing in the moving assembly line at the start of the 20th century. Today, manufacturers can combine the best of all methods, with large-scale production of personalized products. Production typically involves three stages—here, from navy bean to canned beans sold in supermarkets.Primary production The acquisition and processing of raw materials—in this case, navy beans, as well as tomatoes for the saucePRODUCTION IN PRACTICE Native to South America, navy beans are grown either for the immature green pods, eaten fresh as green beans, or for the beans themselves. These are dried and used most commonly in baked beans, a dish that originally came from Boston, MA.CHOOSING THE BEST METHOD ❯ Job production Items are made individually. See pp.272–273. ❯ Batch production A number of items are all made together at the same time. See pp.274–275. ❯ Flow production Suitable for mass-producing identical items on an assembly line. See pp.276–277.❯ Mass customization Mass product is customized by buyer. See pp.278–279. ❯ Continuous production 24/7 line of production, for products with consistent demand. See pp.280–281. ❯ Hybrid processes Mixing batch and ﬂow production or combining other processes. See pp.282–283.HOW OPERATIONS AND PRODUCTION WORK Manufacturing and production$2.33 trillionKEY PRODUCTION FACTORS To make products, businesses need several resourcesthe value of China’s annual manufacturing output in 2011—the largest in the world❯ Capital Money invested in business, including money spent on production tools, such as equipment, machinery, and buildings ❯ Land Natural resources used to create goods and services—for example, physical land or extractable resources such as minerals, lumber, oil, or gas ❯ Labor People employed in a business to produce the goods and services ❯ Enterprise Entrepreneurs and/or leaders who bring the factors of production together to make the whole process happenSecondary productionTertiary productionThe manufacture and assembly of raw materials to turn them into a product or service; in this instance, canned beansServices that support the production and distribution of the baked beans, such as transportation, advertising, warehousing, and insuranceThe raw beans are mixed with tomato sauce, sugar, salt, and secret spices. The ingredients are cooked in vast pressure cookers, ensuring consistent texture and a long shelf life, and then sealed in tins.270 271The labeled cans are transported to warehouses and from there to supermarkets and other outlets to be sold. Several brands vie for market supremacy of this popular convenience food, using advertising, price, and taste differentiation.Job production In job production, items are made individually. Each item is one job, which is usually ﬁnished before another is started. This method is typically used for small-scale production or for large one-time projects. How it works Job production is best suited to a business that has to meet speciﬁc customer requirements. Typically, these are unique requests, which an individual or a team handles from start to ﬁnish. Made-tomeasure suits, or custom-made furniture are examples. The scale may be small, and ﬁrms often start with job production because it issimple and little investment is required. Job production can also be used for complex projects and those involving leading-edge technology, including ﬁlm production, major constructions such as ships for the navy, architect-designed buildings, and structural engineering projects including bridges and tunnels.SERVICES Job production can also apply to services, such as hairdressing or processing an order for pickup. Airline ﬂights come under the same umbrella—ﬂight attendants tailor their services to passengers’ dietary requirements and special needs for items such as wheelchairs.Wedding dress production A bride-to-be can choose to buy a dress off the rack (typically made by batch production) or have one specially designed and made for her, which costs signiﬁcantly more.Bride-to-be at the storeDressmaker commissionedCutting out the dressThe bride cannot ﬁnd the dress of her dreams and opts to pay for a custom garment.A dressmaker is engaged to design a wedding dress to the bride-to-be’s speciﬁcations.The dressmaker makes a pattern and cuts one dress from the bride-to-be’s chosen fabric.HOW OPERATIONS AND PRODUCTION WORK Manufacturing and production$1,211JOB PRODUCTION PROS AND CONS ProsCons❯ Products generally of high quality ❯ Great job satisfaction and pride in work followed through from start to ﬁnish ❯ Producer can satisfy individual customer needs ❯ Can make a proﬁt with only a few customers ❯ For small jobs, word-ofmouth recommendations reduce marketing costs❯ Does not allow for economies of scale, so high production costs ❯ Labor-intensive ❯ Special materials and investment in skills may be required ❯ High price may put off customers, especially in times of recession ❯ Heavy reliance on just a handful of customers272 273the average cost of a wedding dress in the US, in 2014 $ $Sewing the dressDress ﬁttingCompleting the dressThe dressmaker focuses on stitching and ﬁnishing the one garment.After any alterations, the dressmaker is satisﬁed that the dress ﬁts the brideto-be and meets her requirements.The price is high, but the dress is exactly what the bride-to-be wants. Now the dressmaker can start on another dress.Batch production When a number of the same items are made together, it is called batch production. One batch ﬁnishes each stage of the production process before the next batch starts, using the same equipment and steps. How it works Batch production allows a ﬁrm to make a quantity of items in one production run. Factory equipment is geared up in terms of scale and special tools that can be changed for each batch. For example, equipment is set up to make 200 size 8 dresses in red fabric and then adjusted to produce 400 size 10 dresses in blue fabric. Quantities can vary from asfew as four identical items for a local supplier to thousands for a department store, and batches can be made as often as required. Batch production is common in the food, clothing, footwear, paints, adhesive, and pharmaceutical ingredients industries. Each batch must be traceable, with clear date stamping, in order to comply with laws and standards.Bread by the batch Bread is commonly made in batches. A baker might make 100 white rolls, then 50 large brown loaves.Mix bulk ingredients Ingredients for the batch of white rolls are mixed to form a dough.Divide dough After machine-mixing, the bulk dough is divided into small pans.Proof dough The dough is left to rise (proof) in pans.Batch 1 Adjust for second batch The equipment is recalibrated to make 50 large brown loaves. Bulk ingredients for the batch of brown bread are mixed to form a dough.Batch 2Divide dough After machine-mixing, the bulk dough is divided into large pans.Proof dough The dough is left to rise (proof) in pans.HOW OPERATIONS AND PRODUCTION WORK Manufacturing and production12 million274 275BATCH PRODUCTION PROS AND CONSloaves of bread were sold every day in the UK, in 2014ProsCons❯ Economies of scale: low unit costs, as large number is made ❯ Customer offered choice of, for example, size, weight, and ﬂavor ❯ Output and productivity increases with use of specialty/ dedicated machinery❯ Repetitive work, so workers may be less motivated ❯ Costly because may require storage of raw materials, work in progress, and ﬁnished items (see p.139) ❯ Requires detailed planning and schedulingBag up to complete All the rolls ﬁnish the production process together.Bake rollsDe-pan and cool rollsThe whole batch is baked at the same time at the same temperature.The rolls are removed from their pans.Slice and bag loaves The loaves are sliced and packed for sale.Bake loaves Baking time is longer than for Batch 1, as the units are larger.De-pan and cool bread The large brown loaves are removed from their pans.Flow production The purpose of ﬂow (mass) production is to produce a large number of identical, standardized items. This usually happens on a moving line, which can be interrupted when the product is changed. How it works Flow production typically involves large factories equipped with conveyor belts and expensive machinery, the assembly of individual components, which may be bought in from other companies, and the automation of tasks. Car manufacturing is anexample where elements of the car are put together along a line; robot arms may install wheels and workers may perform specialized jobs. Signiﬁcant output is possible with even a small number of workers. Newspaper printers, oil reﬁneries, and chemical plants also use ﬂow production.The production line In ﬂow production, the item being made, such as a car, moves on a conveyor belt through different stages until completion. Components to build the car may have been outsourced or produced in another of the company’s factories. They are all ready to be used along the line.Chassis assemblyWheel assemblyEngine assemblyMain body assemblyWindshield assemblyPARTS ASSEMBLYElectrical assemblyCAR ASSEMBLYHOW OPERATIONS AND PRODUCTION WORK Manufacturing and productionFLOW PRODUCTION PROS AND CONS ProsCons❯ Economies of scale: can produce large number of goods cheaply ❯ Unskilled labor keeps costs low ❯ Materials bought in large quantities, so low cost❯ Expensive machinery requires signiﬁcant investment ❯ Repetitive work means workers may be less motivated ❯ Reliant on equipment: if line breaks, production is haltedGear box assemblyRadiator assembly276 27760 million cars are produced globally each yearSeat assemblyReady for customer Door assemblyFinishingInspectionWhen customer demand is high, car companies may run their production lines continuously.Mass customization Sophisticated technology and manufacturing developments allow mass products to be personalized. The low unit costs of mass production combine with the marketing opportunities of custom-made. How it works Mass customization offers new opportunities for the manufacturing and service industries. Social media, online technology, 3-D modeling tools, e-commerce software, and ﬂexible production systems and processes are allowing customers to conﬁgure products to match their own tastes and needs. Industries such as footwear (particularly athletic shoes), clothing, cars, jewelry, andcomputers already allow consumers to customize their purchases. The price is generally higher than for standardized goods. Revolutionary new technologies are expected to further extend customization, allowing individuals to, for example, scan their body contours and use augmented reality to design and order unique clothing.FOOD MIXES The generation raised on social media expects to personalize every aspect of their lives, and food and drink is set to be a growth area for mass customization. Websites allow consumers to make their own cereal mixes, which is especially useful for those with allergies, and to create their own blends of tea and coffee.Customers design own products Mass customization has enormous potential to change consumerism. For example, consumers can buy shoes designed to their own speciﬁcation via the internet. This is a high-status commodity among certain groups.Lace color Shoe colorLaces ToolsNameThe customer decides On the company’s website, a drop-down menu, with options including style, shape, size, color, and laces, allows consumers to design their own pair of shoes.Sends order to factory The ﬁrm holds no ﬁnished stock but manufactures to order from a range of parts, getting paid by the customer before production.HOW OPERATIONS AND PRODUCTION WORK Manufacturing and production$10 millionthe total value of customized sweets sold by Mars by 2007, including coloured M&M’s278 279FOUR TYPES OF MASS CUSTOMIZATION In his book Mass Customization: The New Frontier in Business Competition, B. Joseph Pine II outlines four distinct types: ❯ Collaborative customization Work with individual customer to develop speciﬁc product to suit their needs. Technology ﬁrm Dell, for example, assembles computers to customer’s speciﬁcation. ❯ Adaptive customization Produce standardized products that are customizable by end-user. For instance, US company Lutron produces a lighting system that lets customers choose own setting from programmed settings.❯ Transparent customization Provide unique products to individuals without overtly stating items are customized: the Ritz-Carlton hotel group keeps a database of preferences for pillows and newspapers to personalize a guest’s stay. ❯ Cosmetic customization Make a standardized product but market it differently: Hertz distinguishes its standard rental car from its #1 Club Gold program.Shoes shipped to customer The customer receives a differentiated product and has the psychological beneﬁt of personal design—at a price. s lace ned d sole ﬁt r e t Pat hione arrow Cus 7.5, n SizeContinuous production During continuous production, a product is made 24 hours a day, seven days a week. The production line runs continuously to cope with demand, and staff work around the clock in shifts. How it works With ﬂow or mass production, the line is stopped to change products or models. Continuous production uses the same concept, but it runs throughout the year so output is nonstop. This method is used for identical commodities with high, consistent demand, including paper, cardboard, packaging, laundry detergent,electronic components, and oil products. As with mass production, processes are automated, stafﬁng levels are kept to a minimum, and quality control is essential. There is high competition in industries using continuous production. Margins may be low, but demand is often relatively stable, encouraging investment in capital equipment.The paper trail Paper is used throughout the world, and factories operate 365 days a year to satisfy constant demand. Lumber is the raw material for papermaking. Once the lumber has been debarked, chipped, and pulped, the ﬁbers are washed and dyed. At the end of its life cycle, some paper is recycled.WoodPapermakingLumber is a renewable resource and logs are stockpiled. Trucks make constant deliveries to processors for pulping.In this continuous process, automated machinery runs 24 hours a day, 365 days a year.Paper recycling Recycled paper is an important resource for the paper industry.HEADBOX Fiber and water are fed onto a moving wire mesh.WIRE SECTION Some of the water is sucked away to leave wet ﬁbers that form paper.280 281HOW OPERATIONS AND PRODUCTION WORK Manufacturing and productionS IEAND CHEM IGLPRODUCT IASOD S PR UCTIONR PEONPAOILL PLANTSGASREFIN ERTRICIT Y LEC ACA:ENDtrees are cut down every year to make paperContinuous production is used for undifferentiated commodities required in large and constant amounts.ENER GY4 billionTYPICAL USESDRYING The paper is dried off.PRESS SECTION More water is squeezed out of the wet sheets.COATING AND CALENDERING The paper is coated, compressed, and smoothed.FINISHING AND SUPPLY The ﬁnished paper is constantly supplied to printers, packers, and newspapers.Hybrid processes Manufacturing ﬁrms may adapt existing processes or combine two production methods for optimal performance, particularly if they make a wide range of products. How it works There are many examples of hybrid processes. One is linked batch ﬂow production, where only two or three pieces of equipment are required and a batch ﬂows from one process to another. This is common in the chemicals and pharmaceuticals industries. For instance, a company may make headache medication and a hay fever remedy in tablet,Combining methods On the classic assembly line, each worker is skilled at producing one type or part of an item. At the other end of the scale, one person completes all stages, creating the ﬁnished product from beginning to end. Cell manufacturing combines ﬂow production with job production to create autonomous units. A number of workers are dedicated to production, or part-production, of a set of goods.capsule, and liquid form, and in varying doses; each batch ﬂows through a series of steps, depending on composition and form, from bulk processing to packaging. Another example is cell manufacturing, which combines job production with ﬂow (mass) production.NEED TO KNOW ❯ Increments Small steps of gradual improvement over a period of time, rather than breakthrough or transformational change ❯ Hybridization Replacing several separate processes with one single hybrid processFlow production One process is handled by one or more workers and that job is completed before the product or part moves on to the next workstation. Worker 1 uses only one set of tools for the process, before the product moves on to Worker 2, and so on down the line. (See pp.276–277.) INPUTWORKER 1WORKER 2PRODUCTION LINEWORKER 3WORKER 4OUTPUT282 283HOW OPERATIONS AND PRODUCTION WORK Manufacturing and productionHYBRID PROCESSES FOR INNOVATION By combining manufacturing processes, companies can create products with new and original qualities. For instance, a food company that makes bread and french fries may speed up production of the fries by baking them in the bread oven ﬁrst. This has the unintended but beneﬁcial consequence of making the fries healthier. A new product is created, which may now be marketed as a new proposition to a different set of consumers.doughbreadlighter fries potatoes french friesJob productionCell manufacturingOne worker creates a one-of-a-kind product, such as a custom kitchen, from start to ﬁnish. This way of working can be more rewarding for the worker, who uses a range of skills, but it tends to be costly for the customer. See pp.272–273.Combining the best of ﬂow and job production, here a group of products or parts is produced in separate small units (cells) made up of a number of workers in the factory. Workers are trained to produce all the items in the set. Dissimilar items can be produced without slowing the production line. The idea is to improve performance by giving each cell a degree of autonomy. INPUTCELL 1CELL 2WORKER PRODUCTION LINECELL 3CELL 4OUTPUTManagement Every manager in a business, particularly in manufacturing, has to ensure that all resources—from materials to equipment and staff— are used efﬁciently, while keeping the customer continually in mind. Managers make key decisions to lay down procedures and set standards and then work continuously to improve processes to ensure that the company remains proﬁtable.Which approach? How people and processes are organized in making and delivering the product to the customer is critical if a company is to survive ﬁerce competition and rapidly shifting consumer demands in a global market. In making decisions about how a business can meet its goals, managers may combine a number of approaches as many are interlinked and achieve similar outcomes.Agile production How can we be more responsive to shifts in customer demand? See pp.296–297.MANAGER OR LEADER? Management and leadership are not the same, but are closely linked: ❯ Managers plan, organize, and coordinate; leaders also galvanize and motivate. ❯ Managers organize workers to maximize efﬁciency; leaders also nurture skills and develop talent. ❯ Managers focus on the bottom line; leaders also look to the horizon. ❯ Managers tell people what to do; leaders also ask questions. ❯ Managers make sure workers are doing everything that needs to be done; leaders also inspire workers to want to do more than needs to be done. The following classic distinction has been attributed to two different business leaders and writers, Peter Drucker and Warren Bennis: management is doing things right; leadership is doing the right things.Time-based management How can we use time effectively? See pp.294–295.No. 1country for innovation in 2014: South KoreaHOW OPERATIONS AND PRODUCTION WORK ManagementEconomies and diseconomies of scaleKaizenWhat scale of operation is best for us? See pp.286–287.How can we drive continuous improvements? See pp.298–299.Lean productionINNOVATE FOCUS ON VALUEINVOLVE EMPLOYEESHow do we minimize resources to reduce costs? See pp.288–289.STRATEGIC ALLIANCES WITH SUPPLIERSUNINTERRUPTED WORKFLOWMINIMIZE WASTECUSTOMERS AT THE HEART OF WHAT WE DOTotal quality management How do we improve customer satisfaction? See pp.292–293.Just-in-time How can we meet customer demand and minimize stock? See pp.290–291.284 285Economies and diseconomies of scale Economies of scale are one of the advantages of large-scale production and result in a lower unit cost of each item produced. However, costs can also go up as the operation grows, resulting in diseconomies of scale. How it works Economies of scale is a simple concept: the more items produced or handled, the cheaper the average (unit) cost, as efﬁciencies and ﬁxed costs are shared across all items. This gives a business a competitive advantage.Supermarkets, for example, buy food in bulk at low unit costs, which they pass on to consumers. However, diseconomies of scale may occur when the operation grows because of high administration costs, wastage from lack of control, or lack of employee productivity.Economies of scale While it may be inefﬁcient for a small dairy to supply milk to a supermarket, it is cost-effective for a large dairy operation producing thousands of bottles. If a delivery is too large, though, wastage can creep in due to associated costs.AVERAGE COST AND REVENUESUPERMARKETDELIVERY OF 100 BOTTLES1 VEHICLEAverage cost highDELIVERY OF 10,000 BOTTLESAverage cost lowFew economies of scale $EconomiesHOW OPERATIONS AND PRODUCTION WORK ManagementNETWORK ECONOMY Online networks, such as eBay and Facebook, rarely stray into diseconomies of scale. They can deliver economies of scale even at an international level: the cost of adding one more user to a network is almost zero. However, the resulting beneﬁts may be huge, because each new user in the network can interact or trade with other members of the network.286 287150 millionthe number of eBay users worldwide in 20142+ VEHICLES = MORE DRIVERS AND FUEL AND POTENTIAL WASTAGESUPERMARKETDELIVERY OF MORE THAN 10,000 BOTTLESAverage cost goes up1 VEHICLE (LARGER, BUT ONLY ONE DRIVER AND SAME FUEL COSTS)of scaleSUPERMARKETDiseconomies of scale OUTPUTLean production The goal of lean production is to reduce the resources used to supply goods and services to consumers. By cutting down human effort, materials, space, capital, and time, lean production cuts costs. How it worksOptimizing the ﬂow of products and services through value streams—sequences of activity that ﬂow horizontally across technologies, assets, and functions to customers—allows the business to respond more quickly to consumer demand. Efﬁciency also makes it simpler and more accurate to manage information.NEED TO KNOW ❯ Kanban cards Toyota’s demanddriven scheduling triggers ❯ Value-stream mapping The process of analyzing how the product gets from start to ﬁnish now and the design of an improved ﬂow for the futureWasteItems produced surplus to customer demandUnproductive time spent waiting for material, information, equipment, toolsLean solutionWaitingWasteLean solutionManufacture based upon a pull system, producing products as customers order themAll resources provided on a just-in-time ( JIT) basis—not too early, not too late (see pp.290–291)WasteWasteExtra, unwanted stock held in inventoryConsumes materials and uses up labor; results in customer complaintsLean solution Kanban cards used to indicate material order points: how much, from where, and to whereDefectsLean production is about getting rid of waste, sometimes called non-valueadded activities. Car manufacturer Toyota has identiﬁed eight areas of waste and a lean approach to counter these.Excess inventoryCase study: how Toyota eliminates wasteOverproductionThe focus in lean production is on efﬁciency to maximize value for the customer, but without affecting quality. Lean seeks to eliminate all activities that do not add value to the production process, including holding inventory (stock), repairing faults, and unnecessary movement of people and products around a manufacturing plant.Lean solution Total quality management (see pp.292–293) used to improve all areasHOW OPERATIONS AND PRODUCTION WORK ManagementBENEFITS OF LEAN PRODUCTION According to a US National Institute of Standards and Technology survey, 40 ﬁrms implementing lean production reported these beneﬁts:Amount of space required reduced by 75% Quality improved by 80%BENEFIT10 millionthe number of cars Toyota expected to sell in 2014Work-in-process inventory reduced by 80% Productivity increased by 50% Lead time (taking product from start to ﬁnish) reduced by 90%Lean solution Material shipped directly from the vendor to the assembly lineWaste Unproﬁtable stages in the production or reworking of a productLean solution Map the value stream to identify non-value-added steps in the process; get it right the ﬁrst timeWasteWastePoor workﬂow, poor layout, and inconsistent working methodsUnderutilization of employees’ mental, creative, and physical skills and abilitiesLean solution Workplace Organization, a systematic method for standardizing the workplaceUnderused peopleTransportation in stages Excess motionSuperﬂuous stages in the transportation processNon-value-added processingPERCENTAGEWaste288 289Lean solution Work cells replace assembly line; better use of labor and employee involvement and communicationJust-in-time The system of production in which an actual order is the trigger for an item to be manufactured is called just-in-time. It enables a ﬁrm to produce only the items required, in the right amount, at the right time. How it works Also called demand-pull production, just-in-time means that stock levels of raw materials, components, work in progress, and ﬁnished goods are kept as low as possible, reducing costs. The system requires detailed planning, scheduling, and ﬂow of resources throughout the production process, now assisted by sophisticated productionscheduling software. Supplies have to be delivered directly to the production line when they are needed, requiring strong relationships and interconnected systems with suppliers. The beneﬁts of reduced inventory are balanced against the costof frequent deliveries and loss of purchasing economies of scale (discounts for bulk buying). The system dates back to 1953, the year Toyota brought in just-in-time manufacturing. The phrase is sometimes used in a more general sense today to mean eliminating waste of resources.NEW STOCK IS DELIVERED TO STORE TO REFILL SHELVESJUST-IN-TIME PROS AND CONS Pros ❯ Lower stock so less storage space and less working capital needed ❯ Demand-pull avoids obsolete, out-of-date stock ❯ Staff spend less time checking and moving itemsCons ❯ No room for error—for instance, if there are any faults in the stock delivered, the whole day’s production is halted ❯ Operation is reliant on suppliers ❯ No cushion for sudden upsurge in demandSYSTEM TRIGGERS DELIVERY FROM SUPPLIER WHEN MINIMUM STOCK LEVEL REACHEDHOW OPERATIONS AND PRODUCTION WORK Management$62 billionCUSTOMER SELECTS ITEM FROM SHELFJust-in-time in retail To reduce stock levels, many supermarkets now use just-in-time deliveries, relying on computer data systems. In manufacturing, systems are often based on Kanban cards— dockets for withdrawing and ordering items at each workstation of the production process.2 3COMPUTER SYSTEM SIGNALS WAREHOUSE290 291the value of Dell computers sold in 2012CASHIER SCANS BARCODECASE STUDY Dell’s just-in-time computers Computer produced when customer orders it: ❯ Customer’s individual speciﬁcation is sent straight to factory ﬂoor. ❯ Just in time manufacturing sees deliveries of supplier parts arriving at one side of the factory and unloaded directly into bins to build customer order. ❯ Inventory and costs are reduced.Total quality management Success though customer satisfaction is the ethos of total quality management (TQM). Everything a company does is relevant, and the focus is on managing and improving processes rather than outcomes. How it works Companies use TQM to create a customer-focused organization that involves all employees in continuous improvement. It is a strategic and systematic approach that puts quality at the heart of the organization’s activities and culture. Customers determine the level of quality, measured through theirsatisfaction. The organization is viewed as a series of horizontal processes that take inputs from suppliers through to the outputs that are delivered to the customer. Recording and measuring performance data is critical, as is effective communication to maintain momentum.WHAT TQM MEANS ❯ Total Involves everyone and all activities in the company ❯ Quality Conformity to meeting customer requirements ❯ Management Quality can and must be managedCase study: The Walt Disney Company Manufacturing companies, in which the focus is on meeting or exceeding customer expectations by making products within certain speciﬁcations, are often used as TQM examples. TQM can also be applied in service industries, of which Disney is a very good example.“TQM is a philosophy for managing an organization to meet stakeholder needs without compromising ethical values.” Chartered Quality InstituteThe Walt Disney Company Disney’s goal is to maximize long-term shareholder value, and part of this involves delivering a magical customer experience at its theme parks.Involve everyone in quality Founder Walt Disney ﬁrmly believed in quality and saw it as everyone’s job, something that could not be delegated.Focus on the customer Disney incorporated the TQM concept of quality into its approach to customer service. Its visitors are seen as guests and treated as VIPs and individuals.Perfect processes Walt Disney viewed the theme parks as factories producing delight. He built quality by designing processes and repeating them.HOW OPERATIONS AND PRODUCTION WORK Management12,000 Disneyland “cast members” are employed to make guests happy EmployeesExceptional serviceDisney calls its employees “cast members.” They are trained in every aspect of delivery, including posture, gestures, facial expressions, and tone of voice.Cast members (employees) are focused on delighting the customer—their sole job is to make visitors happy.SuppliersContinuous improvementDisney collaborates with suppliers—for example, it has partnerships with McDonald’s and Coca-Cola—to ensure consistent quality.“When does the Three O’Clock Parade start?” Cast members are trained to answer this common question by responding with the time the parade will be passing a particular point in the park.292 293NEED TO KNOW ❯ American customer satisfaction index (ACSI) Cross-industry benchmarks for customer satisfaction in the US; NCSI is the UK equivalent ❯ Net Promoter Score (NPS®) Metric for company performance from the perspective of customers, who are divided into promoters, passives, and detractorsWalt Disney saw the theme parks as an incomplete product; today, improvements come from the bottom up.Shared purposeIntegrated systemsWalt Disney started by deﬁning a company culture based entirely on creating a genuine shared purpose that people would be proud to support.Technology supports the experience: for example, the volume of ambient music is the same in all theme parks, delivered through thousands of perfectly placed speakers.Time-based management The general approach that recognizes the importance and value of time and seeks to reduce the level of unproductive time in an organization is called time-based management. How it works The fast pace of competition means a business that can manage time efﬁciently will enjoy a signiﬁcant competitive advantage. This applies to new product development, faster response times to meet changing market and customer needs, and reduced waste. For a business to operate a time-based management system,Case study: managing time in Ford ElectronicsBeforeINVENTORY $200 MILLIONPRODUCTION CYCLE 15 DAYSINVENTORY $100 MILLIONAfterBetween 1988 and 1994, Ford Motor Company’s electronics division implemented a number of change programs. One that used time-based management had a sustained and dramatic impact on the company’s performance. A senior leader led the program with visits to the factory, where the focus was on the length of the production cycle and adding value at every stage. The factory worked with suppliers to improve shipment, reliability, and quality of raw materials used.its people have to be multi-skilled and able to move swiftly between different tasks; its machinery has to be ﬂexible so that production runs can be changed at short notice; and there has to be a culture of mutual trust between workers and managers. Time-based management is a key aspect of lean production.Change created new focus on measuring and improving speed of operation. PRODUCTION CYCLE 1 DAYHOW OPERATIONS AND PRODUCTION WORK Management70%PART OF PROJECT MANAGEMENTof companies use formal projectmanagement methodologiesTime-based management is a critical part of project management. Timing aids include: ❯ Tools such as Gantt charts show the project schedule as a bar chart, making it easy to plot and monitor daily progress and targets. ❯ Project management systems PRINCE2 (PRojects IN Controlled Environments) and similar methods help to structure projects step by step in logical, organized ways.❯ Methodologies such as Agile help project managers working in software development respond to the unpredictable; they are often implemented via the Scrum framework, in which one person takes charge of constant reprioritizing. Based on the premise that software cannot be built up like a product on an assembly line, as it would be out of date before it was released, every area of development is constantly reappraised.Measuring by the unit Measuring the units produced per person had created an environment where supervisors focused on daily production requirements and keeping staff busy.$ NEW FACTORY EVERY YEAR2 1 3 POOR STAFF MOTIVATIONLESS COMPETITIVEMeasuring by cycle Simply measuring performance in a different way—over a shorter production cycle—allowed people to see new opportunities.2 STAFF MOTIVATED294 295Regularly ﬁnding extra ﬂoor space was a necessity due to high inventory. PROFIT LESS THAN $100 MILLION$ NEW FACTORY EVERY 2–3 YEARS1 3MORE COMPETITIVEPROFIT $400 MILLIONReduction in inventory meant ﬂoor space was no longer required so fewer new facilities were needed.Agile production Speed and agility are the key competitive advantages of agile production: the focus is on rapid response to the customer, enabling the business to take advantage of short windows of opportunity. How it worksThe goal of agile production is to stay ahead of the competition. Often incorporating concepts of lean production (see pp.288–289), agile has an extra dimension: meeting customer demand rapidly and effectively. It relies on ﬂexible and collaborative workers, who can deliver swiftly and effectively. The company has to be able to change or increase production quickly. Design of products might incorporate modular concepts, allowing for customization, and strong relationships with suppliers are essential.Rapid response Company setup allows it to respond quickly and effectively to customer and market demandstomer s u Customer demand is trigger to start productionProduct reaches consumerContinuous innovation Constant search for new and better ways to deliver for customerAgile manufacturing The organization has to create a position from which it can alter course as nimbly and swiftly as a cheetah. It needs to be able to retool facilities quickly, modify agreements with suppliers, and continually introduce new ideas and improvements.Integrated technology Effective information systems, often linked to suppliersHOW OPERATIONS AND PRODUCTION WORK Management296 297Modular productsLOCAL EDGEIndependently created parts used in different/ customized productsAgile production is typically adopted by companies in extremely competitive environments with high labor costs, such as North America, where local manufacturing can provide a competitive advantage: ❯ Proximity to customers allows feedback and response. ❯ Small variations in performance and delivery can make a huge difference in customer satisfaction, company reputation, and ﬁnancial results. ❯ Unprecedented levels of speed and personalization cannot be matched by offshore competitors.Knowledge culture Capturing experience, learning from mistakes3 monthsthe time it took Wikispeed to develop a revolutionary new car in 2012 Transportation system Systems, facilities, infrastructure to speed product to customerFlexible workforce Self-organizing, adaptable teamsStrategic partnerships Supplier collaboration rather than contract negotiationKaizen Started in Japan, kaizen is a system of continuous improvement that involves all employees. From senior managers to people on the shop ﬂoor, everyone is encouraged to suggest improvements day to day. How it works standards and then looking for ways to continually improve those standards. It is supported by a framework of training, communication, and supervision, and results in improved efﬁciency, productivity, quality, lead time, and customer loyalty.Kaizen events are implemented through a cycle of activity, known as plan, do, check, act. Central to kaizen are quality, ongoing effort, involvement of every employee as part of their daily work, willingness to change, and communication.BETTER AND BETTER Kaizen was created in Japan after World War II. It comes from the Japanese words kai, which means “change” or “to correct,” and zen, which means “good.” Companies such as Toyota and Canon have seen signiﬁcant improvements by involving their employees in recommendations for change.KAIZEN70InnovCreating good changee at QualityInnovate—ﬁnd and implement better ways to meet requirements and increase productivity.suggestions per employee were implemented at Toyota in 1983EffortGaug eThe kaizen philosophy is “to do it better, make it better, improve it even if it isn’t broken, because if we don’t, we can’t compete with those who do.” Kaizen is rarely about ideas for major change but has more to do with ongoing, systematic, incremental improvement. A relentless attempt to eliminate unnecessary activities, delay, or waste (muda), Kaizen starts with setting highGauge measurements against required standards. CHANGEGOODHOW OPERATIONS AND PRODUCTION WORK Management298 299The ﬁve steps of workplace organization, known as 5S, are the foundations for continuous improvement in kaizen.ndardi a tzeFIVE FOUNDATIONSSeiri (Sort) Standardize operation and activities; make each improvement standard practice, enshrined in the ﬁve foundations, or 5S.Seiton (Streamline)Willingness to changeRetrieve ordered items swiftly and easily to create efﬁcient workﬂow.CommunicationSeiso (Shine)ea surePeople involvementKeep only essential items in the work area. Remove and store all unnecessary items.Measure the operation—for example, the length of the production cycle and amount of in-process inventory.Keep the workspace clean, because cleanliness leads to efﬁciency.Seiketsu (Standardize) Keep consistent work practices, tools, and workstations, and make roles clear.Shitsuke (Sustain) The four cornerstones above become the standard way to operate all the time.Product The items that ﬁrms sell to satisfy a consumer need and to make a proﬁt for the business are broadly termed product, whether they are something tangible like toothpaste or an intangible service such as an insurance policy. In a typical life cycle, a product is developed and launched, and a few customers take it up. The domino effect causes wider distribution. Growth eases as the market becomes saturated, and sales ﬂatten and decline until the product is no longer viable.Product evolution From start to ﬁnish, every product, such as a tube of toothpaste, goes through a process of testing, innovation, and quality control to ensure that it will make the biggest impact on release and throughout its life span. Successful companies understand the limited life span of products and thus invest in the early stages to maximize growth later on.“A lot of times, people don’t know what they want until you show it to them.” Steve JobsNew product idea A company decides to release a tube of toothpaste with a new ﬂavor. Its viability is evaluated and potential competition researched. The new toothpaste also requires other qualities, such as whitening and enamel protection, to capture its segment of the market. See pp.304–305.Testing and development A focus group is assembled to taste the new ﬂavor, along with some variations. Their preferences and comments are noted, and the toothpaste is developed into a usable product. See pp.302–303.HOW OPERATIONS AND PRODUCTION WORK Product$3.6 trillion300 301PRODUCT LIFE SPANthe value of goods traded between EU member states in 2013Home entertainment offers different products to consumers. These are four examples of products at different stages in their life cycle (see pp.184–185): ❯ Introduction 3-D televisions—only recently available for the home ❯ Growth Blu-ray players—steady increase in sales because of enhanced viewing experience ❯ Maturity DVD players—challenged by more sophisticated technology ❯ Decline Video recorders—cheaper and more modern viewing formats now availableProcessD 12 3 ProductPackaging and designQuality managementProduct-process matrixThe toothpaste tube is given a bright, clean, and attractive look. Design considerations include functionality, expense of materials, and an appeal to current trends. See pp.306–307.A period of quality control begins, in which standards of safety and comfort are thoroughly checked. It is far cheaper to correct defects in the design phase than later in production. See pp.308–309.Using a product-process matrix, the company identiﬁes the correct production method for the toothpaste. Because the company makes only a few products, each at a high volume, it decides to use assembly-line production See pp.310–311.New product development Companies cannot stand still. In today’s ﬁercely competitive marketplace, they have to budget for research into new ideas and identify new products to bring to market simply to stay in business. How it works New product development is a process with a number of critical stages to ensure that a business focuses its investment on products that will sell and, above all, make a proﬁt. It starts with an idea, possibly to improve and relaunch an existing product. Some companies run sessions toencourage creativity and generate a pool of ideas, a few of which can be explored. They might work with potential customers and also with suppliers, if part of the manufacturing process is to be outsourced, to reﬁne and develop ideas before ﬁnally bringing the product to market.TRENDING CLAIMS New products are inﬂuenced by trends, reﬂected in the claims on packaging and in advertising. The top claims on new food products in the US from 2000 to 2010, for example, were “natural,” “organic,” “single serving,” and “fresh.”The development process The nature of the idea and the size of the company affects each stage and how long the product takes to reach the market, but the process is generally the same.deenerati g o a nIdeas can come from anywhere: customers may express a need or employees may make suggestions.Screen ideas Criteria help identify products that ﬁt business strategy, will be easy to make, and will be proﬁtable to produce.HOW OPERATIONS AND PRODUCTION WORK Product302 303Test concept Feedback from consumers, using focus groups, interviews, or online evaluation, ensures that an idea is worth pursuing.Analyze market Analysis of opportunity, inﬂuenced by predicted growth and trends, helps build a picture of potential sales.Test market Product is tested on section of market, perhaps a selected geographic area with good representation of target audience.Develop productsFeatures are conﬁrmed, actual product designed—taking account of test-concept stage—and prototype developed.LaunchCompanies ensure distribution and tell customers about new product, through social media or advertising, to kick-start sales.250,000 new products are launched globally each yearInnovation and invention Innovating is more than just having a bright idea—it is the way inventions and ideas reach commercial success. It is the lifeblood of any company, because keeping ahead of the game is essential for survival. How it works Innovation needs a culture that encourages people to be inventive and explore ideas. It also requires processes that can take initial ideas and develop them. Successful businesses such as the 3M, Apple, andGoogle technology companies know how to do this. Innovation is not small, incremental changes, but transformational ones, such as solving an existing problem in a radically different way, or identifying an unknown problem and inventing a solution.From idea to product Innovation is stimulated by many triggers. The idea then requires people to be working in a conducive environment to ensure that it is implemented and makes a difference.Innovation triggersEf ﬁ ciCross -tCoumer nee nsm collabo eation raes suEnv ired agblem/cris rodsmental i s onity encour ivisIdeang vicy/cost sa enCrea ttechnologyNeShifts in society, such as leaps in IT and growing concerns about climate change, as well as internal company developments, create new needs.HOW OPERATIONS AND PRODUCTION WORK Product“Genius is one per cent inspiration, and ninetynine per cent perspiration.”DIFFERENT TYPES OF INNOVATION Sustaining innovation Signiﬁcantly improving existing products, typically through technology—for example, more pixels in cameras, smaller and more powerful laptops Sustainable or eco-innovation New product that has minimal impact on the environment Frugal innovation Low-cost product for emerging mass market304 305Breakthrough innovation Product or service that simultaneously shifts a market and has signiﬁcant outcomes for the world at large, such as the Fairtrade initiative Disruptive innovation Displaces established competitors or changes the norm—for instance, the internet or iPadsThomas EdisonIntellectual property (IP) is the expression of an idea. IP might be a design, an invention, or another type of intellectual creation, and it can be protected by law—for example, with a patent.Individuals and teams need the time and mental space to think originally.The culture and processes of the company have to be favorable for testing the viability of ideas.t ImpacFlat m aLoListrrectly m cogement st nacture ru-term vie ngFamissiosured eals ve re allow e ilur leang at all le niActionBrainstormProductDesign Any product has to be well designed to succeed. Excellent designs for everyday items—from the Anglepoise lamp to reﬂective road signs—have shaped our modern world.CU SH RCO GY OLBR AINST NEW ECHRESEHow it works The starting point for design is an idea for a product that fulﬁlls a need, whether it is a specialty item or something in day-to-day use. The designer has to think of ways in which a product can serve its purpose and meet other criteria, including aesthetics, cost, durability, and environmental considerations. The design may be integral to the product, such as Apple’s rectangular devices with rounded corners, for which it obtained a design patent. Some designs are iconic, such as the Coca-Cola bottle. Yet design is more than just shape. As well as functionality, it includes materials and color, and extends from the products to their packaging.ME R S TOMING ORIDE ASExplore concept From scribbles on a piece of paper, to computer-generated image technology, it may help to visualize options.Product-design process Designs for mass-produced items, such as furniture, lighting, domestic appliances, and communications technology, take a lot of hard work. The process of creating a functional design that looks good has several steps.CONSIDERATIONS FOR DESIGN SUCCESS ❯ Functional Serves a purpose ❯ Aesthetic Enjoyable to use ❯ Innovative Different and new, possibly using innovative technology ❯ Easy to use Understandable and with useful features ❯ Simple Unobtrusive, subtle ❯ Long-lasting Sustainable, not too fashion-sensitive ❯ Environmentally friendly Minimizes resources and pollutionRedesign Next year, the product may need revamping.End product The design of the ﬁnal version that goes on sale may look very different from the initial concept.HOW OPERATIONS AND PRODUCTION WORK Product306 307Develop conceptMake prototypeThe design can be broken into components, such as functional requirements and production options, and each evaluated independently.This might be a single item or a series of prototypes, to test and reﬁne the functionality.10–18%Feedback Now is the time to ﬁnd out what people think of the product and how it could be improved. (EX TERNA LDesign decisionsMARKET IINTERNA G( LBefore full-scale production begins, all decisions have to be made and paperwork, such as intellectual property rights, ﬁnalized.MANUFA CRSCUSTOM Eof the budget for bringing a new product to market is spent on designTURINGQuality management For businesses, quality is not a vague term but a philosophy of meeting or going beyond consumer expectations. Excellent quality management can give a company a key competitive edge. How it works Many consumers might ﬁnd it hard to deﬁne quality, because it can be subjective, but they know it when they see it. However, companies need to deﬁne and measure it. They know that to build a good reputation and thrive, they have to exceed customers’ expectations in terms of quality for both products andservices. To do this, they have a number of standards or key performance indicators (KPIs) for the manufacturing process, and continually measure themselves against these. Quality does not apply just to the product or service itself; it ripples out to the associated people and processes, and across the organizational environment.Cost of quality COST OF DEFECTQuality management is essential to ensure that any defects are nipped in the bud, the earlier the better, and deﬁnitely before they become apparent to the consumer.During production, quality management involves testing, evaluating, and inspecting quality. Defective items may be scrapped. Quality management at the product-design stage is low-cost and integral to the process because it prevents issues farther down the line.CUSTOMER FIRST Before the 1970s, quality was seen as something to be inspected and corrected. Then US businesses began to lose out to Japanese companies—for example, Toyota and Honda were able to produce cars at lower cost and with a much higher quality. The difference was that quality had a strategic meaning for Japanese ﬁrms—they made the customer their priority and were the ﬁrst companies to deﬁne quality as meeting or exceeding customer expectations.PRODUCT DESIGNPRODUCTIONHOW OPERATIONS AND PRODUCTION WORK Product$3.6 million the annual saving Singapore supermarket NTUC FairPrice made by implementing ISO quality standards, 1999–2009308 309NEED TO KNOW ❯ ISO 9000 Set of international quality standards and certiﬁcation demonstrating that companies have met standards speciﬁed ❯ Malcolm Baldrige National Quality Award Annual award given to US companies that demonstrate quality excellence and establish best-practice standards in industry ❯ Deming Prize Japanese award given to companies to recognize efforts in quality improvementWHAT MAKES QUALITY? Manufacturing industry ❯ Conformity to speciﬁcations/standards ❯ Performance ❯ Reliability ❯ Functionality/features ❯ Durability ❯ ServiceabilityService industry Once the product is with the customer, a defect is expensive. Financial cost includes returns, repairs, and recalls, but the impact on the company’s reputation may be even more damaging.LOCATION OF DEFECTPRODUCT WITH CUSTOMER❯ Getting the desired result ❯ Consistency ❯ Responsiveness to customer needs ❯ Courtesy/friendliness ❯ Promptness ❯ Psychological factors, such as good atmosphereProduct-process matrix A product-process matrix is a tool that can help a business to identify the best way to make a product, based on volume and the level of customization.NOT VIABLEHow it worksEVOLVING PROCESS The product-process matrix was ﬁrst introduced by Harvard academics Robert H. Hayes and Steven C. Wheelwright in the Harvard Business Review in 1979. Since then, some companies have worked out the apparent contradiction of how to customize high-volume products (mass customization). Nevertheless, the product-process matrix remains relevant in many industries.Choosing the best method A business, or business unit in a large company, occupies a particular region in the matrix. Different processes suit different products, depending on the stage of their life cycle and the scale of the business.ProductProducts pass through different stages and so does the production process. Businesses typically start with low volume and are highly ﬂexible but not very cost-efﬁcient. A print shop or dressmaker is an example of a company positioned in the bottom left-hand corner of the product-process matrix, where each job is unique and job production is most effective. Production stages then progress through increasing standardization and mechanization to full automation. Companies in the top right-hand corner have high-volume products and a small range so continuous ﬂow production is the best option.Low volume Low standardization; unique, one-off products5 DressmakerChina accounts for one-ﬁfth of global manufacturingHOW OPERATIONS AND PRODUCTION WORK Product310 311Process Sugar reﬁnery Mass production Continuous ﬂow; nonstop process (see pp.280–281)Car assembly RARELY VIABLE An assembly line is not normally a suitable process for making multiple products at low or medium volume.Assembly line Connected line ﬂow; process repeated for each product (see pp.276–277)Low–medium volume Some standardization; multiple productsBakeryHigh volume Standardization; products manufactured in large quantitiesBatch production Disconnected line ﬂow; similar process adjusted for each batch (see pp.274–275)Job production Jumbled ﬂow; complex, unique process design for each order (see pp.272–273)Very high volume High standardization; single commodity productRARELY VIABLE Batch production is not normally a suitable process for making standardized products at high volume.NOT VIABLEControl Essential in any type of organization, control is fundamental when the primary goal is to generate proﬁts. Control needs to cover costs, resources, and quality of the product or service to ensure that the operation runs smoothly. As well as crossing departments, control has to run from top to bottom, with directors formulating strategy while managers allocate resources, people, materials, and equipment and oversee the work of individuals and teams.The chain of control It is simplest to think of a business as an end-to-end chain. Leaders have to make decisions on business goals, strategy, and policies at the start of the chain. This is critical for control along the chain. If there is no clear direction from the start, problems become exacerbated as they travelfarther along the line. Controls are put in place all the way along the chain to ensure that the organization is working toward its goals, that it meets the desired standards, and that individuals and teams are clear about what is involved in speciﬁc tasks.Control in practice: strategic control ABC Cake Company’s goal is to be the top-selling cupcake business. Its directors determine the quantity and quality of cupcakes the company needs to sell and whether to invest in a new factory. They also set the scale of investment and estimate when it will begin to yield returns, and how long it will take for the project to repay its full cost (payback period).FUNCTIONS ALONG THE CHAIN While directors work on strategic investment, policy, and process control, management may use tools such as Six Sigma to perfect operational control. See pp.320–321.Investment relies on cash ﬂowing back into the business from the cupcake sales, balanced by the cost of production.Policies on, say, maintaining the optimum level of inventory are supported along the chain by ﬁnance, HR, and IT.ABC CAKESManagement control The management team ensures that everyone meets their targets, talks with other links in the chain, and works seamlessly to be a top-selling cupcake business.Processes are in place to control costs, with continual reviews of the most efﬁcient use of resources.Procurement purchases raw materials from companies that meet its stringent standards.HOW OPERATIONS AND PRODUCTION WORK Control312 313LEGALLY IMPOSED CONTROL130:1the average ratio of CEO to employee pay of FTSE 100 companies in 2014—compared with a ratio of 47:1 in 1998Many industries are subject to external controls as well as their own: ❯ Financial institutions National and international regulatory controls ❯ Advertising industry National regulation to protect public interest ❯ Health and social care National laws to protect vulnerable members of the public ❯ Manufacturing National regulations on health and safety“Drive thy business or it will drive thee.” Benjamin FranklinABC CAKESABC CAKESTask control Metrics and key performance indicators are set for each task. They control, for example, how long it takes to ice and decorate a batch of cupcakes.KE CO ABC CAGoods received checks on-time delivery and that all inputs are consistently of the right quality. See pp.318–319.Stock control uses sophisticated systems to ensure the optimum level of inventory. See pp.316–317.Production has metrics for the quantity and quality of the cupcakes. See pp.314–315.Marketing benchmarks the price and reviews the promotion of the product against competition. See pp.332–333.MPANYSales works toward detailed targets. See pp.314–315.Managing capacity In terms of production, capacity means how much work can be achieved in a given time. Ideally, a business matches its capacity to customer demand, using its resources with maximum efﬁciency. How it works Every business has to consider how much capacity it needs for its operation, and how to manage this capacity both day-to-day and in the future. Management has to choose a priority: whether to deliver excellent customer service by having extra capacity, and thus price its products or services high; or to manage its resources efﬁciently for a better return on investment, at the risk of disappointing customersif and when demand goes beyond capacity. Businesses may offer consumers incentives to help manage capacity—for instance, cheaper late-morning train fares encourage passengers to travel after rush hour, easing overcrowding on trains that are full to capacity in the early morning. Likewise, many hotel chains do not charge a ﬁxed price for rooms, pricing them according to demand to maintain capacity.Capacity decisions The fundamental decision is whether to compromise on demand or capacity—whether to put customers or the streamlining of operational costs ﬁrst.Customer focus Manage capacity— raise pricesIncrease demandCustomers are happy to have a product immediately but must pay a higher price to cover the cost of holding excess stock.$$$$$$$$To use up stock, pricing policies increase demand by encouraging customers to buy fast—for example, offering on-site deals for older car models.$$The company, in this case a car dealer, keeps more cars in stock than required so it can always satisfy customer demand.SALEHOW OPERATIONS AND PRODUCTION WORK ControlHOW CAPACITY AFFECTS A COMPANY Capacity management is critical to ensure, for example, that a manufacturing operation has the right level of resources to work to a production schedule. It affects many areas of the business, as all are interlinked and cost the company money: ❯ Factory or ofﬁce size ❯ What and how much equipment is needed❯ Stafﬁng levels ❯ Use of labor—for example, shift work ❯ Which materials to use, how much/how often to order ❯ Inventory (stock) levels ❯ Production scheduling ❯ Speed and ease of processes ❯ Type of information technology usedResource focus The company uses resources as efﬁciently as possible. Wastage is kept to a minimum, but satisfying demand is hard because work is at full capacity and output cannot rise.314 315NEED TO KNOW ❯ Potential capacity The capacity that can be made available long-term, a factor that affects investment decisions and business growth ❯ Immediate capacity The maximum potential capacity available in the short term ❯ Effective capacity The total capacity that is realistically achievable when all resources are being used optimally90 millionthe number of iPhone 6 units made by one manufacturer to meet demand in 2014Manage capacity—keep stock low It produces stock according to demand and holds low inventory to minimize unnecessary spending and storage costs.Demand not satisﬁed Company is unable to meet surges in demand; customers may have to wait while production catches up, and business may be lost to competitors.Inventory Companies have to manage inventory (stock) to meet customer demand, even if they trade online and have no physical storefront. Successful inventory management is a complex process. How it works Stock may include ﬁnished goods, work in progress, and raw materials. Getting the right level is a balance between having enough to meet customer demand and having too much, which is costly in terms of ﬁnished goods, storage space, and warehouse staff. Stock may also lose value if it perishes or become unsalable because of changes in fashion or obsolete technology.Effective inventory management involves systems and programs for sales forecasts, production targets, and actual inventory status, plus the physical tracking and handling of the different items. Bar codes and radio-frequency identiﬁcation (RFID) tags have revolutionized inventory management, making it much easier to monitor stock levels.Inventory management Successful inventory management is a ﬁne balance between satisﬁed customers and minimizing the risk of holding too much stock. In this example, the clothing company is managing the supply of T-shirts for a range of sites and for direct delivery to customers.Make sales forecastsOrder from suppliersProductionThe company sets production targets based on prediction of demand.Decisions on the level of raw materials to hold are based on lead times and reliability of suppliers.The quality of raw materials and ﬁnished goods is checked at every stage of production.Smaller storage Firm may use smaller facilities to hold buffer stock—for example, to meet seasonal demand.HOW OPERATIONS AND PRODUCTION WORK Control316 317NEED TO KNOW ❯ First in, ﬁrst out (FIFO) Oldest inventory items sold ﬁrst (or recorded as sold for accounting purposes rather than physically moving goods) ❯ Last in, ﬁrst out (LIFO) Most recently produced items sold ﬁrst (or recorded as sold) ❯ Stock-keeping unit (SKU) A distinct item that has its own stock code ❯ RFID tag A chip that enables remote tracking of an item by radio sensors142,000 different items were handled by Walmart Supercenters in any one store in 2005Main warehouse Company may have one main warehouse or a number of warehouses as hubs for smaller storage facilities.Delivery to customers Efﬁcient and timely delivery is part of the overall customer experience, especially as online shopping grows. Stock is checked in by scanning bar codes or RFID tags.Customer returns Returns are checked out by scanning bar codes or RFID tags. Batch number and other data can be monitored.Quality control There is a series of processes to ensure that a business maintains a prescribed level of quality in its products or services. Quality control is particularly important in industries where safety is an issue. How it works Businesses measure and manage the quality of their output against national legal standards and/or internal standards. For example, the manufacturing industry sets its own standards. Checking takes place against these and any national standards at various points along the production process, such as when raw materials arrive in the factory, during production, and before shipment of ﬁnished goods to the customer.Quality control relies on a predetermined percentage of products for inspection, agreed corrective action, and remedial efforts to minimize future defects. Industries in which safety is paramount, including food, clothing, pharmaceuticals, construction, and car, train, and aircraft manufacture, are subject to extremely strict standards of quality control. Some are there to protect workers—for instance, if they are handling chemicals—while others safeguard the consumer.The bread and butter of quality control Hygiene and safety are essential in the food industry, as in this example of quality control in a factory making prepacked sandwiches. Samples are tested all along the line. Any lapses in quality are not only a dangerous health hazard but would also be extremely damaging to the company’s reputation.Delivery to factoryAssembly lineBefore assembly, weight, chemicals, bacteria, taste, and interaction of individual ingredients are tested.During assembly, weight, temperature, hygiene, and visual appearance are assessed.HOW OPERATIONS AND PRODUCTION WORK Control318 319THE CONSTRUCTION INDUSTRY Standard safety procedures are mandatory in developed countries, including site organization with suitable work gear, limited access, materials storage, and trafﬁc ﬂow; working at heights using appropriate ladders and scaffolds; and avoidance of slips and trips with awareness of obstacles, trailing cables, and uneven or wet surfaces.Packaging station Samples are tested to check that sealing is accurate, labels are correctly applied, and overall presentation is good.$4.4 billionthe value of the prepacked sandwich market in the UKStorageTransportationThe temperature is checked for accuracy and safety, and samples are tested for taste, texture, and contamination by foreign objects.The temperature in the vehicles and their delivery time are checked to ensure product freshness.Six Sigma Used in organizations to strive for near-perfect products and services, Six Sigma is a disciplined, data-driven approach for eliminating defects in any process. How it works The idea is that measuring the number of defects in any process makes it possible to systematically work out how to eliminate them and get as close to zero defects as possible. Individuals are trained to become experts in the different methods, creating a cadre of black belts, green belts, and champions.Every Six Sigma project is carefully documented, follows a deﬁned sequence of steps, and has quantiﬁed value targets, such as increasing customer satisfaction or reducing costs. To achieve Six Sigma quality, a manufacturing process must have 99.99966 percent of output free of defects (3.4 defective parts per million).SIX SIGMA ROLES Six Sigma professionals are experts at improving processes. They drive the implementation of change.5 Control Perform before-andafter analysis; monitor systems; document results; work out recommendations for next steps.Master black belt Trains and coaches black belts and green belts; works at highest level, developing key measures and the strategic direction4 ImproveBlack belt Leads problem-solving projects; coaches project teams, assigning roles and responsibilities; trains green belts Green belt Leads green-belt projects; helps with data collection and analysis for black-belt projectsChampions Translate the company’s vision, mission, and goals to create an organizational deployment (OD) plan and identify individual projects Executives Provide overall alignment by establishing strategic focus of the Six Sigma program within the context of the organization’s culture and its vision of what the customer sees and feelsImplement improvements and so address the root causes of major problems.$320 millionthe sum saved by General Electric with Six Sigma in 1997HOW OPERATIONS AND PRODUCTION WORK ControlCHAMPIONSDeﬁne Deﬁne the project’s purpose and scope; identify processes that need improvement; determine customer needs and beneﬁts.Striving for perfection The DMAIC methodology (standing for Deﬁne, Measure, Analyze, Improve, Control) is an integral part of Six Sigma. It is used for improving existing business processes that are falling below targets and where step-by-step improvements can be made.320 321Mobile-phone maker Motorola used Six Sigma quality as a goal for its manufacturing operations; CEO and chairman Jack Welch made it central to his business strategy at General Electric in the 1990s; tech company Dell has used a form of Six Sigma since 2000 and is now the model for many other businesses.Measure Use data on current processes as a baseline; pinpoint problem locations and occurrences; identify potential areas for improvement.Analyze Identify root causes of problems and check them against data; determine precise improvements that need to be made.²³ of Fortune 500 US organizations were running Six Sigma initiatives by the late 1990s, with the goal of improving quality and reducing costsSupply chain Along the journey from raw material to ﬁnished item in the hands of a consumer, every business needs an efﬁcient supply chain. Supply chain management involves different organizations, people, activities, and resources to take, for example, grains of corn from a ﬁeld to a ﬁnished box of cornﬂakes on the consumer’s breakfast table. The company may outsource parts of the chain to other ﬁrms. It may also send some activities, typically administrative functions, offshore.Supply chain management The traditional supply chain takes raw materials and resources through to a ﬁnished product for the consumer. The company has to manage costs and ensure standards, being particularly careful that it does not harm people orthe environment along the way, from fair wages for labor at the source to recyclable packaging after consumption. Supply chain is big business—in the US, 4.2 million people are employed in warehousing and transport alone.Raw materials and resourcesSupplier and processorManufacturerWhether from a ﬁeld or a mine, raw materials start somewhere.The raw materials are processed, often near their source.Organizations bring resources together to manufacture goods, often near the customer.HOW OPERATIONS AND PRODUCTION WORK Supply chain$688 billion322 323EXTENDING THE CHAINthe cost of supply chain transportation in the US, in 2009❯ Adding value Companies may try to add value along the chain, rather than just seeing it as a way to transport a product from A to B. See pp.324–325. ❯ Delegating functions To save money and use specialized expertise, the business can outsource activities and/or have them done by local companies or a branch of its own company offshore. See pp.326–329. ❯ Returning goods Part of the supply chain involves an efﬁcient system for dealing with goods returned by the consumer. See pp.330–331. ❯ Competitive edge At every stage, the company compares its performance with its competitors to see how it can improve. See pp.332–333. ❯ Ethics and the environment Taking responsibility for avoiding pollution and protecting workers’ rights is part of the package. See pp.334–335.DistributionRetailerConsumerFinished goods are transported to storage depots or retailers.The store displays the products for maximum appeal to the consumer.The consumer enjoys the ﬁnished product, and ideally recycles the packaging.Value chain Rather than looking at the supply chain as merely a series of activities, organizations are increasingly looking at how value is created by each stage of the process. Lowering costs or raising performance are key. How it worksPorter’s value chain Primary activities work directly to create or deliver a product or service, while support activities help to improve their efﬁciency. To apply the value chain, a company has to identify each activity and either lower its cost or differentiate it from its competitors to add value in the customer’s eye.CASE STUDYPRIMARY ACTIVITIES Each department must cooperate and provide necessary information between value-chain activities to make a proﬁt.Harvard Business School professor Michael Porter ﬁrst introduced the concept of a value chain in his book Competitive Advantage. Most organizations have dozens—possibly hundreds—of activities along the supply chain in the process of converting raw materials (inputs) to products or services (outputs). These can be classiﬁed generally as either primary or support activities that all businesses must undertake. The ideaof the value chain is that how activities are organized and carried out determines a company’s costs and thus its margin (proﬁt). Each link of the chain must communicate to other departments clearly and promptly. For example, marketing and sales must make accurate sales forecasts and pass them on in time for procurement to buy the correct type and quantity of raw materials, who in turn must connect with inbound logistics so they can organize receipt of goods.Inbound logisticsOperationsInvolves relationships with suppliers, including all activities to receive, store, and allocate inputsActivities required to transform inputs into outputsPizza Hut’s greatest asset is breaking down complex pizza-making into simple steps unskilled chefs can do. ❯ Inbound logistics Vast global purchase orders for ingredients ❯ Operations Target countries with a liking for Italian food, on a franchise model with local staff ❯ Outbound logistics In-house meals and home delivery service ❯ Marketing Differentiate from other pizza chains ❯ Service Delicious, convenient pizzas at a fair priceSUPPORT ACTIVITIES Although not directly involved in outputs, these support primary activities, improving their efﬁciency and successful function.Pizza Hut’s value chainCompany infrastructureHuman resource managementTechnology developmentProcurementHOW OPERATIONS AND PRODUCTION WORK Supply chainONLINE VALUE CHAIN More than a quarter of the world’s population uses the internet for everyday activities, from shopping and banking to sharing photos and watching TV. To handle this volume, a complex value chain delivers internet services, made up of global and local ﬁrms with assets as diverse as content rights, communications and IT infrastructure, proprietary software, and global brands.$1.93 trillionthe internet value chain revenue in the US, in 2008Outbound logisticsMarketing and salesServiceActivities required to collect, store, and distribute the outputActivities that inform buyers, encourage purchase, and facilitate transactionActivities to keep product working effectively for buyer after it is receivedFunctions such as accounting, legal, ﬁnance, planning, public affairs, and quality assurancePeople activities: recruiting, hiring, training, developing, compensating, and terminatingEquipment, hardware, software, procedures, and technical knowledge used in transformation of inputs into outputsAcquisition of inputs (raw materials) for the company324 325PROFIT MARGIN Proﬁt equals the customer’s willingness to pay more than the sum of all the activities in the value chain.Outsourcing Firms may choose to pay outside suppliers to do work rather than complete the tasks internally. Handing over part or all of production or a service to a third party increases ﬂexibility. How it worksCOMPANIES SURVEYED (%)Outsourcing grew in the 1980s because ﬁrms looked to save costs by contracting peripheral business activities to third parties. But outsourcing today is no longer just about cost savings. It is a strategic tool that is increasingly important in the global economy in the 21st century. Firms may choose outsourcing for elements of the production process, for support1009080functions such as accounting, or because they do not have the specialized knowledge or skills within the organization. Outsourcing may be to a ﬁrm in the same country or it may be to an organization in another country. Rapid expansion of logistics networks and information technology has made it easier to outsource, thus accelerating the growth of outsourcing over the last decade.Top reasons for outsourcing Growth and success for many businesses is underpinned by outsourcing, as a number of ﬁrms ask: why do it ourselves, if another ﬁrm can do it faster, better, or cheaper? Organizations recognize that using external capabilities, capacities, knowledge, and skills opens opportunities. Some ﬁrms now focus only on their core business; in a global survey, this was cited as one of the top reasons for outsourcing.70605036% Lower costsFocus on core business40External provider often beneﬁts from economies of scaleFirm can identify and prioritize its primary activity3020100%36% 13% Improve quality External organization paid for delivering a quality product or serviceHOW OPERATIONS AND PRODUCTION WORK Supply chain90%NEED TO KNOW ❯ Outsourcing Subcontracting work to another company or buying in components for a product rather than manufacturing them ❯ Offshoring Practice of moving a company’s operating base to a foreign country where labor costs are cheaper326 327❯ Network structure Tasks or operations are performed by another company—which may be in the same country, a neighboring country, or overseas—within a network structure of organizationsof ﬁrms worldwide say outsourcing is crucial to growth strategiesEXAMPLES OF BUSINESS TASKS THAT CAN BE OUTSOURCED Outsourcing certain tasks within a business enables focus to remain on core business activities, which helps generate growth as well as income. Some tasks are better suited to outsourcing than others due to factors including expertise, how time consuming a task is, and how much face-to-face time it requires. IT operations, for example, can be highly expensive, requiring expert knowledge and can easily be managed remotely. Human resources, however, is more employee focussed, so better suited to in-house.AccountingComputer/ IT supportManufacturingResearch and developmentTax preparationCORE BUSINESSCustomer supportEngineeringHealthcare servicesLegal services PayrollWeb designLogistics10% Increase speed to market External expertise often brings shorter lead times4% Encourage innovation Frees up internal capability and buys in knowledge and ideas1% Save capital Frees up capital to invest in areas for growth REASONOffshoring Moving jobs outside the country where a company is based is called offshoring. Either the company employs people overseas to perform some functions, or work is outsourced to a third party overseas. How it works Offshoring grew in the 1980s as Western companies with high labor costs realized they could make signiﬁcant savings by manufacturing in countries with lower wages. Information technology (IT) services followed, enabled by the internet and global communications. However, companies are now rethinking this strategy, driven by factors includingthe need to be close to customers, consumer dislike of overseas call centers, high unemployment in Western countries after the 2008 ﬁnancial crisis, global wage equalization, and growing transportation costs. Some ﬁrms are now nearshoring—for instance, US ﬁrms placing operations in Canada—or reshoring, bringing activities back to their home country.Case study: global expertise Offshoring started in India and today it still leads the way. The country’s IT and business processing outsourcing export industries employ more than 2.2 million people and are worth more than $100 billion. Other regions have different areas of expertise—for example, Eastern Europe specializes in IT services.CANADAExamples of offshoring KEYITTechnologyTechnical supportFinancial servicesDesignBack-ofﬁce functionsSoftwareInsuranceCall centersBankingMEXICOBRAZILEngineering Manufacturing CHILEResearch and developmentBusiness processesCustomer supportHOW OPERATIONS AND PRODUCTION WORK Supply chain328 329INDIA: OFFSHORING WORLD LEADER ESTONIAPOLAND IRELANDUKRAINE CZECH REPUBLIC ROMANIAThe Americas and Europe are India’s largest customers and account for 60 percent and 31 percent, respectively, of India’s IT and business processing exports. Services include ﬁnancial services (41 percent), high-tech/telecom (20 percent), manufacturing (17 percent) and retail (8 percent).RUSSIACHINAUNITED ARAB EMIRATES $PHILIPPINESINDIA GHANA MALAYSIA $SINGAPORE SOUTH AFRICA INDONESIA $Reverse supply chain Supply chain takes a product to a customer. Reverse supply chain is the series of activities it takes to retrieve an unwanted or used product from a customer and dispose of it, recycle, or resell it. How it works Companies have to focus on more than simply bringing a product to a customer. Now an efﬁcient reverse supply chain is essential to satisfy consumers, especially for the growing number of online retailers. Manufacturers, too, in industries from carpets to computers, may need reverse supply to recycleproducts to meet environmental regulations. For example, companies have to manage products that are returned from consumers for a refund; products that do not sell and are returned to producers from retailers; or products near the end of their life, where disposal may be subject to environmental legislation.RetrieveReverse logistics The cost to companies of reverse supply is enormous. For example, in the US, statistics from the Reverse Logistics Association suggest that the annual volume of consumer returns is estimated to cost $150–200 billion. This represents about 0.7 percent of gross national product (GNP) and 6 percent of the US’s total annual retail sales of $3.5 trillion.Companies may have processes in place to collect used or unwanted items, whether from the customer or a retailer.CUSTOMER RETURNS US retailers Sears and JCPenney were the ﬁrst stores to allow consumers to return goods with no penalty. This pioneering move in the late 19th century encouraged people to shop with them and helped build a loyal following. British retailer Marks & Spencer at one time had the most lenient returns policy in the retail word—until 2005 they had no time limit on returns, as long as the customer could produce a receipt. $Please return within 28 daysEventual recycling or reconditioning may be considered at the start of design and manufacturing decisions.Manage disposalHOW OPERATIONS AND PRODUCTION WORK Supply chainNEED TO KNOW ❯ Electronic waste (e-waste) Electrical or electronic devices that are unwanted, do not work, or are obsolete ❯ Warehousing Administrative and physical functions necessary for storage of goods, either for selling or retrieval32%of an item’s original product value could be reclaimed as a result of a well-managed reverse logistics systemTransportCustomers expect items to be transported back to the seller in a straightforward system, in person or by a delivery service.Items and components are sorted and separated, ready for reselling, recycling, or disposal.Sort330 331ReceiveEffective inventory management is critical to ensure that inbound items are recorded so the company can keep track of returns.Items are carefully checked on return. If they are to be resold, they must be in pristine condition.InspectBenchmarking Businesses use benchmarking to improve efﬁciency by comparing their performance with that of other organizations. The goal is to identify and learn from best practices within or outside the industry. How it works To improve results, a business may look outside the organization, industry, or country to explore others’ levels of performance and identify how they achieve it. Benchmark areas include unit cost, customer ratings, and pay and beneﬁts. The evaluation takes intoaccount a range of factors, including training, technology platforms, and manufacturing equipment. For example, Formula 1 is often used as a benchmark for teamwork as pit-stop crews have perfected the changing of four tires in less than seven seconds.The process of benchmarkingIdentify need to benchmarkowcia l ing ild buCom pa nThere are several stages to benchmarking performance before a company can start to see cost savings and increased efﬁciency. commer ns aCompare to competition The company gathers information on others’ energy systems and costs.CoMonitor value It measures how much its energy costs have gone down and how well the new lighting system works.eplaces l igh ny r a p ti mngenergy an ors t dm i on saved ey onCompa ny mIn this example, a company wants to improve its energy efﬁciency.HOW OPERATIONS AND PRODUCTION WORK Supply chain49%SOCIAL MEDIA MAKES IT EASYof companies across 44 countries used performance benchmarking in 2008Compe tito r’erg eny useieut e soC02 C02nergy au dit obuildingCompany ca rrIt sees that a comparable company has a much lower carbon footprint.wn foIt changes its lighting system to the one used by the most energy-efﬁcient company in its survey.Analyze differences or gapscient ef ﬁ yrgis more ding l en i u e sbimilar build in at s s g oks’Compan yl oIt is now easier than ever before for organizations to gather data about their competitors. Social media can provide data on customer preferences, brands, and campaigns of other organizations. Analytical tools are available to simplify benchmarking across many different channels.Implement changes332 333Identify changes required It examines its own energy use to see how it could improve.Corporate social responsibility Businesses today must aim not only to do no harm to the environment, people, or communities, but also to show commitment to building a better society. This is termed corporate social responsibility (CSR). How it works For a business, CSR goes further than aiming to be compliant with national or international regulations, managing risks, or corporate philanthropy—it has to be an integral part of every aspect of operations, helping to create a sustainable business. A company still has to be competitive and proﬁtable, but must avoid making decisions merely for shortterm gain. Instead, it has to consider the future impact on society, the environment, and a wide range of stakeholders. Companies now report annually on how they have met their CSR and are benchmarked and ranked against competitors.Community Housing; healthcare; infrastructure; partnering with local institutions; local supplier initiatives; education; training; local employment97%of UK FTSE 100 companies reported on CSR in 2011Environment Company’s carbon footprint, including recycling; water and waste management; energy use; transportationHOW OPERATIONS AND PRODUCTION WORK Supply chain334 335Workforce Workplace safety, health, and well-being; diversity; equal opportunities; learning and development; ethical policies and practicesSuppliers Fair trade, supply-chain ethics, and sustainability (including use of child labor); code of conduct; transportation policiesCSR stakeholders A number of different business areas have to be considered in assessing a company’s CSR, from how it affects people working in and for the company to wider environmental and community implications.Operations Ethical trading including marketing practices and pricing; managing customers; ﬁnancial reporting; policies; valuesCASE STUDY Fairtrade International Many consumers expect the companies they buy their latte from to uphold ethical practices. A US campaign in 2000 pressurized Starbucks to serve Fairtrade coffee. The public wanted to understand the coffee giant’s supply chain as there was concern for the livelihoods of coffee farmers, many of whom are indigenous people. Fairtrade International ensures that coffee farmers receive a fair price for their crop, plus a premium that is invested in improving farming practices. Coffee was one of the ﬁrst products to carry the Fairtrade Mark.How companies work Businesses in the US are registered in the state in which they are domiciled. Most states and the federal government recognize four business structures: sole proprietorship; partnership; corporation; and nonproﬁt corporation. Sole proprietorship An individual (or married couple) may register their business as a sole proprietorship if they plan to conduct operations on their own. This is the simplest form of business structure. The owner is entitled to all revenues and proﬁts, while maintaining personal responsibility for all debts and liabilities. Income from sole proprietorships is taxed as individual income.Partnerships Partnerships are business entities formed by two or more individuals. The most basic form is the general partnership. Partners in a general partnership contribute an agreed-upon share of money, skill, and labor to the enterprise, in exchange for a proportionate share of the proﬁts. Liabilities are thusly divided as well. A limited partnership includes general partners and limited partners (also known as silent partners) who share in the proﬁts but whose losses are generally limited to the size of their initial investment. Similar to a general partnership, a limited liability partnership indemniﬁes one partner from claims arising from other partners’ negligence. Lawyers and doctors frequently operate under this structure.equity is shared by a limited group of stock owners. A publicly held corporation makes shares available to the public through a stock exchange or through over-the-counter markets.Nonprofit corporation A nonproﬁt corporation engages in activities meant to further the public good, such as works in charitable, scientiﬁc, educational, or artistic ﬁelds. Such organizations, most frequently registered with the Internal Revenue Service (IRS) through form 501(c)(3), are generally tax-exempt at the federal and state level. They may in fact make proﬁts and pay competitive salaries, but are prohibited from engaging in political activities.In Canada Businesses in Canada can also be sole proprietorships, partnerships, or corporations. They can also be run as cooperatives, a business that it is owned and controlled by its members. Co-ops are often used by agricultural enterprises. Canadian companies must register in the province or territory in which they are domiciled.CorporationReporting requirementsThe federal government and states recognize corporations as business entities that are separate and apart from employees and shareholders in terms of income and liabilities. This structure protects management and workers in the case of litigation or other claims, but is more complex and subject to greater regulation than a partnership. Such entities must be registered through articles of incorporation. A corporation may be privately held, in which caseBusinesses in the US are subject to a range of ﬁnancial reporting requirements and regulations, depending on structure. Owners of sole proprietorships include income on their individual returns ﬁled annually with the IRS. Corporations must also report income to the IRS, but are subject to additional requirements. Privately held corporations must, at a minimum, ﬁle charter documents, including name and address, with the Secretary of State in the state in which they areUS-SPECIFIC INFORMATION How companies workheadquartered. Publicly traded corporations are subject to considerably greater disclosure requirements. They must ﬁle with the Securities and Exchange Commission quarterly (10-Q) and annual (10-K) reports detailing revenue, income, proﬁts, and losses. They must also ﬁle interim reports (8-K) disclosing signiﬁcant events, such as an acquisition or divestiture, as well as reports (Form 4) that disclose signiﬁcant buying and selling of shares by company insiders.Company law The US Constitution vests in individual states the power to regulate commerce and administer and oversee companies that operate within their borders. States maintain a Department of State or equivalent (such as Massachusetts’ Secretary of the Commonwealth) that act as registrar for commercial endeavors. Departments of State maintain publicly searchable databases of all registered companies, hold administrative hearings, and can take enforcement actions.Taxation The IRS collects taxes from businesses on behalf of both the federal and state governments. At the time of printing, the federal tax rate on corporations ranged from 15 percent to 35 percent. Tax rates vary widely among states, and six states impose no corporate income tax at all. The federal government and states do not collect Value Added Taxes (VAT) from businesses, but many states impose sales tax on consumers that businesses collect at the point of sale. Several states have no sales tax. Sales taxes can also vary depending on the item purchased. For example, in New York state, groceries are tax-free, while takeout meals are taxed at the prevailing rate of 4 percent. New York City also applies an additional sales tax of 4.5 percent to most items. Other municipalities around the country are also free to establish their own sales tax rates.336 337ORGANIZATIONS AND RESOURCES The Small Business Administration website has information on the corporate structures permitted under US law. https://www.sba.govTaxation The Internal Revenue Service provides a number of online services for business owners, including when and where to ﬁle tax returns and how to obtain tax credits. http://www.irs.gov/BusinessesStartups BusinessUSA is a central repository where entrepreneurs can access a range of services. Its website provides information on funding, taxation, hiring, growth strategies, and more. It also offers advice tailored to speciﬁc groups, such as women, veterans, and minorities. http://business.usa.gov The US Department of the Treasury also offers advice and services for would-be proprietors. In addition, it operates the Small Business Lending Fund, which secures loans made to business owners by private banks. http://www.treasury.govRegistering intellectual property The main arbiter for determining whether a product or business method is worthy of exclusivity is the United States Patent and Trademark Ofﬁce. http://www.uspto.govImmigration All employees must be authorized to work in the US through citizenship or some form of visa. US Citizenship and Immigration Services, part of the Department of Homeland Security, determines visa eligibility and enforces immigration rules.In Canada The Canada Business Network offers information about starting and operating a business. http://www.canadabusiness.ca/eng/page/2853/ http://www.entreprisescanada.ca/fra/page/2853/How finance works For publicly traded companies, the Securities Exchange Act of 1934 is the framework for ﬁnancial accounting and reporting. The Securities and Exchange Commission (SEC) enforces the Act. The SEC has established reporting requirements for companies whose shares trade on public exchanges such as the New York Stock Exchange, the NASDAQ Stock Market, and the NYSE Market LLC. Privately held companies are subject to fewer requirements.Tax reporting Both private and public companies must ﬁle tax returns to the Internal Revenue Service on an annual basis. The due date varies based on the ﬁler’s status. Sole proprietorships follow the same schedule as individuals and must ﬁle by April 15 or request an extension. Partnerships must ﬁle by the 15th day of the fourth month after the end of their ﬁscal year. Public companies must ﬁle by the 15th of the third month.Reporting standards Companies must log and report ﬁnancial transactions to the SEC according to Generally Accepted Accounting Standards (GAAP) as established by the Financial Accounting Standards Board, a private, nonproﬁt organization. Due to the increasingly global nature of business, there is a movement to adopt International Financial Reporting Standards (IFRS). In the aftermath of several events in recent years, including the bursting of the so-called dot-com bubble, the increased use of controversial ﬁnancial instruments like mortgage-backed securities (MBS) and collateralized debt obligations (CDO), and the 2007–2008 ﬁnancial crisis, the FASB has adopted a number of new rules aimed at restoring order and clarity in the markets.Financial disclosure Exchange-listed companies must make their ﬁnancial records publicly available on a quarterly and annual basis, respectively. They must report unscheduled, material events (such as an acquisition or divestiture). Ofﬁcers and insiders must declare signiﬁcant purchases or sales of company stock, and the terms of issuance for corporate notes must be detailed. Regulation Fair Disclosure (Reg FD) stipulates that companies must disseminate ﬁnancial information simultaneously to all investors. The SEC amended Reg FD in 2013 to include disclosures through socialmedia channels such as Twitter and Facebook. Public companies must retain a licensed auditing ﬁrm to verify the veracity of their ﬁnancial records. Under SEC rule 3235-AI74 (2003), auditors must retain client records, including worksheets, ﬁnancial data, meeting minutes, electronic correspondence, and other materials used to form an opinion for seven years.Accounting periods For sole proprietorships, the reporting period for tax purposes runs simultaneous to the calendar year. Publicly traded companies may set their own ﬁscal years. Public companies must ﬁle a report for each ﬁscal quarter, as well as a report at the end of each ﬁscal year. Reports generally must be released within 45 days after the close of a quarter.Corporate fraud In addition to its regulatory functions, the SEC, through its Division of Enforcement, is also the US’s chief watchdog when it comes to policing and prosecuting ﬁnancial fraud. The SEC is mainly on the lookout for several types of misconduct: False statements. Corporations must report ﬁnancial information that, to the best of management’s knowledge, is complete and accurate.US-SPECIFIC INFORMATION How ﬁnance worksInsider trading. Corporate insiders, such as ofﬁcers and executives, can legally buy and sell shares in their companies, but not on the basis of non-public information. For example, a CFO cannot unload shares on the basis of negative ﬁnancial news that has not yet been released. Insiders are also barred from tipping off friends, family, and business associates. Ponzi schemes. This is the practice whereby a money manager distributes returns to existing investors from funds acquired from new investors. These schemes generally collapse once a fund runs out of fresh capital. The most infamous Ponzi scheme to date was that orchestrated by fund manager Bernard Madoff, starting in the 1990s and continuing until his arrest in 2008. Pump and dumps. A “pump and dump” occurs when a brokerage acquires a large amount of stock, spreads false news meant to increase the stock’s value, then quickly sells its position before the fraud is uncovered. Front running. This occurs when a brokerage acquires a block of shares in a particular company before executing a large, pending buy order from a client. The client’s order, if large enough, will increase the value of the stock, allowing the ﬁrm to proﬁt from its foreknowledge of the transaction.In Canada The Toronto Stock Exchange is Canada’s largest and most commonly used stock market. It is overseen by the Ontario Securities Commission. Stock markets also operate in Vancouver and Montreal. Businesses operating in Canada must ﬁle tax returns to the Canada Revenue Agency. Forms may be ﬁled through the mail or electronically. Unlike the US, the federal government in Canada imposes a value-added tax known as the Goods and Services Tax (GST). The current rate is 5 percent. The tax is levied on manufacturers and producers throughout the chain of production. In some cases, companies can claim tax credits for VAT already paid. In some provinces, the GST is included in the Harmonized Sales Tax (HST).338 339ORGANIZATIONS AND RESOURCES Financial reporting The Securities and Exchange Commission provides information on ﬁnancial reporting requirements for publicly listed companies. http://www.sec.gov The Financial Accounting Standards Board website features educational webcasts and seminars for ﬁnance and accounting professionals. http://www.fasb.org The Association of Chartered Accountants in the United States offers online training videos, while the CFA Institute maintains a glossary of ﬁnance and investment terms. http://www.acaus.org http://www.cfainstitute.orgCorporate fraud Those who wish to report corporate fraud may approach the SEC directly through its Ofﬁce of the Whistleblower. http://www.sec.gov/whistleblower Similarly, the Internal Revenue Service maintains an ofﬁce through which the public can anonymously report suspected corporate tax cheats. http://www.irs.govIn Canada The Canada Revenue Agency website has information on the GST and other taxation issues. http://www.cra-arc.gc.ca The Ontario Securities Commission offers a number of online resources for companies considering a listing on the Toronto Stock Exchange. http://www.osc.gov.on.caHow sales and marketing works Advertising and marketing in the United States are regulated at both federal and state level. The Federal Trade Commission (FTC) sets national policies and enforces relevant laws passed by Congress. The First Amendment to the US Constitution restricts the government’s ability to limit or inhibit public speech or communication. However, courts over the years have ruled that commercial speech is subject to less protection than noncommercial speech. The Federal Trade Commission (FTC) was established in 1914 through the Federal Trade Commission Act. Much of the FTC’s work involves enforcing truth-in-advertising regulations, a legislative rubric that requires ads to be truthful, not misleading, and backed by scientiﬁc data if appropriate. In a case of suspected false advertising, the FTC can sue the perpetrator in federal court to obtain a cease-anddesist order, freeze assets, and obtain recompense for victims. A bill pending in Congress at the time of writing, the Truth In Advertising Act of 2014, would prevent marketers from using digital tools such as Adobe Photoshop to alter the appearance of models’ bodies and faces in ads. The FTC also enforces legislation aimed at electronic marketing communications, such as email campaigns and telemarketing. For example, the Commission can ﬁle suit against agencies suspected of violating the National Do Not Call Registry. Telemarketers are forbidden from calling consumers who have entered their numbers in the registry. Similarly, the FTC enforces the CAN-SPAM Act of 2003, which requires marketers to give consumers a means to opt out of receiving future messages. The Federal Communications Commission (FCC) also has some authority to regulate commercial speech. For instance, the FCC enforces the CALM ACT of 2012, which stipulates that broadcasters and cable companies must air commercials at the same volume as regular programming.Individual states can set marketing and advertising rules, particularly for highly regulated industries like health care, ﬁnancial services, and real estate. At the state level, the Better Business Bureau accepts and responds to complaints regarding companies doing business within state jurisdictions.In Canada Freedom of speech and expression in Canada is protected by Section Two of the Canadian Charter of Rights and Freedoms. As is the case in the US, commercial speech is afforded less protection than political or other types of expression. Still, the Charter places numerous limitations on the federal and provincial governments’ ability to abridge marketing and advertising communications. For example, Canada’s Supreme Court in Ford v. Quebec (1988) struck down a Quebec law that required all advertising signs to be in French. Commercial speech in Canada is also governed by the Consumer Packaging and Labelling Act (1985). The law prohibits the use of misleading ads and claims on consumer goods.Data protection Unlike Europe, with its centralized Data Protection Directive, the US does not have a single, overarching law on data protection. Rather, Congress has passed a series of laws that together form a framework around the safeguarding of consumers’ privacy and information. Many of these rules are directed at particular industries. For example, the Department of Health and Human Services enforces the Health Insurance Portability and Accountability Act of 1996 (HIPAA). The Act dictates the administrative, physical,US-SPECIFIC INFORMATION How sales and marketing workand technical safeguards that health care insurers and providers must follow to protect patient records. In ﬁnancial services, the Gramm-Leach-Bliley Act of 1999 stipulates the steps that banks, credit unions, and other ﬁnancial institutions must follow to safeguard customer data. The act is enforced by the FTC. Other industries are also subject to speciﬁc privacy and data protection rules.Direct marketing Direct marketing agencies are subject to laws enforced by the above-mentioned agencies, but are also supposed to adhere to self-imposed codes of conduct adopted by the Direct Marketing Association. The DMA is a lobby group for the industry that promotes “responsible, data-driven marketing.” The DMA promulgates member policies on a number of issues, including privacy, the environment, e-commerce, and consumer protection.E-commerce For marketers that conduct campaigns through the internet and social media channels, the Interactive Advertising Bureau (IAB) publishes codes of conduct that members are expected to follow. For example, the IAB expects all members to be transparent about the data and personal information they collect from consumers on the web.340 341ORGANIZATIONS AND RESOURCES Advertising The Federal Trade Commission oversees truth-inadvertising laws and regulations and offers resources to advertisers and marketers to help keep them from running afoul of the rules. On its website, the FTC publishes advisory opinions on how changes to laws or court rulings may have an impact on future enforcement decisions. http://www.ftc.gov/policy/advisory-opinions The Bureau of Consumer Protection, an arm of the FTC, operates an online Business Center that advises businesses how to comply with Do Not Call, CAN-SPAM, and other rules. It also offers general guidelines on advertising and marketing basics, marketing to children, health claims, and “Made in the USA” claims. http://business.ftc.gov/advertising-and-marketingData protection Various federal agencies can provide information on rules, regulations, and methods concerning the protection of consumer data and privacy, depending on the industry. The Department of Health & Human Services publishes an online FAQ for complying with HIPAA. It also posts guidelines for covered entities and their business partners and associates. http://www.hhs.gov For marketers and advertisers who work within the ﬁnancial services industry, the SEC has a web page devoted to the topic of protecting consumers’ ﬁnancial data and personally identiﬁable information (PII). http://www.sec.gov/about/privacy/secprivacyofﬁce.htmIn Canada Canada’s Competition Bureau maintains a website that provides in-depth information on the Consumer Packaging and Labelling Act, as well as on other relevant legislation. http://www.competitionbureau.gc.caHow operations and production work In the US, practices concerning corporate governance, responsibility, ﬁduciary obligations, and social responsibility are broadly governed by the Sarbanes-Oxley Act, passed by Congress in 2002. Also known as the Public Company Accounting Reform and Investor Protection Act, the Sarbanes-Oxley Act of 2002 (SOX) was passed by Congress in the wake of several high-proﬁle corporate accounting scandals— most notably at Tyco International, WorldCom, Enron, and Enron’s auditor, Arthur Andersen. SOX established the Public Company Accounting Oversight Board (PCAOB), which regulates auditing of corporate ﬁnancial statements. It prohibits auditing ﬁrms from operating consulting businesses and stipulates that a company may not engage an auditor if certain members of senior management worked for that company within the prior year. SOX requires Chief Executive Ofﬁcers and Chief Financial Ofﬁcers to sign and attest to the veracity of their company’s ﬁnancial statements. Board audit committees must have at least one independent director. In addition to government oversight, the auditing profession has stepped up self-regulation in the wake of the ﬁnancial scandals. The American Institute of Certiﬁed Public Accountants (AICPA) has in recent years issued several key Statements on Auditing Standards (SAS). SAS 70 sets audit standards for the services industry, SAS 85 requires auditors to obtain written representations from management, and SAS 99 sets out steps to be taken to detect material misstatement and accounting fraud.In Canada Businesses in Canada are governed by the Competition Act. The Act prohibits misleading advertising and marketing practices, and requires truthful statements concerning warranties, guarantees, and prices. It enables wronged parties to sue defendants for fraud in civil court, usually at the provincial level.Standards and quality control In the US, numerous independent standards organizations play a role in ensuring adherence to standards and quality control in various industries, including manufacturing, services, and health care. Many of these standards are promulgated by the International Organization for Standardization (ISO), a nongovernmental organization based in Geneva, Switzerland. ISO 9000 sets out eight principles for achieving quality control and operational consistency. ISO 9001 establishes formal processes that companies must adhere to, including the establishment of formal quality-control committees, to achieve the designation. ISO 3100 stipulates procedures for controlling and managing risk, while ISO 22,000 concerns food safety. There are other, privately sponsored qualitycontrol initiatives in which many large US companies participate. Beyond ISO, one of the most widely adhered to is the Six Sigma program, which was developed by Motorola and widely deployed by General Electric under former CEO Jack Welch. Six Sigma seeks to build processes aimed at removing defects from the manufacturing process.Health, safety, and the environment Companies operating in the US are expected to operate in a socially responsible manner that attempts to minimize environmental impact while protecting worker health and safety. The federal Environmental Protection Agency (EPA) has broad authority to interpret, apply, and enforce federal laws concerning environmental impact. The EPA regulates greenhouse gas emissions, estuarial runoff, and wetlands protection, among other things.US-SPECIFIC INFORMATION How operations and production workTo maintain worker safety, corporations and even small, privately held companies must adhere to standards set by the Occupational Safety & Health Administration (OSHA). OSHA regulations require a workplace that keeps workers safe from everything from slips and falls to major industrial hazards like exposure to toxic chemicals. OSHA has the power to halt production at job sites deemed unsafe. Food production and processing are further subject to health and safety standards set by the Food and Drug Administration (FDA) and the US Department of Agriculture’s Food Safety and Inspection Service.Liabilities, warranties, and guarantees Companies that sell goods and services in the United States must adhere to various consumer protection laws that are generally promulgated and enforced at the state level. For example, New York State maintains a Division of Consumer Protection, California has its Department of Consumer Affairs, and the Texas Attorney General maintains a Consumer Protection unit. These organizations enforce laws concerning the terms and conditions under which goods and services are sold to the public. New York State, for instance, requires stores to post their refund policies in open view, maintain transparent rebate policies, and limit restrictive provisions on gift card redemption.Intellectual property law and patent protection Intellectual property laws in the US are upheld and enforced mainly through the United States Patent and Trademark Ofﬁce (USPTO) and the US Copyright Ofﬁce. The USPTO adjudicates the validity of patent claims and awards patents on new designs of products, services, and business methods. The USPTO also evaluates trademark claims. The Copyright Ofﬁce registers claims and issues certiﬁcates for copyrights on literary, artistic, and design works, such as a corporate logo.342 343ORGANIZATIONS AND RESOURCES Compliance and corporate responsibility The Securities and Exchange Commission enforces Sarbanes-Oxley compliance. http://www.sec.govStandards and quality control ISO’s site provides full information on all of the standards overseen by the organization. http://www.iso.orgHealth, safety, and the environment OSHA’s website offers information on new regulations, compliance tips, and enforcement actions. https://www.osha.gov The EPA has online tools for checking compliance with federal environmental regulations. http://www.epa.gov Information on food safety laws and practices can be obtained from the FDA’s site. http://www.fda.govLiability, warranties, and guarantees In the US, consumer protection generally falls to the state level. Individual state websites provide information on regulations concerning public sale of goods and services.Intellectual property law The USPTO is the main resource for all information concerning the ﬁling of patent applications. http://www.uspto.gov The US Copyright Ofﬁce website includes information about the copyright process and fees. http://copyright.govIn Canada Information on corporate law and operations in Canada can be obtained from the federal government’s Competition Bureau. http://www.competitionbureau.gc.ca http://www.bureaudelaconcurrence.gc.caIndex Page numbers in bold type indicate main entries. 3-D marketing 207 3M 304 4P3C1E framework (marketing) 242 5S (workplace organization) 299 7-Eleven 23 360-degree feedback 85 360-view customer proﬁle 261A A/B testing (mail marketing) 216 absorption costing 142 accounting see ﬁnancial accounting acid-test ratio 149 acquisition of company 31, 41 ACSI (American customer satisfaction index) 293 actionable metrics 253 ACW (after-call work) 219 adaptive customization 279 advertising advertising to sales ratio (A/S) 213 ATL (above the line) 191 BTL (below the line) 190 online 214–15 traditional ofﬂine 212–13 agents, selling through 188–89 agile business 74 agile production 296–97 aging schedule 135 Agricultural Bank of China 161 AHT (average handling time) 219 AIDA (Attention, Interest, Desire, Action) 237 Alibaba Group 161 Amazon 26 amortization and depletion 128–29 annual report 100, 104–05, 106, 109 Apache Hadoop software 263 Apple 20, 304, 306, 315 appraisal see staff evaluationASA (average speed of answer) 219 asset stripping 152 assets and inventory 138–39 audit trail 103 auditing 103, 111, 114–15 automatic call distributor (ACD) 219B B2B lead generation 237 Baby Boomers 194 back-up plan 33 balance day adjustment 103 balance sheets 116–19 analysis 118–19 current assets 138 equation 116 balanced scorecard 85, 147 Bank of China 161 bank line of credit 34, 133, 158–59 Barings Bank 153 batch costing 143 batch production 274–75 bear market 166 behavioral targeting 215 benchmarking 326–27 big data 262–63 billboard marketing 201, 213 blogging 224–27, 228–29 board of directors 52–55 board members, choosing 19 disclosures 107 body language in different cultures 97 BOFU (bottom of funnel marketing) 220 bonds 170–73 book value 124, 150 bookkeeping 102–03 Boots 49 bootstrapping 14 botnet virus 215 BP (British Petroleum) 62–63 branding and rebranding 234–35 brand loyalty 240, 259 personal 181break-even point (BEP) 141 breakthrough innovation 305 brochures and ﬂyers 201, 210 budgets 136–37 bull market 166 bundle pricing 187 Burger King 23 burn rate 30 business accelerators and incubators 38–39 business analytics 250–51 business angels 35, 36–37 business cultures 64–65 business development 232–45 business goals 78–79 business intelligence software 248–49 business launch 27 business ownership 12–25 business plans 32–33 business process reengineering (BPR) 67 business-format franchise 23 buying and selling businesses 40–49C call center locations, top ﬁve 219 call to action (CTA) 239 callable bond 172 CAN-SPAM Act 267 Canon 298 capacity management 314–15 capital investment and lump sums 132 capital markets and securities 170–73 capital and reserves 117 capital structure evaluation 155 cascading 76 cash conversion 135 cash cows 185 cash ﬂow 132–35 corporate failure signs 151 and fraud 152, 153 gap 135HOW BUSINESS WORKS Indexmanagement 134–35 statement 120–21 see also cost accounting; ﬁnancial accounting CEO (chief executive ofﬁcer) 53, 54, 55, 56, 57 chamber of commerce 25 channel margin 189 charitable donations 107 charity 25 chart of accounts 103 checkout technology 255 children’s marketing 266–67 Chrysler 59 churn rate 204 Cisco 72 cleaning (direct mail) 216 clickstream 215 cloaking 231 cloud services 263, 264 Coach 44 Coca-Cola 193, 293, 306 cold calling 211, 218 collaborative customization 279 communication, art of 92, 178 company hierarchy 56–59 company shares 164–65 comparative claims regulation 266–67 competitive product positioning 182 competitor analysis 33 compliance regulation 266–67 conglomerate 46 conservatism 113 consolidated ﬁnancial statements 105 construction industry safety procedures 319 consumer see customer content marketing 220–21 continuous production 280–81 contract costing 143 control, chain of 312–21 control systems 64 cooperatives 24 corporate bonds 173 corporate failure signs 151 corporate social responsibility (CSR) 334–35 environmental accounting 122–23 corporate structure 66–77corporate success 150 corporation tax 106 corporations 16–17 cosmetic customization 279 cost accounting 130–43 see also cash ﬂow; ﬁnancial accounting cost per lead (CPL) 237 cost per thousand (CPT) 213 cost per touch (lead conversion) 238 cost-plus pricing 142 costs, ﬁxed vs. variable 140–41 costs and pricing strategy 33 credit and creditors 36, 109, 117, 119, 156 CRM (customer relationship management) 264–265 C-suite 54 crowdfunding 34, 35, 36 current assets 117 current ratio 149 customer acquisition cost (CAC) 241 behavior 194–95, 258, 259 capital 244 churn rate 204 complaints 240 consumer data collection 254–55 customer relationship management (CRM) 264–65 customer returns 330–31 data regulation 266–67 decision simplicity 204 expectations, and quality 308 feedback surveys 107, 240–41, 265 lifetime value (CLV) 243 loyalty programs 240–41, 255, 260, 261 personalized product design 278–79 proﬁling 258–61 retention 240–41 segmentation 264 selling direct to 188–89 service 146, 190, 265 “sticky” customers 204 uptake 185344 345D data data to decisions transformation 247 mining 153, 249, 251, 257 quality (DQ) 248 visualization 251 warehousing 256–57 debt bad 102 bonds as debt investments 171–72 and business failures 14 capital structure evaluation 155 cash-ﬂow reconciliation 120 corporate failure signs 151 debtor categories 119 factoring 158–59 gearing ratio 174–75 loan interest 115 loan note 158 loan percentage payment and amortization 128 ratio 149 repayments 132, 133 utility company affordability 120 decentralization 67, 74 decision simplicity (consumers) 204 defect measurement 320–21 defensive merger 43 deferred income 114 deferred ordinary shares 165 delayed payment 156 deleverage 175 Dell 279, 291, 321 demand-pull production 290–91 Deming Prize 309 departmental hierarchy 68–69 depletion and amortization 128–29 depreciation 124–27 calculation 115, 118, 126–27 Deutsche Telekom AG 161 Dia 23 differential costing 142 digital asset management (DAM) 253 digital dashboard 249 digital marketing 202–03 direct costs 142 direct mail marketing 216–17INDEXdirect response (DR) marketing 209 direct taxes 106 directors 18, 19, 50, 53, 55, 115 disbursement quota 25 disclosure (blogging) 225 disruptive innovation 305 diversiﬁcation 42 divestitures 44–45 dividends see shares and dividends divisional structure 66, 70–71 doing business as (DBA) 16 donations 133 double-entry bookkeeping 102, 131 due diligence 41, 43 Dunkin’ Donuts 23E earnout 48 EBITDA to sales ratio 148 eco-innovation 305 economic entity assumption 112 economic life 124 economies of scale 286–87 mergers see mergers economy pricing 186 effective capacity 315 efﬁciency 148, 150, 326–27 electronic waste (e-waste) 331 ELT (extract, load, transform) 256 email direct mail marketing 216–17 regulation 266–67 employee relations 92–93 employment laws 80 endorsement regulation 266–67 Enel SpA 161 engagement marketing 204–05 Enron 153 enterprise portal 30 environmental accounting 122–23 environmental concerns, KPIs 147 environmental, social and gorporate criteria (ESG) 60–61 equipment purchase 133 equity 149, 150, 155, 171, 174 ERP (enterprise resource planning) 264 Eurobond 158 events marketing 200, 205, 210exabyte 263 expansion funding 157 Expedia 44 expenses 115, 140, 152 extension strategy 185 external ﬁnancing 158–59 extrinsic motivation 86F face-to-face marketing 200, 205, 221, 260 Facebook 161, 287 factoring 34, 135, 159 factors of production 271 fair trade 335 fast-moving consumer goods (FMCGs) 181 ﬁnance leases 159 ﬁnancing sources 154–75 ﬁnancial accounting 110–29 accounting cycle 102–03 accounts payable and receivable 135, 148 accounts receivable turnover ratio 148 conventions 31 international standards 112–13 KPIs 146 see also cash ﬂow; cost accounting ﬁnancial forecasts 33 ﬁnancial management 100–09 ﬁnancial performance measurement 144–53 ﬁnancial ratios 148–49 ﬁnancial report types 100 ﬁnancial reporting 100–29 ﬁnancial risk and gearing ratio 174–75 ﬁnancial statements 104–09 deconstructing 106–07 fraud, tracking 152–53 for users 108–09 ﬁnished goods inventory 139 ﬁrst in, ﬁrst out (FIFO) 317 FIVA (framework of intangible value areas) 245 ﬁxed/tangible assets 117–19, 124, 125, 133, 138–39, 153ﬂat lattice structure 76 ﬂipping 165 ﬂow production 276–77 ﬂyers 201, 210 Ford 294–95 forecasting 150–51 forensic accounting see fraud, tracking franchise disclosure documents (FDD) 22 franchises 22–23 fraternal organization 24 fraud, tracking 152–53 frequency marketing 209 frugal innovation 305 full cost pricing 142 full disclosure principle 112 functional structure 68–69 funding 154–63 external ﬁnancing 158–59 ﬂotation 160–63 internal ﬁnancing 156–57 start-ups 34–37G GAAP (Generally Accepted Accounting Principles) 113 gearing ratio and ﬁnancial risk 174–75 Generation X and Generation Y 194 General Electric (GE) 60, 320, 321 general ledger 103 General Motors (GM) 59, 161 geographic pricing 187 globalization 20, 105 Global Management Accounting Principle (GMAP) 134 GNC 23 going concern assumption 112, 131 going public 160–63 goodwill 129 Google 26, 79, 304 government bonds 173 governmental accounting 101 grants 35, 133 green taxes 106 greenhouse gas emissions 123HOW BUSINESS WORKS IndexH haptic technology 207 Hearst Corporation 18 Hertz 279 Hewlett Packard (HP) 15 hire-purchase agreements 159 historic cost principle 113, 131 holding company 105 Honda 308 horizontal integration 46–47 human capital 244 human resources 78–97 cycle 80–81 KPIs 147 human rights, and environment 123 hybrid processes 282–83I IBM 72 IKEA 18 immediate capacity 315 inbound marketing 220–31 income and expense statement 114–15 incremental budget 137 increments 282 incubators 38–39 indirect costs 142 indirect taxes 106 inﬂuence markets 208 information management 246–67 infrastructure assets 118–19 initial public offering (IPO) 160–63 innovation and invention 304–05 intangible assets amortization and depletion 128–29 inventory 139 intangible capital 244 integrated marketing communication 190 integration, vertical vs. horizontal 46–47 mergers and acquisitions 42–43 intellectual capital 244–45 interactive marketing 191 interest cover ratio 175interest rates and dividends 169 intermediaries, selling through 188–89 internal ﬁnancing 156–57 internal markets 209 internal start-ups 26 international accounting standards 112–13 internet marketing 202–03 interstitials (advertising) 215 inventory 316–17 inventory and assets 138–39 inventory reduction 157 inventory turnover ratio 148 investment returns 120, 121 investors 35 ﬁnancial ratios warning 149 invoice discounting 158–59 ISO 9000 309 IT and marketing 252–53J JCPenney 330 job costing 143 job production 272–73 John Lewis 93 Johnsonville Foods 77 JPMorgan Chase & Co. 153 just-in-time production 290–91K kaizen improvement system 298–99 Kanban cards 288, 291 key account management (KAM) 209 key performance indicators (KPIs) 146–47 KFC 23 knowledge capital scorecard 245L labor costs 140 labor practices, and environment 123 large cap listed company 163346 347last in, ﬁrst out (LIFO) 317 lateral integration 47 lateral structure 76 lead conversion 238–39 lead generation 236–37 lead nurturing 238 lead scoring 238 leadership strategy and styles 88–89 leadership for team building 90–91 leadership/management differences 284 lean production 288–89 lean start-up 28 leasing costs 115 legally imposed control 313 LEGO 18 Lehman Brothers 100 letter of intent 45 leverage 64 limited companies 16–17 line position 58 line relationship 69 LinkedIn 83 liquidity ratios 149 listed company 163 loans see debt long-tail marketing 198 long-term ﬁnancing 157–59 loyads 261 loyalty programs 240–41, 255, 260, 261 Lutron 279M MACRS (Modiﬁed Accelerated Cost Recovery System) 124 McDonald’s 20, 23, 70, 292 magazine marketing 201, 213 management 284–99 management, and fraud 153 management accounting 130–31 management buy-ins and buy-outs 48–49 management shares 164 management/cost accounting 130–43 management/leadership differences 284 managing capacity 314–15 manpower costs 115 manufacturing franchise 22INDEXmanufacturing and production 270–83 MarCom (marketing communication) 190 mark-up comparison 187 market correction 166 market extension 46 market penetration pricing 187 market research 192–93 market segmentation 194–95 market share 42 market value of equity 150 marketing approaches 196–209 marketing and IT 252–53 marketing mix 178–95 marketing regulations 266–67 marketing technologist 253 Marks & Spencer 330 Mars 18, 279 MarTech conference 253 mass customization 278–79 mass marketing 198–99 matching principle 113 materiality principle 113 matrix guardian 77 matrix structure 72–73 media engagement 221 members (shareholders) 16 merge/purge software 216 mergers and acquisitions 42–43 integration, vertical vs. horizontal 46–47 Merrill Lynch 70 metadata 231 microfranchising 22 micropreneur 30 mid cap listed company 163 millennials 194 mobcast 226 mobile technology 215, 255 Model Business Corporation Act 54 MOFU (middle of funnel marketing) 220 Mondelez 44 monetary unit assumption 112 monopoly 47, 107 motivation and rewards 86–87 Motorola 321 movie advertising 213 multinationals 20–21 mutual organization 24–25naming a company 13, 28 national employment laws 80 negative-option billing 266–67 negotiating strategy 96–97 net assets 117, 118 net proﬁt margin ratio 149 Net Promoter Score (NPS®) 293 network structure 74–75 networking 83, 201 new product development 302–03 newspaper marketing 201, 213 niche marketing 198–99 Nike 20–21 nongovernmental organization (NGO) 25 nonproﬁt organizations 24–25 NTT Group 161 NTUC FairPrice 309Pacman strategy 43 Panda and Penguin (Google) 231 paradigm 64 partnerships 14–15 patent 129 patent trolls 26 pattern matching (data) 251 pay-per-click (PPC) advertising 215 peer-to-peer (P2P) lending 34 Pemsel test 25 performance management 81 performance measurement 144–47 and budgets 137 perpetual bond 172 person culture 65 personal branding 181 personal selling 190 personal warranty 48 petabyte 263 philanthropic sector 25 phishing 267 Pizza Hut 23, 324 place and distribution channels 188–89 planning, programming, and budgeting systems (PPBS) 137 platform corporation 21 podcasting/vidcasting 226–27 point of sale software 255 Ponzi/pyramid scheme 153 portfolio analysis 185 potential capacity 315 power culture 64 predictive analytics 250, 251 preference shares 165 premium pricing 187 price and pricing strategies 186–87 price to earnings ratio 149 primary market 170 private companies 18–19 private foundation 24 private corporation 17 private placing shares 165 process costing 143 Procter & Gamble (P&G) 72 product costing 142–43O OAO Rosneft 161 offshoring 328–29 Ohlson O score 151 OLAP (online analytical processing) cubes 249, 257 oligopoly 107 OLTP tool (online transaction processing) 256 omni-channel customer 261 online advertising 211, 214–15, 260 online lead conversion 239 online value chain 325 operating proﬁt 114–15 operations 33, 121, 147 ordinary shares 165 outbound marketing 210–19 outbound vs. inbound marketing 222–23 outsourcing 326–27 overheads 132 overleveraged 175 overtime pay 51 overtrading 151 owned media 237HOW BUSINESS WORKS Indexdesign 306–07 environmental responsibility 122 evolution 300–11 extension 46 franchise 22 levels 180–81 life cycle 184–85 positioning 182–83 product-process matrix 310–11 promotion 190–91 samples 201 professional corporation (PC) 16 proﬁt, corporate failure signs 151 proﬁt-and-loss statement 114–15 proﬁt margin 143 proﬁt maximization 60 proﬁtability ratios 148 proﬁts, retained 157, 168 project accounting 101 project management 94–95 professional (PMP) 73 time-based management 294–95 tools 94, 295 promotion of product 190–91 property management 17 prospective costs 141 psychological pricing 187 public companies 18–19 public issue shares 165 public limited company (plc) 16 public relations 191 push/pull strategy 189, 220, 222 PwC 18, 145raw materials costs 140 raw materials inventory 139 Recency Bias theory 156 recession, employment turnover 82 recruitment and selection 82–83 red ﬂags indicating fraud 152 referral markets 209 relationship marketing 208–09 remuneration 107 reporting line, altering 67 reporting structure 18, 19, 69 research and development costs 115 residual value 124 retail space optimization 221 retailers, selling through 188–89 retained earnings 150 retained proﬁts 157 return on equity (ROE) ratio 148 return on marketing investment (ROMI) 242–43 revenue recognition principle 113 reverse merger 45 reverse supply chain 330–31 rewards and motivation 86–87 rights issue shares 165 Ritz-Carlton hotel group 279 robot.txt 231 ROI (return on investment) 242 Rolex 18 RSS (rich site summary) 226salaries and wages 115, 132, 152 sales and fraud 152, 153 KPIs 146 pipeline 238 pitch 239 promotion 191, 205 revenue 132 tracking 249 sales tax 106 salvage/scrap/residual value 124 search algorithm 231 search engine optimization (SEO) 230–31 Sears 330quality control 318–19 quality management 308–09 total quality management 292–93 quality product positioning 182 questionable costs 141R radio marketing 201, 210, 213 raising money see funding raw data 251348 349secondary market 171 secondary stock offering 19 securities and capital markets 170–73 Securities Exchange Co 153 selling and buying businesses 40–41 selling price 143 sensory marketing 206–07 sensory testing 207 service costing 143 service jobs 272 share capital, raising 165 share split 166–67 share of voice (advertising) 213 shareholders 60–63 divestitures 45 and ﬁnancial statements 108 funds 117 liability 16, 17 and management 18, 19 shares and dividends corporate failure signs 151 dividends 168–69 share capital, raising 165 share ﬂotation 160–63 share value 62, 71, 120, 121, 159 share value, establishing 166–67 types 164–65 short-term ﬁnancing 156–59 shortage management 135 silo mentality 68, 69 single-member company (SMC) 17 Six Sigma control 320–21 skimming pricing 186 slice and dice data 248 small cap listed company 163 small and medium-sized enterprises (SMEs) 38 social economic scale 261 social enterprise 25 social graph 229 social lead targeting 211 social media marketing 228–29 and benchmarking 327 big data 262 and branding 234 see also blogging social media monitoring 229 sole proprietors 14–15 solvency ratios 149INDEXspam use regulation 266–67 span of control 58 special offers regulation 266–67 spinoffs 44, 45 splog 225 spreadsheets 249 staff evaluation 84–85 performance–management cycle 64 staff position 58 stakeholders 60–63 and corporate social responsibility (CSR) 335 and ﬁnancial statements 108–09 and share value 62 Standard Oil 15 star schema data 248 Starbucks 72, 208, 335 start-up pivot 28 start-ups 26–39 concept development 28–29 funding 34–37 incubators see business accelerators and incubators types 30–31 statistics 109, 251 “sticky” customers 204 stock exchange listing 160–61, 162 stock exchanges, world’s top 162 stock-keeping unit (SKU) 317 straight-line method of depreciation 124–25 strategic capital 244 structural capital 245 subsidiary company 105 Subway 23 success metrics (marketing) 242 sunk costs 141 super angels 35 supplier markets 208 suppliers’ payments 133 supply chain 322–35 surplus management 135 sustainability, KPIs 147 sustainable investment 106 swap ratio 43 sweepstakes and contests regulation 266–67 SWOT analysis 33 synergy 47tangible/ﬁxed assets 117–19, 124, 125, 133, 138–39, 153 task culture 65 tax accounting 114–15, 120 tax payments 106, 109, 115, 119, 120, 133, 169 team-based structure 76–77 team-building leadership 90–91 technology, mass customization 278–79 telemarketing 218–19 regulation 266–67 terabyte 263 TERM (technology-enabled relationship management) 264 term loan 34, 158 ticker symbols 19 time-based management 294–95 TOFU (top of funnel marketing) 220 total quality management 292–93 quality management 308–09 Toyota 288–89, 290, 298, 308 tracking stock 45 trade event marketing 200, 205, 210 traditional marketing 200–02 traditional ofﬂine advertising 212–13 transaction marketing 209 transnational corporation 21 transparent customization 279 trending product claims 302 trial balance 103 tunneling 152 turnover 114–15 TV marketing 200, 210, 213 TVR (television rating point) 213valuation of company 18, 19 value 186 Value Added Tax (VAT) 106 value chain 324–25 value product positioning 182 value-stream mapping 288 vanity metrics 253 venture capitalists (VCs) 35, 37 vidcasting 226–27 Virgin 15 virtual business incubator 39 Visa 161U undertrading 151 underwriters 162 unquoted/unlisted company 19 useful/economic life 124 USP (unique selling point) 33 utility company, debt affordability 120W wages and salaries 107, 132 Walt Disney 292–93 warehousing 331 warrant 172 waste elimination 288–89 Watson Wyatt index 245 Wessex Water 107, 109, 114–15, 117–19, 122–23 wholesalers, selling through 188–89 who’s who 50–65 Wikispeed 287 windfalls 133 WIP (work in progress) 317 WOM (word-of-mouth) marketing 204 working capital/total assets 150 WorldCom 153 Wyndham Hotel Group 23X Xerox 70, 71Z Z-score models, forecasting with 150 Zappos 77 zero-based budget 137 Zeta analysis 151HOW BUSINESS WORKS Acknowledgments350 351Acknowledgments Dorling Kindersley would like to thank Douglas Bell and Debra Wolter for editorial assistance; Margaret McCormack for the index; and Nicola Gary, Vaibhav Rastogi, and Riti Sodhi for design assistance.Credits DK would like to thank Wessex Water for their kind permission to reproduce sections of their 2013 annual report and accounts on pp.100–123; the Radio Advertising Bureau for permission to reproduce the graph on p.212; and Upstream/YouGov for permission to reproduce the graph on p.214. 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