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Contents
How to use this book
Acknowledgements

Theme 1 Marketing and people

Section 1.1 Meeting customer needs
1 Introduction to marketing
2 The market
3 Market research
4 Market positioning

Section 1.2 The market

5 Demand
6 Supply
7 Markets and equilibrium
8 Price elasticity of demand
9 Income elasticity of demand

Section 1.3 Marketing mix and strategy

10 Product and service design
11 Branding and promotion
12 Pricing strategies
13 Distribution
14 Product life cycle and portfolio
15 Marketing strategy

Section 1.4 Managing people

16 Introduction to managing people
17 Approaches to staffing
18 Recruitment, selection and training
 19 Organisational design
20 Motivation in theory
21 Motivation in practice
22 Leadership

Section 1.5 Entrepreneurs and leaders

23 Role of an entrepreneur
24 Entrepreneurial motives and characteristics
25 Business objectives
26 Forms of business
27 Business choices
28 Moving from entrepreneur to leader

Theme 2 Managing business activities

Section 2.1 Raising finance
29 Introduction to finance
30 Sources of finance: internal and external
31 Liability and finance
32 Planning and cash flow

Section 2.2 Financial planning

33 Sales forecasting
34 Sales, revenue and costs
35 Break-even
36 Budgets

Section 2.3 Managing finance

37 Profit
38 Liquidity
39 Business failure

Section 2.4 Resource management

40 Introduction to resource management
41 Production, productivity and efficiency
 42 Capacity utilisation
43 Stock control
44 Quality management

Section 2.5 External influences

45 Economic influences
46 Legislation
47 The competitive environment
48 Quantitative skills for Business
49 How to revise for Business exams
Answers to the questions in Chapter 48
How to use this book
What distinguishes Business from most A level subjects is the importance of
context. Not much business theory is ‘true’ in an abstract way; it becomes true
only when intelligently placed into a business situation. So not only does the
book have many ‘Real business’ cases within the chapters, it also makes
constant reference to actual, up-to-date examples of the main subject matter. In
this way, the reader learns the richness of the subject – and finds it easier to
remember the key issues.
This book has been designed to be useful in several ways. For students:
1. To be read: either before the teacher tackles a topic or after, as a
reinforcement of the theory. Be sure to ask your teacher what she or he
would prefer. When you’ve finished the chapter, have a go at the Revision
questions, which are designed to help you absorb the material you’ve just
been reading.
2. As a reference resource. This book has an excellent index at the back, to
help you track down a small section on ‘overdrafts’ or ‘cash cows’. So it
can be helpful in class – or for homework – as a reference book.
3. As a revision resource. The book has several features in every chapter that
help with revision. When revising, start by reading the ‘Five whys and a
how’ feature. This asks questions relating to the text – and then answers
them. If you feel confident with the questions and the answers, move on to
the ‘Evaluation’. If this also makes sense, you can move on to another
chapter/topic. If, however, you still feel in the dark, you’d better read/re-
read the chapter.
Having gone through that process, it’s time to test yourself against the
specification. This can be seen online or downloaded from
http://qualifications.pearson.com/en/qualifications/edexcel-a-levels/business-
2015.html. When you have the specification in front of you, go through
Themes 1 and 2, making sure to think about the headings (on the left) as well as
the detailed subject content (on the right).
Finally, during revision, tackle ALL of the numerical questions in Chapter 48
(the answers are at the end of Chapter 49).
For teachers:
1. I want a text book I can trust so that I can change things up a bit. ‘This week,
you’re teaching yourself Quality management. Read Chapter 44 with care,
taking notes as you go – and answer Revision questions 1–5. Next Tuesday
I’ll test you on what you know.’ This book is a reading book more than a
reference book, with lots of examples of application to the real world. I try
to set a reading homework early on, then occasionally further reading for
homework. Overall, though, I’m hoping that students will start to take their
own initiative with the reading.
2. All the short questions, case studies and ‘extended writing’ questions at the
end of the chapters have answers and mark schemes in the Edexcel Business
A level Year 1 Answer Guide. This is available as a photocopiable pack or as
part of the Dynamic Learning digital package. If you feel the need for extra
exam papers, my Exam Pack for Edexcel Business AS/First Year is published
by A–Z Business Training Ltd (see www.a-zbusinesstraining.com).
I hope this new book is as enjoyable to use as it was to write.
Acknowledgements
When I started writing text books, research meant going to libraries and
tracking down businesspeople for interview. These days, Google is hugely
helpful, as are the Financial Times, The Grocer and the many business websites
I subscribe to. Happily, face-to-face conversations remain vital. Salvatore
Falcone at Panetteria Italiana and Matteo Pantani at Scoop are my constant
sources of slices of real business life.
I also want to acknowledge some colleagues who have helped along the way.
This excellent Edexcel specification owes a great deal to Isla Billett and Colin
Leith. And the qualities of the book are partly due to my co-authors Nigel and
Andrew, and partly thanks to the hard work of Beth Cleall and Graeme Hall at
Hodder.
And then there are the students and student teachers who chipped in along the
way. My writing career started with a student saying, ‘You should write a book
of these (case studies)’, so thank you Leda Barrett. More recently Yan Wu,
Sujagan Sivananthan, Lauren Cox, Neetu Rathore and Yasmin Safar have been
hugely helpful in keeping me inspired by teaching in general – and particularly
by Business as a challenging, ever-fascinating subject.
Writing a textbook is time-consuming and energy-sapping. So the most
important acknowledgement is to my family, especially my wife Maureen, and
to my grandchildren, who sometimes have to dig me out of my office so that
we can do more important things such as playing trains or digging up the
flower patch.
Finally, the subject itself. It’s a cliché to say that business is ever-changing.
Thankfully, it’s true. So writing a book in 2015 is wonderfully different from
ten years ago.
I hope you enjoy that difference.
Ian Marcousé, April 2015

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Theme 1

Marketing and people

Section 1.1 Meeting customer needs

1 Introduction to marketing
Definition
Marketing can be defined as the department tasked with targeting the
right product at the right target market using the right combination of
price, promotion and place.

Linked to: The market, Ch 2; Market positioning, Ch 4;

Product and service design, Ch 10; Branding and promotion, Ch
11; Marketing strategy, Ch 15.

1.1 Introduction to marketing

Peter Drucker, a famous business academic, says that, ‘The aim of marketing is
to know and understand the customer so well, the product or service fits him
and sells itself.’ In other words marketing is about gaining an understanding of
what product or service is needed to match customer requirements. This might
be through great market research, or through the kind of brilliant insight
shown by the founders of Google, Facebook or Apple.
‘Think like a customer.’
Paul Gillin, author, The New Influencers
To turn this understanding into a profitable business requires the ability to
communicate the customer benefits clearly and consistently. L’Oréal has been
transformed from an also-ran into the world’s biggest cosmetics business on
the back of the brilliant claim of quality and superiority: ‘Because I’m worth
it’. Tesco went from number two in the grocery business to unrivalled number
one with ‘Every Little Helps’. The problems Tesco has suffered since is a
reminder that marketing isn’t simple. If circumstances change, the marketing
may have to change – which, in the case of Tesco, may mean all four aspects of
its marketing: product, price, promotion and place.
1.2 Marketing objectives
A marketing objective is a marketing target or goal that an organisation hopes
to achieve, such as to boost market share from 9 to 12 per cent within two
years. Marketing objectives steer the direction of the business. Operating a
business without knowing your objectives, is like driving a car without
knowing where you want to go. Some businesses achieve a degree of success
despite the fact that they choose not to set marketing objectives, stumbling
across a successful business model by accident. But why should anyone rely on
chance? If firms set marketing objectives, the probability of success increases
because decision making will be more focused.
To be effective, marketing objectives should be quantifiable and measurable.
Targets should also be set within a time frame. An example of a marketing
objective that Nestlé might set is: ‘To achieve a 9 per cent increase in the sales
of KitKat by the end of next year.’

Real business
Marketing objectives in the non-profit sector

Figure 1.1 Christian Aid Week logo

Charities such as Oxfam and Christian Aid need marketing to keep
their brands alive and donations coming in. Typical marketing
objectives that a charity may set could include the following.
• Raise brand awareness. Brand awareness is the percentage of the
market that knows of your brand; that is, they can recognise it from
a list of brand names, or they can quote it unaided. Raising brand
 awareness could be a very important marketing objective for a
smaller charity that is at yet unknown. If a greater percentage of the
general public is aware of a charity’s existence and its activities,
donations may increase, enabling the charity to expand its work.
• Brand loyalty. Brand loyalty exists when consumers return to your
brand rather than swapping and switching between brands. A charity
could set a marketing objective to improve brand loyalty. If existing
donors can be persuaded to set up a direct debit to the charity, the
charity’s cash flow will improve.
• Corporate image. A scandal-hit charity could set a marketing
objective of trying to improve its reputation, in order to protect its
income stream from donors.

1.3 Marketing strategy

Marketing strategy is the medium- to long-term plan for how to achieve your
marketing objectives. The process of thinking it through requires rather more,
though, than simply writing down a plan. In his book Even More Offensive
Marketing, Hugh Davidson says that effective marketing strategy requires
POISE (see Table 1.1).

Table 1.1 POISE (source: adapted from Even More Offensive

Marketing, H. Davidson, Penguin Books)
It is easy to see that software publisher King Digital showed all these features
in its brilliant development and marketing of the Candy Crush saga. Launched
in November 2012, by early 2014 it had the highest daily usage of any mobile
app in the world. It was also grossing an estimated $900,000 a day. King had a
long track record of successful games for Facebook, but was one of the first to
see the scope for mobile gaming. Candy Crush proved a clever combination of
enticing free play plus some irresistible 69p upgrades. King showed every
element within the POISE acronym.
Chapters 10–13 show how firms think their strategies through using the
marketing mix, carefully combining the four main marketing levers: product,
price, promotion and place.

1.4 Making sure your marketing is effective

Effective marketing starts with identifying an opportunity, just as King did with
its Candy Crush game. Instead of assuming that all games had to target trigger-
happy men, King identified other opportunities among girls and older women.
In many small businesses, the owner will come into regular contact with
customers. This allows the owner to hear first-hand about the needs and wants
of the target market. In large businesses, formal market research is undertaken
because head office managers cannot feel sure that they know what customers
think and want. Once consumer wants have been identified, products and
services will need to be designed to match consumer preferences. Finally, a
launch marketing mix must be decided. This involves decisions such as setting
price, choosing an appropriate distribution channel and setting a promotional
strategy.
Figure 1.2 The marketing process

1.5 Why is effective marketing important?

Consumers tend to be quite rational. They will seek out fairly priced products
that satisfy their needs. In a competitive market, firms stand or fall according
to their ability to satisfy the needs of the consumer. Generally, firms that fail
will lack customer loyalty and be punished automatically by the market. These
firms will lose market share and profit. Firms with products and services that
offer genuine consumer benefits will attract revenue and profit.
Consumer tastes do not tend to stay the same for very long. Therefore, a key
aspect of effective marketing is the ability to respond, quickly, to any change in
consumer tastes. Firms that fail to adapt their business model, at a time when
consumer tastes are changing, are normally forced out of business. In recent
years, retail chains such as HMV, Jessops and Blockbuster have collapsed.

Real business
Sensations
Launched in 2002 with celebrity backing from Victoria Beckham and
Gary Neville, Walkers Sensations once had annual sales of over £100
million in the premium crisps market. But by 2009 sales had flagged
seriously, hit by newer, more premium brands such as Kettle Chips.
Instead of watching sales continue to drift, Walkers responded by
relaunching the brand in early 2010, giving it more striking packaging
and launching a wider range of flavours. By 2012 and 2013, the
success of this relaunch won the brand new distribution outlets in
supermarkets and elsewhere. A well-executed marketing strategy
brought the brand back to health (see Figure 1.3).

Figure 1.3 Annual sales of Sensations crisps (source: The Grocer Top
Products Survey)

1.6 The characteristics of effective marketing

Identifying the target market

When a business creates a new market (as Richard Branson is attempting
currently with space tourism), it can aim its product at everyone who can
afford the product. Some time later competitors will arrive, and usually focus
on one segment of the market. In space tourism, perhaps some firms will focus
on thrill-seekers, while others will target wealthy, older travellers seeking a
super-safe, luxury version of the same thrill.
‘Everyone is not your customer.’
Seth Godin, American entrepreneur
To succeed at marketing, you need to know and understand the customers
within your target market: what do they really want from your product? Is it the
satisfaction of using/having the product, or the satisfaction of showing it off to
friends? What are their interests and lifestyle? Having a clear idea of the age,
sex and personality of the target market enables the business to do the
following things.

Focus your market research

A business may focus market research by interviewing only those who make
up the target market. This should make the findings far more reliable. If the
target market is clearly defined, the firm’s market research budget can be spent
with greater effect.

Focus your advertising spending

A business may focus advertising spending on the people most likely to buy the
product. One national TV commercial can cost £500,000; it will reach
millions of people, but how many are really in the target market? Men do not
need to know that ‘Maybe it’s Maybelline’. A product targeting young women
would be advertised far more cost-effectively in magazines such as Look or
New!

Segment your markets

Most markets are not made up of identikit consumers who all want exactly the
same product. In practice, consumer preferences can vary greatly. Firms that
market their products effectively in this situation produce a range of products,
each targeted at specific market segments.
A good example of a company that has used market segmentation to great
effect is British Sky Broadcasting (BSkyB); in 2013, the company made an
operating profit of £1,330 million. Before Sky joined the market, the choice of
what to watch on TV was limited. BBC, ITV and Channel 4 tried in vain to
produce a range of programmes to cover every taste. Sky offered subscribers
a choice of over 800 different channels. Among the target segments are kids,
sports fans, ethnic minorities and fans of different music types: for example,
MTV Base and Performance (classical music). The output of each channel is
carefully matched to a particular consumer interest or hobby. Many of these
channels attract additional charges, which has helped BSkyB to increase its
monthly income (see Figure 1.4).

Figure 1.4 BSkyB growth, 2007–2013

A coherent brand image through a coherent

marketing mix
Firms that market their products successfully use the marketing mix in an
integrated manner to create a coherent and attractive brand image that appeals
to the target market. Marketing success depends upon getting all four
marketing mix decisions right. A good product that is properly priced and
promoted will still fail if distribution is poor. Firms use the marketing mix to
create an attractive and coherent brand image for each of the products that they
sell. Creating the right brand image is important. If the brand image created by
the marketing mix appeals to the target market, there should be an increased
chance that the product will succeed.
The most important thing to remember is that all four elements of the mix must
be co-ordinated. If the marketing mix is not co-ordinated, mixed product
messages will be sent out to the target market. This could create confusion,
leading to disappointing sales. The key, then, is to think through the brand
image that you want to create before making any other decisions on your
product: how you might want to price it, promote it and distribute it.
‘Word-of-mouth marketing has always been important. Today it’s more
important than ever because of the power of the internet.’
Joe Pulizzi, business author

1.7 Short-termist marketing = ineffective marketing

Short-termism describes a business philosophy whereby a firm pursues
strategies that could boost profit in the short run, even if these strategies
damage the firm’s long-run profitability. Some examples of short-termist
marketing strategies are given below.

High prices designed to exploit consumer loyalty or

a dominant market position
In the short run, firms that operate in a market where there is little competition
may be tempted to raise their prices to boost revenues and profits. Over many
years, WHSmith boosted profits by increasing prices. This worked very well at
first, as it seemed to take a while for customers to realise the changes taking
place at the store. By 2012, however, ‘like-for-like’ sales were falling by 5 per
cent a year and in 2013 total sales fell by the same percentage.
A decision to exploit consumers by charging high prices is definitely not a
good example of effective marketing. High prices can also encourage new
competitors to join the industry.

Short-run sales-driven marketing

Some managers believe that their employees can only be motivated to work
hard if they are set targets that are linked to bonuses and other performance-
related payments. An over-reliance on targets and performance-related pay can
create a ruthless and dishonest culture that can affect a firm’s marketing. For
example, a recent BBC investigation suggested that staff at a high-street bank
were encouraged by their supervisors to lie to the bank’s customers, in order
to hit their personal sales targets. Mis-selling inappropriate financial products
to customers can improve a bank’s profitability in the short run; however, if
the unethical marketing practices are exposed, the resulting wave of bad
publicity may hit demand for the firm’s products.

Five whys and a how

1.8 Introduction to marketing – evaluation

Marketing guru Philip Kotler says that ‘marketing only takes a day to learn, but
a lifetime to master ’. It seems easy to learn what customers want – and sell it to
them. In fact, new product launches by big UK companies such as Mars and
Heinz have a success rate of less than 20 per cent. So marketing is harder than
it looks – largely because it is easy to ask questions, but harder to interpret the
results.
All that is certain about marketing is that there is a wrong way to do it. A short-
termist approach based on cynicism will backfire. There may be lots of money
to be made before it backfires, but backfire it will. To give one more famous
quote, from iconic US President Abraham Lincoln: ‘You can fool all the
people some of the time, and some of the people all of the time, but you cannot
fool all the people all the time.’

Key terms
Marketing mix: the plan for getting the right blend of product, price,
promotion and place (the 4Ps).
Marketing objectives: the targets the marketing department must
achieve, such as increasing sales by 15 per cent within 12 months.
Market segmentation: dividing a market up by customers’ age, gender
or income to find areas that are under-served, e.g. bikes for older
people.
Marketing strategy: the medium-to-long-term plan for meeting the
marketing objectives, delivered through the marketing mix.

1.9 Workbook
Revision questions
(25 marks; 25 minutes)
1 In your own words, explain the meaning of the term ‘marketing’.
(3)
2 Why do you think most firms decide to review their marketing
strategy at fairly regular intervals?
(3)
3 What is meant by the phrase ‘target market’?
(2)
4 Outline two reasons why it is important for firms to be able to
identify their target market.
(4)
5 Outline one possible marketing objective for each of these
companies:
a) Manchester United FC
b) easyJet
c) Topshop.
(6)
6 Explain how market segmentation has helped companies such as
BSkyB to improve their profitability.
(3)
7 Explain how online advertising might help a business to focus its
advertising spending on its target market.
(4)
Data response 1
The role of chance/luck
Effective marketing usually comes about as a result of careful planning.
However, in some cases, firms stumble across a successful marketing
strategy. Morgan cars is a conservatively run private business. The
production methods used by the company have hardly changed in 50
years. Cars are still made largely by hand. Morgan’s best-selling cars
are based on designs that have not been changed for decades. In
most industries, this approach would be a recipe for disaster.
Fortunately for Morgan, the cars continue to sell well within a tiny
segment comprised of middle-aged men who want a hand-built British
sports car. Morgan has not deliberately engineered its successful use
of segmentation, it has happened accidentally; the company has been
fortunate.

Figure 1.5 A Morgan car

Questions (30 marks; 30 minutes)
1 From your reading of the text, assess whether Morgan’s success is
all down to luck.
 (10)
2 Evaluate the marketing problems Morgan cars could face if it
attempts to expand.
(20)

Table 1.2 Research measurement of sales potential of new brands

Data response 2

Figure 1.6 KitKat Chunky Double Caramel bar

Nestlé Confectionery’s flagship brand KitKat, which has annual retail
sales of £184 million (year to 21 June 2014; source: IRI), announced
what the company called ‘our most significant launch for its Chunky
format in fifteen years’ – KitKat Chunky Double Caramel.
The new bar offers consumers what Nestlé describes as ‘a unique
concept in chocolate singles’ – two portionable halves, each containing
a contrasting texture of caramel. One half features a smooth runny
caramel inside, while the other half contains a crunchy caramel filling.
Each caramel texture sits on top of crispy wafer and is covered in thick
milk chocolate. The bar, which is aimed at 25–35 year olds, has a
recommended retail price (RRP) of 58p, with stock available from 25
August 2014.
Nestlé UK and Ireland spokesperson James Maxton says: ‘Consumer
research has shown that a huge 71 per cent of consumers would
either probably or definitely buy Double Caramel compared to the
typical new product propensity to buy of 54 per cent.’ This form of
market research is widely used to judge whether or not a new product
will succeed. Table 1.2 shows some examples from September 2014
Grocer magazines.
The new KitKat bar was supported by a digital and social media
campaign set to reach 23 million people. A viral film designed for
YouTube launched in September and was amplified through social
media and digital channels, including Facebook and Google.
Addressing retailers, Nestlé’s James Maxton said:
‘KitKat has over one million fans on Facebook who will be keen to
try this major new launch for themselves. Retailers should therefore
expect a high level of trial. In order to capitalise, be sure to stock up
from launch and create as high impact off-shelf displays as possible
so shoppers cannot miss them.’
Source: adapted from www.wholesalenews.co.uk
Questions (30 marks; 35 minutes)
1 Nestlé is targeting the 25–35-year-old segment of the market with
KitKat Double Caramel. Assess two advantages there may be in
targeting KitKat Double Caramel at this segment.
(8)
2 Look at Table 1.2. Based on the figures, explain why Fruitopolis
yoghurt gets such a better overall score than the Butterkist
popcorn.
(4)
3 Evaluate the factors likely to be the most important in determining
how well KitKat Double Caramel sells.
(18)
Extended writing
1 In November 2014, ‘Share Radio’ was launched in the UK. A digital-
 only radio station, its focus is personal finance. Its founder/owner is
especially keen to help teenagers learn more about money. Evaluate
how best to market this new station effectively.
(20)
2 Several lower-league football clubs have found attendance figures
slipping in recent years. Evaluate the best way to build attendance
figures at a local sports club of your choice.
(20)
Section 1.1 Meeting customer needs

2 The market
Definition
The market is where buyers meet sellers, either face-to-face or online.

Linked to: Market research, Ch 3; Market positioning, Ch 4;

Pricing strategies, Ch 12; Marketing strategy, Ch 15.

2.1 Mass marketing

Mass marketing is the attempt to create products or services that have universal
appeal. Rather than targeting a specific type of customer, mass marketing aims
the product at the whole market. The intention is that everyone should be a
consumer of the product. Coca-Cola is a good example of a firm that uses
mass marketing techniques. The company aims its product at young and old
alike. Its goal has always been to be the market leader and remains the same
today. The ultimate prize of mass marketing is the creation of generic brands.
These are brands that are so totally associated with the product that customers
treat the brand name as if it was a product category. Examples include ‘Coke’
(cola) and ‘Bacardi’ (white rum).
Figure 2.1 Mass marketing
As shown in Figure 2.1, when mass marketing is carried out successfully, it can
be highly profitable. Firms such as Ryanair set out to be high-volume, mass
market operators and achieve handsome profits. However, it is important to
note that mass marketing does not have to go hand in hand with low prices. For
example, Nintendo, when it launched the DS, decided to become the handheld
games console. Superb launch advertising and excellent games software
development meant that it achieved mass market sales while keeping its prices
high. Even now, with its sales entering the decline phase of its product life
cycle (see Figure 2.2), it remains the dominant brand in its market. Mass
marketing does not have to aim at the lowest common denominator.
Figure 2.2 Worldwide annual sales of Nintendo handheld consoles
(2003–2013) (source: VGChartz.com)

2.2 Niche marketing

A niche market is a very small segment of a much larger market. Niche
marketing involves identifying the needs of the consumers that make up the
niche. A specialised product or service is then designed to meet the distinctive
needs of these consumers. A niche market product sells their prices are in
relatively low volumes. As a result, their prices are usually higher than the
mass market alternative. Niche market operators often distribute their products
through specialist retailers, or directly to the consumer via the internet.
An entrepreneur wanting to set up a niche market business must first identify a
group of people who share a taste for a product or service that is currently
unsatisfied. A product or a service must then be designed that is capable of
meeting this unsatisfied need. It’s not that a Bounty bar is better than a Mars
bar, but only the Bounty bar gives a hit of coconut sweetness. Finally, the niche
must be large enough to support a profitable business. Many new niche market
businesses fail because the revenue generated from their niche market business
is not high enough to cover the costs of operating.
Small niche operators lack the economies of scale required to compete on
price with larger, established operators. Instead, the small firm could try to
find a small, profitable niche. The amount of profit generated by this niche
needs to be high enough for the small firm, but too trivial for the big business.
Rubicon Exotic has just a 0.6 per cent share of the £2.5 billion UK market for
fizzy drinks. Happily, sales of £14 million are profitable enough to satisfy the
requirements of Rubicon Drinks, with its low overheads. Small, niche market
businesses survive on the basis that they occupy a relatively unimportant
market niche. Larger firms operating in the mass market are happy to ignore
the niche businesses because they represent too small an opportunity to be
worth their while.

Mass v. niche
Let no-one doubt it. Every business would love to have the central, mass
market positioning of Wrigley (92 per cent share of UK chewing gum market)
or Pampers (63 per cent of UK market for disposable nappies). Better still
might be Colgate, with its 45 per cent share of the world market for toothpaste.
Unfortunately, for the vast majority of businesses, this glorious position is not
an option. Yes, Branston can take on Heinz’s mass market positioning in the
baked bean market, but who would expect this to be profitable?
The conclusion is clear: if someone else has already ‘captured’ the mass
market, you would be wiser to find your own, profitable niche. Then, who
knows, in the long term you may be able to move from a strong niche
positioning to chip away at the mass market leader. This is what happened to
Twinings tea, which – many years ago – was a tiny, upmarket tea brand in a
market dominated by PG Tips and Tetley. In 2014, Twinings toppled Tetley to
take second place in the sector – and not too far short of market leader PG Tips
(Figure 2.3).
‘Most large markets evolve from niche markets.’
R. McKenna, businessman

Figure 2.3 UK tea sales (2000–2014) (source: The Grocer Top

Products Survey)
When choosing a niche positioning, the key issues are authenticity and the
ability to gain a true understanding of the niche (Figure 2.4). In its sector,
Alpro has proved masterful at understanding the consumers who believe that
dairy products are bad for them. In a completely different sector, the German
company Haribo started in a small niche which has grown to become the heart
of the UK’s sugar confectionery market.

Figure 2.4 Logic chain: growing your niche

‘Increasingly, the mass market is turning into a mass of niches.’
Chris Anderson, author of The Long Tail

Table 2.1 Characteristics of successful products in mass and niche

markets

Real business
Hall’s Soothers
The £1 billion UK market for sugar confectionery is ferociously
competitive. Skittles battle against Jelly Babies, Fruitella against
Starburst and so on. In a niche of its own, though, comes Hall’s
Soothers: fruit sweets with a strongly medicinal image – for soothing
sore throats. With a recommended retail price of 72p per pack, sales
of £16.5 million were achieved in 2014. These sales would have been
very profitable as the brand had little direct competition.
Source: The Grocer Top Products Survey 2014

2.3 Market size

If a business has a large share of a market, it may worry that boosting sales
further may bring investigations from the Competition and Markets Authority.
Therefore, its best way to achieve further growth is by encouraging growth in
the market sector as a whole. In the UK, Wrigley has a 90 per cent share of
chewing gum sales. So anything it could do to boost the size of the market
would help boost its own sales.
In these circumstances, businesses might sponsor research by academics into
the health-giving properties of the product. Ocean Spray has a 66 per cent
share of the UK market for cranberry juice. So research into the supposed
benefits of ‘cranberries – the superfruit’ could boost sales in the market as a
whole, from which Ocean Spray would get 66 per cent of the benefit. Needless
to say, for a company with a 25 per cent market share, boosting the market as a
whole would make little sense, as 75 per cent of the benefit would be enjoyed
by competitors.

2.4 Market share

Nothing is more important to a marketing department than the market share of
its key brands. External factors largely control market size – for example, the
weather or the state of the economy. Market share, by contrast, is largely the
product of the marketing department’s successes or failures. In 2013, UK sales
of Galaxy fell by 5.3 per cent, while sales of Cadbury Dairy Milk rose by 14
per cent. Perhaps Mars (Galaxy) focused too much on a slick new TV
advertising campaign with the copy line ‘Why have cotton when you can have
silk?’ Cadbury, by contrast, focused on new product development, such as the
launch of Dairy Milk with Oreo cookies.
In setting a market share objective, a company would need to be cautiously
optimistic – for example, aiming to push a brand such as Snickers from its 2.5
per cent share of the £3.6 billion UK chocolate market to 3 per cent within the
next two years. This would be ambitious, but conceivable. Note that a 3 per cent
market share would generate annual sales of £108 million, making it perfectly
possible to afford a marketing budget of perhaps £10 million – allowing for a
substantial TV advertising campaign as well as a significant budget for social
media advertising.

2.5 Brands
Faces can just merge into a crowd and disappear. Products would be the same
without branding. A brand can be given a ‘personality’, which helps it to be
recognised and remembered. Think of the different personalities of brands
such as Peperami, BMW, Ryanair and Nespresso. Effective branding is a key
aspect to establishing a successful niche market brand. It is also at the heart of
achieving product differentiation.
The subject of branding is covered fully in Chapter 11.

2.6 Dynamic markets

Companies such as Cadbury and Heinz are lucky enough to operate in very
long-lived, stable markets. Many others have to operate in a situation of
competitive or market turmoil in which yesterday’s grower is today’s loser. At
the time of writing, Sony’s ten-month-old PS4 had outsold Microsoft’s One by
more than 2:1. But Microsoft has just spent $2.5 billion on software sensation
Minecraft. This might mean that future versions of the game will be launched
for One but not the PS4. This could hit the PS4 hard. Games software is a
dynamic market indeed.
There are four key factors to consider in dynamic markets:
1 Online retailing. This distribution channel is dynamic and quite
unpredictable. According to research group IGD, in 2014 online grocery
 sales accounted for just 4.4 per cent of the UK grocery market. As the
market is so huge (£175 billion), it still comes to a tidy sum – £7.7 billion –
but that is less than the UK sales of Aldi and Lidl combined. IGD forecasts
that by 2017 online grocery sales will have a 6 per cent market share. Is that
dynamic?
By contrast ASOS plc has grown its online sales from £8.3 million in
2003 to £975 million in 2014 and a planned £2,500 million by 2020. That’s
dynamic! Another way of measuring the dynamism of online is to look at
the retailers who have been broken by online competition, such as Game,
HMV and Phones4U.
2 How markets change. Even physical (as opposed to digital/online) markets
change significantly over time. A key factor is changing affluence levels. In
the last 20 years, Britons have doubled the amount of their income they
spend on eating out. This has created huge new business opportunities for
independent restaurants and for chains such as Gourmet Burger Kitchen and
Strada. Another change has occurred in grocery purchasing, where sales of
‘ethical’ food and drink rose from £1.35 billion in 2000 to £7.7 billion by
2012. The big gainers were Fairtrade Foods – which more than quadrupled
their sales – and Rainforest Alliance.
3 Innovation and market growth. Innovation means bringing a new idea to life,
such as launching a new product or service onto the market. Innovation can
help a business gain market share, but can also spur market growth. When
Coca-Cola launched ‘Life’ in 2014, the company’s head of marketing said:
‘One of the driving factors behind our category’s success is the relentless
pace of innovation. Last year innovation (i.e. new products) added £241m in
terms of value to the category.’ In other words, new products encourage
customers to try something new and therefore boost market growth.
4 Adapting to change. The case of Coca-Cola Life is a classic of adapting to
change. With clear evidence that consumers were buying fewer cans of full-
sugar fizzy drinks, Coca-Cola brought out a product with 89 calories
instead of the 139 in the red can, in the hope of winning customers back.
Heinz did something similar in the £580 million ‘table sauce’ category of
the grocery trade. Spotting growing sales for chilli sauces, they introduced
Mexican Chilli Ketchup and Sweet Chilli Ketchup to the UK in 2013. As
consumer tastes change, and fashion changes, and competitors come and
go, every business needs to be clever about adapting rather than waiting and
then be forced to change.
2.7 How competition affects the market
In most markets, competition is a key factor, and potential competition is
equally important. Wrigley, in 2006, had a 94 per cent share of the UK market
for chewing gum. Then Cadbury launched Trident gum in a blaze of TV
advertising. Trident quickly achieved sales of £25 million, taking sales from
Wrigley. By 2014, Wrigley had seen Trident off (sales had slumped to under
£4 million) and Wrigley’s share had recovered to 92 per cent. But managers at
Wrigley won’t have forgotten the huge shock caused by Cadbury. Potential
competition can keep companies on their toes as much as actual competition.
Competition is the pressure that keeps businesses from getting careless and
complacent. Try travelling on Virgin West Coast (the sole operator of trains
from London to Manchester) and you quickly learn this. A standard class open
return ticket for 19 December 2014 was £321! Careful research could have
uncovered a return to New York for that sum of money. Virgin has no
competition and therefore it can charge high prices and give no more than the
minimum service level agreed in its monopoly contract with the government.
For most companies, competition, not monopoly, is the norm. This makes it
hard to charge high prices unless customers perceive the business as offering
an outstanding product or service. This encourages companies to try their best
to be innovative and creative about how to improve their product range and
service level. From a customer point of view, that means important things such
as cars today being hugely more reliable than they once were and much wider
consumer choice across markets from magazines to cosmetics to chocolate
bars.

2.8 The difference between risk and uncertainty

Between 2009 and 2014, Jaguar Land Rover enjoyed a sales boom based
largely on success in China and Russia. Then, with little warning, a collapse in
the price of the Russian rouble meant that Russians would face a doubled
Range Rover price in 2015. Sales in Russia at the end of 2014 were already
falling sharply; no-one knew how bad it would be in 2015.
So, was this a problem of risk or uncertainty? The difference is that risk can be
quantified whereas uncertainty cannot. No economist foresaw the collapse in
the oil price that led to a halving in the value of the rouble – so it was
impossible to quantify this risk. At the start of 2014, if Jaguar Land Rover
managers had brainstormed ‘biggest risks we face this year ’, a halving of the
value of the rouble would not have come up.
Uncertainty such as that caused by the rouble collapse is part of business life.
Whether it is Sainsbury’s lurching from 32 quarters of successive growth to a
sales downturn caused by Lidl/Aldi, or ASOS hit by a stronger pound,
uncertainty is a constant.
So what exactly is risk? This is best answered with statistics. Data from
America shows that only 40 per cent of new, independent restaurants survive
until the end of year three. So their failure rate is 60 per cent and therefore the
risk of failure can be quantified at 60 per cent. Assuming the same is true in
Britain and elsewhere, does that mean that no-one in their right mind should
start their own restaurant? Well, no. But it does mean three things:
1 No-one should risk their life savings opening a new, independent restaurant.
2 It may be worth considering a lower-risk proposition, such as buying a
franchise to operate a successful restaurant brand such as TGI Fridays.
3 It can only be worth opening a high-risk independent restaurant if there are
big profit margins, allowing the chance of big profits if the business
succeeds (pizza falls into this category, because £1 of ingredients can be
sold for £10).
In business, risks are assessed and – where possible – quantified, to help
managers make better decisions. Whatever decision is made, factors causing
uncertainty (including simple bad luck) will then affect whether the decision
turns out well or badly.

Five whys and a how

2.9 The market – evaluation
Which is better? Is it mass or niche marketing? The answer is that it depends. In
the bulk ice cream market, large packs of vanilla ice cream have become so
cheap that little profit can be made. It is better by far, then, to be in a separate
niche, whether regional, such as Mackie’s Scottish ice cream, or upmarket,
such as Rocombe Farm or Häagen-Dazs. The latter can charge ten times as
much per litre as the mass market own-label bulk packs.
Yet would a film company prefer to sell a critic’s favourite or a blockbuster
smash hit? The answer is the latter, of course. In other words, the mass market
is great, if you can succeed there. Businesses such as Heinz, Kellogg’s and
even Chanel show that mass marketing can be successful and profitable in the
long term.

Key terms
Economies of scale: factors that cause costs per unit to fall when a
firm operates at a higher level of production.
Franchise: a business that sells the rights to the use of its name and
trading methods to local businesses.
Generic brands: brands that are so well known that customers say the
brand when they mean the product (for example, ‘I’ll hoover the floor’).
Product differentiation: the extent to which consumers perceive your
brand as being different from others.
2.10 Workbook
Revision questions
(30 marks; 30 minutes)
1 Identify two advantages of niche marketing over mass marketing.
(3)
2 Give three reasons why a large firm may wish to enter a niche
market.
(3)
3 Why may small firms be better at spotting and then reacting to new
niche-market opportunities?
(3)
4 Give two reasons why average prices in niche markets tend to be
higher than those charged in most mass markets.
(2)
5 Outline two reasons why information technology has made niche
marketing a more viable option for large firms.
(4)
6 Explain why it is important for a large firm to be flexible if it is to
successfully operate in niche markets.
(2)
7 In your own words, explain why niche market products may generate
higher profit margins than mass market products.
(3)
8 A new chairman sets the chief executive of Tesco the corporate
objective of restoring Tesco’s UK market share to 32 per cent from
its current figure of 28.5 per cent. Outline two possible marketing
objectives that might help achieve this target.
(4)
9 a) If a company operating in a stable market sees its market share
fall from 5 per cent to 4 per cent, what would be the percentage
impact on its sales revenue?
 (2)
b) How might the business respond to such slippage in its market
share?
(4)
Data response 1
The return of mass marketing to the car industry
For many years, car manufacturers such as Toyota and Nissan have
sought out market niches in an attempt to improve profitability. Cars
such as the Toyota Prius, a hybrid electric-powered vehicle, are not
intended to sell in high volumes. Instead, niche market cars sell for high
prices, delivering a higher profit margin per car than more conventional
mass market models.
However, in the last couple of years, there are signs that car
manufacturers have sought a return to conventional mass marketing,
particularly in Asia where rapid rates of economic growth have created
a growing middle class. At present both the Indian and the Chinese car
markets are unsaturated. For example, only 4 per cent of households
in India have a car, whereas the corresponding figure in the US is 88
per cent. Income per head, while increasing rapidly, is still low by
American and European standards, and so far this has limited the
demand for new cars in India.
The car market in India is dominated by Suzuki Maruti, a joint venture
between a Japanese and an Indian company. In early 2014, its top
seller was the Alto 800 model, with prices starting at £2,600 for a new
car. This mass market car has seen off the unsuccessful attempt by
Indian rival Tata to introduce a £1,500 car, the Nano. Indian car buyers
are willing to accept compromises with western safety standards, but
still want a degree of comfort and, especially, reliability. Suzuki Maruti,
with a market share of more than 40 per cent, provides exactly this.
Environmentalists have expressed their concerns that cheap, mass
market cars such as the Alto add to the problem of global warming and
climate change. In 2014, Suzuki Maruti estimated they would sell
nearly one million cars in India.
Questions (40 marks; 45 minutes)
1 a) What is meant by a niche market product?
(2)
b) Explain why the Toyota Prius is a good example of a niche market
product.
(4)
2 Explain two reasons why the Indian car market has grown.
(4)
3 a) What is meant by a mass market product?
(2)
b) Explain why the Tata Motor’s ‘People’s car’ is a good example of
a mass market product.
(4)
4 Assess two advantages and two disadvantages for European car
manufacturers, such as Renault, of mass marketing £2,000 cars in
India.
(8)
5 £2,000 cars can be profitably made in India. Explain why UK
consumers are unlikely to benefit from similar low prices.
(4)
6 Evaluate whether companies such as Tata Motors should take into
account the concerns of environmentalists when making their
business decisions.
(12)
Data response 2
Winter melon tea
Mass market soft drinks like Coca-Cola and Pepsi are very popular in
countries such as Hong Kong and Singapore. In an attempt to survive
against the imported competition, local producers of soft drinks have
managed to establish a flourishing niche market for traditional Asian
drinks sold in 33cl cans. Sales of these niche market products have
been rising but from a very low level.
Consumers that make up this niche market are encouraged to believe,
through advertising, that traditional drinks such as winter melon tea
and grass jelly drink are healthier than their mass market alternatives.
Other firms use economic nationalism to sell their drinks, using slogans
such as ‘Asian heritage’ in their advertising.
However, producers of traditional drinks could now become a victim of
their own success. Foreign multinationals have noticed the rapid
growth of this market niche, and in response they have launched their
own range of traditional drinks.
Questions (30 marks; 35 minutes)
1 a) What is meant by a mass market product?
(2)
b) Explain why Asian traditional drinks are examples of niche market
products.
(4)
2 Assess two ways in which the producers of traditional drinks, such
as winter melon tea and grass jelly drink, created product
differentiation.
(8)
3 Niche market products are normally more expensive than most mass
market products. Using the example of traditional Asian drinks,
explain why this is so.
(4)
4 Evaluate whether the local producers of Asian traditional drinks will
be able to survive in the long term given that their products now
have to compete against me-too brands produced by foreign
multinationals such as Coca-Cola and Pepsi.
(12)
Extended writing
1 Choose one of the following markets: women’s fashion retailing;
computer console software; chocolate bars. For the market of your
choice, evaluate whether sales are dominated by mass market or
niche market products/brands.
 (20)
2 Evaluate the view held by some commentators that it is virtually
impossible to succeed when trying to turn a niche market into a
mass market product.
(20)
Section 1.1 Meeting customer needs

3 Market research
Definition
Market research gathers information about consumers, competitors
and distributors within a firm’s target market. It is a way of identifying
consumers’ buying habits and attitudes to current and future products.

Linked to: The market, Ch 2; Market positioning, Ch 4;

Demand Ch 5; Price elasticity of demand, Ch 8; Product and
service design, Ch 10; Pricing strategies, Ch 12.

3.1 Product and market orientation

Effective marketing is usually based around an approach that is market-
orientated, rather than product-orientated. In a market-orientated business,
managers take into account the needs of the consumer before making any
decision. They put the customer at the heart of the decision-making process.
‘The aim of marketing is to know and understand the customer so well the
product or service fits him and sells itself.’
Peter Drucker, business author/guru
Some firms still use a product-orientated approach to marketing. This leads
managers to focus on what the firm does best; internal efficiency comes before
consumer preferences. Product orientation may lead the business towards the
following approaches.
• The hard sell: employing a large sales force to go out and convince
consumers that they should buy your product. Individualised sales targets,
low basic salaries and high rates of commission ensure that sales staff will
be incentivised to hit their targets, enabling the firm to sell the products that
it has already produced.
• Cutting costs and prices: if a product-orientated firm’s products are not
 selling very well, managers tend to respond to this crisis by cutting costs. If
costs can be cut, retail prices can also be cut without any loss of profit
margin.
The problem with the above approaches is that they keep the business doing
what it traditionally does, without anticipating customers’ changing needs. That
is what happened to Sony, who once dominated the world market for personal,
portable music. When the iPod arrived, Sony kept on trying to tweak their
‘Walkman’ product instead of accepting that the digital world had arrived.
On the other hand, there are some weaknesses in market orientation. The death
of Rover Cars (once one of the world’s biggest car producers) was partly due
to this. Rover management thought customers could be attracted by marketing
gimmicks such as ‘special edition’ cars, or cars with angular steering wheels.
A greater focus on the quality and reliability of the product would have been
far more effective. Fortunately, the Land Rover part of the business was sold
off and in recent years has flourished in Britain under the leadership of Tata
Motors of India.

Real business
Gap

Figure 3.1 Gap

By 2011, Gap’s chief executive, Glenn Murphy, had seen sales fall
steadily since his appointment in 2007, and the American clothes
retailer had been overtaken by Zara as the world’s number one
clothing retailer.
Gap suffered from falling sales and market share because it failed to
keep up to date with changes in fashion. It built its reputation around
selling ‘preppy’ clothes. Consumer tastes had moved on, but Gap did
not. In 2011, Murphy switched the business towards a more market-
orientated approach. Qualitative market research was used to help
develop a new strategy. In early 2012, Gap introduced new ranges of
more brightly coloured clothing, livelier store designs and designer
collaborations. In 2013, for the first time in many years, Gap
announced that sales were above target and that profits were ahead
of expectations. In the second quarter of 2013, its profits were 25 per
cent higher than in 2012.

3.2 Primary and secondary market research

One of the biggest causes of business failure is poor market understanding.
This is why market research has the potential to be valuable to every business.
For a business start-up, finding out the market size and competitors’ strengths
and weaknesses are all-important. For an established business, market research
can reveal where customers are starting to lose faith in a particular product or
brand – perhaps opening up an opportunity for an innovative new product.
So how can firms find out this type of information? The starting point is
secondary research: unearthing data that already exists.

Methods of secondary research

Internet
Most people start by ‘Googling’ the topic. This can provide invaluable
information, though online providers of market research information will
want to charge for the service. With luck, Google will identify a relevant
article that can provide useful information.

Trade press
Each week, The Grocer magazine provides a full analysis of a market. For
example 22 November 2014 showed that annual sales of chilled pies amount to
£240 million, with beef outselling chicken 3:1. Every major market is served
by one or more magazines written for people who work within that trade.
Spending £3 on an issue of The Grocer provides lots of statistical and other
information. Many trade magazines are available for reference in bigger
public libraries.

Government-produced data
The government-funded National Statistics produces valuable reports, such as
the ‘Annual Abstract of Statistics’ and ‘Labour Market Trends’. These provide
data on population trends and forecasts; for example, someone starting a hair
and beauty salon may find out how many 16–20-year-old women there will be
in the year 2020.
Having obtained background data, further research is likely to be tailored
specifically to the company’s needs, such as carrying out a survey among 16–
20-year-old women about their favourite haircare brands. This type of first-
hand research gathers primary data. Some of the pros and cons of primary and
secondary research are given in Table 3.1.
Table 3.1 The pros and cons of primary and secondary research

Methods of primary research

The process of gathering information directly from people within your target
market is known as primary research (or field research). When carried out by
market research companies it is expensive, but there is much that firms can do
for themselves.
For a company that is up and running, a regular survey of customer
satisfaction is an important way of measuring the quality of customer service.
When investigating a new market, there are various measures that can be taken
by a small firm with a limited budget.
• Retailer research: the people closest to a market are those who serve
customers directly – the retailers. They are likely to know the up-and-
coming brands, the degree of brand loyalty and the importance of price and
packaging, all of which is crucial information.
• Observation: when starting up a service business in which location is an all-
important factor, it is invaluable to measure the rate of pedestrian (and
possibly traffic) flow past your potential site compared with that of rivals. A
sweet shop or dry cleaners near a busy bus stop may generate twice the sales
of a rival 50 yards down the road.
For a large company, primary research will be used extensively in new product
development. For example, if we consider the possibility of launching Orange
Chocolate Buttons, the development stages, plus research, would probably be
as shown in Table 3.2.
Table 3.2 Primary research used in new product development (Orange
Chocolate Buttons)

Real business
The Toyota MR2
When Toyota launched the MR2 sports car, sales were higher than
expected. The only exception was in France, where sales were very
poor. The Japanese head office asked the executives of Toyota
France to look into this. Why had it been such a flop? Eventually, the
executives admitted that they should have carried out market research
into the brand name MR2 prior to the launch. Pronounced ‘Em–Er-
Deux’ in France, the car sounded like the French swear word merdre
(crap).

3.3 Qualitative research

This is in-depth research into the motivations behind the attitudes and buying
habits of consumers. It does not produce statistics such as ‘52 per cent of
chocolate buyers like orange chocolate’; instead it gives clues as to why they
like it (is it really because it’s orange, or because it’s different/a change?).
Qualitative research is usually conducted by psychologists, who learn to
interpret the way people say things, as well as what they say.
‘Eighty to ninety percent of our behaviour is determined by our
subconscious mind. The problem market researchers face is that they
communicate with the conscious mind of consumers.’
Robert Poldervaart, researcher
Qualitative research takes two main forms, as described below.

Group discussions (also known as focus groups)

These are free-ranging discussions led by psychologists among groups of six
to eight consumers. The group leader will have a list of topics that need
discussion, but will be free to follow up any point made by a group member.
Among the advantages of group discussions are that they:
• may reveal a problem or opportunity the company had not anticipated
• reveal consumer psychology, such as the importance of image and peer
pressure.

Real business
Selling luxury in China
A 2013 quantitative study showed that Louis Vuitton, Hermes and
Chanel are the luxury brands with the highest reputation in China. But
do they share the same image characteristics? To find out, a
qualitative study was carried out, depth interviewing people from three
groups: the ‘nouveau (super) riche’, ‘gifters’ and ‘middle class luxury’.
The study found that the first two groups were price insensitive;
indeed, high prices were in some ways attractive. However, the third
group was very price sensitive within a restricted number of acceptable
western brands. These groups could be targeted quite differently – for
example, online.

Depth interviews
These are informal, in-depth interviews that take place between a psychologist
and a consumer. They have the same function as group discussions, but avoid
the risk that the group opinion will be swayed by one influential person.
Typical research questions are shown in Table 3.3.

Table 3.3 Typical research questions

3.4 Quantitative research

This asks pre-set questions on a large enough sample of people to provide
statistically valid data. Questionnaires can answer factual questions, such as
‘How many 16–20 year olds have heard of Chanel No 5?’ There are three key
aspects to quantitative research:
• sampling, ensuring that the research results are typical of the whole
population, though only a sample of the population has been interviewed
• writing a questionnaire that is unbiased and meets the research objectives
• assessing the validity of the results.

Figure 3.2 Logic chain: getting research right

3.5 Limitations of market research, sample size and

bias
Although the most obvious limitation of market research is its accuracy (dealt
with below), a more important problem may be its validity – that is, whether
the findings tell you anything meaningful. Market research can uncover
consumer views on minor things, such as the level of interest in a new Cadbury
Dairy Milk bar with cashew nuts. But Steve Jobs always claimed that market
research was incapable of seeing potential in real leaps forward. So the Apple
iPod, iPhone and iPad received no market research backing. Not that he was the
first to think this way. Henry Ford, in the 1920s, said that if he had asked
customers, ‘they’d have asked for a faster horse’ (rather than a car).
‘Running a company on market research is like driving while looking in
the rear view mirror.’
Anita Roddick, founder of Body Shop

Sample size
A key consideration is to determine how many interviews should be conducted.
Should 10, 100, or 1,000 people be interviewed? The most high-profile
surveys conducted in Britain are the opinion polls asking adults about their
voting intentions in a general election. These samples of between 1,000 and
1,500 respondents are considered large enough to reflect the opinions of the
electorate of 45 million. How is this possible?
Of course, if you only interviewed ten people, the chances are slim that the
views of this sample would match those of the whole population. Of these ten,
seven may say they would definitely buy Chocolate Orange Buttons. If you
asked another ten, however, only three may say the same. A sample of ten is so
small that chance variations make the results meaningless. In other words, a
researcher can have no statistical confidence in the findings from a sample of
ten.
A sample of 100 is far more meaningful. It is not enough to feel confident
about marginal decisions (for example, 53 per cent like the red pack design
and 47 per cent like the blue one), but is quite enough if the result is clear-cut
(such as, 65 per cent like the name ‘Spark’; 35 per cent prefer ‘Valencia’).
Many major product launches have proceeded following research on as low a
sample as 100.
With a sample of 1,000, a high level of confidence is possible. Even small
differences would be statistically significant with such a large sample. So why
doesn’t everyone use samples of 1,000? The answer is because of the cost of
doing so. Hiring a market research agency to undertake a survey on 100
people would cost approximately £10,000. A sample of 1,000 people would
cost three times that amount, which is good value if you can afford it but not
everyone can. As shown in the earlier example of launching Orange Buttons, a
company might require six surveys before launching a new product. So the
amount spent on research alone might reach £180,000 if samples of 1,000
were used.

Sample bias
Even with a large sample size, it is possible to get inaccurate findings due to
sample bias. In 1936, an American magazine made the wrong forecast of a
Presidential election despite a sample of 2.4 million potential voters. The
magazine announced that the Republican candidate would win with 55 per cent
of the poll. When Democrat F.D. Roosevelt won a landslide, commentators
laughed at the ‘useless’ new science of sampling. Yet a sample of just 3,000 by
the Gallup Poll predicted the result correctly. This proved that the size of a
sample is no guarantee of accuracy. The magazine had a huge sample, but it
had drawn it from telephone directories and car owners – both affluent
populations in the 1930s. Dr Gallup had made sure to find a sample that was
truly representative of ordinary Americans. Sampling, then, is more about
accuracy than size – though size still matters.

3.6 Use of IT to support market research

Websites
Many websites automatically generate customer questionnaires. They might
target everyone through the home page or focus on a subgroup, such as
browsers of John Lewis online interested in baby products. Although this
seems a great way to get ‘free’ research data, there are many negatives. Setting
up the programme and the automated data collection takes man hours, and
there are important questions to ask about the reliability of the findings. Who
answers web questionnaires? There could be a bias towards those with time on
their hands (pensioners?) or towards those who think particularly highly of the
product/company.

The use of social media

Social media provide the interactivity that may help create some bonding
between consumer and brand. This may lead to richer market research
findings. Social media can provide a way to gain a fuller understanding of
what customers really love about the brand and the product range. It can help
gain a fuller understanding of customers and the market you are serving. In the
past, this was attempted through market research, but the interactions between
company and customer have the potential to be much richer. When Innocent
Drinks recently introduced their first grass-covered van to Ireland, they asked
blog followers to suggest a name. ‘LamborGreeny’ was one of many
suggestions.

Figure 3.3 Innocent Drinks is known for their smoothies

The second benefit is derived from the first. Stronger relationships between
consumer and brand can cement brand loyalty – and, in the long run, there are
few more valuable attributes than that.

Databases
In May 2014, 74 per cent of UK grocery shopping was done with the use of so-
called loyalty cards, such as Tesco’s Clubcard. This provides the retailer with a
multi-million user database, which can be interrogated to find out answers to
quantitative questions, such as what percentage of purchases of Lynx are
among households with boys under 12? Classic research on a small sample of
the population can never beat finding out facts from a huge database.

3.7 Market segmentation

Segmentation means finding ways to divide a market up to identify untapped
opportunities, perhaps among older consumers, or among those who believe
they are wheat intolerant. Market segmentation is the acknowledgement by
companies that customers are not all the same. ‘The market’ can be broken
down into smaller sections in which customers share common characteristics,
from the same age group to a shared love of Manchester United. Successful
segmentation can increase customer satisfaction (if you love shopping and
‘celebs’, how wonderful that Look magazine is for you!) and provide scope for
increasing company profits. After all, customers may be willing to pay a
higher price for a magazine focused purely on the subjects they love, instead
of buying a general magazine in which most of the articles stay unread.
For new, small companies, segmentation is a valuable strategy for breaking in
to an established market. For large companies, market segmentation involves
two possibilities:
1 Simply to add one niche product to a portfolio otherwise dominated by the
mass market.
2 Multiple segmentation, in which a wide portfolio of niche brands can add
up to a market-leading position. This approach would have risked being
only marginally profitable in the past, but flexible, high-tech manufacturing
systems can make it cost-effective to produce differently targeted products
on the same production line. A good example is Ella’s Organic – a baby
food company which has enjoyed sales growth from £2 million a year in
2009 to £30 million in 2014 by spreading the idea of food good for babies
across a series of different sectors (and 15 countries overseas).
To successfully segment a market, the steps are as follows.
1 Research into the different types of customer within a marketplace – for
example, different age groups, gender, regions and personality types.
2 See if they have common tastes/habits; for example, younger readers may be
 more focused on fashion and celebrities than older ones.
3 Identify the segment you wish to focus on, then conduct some qualitative
research into customer motivations and psychology.
4 Devise a product designed not for the whole market but for a particular
segment; this may only achieve a 1 per cent market share, but if the total
market is big enough, that could be highly profitable.

Real business
In 2003, Camilla Stephens started a pie business that struggled to
become profitable. It needed to be refinanced and downscaled in 2004,
but from a smaller base it began to grow. Before starting the business,
Camilla had been Head of Food at Starbucks UK and also Deputy
Editor of Good Housekeeping magazine, so she had a terrific
understanding of food trends. Seeing the success of Innocent Drinks
and Green & Black’s, she focused clearly on hand-made, very high-
quality, high-priced pies. Think Chicken and Red Pepper rather than
Chicken Balti.
In the early years, the pie business supplied local cafés and caterers,
but in 2006 Camilla (with new partner/husband James Footit)
developed the Higgidy brand. This proved an incredible turning point.
Within 18 months, Higgidy was stocked in Sainsbury’s, Booths and
Waitrose supermarkets, giving national distribution and a big boost to
sales. By taking their time to understand the market segment for posh
pies, Higgidy was put on track to achieve success in the static market
for pies and pastries. In Figure 3.4, Higgidy’s success is contrasted
with the flat sales position for mass-market Pukka Pies.
Figure 3.4 Higgidy sales growth (source: The Grocer magazine, 2010–
2014)

Five whys and a how

3.8 Market research – evaluation

In large firms, it is rare for any significant marketing decision to be made
without market research. Even an apparently minor change to a pack design
will only be carried out after testing in research. Is this overkill? Surely
marketing executives are employed to make judgements, not merely do what
surveys tell them?
The first issue here is the strong desire to make business decisions as
scientifically as possible; in other words, to act on evidence, not on feelings.
Quantitative research, especially, fits in with the desire to act on science not
hunch. Yet this can be criticised, such as by John Scully, former head of Apple
Inc, who once said: ‘No great marketing decision has ever been made on the
basis of quantitative data.’ He was pointing out that true innovations, such as the
Apple iPad, were the product of creativity and hunch, not science.
The second issue concerns the management culture. In some firms, mistakes
lead to inquests, blame and even dismissal. This makes managers keen to find a
let-out. When the new product flops, the manager can point an accusing finger
at the positive research results: ‘It wasn’t my fault. We need a new research
agency.’ In other firms, mistakes are seen as an inevitable part of learning. For
every Sinclair C5 (unresearched flop), there may be an iPod (unresearched
moneyspinner). In firms with a positive, risk-taking approach to business,
qualitative insights are likely to be preferred to quantitative data.

Key terms
Bias: a factor that causes research findings to be unrepresentative of
the whole population – for example, bubbly interviewers or misleading
survey questions.
Primary research: finding out information first-hand – for example,
Coca-Cola designing a questionnaire to obtain information from people
who regularly buy diet products.
Secondary research: finding out information that has already been
gathered – for example, the government’s estimates of the number of
14–16 year olds in Wales.
Sample size: the number of people interviewed; this should be large
enough to give confidence that the findings are representative of the
whole population.

3.9 Workbook
Revision questions
(35 marks; 35 minutes)
1 State three ways in which a cosmetics firm could use market
research.
 (3)
2 Outline three reasons why market research information may prove
inaccurate.
(6)
3 Distinguish between primary and secondary research.
(3)
4 What advantages are there in using secondary research rather than
primary?
(3)
5 State three key factors to take into account when writing a
questionnaire.
(3)
6 Explain two aspects of marketing in which consumer psychology is
important.
(6)
7 Outline the pros and cons of using a large sample size.
(4)
8 Identify three possible sources of bias in primary market research.
(3)
9 Explain why street interviewing may become less common in the
future.
(4)
Data response
Each year, more than £1,500 million is spent on pet food in the UK. All
the growth within the market has been for luxury pet foods and for
healthier products. Seeing these trends, in early 2014 Town & Country
Petfoods launched ‘HiLife Just Desserts’, a range of pudding treats for
dogs. They contain Omega-3 but no added sugar and therefore have
no more than 100 calories per tin.
Sales began well, especially of the apple and cranberry version. Now
sales have flattened out at around £1 million a year and the company
thinks it is time to launch some new flavours. They commissioned
some primary research that was carried out using an online survey
linked to pet care websites. The sample size was 150.
The main findings of the online survey are shown below.
1 Have you ever bought your dog a pet food pudding?

2 Which of these flavours might you buy for your dog?

The marketing director is slightly disappointed that none of the new

product ideas has done brilliantly, but happy that there’s one clear
winner. She plans a short qualitative research exercise among existing
HiLife customers and hopes to launch two new flavours in time for the
annual Crufts Dog Show in three months’ time.
Questions (30 marks; 35 minutes)
1 Explain whether the sample size of 150 was appropriate in this case.
(4)
2 Explain one possible drawback of using an online survey.
(4)
2 Assess the marketing director’s conclusion that ‘none of the new
product ideas has done brilliantly’, but that she is ‘happy that there’s
one clear winner’.
(10)
3 a) Explain one method of qualitative research that could be used in
this case.
(4)
b) Assess two ways in which qualitative research may help the
marketing director.
(8)
Extended writing
1 ‘Market research is like an insurance policy. You pay a premium to
reduce your marketing risks.’ Evaluate this statement.
(20)
2 Steve Jobs, boss of Apple, once said that he ignored market
research in the early stages of the iPad. He believes that research is
useful in relation to existing products, but does not work with
innovative new products.
a) Why might this be?
b) How could research be used to best effect for assessing new
innovations?
(20)
Section 1.1 Meeting customer needs

4 Market positioning
Definition
When launching a new product or service, companies need to decide
where exactly they want to position the brand in relation to customer
perceptions and the positioning of competitors. This is largely achieved
by market mapping.

Linked to: The market, Ch 2; Market research, Ch 3; Demand,

Ch 5; Product and service design, Ch 10; Pricing strategies, Ch
12.

4.1 Market mapping

Market mapping is carried out in two stages.
1 Identify the key features that characterise consumers within a market;
examples in the market for women’s clothes would be: young/old and high
fashion/conservative.
2 Having identified the key characteristics, place every brand on a grid such as
that shown in Figure 4.1; this will reveal where the competition is
concentrated, and may highlight gaps in the market.
Figure 4.1 Example of a market map for fast food
Using this approach could help in identifying a product or market niche that
has not yet been filled. In the market map shown in Figure 4.1, there appears to
be an available niche for healthy eating for younger customers within the fast
food sector. The market map points to the possibility of this positioning, but
then it would be up to the entrepreneur to investigate further. There may be a
niche, but too small to provide an opportunity for a profitable business.
A great example of positioning is Aldi’s position within the UK’s price-
motivated segment of the grocery market. With Asda, Lidl and Iceland as its
direct competitors, Aldi has seen its sales boom as a result of persuading
middle-Britain that shopping at Aldi is sensible rather than cheapskate. Its
slogan ‘Spend a little. Live a lot’ is about having a good time – not about ‘low,
low prices’. Figure 4.2 shows the value to Aldi of astute positioning.
Figure 4.2 Year-on-year percentage change in sales in UK grocery
market, 12 weeks to November 2014 (source: Kantar Worldpanel)

4.2 Competitive advantage of a good or service

Figure 4.2 shows the success of Aldi and Lidl within the UK grocery market in
2014. Both had carved out a competitive advantage based on cost. They had
chosen to offer a limited range of products and to only accept brands willing
to compromise on price. Tesco or Sainsbury’s offer customers a full shopping
basket; Heinz Ketchup will be there, as will Marmite and Maltesers. Lidl and
Aldi work to a different model: they offer shoppers a valuable, low-cost
shopping basket of good quality – but they don’t promise a full range. So an
Aldi shopper may leave feeling a bit disappointed not to have got Maltesers,
but there would be no sense of surprise. Because of this approach, brands have
to work hard to get stocked by Aldi or Lidl; they have to offer good deals or
else they know they won’t be stocked at all. This allows Aldi and Lidl to charge
lower prices than their competitors, which is why customers seek out the
stores.
‘Competitive advantage is a company’s ability to perform in one or more
ways that competitors cannot or will not match.’
Philip Kotler, marketing guru
Competitive advantage can also be achieved by differentiation – that is, setting
yourself apart from your rivals. BMW achieves this in the UK car market;
Apple achieves it in the market for mobile phones. It may be a result of great
design or advanced technology – or simply a consequence of great marketing,
as in the case of Coca-Cola. The great strength of this market positioning,
though, is that the competitive advantage enables the producer to (within
reason) set the price without worrying about the competition.
Figure 4.3 shows the position of supermarkets in the market on a continuum
from lowest cost to most highly differentiated. Perhaps the fact that Morrisons
and Tesco appear in the middle of the continuum is the reason for their recent
trading problems (see Figure 4.2).

Figure 4.3 Competitive advantage in the UK grocery market: avoid

being the piggy in the middle
‘If you don’t have a competitive advantage, don’t compete.’
Jack Welch, former boss of the US giant General Electric

4.3 The purpose of product differentiation

Product differentiation is the degree to which consumers perceive that your
brand is different from its competitors. A highly differentiated product is one
that is viewed as having unique features, such as Marmite or the iPhone. A
highly differentiated product may have substitutes. However, if differentiation
is strong enough, consumers will not even bother looking at these other brands
when making their purchasing decisions. The substitutes available are not
acceptable to the consumer. A product’s point of differentiation is often
described as a unique selling point, or USP.

Creating product differentiation

Product differentiation can be created in two ways. One is actual differentiation
that creates genuine consumer benefits. Actual product differentiation can be
created by:
• a unique design that is aesthetically pleasing to the eye (for example,
Scandinavian furniture from IKEA)
• a unique product function (for example, a mobile phone with a unique new
feature)
• a unique taste (for example, Dr Pepper)
• ergonomic factors (for example, a product that is easier to use than its
rivals)
• superior performance (for example, a Dyson vacuum cleaner).
The second type of differentiation involves creating differences that exist only
in the mind of the consumer. A product can be differentiated by psychological
factors, despite the fact that it is not physically different from a similar product
produced by the competition. Imaginary product differentiation can be created
via persuasive advertising, celebrity endorsements and sponsorship. When a
product is consumed, it is not just the product itself that is consumed; buyers
also enjoy ‘consuming’ the brand’s image too. Many people are prepared to
pay a price premium for a product that has a brand image that appeals to them.
The purpose behind product differentiation is two-fold:
1 To insulate the product or service from the competitive market. Marmite is
‘spread’ that goes on bread or toast; but if there’s a cut in the price of rival
spreads, honey or jam, sales of Marmite will hardly register a blip. And this
is what companies seek: a world in which they control their market position
and, therefore, their sales. No company wants fierce, direct competition.
2 To enable the business to increase its prices if costs go up, in order to
protect its profit margins. As is discussed in Chapter 8, this suggests that the
higher the product differentiation, the lower the price elasticity.
‘There is no such thing as a commodity. It is simply a product waiting to be
differentiated.’
Philip Kotler, marketing guru
Figure 4.4 Logic link: boosting product differentiation

4.4 Adding value to products or services

Adding value means stretching the difference between the cost of bought-in
goods and services and the price that a company can get for its goods. In some
cases, the added value may be huge, such as the difference between the price of
a Starbuck’s coffee and the cost of the coffee beans, milk and sugar. In other
cases, the added value may be quite slim, as in the case of a Ford Focus, which
is assembled by Ford from lots of parts bought-in from other suppliers.
Traditionally, in the catering trade, the rule-of-thumb has been to charge
customers four times the cost of ingredients. So a £5 piece of steak is priced at
£20. The remaining £15 is far from profit, of course. It is needed to pay the
wage bill, the rent, the bills, the advertising and so on.
So how can value be added to a product or service? The most common ways
are:
1 To create an image that is so attractive or quirky that people are willing to
pay more to be associated with the brand. At the time of writing, lots of
people want jackets or jumpers that shout Jack Wills or SuperDry.
Wonderfully for the producer, customers are paying a price premium to
advertise the company’s brand.
2 To create a truly fantastic product or service. The Taj hotel chain has a
wonderful reputation for good customer service – travellers will pay a
premium for that.
3 To wrap the product up in a way that makes it seem remarkably clever (and
perhaps costly to produce). There is a reluctance to spend a lot on an
English breakfast because we all know how to cook it. But although it may
be no cleverer to make waffles and maple syrup, customers may be more
impressed. So a waffle with 20p of ingredients sells for £3, while a £2
breakfast sells for £4.

Five whys and a how

4.5 Market positioning – evaluation
In recent decades, Real Madrid and Manchester United have both tried to
position themselves as the most glamorous football club in the world. At the
time of writing, Real Madrid has achieved this. Barcelona might play the best
football and Bayern Munich might be the best team, but Real’s point of
differentiation is glamour. The clever thing is that this point of differentiation
adds value – people will pay more for a glamorous shirt.
This, then, is the key message behind market positioning: choose a position
that customers find acceptable, while the company finds it profitable, then work
out how to secure it. Advertising, packaging and all other forms of promotion
must focus on making customers believe in that market position.

Key terms
Market map: a grid plotting where each existing brand sits on scales
based on two important features of a market; for example, in the car
market: luxury/economy and green/gas guzzling.
Price elasticity: a measurement of the extent to which a product’s
demand changes when its price is changed.
Unique selling point: a consumer benefit that no rival can match,
perhaps because it is protected by a strong patent.

4.6 Workbook
Revision questions
(30 marks; 30 minutes)
1 Identify three markets where age is a crucial factor in drawing up a
market map.
(3)
2 The UK population is growing older, with a rising proportion of over
60s. Outline two business opportunities that may arise as the
population gets older.
(4)
3 Give three possible sources of competitive advantage for an
independent clothes shop.
(3)
4 Why might it be difficult to differentiate a mass market brand?
(4)
5 What would you say is the USP of each of the following:
a) Maltesers
b) the latest iPhone
c) Marmite?
(6)
6 Suggest four ways in which value could be added to a plank of
wood.
(4)
7 Explain how your school or college differentiates itself.
(6)
Data response
Galaxy chocolate at 15p – head for India
Around the globe, the $100 billion chocolate market is a battle
between three multinationals: Mars, Nestlé and Mondelēez (the Kraft
subsidiary that includes Cadbury). An exception is India, where Mars
has no significant foothold. Given that India is the world’s fastest-
growing market for chocolate, it should be no surprise that Mars was
determined to tackle this issue. In November 2013, it launched Galaxy
‘Premium’ chocolate to take on the might of Cadbury Dairy Milk.
Its approach to the launch showed all the signs of desperation.
Although the Galaxy launch was supported by a glossy advertising
campaign featuring Bollywood actor Arjun Rampal and model Sapna
Pabbi, Mars priced Galaxy extremely competitively. In the middle of the
market, Cadbury Dairy Milk had a 38 gram ‘value’ pack priced at 22p
and a 60 gram Dairy Milk ‘Silk’ pack for 55p. Mars priced a 40 gram
pack of Galaxy at 15p.
Mr Natarajan, general manager of Mars India, said:
‘India is the world’s fastest growing chocolate market and the
moulded chocolate segment is the fastest growing sector. India is a
very important market for Mars. With this launch we are entering an
extremely dynamic segment with our business objective of growing
our product range in India.’
The market for chocolate in India has a value of just £555 million at the
moment. It is this small because Indians currently eat less than a
sixtieth of the amount of chocolate eaten in Britain (0.165 kg per
person per year, compared with our 10.2 kg!). But the market is
forecast by Cadbury to grow at 23 per cent a year between 2013 and
2018, which will take it towards the UK’s market size.

Figure 4.5 Chocolate market share percentage, India 2013

Mr Natarajan’s marketing strategy has two further elements to it.
There is a marketing plan targeting the 0–18 age category, based on
free distribution of sweets twice a year, on Independence Day and
again on Republic Day. The 19–35s are also targeted using a tie-up
with Facebook. One week before a friend’s birthday, Facebook sends
the message ‘Do you want to send chocolates on your friend’s
birthday?’ There can be no doubt that Mars is determined to succeed.
Questions (30 marks; 35 minutes)
1 Assess two possible reasons why Mars wants to build a market
share in India.
(8)
2 From the text, assess how well Mars has used market positioning in
its launch of Mars Premium chocolate in India?
(10)
3 Evaluate how Mars, India, might add more value to its Galaxy brand
to enable it to charge a higher price.
(12)
Extended writing
1 Choose one of these products/services: Burger King, Domino’s
Pizza, Topshop, Pepsi. Evaluate whether their current market
positioning is right for the brand.
(20)
2 To what extent is there effective product differentiation within the
market of your choice? Evaluate how that differentiation has been
achieved.
(20)
Section 1.2 The market

5 Demand
Definition
‘Demand’ measures the level of interest customers have in buying a
product. To be effective, that interest must be backed by the ability to
pay.

Linked to: The market, Ch 2; Supply, Ch 6; Markets and

equilibrium, Ch 7; Pricing strategies, Ch 12; Moving from
entrepreneur to leader, Ch 28.

5.1 Introduction
Managers and owners seek control over the day-to-day events affecting their
business. Ice cream entrepreneurs hate the fact that – however great their ice
cream – the weather is the single biggest determinant of daily demand. There
are many factors that affect the demand for different products and services.
Business people try, as much as possible, to bring the factors within their
influence and ideally control. Even if the weather cannot be controlled,
businesses try to combat its effects. In central London, Italian ice cream
parlour Amorino also specialises in 15 different flavours of hot chocolate – to
keep customers coming even when the weather is poor.
‘What the customer demands is last year ’s model, cheaper. To find out what
the customer needs you have to understand the customer.’
Edna St Vincent Millay, 1920s poet and playwright

5.2 Main factors affecting demand for a product or

service

Price
Price affects demand in three ways.
1 You may want an £80,000 Mercedes convertible, but you cannot afford it;
the price puts it beyond your income level. The higher the price, the more
people there are who cannot afford to buy.
2 The higher the price, the less good value the item will seem compared with
other ways of spending the money. For example, a Chelsea home ticket
costing £48 is the equivalent of going to the movies six times. Is it worth it?
The higher the price of an item, the more there will be people who say no.
3 It should be remembered that the price tag put on an item gives a message
about its ‘value’. A ring priced at 99p will inevitably be seen as ‘cheap’,
whether or not it is value for money; so although lower prices should boost
sales, firms must beware of ruining their image for quality.

Figure 5.1 Logic chain: impact of price on demand

Prices of other goods

The demand for PS4s is affected not only by the price Sony sets for its
console, but also prices set by others. In May 2014, Microsoft cut the price of
its ‘One’ console by $100, boosting its demand at the (temporary) expense of
the PS4. This shows that the two products are substitutes for each other. In
other words, they are competitors, where the success of one is at the expense of
the other.
Another factor affecting sales of the PS4 is the price set by software producers
for PS4 games. If these rose from £40 each to £50, this would have an effect
on sales of Sony PS4 hardware. Some potential customers would stick with
their PS3 and others might look towards the Microsoft product. So PS4
software and PS4 hardware are complementary goods, where sales of one
have a positive effect on sales of the other. See Table 5.1 for more detail on
this.

Table 5.1 Impact on PS4 console sales of price changes by other

products

Changes in consumer incomes

The British economy usually grows at a rate of about 2.25 per cent a year. This
means that average income levels double every 30 years. Broadly, when your
children are aged about 16–18, you are likely to be twice as well off as your
parents are today. Economic growth means we all get richer over time (and
spend more time in traffic jams).
The demand for most products and services grows as the economy grows.
Goods like cars and cinema tickets are normal goods, for which demand rises
broadly in line with incomes. In some cases, it grows even faster; for example,
if the economy grows by 3 per cent in a year, the amount spent on foreign
holidays can easily rise by 6 per cent. This type of product is known as a
luxury good.
Other goods behave differently, with sales falling when people are better off.
These products are known as inferior goods. In their case, rising incomes
mean falling sales. For example, the richer we get, the more Tropicana we buy
and the less Tesco orange squash. As orange squash is an inferior good, a
couple of years of economic struggle (and perhaps more people out of work)
would mean sales would increase as people switch from expensive Tropicana
to cheap squash.

Fashion, tastes and preferences

This category contains some quite different influences upon demand. Fashion
is difficult to manage because, by definition, the term implies that what goes up
must come down. Very few brands stay in fashion for ever. It was the huge
height of the fashion for FCUK that made the logo unwearable once consumer
taste had moved on. French Connection suffered seven lean years after that
happened.
Yet some brands do seem to be eternally fashionable, such as Chanel, Jack
Daniels and Nike. This adds value to the brand and therefore allows higher
prices to be charged, and higher profits to be made.
‘The customer is never wrong.’
Cezar Ritz, hotelier
Consumer tastes and preferences can be fickle, but in many markets there is a
core of stability that helps companies feel confident about ongoing demand. A
good example is the demand for fitness club/gym membership. Yes, it may
suffer a bit during a recession, but the ongoing consumer preference for this
expenditure has been proven over several decades.
For an example of the fickle consumer, one need look no further than food and
drink. Egged on by TV programmes and social media wanting ‘a story’, tastes
lurch from ‘no carb diets’ to ‘low-cal foods’ and back again. Meat can be good
(protein) or bad (fat) and orange juice has a similarly schizophrenic existence.
For the producer, stable demand is the desirable state of affairs, but oh-so hard
to achieve.
‘There is only one boss. The customer. And he can fire everybody in the
company from the chairman on down, simply by spending his money
somewhere else.’
 Sam Walton, founder of Walmart

Real business
In 2014, the value of the UK market for chocolate was unchanged
from 2013 at £2.5 billion, though sales volumes slipped by 2.5 per cent.
Given the static nature of the market as a whole, some of the shifts in
brand sales were startling. See Figure 5.2 for some shockers.

Figure 5.2 Percentage change in sales volume since 2013 for

chocolate bars in the UK market (year to 16 August 2014) (source: IRI
Infoscan)

Advertising and branding

In 2013, ice cream bar Magnum was backed by £4 million of advertising
support. That was much more than any other UK ice cream brand. In fact,
Magnum advertising represented more than 40 per cent of all ice cream
advertising that year. Perhaps as a result, Magnum’s sales rose by 17.6 per cent
to £102.8 million. Unsurprisingly, advertising spending can boost demand.
In the long run, branding is more important than advertising. If the brand is
one that the consumer finds memorable, can identify with and may even be
proud to be associated with, the payback to the brand owner can be huge. In its
2014 rankings of global brands, Forbes magazine placed Google as Number
1, with a brand value of $159 billion (Table 5.2). The value of a brand is its
ability to command a higher price for products and to achieve high levels of
customer loyalty.

Table 5.2 Ranking of global brands, 2014

Demographics
Demographics breaks down population data – for example, by age, ethnic
origin or gender. In the UK market for yoghurt, two of the top ten brands are
focused on children: Petits Filous (sales of £98 million in 2013) and Munch
Bunch (£54.4 million in 2013). Demographically based brands such as these
transformed demand in the yoghurt market. In 1970, the UK market consisted
solely of plain, unsweetened yogurt in glass jars – and sales were just £5
million. Today’s UK market is worth more than £2,000 million (figures from
The Grocer, 21 December 2013).
Today, the most exciting area for demographic opportunity is old people.
Figure 5.3 shows the growth to come in this age group. A glance at daytime
TV shows the huge range of products and services in this category.

Figure 5.3 UK population by age category (source: ONS projections for

England)

External shocks
In May 1996, the EU banned all exports of beef from the UK. The reason was
‘mad cow disease’, which could be passed on to humans in the form of a
ghastly disease (CJD) that rotted the brain and could kill you. The ban would
only be lifted in 2006, giving ten years of a massive reduction in beef exports
and a collapse in the market price of beef in the UK. For beef farmers, this was
a devastating shock.
Although not as dramatic, most businesses will have to face some kind of
external shock on a fairly regular basis. In south Nottingham in 2014/2015,
work building a new tram system closed down a series of roads for months.
Some shop owners in the Clifton district suffered falls in demand as high as 40
per cent for a six-month period. Some boarded-up shops show the impact of
this on cash flow. In fact, businesses that survive this period may find trade
improves as a result of a glossy new tram system. But if you run out of cash,
the future becomes irrelevant.
Among many potential causes of external shock are:
• natural disasters, such as flooding (UK) or earthquakes (many other parts of
 the world)
• a change in the law, such as the August 2014 ban on vacuum cleaners with
more than 1,600 watts of power
• an unexpected change of mind by a major customer or supplier.
Some small firms may sell more than 50 per cent of their output to Tesco; a
sudden cancellation would devastate the business. In September 2014,
Phones4U closed itself down because Vodafone decided to stop selling its
phones through the retail outlet. This was a devastating shock for
Phones4U’s 5,500 staff, though less of one, perhaps, for the company’s
private equity owner BC Capital, which had managed to pay itself enough in
2013 to make a profit on its investment in the now-to-be-liquidated business.

Seasonal factors
Most firms experience significant variations in sales through the year. Some
markets, such as ice cream, soft drinks, lager and seaside hotels, boom in the
summer and slump in the winter. Other markets, such as sales of perfume,
liqueurs, greetings cards and toys, boom at Christmas. Other products with less
obvious seasonal variations in demand include cars, cat food, carpets,
furniture, TVs and newspapers. The variation is caused by patterns of customer
behaviour and nothing can be done about that. A well-run business makes sure
that it understands and can predict the seasonal variations in demand; and then
has a plan for coping.

5.3 Demand risks

There are two situations that every manager should beware of: undiversified
demand and overtrading.

Undiversified demand
When Andrew and Debbie Keeble won a £5 million order from Tesco for their
Heck sausages, they were thrilled. But it meant that Tesco accounted for 75 per
cent of all the brand’s sales. This put the small business in a very vulnerable
position. It had to create the production capacity to meet the orders, but that
might leave them with impossibly high costs if Tesco decided to cancel.
Similar problems of undiversified demand occur when a business is dependent
on just one product (think ‘loom bands’ as a craze that came and went).
The answer is to try to diversify – that is, to spread risk by finding new sources
of demand and therefore being less reliant upon any single source.

Overtrading
Sometimes small businesses grow so fast that they struggle to generate enough
cash to meet rising bills due to rising production levels. The problem is that
meeting next month’s higher demand levels requires extra cash spent today
(more materials and components, more staff and so on). Overtrading means
running so fast that the cash position is on a knife edge, probably at the
overdraft limit. That is risky. The topic of overtrading is dealt with in more
depth in Chapter 28.

Five whys and a how

5.4 Demand – evaluation
The cleverest judgements to be made in business come from the ability to
separate what is from what could be. For 20 years, Britain’s Financial Times
(business) newspaper was priced at £1 – a small premium to the other ‘quality’
papers, The Times and The Guardian. Then, between 2007 and 2010, the price
of the Financial Times was increased until – at £2.50 – it became treble the
price of its rivals. Astonishingly, sales were virtually unaffected. Those who
wanted an economics and business-focused paper had nowhere else to go. A
clever executive had spotted the opportunity to make considerably more profit
from the paper. Such good judgement is based upon sound understanding of
market demand; that is, a really fine understanding of what customers think,
feel and want.

Key terms
Complementary goods: these are bought in conjunction with each
other, such as eggs and bacon or cars and petrol.
Inferior goods: ones for which sales fall when people are better off, but
rise when consumers are struggling financially.
Luxury goods: ones for which sales rise rapidly when people are better
off, but may fall rapidly in hard times.
Normal goods: ones for which sales move in line with changes in
consumer incomes, e.g. sales at dry cleaning outlets.
Seasonal variation: change in the value of a variable (for example,
sales) that is related to the seasons.
Substitutes: products or services in competition with each other, so
customers will substitute one for the other (e.g. Dairy Milk and
Galaxy).

5.5 Workbook
Revision questions
(35 marks; 35 minutes)
1 Demand up or down?
a) When a substitute good cuts its prices.
(1)
b) When a complementary good increases its prices.
(1)
2 The giant Procter & Gamble cut its 2014 spend on UK advertising
 by 9 per cent and switched spending away from TV towards social
media. UK sales in 2014 were flat, meaning a slight fall in volume
terms. What does this imply about the effect of marketing spending
upon demand?
(5)
3 In your own words, explain the term ‘inferior good’ and give your
own example.
(3)
4 How might demand for UK hotel rooms be affected by a sharp
economic downturn in America?
(4)
5 Outline three conclusions the chief executive of Tesco might draw
from the following United Nations’ population forecasts.
(6)

6 Use your knowledge of one of the following to explain the two

factors you believe are the most important in determining the
demand for:
a) Arsenal season tickets
b) Vittel bottled water
c) Vogue magazine
d) KitKat four-finger pack.
(4)
7 Suggest one way in which a business could try to estimate the
future demand for its brand new product.
(3)
8 Examine two possible reasons for the boost to demand outlined in
the following quote from Dundee FC website in 2014:
(8)
 ‘The Club has been bowled over with the sales of season tickets to
date, with an incredible increase of 150 per cent on the same period
last year. The Manager and Board of Directors have been delighted
by the level of both renewals and new sales … with 40 per cent of
sales being either previously lapsed season ticket holders or
supporters buying for the first time.’
Data response
Factors affecting demand for breakfast cereals
Over recent years, many factors have affected the UK market for
breakfast cereals. The single most important is probably health – or
the perception of health. Between 2007 and 2013, the market grew
£240 million by value – with almost all the gains going to existing and
new brands perceived to be healthy. In 2007, Kellogg’s Special K’s
focus on dieters made it seem healthy. In 2013, Weetabix, oat-based
products and mueslis such as Alpen had the winning formula.
A second influence was the decision by the last government, in 2008,
to prevent cereal producers from advertising children’s brands in
children’s TV slots. This had little immediate effect on sales, but slowly
it seems to have hurt brands such as Sugar Puffs and Frosties. (NB
‘healthy’ Alpen has more calories per 100 grams than Frosties, but
marketing is about perceptions, not realities.) Despite the general
strengths of ‘healthy’ cereals, Kellogg’s has achieved success with
Krave – a chocolate-based, indulgent cereal supposedly aimed at
young men.
Figure 5.4 Annual UK breakfast cereal sales (source: The Grocer
magazine)
One other factor has been hugely important to this market – the
continuing move away from sit-down breakfasts towards breakfasts
on-the-go. In some ways, the producers can capture this change
through cereal bars, but once out of the house, school children in
particular may end up buying crisps and an energy drink rather than
cereal. In 2013, the market for breakfast cereal grew 2.7 per cent by
value, but fell 2.8 per cent by volume.
The final issue has been the recession. This has hit manufacturers in
two ways: first, it has forced them to fight harder with promotional
pricing, thereby lowering profit margins. In 2012, half of all breakfast
cereal was bought on special offer. Second, and at least as important,
there has been a switch to supermarket own-label cereals. In 2007,
18.9 per cent of sales were supermarket brands. By 2013, this figure
had risen to 21.5 per cent.
Table 5.3 shows the actual UK sales figures recorded each year by The
Grocer magazine. Weetabix is number 1 and Quaker’s Oatso Simple
has overtaken Special K to become number 2.
Questions (30 marks; 35 minutes)
1 Following a decline in its sales in 2009 and 2010, Special K had a
great year in 2011. Explain two factors that may have caused this.
(4)
2 Assess two factors that may have affected the demand for Alpen
between 2007 and 2013.
(8)
3 a) Calculate the market share for Frosties (to two decimal points) in
2007 and again for 2013.
(2)
b) Explain why this information might be important to Kellogg’s,
owners of the Frosties brand.
(4)
4 From the information provided and your wider knowledge, evaluate
two factors that might affect the total market size for cereals over
the coming 12 months.
(12)

Table 5.3 UK sales figures: cereals

Extended writing
1 In late 2014, the global price of oil collapsed – partly because of a
fall in demand in countries such as the UK. Evaluate the key factors
that might lead to a recovery in UK demand for oil in the future.
 (20)
2 In a declining market for boxed chocolate assortments (such as
Quality Street), Lindt Lindor has been enjoying sharply rising sales.
Evaluate how a business might set about boosting sales of its
brands despite a decline in the market as a whole.
(20)
Section 1.2 The market

6 Supply
Definition
‘Supply’ is the quantity of a product that producers are able to deliver
within a specific time period.

Linked to: Markets and equilibrium, Ch 7; Product and service

design, Ch 10; Distribution, Ch 13; Approaches to staffing, Ch
17; Capacity utilisation, Ch 42; Stock control, Ch 43.

6.1 Introduction
If demand can be visualised as customers filling up their supermarket trolleys,
supply is the huge truck unloading at the back of the store. If the truck is from
Warburtons, the delivery is the end of a supply chain that started with raisins
drying in Turkish fields and flour milled in Canada. From the customer ’s point
of view, they probably do not care about the complexities of sourcing the
ingredients and producing the goods. They just want the right quantities of the
right products to turn up on time – and with the right prices on the bill. Not
many people think about supply.
‘Only recently have people begun to recognise that working with suppliers
is just as important as listening to customers.’
Barry Nalebuff, US business author
Figure 6.1 Logic chain: benefits of buoyant supply

6.2 What should firms supply?

In some cases, this is an easy question to answer. When Fulham play Stoke, the
26,000 seats will provide more than enough supply. The ticket office will sell
to whoever is willing to pay the price. The available supply will be 26,000; the
demand may be around 20,000, leaving a surplus of 6,000.
In other cases, the supply may be harder to plan for. A farmer planting a field
with apple trees knows that the first fruit crop will begin in two to five years’
time. So the actual supply in three years’ time is very uncertain. This is
important because the big supermarket chains will only deal with suppliers
who promise to deliver the right quantity at the right time.
Profit-focused firms will want to supply at the level that makes as a high a
profit as possible. This is known as the profit-maximising point. In the example
shown in Table 6.1, the profit-maximising point occurs when the business
supplies 40,000 units per week.
Table 6.1 Example to show the profit maximising point for a business

6.3 Factors leading to a change in supply

Changes in costs of production

Changes in costs of production include the cost of materials, rent, fuel, salaries
and advertising. The higher the costs, the lower the incentive to supply. This is
because the higher the costs, the lower the profit per unit. Of course, if all your
competitors face the same cost increases, you may not worry. You may simply
assume that if everyone puts their prices up, market share figures should
remain unchanged.

Introduction of new technology

This could have a significant effect on production costs and efficiencies.
Figure 6.2 shows the dramatic rise in recent business purchases of industrial
robots (especially from China). Robots can have a direct impact on labour
productivity and therefore costs per unit. A big increase in the supply of robots
can lower production costs and also help to boost production capacity.
Therefore, supply is not only cheaper but also more plentiful.
Figure 6.2 Global sales of industrial robots (source: World Robotics
Report, IFR Statistical Department)

Indirect taxes
Indirect taxes are taxes levied by government onto goods and services. The
most widespread one in the UK is the 20 per cent rate of VAT put onto most
goods and services (though not food). Another indirect tax is ‘duty’ – special
taxes put onto things the government believes to be socially undesirable, such
as alcohol and petrol. If the government decided to increase the duty on petrol,
this would add to the cost of supply. Therefore, oil companies would wish to
supply less petrol to the market. This would push the price up.

Government subsidies
The reverse of taxation is subsidy. This is when the government wants to
promote supply and therefore gives businesses a financial contribution
towards supply. In March 2013, the BBC reported on a Nottinghamshire
farmer who received a £50,000 grant each year for running his 585 acres.
Later in the year, the government offered subsidies worth perhaps £17 billion
to encourage the building of four new nuclear power plants. Subsidies
encourage extra supply.

External shocks
Cars are made of steel and aluminium, but also use a lot of copper. These
metals are commodities with prices governed by the world market. Figure 6.3
shows the world copper price between 2000 and 2014, varying from a low of
$1,377 to a high of $9,881. For car producers, getting used to a price per tonne
of around $8,000 in 2006–2008, the world recession that hit in late 2008 saw
the copper price crash to $3,105. Any car company that bought stockpiles of
copper at $8,000 would suffer significant losses when the market price fell in
that way.
Figure 6.3 Copper, price per tonne (source: www.indexmundi.com)

Other possible external shocks

A natural disaster, such as a flood or earthquake, can disrupt supply lines,
causing particular problems for manufacturers or retailers who choose to
carry very low stocks; inevitably a supply shortfall leads to price rises.
In September 2014, Vodafone told retailer Phones4U that it would no longer
supply it with phones. The owners of Phones4U responded by closing down
the business. It said that without supply the business would have nothing to do;
therefore, closure was the only option.

Physical constraints
In the short term, businesses may not be able to change one or more of the key
factors determining supply. Between January 2004 and August 2008, the world
price for copper rose from $2,500 to $8,000 per tonne. Despite the huge
opportunity to make profits, copper mining companies struggled to increase
supply. The mines were working to full capacity and no new copper mines
were discovered and opened during this time. By 2014, though, new copper
mines started to open, such as the Totten mine in Canada. This extra supply
eased the copper price down to $6,600 by April 2014.
‘When you went into a Boston Chicken and ordered a quarter chicken,
white, with mash and corn, when that was rung up it would signal all the
way along the supply chain the need for more potatoes to be put on a truck
a thousand miles away.’
 Stephen Elop, Vice President, Microsoft

6.4 Drawing a supply curve

A supply curve can be drawn to show how supply increases when customers
are willing to pay more for the product. In the example shown in Figure 6.4,
companies are willing to supply 20,000 tonnes when the price is $4,000. If the
price were to rise further, to $6,000, suppliers would be delighted to offer
30,000 tonnes of supply.

Figure 6.4 A supply curve

The supply curve is drawn on the assumption that suppliers can respond
quickly to changes in demand. This would be possible if plenty of the product
was kept in storage, or if the production process is speedy and flexible enough
to be increased at will.

Five whys and a how

6.5 Supply – evaluation
When considering supply factors, timescale is a hugely important issue. In the
short term, companies can vary supply only up to the limit of their maximum
production capacity. In the longer term, they can build new factories or buy in
new, faster machinery, but only if they are sure that demand will stay high. One
of the reasons the UK recovered so slowly from the 2009 recession was that
company investment spending stayed exceptionally low. Companies were not
convinced that there was any purpose in investing in extra supply. At a time of
austerity, where was the extra demand going to come from? So when there is a
question on supply, every answer should clarify the timescale involved – short
term or long term.

Key terms
Market price: the price of a commodity that has been established by
the market – that is, where supply equals demand.
Supply chain: the whole path from suppliers of raw materials through
production and storage on to customer delivery.
Supply curve: a line showing the quantity of goods firms want to supply
at different price levels (the higher the price, the more enthusiastic the
supply).

6.6 Workbook
Revision questions
(30 marks; 30 minutes)
1 Explain why a fall in supply increases price.
(4)
2 How might a rise in the national minimum wage affect the supply of
goods in the UK?
(3)
3 Identify two possible physical constraints that could stop a railway
company from completing engineering works on time.
(2)
4 Consider the following.
a) Draw a supply curve for Cadbury Creme Eggs, based on the data
shown in Table 6.2.
(5)
b) Why might Cadburys be unwilling to supply any Creme Eggs at a
price of 20p each?
(2)
5 Use your knowledge of one of the following to explain the two
factors you believe are the most important in determining the supply
 of:

Table 6.2 Data for Cadbury Creme Eggs

a) Arsenal season tickets
b) Vittel bottled water
c) Vogue magazine
d) KitKat four-finger pack.
(6)
6 China produces half the world’s steel. Explain the implications of this
for suppliers of iron ore to China.
(4)
7 Explain how a government fish subsidy might affect the supply of
cod to UK consumers.
(4)
Data response
In 2014, potato prices were 75 per cent lower than their peak the
previous year. Early 2013 had seen dreadful weather in the UK, with
exceptionally high rainfall leading to flooding. Potato crops struggled to
get established so the harvest was late and small. As a result of this
supply shortfall, the price of potatoes shot up, reaching a peak of £390
a tonne – literally ten times the price potatoes had been five years
before.
In 2014, good weather across the UK and the EU made the summer a
good one for potato supplies. In the UK, the planted area for potatoes
was unchanged at 120,000 hectares, but the crop was 20 per cent
higher. By mid-September, the UK potato price was £98 a tonne. In
other western European markets, potato prices were as low as £54 a
tonne, as supply outstripped demand.
For British fish and chip shops, the outcome was a significant boost to
profit margins. Chip shops serve nearly half a kilogram of potatoes in a
portion of chips (three times more than McDonald’s fries), so the high
supply price in 2013 was quite a burden. And because UK households
were still struggling financially from the effects of the weak economic
recovery, chip shops kept their retail prices unchanged. The 2014 fall
in the cost of potatoes came as a blessed relief.
Questions (20 marks; 25 minutes)
1 Construct a labelled diagram to show the impact of the bad weather
on the 2013 UK supply of potatoes. Briefly explain what it shows.
(8)
2 Explain why the potato price fell in 2014.
(4)
3 Explain in your own words how the change in the price of potatoes
would have affected fish and chip shop profits in 2013.
(8)
Extended writing
1 Some farmers specialise in a single crop; others have a mixed farm
with different crops plus livestock. Evaluate the strengths and
weaknesses of each in a world where market prices are affected by
changing supply conditions globally.
(20)
2 Evaluate the possible effects on the supply of commodities of a
continuing sharp rise in global temperatures as a result of climate
change.
(20)
Section 1.2 The market

7 Markets and equilibrium

Definition
Equilibrium is the point where there is a balance between supply and
demand; this makes the price stable (though, if demand was high
enough, the equilibrium point might be at a very high price).

Linked to: Demand, Ch 5; Supply, Ch 6; Pricing strategies, Ch

12; Stock control, Ch 43.

7.1 Introduction
In markets where products are differentiated from each other, perhaps by
branding, prices are set by producers. The price of Chanel No 5 perfume
(£91.50 for a tiny 7.5ml bottle) is set by Chanel. But in some important markets
there is no product differentiation. Food and drink producers around the world
need to buy sugar and coffee. They buy it by the tonne at the world’s market
price. At the time of writing, sugar is about 10p per pound weight, whereas
coffee is about £1.30 per pound. In commodity markets, the price is
determined by market forces – that is, supply and demand. The price that pulls
demand to the same point as supply is the equilibrium price.
‘Markets reduce everything, including human beings and nature, to
commodities.’
George Soros, billionaire financier

7.2 Drawing a demand curve

A demand curve can only be drawn after gathering evidence about the likely
level of sales at different prices. If you had the rights to a one-off ‘Evening
with J.K. Rowling’, in which Harry Potter ’s creator was to speak for the first
time about ‘Harry’s Greatest Adventure’, what would you charge for the
tickets? Ideally, you would try to work out what the demand would be at
different prices (see the demand curve shown in Figure 7.1). Then you could
find out the cost of hiring differently sized venues, to create a supply curve.
From that, you would be able to work out the most profitable combination of
price and demand.

Table 7.1 Research findings of demand for tickets

Figure 7.1 Demand curve for J.K. Rowling tickets

The graph shown in Figure 7.1 is based on (assumed) research findings given
in Table 7.1.
Once the curve has been drawn up, you can use it to work out, for instance, the
right price to charge if you hire the City of Manchester Stadium, which would
be able to seat 35,000 people for the evening ‘show’.
‘Buy land, they ain’t making any more of it.’
Will Rogers, early twentieth-century Hollywood legend

7.3 Interaction of supply and demand

In the above example, if you found that there were three venues in Manchester
capable of holding this level of audience (including Manchester United
football stadium, which could easily take 40,000), you could draw a supply
curve on the same graph as the demand curve.

Figure 7.2 Supply and demand curves for a one-off evening with J.K.
Rowling
Figure 7.2 shows that the most sensible outcome would be to hire the City of
Manchester stadium and price the tickets at £68 in order to fill the 35,000 seats.
The price at which supply equals demand is known as the market price.
The interaction of supply and demand is an important factor in many business
decisions. In this case, the focus is on the price of tickets. Globally, the world
oil price has an enormous effect on firms. This is also determined by supply
and demand. In early 2008, tight oil supplies plus booming demand from
China pushed the world oil price up to $120 per barrel (quadruple the figure
from three years before). By 2010, a rise in supply and (recession-influenced)
slippage in demand allowed the oil price to fall back to $65 per barrel. When
global economic recovery arrived in early 2014, the oil price rose to $100 a
barrel, before rising supply pushed the price down to $50.
‘The market has no morality.’
Michael Heseltine, businessman and Conservative politician
Table 7.2 shows the impacts of different supply and demand conditions on the
price of oil (or any other commodity).

Table 7.2 The impacts of different supply and demand conditions on

price

Real business
A torn 50 p ticket to see the Rolling Stones at Reading Town Hall in
1963 had been gathering dust in the back of a drawer. Turning it over,
the owner saw (and had forgotten) the signatures of the five original
band members. It was put up for auction at Bonhams in June 2014.
Demand was high enough for this rare item to be sold for £850.
Figure 7.3 The Rolling Stones in concert in the 60s

7.4 Supply and demand in practice

A well-run business is sensitive to demand. Its managers realise that demand is
a complex, ever-changing factor. Running a hotel is a good example. Demand
for hotel rooms is weakest on a Sunday night, so room rates are at their lowest.
For city centre hotels, Saturday night may be a good night for bringing in
wealthy night-clubbers, but business customers from Monday to Thursday are
the biggest ‘money-spinners’. Look at the room rates shown in Table 7.3 for a
Leeds hotel in October 2014.

Table 7.3 Room rates for a Leeds hotel in October 2014 (source:
www.laterooms.com. Hotel: Hilton, Leeds City)
What the room prices show is a business that is tuned into its customers well
enough to know that the rates need to be different on different days.
Most businesses not only face daily sales variations but also seasonal ones.
Carpet and furniture sales rise in the spring, as people see the wear and tear
more clearly in the spring sunshine. Swimwear and holiday sales peak in the
summer, while toy and perfume businesses can take 50 per cent of their year ’s
sales in the five weeks leading up to Christmas. Businesses that are close to
their customers make sure that seasonal sales cause no surprise.
The key to meeting varying demand is to anticipate it by varying supply. The
toy shop buys in extra supplies and hires extra, temporary staff in September.
The stock is in place and the staff are trained comfortably before the Christmas
rush. Cadbury starts making pre-Easter Creme Eggs from the summer of the
previous year to ensure that plenty of stock is available for the amazing peak
sales of this major UK brand.
Figure 7.4 Demand and supply of apples

Five whys and a how

7.5 Markets and equilibrium –evaluation

In theory, markets stabilise at an equilibrium price. High prices pull forward
more supply, which brings price back down again. And when prices are low,
demand rises (and supply falls), which pulls prices back up again. This is why
government should not need to intervene if the price of wheat or pork shoots
up – the market will sort it out.
Unfortunately, there is an exception to this – and that is the human factor.
Markets are governed by people’s decisions, and when prices rise, speculators
see opportunities. Some of those speculators are wealthy householders, seeing
opportunity in rising house prices and therefore trying to buy a second house.
Others are professional traders, wanting to make a profit today from a
possible price rise in wheat tomorrow. When speculators get involved, high
prices can attract more demand rather than less. There is then a risk of a
speculative bubble, which can ultimately lead to a crash when the bubble bursts.
That was the problem in 1929, in 1999 and in 2007. History suggests that the
phenomenon will inevitably happen again – but it doesn’t point to when.

Key terms
Commodity markets: these cover undifferentiated products such as
rice, oil or gold. The principle is that every kilo is the same as every
other kilo, so traders can buy and sell without needing to worry which
kilo they are dealing in.
Demand curve: a line showing the demand for a product at different
prices (the higher the price, the lower the demand).
Market price: the price of a commodity that has been established by
the market – that is, where supply equals demand.

7.6 Workbook
Revision questions
(35 marks; 35 minutes)
1 Choose one of the following terms, and explain what it means:
a) stock market
b) labour market
c) foreign exchange market.
(4)
2 State the probable impact on price of:
a) falling demand, while supply remains unchanged
 b) rising supply at a time when demand is unchanged
c) rising demand at a time of falling supply.
(3)
3 When a shortage of Ed Sheeran tickets allows touts to charge
£400, only wealthy people can get to the concerts. Most people
would not worry about this. But why might people be concerned
about a high ‘market price’ if there was a shortage of water at a time
of drought?
(4)
4 Explain why the price of a hotel room might be high on a
Wednesday night.
(4)
5 Consider the following.
a) Draw supply and demand curves for oranges, based on the data
shown in Table 7.4.
(5)

Table 7.4 Market data for oranges

b) Why may orange growers be unwilling to supply any oranges at
10p each?
(2)
6 Explain how market movements might ensure that a sharp rise in
the price of apples proves temporary.
 (4)
7 Examine Figure 7.2 (supply and demand for J.K. Rowling in
Manchester) on page 40 and answer the following:
a) Why is £68 the right price to charge for the tickets?
(4)
b) What would the effect be of setting a price of £80 for the tickets?
(5)
Data response 1
The market for rice
Rice output in India is set to climb to a record in 2013, according to
Bloomberg. The crop should increase by 2.4 per cent to 95 million
tonnes. There are two main reasons for this within the world’s second-
largest rice producer: first, an early monsoon will have encouraged a
bigger area to be planted for rice in 2013 than 2012; and second, the
Indian Agriculture Ministry has been encouraging farmers to use higher
yielding ‘hybrid’ seeds. These can boost yields by one tonne per
hectare; in 2012, there were 39 million hectares of rice planted in India.
India is the world’s biggest exporter of rice, so its extra output will have
an impact on world supply levels. This might put pressure upon the
price of rice as global commodity stockpiles are expected to rise for
the seventh year in a row. The US Department of Agriculture expects
stockpiles to rise 2.7 per cent to 108.6 metric tonnes in 2013/2014.
World output of 480 million tonnes is forecast to exceed demand by
2.8 million tonnes.
The situation is a far cry from 2008, when the price of rice topped
$1,000 a tonne, sparking food riots in many parts of the developing
world. A US government report later concluded that the 2008 ‘price
increase was not due to crop failure or a particularly tight global rice
supply situation. Instead, trade restrictions by major suppliers, panic
buying by several large importers and a weak dollar were the immediate
cause of the rise in rice prices.’ Speculative buying by market traders
was almost certainly a further explanation of the trebling of prices
within six months.
Figure 7.5 World commodity price: rice (source: www.indexmundi.com)
Questions (30 marks; 35 minutes)
1 Explain why production of rice in India may be significant for the
world market price.
(4)
2 Assess two implications for the market price of rice of ‘world output
of 480 million tonnes forecast to exceed demand by 2.8 million
tonnes’.
(8)
3 Construct a labelled graph of the changes in the supply and demand
for rice in India in 2013.
(6)
4 Assess the possible impact of ‘speculative buying by market traders’
on the market for rice.
(12)
Data response 2
Supply, demand and the entrepreneur
By the edge of Lake Victoria, Tanzania, is a village with 2,000 people.
It is poor, but has its own fishing boats, boatbuilder, vegetable field and
(tiny) street market. The villagers work together, but individuals can
keep any money they make. One villager, Pembo, noticed that – year
after year – the villagers planted tomatoes in the ideal growing
conditions of the rainy season.
But when the tomatoes were ripe, the price in the local market town
was too low to make a profit. Fewer people wanted to buy them (they
grew their own) and far more growers brought tomatoes to the
marketplace.
In August 2014, Pembo marked out a large patch of sandy earth by
the side of the lake and sowed tomato seeds. As the rainy season was
over, he had to water by hand. Every day he spent hours collecting
water in a bucket from the lake and watering each plant. He marked his
patch out carefully and replanted each seedling to give it the space to
grow. He tied them, tended them and eventually was able to harvest
them and take them to the market. Whereas the villagers’ tomatoes
usually fetched $2 per bushel, Pembo’s made $5. As he had done all
the work himself, the villagers accepted that he kept all the money: this
proved to be just over $100 for two months’ work (about six times the
average income). He used the $100 to buy a second-hand motorbike
with a trailer.
Others in the village soon copied the method for growing tomatoes,
though Pembo was already onto his next idea. He paid two 12 year
olds to look after his own patch, while he talked to a hotel in the
Serengeti National Park about supplying all their fruit and vegetables.
Questions (40 marks; 40 minutes)
1 Assess two possible motives for Pembo’s business start-up.
(8)
2 Assess the understanding of supply and demand shown in Pembo’s
start-up of his tomato patch. Use a diagram to aid your answer.
(10)
3 Assess whether this business idea of out-of-season tomato growing
will continue to succeed.
(10)
4 Assess whether Pembo is likely to prove a really successful
businessman in the longer term.
 (12)
Extended writing
1 Look at the ‘Real business’ box on page 40. How can an old 50p
concert ticket be worth £850? Explain your reasoning.
(20)
2 China is the world’s biggest purchaser of almost every commodity
and the world’s biggest producer of most industrial items. Evaluate
how a sharp economic downturn in China might affect the
equilibrium of markets worldwide.
(20)
Section 1.2 The market

8 Price elasticity of demand

Definition
Price elasticity measures the extent to which demand for a product
changes when its price is changed.

Linked to: Demand, Ch 5; Income elasticity of demand, Ch 9;

Branding and promotion, Ch 11; Pricing strategies, Ch 12.

8.1 Introduction
When a company increases the price of a product, it expects to lose some sales.
Some customers will switch to a rival supplier; others may decide they do not
want (or cannot afford) the product at all. Economists use the term ‘the law of
demand’ to suggest that, almost invariably:

Figure 8.1 The law of demand

Price elasticity looks beyond the law of demand to ask the more subtle
question: ‘When the price goes up, by how much do sales fall?’ Elasticity
measures the extent to which price changes affect demand.

8.2 Price elasticity of demand

In the short term, the most important factor affecting demand is price. When
the price of the Independent newspaper increased from £1.20 to £1.40 in 2013,
sales fell by 9 per cent between May and October, whereas the Telegraph’s
price rise from £1 to £1.20 (the year before) cut sales by just 4 per cent.
Readers of the Independent proved more price sensitive than readers of the
Telegraph. Therefore, the owners of the Telegraph could feel delighted with
their pricing decision. Selling 4 per cent fewer papers but receiving 20 per
cent more for each one sold meant a significant boost to revenue and profits.
The crucial business question is: how much will demand change when we
change the price? Will demand rise by 1 per cent, 5 per cent or 25 per cent
following a 10 per cent price cut?
Some products are far more price sensitive than others. Following a 5 per cent
increase in price, the demand for some products may fall sharply, say by more
than 20 per cent. The demand for another type of product may fall by less than
1 per cent.

Figure 8.2 The impact of a 10 per cent price rise on sales

Price elasticity can be calculated using the formula shown below:

Price elasticity measures the percentage effect on demand of each 1 per cent
change in price. So if a 10 per cent increase in price led to demand falling by
20 per cent, the price elasticity would be 2. Strictly speaking, price elasticities
are always negative and therefore the actual figure is −2. This is because a
price rise pushes demand down, and a price cut pushes demand up. The figure
of −2 indicates that, for every 1 per cent change in price, demand will move by
2 per cent in the opposite direction.

8.3 Determinants of price elasticity of demand

Why do some products, services or brands have low price elasticity of demand
and some high elasticity? Why is the price elasticity of demand for Branston
Baked Beans higher than that of Heinz Baked Beans? Or the price elasticity of
demand for the Financial Times as low as −0.05 while the price elasticity of
demand for Look magazine is as high as −2.0 (that is, 40 times higher)?

Figure 8.3 Choice of newspapers and magazines

The main determinants of price elasticity are as follows.

The degree of product differentiation

This is the extent to which customers view the product as being distinctive
from its rivals. Look may be an excellent magazine, but it is offering the same
mix of fashion, shopping and ‘celebs’ as many other magazines aimed at
young women. So if the cover price is increased, it is easy for readers to
switch to an alternative, whereas readers of the Financial Times do not have
any other options. Therefore, the higher the product differentiation, the lower
the price elasticity of demand.

The availability of substitutes

Customers may see 7 Up and Sprite as very similar drinks. In a supermarket,
they may buy the cheaper of the two. At a cinema, though, only Sprite may be
available. At a train station vending machine, almost certainly Sprite will be the
only lemonade. This is because it is a Coca-Cola brand and the company’s
distribution strength places Sprite in locations where 7 Up never goes. When
Sprite has no direct competition, its price elasticity is much lower; therefore,
the brand owner (Coca-Cola) can push the price up without losing too many
customers.

Branding and brand loyalty

Products with low price elasticity of demand are those that consumers buy
without thinking about the price tag. Some reach for Coca-Cola without
checking its price compared with Pepsi, or buy a Harley-Davidson motorcycle
even though a Honda superbike may be £4,000 cheaper. Strong brand names
with strong brand images create customers who buy out of loyalty.

Real business
Boosting revenue
When the Telegraph newspaper increased its price from £1 to £1.20,
its daily sales fell by 4 per cent, from 604,000 to 579,000 copies per
day. This caused the following effect on daily revenue:
• Before price rise: price £1 x sales volume 604,000 = £604,000.
• After price rise: price £1.20 x sales volume 579,000 = £694,800.
That is, sales revenue rose by £90,800 per day, a 15 per cent
increase. As the slight fall in sales volume would reduce total variable
costs, the impact on profit would have been even greater.

8.4 Classifying price elasticity

Price-elastic demand
A product with price-elastic demand has a price elasticity of above 1. This
means that the percentage change in demand is greater than the percentage
change in price that created it. For example, if a firm increased prices by 5 per
cent and as a result demand fell by 15 per cent, price elasticity would be:

The higher the price elasticity figure, the more price elastic the demand.
Cutting price on a product with price-elastic demand will boost total revenue.
This is because the extra revenue gained from the increased sales volume more
than offsets the revenue lost from the price cut. On the other hand, a price
increase on a product with price-elastic demand will lead to a fall in total
revenue.

Price-inelastic demand
Products with price-inelastic demand have price elasticities below 1. This
means the percentage change in demand is less than the percentage change in
price. In other words, price changes have hardly any effect on demand, perhaps
because consumers feel they must have the product or brand in question: the
stunning dress, the trendiest designer label or – less interestingly – gas for
central heating. Customers feel they must have it, either because it really is a
necessity or because it is fashionable. Firms with products with price-inelastic
demand will be tempted to push the prices up. A price increase will boost
revenue because the price rise creates a relatively small fall in sales volume.
This means the majority of customers will continue to purchase the brand but
at a higher, revenue-boosting price.
Table 8.1 Summary of price elasticity of demand

8.5 The value of price elasticity to decision makers

Being able to estimate a product’s price elasticity of demand is a hugely
valuable aid to marketing decision making. At West Ham United, ticket prices
for under-16s vary, from £70 in top seats for top games such as Manchester
United, all the way down to £1 when trying to fill the stadium against less
attractive opposition on midweek winter evenings. Unusually for a business,
the objective is to fill the stadium rather than maximise revenue. Understanding
the price elasticity of demand (PED) for junior tickets helps West Ham achieve
an average capacity utilisation of 95 per cent or more. A business that knows
its price elasticity can make better decisions than one that is in ignorance.

Real business
In May 2014, Microsoft cut the US price of its new Xbox One console
from $500 to $400. As a result, the June sales volumes doubled. So a
20 per cent price cut boosted demand by 100 per cent (five times the
amount), suggesting that the short-term price elasticity of the Xbox
One was −5.

Data on a product’s price elasticity of demand can be used for two purposes, as
outlined below.

Sales forecasting
A firm considering a price rise will want to know the effect the price change is
likely to have on demand. Producing a sales forecast will make possible
accurate production, personnel and purchasing decisions. For example, in
September 2013, Nintendo cut the price of its Wii U in America by 15 per cent,
from $350 to $299. In October–November 2013, sales rose by 150 per cent. At
that time, the price elasticity of the Wii U proved to be:

Nintendo could then use that knowledge to predict the likely impact of future
price changes. Another price cut of 10 per cent could lead to a sales increase of
50 per cent (−10% × −5 = +50 per cent). This information can be passed on to
operations and HR, to get the staff in place to produce 50 per cent more stock.

Pricing strategy
There are many external factors that determine a product’s demand, and
therefore its profitability. For example, a soft drinks manufacturer can do
nothing about a wet, cold summer that causes sales and profits to fall.
However, the price the firm decides to charge is within its control, and it can be
a crucial factor in determining demand and profitability. Price elasticity
information can be used in conjunction with internal cost data to forecast the
implications of a price change on revenue.

Example
A second-hand car dealer currently sells 60 cars each year at an average price
of £2,500 per car. This means a revenue of:

From past experience, the salesman believes the price elasticity of his cars is
approximately −0.75. The dealer is thinking about increasing his prices to
£3,000 per car, an increase of 20 per cent. Using the price elasticity
information, a quick calculation would reveal the impact on sales:

That is, a sales decline of 9, causing car sales to slip from 60 to 51.
On the basis of these figures, the new revenue would be:

So, even though the price rise cuts sales to 51 cars, the revenue actually
increases.

8.6 Strategies to reduce price elasticity

All businesses prefer to sell products with price-inelastic demand. Charging
more for a price-inelastic product guarantees an increase in short-term profit.
If a firm has price-elastic products, it will always feel vulnerable, as a rise in
costs may be impossible to pass on to customers. And if a firm is tempted to
cut the price of a product with price elastic demand, sales will probably rise so
sharply that competitors will be forced to respond. A price war may result.
It is important to realise that a product’s price elasticity of demand is not set in
stone. Price elasticity is not an external constraint. The most important
influence on a brand’s price elasticity of demand is substitutability. If
consumers have other brands available that they think deliver the same
benefits, price elasticity will be high. So, to reduce a brand’s price elasticity of
demand, the firm has to find ways of reducing the number of substitutes
available (or acceptable). How can this be done?

Increasing product differentiation

Product differentiation is the degree to which consumers perceive that a
product is different (and preferably better) than its rivals. Some products are
truly different from others, such as Cadbury Dairy Milk, with its distinctive
taste. Others are successfully differentiated by image, such as Versace Jeans or
Coca-Cola. Wearing Versace Jeans makes a statement about the wearer, even if
the cloth itself is no different from that used by Levi’s or Wrangler.

Reducing the competition

One way to reduce price elasticity is to eliminate competition. This might be
done through predatory pricing: a deliberate attempt to force a competitor out
of a market by charging a low, loss-making price. The reduction in the number
of substitutes available allows the predator to raise its prices. If there are no
cheaper substitutes available, the customer is forced to pay the higher prices or
go without. The same effect can be achieved by takeover bids (for example, the
purchase by Adidas of Reebok footwear).

Figure 8.4 Logic chain: lowering price elasticity

Five whys and a how

8.7 Price elasticity of demand – evaluation

For examiners, elasticity is a convenient concept. It is hard to understand, but
very easy to write exam questions on! But how useful is it in the real world?
Would the average marketing director know the price elasticities of his or her
products?
In many cases, the answer is no. Examiners and textbooks exaggerate the
precision that is possible with such a concept. The fact that the price elasticity
of the Telegraph proved to be −0.2 in 2012 does not mean it will always be that
low. Price elasticities change over time, as competition changes and consumer
tastes change.
Even though elasticities can vary over time, certain features tend to remain
constant. Strong brands such as BMW and Coca-Cola have relatively low price
elasticity. This gives them the power over market pricing that ensures strong
profitability year after year. For less established firms, these brands are the
role models: everyone wants to be the Coca-Cola of their own market or
market niche.

Key terms
External constraint: something outside the firm’s control that can
prevent it achieving its objectives.
Predatory pricing: pricing low with the deliberate intention of driving a
competitor out of business.
Price-elastic: a product with demand that is highly price sensitive, so
price elasticity is above 1 (strictly speaking, from minus 1 to minus
infinity).
Price-inelastic: a product with demand that is not very price sensitive,
so price elasticity is below 1 (strictly speaking, between minus 0.01
and minus 0.99).

8.8 Workbook
Revision questions
(35 marks; 35 minutes)
1 a) If a product’s sales have fallen by 21 per cent since a price rise
from £2 to £2.07, what is its price elasticity of demand?
(4)
b) Is the demand for the product price elastic or price inelastic?
 (1)
2 Outline two ways in which Nestlé could try to reduce the price
elasticity of its Aero chocolate bars.
(4)
3 A firm selling 20,000 units at £8 is considering a 4 per cent price
increase. It believes its price elasticity is −0.5.
a) Calculate the effect on revenue.
(6)
b) Outline two reasons why the revenue may prove to be different
from the firm’s expectations.
(4)
4 Explain three ways a firm could make use of information about the
price elasticity of demand of its brands.
(6)
5 Identify three external factors that could increase the price elasticity
of demand of a brand of chocolate.
(3)
6 A firm has a sales target of 60,000 units per month. Current sales
are 50,000 per month at a price of £1.50. If its products have a
price elasticity of demand of −2, what price should the firm charge to
meet the target sales volume?
(5)
7 Why is price elasticity always negative?
(2)
Data response 1
A firm selling Manchester United pillow cases for £10 currently
generates an annual turnover of £500,000. The marketing director is
considering a price increase of 10 per cent.
Questions (15 marks; 20 minutes)
1 Given that the price elasticity of demand of the product is believed
to be −0.4, calculate:
 a) the old and the new sales volume
b) the new revenue.
(7)
2 If the firm started producing mass-market white pillow cases, would
their price elasticity of demand be higher or lower than the
Manchester United ones? Explain your reasoning.
(8)

Figure 8.5 Heinz Tomato Ketchup

Data response 2
Sauces and sources
Heinz Tomato Ketchup is an iconic brand, more than 100 years old. It
dominates the market for ketchup with annual sales of £125 million in
the UK. It has a share of UK tomato sauce sales believed to be over
75 per cent. It has no effective branded competition, though sales of
supermarket own-label ketchups can be considerable.
In 2013, it took a risk by increasing its prices by 10 per cent, even
though the average price increase for ‘table sauces’ was only 3.5 per
cent. The result was a 5 per cent fall in Heinz sales volumes.
Heinz says that the major growth stories in table sauces come from
more exotic flavours, such as Mexican Chilli and Heinz Sweet Chilli.
Perhaps this increased competition explains the collapse in sales of
Levi Roots’ Reggae Reggae Barbeque Sauce, which suffered a 17 per
cent fall in 2013 sales volumes following a price rise of 8.5 per cent.
Table 8.2 sets out the full story (sources for the whole story: The
Grocer and Mysupermarket.com).

Figure 8.6 Reggae Reggae Sauce

Table 8.2 Reggae Reggae Sauce sales, 2012 and 2013 (source: The
Grocer magazine)
Questions (34 marks; 35 minutes)
1 a) Calculate the price elasticity of demand for Heinz Tomato Ketchup
in 2013.
 (4)
b) Assess two reasons why this product may have this degree of
price elasticity of demand.
(8)
2 a) Calculate the price elasticity of demand for Reggae Reggae Sauce
in 2013.
(4)
b) It is believed that the price elasticity of demand for Reggae
Reggae Sauce is higher now than in the past. Explain two possible
reasons why this might have occurred.
(8)
3 The figures suggest that Heinz Tomato Ketchup has a significantly
lower price elasticity of demand than that of Reggae Reggae Sauce.
Assess the implications of that for Heinz.
(10)
Extended writing
1 You have been appointed marketing director of Topshop and set the
goal of reducing the price elasticity of its retail sales. Evaluate how
you might go about achieving this objective.
(20)
2 Evaluate how the price elasticity of demand for a product such as
the iPhone 6 might change over the four phases of its life cycle:
birth, growth, maturity and decline.
(20)
Section 1.2 The market

9 Income elasticity of demand

Definition
Income elasticity measures the extent to which demand for a product
changes when there is a change in consumers’ real incomes. The
shorthand YED is often used for income elasticity of demand.

Linked to: Price elasticity of demand, Ch 8; Economic

influences, Ch 45.

9.1 Introduction
Price elasticity focuses on what the business can do to maximise its revenue
and profit given the products it has, their differentiation and competitors.
Income elasticity starts from a different point. It looks at how a company’s
sales will be affected by changes in the economy – that is, changes that are
totally outside the company’s control. As shown in Figure 9.1, falling
household incomes and confidence at the start of the recession hit UK car sales
sharply in 2008 and 2009. A 5 per cent fall in real incomes pushed new car
sales down by 15 per cent between 2007 and 2009. This was nothing compared
with Italy and Greece when austerity measures hit them between 2010 and
2012. Car sales in Italy halved, while in Greece they fell by 75 per cent. All car
companies could do to survive was to cut production and cut costs (and look to
China where car sales were still booming).
Figure 9.1 New car sales and the economy
Income elasticity is important because it shows the direction and the extent to
which sales change when real incomes change.

9.2 What is meant by real incomes?

The government’s Office for National Statistics (ONS) provides data each
month on the rate of change in average earnings. This is the amount the
average employee receives before any deductions for tax or pension
contributions. That is their gross income. In July 2014, this figure for average
pay was 0.6 per cent higher than the previous year. So people were 0.6 per cent
better off.
Or were they, because in that same period prices (the rate of inflation) rose by
1.6 per cent. So consumers had 0.6 per cent more income, but had to pay 1.6
per cent more for their shopping basket. In effect, then, they were 1 per cent
worse off.
Real incomes are measured, then, by the formula:
% rise in average earnings minus % rise in prices = % change in real
income
Another way of expressing this is to say that real incomes are incomes after
allowing for inflation.
9.3 Calculating income elasticity of demand
In the recession year of 2009, UK car sales fell by 6 per cent. More expensive,
luxury cars were especially hard hit. BMW sales fell 12 per cent, Lexus by 28
per cent and Bentley by 50 per cent! Some cheaper cars actually enjoyed sales
increases, with Skoda sales up by 1 per cent and Fiat by 9 per cent. These
changes in sales were a consequence of the different income elasticities of
demand for these different brands.
Income elasticity is calculated using the formula shown below:

For example, in 2009 real incomes in the UK fell by 6 per cent. Therefore, the
income elasticity of demand for the car market as a whole was:

So the UK car market proved to have an income elasticity of 1 (meaning a one-

for-one relationship between changes in income and changes in demand). The
car brands mentioned above had the income elasticities shown in Table 9.1.

Table 9.1 UK car income elasticities of demand calculated from the

2009 recession year

9.4 Interpreting numerical values for income

elasticity
There are three categories a product can be put into:
• a ‘normal good’, with positive income elasticity of demand, and a YED of
between 0.1 and 1.5
• a ‘luxury’ good, with very positive income elasticity of demand more than
1.5
• an ‘inferior ’ good – that is, one with negative income elasticity of demand
(so, as people get better off, they buy less of it, perhaps including orange
squash or Asda Value Milk Chocolate).
In the case of the data in Table 9.1 you can see that BMW, Lexus and Bentley
are luxury car brands because they each have an income elasticity of demand
of more than +1.5. And, clearly, if BMW is a luxury, Lexus is a greater luxury
and Bentley is a huge self-indulgence! Note that Bentley’s figure of +8.3
implies that in a year when real incomes rise by 3 per cent, Bentley sales
should jump by 3 × 8.3 = 25%. In the first eight months of 2014, with the UK
economy growing at 3 per cent, Bentley sales were up by 21 per cent.
Table 9.1 also shows two ‘inferior ’ goods: Skoda and Fiat. Both enjoyed rising
sales when the economy worsened. Note here that the term inferior is not a
comment on the quality of the item. It is simply a technical term for a product
or service that has negative income elasticity.

9.5 Factors influencing income elasticity of demand

Why do some products, services or brands have positive and others have
negative income elasticity of demand? And why is the income elasticity for
some items strongly positive and for others only slightly positive? The main
factors influencing income elasticity are as follows.

Whether the product is a necessity or a self-

indulgence
When incomes are rising, people feel happier to splash out on luxuries.
Therefore, posh hotels, business-class travel and champagne all enjoy sales
booms in good times, but suffer sharp sales declines when real incomes are
falling. During the global recession year of 2009, champagne exports from
France fell by 28 per cent. So, for luxury products, income elasticities are
strongly positive, such as +4. It is important, then, to remember that a figure as
high as +4 is wonderful when the economy is healthy, but a huge burden when
times are tough.
‘In the affluent society, no useful distinction can be made between luxuries
and necessities.’
J.K. Galbraith, great economist and author (The Affluent Society)
By contrast, necessity goods will have low (but, usually, positive) income
elasticities of demand. Toilet paper, shampoo and petrol will all tend to have
advancing sales when real incomes are rising, but not by much. Sales of toilet
paper, for example, seem to have an income elasticity of demand of about +0.5.
If households are 2 per cent better off, they spend an extra 1 per cent on toilet
paper.

Who buys the product

Some luxury products are bought only by the super-rich. Their incomes may
not be affected by a change in ‘average’ real incomes. So although a time of
recession may hit sales of £800 handbags from Mulberry, the demand for
Hermes or Chanel bags may be unaffected. It is important to measure income
elasticity of demand for each individual brand rather than assume that all posh
bags are the same.
‘You do not build brand value by saying how cheap you are. You do build
brand value by reinforcing how special you are.’
Larry Light, brand consultant

Positive and negative elasticity

When measuring income elasticity, it is crucial to state whether the answer is
positive or negative. Between 2008 and 2013, the UK economy was struggling
more than at any time since the 1930s. Yet Poundland’s sales trebled between
2008 and 2014 and grocery discounters Lidl and Aldi enjoyed a sales and
profit boom. When real incomes are falling, consumers trade down to where
they can find the right value and the right prices for their slimmed-down
wallets. When falling incomes lead to a sales boom, the product or service has
negative income elasticity.
By contrast, the majority of products and services have positive income
elasticity of demand – that is, the better off we feel, the more we spend and buy.
Most goods are ‘normal’, in that their income elasticity is about +1, meaning
that a 3 per cent rise in real incomes would cause a 3 per cent rise in sales.

9.6 The significance of income elasticity to

businesses
Knowing the income elasticity of a product is vital in order to develop a well-
balanced product portfolio. Because inferior goods sell well during
recessions, it is helpful for a company to have inferior goods as well as luxury
goods. Nevertheless, as the UK economy tends to grow at around 2.5 per cent a
year in the long term, normal and luxury goods are the most important part of
a long-term strategy.
Data on a product’s income elasticity can be used for two purposes, as outlined
below.

Sales forecasting
In November 2008, Poundland had 200 stores. By December 2014, the number
had risen to 550. By the end of 2014, with the worst of the recession over, how
many shops should it plan to open in the coming years? A clear starting point
was to look at forecasts of economic growth in the UK, together with forecasts
of likely changes in real incomes. If and when the forecasts turned strongly
positive, it would probably forecast that Poundland sales would be flattening
off and therefore store-opening plans should be put on hold.
For a company such as Jaguar Land Rover, a quite different sales forecast
would be made. Rising real incomes would mean higher sales and, therefore,
at some stage, higher production capacity and hiring and training new staff.

Financial planning
Once a business can forecast its future sales level, it can start to plan for the
financial implications. If sales are likely to boom, higher production will be
needed and probably a significant amount of extra funding, perhaps requiring
a bank loan or a rights issue (asking existing shareholders to buy extra shares
at a discount). If sales look likely to fall, a finance director will know that a trip
to the bank would be a mistake. The business will try to find a plan to cut its
cash outgoings in order to survive the problem period.

Figure 9.2 Logic chain: using income elasticity data

Five whys and a how

9.7 Income elasticity of demand – evaluation
Income elasticity is a hugely important concept because it acknowledges how
vulnerable companies can be to changes in the economy. When economic
growth is steady, some chief executives forget that bad times can arrive
suddenly and unexpectedly. By the time a recession has started, it may be too
late to try to find a new product with negative income elasticity. So much
cleverer to be Volkswagen, having already acquired Skoda, or Renault, with its
low-priced Dacia brand.
Success in business is largely about thinking and planning ahead, allowing
long-term strategies to be developed. Just focusing on price elasticity can
deceive a boss into thinking s/he has more control over demand than is really
the case. Income elasticity is the reminder that demand is, at least in part, a
function of forces outside the firm’s control.

Key terms
Negative income elasticity: a product for which sales fall when people
are better off (but rise when people are worse off).
Positive income elasticity: a product for which sales rise when people
are better off (but fall in recessions).
Recession: two or more quarters of negative economic growth.

9.8 Workbook
Revision questions
(30 marks; 30 minutes)
1 Calculate the income elasticity of demand for a product that sold
20,000 units in 2008, and 22,400 in 2009, when real incomes in the
UK fell by 6 per cent.
(4)
2 For each of the following, explain whether you think the
product/service is a normal, a luxury or an inferior good. Make your
reasoning clear.
a) a railway commuter’s return ticket
b) a trip for the family to Disneyland Paris
 c) a can of Tesco Value tomato soup.
(9)
3 Are these products normal, luxury or inferior?
a) Product A: income elasticity −1.5
b) Product B: income elasticity +4.5
c) Product C: income elasticity +0.9.
(3)
4 See the quote by Larry Light on page 53. Explain the implications of
the quote for the income elasticity of demand for a product or
service of your choice.
(5)
5 Explain the circumstances that might lead a product that is a normal
good to become an inferior good over a period of two or three
years.
(3)
6 Pol Roger champagne sells 10,000 bottles a month in the UK at
£30 a time. Its PED is −0.4 and its YED is +6.
a) Calculate the value of its UK sales next year if real incomes rise
by 2.5 per cent.
(3)
b) Briefly explain how Pol Roger might use the data on its price
elasticity of demand.
(3)
Data response
Income elasticity
Figure 9.3 shows the difference between the rise in wages and the rise
in prices between 2001 and 2014 – and therefore shows the trends in
real wages. In the period from January 2010 to July 2014, Aldi’s share
of the UK grocery market rose from 2.8 per cent to 4.8 per cent, while
Tesco’s share fell from 30.3 per cent to 28.9 per cent. Look at Figure
9.3 and answer the questions below.
Figure 9.3 Percentage change in earnings compared with prices
(Consumer Prices Index) (source: ONS, September 2014)
Questions
(25 marks; 30 minutes)
1 Explain what the graph is showing about real wages in the UK
between 2001 and 2014.
(5)
2 Assess what the text and diagram imply about the income elasticity
of:
a) Tesco
b) Aldi (no need for calculations).
(8)
3 In mid-2013, UK households were suffering a 2 per cent fall in real
incomes. In that period, sales at Aldi rose by 18 per cent.
a) Calculate the implied income elasticity figure for Aldi.
(4)
 b) Assess two possible factors that may be distorting the apparent
correlation between Aldi’s sales and consumers’ real incomes.
(8)
Extended writing
1 A young designer of women’s shoes wants to create a top-end
luxury shoe brand. Evaluate how this might be achieved and the
advantages and disadvantages of achieving it.
(20)
2 Evaluate the possible difficulties of determining the income elasticity
of demand for a brand such as the Samsung Galaxy, given the ever-
changing nature of the mobile phone market.
(20)
Section 1.3 Marketing mix and strategy

10 Product and service design

Definition
Design means finding the right balance between creating something
that people desire to have, that they can afford to buy and that works
reliably.

Linked to: Market research Ch3; Market positioning, Ch4;

Price elasticity of demand, Ch8; Branding and promotion,
Ch11; Quality management, Ch44.

10.1 Introduction to design

The design of a product is not just about its appearance and shape. It is also
about the product’s function, quality and durability. Designers work to a design
brief, which tells them the criteria for looks, cost and quality. All must be
considered in designing the finished product. Larger firms have their own
design teams on the payroll. Smaller firms may rely on design consultants to
turn a product idea or requirement into a finished product.
Good design adds value to products and can be the key differentiator that
marks one brand out from its competitors. No other UK firm has been quite as
successful at this as Dyson Ltd. Famously, James Dyson created 5,127
prototypes of his first vacuum cleaner before he was satisfied that he had
perfected the cleaning mechanism. The modern Dyson empire, though, with
global sales of £6 billion and profits of £800 million a year, owes a huge
amount to visual (aesthetic) design. The patent on Dyson’s ‘dual cyclone’
vacuum mechanism expired in 2001. Yet the distinctiveness of the products has
continued to generate huge sales success even though Dyson prices are often
double those of its competitors.
Figure 10.1 James Dyson

10.2 The design mix

‘When you say ‘design,’ everybody thinks of magazine pages. So it’s an
emotive word. Everybody thinks it’s how something looks, whereas for
me, design is pretty much everything involved in making something.’
James Dyson, vacuum design billionaire
A useful way to consider design is through the design mix. Every designer
must consider the following three factors.
1 Aesthetics: the look, feel, smell or taste (that is, the appeal to the senses).
2 Function: does it work? Is it reliable? Is it strong enough or light enough for
the customer ’s purpose?
3 Economic manufacture: is the design simple enough for it to be made
quickly and efficiently and therefore relatively cheaply?
Figure 10.2 The design mix
In some cases, all three factors will be of equal importance. In most, there will
be a clear priority. As Figure 10.2 shows, with own-label lemonade, cheap
production would be the overwhelming priority. So design will focus on
simplicity, using a standard plastic bottle shape and low-cost materials that are
easy to manufacture. For BMW, design for function would be important, as
would the car ’s appearance. Production costs will be a lower priority. Firms
decide on their design mix after careful market research to identify the
purchasing motivations of existing and potential customers. Table 10.1 gives
some indications of other design priorities for businesses.
Table 10.1 Design priorities for different products and services

Real business
Design disaster
In early 2014, Adam Pritchard, boss of £8 million juice brand
‘Pomegreat’, relaunched the brand as ‘Simply Great’ with a new pack
design featuring ‘superhero’ brand mascots. Pomegreat had built up
sales steadily since its launch in 2000, securing supermarket listings
and a ‘loyal, middle-aged customer base’. Pritchard believed that a
new, younger market could be attracted by the superhero logos and a
new range of ‘superfruits’, including mango and cranberry.
The result was a sales disaster. Within six months. sales had halved.
Old-time customers walked away while very few new ones were
attracted. Pritchard bit the bullet, brought out a new-but-like-the-old
design in early November 2014 and within weeks sales were jumping
ahead.
Design matters.
Figure 10.3 The design process

10.3 Changes in the mix to reflect social trends

Concern over resource depletion

With the global population forecast to grow from seven to eleven billion by
the end of the century, people worry that key resources such as fresh water will
not be able to keep up. They may be depleted to the point that there is not
enough to go round. The same could be true of any other resource that is finite
– that is, in limited supply. By definition, that is true of minerals such as iron
ore and gold, as we have only one planet. Other resources that are a concern
include fish stocks, crops that like cool climates (if the planet continues to get
warmer) and essentials such as oil and wood.
Sustainability means that the purchase you make will not affect long-term
supplies of the product because it is automatically replenished. For example,
although cod is an endangered fish, with a serious risk that supplies will dry
up, there are plenty of supplies of other fish available, such as pollock. Birds
Eye has given in to pressure to reduce the amount of cod in its fish fingers,
using pollock instead. Pollock and chips, anyone?
As resources deplete, their price will rise. This will be the signal for designers
to try to find alternative solutions based on different materials. Oil is the basis
for all plastics. If oil starts to run out, there may need to be a switch back from
plastic bottles to glass. Fortunately, that may be aesthetically pleasing.

Designing for waste minimisation and re-use

A well-designed product can be manufactured with minimal wastage. This
process starts with computer-aided design (CAD) software, which enables the
designer to work out the wastage implications of the production process. Waste
minimisation keeps production costs down and helps reduce the environmental
footprint of the business. This, in turn, might be used as a marketing message
to convey to customers: ‘We are serious about every aspect of the
environment.’
Re-usage is also potentially important. Economic growth in the twentieth
century was associated with an increasingly disposable society. Disposable
lighters, razors, torches and even clothes became fashionable.

Recycling
Waste materials can be disposed of in one of only three ways: burn them, bury
them or reuse them. Burning them directly increases greenhouse gas emissions
and burying them is not only destructive of the environment, but can also cause
air pollution. The ideal solution is therefore recycling, which means re-using
as much as possible of the original materials. There are simple solutions to
this that shoppers seem uninterested in: for instance, getting milk from a
milkman who collects, washes and refills glass milk bottles; people are
sufficiently ill-focused to make a fuss about recycled plastic when there is a
much better solution available. Nevertheless, individual businesses cannot
concern themselves with re-educating the public; their duty is to attract custom.
‘A common mistake that people make when trying to design something
completely foolproof is to underestimate the ingenuity of complete fools.’
Douglas Adams, author of Hitchhiker’s Guide to the Galaxy
In 2014, Colgate–Palmolive announced their intention that by 2020 they would
switch to using environmentally friendly toothpaste tubes made from a mixture
of paper pulp and recyclable plastic. This may have an impact on the aesthetics
of the toothpaste tube (drabber colours, perhaps, or less comfortable to hold).
But there will also be a functional benefit that can translate into a new
marketing proposition: good for your teeth; good for the planet.

Figure 10.4 Logic chain: design matters

10.4 Ethical sourcing
The Ethical Sourcing Forum (ESF) has been operating since 2002 to try to
give western companies an idea about the reality of working conditions and
practices in different parts of the world. In January 2014, they published a
report on Bangladesh – doubtless in the aftermath of the 2013 Rana Plaza
industrial disaster in which 1,130 garment workers were crushed to death. ESF
carried out their research in 400 factories in Bangladesh and found huge
inconsistencies within this little-regulated business environment. In 40 per cent
of footwear factories, there were too few emergency evacuation exits. The
same industry was the worst on a series of measures: wages, excessive
working hours and many others. One of the most striking findings was that in
80 per cent of cases in the footwear sector, inspectors were unable to find
evidence that workers were allowed a day off a week (as is required by local
laws).
For western retailers of clothing and footwear, the working conditions in
countries such as Bangladesh, India and Cambodia have become an important
issue. Not, in reality, due to the ethical and moral values of the company
directors, but because several embarrassing TV and newspaper revelations in
the past have made them wary of bad publicity. For ‘ethical sourcing’, it is
better to assume ‘sourcing based on fear of ethical revelations’. These are not
the same thing.
The term ethical sourcing can be taken in two ways:
1 Sourcing based on the manufacturer or retailer ’s ethical values: this might
include buying supplies from known businesses or farms, where the
customer knows the supplier treats staff, animals and the environment with
respect. Implicitly, for this to be based on ethics, the customer must be
prepared to sacrifice some profit in this buying process.
2 ‘Ethical sourcing’ may also be a buzz-term, almost a cliché within a
business. In 2009, Cadbury announced that its Dairy Milk brand would ‘go
Fairtrade’. It remains so, yet most Cadbury brands based on Dairy Milk
chocolate are not Fairtrade. This surely suggests that Cadbury took that
purchasing decision on the grounds of consumer image and profit
maximisation, not through principle. Does this matter? Well, yes, because it
would be nice to trust that a company is genuinely concerned about ethical
sourcing; in most cases, you have to read the packaging with great care to
be sure of how the supplies have been obtained.
Recent years of recession have made it look as if the British consumer takes
‘premium’ sourcing seriously only in good times. When the 2009 recession
arrived, sales of organic food reversed a longstanding upwards sales trend
(see Figure 10.5). The slight economic recovery in 2013 presaged a slight
improvement in sales of organics. During that same period, sales of Fairtrade
produce rose sharply, but that may have been mainly due to supply decisions
(Cadbury and Dairy Milk, and Nestlé and Fairtrade KitKat) rather than demand
ones.
And what is the relevance of all this to design? In some companies, there will
be little or none. Designers at Apple have a critical job to do – but they are not
involved at all in the process of getting the products made. Many would have
no idea of where key components are made – or the conditions for the workers
involved. In other companies, designers would have a greater overall
responsibility for the coherence of the product. There is not much point in a
beautifully designed dress being made from sustainably sourced cotton if the
silk lining is made by child labour in south-east Asia.

Figure 10.5 Sales value of organic food in the UK (source: Soil

Association Annual Reports)

Five whys and a how

10.5 Product and service design – evaluation
The fundamental theme for evaluating any question involving design is the
contrast between long- and short-term thinking. Part of the brilliance of
Mercedes engineering is that, although the cars develop year by year, there are
design themes that keep a Mercedes completely recognisable. Companies
whose objective is short-term profit maximisation are unlikely to think in this
way. The key is to take a long-term view, then stick to it. This is what
Pilkington did with its self-cleaning glass, which took ten years to perfect. The
Toyota Prius took more than ten years to become profitable. As a past
Guinness advertisement once said: ‘Good things come to those who wait.’
‘Design can be art. Design can be aesthetics. Design is so simple, that’s why
it is so complicated.’
Paul Rand, art director and logo designer

Key terms
Prototype: a test model of a planned design, used to see if it functions
properly, with durability, reliability and safety.
Sustainability: making something using materials that will still be around
for future generations, perhaps because you are planting a tree for
every one you fell.

10.6 Workbook
Revision questions
(30 marks; 30 minutes)
1 Explain how resource depletion might affect the future design of
motor cars.
(4)
2 Explain where you would plot the following on Figure 10.2. Give
your reasoning:
a) the latest iPhone
b) the packaging of a Cadbury £5 Easter egg
c) a new double-decker bus for London.
(9)
3 Explain two marketing advantages that good design could bring to a
business of your choice.
(8)
4 How are the concepts of short-termism and design linked?
(3)
5 Briefly state and explain whether ethical sourcing would be important
to customers in the following circumstances:
a) the sourcing of a meat pie at Charlton FC’s snack bar
b) the sourcing of a meat pie at Dundonald Primary School
c) the sourcing of a silk scarf sold at a department store.
(6)
Data response
General Atomics: making a killing from drones
Drones are unmanned aircraft that are used for military and
surveillance purposes. The market for drones is dominated by four
American companies: Boeing, Grummand Northrop, Lockheed Martin
and General Atomics. The biggest buyer of drones is the American
government. They have been used in Afghanistan and Pakistan to kill
locals who were terrorist suspects. From the government’s point of
view, the main advantage of drones over boots on the ground is that
they enable a government to kill its enemies without risking the lives of
its service personnel. There is a huge amount of profit to be made
from supplying the government with military equipment such as drones.
According to the Stockholm International Peace Research Institute,
the American government’s military budget in 2013 was $640 billion,
which is more than the rest of the world’s military spending put
together.
The MQ-9 Reaper is an armed drone that fires Hellfire missiles. It was
developed by General Atomics for the US government at a cost of
$2.8 billion. Unsurprisingly, the research and development programme
that led to the creation of the MQ-9 Reaper was kept secret to ensure
that competitors to General Atomics were unable to design a ‘me-too’
product. The $2.8 billion investment made by General Atomics has paid
off. By 2013, the American government had bought 106 Reapers at a
cost of over $6 billion. Now General Atomics has a new drone to sell –
the Avenger. As the photo shows, even though drones may never be
seen by the enemy, the design features matter – a warplane should
look aggressive; the Avenger certainly does.
Questions (40 marks; 45 minutes)
1 Use the design mix to assess the right combination of function,
aesthetics and economics when designing a plane such as the
Avenger.
(10)
2 Look at the James Dyson quote on page 56. Assess how well his
thoughts relate to the world of General Atomics and drone
bombers.
(10)
3 Evaluate the importance of design to the profitability of a business
such as General Atomics.
(20)
Extended writing
1 Evaluate the extent to which success is guaranteed for a producer
with a brilliantly designed new product.
(20)
2 The Co-op, Waitrose and Sainsbury’s all boast about their ethical
sourcing. Yet, in 2014, annual sales growth at each company was
−1.3 per cent, +5.6 per cent and −2.5 per cent, respectively.
Evaluate whether consumers really care about ethical sourcing.
(20)
Section 1.3 Marketing mix and strategy

11 Branding and promotion

Definition
Branding is the skill of giving a product or service distinctiveness –
even personality. Promotion is the part of the marketing mix that
focuses on persuading people to buy the product or service.

Linked to: Market research, Ch 3; Product and service design,

Ch 10; Marketing strategy, Ch 15.

11.1 Introduction to branding

Branding is the process of creating a distinctive and lasting identity in the
minds of consumers. Establishing a brand can take considerable time and
marketing effort, but once a brand is established it becomes its own means of
promotion. The brand name is recognised and this makes it more likely that the
customer will buy the product for the first time. If the experience is
satisfactory, the customer is very likely to continue to choose the brand. Once
established, branding has many advantages, such as the following:
• It enables the business to reduce the amount spent on promotion.
• Customers are more likely to purchase the product again (repeat purchase).
• It is easier to persuade retailers to put the products in their stores.
• Other products can be promoted using the same brand name.
‘The best advertising is done by satisfied customers.’
Philip Kotler, marketing guru

Real business
In June 2014, in the streets of Uruguay, only one brand mattered:
Adidas, as worn by Luis Suarez. His two goals against England when
half-fit, plus what was taken as European Suarez persecution when he
was banned from the World Cup, made him a super-hero. Adidas boots
went from being desirable to being essential. Elsewhere in 2014, Nike
won the sales battle with Adidas. Not in Uruguay.

11.2 Types of branding

Individual brand
Some brands are so powerful and distinctive that they stand on their own, such
as Marmite. Do you know who makes Marmite? Probably not. Unilever is keen
to have its corporate brand on many other products, but with Marmite you
have to read the small print at the back of the label. The manufacturer has no
interest in you associating Marmite with other Unilever brands such as Persil
or Wall’s (Marmite ice cream, anyone?). A huge benefit of keeping brands
individual is that a publicity disaster for one has no effect on the others. At the
time of writing, Tesco is getting a daily hammering by news media, which
must have a dampening effect on the image and sales throughput at Tesco Extra
(hypermarkets), Tesco Online, Tesco Metro and so on.

Brand family
Cadbury is now one division of the huge, American-owned Mondelez
International. Cadbury itself is perhaps the ultimate British brand family.
Whether you buy a Twirl, a Wispa or a bar of Dairy Milk, the Cadbury logo is
prominent. It adds value, it adds acceptability (‘I’ll try that, it’s from Cadbury’)
and it adds a comforting familiarity – we know we’ll like the chocolate taste
and texture because we’ve known it since childhood. A good brand has
emotional qualities (even if they’re largely subconscious). Even if you know
that Cadbury is now owned by an American multinational, it makes no
difference to the warmth of the association with the brand.

Corporate brand
In the global food business, there are three mighty corporations: Nestlé,
Unilever and Mondelez. Of those, only Nestlé feels the need to put its logo on
everything. So it’s Nestlé KitKat, Nestlé Cheerios and Nestlé Munch Bunch
yoghurt. Nestlé wants to reinforce its corporate brand – clearly believing that it
adds credibility to the individual brand names. From a UK perspective, this
may not really be true; but if you went into a shop in Thailand and saw a Nestlé
branded ice cream, it might provide the reassurance you need.
Branding became important in Britain in the nineteenth century as a way to
reassure customers of quality and reliability in a world where shopkeepers
regularly added (cheaper) powdered chalk to flour and sawdust to tobacco.
Today we have consumer protection laws, but occasional scares such as the
2012 horsemeat scandal remind us of why it is nice to have a brand to trust.
‘The art of marketing is the art of brand building. If you are not a brand
you are a commodity.’
Philip Kotler, marketing guru
Among the benefits of strong branding are:
• Added value: a strong brand gives reassurance and may provide aspirational
benefits; some men grow up aspiring to own a BMW or a Ferrari. The brand
sums up all the benefits consumers see in the product (or service) and
therefore adds value to the purchase.
• Charging premium prices: a recent report showed that the UK market leader
in instant coffee (Nescafé) can charge customers £19.52 per kilo, while
supermarket own-label coffees average £12.25. That premium of £7.27 per
kilo means Nescafé is priced nearly 60 per cent higher than own-label
coffees. This added value gives huge scope for making Nescafé a very
profitable brand.
• Reduced price elasticity: strong branding can be placed somewhere on the
spectrum from brand loyalty to brand obsession. People willing to queue 24
hours for a new phone must come into the obsession category. But there are
others: football club supporters, players of Grand Theft Auto and those who
have to be dressed in a particular fashion brand. Brand loyalty lowers price
elasticity, enabling the producer to push prices up with little damage to sales
volumes. Brand obsession makes this passport to profit even easier.
• Combatting the discounters: at a time when Lidl, Aldi and Poundland are
among our most successful retailers, weak brands are being squeezed out. In
2013, a remarkable thing happened: a £100 million brand, number two in its
market (disposable nappies), withdrew from the UK market (see Figure
11.1). Huggies gave up in its battle against Pampers. The owner of Huggies
(Kimberley Clark) said it couldn’t make a profit when up against the strength
 of Procter & Gamble’s Pampers. A strong brand gives you the power to hold
firm against discount retailers. Weaker brands have to cut their prices to £1
(for Poundland) or accept marginally profitable orders from other retailers.
Weak brands always struggle to survive.

Figure 11.1 UK market for disposable nappies (source: The Grocer,

2009–2014)
‘Authentic brands don’t emerge from marketing cubicles or advertising
agencies. They emanate from everything the company does…’
Howard Schultz, founder of Starbucks

11.3 Ways to build a brand

Building a brand has a timescale that matches the phases of a product life cycle.
Heinz has built a brand in the UK based on more than a hundred years of beans,
soup and ketchup. By contrast, Snapchat built a brand in months rather than
decades. Possibly that makes Snapchat’s brand quite brittle, whereas Heinz
could cope with the odd flash of bad publicity.
Ways to build a brand include the following:
• Unique selling points (USPs) are an extreme version of product
differentiation. Coca-Cola’s USP is that it was the original cola drink; no-one
can match that. In many cases, though, a USP is a temporary benefit because
it can be copied. Most of the iPhone’s original features have been copied by
rivals; often its main differentiator is simply the brand name.
• Advertising: in 2014, Nestlé backed its superstar £425 million brand Nescafé
 with £10 million of advertising (mainly on TV). The previous year it did
much the same. When a brand is as profitable as Nescafé, it would be foolish
to do anything else. Partly the advertising is to keep reinforcing messages
about the superiority of the product, and partly it is to encourage new,
younger buyers to tap into the mainstream consumer decision. In the UK,
coffee means Nescafé.
• Sponsorship: this is an attempt at long-term brand-building that, when done
cleverly, can help give a brand a ‘personality’. Over the years, Richard
Branson’s Virgin has been clever at this. More recently, Red Bull has taken
some beating. It supports its £250 million UK brand with its backing for
extreme sports and Formula 1 motor racing. The cool image established by
this helps it fight Coca-Cola’s energy drink brands: Monster and Relentless.
• Use of digital media: not everyone can afford to sponsor an F1 team (its
sponsorship costs Red Bull £80–£100 million a year). So social media offer
interesting alternatives. Adwords (bought from Google) allows an advertiser
to spend a fixed maximum. Soft drink producer AG Barr could promote its
Rockstar energy drink by ‘buying’ Red Bull. It might pay Google 50p for
listing Rockstar above Red Bull, whenever anyone ‘Googles’ Red Bull. If it
set a maximum spend of £40,000, then after 80,000 Red Bull Googles its
money would run out. In the meantime, AG Barr would hope to have
attracted lots of energy drink fans to consider the Rockstar brand.
‘Your premium brand had better be delivering something special, or it’s
not going to get the business.’
Warren Buffett, multi-billionaire investor

11.4 Changes in branding and promotion to reflect

social trends

Viral marketing
For more than 30 years, marketing companies have been fascinated by the
thought that brand messages can spread like a virus, from mouth to mouth.
Many premium products were launched into highly selected retail outlets and
promoted only in selected magazines, in the hope that word would spread. This
is how Häagen-Dazs ice cream began and how Jimmy Choo developed (more
than 20 years ago). Today’s social media add a huge extra dimension to viral
marketing – speed. One tweet from Ronaldo (32 million followers) about a
great restaurant could book the place out for months to come. Inevitably, then,
companies try to find ways to manipulate supposedly ‘social’ media for their
own commercial benefit.
‘Focus on how to be social, not how to do social.’
Jay Baer, US marketing consultant and author

Social media
This has become a serious alternative to standard press or TV advertising.
There are three important benefits to firms from this form of digital
marketing:
• The targeting can be especially tightly targeted at the precise tastes and habits
of each individual, including noting changes in their behaviour, such as
when they move from home to university.
• Traditional advertising was a one-way process from company to customer;
social media provide the interactivity that may help create some bonding
between consumer and brand.
• The success of crowdfunding sites such as KickStarter show that people are
interested in getting involved in businesses, as long as they share the
apparent aspirations of the proprietors. This, again, helps create a two-way
bond.

Real business
At Christmas 2014, there was an advertising battle for hearts and
minds between John Lewis, Sainsbury’s and Marks & Spencer. John
Lewis featured a tearjerker based on penguins, Marks & Spencer went
for fairies and ‘magic sparkle’, and Sainsbury’s focused on the famous
Christmas football match on the First World War frontline. All three
spent millions on making the TV advertisements and buying the airtime.
But what about the social media impact of the three campaigns? Retail
Week magazine reported (12 December 2014) that the campaigns
could be measured on ‘Buzz’ (blogs, forums and tweets), on Reach
(how many accessed the commercials through social media) and
Hashtag use. The social media results are shown in Table 11.1.
Table 11.1 Social media results of three Christmas advertising
campaigns
Understandably, Retail Week declared Sainsbury’s the winner.

For companies, the ultimate question is whether spending on social media

provides a sufficient return on the money spent. Although this question cannot
be answered satisfactorily by most companies, they feel that they are better off
being in than out. The company that ignores the digital, online world may
become the Morrisons of its own sector.

Figure 11.2 Logic chain: traditional v. online advertising

Real business
In 2014, with coffee sales stalling in America, Starbucks decided to
broaden its appeal from its target of young professional adults.
Parents started to notice their teenage and pre-teen kids showing
new-found enthusiasm for Starbucks’ 13,000 US outlets. The
company had started selling a ‘secret menu’ of drinks that had gone
viral via posts on Instagram and other social media. Only those in the
know would think to ask for a ‘Grasshopper Frap’ or a ‘Cotton Candy
Frap’. One parent reported that, when her tweenaged daughter asked
for a Cotton Candy Frap, the shocking pink drink was served with a
knowing wink. The thrill of posting a pic to her mates seemed to make
up for the vile taste. Apparently, McDonald’s and others are playing
with the secret menu concept after Starbucks’ success.

Emotional branding
Like viral marketing, this is nothing new. The Andrex puppy arrived in 1972,
and since then has appeared in countless commercials, all trying to create an
emotional connection with the brand. All that may prove to be different is the
ease with which a two-way connection can be created and – perhaps even more
powerfully – a community of followers can be established that becomes self-
sustaining. This, in theory, should be a bunch of fans who post emotional
commitments to the brand, be it a fashionable restaurant or a pop group. The
reality, though, is often that for every fan there is another disillusioned fan,
keen to break the emotional bonds. In business, there are rarely any easy ways
of marketing your product.

11.5 What is promotion?

Promotion is a general term that covers all the marketing activity that informs
customers about a product and persuades them to buy it. The different elements
of promotion can be grouped into two broad categories: those that stimulate
short-term sales and those that build sales for the long term. This distinction
provides the basis for analysis of most business situations and questions.
Types of promotion for building long-term sales include those described
below.
Persuasive advertising
Persuasive advertising is designed to create a distinctive image. A good
example is BMW, which has spent decades persuading us that it produces not a
car but a ‘Driving Machine’. Advertising of this kind has also helped to create
clear consumer images for firms such as Tesco and L’Oréal (see Table 11.2).

Table 11.2 Examples of persuasive advertising

Real business
Social media advertising – Samsung
Samsung has its own YouTube channel which it uses to publicise short,
humorous films designed to boost its smartphone sales by niggling at
Apple’s iPhone. The films portray Apple users as middle-aged and
mock them gently for being out of touch with modern technology. The
best-known of these clips shows Apple fans queuing outside an Apple
store for the latest iPhone. While waiting, the middle-aged Apple fans
notice younger pedestrians walking by with phones that are
‘magnificent’. Samsungs, of course. Further use of social media to
spread these films virally helped undermine Apple’s once-impregnable
share of the US market for smartphones.
Public relations
This is the attempt to affect consumers’ image of a product without spending
on media advertising. It includes making contacts with journalists to try to get
favourable mentions or articles about your product. It would also include
activities such as sponsorship of sport or the arts (see Figure 11.3). In 2014,
Waitrose decided to sponsor the England cricket team. The upmarket image of
cricket would be the perfect match for the posh image of Waitrose stores.

Figure 11.3 Sports sponsorship can boost a brand’s image

Types of promotion for sparking short-term sales include those described
below.

Buy one get one free (BOGOF)

This type of offer is a desperate, highly short-sighted way to generate sales. It
will boost demand, but at the cost of short-term profit margins and at the risk
of undermining the credibility of the brand. Would BMW do it (buy one BMW
get another free)? Would Apple? No. Nor should anyone else.

Seasonal price promotion

After the summer, seaside hotels face months of empty rooms. Sensible, then,
to promote price promotions on your website, or on hotel websites such as
Laterooms.com. This can be an effective way to boost capacity utilisation and
cash flow.

Five whys and a how

11.6 Branding and promotion –evaluation
Successful branding is one way to ensure good distribution and good in-store
display. Shopkeepers want to show off the latest and the classiest brands. The
big question in business is, how can you make a brand desirable? It isn’t
enough simply to make a high-quality product and charge a lot for it.
Customers desire authenticity, distinctiveness and aesthetic quality in their
brands; this can be hard to achieve. The US chocolate giant Hershey has all of
these things, but repeated research has shown that the British won’t accept the
Hershey brand.
Whenever writing about branding and promotion, there are two central lines of
thought: one, branding success is hugely difficult and may sometimes be partly
a matter of luck (right time, right place); and two, promotion always needs to
be rooted in long-term strategy; short-term sales fixes risk damaging the
brand.

Key terms
Capacity utilisation: this measures actual usage of your facilities as a
percentage of the maximum possible, e.g. a half-empty hotel has 50
per cent capacity utilisation.
Corporate brand: a brand that represents the whole company as well
as its products. For example, every JCB construction vehicle features
the JCB company logo.
Crowdfunding: obtaining external finance from many individual, small
investments, usually through a web-based appeal.

11.7 Workbook
Revision questions
(45 marks; 45 minutes)
1 Read the quote by Howard Schultz on page 63. What implications
does that have for running a business?
(4)
2 a) Analyse one of the following brands, examining what you think its
qualities are: Galaxy chocolate, TGI Fridays, Nike footwear,
Nintendo.
 (4)
b) For the brand you analysed, explain how its qualities add value.
(4)
3 a) Give two examples of a brand family.
(2)
b) Give two examples of individual brands.
(2)
4 In your own words, explain what is meant by viral marketing.
(3)
5 Outline how your school might promote itself through social media.
(4)
6 Explain what form of promotion you think would work best for
marketing:
a) a new football game for the PS4
b) a small, family-focused seaside hotel
c) organic cosmetics for women.
(9)
7 Why is it important for businesses to monitor the effect of their
promotional activity?
(4)
8 What is meant by the phrase ‘promotion needs to be effective’?
(4)
9 Explain why promotion is essential for new businesses.
(5)
Data response
Getting started in business – the cronut craze
It’s 5 am, Soho, Manhattan, and dozens of people are already in line.
Only three hours until the Dominique Ansel bakery opens. Are they
looking for work? No, they’re queuing for New York’s food craze of
2013: the cronut. And when the shop opens, they’ll happily hand over
$10 for a box containing just two of the pastries. It is said that they
can be resold at ten times the retail price, but as each customer is
allowed just one box, this would be a hard way to make a living.

Figure 11.4 The cronut craze

The cronut craze started in mid-May 2013 when bloggers spread the
word about the new combination of donut and croissant at this new
bakery. Baker-proprietor Ansel makes the flaky layers of a croissant
into a ring shape, deep-fries it, then inserts patisserie cream and tops
it off with a swirl of icing. Only 200 are made each day, so they sell out
by just after 9.00 each morning. Ansel is trying to find a way to
manufacture the cronut to meet demand throughout America. Until he
does, the queues will persist.
Remarkably, Ansel has been allowed to trademark the name ‘cronut’,
so although he has many imitators already, the ‘doissant’, the ‘zonut’
and the ‘dosant’ have not been able to convince customers that they
are the real thing. This has helped him keep the price at more than
double the typical price for a New York pastry.
But are the cronuts any good? College students Danielle Owens and
Camara Lewis clearly think so, as they’ve succeeded six times in
queueing and eating the cakes. Each month, Dominique Ansel changes
the flavour of the pastry crème filling, to encourage repeat purchase.
The Financial Times reports that ‘The deeply buttery pastry is
wonderful, crispy and stacked high with greedy, messy-to-eat layers;
the lemon-maple cream is pleasingly sickly.’ Visitors from around the
US make a beeline for the bakery. Ansel has made a brilliant start so
far to his business career. But can he turn the cronut into a nationwide
success?
Questions
(30 marks; 30 minutes)
1 Explain any evidence here of viral marketing.
(4)
2 Assess the importance of social media in the development of the
cronut business.
(10)
3 Examine three factors that may determine whether Ansel succeeds
in making cronuts a successful brand in the long term. Explain which
one you believe will prove the most important.
(16)
Extended writing
1 Evaluate whether it is time for a brand such as Cadbury Dairy Milk
to abandon traditional TV and press media to spend their whole
advertising budget on digital and social media.
(20)
2 Heinz has found that its famous brand limits it from expanding its
product portfolio, as people won’t accept Heinz chilled ready meals
or Heinz pizzas. Evaluate how it might try to overcome this
consumer resistance.
(20)
Section 1.3 Marketing mix and strategy

12 Pricing strategies
Definition
Price is the amount paid by the customer for a good or service. A
pricing strategy is the plan for setting a product’s price for the medium-
to-long term.

Linked to: Market research Ch 3; Market positioning, Ch 4;

Price elasticity of demand, Ch 8; Marketing strategy, Ch 15.

12.1 How important are decisions about price?

Price is one of the main links between the customer (demand) and the producer
(supply). It gives messages to consumers about product quality and is
fundamental to a firm’s revenues and profit margins. As part of the marketing
mix, it is fundamental to most consumer buying decisions. The importance of
price to the customer will depend on several factors, as discussed below.

Customer sensitivity to price

Consumers have an idea of the correct price for a product (see Figure 12.1).
They balance price with other considerations. These include the factors set out
below.

The quality of the product

Products seen as having higher quality can carry a price premium; this may be
real or perceived quality.

How much consumers want the product

All purchases are personal; customers will pay more for goods they need or
want.

Consumers’ income
Customers buy products within their income range; consumers with more
disposable income are less concerned about price. Uncertainty about future
income will have the same effect as lower income. If interest rates are high,
hard-pressed home-buyers will be much more sensitive to price; they need to
save money and so they check prices more carefully and avoid high-priced
items.

Figure 12.1 The ‘right’ price

Table 12.1 Price sensitivity in practice

12.2 Types of pricing strategy

A pricing strategy is a company’s plan for setting its prices over the medium-
to-long term. In other words, it is not about deals such as ‘This week’s special:
40 per cent off!’ Short-term offers are known as pricing tactics.
For new products, firms must choose between two main pricing strategies:
1 Skimming
2 Penetration.
The main advantages of each are shown in Table 12.2.

Skimming
This is used when the product is innovative. As the product is new, there will be
no competition. The price can therefore be set at a high level. Customers
interested in the new product will pay this high price. The business recovers
some of the development costs, making sure that enthusiasts who really want
the product pay the high price they expect to pay. For example, the first DVD
players came onto the UK market at a price of around £1,000. Firms use the
initial sales period to assess the market reaction. If sales become stagnant, the
price can be lowered to attract customers who were unwilling to pay the initial
price. The price can also be lowered if competitors enter the market.

Penetration
Penetration pricing is used when launching a product into a market where there
are similar products. The price is set lower to gain market share. Once the
product is established, the price can be increased. It is hoped that high levels of
initial sales will recover development costs and lead to lower average costs as
the business benefits from bulk-buying benefits.

Figure 12.2 Logic chain: pros and cons of penetration pricing

Table 12.2 Advantages and disadvantages of price skimming and price
penetration

Real business
After years of dominance by Nike and Adidas, local sports footwear
manufacturers made inroads into the Chinese market in 2010. Local
brand Li Ning pulled alongside Adidas as the industry number two
(market share by volume). The head of JWT China (advertising agency)
said, ‘The moment that a local brand can command the same price as
a multinational brand is the day that a breakthrough has been made.’
To push further, Li Ning announced a new, higher-priced product range
to sit 15 per cent below its foreign rivals. But by 2013, Li Ning was
reporting sales slumping by 25 per cent and more than 1,000 store
closures. At the same time, Nike sales in China slipped by just 3 per
cent. The price breakthrough hasn’t happened yet.
Figure 12.3 Li Ning brand

Pricing strategies for existing products

Cost-plus
For existing products, the key is to be clear about where your brand is
positioned in the market. Pricing strategy on the latest Mercedes sports car will
be based on the confidence of the company in the strength of its brand name.
Mercedes will not worry about what Ford or Mazda charge for a sports car, or
even the prices of its BMW or Lexus rivals. Mercedes can price a sports car on
the basis of cost-plus. That means calculating the production costs per car, then
adding a percentage mark-up that reflects the profit level the company wants
from the product. Naturally, every business would like to be able to use this
method. It virtually guarantees making a profit – and perhaps a large profit.
But few businesses are in a position to ignore competitors’ prices. In autumn
2014, a new Mercedes SL sports car carried a price tag of £72,500.
To calculate a price based on cost-plus:
Cost–plus formula: Unit cost + (% mark-up)
Step 1 – calculate unit cost:
Step 2 – add your desired mark-up (clothes shops typically add a 100 per cent
mark-up; small grocers add around 25 per cent).
For example: a business manufactures educational DVDs. Fixed costs are
£40,000 a month and variable costs are £5 per DVD. The business produces
20,000 a month.
Total costs are:

Unit costs are therefore:

Assuming a 200 per cent mark up, the selling price is:

‘If you’re starting a service business, markup is more difficult to calculate

because variable costs are hard to work out.’

Competitive
This is when the price is set at the market level or at a discount to the market.
This happens in highly competitive markets, or in markets where one brand
dominates. When Branston Baked Beans were launched in 2006, they were
priced at 41p, compared to the 44p charged by the price leader, Heinz. By
2014, the Asda price of Branston was 50p to the 68p of Heinz, implying that
Branston is still a price taker, but in a significantly weaker position now than
then. Every business would like to set its own prices based on cost-plus.
Mercedes can and Heinz can. Those that cannot use competitive pricing, which
means that they have no real control over their future revenues.
‘The moment you make a mistake in pricing, you’re eating into your
reputation or your profits.’
Katharine Paine, business executive
Predatory
Predatory pricing means pricing low enough to drive a rival or rivals out of
business. Typically, the predator would be hoping that, having eliminated the
competition, prices can then be set much higher. Clearly this approach can only
work if:
• the predator is strong financially, perhaps because the product or service
involved in the price war is not an important part of the overall business; at
present, Cadbury and Mars are fighting hard for a share of the small but
growing share of the chocolate market in India. Cadbury sell their chocolate
bars at a unit price of 10p; even if this caused losses to Cadbury in the
attempt to ‘kill off’ Mars, it wouldn’t be a big problem as sales in India
represent less than 5 per cent of Cadbury sales.
• the other company or companies are weak financially; if, for example, a
huge outsourcing company such as Serco chose to undercut a small local
competitor in one part of the country, it might be very easy to drive it out of
business; this would be illegal, but only if it can be proved that the price
cutting had the intention of driving a rival out of business. Generally, price
cutting rarely gets a bad press from consumers or the media.

Psychological
This is perhaps more of a tactic than a strategy. At the time of writing, all the
UK’s big five supermarkets are charging 49p for a pint of milk. They are all
concerned about pushing the price to or beyond 50p because they think 50p is
a psychological price barrier. In other words they believe that price elasticity
will be higher in changing from 49p to 50p than it was when the price rose
from 48p to 49p.
So producers and retailers believe that consumers have certain psychological
price barriers that are hard to cross without losing sales. In the car market,
£9,999 seems quite a bit less than £10,499. In Primark, £9.99 seems quite a bit
less than £10.99 and so on.

Choosing a pricing strategy

The choice of pricing strategy will depend on the competitive environment.
Figure 12.4 shows how the choice of pricing strategy will vary according to
the level of competition.

Figure 12.4 Factors affecting choice of pricing strategy

12.3 Factors that determine the appropriate pricing

strategy
Many companies conduct regular market research into pricing. They use
monthly ‘retail audits’ to get regular feedback on whether customers see their
prices as value for money. If there is a slippage in this rating, there would be
serious thought given to cutting prices or to trying to rebuild ‘value’ by more
advertising or perhaps a packaging or product revamp. Companies know that
pricing is the key to sales revenue and therefore keep a constant eye on it.

Product differentiation
However much competition there is in the market, a well-differentiated product
can stand apart. In the crowded UK market for chocolate bars, Bounty is
wonderfully differentiated. In fact it could be said to have a unique selling
point – that unbelievably sweet coconut filling. Some are hooked on that;
others avoid it. Generally, if people feel strongly for or against a product, it is
probably in a good position to withstand competition. Highly differentiated
products can think in terms of cost-plus pricing.

Strength of the brand

Few methods of differentiation are as effective as strong branding. A coconut
filling can be copied by a rival producer tomorrow; but no-one else can call it
a Bounty bar. Super-strong brands such as Wrigley (92 per cent market share)
or Pampers (63 per cent market share) can use cost-plus pricing and launch
new products on the basis of skimming the market.

Amount of competition
The fiercer the competition in a market, the more important price becomes.
Customers have more choice, so they take more care to buy the best-value
item, whereas a business with a strongly differentiated position is able to
charge higher prices. The more direct the competition, the more likely it is that
competitive pricing will be required. Predatory pricing is an absolute last
resort.

Price elasticity of demand

The three above factors (differentiation, branding and competition) can all be
summed up in a single figure: price elasticity. A highly differentiated, strong
brand will have low price elasticity of demand and therefore be able to set its
price without too much concern about sales volumes – ideal for cost-plus
pricing.
For a product or service with high price elasticity of demand, competitive
pricing is inevitable, but may make it very hard to generate a profit. These are
the circumstances in which a large business might be tempted to take predatory
action – to eliminate weaker competitors and thereby remove some of the
pressure to cut prices.

Stage in the product life cycle

At certain times during a product’s life cycle, pricing is especially important.
Incorrect pricing when the product is launched could cause the product to fail.
At other stages in the product’s life, pricing may be used to revive interest in
the brand.
There are two basic pricing decisions: pricing a new product and managing
prices throughout the product life. Both decisions require a good
understanding of the market: consumers and competitors. Many businesses
launch at relatively good value prices and hold prices down in the early growth
phase of the business. When growth develops further, prices are steadily
increased and remain high during the maturity and early decline phases. Only
when decline becomes entrenched may prices be cut to try to keep the business
going for longer.

Real business
London’s Hoxton Hotel
To build up its business, for its first ten years of trading, London’s
Hoxton Hotel promised to sell five rooms per night at £1 and another
five at £29. The other 190 were at the ‘normal’ rate of £249! The
Hoxton used this device to get customers to register as members of
the Hoxton Fan Club. Only they were told when the sale was taking
place of the £1 rooms. So this pricing trick gave the Hoxton a terrific
email list of people interested in London hotel rooms. Today, you have
to get used to weekday prices starting at £249.

Costs and the need to make a profit

Pricing is critical because, unlike the other ingredients in the marketing mix, it
is related directly to revenue through the formula:
revenue = price × units sold
Pricing involves a balance between being competitive and being profitable. An
important part of that is a good understanding of costs. These costs must
include purchasing, manufacturing, distribution, administration and marketing.
Cost information should be available from the company’s management
accounting systems.
The lowest price a firm can consider charging is set by costs. Except as a
temporary promotional tactic (a loss leader), businesses must charge more for
the product than the variable cost. This ensures that every product sold
contributes towards the fixed costs of the business.

12.4 Changes in price to reflect social trends

Online sales
The growth of Amazon.com has been a classic in pricing strategy. Boss Jeff
Bezos wanted to build Amazon into the world’s biggest online shop and used
pricing quite ruthlessly as part of this programme. In the phenomenon that was
the publishing of Harry Potter books, Amazon slashed prices to half price or
less, threatening the survival of independent book shops. Indeed many called its
actions ‘predatory’. The number of independent book shops in the UK fell
from 1,535 in 2005 to 987 by the beginning of 2014.
Without doubt, buying online makes it easier to compare prices and to buy
from the cheapest. This is great for consumers, for as long as there is
competition to the giants such as Amazon. As shown in Figure 12.5, UK
shoppers are especially inclined to shop online.

Figure 12.5 Online retail shares of home market, 2014 (estimate)

(source: Centre for Retail Research)

Price comparison sites

Useful though online shopping is for consumers, price comparison sites suffer
from conflicts of interest, which lead to a lack of clarity about what they are.
These sites are not necessarily designed to find you the best deal; they may be
designed to get the best deal for the site. In other words, they may propose a
‘best deal’ that is not the cheapest, but gives the site the highest rate of
commission. Despite these doubts, usage of the sites seems to grow steadily,
backed by huge investments in advertising.
 ‘With the advent of the internet, customers are able to compare prices
easily and this has raised the importance of pricing among the 4Ps.’
Philip Kotler, marketing guru

Five whys and a how

12.5 Pricing strategies – evaluation
Economists think of price as a neutral factor within a marketplace. Many
businesses would disagree, especially those selling consumer goods and
services. The reason is that consumer psychology can be heavily influenced by
price. A ‘3p off’ sticker makes people reach for the Mars bars, but ‘50% off’
might make people wonder whether they are old stock or have suffered in the
sun; they are too cheap.
When deciding on the price of a brand new product, marketing managers have
many options. Pricing high may generate too few sales to keep retailers happy
to stock the product. Yet, pricing too low carries even more dangers. Large
companies know there are no safe livings to be made selling cheap jeans,
cheap cosmetics or cheap perfumes.
If there is a key to successful pricing, it is to keep it in line with the overall
marketing strategy. When Häagen-Dazs launched in the UK at prices more than
double those of its competitors, many predicted failure. In fact, the pricing was
in line with the image of adult, luxury indulgence and Häagen-Dazs soon
outsold all other premium ice creams (though today Ben & Jerry’s is number
one). The worst pricing approach would be to develop an attractively
packaged, well-made product and then sell it at a discount to the leading
brands. In research, people would welcome it, but deep down they would not
trust the product quality. Because psychology is so important to successful
pricing, many firms use qualitative research, rather than quantitative, to obtain
the necessary psychological insights.

Key terms
Loss leader: pricing a product below cost in order to attract further,
profitable business. Sony did this at the launch of the PS3 and the
PS4 – bring customers in who will then buy accessories and software.
Price elasticity: a measurement of the extent to which a product’s
demand changes when its price is changed.
Price sensitive: when customer demand for a product reacts sharply to
a price change (that is, demand is highly price elastic).
Pricing tactics: short-term pricing responses to opportunities or
threats.

12.6 Workbook
Revision questions
(35 marks; 35 minutes)
1 Explain why price is fundamental to a firm’s revenues.
(3)
2 Look at Figure 12.1. Outline two factors that would affect the
‘psychologically right price range’ for a new Samsung phone.
(4)
3 Explain how the actions of Nike could affect the footwear prices set
by Adidas.
(3)
4 Look at Table 12.1, on the price sensitivity of products, brands and
services. Think of two more examples of highly price-sensitive and
two examples of not-very-price-sensitive products, services or
brands.
(4)
5 Explain the difference between pricing strategy and pricing tactics.
(2)
6 For each of the following, decide whether the pricing strategy should
be skimming or penetration. Briefly explain your reasoning.
a) Richard Branson’s Virgin group launches the world’s first space
tourism service (you are launched in a rocket, spend time
weightless in space, watch the world go round, then come back to
earth).
(4)
b) Kellogg’s launches a new range of sliced breads for families who
are in a hurry.
(4)
c) The first robotic washing machine is launched. It washes, dries
and irons the clothes – and places them in neat piles.
(4)
7 Is a price-elastic product likely to be priced competitively or on a
cost-plus basis? Explain your reasoning.
 (3)
8 Outline two circumstances in which a business may decide to use
predatory pricing.
(4)
Data response 1
On 1 February 2014, Tesco Price Check provided the information
given in Table 12.3 on the prices of shampoo brands. Study the table
and then answer the questions that follow.

Table 12.3 Prices of shampoo brands in January 2014

Questions (30 marks; 30 minutes)
1 Explain why it may be fair to describe Vosene shampoo as a price-
taker.
(4)
2 John Frieda shampoo is priced at more than 40 times the level of
supermarket budget shampoos (per ml). Assess two reasons why
customers may be willing to pay such a high price.
(8)
3 Examine the position of the long-established brand Head &
 Shoulders within the UK market for shampoo. What pricing strategy
does it seem to be using and why may it be possible to use this
approach?
(6)
4 Assess whether dogs should have ‘better’ shampoo than kids.
(12)
Data response 2
New product pricing strategy
Before the October 2012 launch of Maruti Suzuki’s new Alto 800, the
company set itself a target unprecedented in the history of the Indian
automobile industry. Maruti called it the ‘50/20/10 target’. It meant
aiming for 50,000 test drives and 20,000 deliveries – all within the first
10 days.
To make it harder to achieve, the car market was slipping backwards in
autumn 2012 as the Indian economy grappled with 10 per cent inflation
and high interest rates. With such high inflation, it would have been
understandable if Maruti had priced their new Alto model 10 per cent
higher than the previous one. Instead it made headlines by launching at
2 per cent below – even though the specification had been upgraded.
Prices for the Alto started at £2,500, with £3,400 for the highest spec.
Figure 12.6 The Maruti Alto 800
On the morning of the tenth day, Maruti Suzuki’s Managing Executive
Officer for marketing and sales announced: ‘We crossed all three
targets. We launched in 821 cities and 1,130 outlets.’ That morning,
the new Alto had crossed 27,000 bookings and 10,200 deliveries.
Getting the pricing right was critical because Maruti, for so long the
dominant force in India with a 45 per cent market share, had lost three
percentage points in the previous year. This was partly because the
Alto model, which had once sold 35,000 cars a month, had seen its
sales slip to 18,000 by early 2012. And with small cars such as this
taking 70 per cent of the Indian car market, the Alto launch was vital.
When asked whether this pricing might spark a price war, Maruti
suggested that it was simply making use of its competitive advantage.
An independent auto analyst confirmed that ‘Maruti enjoys huge
economies of scale, even at lower margins. No other company can do
that.’

Figure 12.7 Market for new cars: India v. UK (source: www.oica.net)

The reduced price is intensifying competition in the market in what
Abdul Majeed, Partner at PwC, calls the ‘volume game’. He explains
that Maruti’s pricing may initially spark a price war, but it is important to
develop the market three or four years down the line, as it would
generate high volumes. ‘If you can’t sell 200,000 to 300,000 cars, you
can’t make money’, he says. In the short term, margins will feel the
pinch, but in the long run the move will be beneficial, as small cars still
make up 70 per cent of the Indian car market. ‘Car makers will have to
take the risk’, says Majeed.
A year on, in September 2013, the Alto was India’s top-selling car and
Maruti’s market share had recovered from 41 to 43.5 per cent since
the same month in 2012.
Questions (25 marks, 30 minutes)
1 Examine one way in which market trends in new car sales in India
(see Figure 12.7) might have influenced the pricing decision for the
new Alto 800.
(5)
2 Assess two possible implications for the Indian car market if Maruti’s
pricing does ‘spark a price war’.
(8)
3 Assess whether Maruti was wise to adopt a penetration pricing
strategy for its new Alto model.
(12)
Extended writing
1 At a supermarket, a Mars Bar is priced at 79p and a pack of three at
£1. From the point of view of the consumer and the producer,
evaluate whether both these prices can be right.
(20)
2 Research the launch prices and sales of Sony’s PS4 and the
Microsoft One in 2013/2014. Evaluate whether pricing was the key
reason for Sony’s sales success.
(20)
Section 1.3 Marketing mix and strategy

13 Distribution
Definition
Distribution is about availability (how to get the product to the right
place for customers to make their purchases). It includes physical or
online distribution availability and visibility.

Linked to: The market, Ch 2; Branding and promotion, Ch 11;

Pricing strategies, Ch 12; Marketing strategy, Ch 15.

13.1 Introduction to distribution

Within the framework of the marketing mix, distribution is known as ‘place’.
This can be unhelpful because it suggests that manufacturers can place their
products where they like (for example, at the entrance of a Waitrose store). The
real world is not like that. Obtaining distribution in Waitrose is a dream for
most small producers, and a very hard dream to turn into reality. For new
firms in particular, place is the toughest of the 4Ps.
Persuading retailers to stock a product is never easy. For the retailer, the key
issues are opportunity cost and risk. As shelf space is limited, stocking a
particular chocolate bar probably means scrapping another; but which one
should the retailer choose? What revenue will be lost? The other consideration
is risk. A new, low-calorie chocolate bar may be a slimmer ’s delight, but high
initial sales might slip, leaving the shopkeeper with boxes of slow-moving
stock.
For the manufacturer, an important aspect of distribution strategy is whether
your product is a planned purchase or whether it is bought on impulse. Impulse
purchasing implies the need to maximise distribution – and to make sure of
great displays, such as close to the till. So if you are selling Tic Tac mints or
strawberry lip balm, you incentivise the retailers by offering them fat profit
margins, and help them by giving out display units to show off the product to
its best advantage. With a planned purchase, distribution and display become
less important because the customer will come to look for the item they want.
Therefore, the supplier doesn’t need to offer such generous retail profit
margins; in a sense, the product is selling itself. A good example might be a
Flymo lawnmower or BaByliss hair straighteners.

13.2 Choosing appropriate distributors

When a new business wants to launch its first product, a key question to
consider is the distribution channel: in other words, how the product passes
from producer to consumer. Should the product be sold directly, as with pick-
your-own strawberries? Or via a wholesaler, then a retailer, as with crisps
bought from your local shop? This decision will affect every aspect of the
business in the future, especially its profit.
Manufacturers must decide on the right outlets for their own product. If Chanel
chooses to launch a new perfume, ‘Alexa’, backed by Alexa Chan, priced at
£69.99, controlling distribution is vital. The company wants it to be sold in a
smart location where elegant sales staff can persuade customers of its
wonderful scent and gorgeous packaging. If Superdrug or Morrisons want to
stock the brand, Chanel will try hard to find reasons to say no.
Yet the control is often in the hands not of the producer, but of the retailer. If
you come up with a wonderful idea for a brand new ice cream, how would you
get distribution for it? The freezers in corner shops are usually owned by
Wall’s and Mars, so they frown upon independent products being stocked in
‘their ’ space. To the retailer, every foot of shop floor space has an actual cost
(the rental value) and an opportunity cost (the cost of missing out on the profits
that could be generated by selling other goods). In effect, then, your brand new
ice cream is likely to stay on the drawing board because obtaining distribution
will be too large a barrier to entry to this market.
‘Establish channels for different target markets and aim for efficiency,
control and adaptability.’
Philip Kotler, marketing guru

13.3 Distribution channels

There are five main channels of distribution.
Traditional physical channel
Small producers find it hard to achieve distribution in big chains such as B&Q
or Sainsbury’s, so they usually sell to wholesalers who, in turn, sell to small
independent shops. The profit mark-up applied by the ‘middleman’ adds to the
final retail price, but a small producer cannot afford to deliver individually to
lots of small shops.

Direct to retailer
Larger producers cut out the middleman (the wholesaler) and sell directly to
retail chains, from Boots to Tesco. This is more cost-effective, but exposes the
seller to tough negotiation from the retail chains on prices and credit terms.
Large retailers also demand that manufacturers pay for special offers and price
promotions, from BOGOFs (buy one get one free) to boxes of Maltesers for
£1.

Be your own retailer

Although Apple, Chanel and Burberry are known for iconic product design,
they also love to control their distribution, display and sales by running their
own shops. In China, Burberry decided to buy out its retail partner so that it
could get closer to the market.
‘Get closer than ever to your customers. So close that you tell them what
they need well before they realise it themselves.’
Steve Jobs, founder of Apple Inc.

Direct online
Using this channel of distribution, the producer sells directly to the consumer.
Manufacturers can do this through mail order or – far more likely today –
through a website. This ensures that the producer keeps 100 per cent of the
product’s selling price. The benefit of the direct distribution channel is that the
producer ’s higher profits can finance more spending on advertising, website
development or new product development.
Online retail
Small firms often lack the ability and/or the finance to build a successful e-
commerce sales platform. So it can make sense to piggy-back on an established
platform such as eBay in the West or the amazingly successful TaoBao in
China. TaoBao has more than two million businesses using the site to sell to
the hundreds of millions of China’s online shoppers. TaoBao is one part of
Jack Ma’s Alibaba business that had sales, in 2014, of $420 billion – dwarfing
Amazon and eBay combined.

Real business
In 2013, internet sales of groceries rose by 19 per cent according to
market research agency Kantar. By comparison, sales from grocery
shops only rose by 2 per cent. This trend towards online shopping has
been developing for ten years and may be accelerating. In the four
days leading up to Christmas 2013, 15 per cent of all grocery sales
were online. No wonder that Morrisons, the only UK grocery chain with
no online presence, was rapidly losing market share. In (belated)
response, Morrisons started its first online deliveries in a test market in
Warwickshire in January 2014. The same company proved
extraordinarily slow to spot the success of smaller, urban grocery
outlets such as Tesco Metro.

Figure 13.1 E-commerce share of UK grocery spending, 2003–2013

(source: Kantar Worldpanel, ‘Shopping for Groceries’, 6 August 2013)
13.4 Changes in distribution to reflect social trends

Online distribution
A company such as Supergroup plc (owner of the Superdry brand) has retail
outlets in many countries but not all. They might sell 100 jackets to a South
American wholesaler, who then sells them to shops in Rio and Caracas. If the
retail price is to be the equivalent of £100, they may need to sell to the
wholesaler for £35. This will create the chain:

Figure 13.2 Prices charged at each stage of the distribution chain

So although it is a Superdry product with the intellectual property owned by
Supergroup plc, the company only gets £35 per jacket, while the wholesaler
makes £15 and the retailer gets £50 (clothing retailers usually work on a 100
per cent mark-up). How much better, then, for Supergroup if a shopper in Rio
simply buys the item from the Superdry website. They can get £100 for the
jacket instead of £35.
From the consumer ’s point of view, there are also huge benefits from
purchasing online. Most shops stock a relatively narrow range of sizes, aimed
at the ‘average’ 65 per cent of the market. People bigger or smaller than that
will struggle in the high street. This is understandable because the wider the
range of sizes you keep on the shelves or in the stockroom, the fewer the
number of items you’ll have the room to display or store: a classic issue of
opportunity cost. For an online seller with a warehouse in a cheap-rent part of
town, it’s not an issue. The same goes for customers with a quirky taste in
music, or books or vintage clothes: these days there is a long tail of small
firms, each specialising in minority tastes too small to make a profit in the
high street.
‘Distribution has really changed. You can make a record with a laptop in
the morning and have it up on YouTube in the afternoon and be a star
 overnight.’
Bonnie Raitt, singer

Changing from product to service

Is there a difference between distributing a service compared with distributing
a product? Largely the answer is no. Your grandparents bought insurance from
‘The Man from the Pru’, who knocked on doors monthly to collect insurance
premiums from clients. Your parents (when younger) bought insurance
directly over the phone or by going into a Prudential Insurance high street
shop. Today they buy insurance from a combination of online (direct with the
company or via the ‘retailers’: Moneysupermarket.com,
Comparethemarket.com and so on) and by phone. In other words, selling
services has been affected by modern online trends as much as anything else.
Of course there are some services that may never be affected significantly by
online distribution because they are about physical experiences. So it’s hard to
see how clubbing, staying at a hotel, going on holiday or taking your partner
to a restaurant can change much over time. The only change is to the way such
experiences are booked, and much of that is already online.
Figure 13.3 Logic chain: distribution and the virtuous circle

Five whys and a how

13.5 Distribution – evaluation
Place is of particular importance in business because it can represent a major
barrier to entry, especially for new small firms. The practical constraint on the
amount of shop-floor space makes it hard for new products to gain acceptance,
unless they are genuinely innovative. Therefore, existing producers of branded
goods can become quite complacent, with little serious threat from new
competition.
Famously, in the nineteenth century, Ralph Waldo Emerson said: ‘If a man can
make a better mousetrap, though he builds his house in the woods the world
will make a beaten path to his door.’ In other words, if the product is good
enough, customers will come and find you. In a modern competitive world,
though, the vast majority of products are not that exciting or different from
others. So it is crucial to provide customers with convenient access to your
products and/or shelf space in an eye-catching location. Getting products into
the right place should not be taken for granted.

Key terms
Barrier to entry: factors that make it hard for new firms to break into
an existing market (for example, strong brand loyalty to the current
market leaders).
E-commerce: literally, electronic commerce – carried out online.
Impulse purchasing: buying in an unplanned way (for example, going to
a shop to buy a paper, but coming out with a Mars bar and a Diet
Coke).
Long tail: the huge number of tiny businesses appealing to minority
tastes that can find a profitable existence online because they can
target the whole planet, not just the local area.
Opportunity cost: the cost of missing out on the next best alternative
when making a decision (or when committing resources).
Wholesaler: the middleman between the producer and retailers, who
breaks bulk down from container lorry-loads into manageable parcels,
such as a case of 12.

13.6 Workbook
Revision questions
(30 marks; 30 minutes)
1 Outline the meaning of the term ‘place’.
(2)
2 Explain in your own words why it may be that ‘place is the toughest
of the 4Ps’.
(4)
3 Outline what you think are appropriate distribution channels for:
a) a new F1 racing game for mobiles and tablets
b) a new adventure holiday company focusing on wealthy 19–32 year
olds.
(6)
4 Retailers such as WHSmith charge manufacturers a rent on prime
store space, such as the shelving near to the cash tills.
a) How might a firm work out whether it is worthwhile to pay the
extra?
(3)
b) Why may new small firms find it hard to pay rents such as these?
(3)
5 Explain in your own words what is meant by the phrase ‘a better
 mousetrap’.
(3)
6 Outline three reasons for the success of direct online distribution in
recent years.
(5)
7 Explain why modern businesses seek ‘multi-channel distribution’.
(4)
Data response 1
Getting distribution right
Secondary data can be hugely helpful to new companies looking for
distribution of their first products. A company launching the first ‘Kitten
Milk’ product has to decide where to focus its efforts. Where does cat
food sell? Is it in pet shops, in corner shops or in supermarkets? Desk
research company BMRB reports that, whereas 65 per cent of dog
owners shop for pet food at supermarkets, 81 per cent of cat owners
do the same. A different source (TNS) puts the cat food market size at
£829 million. TNS also shows that the market is rising in value by
around 2.5 per cent a year.
Further secondary data shows that pet food shoppers spend only 80
per cent of the amount they intend to when they go to a shop. This is
because poor distribution stops them finding what they want. And 50
per cent of shoppers will not return to the same store after being let
down twice by poor availability.
Questions (20 marks; 25 minutes)
1 What is meant by the term ‘market size’?
(2)
2 a) The year 1 sales target for Kitten Milk is £5 million. Calculate what
share of the total market for cat food that would represent.
(4)
b) Explain why it might be hard to persuade retailers to stock a
product with that level of market share.
(4)
3 The marketing manager for Kitten Milk is planning to focus
distribution efforts on getting the brand placed in pet shops. Assess
whether this seems wise.
(10)
Data response 2
An arm’s length from desire
From its origins in America in 1886, Coca-Cola has been a marketing
phenomenon. It was the world’s first truly global brand; it virtually
invented the red, jolly Christmas Santa, and its bottle design (1919)
was the first great piece of packaging design.
Yet a 1950 Time magazine article quoted another piece of marketing
genius: ‘Always within an arm’s length of desire.’ The marketing experts
at Atlanta (home of Coca-Cola) realised nearly 60 years ago that sales
of Coca-Cola were limited mainly by availability. Especially on a hot
day, a cold Coke would be desired by almost anyone who had it an
arm’s length away. This led the company to develop a distribution
strategy based on maximum availability, maximum in-store visibility and
therefore maximum impulse purchase.
From then on, Coca-Cola targeted four main types of distribution:
1 in supermarkets and grocers
2 in any kiosk in a location based on entertainment (for example, a
bowling alley or a cinema)
3 in any canteen, bar or restaurant
4 in a vending machine near you; automatic vending proved one of the
most valuable ways of building the market until worries about
healthy eating saw them banned in schools; a vending machine is
the ultimate barrier to entry.
Overall, though, the Coca-Cola approach to distribution set out in
1950 is what most companies still try to do today.
Questions (30 marks; 35 minutes)
1 What is meant by the term ‘distribution’?
(2)
2 Explain how a vending machine can be a ‘barrier to entry’ to new
competitors.
(4)
3 Explain what the text means by the difference between ‘maximum
availability’ and ‘maximum visibility’.
(4)
4 From all that you know about today’s Coke, Diet Coke and Coke
Zero, evaluate whether Coca-Cola’s distribution strategy was the
single most important factor in the firm’s marketing success.
(20)
Extended writing
1 Evaluate the proposition that ‘internet retailing will mean the death
of the high street’.
(20)
2 You have just developed a new console game that combines the
appeal of Candy Crush with the force of Call of Duty. Evaluate how
to achieve strong enough distribution to make this product a hit in
the UK.
(20)
Section 1.3 Marketing mix and strategy

14 Product life cycle and portfolio

Definition
The product life cycle is the theory that all products follow a similar
pattern over time, of development, birth, growth, maturity and decline.
The product portfolio places brands into a matrix based on market
share and market growth.

Linked to: Market research, Ch 3; Pricing strategies, Ch 12;

The market, Ch 2; Capacity utilisation, Ch 42.

14.1 What is the product life cycle?

The product life cycle shows the sales of a product over time. When a new
product is first launched, sales will usually be slow. This is because the product
is not yet known or proven in the market. Retailers may be reluctant to stock
the product because it means giving up valuable shelf space to products that
may or may not sell. Customers may also be hesitant, waiting until someone
else has tried it before they purchase it themselves.
If the product does succeed, then it enters the growth phase of the product life
cycle, with new customers buying and existing customers making repeat
purchases. However, at some point sales are likely to stabilise; this is known as
the maturity phase. This slowing down of the growth of sales might be because
competitors have introduced similar products or because the market has now
become saturated. Everyone who wants one has bought one, so sales fall back
to replacement purchases only.
At some point sales are likely to decline, perhaps because customer tastes have
become more sophisticated. So orange squash sales decline as people buy
more fresh orange juice. A decline in sales may also be because competitors
have launched a more successful model or the original creator has improved
its own product; for example, the iPad drawing sales from the iPhone.
The five key stages of a product’s life cycle are known as: development,
introduction, growth, maturity and decline. These can be illustrated on a
product life cycle diagram. The typical stages in a product’s life are shown in
Figure 14.1.

Figure 14.1 The product life cycle

14.2 What is the value of the product life cycle?

The product life cycle model helps managers to plan their marketing activities.
Marketing managers will need to adjust their marketing mix at different stages
of the product life cycle, as outlined below.
• In the introduction phase, the promotion may focus on making customers
aware that a new product exists; in the maturity phase, it may focus more on
highlighting the difference between your product and competitors that have
arrived since its introduction.
• At the beginning of the life cycle, a technologically advanced product may
be launched with a high price (think of the iPhone); over time the price may
fall as newer models are being launched. By considering the requirements of
each stage of the life cycle, marketing managers may adjust their marketing
activities accordingly.
Managers know that the length of the phases of the life cycle cannot easily be
predicted. They will vary from one product to another and this means the
marketing mix will need to be altered at different times. For example, a
product may be a fad and therefore the overall life of the product will be quite
short. Many fashions are popular only for one season and some films are
popular only for a matter of weeks. Other products have very long life cycles.
The first manufactured cigarettes went on sale in Britain in 1873. By chance,
sales hit their peak (120 billion) exactly 100 years later. Since 1973 sales have
gently declined.
It is also important to distinguish between the life cycle of a product category
and the life cycle of a particular brand. Sales of wine are growing, but a brand
that was once the biggest seller (Hirondelle) has virtually disappeared as wine
buyers have become more sophisticated. Similarly, confectionery is a mature
market but particular brands are at different stages in their life cycles: Mars
bars are in maturity while Maltesers are in the growth stage, even though the
brand is 80 years old!

14.3 Extension strategies

The aim of an extension strategy is to prevent a decline in the product’s sales
in the medium-to-long term. The two main variables for basing a new
extension strategy are the product itself and the way it is promoted.
Table 14.1 Examples of how the marketing mix may vary at different
stages of the product life cycle

Product
Over the years, detergents such as Persil have had innumerable ‘New
Improved!’ formulations and relaunches. In the past, these offered ‘Whiter than
ever!’ washes, though more recently the trend has been for smaller pack sizes
(more concentrated) or presenting the product in tablet rather than loose form.
The point is to incorporate new product technology and therefore fight off new
brand challengers.
Successful product-based extension strategies include:
• McDonald’s, in 2007, relaunching itself with different design (greens rather
than red) and a menu featuring more salads, more fruit and coming clean
about calories per item
• Innocent Drinks, facing falling sales for their smoothies in 2013/2014,
launching ‘Super Smoothies’ with product claims about their health-giving
properties
• Maltesers, stretching the brand by launching Malteaster bunnies and Teasers
chocolate bars.

Promotion
Simply running a new advertising campaign or switching from traditional to
social media does not comprise an extension strategy. Something more
substantial and long term is required. Good examples include the following:
• By targeting a new segment of the market: when sales of Johnson &
Johnson’s baby powder matured, the company repositioned the product
towards adults; sales boomed.
• By developing new uses for the product: the basic technology in hot-air paint
strippers, for example, is no different from that in a hairdryer.
• By increasing the usage of a product: Actimel’s ‘challenge’ was for
consumers to eat one pot a day for a fortnight – a wonderful way to
encourage increased consumption.
Figure 14.2 The effect of extension strategies
The continued success of products such as Coca-Cola and Kellogg’s
cornflakes is not just due to luck; it is down to sophisticated marketing
techniques that have managed to maintain sales over many years despite fierce
competition. The Kellogg’s logo is regularly updated, new pack sizes are often
introduced, and various competitions and offers are used on a regular basis to
keep sales high.
Given the fact that developing a product can involve high costs and that there is
a high failure rate of new products, it is not surprising that, if a product is
successful, managers will try to prolong its sales for as long as it is profitable.
Who would have thought, in the 1880s, that a frothy drink would still be a huge
seller more than 125 years later? Clever Coke.

14.4 New product development (NPD)

New product development includes the people and processes involved in
turning new ideas into products (or services) ready for launch. It is likely to
involve research and development (R&D), market research, product
engineering and design, plus expertise in packaging, advertising, pricing and
branding. It represents all the activities categorised as ‘development’ in the
product life cycle. Some examples of NPD are so excellent (think iPhone, the
PS4 or Snapchat) that their life cycles have a remarkably easy start.
Unfortunately, even consumer giants such as Cadbury and PepsiCo have poor
success rates with new product launches. The statistics are hard to find, but it
seems that fewer than one in five new products becomes a commercial success.
Clearly there must be many reasons why it is hard to create a successful new
product, though the single most important is the cautious consumer who would
rather buy a trusted product than a new one.
Key influences on successful NPD include:
• a clear understanding of the consumers within a certain market segment, with
a special focus on their future needs or wants
• the creativity to be able to see how an everyday problem or issue can be
solved innovatively
• enough resources (money and manpower) to be able to develop an idea
effectively and market it persuasively.
When a new product succeeds, the consequences can be transformational.
Nintendo’s Wii U was looking down and out before the launch of Mario Kart 8
saw sales of the hardware rise by 600 per cent in June 2014. So the value of
NPD cannot be doubted. A successful new product can create its own new life
cycle – giving an entire business a morale and profit boost.

Real business
Nine out of ten fail
In July 2014, the chief executive of US marketing consultancy ‘Dine’
was interviewed about the causes of new product launch failures. He
said that, in America, the failure rate among new food products is nine
out of ten. He blamed three main causes:
• undercapitalised launches, i.e. good idea, but an underfunded
marketing campaign
• ‘customer insight is slightly off’, e.g. launched too early or too late,
or slightly wrong market positioning
• overly innovative idea (he cited bubble-gum flavoured milk) where the
producer is pursuing disruptive innovation when incremental
innovation would be superior.

14.5 The product portfolio

Product portfolio analysis examines the existing position of a firm’s products.
This allows the firm to consider its existing position and plan what to do next.
There are several different methods of portfolio analysis. One of the best
known was developed by the Boston Consulting Group, a management
consultancy; it is known as the Boston Matrix.
The Boston Matrix shows the market share of each of the firm’s products and
the rate of growth of the markets in which they operate. By highlighting the
position of each product in terms of market share and market growth, a
business can analyse its existing situation and decide what to do next and where
to direct its marketing efforts. This model has four categories, as described in
Figure 14.3.
Figure 14.3 Product portfolio: the Boston Matrix

Cash cow: a high share of a slow-growing market

In Figure 14.3, product A has a high market share of a low-growth market. The
size of the circle depends on the turnover of the product. This type of product
is known as a cash cow. An example of a cash cow might be Heinz Baked
Beans. The overall market for baked beans is mature and therefore slow
growing. Within this market, the Heinz brand has a market share of more than
50 per cent. This type of product generates high profits and cash for the
company because sales are relatively high, while the promotional cost per unit
is quite low. Heinz can therefore ‘milk’ cash from baked beans to invest in
newer products, such as Heinz Organic Ketchup.

Problem child: a low share of a fast-growing market

Product B, by comparison, is in a high-growth market but has a low market
share. This type of product is known as a problem child (also called a
‘question mark’). A problem child may well provide high profits in the future;
the market itself is attractive because it is growing fast and the product could
provide high returns if it manages to gain a greater market share. However, the
success of such products is by no means certain and that is why they are like
problem children: they may grow and prosper or things may go wrong. These
products usually need a relatively high level of investment to promote them,
get them distributed and keep them going.

Rising star: a high share of a growing market

Rising stars such as product C have a high market share and are selling in a
fast-growing market. These products are obviously attractive; they are doing
well in a successful market. However, they may well need protecting from
competitors’ products. Once again, the profits of the cash cows can be used to
keep the sales growing. Heinz Organic Soups are in this category. They are
very successful, with fast-growing sales, but still need heavy promotion to
ensure their success.

Dogs: a low share of a stable or declining market

The fourth category of products is known as dogs. These products (like
product D in Figure 14.3) have a low share of a low-growth market. They hold
little appeal for a firm unless they can be revived. The product or brand will be
killed off once its sales slip below the break-even point.

The purpose of product portfolio analysis

Product portfolio analysis aims to examine the existing position of the firm’s
products. Once this has been done, the managers can plan what to do next.
Typically, this will involve four strategies.
1 Building: this involves investment in promotion and distribution to boost
sales and is often used with problem children (question marks).
2 Holding: this involves marketing spending to maintain sales and is used with
rising star products.
3 Milking: this means taking whatever profits you can without much more new
investment and is often used with cash cow products.
4 Divesting: this involves selling off the product and is common with dogs or
problem children.
The various strategies chosen will depend on the firm’s portfolio of products.
If most of the firm’s products are cash cows, for example, it needs to develop
new products for future growth. If, however, the majority are problem
children, then it is in quite a high-risk situation; it needs to try to ensure some
products do become stars. If it has too many dogs, then it needs to invest in
product development or acquire new brands.

Five whys and a how

14.6 Product life cycle and portfolio – evaluation

The product life cycle model and portfolio analysis are important in assessing
the firm’s current position within the market. They make up an important step
in the planning process. However, simply gathering data does not in itself
guarantee success. A manager has to interpret the information effectively and
then make the right decision. The models show where a business is at the
moment; the difficult decisions relate to where the business will be in the
future.
Product portfolio analysis is especially useful for larger businesses with many
products. It helps a manager to look critically at the firm’s product range. Then
decisions can be made on how the firm’s marketing spending should be
divided up between different products. By contrast, the product life cycle is of
more help to a small firm with one or two products.

Key terms
Cash cow: a product that has a high share of a low-growth market.
Dog: a product that has a low share of a low-growth market.
Extension strategy: marketing activities used to prevent sales from
declining.
Portfolio analysis: an analysis of the market position of the firm’s
existing products; it is used as part of the marketing planning process.
Problem child: a product that has a small share of a fast-growing
market.
Rising star: a product that has a high share of a fast-growing market.

14.7 Workbook
Revision questions
(40 marks; 40 minutes)
1 Identify the different stages of the product life cycle. Give an
example of one product or service you consider to be at each stage
of the life cycle.
(4)
2 Explain what is meant by an ‘extension strategy’.
(4)
3 ‘Without new product development every business must die.’ Is this
true?
(6)
4 How is it possible for products such as Barbie to apparently defy
the decline phase of the product cycle?
(7)
5 What is meant by ‘product portfolio analysis’?
(3)
6 Distinguish between a cash cow and a rising star in the Boston
Matrix.
(4)
7 Explain how the Boston Matrix could be used by a business such as
Cadbury.
 (5)
8 Firms should never take decline (or growth) for granted. Therefore,
they should never take success (or failure) for granted. Explain why
this advice is important if firms are to make the best use of product
life cycle theory.
(7)
Data response
Monster life cycle
The market for energy drinks is dominated by Red Bull. First launched
in 1987, its UK sales have grown steadily to reach £248 million in
2013. With the market for energy drinks still rising at 10–15 per cent
per year, many other companies are determined to take their share of
this success. The attractions are obvious. Not only are sales rising
faster than for soft drinks as a whole, but the price per litre is much
higher. On 30 December 2013, Tesco charged 49p for a 330ml can of
Coca-Cola and £1.58 for 330ml can of Red Bull.
As Coca-Cola observed the growth of Red Bull during the ‘noughties’,
it resolved to launch its own rivals. First came ‘Relentless’ in late 2006,
which received its first serious promotional push by being given away
at the 2007 Reading and Leeds Music Festivals. Since then, it has
focused on sponsoring ‘extreme’ sports. As shown in Figure 14.4,
Relentless has achieved significant sales, though sales fell by £5 million
between 2011 and 2013.
Perhaps sensing that Relentless was not the answer, in 2010 Coca-
Cola took over the distribution of a US energy drink called Monster.
The brand holds a 35 per cent share of the $30 billion US market for
energy drinks, though there have been questions raised in Congress
about the safety of the product. Energy drinks are heavy in three
ingredients: caffeine, taurine and sugar. In fact, the caffeine level is no
higher than in coffee, but the combination of ingredients is thought by
some to place it in between alcoholic and soft drinks.
Figure 14.4 Energy drink life cycles
Is Monster a real challenger to Red Bull in the UK? With a sales
increase of 30 per cent in 2013 compared with 6 per cent for Red Bull,
Coca-Cola can hope. But the risk must remain that the Monster life
cycle will end up following that of Relentless. Time will tell.
Questions (25 marks; 30 minutes)
1 Briefly explain the meaning of the term product life cycle.
(3)
2 Give the stage of the product life cycle for each of the following in
2013:
a) Relentless
b) Monster.
(2)
3 Assess two possible extension strategies Coca-Cola might use with
Relentless in coming years.
(8)
4 Assess the factors that will influence the future life cycle of Monster
in the UK.
(12)
Extended writing
1 After many decades of success in the UK, breakfast cereal
manufacturers are suffering from a decline in the market size as
consumers want to eat breakfast on the move instead of in the
kitchen. Evaluate a suitable extension strategy for a cereal producer
such as Kellogg’s.
(20)
2 Cadbury has a wide range of chocolate brands including Dairy Milk,
Flake, Crunchie, Twirl and Fudge. It wishes to push its UK market
share from 34 per cent to 38 per cent within the next two years.
Evaluate the extent to which the Boston Matrix might help in
achieving this goal.
(20)
Section 1.3 Marketing mix and strategy

15 Marketing strategy
Definition
Marketing strategy is a carefully evaluated plan for future marketing
activity that balances company objectives, available resources and
market opportunities. It is implemented through the marketing mix.

Linked to: Market research, Ch 3; Market positioning, Ch 4;

Product and service design, Ch 10; Pricing strategies, Ch 12.

15.1 What are the keys to a successful marketing

strategy?
A strategy is the plan of the medium-to-long-term actions required to achieve
the company goals or targets. Selecting the best marketing strategy means
finding a fit between the company objectives, customer requirements and the
activities of competitors.
The aim of this planning is to shape the company’s activities and products to
generate the best returns for the business. Marketing strategy is about adding
value. It takes advantage of any unique selling points. It helps the business to
identify the right mix between design, function, image and service.

Strategy is about the future

The term ‘strategy’ implies looking to the future. It is important not to look at
what is working well now but at what the future prospects are. Toyota
recognised that there was a growing interest in environmental issues. It started
to invest in the production of hybrid cars. Although requiring significant
investment with no sure return, Toyota executives felt that this was the way
forward. The move was highly successful, with global sales of more than four
million cars by the end of 2014.
Strategy must be achievable
Strategy is concerned with what is possible, not just desirable. It must take into
account market potential and company resources. The company needs to
recognise its own limitations and potential. It also needs to consider economic
and social circumstances. If the world economy is weakening, firms will be
much more cautious about entering new export markets. If the home market is
stagnating, businesses may well concentrate on lower-priced ‘value’ products.

Strategy is company specific

Each company will have a different marketing strategy. The strategy selected
will reflect the individual circumstances of the business. Within the same
industry, one company may be aiming to increase market share while another
looks for cost reductions in order to compete on price. The tyre industry is a
good example of this. The market leaders were faced with increasing price
competition from developing countries. They had to develop new marketing
strategies. Their responses differed: Goodyear reduced costs; Michelin put its
effort into innovation and widened its product range; Pirelli decided to
concentrate on the market for luxury and speed.
Marketing strategy is the marketing plan of action that:
• contributes to the achievement of company objectives
• finds the best fit between company objectives, available resources and
market possibilities
• looks to the future
• is carefully thought out
• is realistic.

Real business
New strategy at Morrisons
Faced with a 7 per cent decline in like-for-like sales in the early months
of 2014, supermarket chain Morrisons announced a major switch in
marketing strategy. For several years leading up to May 2014,
Morrisons had focused TV advertising on its concept of ‘Market Street’
– focusing on the fresh food stalls at the entrance to the stores.
Presented by TV stars Ant and Dec, this advertising campaign was
suddenly thrown to one side. Now the focus was to be ‘I’m cheaper’,
with the new slogan backed by the media announcement of ‘biggest
ever’ price cuts.
Cynics regarded the announcement of this new marketing strategy as
a desperate attempt by Chief Executive Dalton Phillips to keep his job.
Others saw it as a logical response to the market share gains achieved
by the German discounters Aldi and Lidl. Phillips told the press: ‘We
are confident that these meaningful and permanent reductions in our
prices will resonate strongly with consumers.’

15.2 Marketing strategy for mass markets

To succeed in a mass market, a brand needs to be differentiated in a way that
makes it interesting but not niche. In the UK chocolate market, Cadbury Dairy
Milk is the dominant force, with annual sales of £500 million. But Galaxy is
also a mass market force, with sales of just over £200 million. Cadbury’s
marketing strategy is easy: it simply promotes Dairy Milk as an iconic brand –
everyone knows where it sits at the heart of the chocolate market. Mars
(owners of Galaxy) positions Galaxy as special and smooth, but has to beware
of making it a special-occasion-only brand (lots of prestige, but much lower
sales than a brand for everyday).
If a brand succeeds in the mass market, it can enjoy:
• distribution levels of close to 100 per cent (i.e. all shops want to stock it)
• control over advertising and promotion (retailers cannot force the market
leader ’s hand); in the year to 30 June 2014, Cadbury spent nothing on Dairy
Milk, while Galaxy had a spend of more than £10 million; Dairy Milk sales
rose 5.5 per cent by value during that period
• a degree of control over pricing, though it can never get too greedy –
because it is the mass market.
‘There is no victory at bargain basement prices.’
Dwight D. Eisenhower, US General, then President

Real business
Both McVitie’s Jaffa Cakes and Burton’s Jammie Dodgers are well-
known biscuit brands, but the former is distributed in 90 per cent of
retail outlets, whereas the latter is in only 64 per cent. Both companies
have a similar view of the right outlets for their products (for example,
supermarkets, corner shops, garages, canteens and cafés), so why
may Burton’s be losing out to McVitie’s in this particular race? Possible
reasons include the following.
• Jaffa Cakes have higher consumer demand; therefore, retail outlets
are more willing to stock the product.
• Jammie Dodgers may have more direct competitors; high product
differentiation may make Jaffa Cakes more of a ‘must stock’ line.
• If Jaffa Cakes have more advertising support, retailers know
customers will ask for the product by name while the advertising
campaign is running.

15.3 Marketing strategy for niche markets

A niche within the confectionery market is for chewing gum. Some niches have
several brands competing on equal terms, but the £300 million UK chewing
gum market is dominated by Wrigley. In the year to June 2014, Wrigley
(owned by Mars) had a 92.5 per cent market share! When Cadbury decided to
break into this niche, it launched a range of different flavours under the brand
name Trident. Cadbury boasted that it would be looking for £20 million of
sales growth each year for the first five years. As you can see in Figure 15.1,
the launch year of 2007 was a success, but if Cadbury looked back at this
venture they would realise that it was a waste of their money and time.

Figure 15.1 Sales of Trident chewing gum (source: The Grocer

magazines, 2007–2014)
Often, marketing within niche markets needs a patient approach. Customers
within niches are often experts on the product category and may be very
choosy. So a great deal of marketing focuses on reinforcing the distinctive
characteristics of each product. In the super-premium sector of the ice cream
market, Ben & Jerry’s combination of quirky flavours and social
responsibility has helped it win a battle against Häagen-Dazs.

15.4 Marketing strategy for business to consumer

markets (B2C)
The key to successful marketing is that every element in the mix should be co-
ordinated towards delivering a marketing strategy that fits in with the
marketing objectives. This is relatively easy to think through in relation to a
business that targets the consumer (B2C). Whether it is a product or service,
the consumer expects a reality that conforms to the image and therefore
delivers value for money. In many cases, the image itself may be at the heart of
the proposition. If so, keeping that image vibrant and distinctive may be a
critical focus of the marketing mix.
‘Don’t sell the steak, sell the sizzle.’
Advice on advertising from Elmer Wheeler, US business writer

15.5 Marketing strategy for business to business

markets (B2B)
B2B means selling to other businesses, be they retail distributors or businesses
that have no direct connection with the public, such as a chemical refinery or a
sawmill. The key aspect of B2B marketing strategy is that there tend to be
different priorities. Consumers buy with a lot of emotion. We love Cadbury
because it was a big treat as a kid; we love Apple because it makes us look cool
(and wealthy!). Businesses try to buy with no emotion whatever. They want to
buy the best product for the best price with the best and most reliable service.
So glossy advertising becomes less important. The key is understanding the
business customer ’s needs – and meeting them.
A producer of sandwiches for the consumer market might gain a huge order to
feed the staff daily at a nearby sawmill employing 800 people. This B2B order
carries the financial disadvantage that the customer will want to pay on credit
(perhaps 60 days), which hurts the supplier ’s cash flow. It also switches the
marketing priorities. Instead of smiley customer service being a priority, the
sandwiches have to be delivered by a certain time, to a specified quality – and
there will be no acceptable excuses for failure.

B2B and the marketing mix

• In some cases companies will be selling homogenous goods to other
businesses, e.g. 10 litres of white paint or 5,000 light switches. This will
make price the most important element in the mix.
• A business such as Rolls-Royce Motors needs thick, blemish-free soft leather
for making the car seats; in this case, product will be the key to successful
sales.
• Nissan UK wants its most important suppliers right next to its Sunderland car
factory, so that they can deliver on a just-in-time basis (see Chapter 43). This
makes place the most important part of the mix.
• Unless you are an iconic brand, such as Marmite, to keep shelf space in big
supermarket chains requires producer/suppliers to fund regular price or
‘BOGOF’ promotions. In this case, promotion is the key.
Figure 15.2 Logic chain: B2B v. B2C

15.6 How businesses develop customer loyalty

Customer loyalty implies more than repeat purchase. It suggests a real
emotional connection, as a football supporter might have with his or her team.
That connection may be based on something like love, or on faith, as in ‘I trust
Colgate’. Other connections may be a bit looser, but still important, as with
liking to wear Nike or eat Nando’s.
The heart of this connection has to be the product/service itself. Going to
Nando’s is partly about the menu, partly about the quality of the food and partly
about the relaxed, youthful but efficient service. You go out feeling better than
when you went in. So you come back. The starting point, therefore, is to really
study your customers – and make sure that every aspect of the customer
experience works for them.
‘The first step in exceeding your customer ’s expectations is to know those
expectations.’
Roy H. Williams, author and marketing consultant
Yet customer loyalty is about much more than the product. It is often said that,
in blind tests, people prefer Pepsi to Coke. Yet Coke outsells Pepsi 5–1 in the
UK. In this case, the emotional connection is probably one established in
childhood: Coke manages to persuade kids that Coke is associated with
Christmas, summer holidays, special occasions and happiness generally. That
is highly skilful (if manipulative) advertising and promotion.
In the short term, marketing may be about shifting products; in the long term, it
is usually rooted in creating the right image to appeal to the right target
market. This is why qualitative research is so widely used by firms.
‘There is only one boss. The customer. And he can fire everyone in the
company from the chairman on down, simply by spending his money
somewhere else.’
Sam Walton, founder of Walmart

Five whys and a how

15.7 Marketing strategy – evaluation
The most important marketing strategies are the long-lived ones. ‘Have a
break, have a KitKat’ started in the early 1990s and served well for 20 years. It
not only became a promotional strategy but also influenced the product as
well, making multi-packs more relevant, as people could hand out KitKats to
co-workers or kids. Even longer lived is Audi’s phrase, used worldwide,
‘Vorsprung durch Technik’ (‘advancement through technology’), which was
first used in 1982 in UK advertising. In 1982, Audi was just a producer of mass
market cars; brand owner Volkswagen’s 1990s decision to push the brand
upmarket fitted in with the positive imagery created by the advertising.
Brand owners and their advertising agencies are always looking for a strategy
‘with legs’ – that can last decades rather than years. Weak exam answers see
marketing as a series of quick fixes; marketing strategy should always be seen
as a key part of far-sighted business practice.

Key terms
Homogenous goods: these have no points of differentiation and
therefore each one is the same as every other (making competition
focus on price).
Product differentiation: the extent to which consumers perceive your
brand as being different from others.

15.8 Workbook
Revision questions
(35 marks; 35 minutes)
1 What is marketing strategy?
(2)
2 What is a unique selling point? Give two examples.
(4)
3 Explain how one of the following products is differentiated from its
rivals:
a) Marathon chocolate bar
b) Microsoft Xbox One
c) Heinz Tomato Ketchup.
(4)
4 Outline two pieces of quantitative data that might help a business
develop its marketing strategy.
(4)
5 Why is it important for a firm to examine its internal resources
before deciding on a strategy?
(3)
6 How does marketing strategy relate to the objectives of a
business?
(4)
7 Outline two advantages of niche marketing over mass marketing.
(4)
8 Give three reasons why a large firm may wish to enter a niche
market.
(3)
9 Explain why small firms may be better at spotting and reacting to
new niche-market opportunities?
(3)
10 Outline two reasons why average prices in niche markets tend to
 be higher than those charged in most mass markets.
(4)
Data response 1
Morrisons’ marketing strategy
In the 12 weeks to 30 March 2014, sales at UK grocery discounter
Aldi rose by 35.3 per cent, while at rival Morrisons they fell by 3.8 per
cent. This compounded a wretched two-year period for Morrisons –
the worst since Dalton Phillips took over as chief executive in January
2010 (see Figure 15.3). On 8 May 2014, the Daily Telegraph reported
that:
‘The supermarket chain slashed the price of 1,200 lines by 17 per
cent last week to counter the rise of the discounters and to reignite
its two-year attempt to report like-for-like sales growth. “I’m very
confident we are doing the right things,” Mr Philips said. “My job is to
make big, bold decisions. The proof will be when there are more
items in more baskets; how could it not be the right strategy to
tackle this on price?”
Sainsbury’s outgoing chief executive, Justin King, accused Morrisons
of “playing catch-up” in lowering prices and said customers were
enticed by ethically sourced products rather than simply price.’
Later, Phillips said that shareholders would ‘hold our feet in the fire’ if
the price-cutting strategy proved unsuccessful, but he was convinced
that this was the right long-term positioning for Morrisons.
Figure 15.3 UK grocery market share, 2012–2014 (source: Kantar
Worldpanel)
Questions (25 marks; 30 minutes)
1 Explain why price cutting in this case can be called a strategy rather
than a tactic.
(4)
2 Outline two factors that may determine whether Morrisons’ 2014
strategy proves successful.
(5)
3 Explain one possible weakness in the strategy as outlined in the
data provided.
(4)
4 In Morrisons’ circumstances, assess the probable effectiveness of
its new marketing strategy.
(12)
Data response 2
Apple’s cash machine
The Apple iPod was launched in 2001, into a market dominated by
Sony. For a company based on computers, the move into personal
music appeared risky. As the graph in Figure 15.4 shows, sales grew
slowly; iTunes was launched in 2002 but only in late 2004 did iPod
sales move ahead dramatically. This was partly due to the launch of
the iPod Mini, but also coincided with the start of the brilliant
‘silhouette’ advertising campaign. In fact, Apple has handled iPod’s
marketing strategy very cleverly.

Figure 15.4 Worldwide iPod sales volume (three-monthly periods)

(source: Apple Inc accounts)
iPod marketing mix
• Product: quick product development, from iPod 2001 to iPod Mini
2003, iPod Photo 2004 to iPod Shuffle 2005, and the iPod Touch in
late 2007 and iPod Touch 4g in late 2010. As with all its competitors,
the iPod is made (very cheaply) in China, so the key to its success is
the stylish design, not high-quality manufacture.
• Price: always startlingly high; at launch, the iPod was over £200;
even in 2014 prices for the iPod Touch were as high as £329,
whereas other MP3 players cost as little as £20. Apple has managed
the business dream of achieving market penetration at prices that
skim the market.
• Place: nothing new here; Apple has distributed the iPod through the
normal mixture of department stores, electrical shops and online
retailers.
• Promotion: brilliant and lavish use of posters and TV, featuring one of
the all-time great images, the ‘silhouette’.
The key to the strategy has always been to achieve high credibility
through brilliant design and a non-corporate image. Consumers have
tended not to notice that the iPod is an amazing cash machine. In the
year to March 2014, the revenues generated by iPod and iTunes came
to $19,960 million.
Questions (40 marks; 50 minutes)
1 a) What is meant by the term ‘product life cycle’?
(2)

Figure 15.5 iPod

b) Assess what Figure 15.4 shows about iPod’s product life cycle.
(8)
2 Assess which of the elements of iPod’s marketing mix have been the
most important in its sales success.
(10)
3 Given the business’s success with the iPod, iPhone and iPad,
evaluate whether Apple should now make a move towards the
games console business, competing with Nintendo, Sony and
Microsoft.
 (20)
Extended writing
1 Evaluate the quote by former President Eisenhower: ‘There is no
victory at bargain basement prices.’
(20)
2 Evaluate the proposition that ‘Marketing strategy can be successful
only if a firm has set the right objectives.’
(20)
Section 1.4 Managing people

16 Introduction to managing people

Definition
Managing people is the task of every manager – and usually their most
important one. The business department known as ‘Personnel’ (or
human resource management) manages the process of recruiting,
training and incentivising staff.

Linked to: Approaches to staffing, Ch 17; Recruitment,

selection and training, Ch 18; Organisational design, Ch 19;
Motivation in practice, Ch 21; Leadership, Ch 22.

16.1 People are our most important asset

In company accounts, including those of Center Parcs and Churchill China plc,
the business cliché is set out: ‘Our people are our most important asset.’ In the
case of Center Parcs, this probably isn’t true. The biggest assets of the business
are probably the brand name plus the market positioning: safe, healthy,
outdoor holidays for the whole family. Yet the company makes the claim
because managers want staff to feel appreciated; and, of course, holidaymaker
satisfaction does depend on the friendliness and efficiency of staff. But does it
have to be this staff and these people? Or could the current staff all be replaced
tomorrow by younger, cheaper people? In which case, the ‘important asset’
claim would be a hollow one.
Contrast the situation at Center Parcs with that at Churchill China. Churchill
employs people with the skill to make the tableware you would eat from at the
Ritz hotel or the finest Michelin-starred restaurants: skilfully made and
beautifully decorated. Churchill is the market leader in supplying china plates,
cups, etc. to the UK’s hospitality industry. The company’s annual report for
2014 highlights the company’s 200 years of manufacturing in Stoke-on-Trent
and the ‘talented, dedicated team’ that makes the company what it is today.
These skilled staff really are a vital asset, which is why Churchill never
followed the practice of others who ‘outsourced’ production to the Far East.
‘Employees are a company’s greatest asset – they’re your competitive
advantage. You want to attract and retain the best; provide them with
encouragement, stimulus, and make them feel that they are an integral part
of the company’s mission.’
Anne Mulcahy, former chief executive, Xerox Corporation
Although few Personnel Directors would admit it, some companies regard
their staff as costs rather than assets. As such, they seize every opportunity to
cut these costs, perhaps by outsourcing tasks or by changing employment
contracts from permanent and full-time towards the insecure world of zero-
hours contracts. When unemployment is high, it is easy to see that companies
can get away with such indifference towards their employees’ security and
morale. Well-run companies with sights on long-term success would do
everything they can to avoid breaking the bond of trust that should exist
between management and staff.
‘Everyone talks about building a relationship with your customer. I think
you build one with your employees first.’
Angela Ahrendts, former chief executive, Burberry plc

Real business
In November 2014, Airbus won a £9 billion order for 50 wide-bodied jet
planes from Delta Airlines. This was a huge success for the European
plane maker because Delta is an American airline that usually buys
from Boeing. Boeing and Airbus each have around 50 per cent of the
world market for manufacturing passenger planes, but most US airlines
buy from US Boeing. The reason for the Airbus success was largely
down to production capabilities. Airbus was able to promise delivery
dates of 2017 for 25 of the planes and 2019 for the remainder. Boeing
has struggled to increase production levels, and couldn’t promise
delivery until 2021! In the past, Boeing responded to downturns in
orders by making staff redundant and outsourcing production of
aircraft parts to Japan, Malaysia and other parts of the world. Now, in
its production base in Seattle, on America’s west coast, it no longer
has enough skilled, experienced staff to take on extra orders. Perhaps
staff were their biggest asset after all.
Figure 16.1 Different ways of viewing people in a business

16.2 Keys to effective people management

Fundamentally, there are two key goals when managing people:
• making sure you have the right number of staff, with the right skills and
experience and in the right places, to meet all production and customer
service requirements
• making sure those staff understand the business culture (‘the way we do
things round here’) and are motivated in the right way, to ensure that quality
 standards match or beat customer expectations.
It is important to realise that neither of those goals need be met by a personnel
department. In small businesses, it will often be the case that one director has
responsibility for personnel issues, but this might be one among several duties.
Therefore, hiring and training staff may be carried out by a director with no
professional background or training in personnel. But such people can
sometimes be fantastic in the role. A small building business may hire a fresh-
from-college bricklayer and do a terrific job in instilling the company’s
attitude to quality standards, in how to deal with customers and in the pace and
productivity of the working day.
‘Your employees come first. And if you treat your employees right, guess
what? Your customers come back, and that makes your shareholders happy.
Start with employees and the rest follows from that.’
Herb Kelleher, co-founder of South West Airlines
Despite this, exam questions tend to assume that personnel tasks such as
recruitment are carried out by personnel departments. These can be central
parts of an organisation or end up semi-detached, regarded by most managers
as a bureaucratic weight on the firm’s shoulders. The key is to keep the
personnel department fresh, by regularly placing staff into other departments
so that they really understand the business: two weeks on the road, selling
products; four weeks in the factory, learning every process and skill and so on.
If the personnel department is acknowledged internally to be a valuable part of
the whole, managers from other departments will come to discuss their needs.
Personnel managers can then work on solving the people problems of others.
See Table 16.1 for more detail.

Table 16.1 Personnel problem solving

16.3 Planning your staffing needs
Personnel planning is about thinking ahead so that staff have the right balance
of the right skills in each year into the future. In 2013, Fulham FC started the
season with the oldest squad in the Premier League (by far). At the season end,
the club was relegated. A succession of managers had failed to develop an
effective personnel plan. The key components of such a plan are set out below.
1 Audit what you have at the moment: how many staff and what are their skills;
ideally, this audit would include aspirations (for example, staff who say ‘I’d
love to travel’ or ‘I’ve always wanted to learn a foreign language’).
2 Analyse the business plan to turn plans into people. For example, if Lidl’s
corporate plan says ‘20 new stores to be opened in Britain in the next two
years’, the workforce plan can be set: 20 new stores, each staffed by 120
people = 2,400 new staff needed.
3 Take into account the changes on the way from here to there. How many will
leave to retire, have kids or a career change? Some football teams age
together; eleven 29-year-olds may be great, but four years later there will
be a problem.
4 Calculate the gaps that need to be filled between now and two years’ time.
An example of a human resource (HR) plan by UK grocery chain Tesco is
given in Table 16.2. Having completed this process (which should be done
carefully, with full consultation with every senior manager), it is time to put it
into practice. The process of human resource planning includes recruitment
and selection, training and development, redeployment and sometimes planned
redundancies.

16.4 Instilling staff culture and motivation

It isn’t enough to have the right number of people in the right places. These
people must give their best and do so in a manner that fits in with the overall
company style and ethos. The sandwich chain Pret a Manger has been brilliant
at this. They recruit on the basis of personality, not skill, then train people with
care. The result is that every branch of Pret seems to be staffed by friendly,
helpful but energetic/quick staff – exactly what an office worker wants at
lunchtime.
When new recruits have been appointed, they should begin with an induction
training programme that focuses on the company traditions and culture. At
Harrods, the vast store is a maze, so every member of staff asks every
customer whether they need help finding their next destination. At Aldi,
customers expect no more than efficient, speedy service.
When it comes to motivation, though, there are big issues to consider.
Personnel departments love to get involved with incentivising staff – that is,
creating rewards systems that are intended to encourage the behaviours the
company wants from staff. In furniture retailing, a 2 per cent commission rate
is common for shop-floor sales staff. So a £1,200 leather sofa is worth an
extra £24 in the wage packet. This should prove a good incentive to sell
effectively, without being such a fantastic sum of money that staff oversell or
mis-sell to people who may later regret their purchase (and complain bitterly
online).
The important thing here is to learn the difference between incentivisation and
motivation. Yes, incentives may sometimes be useful, but they are not a way to
motivate staff. Motivated staff give their best in every way they can, such as the
Business teacher who always gets work marked and returned for the next
lesson. No-one’s paying a bonus for this; it is simply motivation. Incentives
never get people to give their best, only to get people to do more of the most
important job function, e.g. paying a striker £1,000 per goal they score. But the
problem with incentives is the unintended consequences. Suddenly your team is
scoring fewer goals because the striker is too greedy in the penalty box.
Chapters 20 and 21 cover this issue with care.

Table 16.2 Components of a human resource plan for Tesco

‘The factory of the future will have only two employees, a man and a dog.
The man will be there to feed the dog. The dog will be there to keep the
man from touching the equipment.’
 Warren Bennis, business author

Five whys and a how

16.5 Introduction to managing people – evaluation

Some firms talk about staff being an important asset without seeming to
believe it. But there’s every reason to think that, for the majority of firms, staff
really are that important. Currently Jaguar Land Rover (JLR) is one of
Britain’s most successful businesses. It needed huge investment from owner
Tata Motors, but Tata would not have invested without the brilliantly successful
Evoque car, designed and manufactured by some highly motivated British
engineers. (Between 2010 and 2014, JLR sales to China rose fivefold, from
26,000 to 130,000, largely due to sales of the Evoque.) When management and
the workforce really believe that they can succeed together, the results can be
fantastic. Labour turnover at JLR is less than 2 per cent as staff want to carry
on being part of this great success.
As a rule, then, it is reasonable to think that wise organisations make sure that
staff feel wanted, trusted and secure, give them regular training and make sure
that the job they do is stimulating and motivating.

Key terms
Labour turnover: the number of staff leaving a company as a
percentage of the number employed.
Outsourcing: taking a task traditionally run by your own staff (such as
Security) and putting it out to tender, with the lowest bid winning the
contract.
Redeployment: retraining a staff member to give the skills required to
take on a new job role.
Zero-hours contracts: employment contracts that agree employee
duties and hourly pay rates, yet offer no guarantee of any work (and
therefore income) in any specific week.

16.6 Workbook
Revision questions
(30 marks; 30 minutes)
1 Give three reasons why managing people is important to a business
such as a low-cost airline.
(3)
2 Outline two possible reasons why an employee might prefer a full-
time job to a zero-hours contract.
(4)
3 Pret a Manger recruits a high proportion of its staff from overseas.
Explain why it may choose to do that.
(4)
4 Explain one situation in which a clothing chain such as Topshop
might need to:
a) redeploy 20 staff
b) outsource a job function.
(8)
5 Do you agree with Angela Ahrendts (see page 96)? Explain your
reasoning.
(5)
6 Explain one advantage and one disadvantage to a firm of having a
high proportion of staff who have been with the business for 20+
 years.
(6)
Data response
Churchill China
Churchill China plc is a pottery company based in Stoke-on-Trent. It is
shortly coming up to its 200th anniversary and is relatively rare in
Stoke (once the world’s leading pottery region) for still manufacturing
locally. On the face of it, the company is going nowhere. Sales revenue
is lower today than in 2006, and exports have changed little in the last
ten years.
Yet there has been an interesting shift in strategy. In 2006, revenue
came in a 55:45 ratio of B2B sales to B2C sales. In the first half of
2014, the ratio was 80:20. Churchill has switched to becoming
overwhelmingly a supplier of china plates, cups, etc. to hotels,
restaurants and the catering trade generally. Indeed it is now the UK’s
market leader in supplying to the ‘hospitality industry’. This is a nice
niche position to be in because it is more to do with small-scale,
tailored production than the mass market. This keeps Churchill’s trade
business away from direct competition from the Far East. It also may
give rise to a real growth path in the future, given that eating out
remains a growth trend in Britain (and elsewhere in the west).
Even prior to 2006, Churchill had largely given up producing china for
the retail market. Instead it designed ‘tableware’ in the UK, but had it
made in the Far East. So the fall-away in retail sales has quite a few
economic positives. Churchill is now focusing on producing in the UK
for the UK market – though it is also developing stronger export sales
within the hospitality trade. In the first half of 2014, Churchill’s B2B
sales to continental Europe rose by 20 per cent.
Throughout recent years, Churchill has invested in new technology,
especially in robotic kiln-loading and unloading. That means that there
are fewer low-skilled jobs in the factory today than in 2006.
Fortunately, the jobs that remain are extremely highly skilled, making it
hard for others to copy the quality and variety of Churchill’s output.
Hence its status as market leader.
Table 16.3 Overall operational performance of Churchill China, 2006–
2014 (for 2014, first half figures doubled up)
Questions (40 marks; 45 minutes)
1 Explain the difference between B2B and B2C.
(4)
2 a) Calculate the cost of staff as a percentage of sales revenue in
2007 and again in 2013.
(4)
b) Explain one conclusion you can draw from the figures you have
calculated.
(4)
3 Assess two reasons why small-scale, tailored production might suit a
company with highly skilled staff.
(8)
4 Evaluate whether it would be right to say that Churchill China’s staff
are its greatest asset.
(20)
Extended writing
1 For one of its Christmas TV commercials, Waitrose boasted that
‘people who own the business care more’. Yet regular surveys by
The Grocer magazine suggest that customer service at Waitrose is
significantly worse than at Asda or Morrisons. Evaluate the possible
factors that might make staff at one supermarket care more about
customers than the staff at another.
(20)
2 Your friend the Emir of Bhutan has just bought Birmingham FC and
appointed you as manager. All the staff have been sacked so that
you can start afresh (with a £200 million budget). Evaluate the key
principles that would influence your people management plan.
(20)
Section 1.4 Managing people

17 Approaches to staffing
Definition
Staffing is the thinking behind the broad approach to staff (asset or
cost?) and the specifics of how many people are needed in each role.

Linked to: Introduction to managing people, Ch 16;

Recruitment, selection and training, Ch 18; Motivation in
practice, Ch 21.

17.1 Staff as an asset; staff as a cost

Some companies manage to be consistently good employers over time. They
pay pensions, they do all they can to avoid redundancies and they invest in staff
training. They say, with some substance: ‘Staff are our most important asset.’
Other firms treat staff consistently meanly, paying the lowest wages they can
get away with, perhaps holding them to zero-hours contracts. Billionaire
Mike Ashley’s Sports Direct business has 20,000 staff on a particularly severe
zero-hours contract that means the employee is not allowed to work for
anyone else. So even if Sports Direct says ‘zero’ for next week’s working
hours, the employee is not allowed to work for anyone else. Mr Ashley
appears to regard his staff as a cost, not an asset.

17.2 Flexible workforce

During the 2009 recession, British engineer JCB found, at one point, that UK
demand for its construction vehicles had fallen by 90 per cent. That’s extreme,
but it indicates that businesses need flexibility within their operations. In
addition to economic factors, this need may have increased for a number of
reasons.
• Ever-improving technology means that the marketplace is subject to frequent
and often rapid change. Firms need to be able to anticipate these changes and
 respond to them quickly in order to maintain a competitive edge.
• Many consumers want more customised goods and services (that is, better
tailored to smaller segments of the population); firms have to adapt the
production process in order to meet demand, while still operating efficiently
and keeping costs down.
• Increasing competition, especially from overseas firms, has forced
businesses faced with fluctuating or seasonal demand to introduce greater
operational flexibility, in order to eliminate any unnecessary costs.
To succeed in modern markets that are often fragmented into relatively small
niches, and where customer tastes are ever-changing, many firms have adopted
lean production. This approach implies the use of machinery that can quickly
be reprogrammed to carry out a range of tasks, and the creation of a multi-
skilled and flexible workforce that can quickly adapt – and be adapted – to meet
a firm’s changing requirements.

Real business
Benefits of flexible working
As part of its pitch to get top graduates to apply for a job, Lloyds Bank
makes this statement about its flexible work practices: ‘To help you
strike the right balance between work and your personal life, we’ll
consider flexible working arrangements. These include the potential for
part-time, job sharing, variable daily hours and a “compressed working
week”.’ Lloyds believes that both it and its staff can benefit from non-
traditional work flexibility.
Source: www.lloydsbankinggroup-careers.com, 2014

17.3 Achieving greater flexibility within the

workforce
There are a number of ways in which firms can attempt to increase the level of
workforce flexibility, some of which are described below.

Multi-skilling
This occurs when workers are given the scope and ability to carry out a variety
of tasks, rather than specialising in completion of one particular area. This can
be encouraged through the use of job rotation, in which workers carry out an
increased number of tasks at the same level of difficulty. In a hotel, for
instance, the people who are usually on reception could spend time organising
wedding parties, giving them a wider understanding of the business. In Japan,
this is known as horizontal promotion, as it implies that the company has
enough faith in the individual to invest time and money in training him or her
for an extra job.
Multi-skilling the workforce should mean that a firm’s human resources can be
used more effectively. It ensures that employees are equipped with the skills
needed to cover for staff absences, minimising any disruption or loss of
production that this may otherwise have caused. Individual workers may
respond positively to the increased variety and new challenges provided,
improving motivation and productivity. However, firms may be unwilling to
bear the costs of additional training unless the benefits of adopting a new
approach are obvious and immediate. See Table 17.1.

Table 17.1 Multi-skilling: benefits and drawbacks

Part-time and temporary

In recent years, there has been a significant increase in the number of part-time
employees. Figure 17.1 shows that around a third of all employees in Britain
work part-time.
Employers love part-time workers because they give flexibility, such as to
have extra transport staff during rush hours. There is some doubt, though,
about whether part-time work is what employees want – or simply have to
accept. A May 2014 Financial Times report suggested that 40 per cent of the
part-timers want more working hours. Other research suggests that 20–25 per
cent want full-time work.

Figure 17.1 Employment in Britain, December 2013 (source: ONS)

Temporary work operates in a similar way. Giving staff short-term contracts
makes it easy for the company to cut staff without getting criticism; all they
need to do is allow the contract to lapse, and the staff member has gone.
With short-term contracts and all the other forms of employee flexibility, the
problem for the employee is: a) am I earning enough and regularly enough to
feed my kids and b) how can I possibly get a bank or building society to trust
me with a mortgage?

Flexible hours and home-working

Greater flexibility can also be created by moving away from the traditional 9–
5 working day and 38-hour working week, in order to respond more
effectively to customer demands. There are a number of methods used by
firms to vary the pattern of working, including the use of part-time work, job
sharing, annualised hours contracts and flexitime. For example, banks,
insurance companies and mobile phone operators make extensive use of
flexitime systems to provide 24-hour employee cover via the telephone and
internet, in order to provide customers with greater convenience. Introducing
greater time flexibility can also have a number of benefits for employees who
may have family or other commitments during normal working hours.
Providing staff with more flexible working arrangements can help to improve
recruitment, increase motivation and reduce labour turnover, leading to
reduced costs and boosts to productivity.

Figure 17.2 Flexible working arrangements offered by large firms

(source: DTI, CIPD and industry estimates)
A particular type of time flexibility comes from zero-hours contracts. In April
2014, government statistics showed that 1.4 million zero-hours contracts were
in use in the UK. Only two years before, the estimate had been just 200,000. A
zero-hours contract is an employment contract like any other, except that
whereas a full-time teacher contract might state a minimum of 35 hours a
week, a zero-hours one states a minimum of zero. In other words, the
employer guarantees nothing. The reality might be that workers are told on a
Thursday what work they are being offered for the following week. If it is zero
hours, a family could go hungry. The prospects of getting a mortgage are also
zero. These contracts are especially common among jobs taken by younger
workers and in poorly paid sectors. In hotels and catering, 26 per cent of staff
have zero-hours contracts. For employers, it is wonderful to turn a fixed cost
into a variable one. For the staff, flexibility becomes insecurity.
Another type of flexible worker is the home-worker. This is someone who
works at home, probably on a laptop connected permanently to the main office.
In some cases, it can be that a full-time employee does two days a week at
home – with fewer distractions from the phone, from meetings and from
gossipy staff. In other cases, the business may want as few people as possible at
head office, to keep overhead costs down, so they encourage staff to work at
home, and perhaps occasionally come in and ‘hot-desk’.

Figure 17.3 Working at home

Some really enjoy this arrangement, whereas it makes others feel insecure.
Ideally, an employee would have this as an option; it would be much less
satisfactory if it were forced upon the worker.

Real business
Home-working eases stress levels
Working from home reduces stress in office workers, but leads to fears
about career progression, according to research. A survey of 749 staff
in managerial or professional positions conducted by Durham Business
School showed that home-workers worried about missing out on
‘water–cooler networking’, where potential opportunities for moving up
the ladder are discussed informally in the office.
Despite these concerns, the study also found that working from home
generally had a positive effect on an employee’s work–life balance,
giving them more time with the family, and leading to less stress and
less chance of burnout.
Source: www.PersonnelToday.com

Outsourcing
Outsourcing involves a firm finding an external business to carry out part of
the production process, in order to cut costs or achieve a better level of
service. For example, it may involve hiring cleaning or catering services from
other companies. All firms need enough workers to respond to sudden
increases in customer demand, without having to bear the cost of employing
unnecessary staff should sales decline temporarily. One way is through the use
of temporary contracts, agency staff and subcontracting or outsourcing
certain operations to other firms. Flexible temporary staff enable firms to
respond to a sudden rise in sales by increasing the workforce quickly – and
then reducing its size just as quickly, should the sales increase prove to be
temporary. However, while a reliance on temporary staff and external
organisations may help to reduce costs and improve reaction to change,
productivity may be harmed by a lack of expertise and worker loyalty to the
firm.
‘Businesses are no longer receiving the cost savings from outsourcing that
they once did.’
Gerald Chertavian, US social entrepreneur

17.4 Distinction between dismissal and redundancy

There are three main circumstances when companies need to dispense with the
services of staff:
1 When individual staff members lack the competence to carry out their duties
effectively – or are too disruptive.
2 When economic or other factors depress demand throughout an industry,
forcing companies to cut costs in order to stay above their break-even level
of operation.
3 When competitive or other factors cause the business to lose market share in
a way that forces management to cut staff. In 2013, Blackberry cut 40 per
cent of its staff (4,500 people) to try to stay alive.
In the latter two cases, the requirement to cut staff is about posts not people;
supervisor jobs may be cut from 200 to 120. This is redundancy. From the
firm’s point of view, it isn’t making people redundant; it is accepting that the
job is redundant. In the UK, large firms that are planning redundancies have to
give staff three months’ notice that this is about to happen. That period is for
consulting with employees or their trade unions, but usually there is no
changing the mind of the company. Having decided on the redundancies, there
are legal requirements for the minimum redundancy payments, as long as staff
have been employed for at least two years. These are:
• half a week’s pay for each full year of working when you were under 22
• one week’s pay for each full year of working when you were 22–40
• one and a half week’s pay for each full year of working when you were 41
or older.
Whereas redundancy is about the job, dismissal is about the individual. An
employee can be dismissed on the spot for ‘gross misconduct’, such as being
violent or stealing. An employee can also be dismissed fairly, just for lack of
competence, as long as the management can demonstrate fairness in giving
warnings and in offering retraining or a switch to an easier job. Dismissal
comes with no payments at all.
‘You do not get good people if you lay off half your workforce just
because one year the economy isn’t very good and then you hire them
back.’
Kenneth Iverson, chairman, Nucor Corporation
Figure 17.4 Logic chain: redundancy v. dismissal

17.5 Employer–employee relationships

Intelligent bosses realise that success depends on the full participation of as
many staff as possible. Football managers typically use the club captain as the
representative of the players. Small firms may have an informal group
consisting of one person from each department; monthly meetings are used as
a way to raise issues and problems, and discuss future plans. In larger firms,
more formal methods are used to ensure that there is a structure to allow an
element of workplace democracy. Alternatively, the organisation’s staff may
belong to a trade union that represents their interests through collective
bargaining.

Trade unions and collective bargaining

A trade union is an organisation that employees pay to join in order to gain
greater power and security at work. The phrase ‘unity is strength’ is part of the
trade union tradition. One individual worker has little or no power when
discussing pay or pensions with his or her employer; union membership
provides greater influence collectively in relations with employers than
workers have as separate individuals.
Some people assume that union membership is only for people in low-status
jobs. In fact, although trade unions are in decline in Britain, some powerful
groups of ‘workers’ remain committed to membership. For example, the PFA
(Professional Footballers’ Association) includes almost all Premiership
players, and more than 75 per cent of airline pilots belong to their union,
BALPA.
Traditionally, unions concerned themselves solely with obtaining satisfactory
rates of pay for a fair amount of work in reasonable and safe working
conditions. Today the most important aspect of the work of a trade union is
protecting workers’ rights under the law. Far more time is spent on health and
safety, on discrimination and bullying, on unfair dismissal and other legal
matters than on pay negotiations. One other important matter today is
negotiations over pension rights. Recently, many companies have cut back on
the pension benefits available to staff; the unions fight these cutbacks as hard as
they can.
Traditionally, the key function of a union was ‘collective bargaining’. This
means that the union bargains with the employers on behalf of all the workers
(for example, that all nurses should get a 2.4 per cent pay rise). In April 2014,
a one-year wrangle between the Post Office and the Communication Workers’
Union resulted in agreement to pay rises of up to 7.3 per cent.

Real business
Unite
In March 2013, workers at Greencore’s cake factory in Hull voted
overwhelmingly to accept management’s offer to restore pay and
conditions to their original levels. This was the culmination of an 18-
month dispute. In October 2011, Greencore (supplier of cakes to
Tesco and other supermarkets) gained agreement from its staff and
trade union to a temporary cut in payments for overtime and bank
holiday working. A year later, though, when the ‘temporary’ period was
over, the company refused to reinstate the original terms. Staff who
were mainly paid minimum wage levels stood to lose £40 a week
(according to Unite, their trade union). Legal appeals and a one-day
strike followed – eventually leading to the company’s climb-down.

‘The two sides of industry have traditionally always regarded each other in
Britain with the greatest possible loathing, mistrust and contempt. They are
both absolutely right.’
Auberon Waugh, writer

Individual bargaining
Most employers are in favour of individual rather than collective bargaining.
Quite simply, it puts the boss in a stronger position. This situation may be
presented as a matter of ‘freedoms’, but at heart it is a matter of power. The
huge decline in union membership in America and Britain in the past 30 years
has coincided with a significant reduction in income equality. Individuals’ weak
bargaining power has meant that workers today are far worse off compared
with their managers than would have been the case 30 years ago.

Five whys and a how

17.6 Approaches to staffing – evaluation
The adoption of a flexible approach and a more flexible workforce can, in
principle, be an attractive prospect for any modern business, offering a
number of benefits, including reduced costs and an increased ability to respond
to changing customer demands. The separation of employees into highly
valued core workers and an easily dispensable periphery may allow a business
to ‘pick and mix’ skills and obtain the exact combination required within the
market at that particular moment in time.
However, it can also lead to a number of problems in the long term, especially
if it creates insecurity among peripheral workers that leads to high levels of
staff turnover. The ability to cut labour costs quickly and easily in the face of a
downturn in the market has obvious attractions. However, in the long term, the
establishment of a multi-skilled and loyal workforce, able to adapt and
diversify into new markets, may lead to even greater success.

Key terms
Core workers: employees who are essential to the operations of a
business, supporting whatever makes it distinctive or unique. Such
workers are likely to receive attractive salaries and working conditions,
and enjoy a high degree of job security.
Flexible approach: an approach to operations that implies a move
away from mass production to batch production, the use of machinery
that can be quickly reprogrammed to carry out a range of tasks, and
the creation of a multi-skilled and flexible workforce that can quickly
adapt to meet a firm’s changing requirements.
Hot-desk: an approach that provides a temporary desk for home-
workers to use when they come to the main office; they are not
allowed to leave any of their own possessions there.
Outsourcing: taking a task traditionally run by your own staff (such as
Security) and putting it out to tender, with the lowest bid winning the
contract.
Peripheral workers: those workers who are not seen as being central
to a firm’s operations. They may carry out necessary tasks, but may
be required only on a temporary basis and may be easily replaced.
Subcontracting: where another business is used to perform or supply
certain aspects of a firm’s operations (see ‘Outsourcing’).
Zero-hours contracts: employment contracts that agree employee
duties and hourly pay rates, yet offer no guarantee of any work (and
therefore income) in any specific week.

17.7 Workbook
Revision questions
(40 marks; 40 minutes)
1 Why could increased market change have an effect on the way
people are employed today?
(3)
2 Outline two reasons why firms may have chosen to adopt a more
flexible approach to workforce arrangements.
(4)
3 Briefly explain what is meant by the term ‘lean production’.
(3)
4 Explain, using examples, what is meant by the term ‘multi-skilling’.
(4)
5 Why might a company encourage its staff to work from home
rather than in a central office?
(3)
6 In 2013, a newspaper said that ‘100 workers have been dismissed
(at a local factory) because of weak trading’. Explain why the paper
was incorrect.
(3)
7 State two ways in which a bank offering telephone and internet
services to customers would benefit from introducing greater time
flexibility.
(4)
8 Outline one advantage and one disadvantage to joining a trade
 union when you start your first job.
(6)
9 Outline two reasons why a firm’s employees may welcome the
decision to move towards increased labour flexibility.
(4)
10 Examine two reasons why the move towards greater flexibility
might lead to increased insecurity within the workforce.
(6)
Data response 1
Flexible working at First Direct
First Direct is one of the UK’s leading commercial banks, providing a
wide range of financial services via telephone and the internet to 1.2
million customers. When First Direct began, high street banks opened
only between 9.00am and 3.00pm, Monday to Friday. However, the
company set out to create a different business model, based on the
customer need for greater convenience. Since its establishment, First
Direct’s reputation has rested on the fact that it is the bank that never
closes. It ignores weekends and bank holidays. Operators in the
company’s call centres handle approximately 235,000 calls each week,
with more than 13,000 daily coming outside normal working hours.
The company’s operations have required it to develop a working
culture that is very different from the traditional model. This has
included longer shifts, a high proportion of part-time and home-based
workers, and reliance on so-called ‘mushrooming’ – a term used to
describe workers employed to work night-time shifts.
First Direct appears to have succeeded on a number of levels. The
quality of its customer service has resulted in high rates of customer
retention. Employees also appear to approve of the company’s
approach to flexible working; labour turnover, at 14 per cent, is far
below the average for call centres, and 90 per cent of female staff
return to their jobs after maternity leave.
Questions (30 marks; 35 minutes)
1 Give two examples of flexible working practices used by First Direct.
 (2)
2 Assess two possible benefits for a business such as First Direct of
creating a more flexible workforce.
(8)
3 Evaluate whether the creation of a more flexible workforce is crucial
to the continuing success of a company such as First Direct.
(20)
Data response 2
Life on zero-hours contracts
Chris Morrison: I’m 28, single and work in retail. One week I can have
30-plus hours, the next I’ll have less than 15. It’s next to impossible to
maintain a decent standard of living when your wages are so
unpredictable. I struggle to pay bills sometimes. The company I work
for has cut back to a bare essential crew but still expects the same
level of service, which is next to impossible to do. I often leave work
feeling very stressed, which is not good for my health.
Harry Thompson: I’m a student and have had a few zero-hours
contracts, from working in factories wrapping cheese in cling film to
picking out spare parts in a vending machine factory. Zero-hours
contracts were useful occasionally, but I’d support any attempts to
regulate them. I worked on zero hours during the summer and, when I
was on a week-long placement, I was told that part of the factory had
a technical problem so its contracted employees couldn’t work – so
they sent home the people on zero-hours contracts and replaced us
with the contracted employees. It is not a nightmare for a student, but
you can’t plan a life on zero hours. I can’t imagine being on low pay
living on the brink and then just being told to go home when there isn’t
any work. If zero-hours contracts were regulated, they’d almost
certainly have hired people to do the work anyway, but with proper
rights and stability.
Source: The Guardian, 30 April 2014
Questions (30 marks; 35 minutes)
1 Give two complaints about zero-hours contracts made by both Chris
and Harry.
 (2)
2 For firms, an alternative to zero-hours contracts is to outsource the
work to specialist companies. Assess two possible downsides to
outsourcing a job such as nursing.
(8)
3 The move to zero-hours contracts is said to be a way to adapt the
organisational structure to improve competitiveness. Using the
evidence and your wider knowledge, evaluate how likely it is to
achieve this effect.
(20)
Extended writing
1 Management guru Robert Townsend urged companies to dismantle
their personnel departments and make sure that every manager felt
responsible for training and motivating their own staff. Evaluate
whether that idea would work in a big, modern business such as
McDonald’s.
(20)
2 Evaluate the possible impact of adopting more flexible working
practices on the international competitiveness of a firm such as
Cadbury.
(20)
Section 1.4 Managing people

18 Recruitment, selection and

training
Definition
Recruitment (and selection) means filling job vacancies by defining the
job, attracting suitable candidates and selecting those best suited to fill
it. Training means work-related education, where employees learn new
skills or develop the skills they already possess.

Linked to: Introduction to managing people, Ch 16; Approaches

to staffing, Ch 17; Production, productivity and efficiency, Ch
41.

18.1 The need for effective recruitment

Every service business relies on its staff to present the face of the organisation
to the customer. It can be a gloomy, perhaps bored face, or it can be lively and
smiling. Many factors are involved in this stark difference, but it certainly
helps if you recruit bright, enthusiastic staff in the first place.

Real business
Ryanair and easyJet compete for qualified pilots
The rapid growth of low-cost airlines has forced Ryanair and easyJet
to compete fiercely for the scarcest resource: qualified pilots. Table
18.1 shows what each airline was offering in summer 2014 to attract
potential recruits.
Table 18.1 Terms and conditions of employment (source: easyjet.com
and ryanair.com)

18.2 The recruitment process

The recruitment process may be triggered by a number of events. For example,
an existing employee may have chosen to leave his or her job, perhaps as a
result of retirement or after finding employment elsewhere. At this point, it
would be worth analysing the vacant job role. Do all of the responsibilities
associated with the vacant job still need to be carried out or are some
redundant? Could the remaining duties be reorganised among the existing
employees? Alternatively, additional workers may need to be recruited in
order to support a firm’s expansion strategies, or employees with new skills
may be required to help develop new products or new markets.
Once the firm has established its human resources requirements, the next step
is to consider the nature of work and workers required in order to draw up a
job description and a person specification.
Both documents have an important influence on recruitment and selection; they
can be used not only to draw up job adverts, but also to assess the suitability of
candidates’ applications and may also form the basis of any interview
questions.

Job description
A job description relates directly to the nature of the position itself, rather than
the person required to fill it. Typically, a job description would contain the
following information:
• the title of the post
• details of the main duties and tasks involved
• the person to whom the job holder reports and any employees for whom the
job holder is responsible.

Person specification
A person specification identifies the abilities, qualifications and qualities
required of the job holder in order to carry out the job successfully. The main
features of a person specification include:
• any educational or professional qualifications required
• necessary skills or experience
• suitable personality or character – for example, ability to work under
pressure or as part of a team.

Real business
By 2014, recovery from recession and policies such as near-zero
interest rates had created a recruitment boom in the City of London.
KPMG is one of the biggest employers of graduates, hiring
approximately 1,000 university leavers each year. The accountancy
firm goes to great lengths to ensure that they hire the best possible
people. Their recruitment begins with an online application form. After
the form has been completed, applicants are sent a hyperlink to a
Situational Judgement Test (SJT). The test asks candidates how they
would respond to a series of challenging work-based situations. Those
who pass the SJT are then invited to sit another online test, designed
to assess the candidates’ numerical and verbal reasoning. If this test is
also passed, applicants are interviewed over the telephone to see
whether they have the right ‘behavioural capabilities’.
The next hurdle is the Immersive Assessment Centre – a one-day visit
to KPMG’s offices in central London where prospective employees’
communication and decision-making skills are assessed. Candidates
are required to respond to emails and voicemails sent from fake
clients. The day ends with two simulated meetings. Pass this and you
are through to the sixth and final stage of the process: an interview.

18.3 Internal recruitment

A business may choose to fill a vacancy internally – that is, from the existing
workforce. This could be done either by redeploying or by promoting a
worker from elsewhere in the business. Although internal recruitment can have
a number of benefits, it also has a number of disadvantages and is obviously of
no use when a business needs to expand its workforce in order to respond to an
increase in demand. See Table 18.2.

Table 18.2 Internal recruitment: advantages and disadvantages

18.4 Recruiting external candidates

Firms can choose from a range of methods to attract external candidates to fill
a job vacancy. The advantages and disadvantages of external recruitment are
set out in Table 18.3.
Table 18.3 External recruitment: advantages and disadvantages

Methods of recruitment
Methods of recruiting external candidates include those set out below.

Media advertising
Firms may place job adverts in newspapers or specialist magazines, on the
radio or TV or by using dedicated employment websites, such as
www.monster.co.uk.

Job centres
These are government-run organisations which offer a free service to firms
and tend to focus on vacancies for less-skilled manual and administrative jobs.

Commercial recruitment agencies

Examples of commercial recruitment agencies include Alfred Marks or Reed,
which will carry a number of human resources functions, including
recruitment, on behalf of firms in return for a fee.

Executive search consultants

Executive search consultants are paid to directly approach individuals – usually
those in relatively senior positions. (This is known as poaching or
headhunting.)

Firm’s own website

In addition, many businesses have careers pages on their own websites, which
are used to advertise vacancies.

Factors influencing choice of method

The choice of recruitment method or methods used by a business will depend
on a number of factors, including the:
• cost of the recruitment method
• size of the recruitment budget
• location and characteristics of the likely candidates.

18.5 The selection process

Once a number of suitable candidates have applied for the vacancy, the
selection process can begin. This will involve choosing the applicant who most
closely matches the criteria set out in the person specification for the job. A
number of selection techniques exist, including those set out below.

Interviews
This is still the most frequently used selection technique; an interview may
consist of one interviewer or a panel. Interviews are relatively cheap to
conduct and allow a wide variety of information to be obtained by both sides,
but are often susceptible to interviewer bias or prejudice. They are, therefore,
considered to be an unreliable indicator on their own of how well a candidate
will carry out the job in question.

Testing and profiling

Aptitude tests measure the level of ability of a candidate such as, for example,
the level of ICT skills. Psychometric profiling examines personality and
attitudes – for example, whether the candidate works well under pressure or is
an effective team player. Profiling is commonly used as part of management
and sales consultancy recruitment, but it is questionable as to whether
recruiting a ‘personality type’ for a particular job is desirable. Recruiting a
wider range of personalities may lead to a more interesting and creative
environment.

Assessment centres
These allow for a more in-depth assessment of a candidate’s suitability by
subjecting them to ‘real-life’ role plays and simulations, often over a number
of days. Although assessment centres are considered to be an effective
selection method, they can be expensive and tend, therefore, to be reserved for
filling more senior management positions. See Figure 18.1 for an illustration
of the stages in the recruitment process.

Figure 18.1 Stages in the recruitment process

Although a firm can only be certain that the right person has been recruited
once he or she starts work, effective recruitment and selection will reduce the
risk involved. There are a number of methods that can be used to evaluate the
process, including calculating the cost and time involved in filling a vacancy,
the percentage of candidates who actually accept job offers and the rate of
retention of staff once employed.

Real business
Do employers still want graduates?
According to research published by the IPPR (Institute of Public Policy
Research) in June 2014, the UK economy is expected to create an
additional 14.4 million jobs over the next decade. The study claims that
two-thirds of these new jobs will be in medium and low-skilled
industries, such as building, administration and social care. In response
to their own report, the IPPR have called for more students to
consider vocational courses, rather than university degrees. More than
a quarter of graduates suffer from ‘low-earner anxiety’ and are less
likely to be happy with their pay than non-graduates. According to the
IPPR, this suggests that a degree can promote ‘a false sense of
earnings capability’.

18.6 Costs of recruitment and selection

Recent research puts the average cost for recruiting new staff at around £1,850
per employee. This is only a small part of the overall loss to the business,
which includes hiring temporary workers before the employee starts and the
28 weeks it takes for new workers to reach their optimum productivity level.
The overall loss is important because it emphasises that companies must get
their recruitment and selection methods right. Spending thousands to hire
someone, then having to do it all again when they leave, is really costly.
Among the main direct costs of recruitment and selection are management
time spent interviewing candidates (perhaps £800), recruitment agency fees
(£450), advertising (£400) and HR time spent administering the process
(£200). Some of these costs will change over time, especially advertising, as
firms switch to cheaper digital communication. Overall, though, the cost is not
huge in relation to the potential losses from high labour turnover if the
recruitment and selection process is bungled.

18.7 Training
The purpose of training is to help employees to develop existing skills or gain
new ones. The benefits and costs of training are given in Table 18.4. Types of
training include those set out below.
Table 18.4 Training: benefits and costs

Induction training
Induction training aims to make newly appointed workers fully productive as
soon as possible by familiarising them with the key aspects of the business.
Induction would typically include:
• information on important policies and procedures, such as health and safety
• a tour of the organisation and an introduction to colleagues
• details of employment; for example, payment arrangements, holiday
entitlement, and so on, and basic duties.

On-the-job training
For this method of training, employees are not required to leave their
workplace but actually receive instruction while still carrying out their job.
This means that workers can receive training while remaining productive to
some extent. Common methods include mentoring and coaching. A key benefit
of on-the-job training is that it is specific to the particular workplace. Instead
of being taught in general about stock control systems, Sainsbury’s staff learn
about the Sainsbury’s stock control software and stock management. A
government survey of employers published in January 2014 found that 52 per
cent of staff had received on-the-job training in the previous year. This is
compared with 49 per cent of staff taking off-the-job training.

Figure 18.2 Logic balance: on-the-job training

Off-the-job training
For off-the-job training, employees leave their workplace in order to receive
instruction. This may involve using training facilities within the firm – for
example, seminar rooms, or those provided by another organisation, such as a
university, college or private training agency. Although this will inevitably
involve a temporary loss of production, it should allow the trainee to
concentrate fully on learning and perhaps allow access to more experienced
instructors than those available within the workplace.
18.8 Costs of training
The costs involved in training staff should be accepted as a valuable and
responsible part of the role of an employer. Not all companies see things that
way. Among small firms employing 2–4 people, 48 per cent provide no staff
training at all. This figure declines to 7 per cent as the company size increases
to 25–99 staff and falls to zero for those employing 100+. As shown in Figure
18.3, the average spend on training amounted to £2,550 per employee in 2013.
Note that this figure includes everything, including the salaries of the human
resource staff involved in organising the training, and the salaries of the staff
being trained! The average staff member would struggle to believe that they
had received £2,550 worth of training in a year.
According to government data, between 2011 and 2013, there was a significant
fall in the amount employers spent on staff training. This is surprising given
that this was a period of quite sharply improving company profitability, with
rising dividends being paid out to shareholders. Furthermore it was a period of
rising employee numbers. Figure 18.3 shows the severity of the decline, with
the amount being spent per employee falling by 17 per cent between 2011 and
2013.

Figure 18.3 Training costs for UK companies (source: figures from UK

Commission’s Employer Skills Survey 81, January 2014)
Five whys and a how
18.9 Recruitment, selection and training –
evaluation
Recruitment and training are key aspects of human resources management
(HRM) and the importance of effective HR strategies in helping a firm –
however large or small – to achieve its objectives cannot be overstated.
‘Having the right person with the right skills in the right job at the right time’
will allow a business to maintain or improve its competitiveness; having the
wrong person is likely to lead to a deterioration in performance and an
increase in costs. Many organisations continue to view training in particular as
an avoidable expense, choosing to cut training budgets when under pressure to
cut costs, or to poach employees already equipped with the necessary skills
from other firms. New employees can bring a number of benefits, including
fresh ideas and approaches to work. However, such an approach may fail to
weigh up the possible long-term impact on the quality and motivation of the
workforce, and the implications of this for productivity and competitiveness.

Key terms
Induction training: familiarises newly appointed workers with key
aspects of their jobs and their employer, such as health and safety
policies, holiday entitlement and payment arrangements. The aim is to
make employees fully productive as soon as possible.
Labour turnover: the number of staff leaving a company as a
percentage of the number employed.
Off-the-job training: where employees leave their normal place of work
in order to receive instruction, either within the firm or by using an
external organisation such as a college or university.
On-the-job training: where employees acquire or develop skills without
leaving their usual workplace, perhaps by being guided through an
activity by a more experienced member of staff.

18.10 Workbook
Revision questions
(40 marks; 40 minutes)
1 Outline two reasons why a business may need to recruit new
employees.
(4)
2 Briefly explain the difference between a job description and a person
specification.
(4)
3 Outline two factors that would influence the method of recruitment
used by a business.
(4)
4 Suggest two reasons why internal recruitment may not be a suitable
means of filling vacancies for a rapidly expanding business.
(2)
5 Outline one advantage and one disadvantage of external
recruitment.
(4)
6 Examine one suitable method for recruiting applicants to each of the
following job roles:
a) a caretaker for a local school
b) a temporary sales assistant for a high street retailer over the
Christmas period
c) a marketing director for a multinational company.
(12)
7 Outline one advantage and one disadvantage of using interviewing
as a method of selecting candidates for a job vacancy.
(4)
8 Suggest two methods that a firm could use to evaluate the
effectiveness of its recruitment and selection procedure.
(2)
9 Outline two reasons why a firm should provide induction training for
newly recruited employees.
(4)
Data response 1
Etsy
Etsy is an American-based e-commerce business that competes
against eBay by specialising in selling vintage and handmade bags,
furniture, jewellery and toys.
In 2012, Chief Technical Officer (CTO) Kellan Elliot-McCrea realised
that the company had a problem: 80 per cent of their customers were
female. However, only three out of their 110 website engineers were
women. Elliot-McCrea saw this as a problem because she believed that
there was a danger that the engineers who designed the website might
become disengaged with the company’s customers. She responded by
launching a recruitment drive that was designed to hire more women in
order to create a better gender balance.
Etsy decided against lowering their standards. Female applicants were
expected to have the same qualifications, skills and experience as their
male counterparts. However, the company did decide to change its
aggressive style of interviewing that placed greater emphasis on speed
and bluster, rather than on technical knowledge. They also offered
$5,000 grants that were paid selectively to women programmers in
return for attending a three-month Hacker School set up by Etsy in
New York City.
The programme is working; by 2013, 20 out of the company’s team of
110 engineers were women.
Source: adapted from Business Insider, 11 February 2013

Questions (25 marks; 30 minutes)

1 Outline one possible reason why most of Etsy’s team of engineers
were men.
(3)
2 Assess how businesses like Etsy might benefit from employing a
more diverse workforce.
(10)
3 Assess the pros and cons of on-the-job and off-the-job training for
companies like Etsy.
 (12)
Data response 2
Are butlers born, not made?
Butlers, the discreet mainstays of high society in the nineteenth and
early twentieth centuries, are enjoying a renaissance. While middle
classes in the US and Europe have suffered during the five years of
economic crisis, the ultra-rich have fared far better during and since
the recession. Amid growing demand, butler training courses have
flourished. For recent training offered by the Italian Butlers
Association, 70 people applied for ten places. Candidates were
selected through written applications and an interview. Aspiring butlers
met in Rome’s Empire Palace Hotel. They were taught how to polish
silver and set the table for brunch on a boat, and were lectured on the
subtle art of escaping from a talkative guest. They were also taught
the basics of wine tasting and serving.
Some scoff at the idea that butlering can be taught in a classroom.
‘They’re taking anybody, including somebody who might have been a
truck driver for 20 years who decides he want to be a butler’, says
John Pettman, a former butler who now recruits staff for families on
the Forbes Billionaires List.
Source: Reuters, 16 May 2014

Questions (25 marks, 25 minutes)

1 Outline two personal qualities to be expected of a butler to a
billionaire.
(5)
2 Assess two possible benefits of training prospective butlers in the
classroom.
(8)
3 Assess what might be included in a programme of induction training
for a new butler.
(12)
Extended writing
1 Stamford Software Solutions, a medium-sized IT company based in
the south-east of England, needs to recruit a new sales manager.
Evaluate how the company should do this.
(20)
2 According to the Leitch Report, UK employers spend an estimated
£33 billion in total each year on training, yet one third of employers
provide no training at all. Evaluate the most likely consequences for
firms who choose not to train their staff.
(20)
Section 1.4 Managing people

19 Organisational design
Definition
Organisational design means creating the formal hierarchy that
establishes who is answerable to whom throughout the organisation.
When presented as a diagram, it shows the departmental functions
plus the vertical and horizontal links that represent the formal
communications system.

Linked to: Motivation in theory, Ch 20; Motivation in practice,

Ch 21; Leadership, Ch 22.

19.1 Introduction
As organisations became larger and more complex, early management
thinkers such as F.W. Taylor and H. Fayol considered how to structure an
organisation. Both saw the function of organisations as converting inputs, such
as money, materials, machines and people, into output. Therefore, designing an
organisation was like designing a machine, the objective being to maximise
efficiency.
Taylor and Fayol based their thoughts largely on the way an army is organised.
The key features of the hierarchy would be as follows:
• To break the organisation up into divisions with a common purpose: in
business, this would usually be the business functions: marketing, finance,
people and resource management.
• Every individual would answer to one person: their line manager.
• No manager would be overloaded with too many subordinates, so the span
of control would be kept low.
• To achieve low spans of control, it would be necessary to have many
management layers. Examples of management layers are shown in Table
19.1.
Table 19.1 Examples of management layers

19.2 The growing business

In the early stages of a new business, there are often only one or two people
involved. When the business is so small, the day-to-day tasks are carried out by
the owner/s; no formal organisation is needed as communication and co-
ordination will be carried out on an informal, face-to-face basis. However, as
the business grows and more people become involved, the firm will need to
develop a more formal organisational structure. This will show the roles,
responsibilities and relationships of each member of the firm. This is often
illustrated through an organisational chart. This is a diagram that shows the
links between people and departments within the firm. It also shows
communication flows/channels, lines of authority and layers of hierarchy.
Each of these terms will be explained later in the chapter.
When Matteo Pantani founded Scoop ice cream in Covent Garden in 2007, he
employed only part-time staff at the counter to serve the ice cream and take the
money. Matteo made the ice cream and ran the business. He did not need to
think about a ‘hierarchy’ or a ‘structure’; the organisational structure that
existed in 2007 is shown in Figure 19.1.
Figure 19.1 Scoop: old organisational structure
As the business grew, he opened a second outlet in 2010, in Brewer Street,
Soho, and a third in South Kensington in 2012. This meant he needed managers
to run the other outlets, while Matteo was largely at Covent Garden. By mid-
2014, the organisational hierarchy looked like the one shown in Figure 19.2.
The point, of course, is to appreciate how much more complex a hierarchy
becomes as the business grows.

19.3 Organisational structure

This section will examine the main areas of theory associated with
organisational structure and how it is designed. To help clarify, references will
be made to the organisational structure in Figure 19.2.

Levels of hierarchy
These show the number of different supervisory and management levels
between the bottom of the chart and the top of the hierarchy. Figure 19.2 shows
that at Scoop there are now four levels of hierarchy. In an organisation such as
Tesco plc, which employs more than 500,000 staff, it is easy to see how there
might be 25 levels of hierarchy. This will cause problems with extremely slow
(and unreliable) communications between top and bottom of the organisation.
TV programmes such as Undercover Boss show consistently how hard it is for
the chief executive to understand the problems faced by those on the shop
floor.

Span of control
This describes the number of people directly under the supervision of a
manager. Matteo has the widest span of control, as he has four staff under him
directly. If managers have very wide spans of control, they are directly
responsible for many staff. In this case, they may find that there are
communication problems, or the workers may feel that they are not being
given enough guidance. The ideal span of control will depend upon the nature
of the tasks and the skills and attitude of the workforce and manager. (See
Table 19.2.)

Figure 19.2 Scoop: new organisational structure

Table 19.2 Advantages and disadvantages of a narrow span of control

Chain of command
This shows the reporting system from the top of the hierarchy to the bottom;
that is, the route through which information travels throughout the
organisation. In an organisation with several levels of hierarchy, the chain of
command will be longer and this could create a gap between workers at the
bottom of the organisation and managers at the top. If information has to travel
via several people, there is also a chance that it may become distorted.
Centralisation and decentralisation
This describes the extent to which decision-making power and authority is
delegated within an organisation. A centralised structure is one in which
decision-making power and control remains in the hands of the top
management levels. A decentralised structure delegates decision-making power
to workers lower down the organisation. Many organisations will use a
combination of these approaches, depending upon the nature of the decision
involved. For example, in many schools and colleges, the decisions
concerning which resources to use will be decentralised – that is, taken by
teachers as opposed to the senior management team. Other decisions,
concerning future changes in subjects being offered, may be centralised – that
is, taken by senior managers.
‘It’s a paradox that the greater the decentralisation, the greater the need for
both leadership and explicit policies from the top management.’
Bruce Henderson, chief executive, Boston Consulting Group
Influences on centralisation v. decentralisation are primarily internal – that is,
within the business. Often they represent alternatives that look rosier if the
opposite approach has proved disappointing. Therefore, there is a risk that a
company in difficulties will lurch from one approach to the other – and
perhaps back again. The Waterstones book shop chain has suffered from this. It
was set up by founder Tim Waterstone as a decentralised, locally oriented
chain of stores. When bought by WHSmith, book buying and store layouts
were centralised. Today they are back with a more localised, decentralised
approach.
Figure 19.3 Logic chain: centralised v. decentralised organisations

19.4 Types of structure

Tall
A hierarchy is tall when there are lots of layers of management – all
responsible for relatively few people. In other words, the span of control is
narrow. In Figure 19.4, you can see a relatively tall hierarchy on the left. It
takes four layers of management to run 81 shop-floor staff because each
manager is directly responsible for only three people. On the right, only two
layers of management are needed because the span of control is nine.

Figure 19.4 Organisational structures with the number of people at

each level of the hierarchy
In Figure 19.4, the whole staff remains quite small at around 100. At the time
of writing, Tesco plc has over 500,000 staff. Imagine how tall the hierarchy
would have to be, especially if Tesco has a narrow span of control throughout
the business. That, in turn, would mean too many layers for a message to get
successfully and speedily from the shop floor to the chief executive.
‘If a sufficient number of management layers are superimposed on top of
each other, it can be assured that disaster is not left to chance.’
Norman Augustine, US chief executive
So why would any business want a tall hierarchy? If the business wants to avoid
mistakes, it will make sure that everyone is carefully supervised. That requires
a narrow span of control and therefore a tall hierarchy. If you are a young
company needing to make quick, smart decisions, you will want a flat
hierarchy in which the boss can really know the thoughts from the shop floor.
In a middle-aged company with successful brands, avoiding mistakes may be
the priority.

Flat
If the hierarchy is flat, vertical communication should be speedy and perhaps
direct (shop-floor worker talking straight to the boss instead of talking
through his or her manager). This is a huge help in the service sector, where
most shop-floor workers are in daily touch with customers, giving them
fantastic insights. There should be nothing to stop the boss sharing these.
‘Every management layer you can strip away makes you more responsive.’
John Whitney, US academic
So the younger and more dynamic the market, the better it is to have a flat
structure. Also, from the worker ’s point of view, a flat structure implies a wide
span of control. That means every boss is in charge of quite a lot of staff,
which in turn means that it is impossible to supervise everybody closely. So a
wide span will give employees more flexibility to do things their own way,
which has the potential to be motivating.

Matrix
Whether a structure is tall or flat, most people at work know who their boss is;
in other words, the lines of accountability are clear. I work for you and if I do
well you praise me and if I do badly, you know – and act accordingly. You are
my ‘line manager ’.
In a matrix structure, it is different. My job description may say I work in
marketing, but I may have been put (or volunteered to go) into a project team
that is ‘cross-functional’. In other words, it may include a design engineer
from operations, an accountant and a marketing executive, all working
together to find a solution to a problem – or working on an innovative new
product.
Table 19.3 Advantages and disadvantages of a matrix structure

19.5 Impact of organisational structure on efficiency

and motivation
In the past, some firms had very tall hierarchical structures, which meant there
were many layers of management, often with quite narrow spans of control.
This made them expensive to run, because of the management salaries that had
to be paid. Tall structures also resulted in longer chains of command, which
could have a negative impact on communication. More recently, companies
have become flatter, meaning fewer layers of management, with each manager
having a wider span of control. Although some managers dislike this increased
responsibility, workers often thrive with increased independence. Furthermore,
the firm will have reduced overhead costs, which means greater business
efficiency.
Why is organisational structure so important?
As a firm grows, more people will become involved and, to ensure that the
different tasks are fulfilled, it will be vital that every person is clear about what
the role involves and who they are answerable/accountable to and responsible
for. Poor organisational structures will lack co-ordination, causing the
following problems of business efficiency:
• poor communication leading to mistakes
• duplication of tasks
• tasks being overlooked
• departments failing to work together effectively.
In the longer term, these problems will create a sub-standard service and this
will have an impact on the firm’s sales, revenue and profit. As a firm expands,
it must ensure that its organisation structure accommodates the growth.

And what is the impact of different structures on

motivation?
Motivation comes from within; it is the desire to push yourself to achieve what
you want to achieve (not for an external reason, such as money). Key
influences on motivation are scope for initiative and responsibility. Both are
extremely unlikely in a tightly supervised role, and therefore a narrow span of
control/tall hierarchy is likely to be a hindrance. Much more promising is a
less structured, flat hierarchy. This was how Microsoft, Apple, Google and
Facebook all started. Individuals were given the freedom to develop their own
ideas within a loose, but flat structure. They all did pretty well. The same logic
applies to decentralisation (potentially motivating) versus centralisation (little
scope for motivation).
It would be wrong, though, to simplify these things. Simply having a flat
structure guarantees nothing. At the time of writing, both Asda and Morrisons
have removed a whole middle-management layer in their stores. This makes
their structures flatter. Yet if all that results is more work for everyone left in
post, it is improbable that motivation will improve. For a flat structure to be
effective, it needs to be thought through so that everyone has the time to think –
and perhaps talk – about the fundamental issues that can help make a success of
the business.
 ‘Every company has two organisational structures: the formal one is
written on the charts; the other is the living relationship of the men and
women in the organisation.’
Harold Geneen, US management guru

Five whys and a how

19.6 Organisational design – evaluation
There is no ‘ideal’ organisational structure or span of control. What works for
one business may fail in another, even if both are the same size. In exams, there
will usually be hints about whether the structure is working. A flat hierarchy
may be at the heart of an innovative business, or there may be signs that staff
lack direction and morale. A tall hierarchy may be at the centre of a focused,
career-orientated workforce, or it may be bureaucratic and incapable of a
quick decision. The judgement is yours.

Key terms
Cross-functional: ‘across the functions’; in other words, it draws from
all the functions instead of just one.
Delayering: removing a management layer from the organisational
structure.
Line manager: a manager responsible for meeting specific business
targets and responsible for specific staff.
Matrix structure: where staff work in project teams in addition to their
responsibilities within their own department. Therefore, staff can be
answerable to more than one boss.
Span of control: the number of staff who are answerable directly to a
manager.

19.7 Workbook
Revision questions
(35 marks; 35 minutes)
1 What is meant by the chain of command?
(2)
2 Define span of control.
(2)
3 Some theorists believe that the ideal span of control is between
three and six. To what extent do you agree with this?
(5)
4 Explain two implications of a firm having too wide a span of
control.
(4)
 5 Explain what an organisational chart shows.
(4)
6 Why is it important for a growing firm to think carefully about its
organisational structure?
(5)
7 State three possible problems for a business with many levels of
hierarchy.
(3)
8 What is meant by the term ‘accountable’?
(2)
9 What do you think would be the right organisational structure for
a hospital? Explain your answer.
(4)
10 In your own words, explain the meaning of the term ‘matrix
management’.
(4)
Data response 1
Management changes at ailing Morrisons could see 2,000
jobs axed
Morrisons is set to reveal a management restructuring in its stores
within weeks that could lead to as many as 2,000 job losses. The
move, resulting from trials of slimmed-down management structures is
likely to affect middle-managers overseeing product categories such as
fresh food or non-food across the supermarket’s 500 UK stores.
The restructuring echoes those by other supermarkets who are also
trying to cut costs in stores as grocery sales shift online and prices
come under pressure from discounters such as Aldi and Lidl.
‘Restructures are going to happen everywhere because sales volumes
are going down and aren’t coming back, so to keep shareholders
happy costs have got to come down’, one industry insider said.
Currently each Morrisons store has a manager, a deputy manager and
three or four assistant deputy managers who oversee broad product
categories such as fresh food. Supervisors for individual departments,
such as green groceries, meat or fish, report to them. Under the new
structure departments will be merged and these posts would be
replaced by team leaders, who will spend most of their time working on
the shop floor.
Source: adapted from The Guardian, 4 June 2014
Questions (30 marks; 35 minutes)
1 Explain how Morrisons’ organisational chart will change following the
restructuring.
(4)
2 Analyse the probable thinking behind Morrisons’ decision to change
its management structure.
(6)
3 Evaluate whether the changes are guaranteed to improve Morrisons’
profitability.
(20)
Data response 2
Chicken Little
Peter (known as ‘Paxo’) Little set up his free-range chicken farm in the
early 1990s. At the time, it was an unusual move, especially on the
grand scale envisaged by ‘Paxo’. His farm had the capacity to produce
250,000 chickens every 45 days; that is, four million birds a year. Since
then, the business has grown enormously, to a turnover of £25 million
today.
But Paxo is getting concerned that his business is not as efficient as it
used to be. As managing director, he finds that he rarely hears from
junior staff; not even the quality manager’s five staff, who used to see
him regularly. As he said recently to the operations director, ‘the
communication flows seem like treacle today, whereas they used to be
like wildfire’.
Fortunately, the boom in demand for free-range and organic produce
has helped the business. So even though the team spirit seems to
have slipped away, profits have never been higher. Unfortunately, the
marketing director repeatedly talks about rumours that a huge Dutch
farming business is about to set up poultry farms in Britain. That could
‘set the cat among the chickens’, in other words, provoke quarrelling
and dissention.
Questions (35 marks; 40 minutes)
1 a) From Figure 19.5, give the managing director’s span of control.
(1)
b) Assess the strengths and weaknesses of this organisational
structure.
(10)
c) Assess the importance of personnel management within this
business.
(10)
2 Explain why vertical communications may not be as effective today
as in the past at Chicken Little.
(4)
3 Assess the ways in which the factory manager may benefit or suffer
from the organisational structure shown in Figure 19.5.
(10)

Figure 19.5 Organisational structure of Chicken Little farms

Extended writing
1 For a business of your choice, evaluate why it may be moving
 towards – or moving away from – a centralised management
approach.
(20)
2 Organisational hierarchies were originally modelled on the Army, with
many ranks and clarity about who was the boss of whom. Evaluate
whether this approach is out of date in a business world dominated
by online sales and online businesses.
(20)
Section 1.4 Managing people

20 Motivation in theory
Definition
According to American psychologist Professor Frederick Herzberg,
motivation occurs when people do something because they want to do
it; others think of motivation as the desire to achieve a result.

Linked to: Motivation in practice, Ch 21; Leadership, Ch 22;

Production, productivity and efficiency, Ch 41.

20.1 Introduction
A study by the Hay Group found that just 15 per cent of UK workers consider
themselves ‘highly motivated’. As many as 25 per cent say they’re ‘coasting’
and 8 per cent admit to being ‘completely demotivated’. In the same survey,
employees felt they could be 45 per cent more productive if they were doing a
job they loved. Poor management is part of the problem, as 28 per cent say
they would be more productive with a better boss.
The Hay Group calculates that if the under-performance was tackled
successfully, the value of UK output would rise by more than £350 billion a
year. So motivation matters. This is why it merits a unit to itself and is the
reason why many consider motivation theory to be the most important topic
within Business A level.

20.2 F.W. Taylor and Scientific Management

Although there were earlier pioneers, a good starting point for the study of
motivation is F.W. Taylor (1856–1917). As with most of the other influential
writers on this subject, Taylor was American. His influence over the twentieth-
century world has been massive. Much business practice in America, Europe,
Japan and the former Communist countries is still rooted in his writing and
work.
A recent biography of Taylor is titled The One Best Way; this sums up neatly
Taylor ’s approach to management. He saw it as management’s task to decide
exactly how every task should be completed, then to devise the tools needed to
enable the worker to achieve the task as efficiently as possible. This method is
evident today in every McDonald’s in the world. Fries are cooked at 175
degrees for exactly three minutes; then a buzzer tells employees to take them
out and salt them. Throughout every McDonald’s is a series of dedicated,
purpose-built machines for producing milkshakes, toasting buns, squirting
chocolate sauce, and much else. Today, 120 years after his most active period
working in industry, F.W. Taylor would feel very much at home ordering a Big
Mac.
‘In our scheme, we do not ask the initiative of our men. We do not want any
initiative. All we want of them is to obey the orders we give them, do what
we say, and do it quick.’
F.W. Taylor, The Principles of Scientific Management, 1911
So, what was Taylor ’s view of the underlying motivations of people at work?
How did he make sure that the employees worked effectively at following ‘the
one best way’ laid down by managers?
Taylor believed that people work for only one reason: money. He saw it as the
task of the manager to devise a system that would maximise efficiency. This
would generate the profit to enable the worker to be paid a higher wage.
Taylor ’s view of human nature was that of ‘economic man’. In other words,
people were motivated only by the economic motive of self-interest.
Therefore, a manager could best motivate a worker by offering an incentive (a
‘carrot’) or a threat (the ‘stick’). Taylor can be seen as a manipulator, or even a
bully, but he believed his methods were in the best interests of the employees
themselves.
Taylor ’s influence stemmed less from his theories than his activities. He was a
trained engineer who acted as a very early management consultant. His
methods were as follows.
• Observe workers at work, recording and timing what they do, when they do
it and how long they take over it (this became known as time and motion
study).
• Identify the most efficient workers and see how they achieve greater
efficiency.
• Break the task down into small component parts that can be done quickly and
repeatedly.
• Devise equipment specifically to speed up tasks.
• Set out exactly how the work should be done in future; ‘each employee’,
Taylor wrote, ‘should receive every day clear-cut, definite instructions as to
what he is to do and how he is to do it, and these instructions should be
exactly carried out, whether they are right or wrong’.
• Devise a pay scheme to reward those who complete or beat tough output
targets, but that penalises those who cannot or will not achieve the
productivity Taylor believed was possible; this pay scheme was called piece
rate – no work, no pay.
As an engineer, Taylor was interested in practical outcomes, not in psychology.
There is no reason to suppose he thought greatly about the issue of motivation.
The effect of his ideas was profound, though. Long before the publication of
his 1911 book The Principles of Scientific Management, Taylor had spread his
managerial practices of careful measurement, monitoring and – above all else
– control. Before Taylor, skilled workers chose their own ways of working
and had varied, demanding jobs. After Taylor, workers were far more likely to
have limited, repetitive tasks, and to be forced to work at the pace set by a
manager or consultant engineer.
Among those influenced by Taylor was Henry Ford. His Model T was the
world’s first mass-produced motor car. By 1911, the Ford factory in Detroit,
USA, was already applying Taylor ’s principles of high division of labour,
purpose-built machinery and rigid management control. When Ford
introduced the conveyor belt in 1913, he achieved the ultimate Taylorite idea:
men’s pace of work dictated by a mechanical conveyor belt, the speed of which
was set by management.
Eventually workers rebelled against being treated like machines. Trade union
membership thrived in factories run on Taylorite lines, as workers wanted to
organise against the suffocating lives they were leading at work. Fortunately,
in many western countries, further developments in motivation theory pointed
to new, more people-friendly approaches.
‘Blue collar and white collar call upon the identical phrase: “I’m a robot”.’
Studs Terkel, much-missed US journalist (from his book Working, 1974)
Real business
More than 100 years after F.W. Taylor’s book was published, 2013
saw a wave of criticism of the working conditions at Amazon.com
distribution depots in Britain and Germany.
Many staff work under zero-hours contracts that provide no
guaranteed income but they can still have to walk up to 15 miles during
a shift, while toilet breaks are monitored and timed. It is also claimed
they can be sacked and re-hired.
Former staff at Amazon’s warehouse in Rugeley, Staffordshire, told
newspaper reporters that they were hired for 12 weeks before being
sacked and re-employed so that the company did not have to give
them the same rights as full-time employees.
An investigation by Channel 4 News found that employees are tracked
using GPS tags while inside the warehouse. A BBC Panorama reporter
concluded that the work was much harder physically than seemed
reasonable. If staff are found to breach any of the company’s rules,
such as talking to colleagues or leaving work early, they can be
dismissed on a ‘three strikes and you are out’ basis.
F.W. Taylor would have agreed with Amazon’s desire for full control of
workers’ actions, but would have made more effort to make sure that
the job requirement represented a ‘fair day’s work’.

20.3 Elton Mayo and human relations theory

Elton Mayo (1880–1949) was a medical student who became an academic with
a particular interest in people in organisations. Although an Australian, he
moved to America in 1923. Early in his career, his methods were heavily
influenced by F.W. Taylor. An early investigation of a spinning mill in
Pennsylvania identified one department with labour turnover of 250 per cent,
compared with 6 per cent elsewhere in the factory. His Taylorite solution was
to prescribe work breaks. These had the desired effect.
Mayo moved on to work at the Hawthorne plant of Western Electric Company
in Chicago. His investigations there are known as the Hawthorne experiments.
He was called in to Hawthorne to try to explain the findings of a previous test
into the effects of lighting upon productivity levels. The lighting conditions for
one work group had been varied, while those for another had been held
constant. The surprise was that, whatever was done to the lighting, production
rose in both groups. This proved that there was more to motivation and
efficiency than purely economic motives.
Between 1927 and 1932, Mayo conducted a series of experiments at
Hawthorne. The first is known as the Relay Assembly Test. Six volunteer
female assembly staff were separated from their workmates. A series of
experiments was carried out. The results were recorded and discussed with the
women. Every 12 weeks, a new working method was tried. The alternatives
included different:
• bonus methods, such as individual versus group bonuses
• rest periods
• refreshments
• work layouts.
Before every change, the researchers discussed the new method fully with the
operators. Almost without exception productivity increased with every change.
At the end, the group returned to the original method (48-hour, 6-day week
with no breaks) and output went up to its highest level yet! Not only that, but the
women claimed they felt less tired than they had at the start.
The experiments had started rather slowly, with some resistance from the
operatives. Progress became much more marked when one member of the
group retired. She was replaced by a younger woman who quickly became the
unofficial leader of the group.

Mayo’s conclusions
Mayo drew the following conclusions from his experiments:
• The women gained satisfaction from the freedom and control over their
working environment.
• ‘What actually happened was that six individuals became a team and the team
gave itself wholeheartedly and spontaneously to co-operation in the
experiment’ (Mayo, 1949).
• Group norms (expectations of one another) are crucial and may be
influenced more by informal than official group leaders.
• Communication between workers and managers influences morale and
 output.
• Workers are affected by the degree of interest shown in them by their
managers; the influence of this upon motivation is known as ‘the Hawthorne
effect’.
The consequences of Mayo’s work were enormous. He influenced many
researchers and writers, effectively opening up the fields of industrial
psychology and industrial sociology. Many academics followed Mayo’s
approach in what became known as the human relations school of
management.
Businesses also responded to the implications of Mayo’s work for company
profitability and success. If teamwork, communications and managerial
involvement were so important, firms reasoned that they needed an
organisational structure to cope. In Taylor ’s era, the key person was the
engineer. The winners from Mayo’s work were personnel departments. They
grew throughout America and Britain in the 1930s, 1940s and 1950s as
companies tried to achieve the Hawthorne effect.

20.4 Maslow and the hierarchy of needs

‘Direction and control are of limited value in motivating people whose
important needs are social and egotistic.’
Douglas McGregor, author of The Human Side of Enterprise
Abraham Maslow (1908–1970) was an American psychologist whose great
contribution to motivation theory was the ‘hierarchy of needs’. Maslow
believed that everyone has the same needs, all of which can be organised as a
hierarchy. At the base of the hierarchy are physical needs, such as food, shelter
and warmth. When unsatisfied, these are the individual’s primary motivations.
When employees earn enough to satisfy these needs, however, their motivating
power withers away. Maslow said that ‘It is quite true that humans live by bread
alone – when there is no bread. But what happens to their desires when there is
bread?’ Instead of physical needs, people become motivated to achieve needs
such as security and stability, which Maslow called the safety needs. In full,
Maslow’s hierarchy consisted of the elements listed in Table 20.1.
Table 20.1 Maslow’s hierarchy of needs: implications for business
Ever since Maslow first put his theory forward (in 1940), writers have argued
about its implications. Among the key issues raised by Maslow are the
following.
• Do all humans have the same set of needs? Are there some people who need
no more from a job than money?
• Do different people have different degrees of need; for example, are some
highly motivated by the need for power, while others are satisfied by social
factors? If so, the successful manager would be one who can understand and
attempt to meet the differing needs of her/his staff.
• Can anyone’s needs ever be said to be fully satisfied? The reason the
hierarchy diagram (see Figure 20.1) has an open top is to suggest that the
human desire for achievement is limitless.
Figure 20.1 Maslow’s hierarchy of needs
Maslow’s work had a huge influence on the writers who followed him,
especially McGregor and Herzberg. The hierarchy of needs is also used by
academics in many subjects beyond Business, notably Psychology and
Sociology.

20.5 Herzberg’s two-factor theory

The key test of a theory is its analytic usefulness. On this criterion, the work of
Professor Fred Herzberg (1923–2000) is the strongest by far.
The theory stems from research conducted in the 1950s into factors affecting
workers’ job satisfaction and dissatisfaction. It was carried out on 200
accountants and engineers in Pennsylvania, USA. Despite the limited nature of
this sample, Herzberg’s conclusions remain influential to this day.
Herzberg asked employees to describe recent events that had given rise to
exceptionally good feelings about their jobs, then probed for the reasons why.
‘Five factors stand out as strong determiners of job satisfaction’, Herzberg
wrote in 1966, ‘achievement, recognition for achievement, the work itself,
responsibility and advancement – the last three being of greater importance for
a lasting change of attitudes’. He pointed out that each of these factors
concerned the job itself, rather than issues such as pay or status. Herzberg
called these five factors ‘the motivators’.

Figure 20.2 Comparison of satisfiers and dissatisfiers

The researchers went on to ask about events giving rise to exceptionally bad
feelings about their jobs. This revealed a separate set of five causes. Herzberg
stated that ‘the major dissatisfiers were company policy and administration,
supervision, salary, interpersonal relations and working conditions’. He
concluded that the common theme was factors that ‘surround the job’, rather
than the job itself. The name he gave these dissatisfiers was hygiene factors;
this was because fulfilling them would prevent dissatisfaction, rather than
causing positive motivation. Careful hygiene prevents disease; care to fulfil
hygiene factors prevents job dissatisfaction.
To summarise: motivators have the power to create positive job satisfaction,
but little downward potential; hygiene factors will cause job dissatisfaction
unless they are provided for, but do not motivate. Importantly, Herzberg saw
pay as a hygiene factor, not a motivator. So a feeling of being underpaid could
lead to a grievance; but high pay would soon be taken for granted. This
motivator/hygiene factor theory is known as the ‘two-factor theory’ (see Table
20.2).
‘Motivators and hygiene factors are equally important, but for different
reasons.’
F. Herzberg

Table 20.2 Herzberg’s two-factor theory

Movement and motivation

Herzberg was keen to distinguish between movement and motivation.
Movement occurs when somebody does something; motivation is when they
want to do something. This distinction is essential to a full understanding of
Herzberg’s theory. He did not doubt that financial incentives could be used to
boost productivity: ‘If you bully or bribe people, they’ll give you better than
average performance.’ His worries about ‘bribes’ (carrots) were that they
would never stimulate people to give of their best; people would do just
enough to achieve the bonus. Furthermore, bribing people to work harder at a
task they found unsatisfying would build up resentments, which might backfire
on the employer.
Herzberg advised against payment methods such as piece rate. They would
achieve movement but, by reinforcing worker behaviour, would make them
inflexible and resistant to change. The salaried, motivated employee would
work hard, care about quality and think about – even welcome – improved
working methods.
‘If you do something because you want a house or a Jaguar, that’s
movement. It’s not motivation.’
F. Herzberg

Job enrichment
The reason why Herzberg’s work has had such an impact on businesses is
because he not only analysed motivation, he also had a method for improving
it. The method is job enrichment, which he defined as ‘giving people the
opportunity to use their ability’. He suggested that, for a job to be considered
enriched, it would have to contain the following.

A complete unit of work

People need to work not on just a small repetitive fragment of a job, but a full
challenging task; Herzberg heaped scorn upon the ‘idiot jobs’ that resulted
from Taylor ’s views on the merits of high division of labour.

Direct feedback
Wherever possible, a job should enable the worker to judge immediately the
quality of what she or he has done; direct feedback gives the painter or the
actor (or the teacher) the satisfaction of knowing exactly how well they have
performed. Herzberg disliked systems that pass quality inspection off onto a
supervisor: ‘a man must always be held responsible for his own quality’. Worst
of all, he felt, was annual appraisal, in which feedback is too long delayed.
Direct communication
For people to feel committed and in control and to gain direct feedback, they
should communicate directly – avoiding the delays of communicating via a
supervisor or a ‘contact person’. In itself, it is hard to see the importance of
this. For a student of Business, it leads to an important conclusion: that
communication and motivation are inter-related.
‘In industry, there’s too much communication. And of course it’s passive…
But if people are doing idiot jobs they really don’t give a damn.’
F. Herzberg

Figure 20.3 Herzberg logic chain: take care of hygiene factors and
motivators
Conclusion
Herzberg’s original research has been followed up in many different
countries, including Japan, Africa and Russia. An article he wrote on the
subject in the Harvard Business Review in 1968 (called ‘Just one more time,
how do you motivate employees?’) has sold more than one million reprinted
copies. His main insight was to show that, unless the job itself was interesting,
there was no way to make working life satisfying. This led companies such as
Volvo in Sweden and Toyota in Japan to rethink their factory layouts. Instead
of individual workers doing simple, repetitive tasks, the drive was to provide
more complete units of work. Workers were grouped into teams, focusing on
significant parts of the manufacturing process, such as assembling and fitting
the gearbox, and then checking the quality of their work. Job enrichment
indeed.

Five whys and a how

20.6 Motivation in theory – evaluation

Most managers assume they understand human motivation, but they have never
studied it. As a result, they may underestimate the potential within their own
staff, or unthinkingly cause resentments that fester.
The process of managing people takes place in every part of every
organisation. So every manager should be aware of motivation theory. In some
cases, ignorance leads managers to ignore motivation altogether; they tell
themselves that control and organisation are their only concerns. Other
managers may see motivation as important, but fail to understand its subtleties.
For these reasons, there is a case for saying that the concepts within this unit
are the most important in the whole subject. Certainly it is true to say that
Taylor, Mayo, Maslow and Herzberg are studied from Russia to Japan and
Angola to Zimbabwe.

Key terms
Division of labour: subdividing a task into a number of activities,
enabling workers to specialise and therefore become very efficient at
completing what may be a small, repetitive task.
Hygiene factors: ‘everything that surrounds what you do in the job’,
such as pay, working conditions and social status; all are potential
causes of dissatisfaction, according to Herzberg.
Job satisfaction: the sense of well-being and achievement that stems
from a satisfying job.
Piece rate: paying workers per piece they produce (for example, £2 per
pair of jeans made).
Productivity: output per person (that is, a measure of efficiency).
Trade union: an organisation that represents the interests of staff at
the workplace.

20.7 Workbook
Revision questions
(30 marks; 30 minutes)
1 Which features of the organisation of a McDonald’s could be
described as Taylorite?
(3)
2 Explain the meaning of the term ‘economic man’.
(3)
3 Explain how workers in a bakery may be affected by a change
from salary to piece rate.
(4)
 4 Which two levels of Maslow’s hierarchy could be called ‘the lower-
order needs’?
(2)
5 Describe in your own words why Maslow organised the needs into
a hierarchy.
(3)
6 State three business implications of Maslow’s work on human
needs.
(3)
7 Herzberg believes pay does not motivate, but it is important.
Why?
(3)
8 How do motivators differ from hygiene factors?
(3)
9 What is job enrichment? How is it achieved?
(3)
10 If staff absenteeism is increasing, it is likely to be because (choose
one answer):
a) hygiene factors are over-rewarded
b) wage increases are outstripping inflation
c) there’s too much self-actualisation
d) division of labour is too high.
(1)
11 Herzberg’s ‘hygiene factors’ relate best to (choose one answer):
a) Taylor’s focus on the ‘one best way’
b) Maslow’s concept of self-actualisation
c) Taylor’s idea of self-actualisation
d) Maslow’s physiological needs.
(1)
12 Maslow’s idea of ‘self-actualisation’ means (choose one answer):
a) striving to get a promotion
 b) finding just what you’re capable of
c) getting the money rewards you deserve
d) finally enjoying true self-esteem.
(1)
Data response 1
Look back at Figure 20.2. It shows the results of Herzberg’s research
into the factors that cause positive job satisfaction and those that
cause job dissatisfaction. The length of the bars shows the percentage
of responses.
Questions (25 marks; 25 minutes)
1 Give the factors that had the least effect on satisfaction or
dissatisfaction.
(1)
2 Herzberg categorises ‘Salary’ as a hygiene factor, i.e. underpayment
is a source of demotivation. Assess that view based on the evidence
in Figure 20.2.
(10)
3 Separate research by Herzberg showed that ‘responsibility’ had the
longest-lasting effects on job satisfaction. Explain why this might be
so.
(4)
4 Assess which of the factors is the most important motivator.
(10)
Data response 2
Tania was delighted to get the bakery job and looked forward to her
first shift. It would be tiring after a day at college, but £52 for eight
hours on a Friday would guarantee good Saturday nights in future.
On arrival, she was surprised to be put straight to work, with no more
than a mumbled: ‘You’ll be working packing machine B.’ Fortunately,
she was able to watch the previous shift worker before clocking-off
time, and could get the hang of what was clearly a very simple task. As
the 18.00 bell rang, the workers streamed out, but not many had yet
turned up from Tania’s shift. The conveyor belt started to roll again at
18.16.
As the evening wore on, machinery breakdowns provided the only,
welcome, relief from the tedium and discomfort of Tania’s job. Each
time a breakdown occurred, a ringing alarm bell was drowned out by a
huge cheer from the staff. A few joyful moments followed, with dough
fights breaking out. Tania started to feel quite old as she looked at
some of her workmates.
At the 22.00 meal break, Tania was made to feel welcome. She
enjoyed hearing the sharp, funny comments made about the shift
managers. One was dubbed ‘Noman’ because he was fat, wore a white
coat and never agreed to anything. Another was called ‘Turkey’
because he strutted around, but if anything went wrong, got into a
flap. It was clear that both saw themselves as bosses. They were not
there to help or to encourage, only to blame.
Was the bakery always like this, Tania wondered? Or was it simply that
these two managers were poor?
Questions (25 marks; 30 minutes)
1 Assess the working lives of the shift workers at the bakery, using
Herzberg’s two-factor theory.
(10)
2 If a managerial follower of Taylor’s methods came into the factory,
how might she or he try to improve the productivity level?
(5)
3 Later on in this (true) story, Tania read in the local paper that the
factory was closing. The reason given was ‘lower labour productivity
than at our other bakeries’. The newspaper grumbled about the
poor attitudes of local workers. Assess the extent to which there is
justification for this view.
(10)
Extended writing
1 Followers of F.W. Taylor and Professor Herzberg each set about
increasing the motivation of teachers. Evaluate which would be the
most successful.
 (20)
2 Evaluate the changes that might occur if Tesco’s new boss decided
to apply Maslow’s hierarchy of needs to the whole workforce.
(20)
Section 1.4 Managing people

21 Motivation in practice
Definition
Assessing how firms try to motivate their staff and how successful
these actions are. In this context, companies take ‘motivation’ to mean
enthusiastic pursuit of the objectives or tasks set out by the firm.

Linked to: Approaches to staffing, Ch 17; Organisational

design, Ch 19; Motivation in theory, Ch 20.

21.1 Introduction
There are four main variables that influence the motivation of staff in practice:
1 financial incentives
2 empowering the employees: delegation, consultation and empowerment
3 team and flexible working
4 job enlargement: job enrichment and job rotation.
All four will be analysed with reference to the theories outlined in Unit 20.

21.2 Financial reward systems

Piecework
Piecework means working in return for a payment per unit produced.
Pieceworkers receive no basic or shift pay, so there is no sick pay, holiday pay
or company pension.
Piecework is used extensively in small-scale manufacturing; for example, of
jeans or jewellery. Its attraction for managers is that it makes supervision
virtually unnecessary. All the manager needs to do is operate a quality control
system that ensures the finished product is worth paying for. Day by day, the
workers can be relied upon to work fast enough to earn a living wage.

Disadvantages of piecework
Piecework has several disadvantages to firms, however, including the
following.
• Scrap levels may be high, if workers are focused entirely on speed of output.
• There is an incentive to provide acceptable quality, but not the best possible
quality.
• Workers will work hardest when they want higher earnings (probably before
Christmas and before their summer holiday); this may not coincide at all
with seasonal patterns of customer demand.
• Worst of all is the problem of change; Herzberg pointed out that ‘the worst
way to motivate people is piece rate… it reinforces behaviour ’; focusing
people on maximising their earnings by repeating a task makes them very
reluctant to produce something different or in a different way (they worry
that they will lose out financially).

Motivation
Famous sayings
‘There is no room for criticism on the training field. For a player –
and for any human being – there is nothing better than hearing “well
done”. Those are the two best words ever invented in sports.’
Sir Alex Ferguson
‘Motivation is everything. You can do the work of two people, but
you can’t be two people. Instead, you have to inspire the next guy
down the line and get him to inspire his people.’
Lee Iacocca, successful boss of Chrysler Motors
‘I have never found anybody yet who went to work happily on a
Monday that had not been paid on a Friday.’
Tom Farmer, Kwik-Fit founder
‘Motivating people over a short period is not very difficult. A crisis will
 often do just that, or a carefully planned special event. Motivating
people over a longer period of time, however, is far more difficult. It
is also far more important in today’s business environment.’
John Kotter, management thinker
‘My best friend is the one who brings out the best in me.’
Henry Ford, founder of Ford Motors
Source: Stuart Crainer (1997) The Ultimate Book of Business
Quotations, Capstone Publishing.

Real business
Most football clubs have signed expensive new players who
subsequently fail to perform on the pitch. In 2013, Liverpool decided to
overcome this problem by offering newly signed players lower basic
salaries offset by lucrative performance-related bonuses. Football
clubs that link pay to performance pay bonuses for each game won,
goals scored, clean sheets and featuring in the starting line-up.
According to Managing Director Ian Ayre, ‘From the football club’s
perspective, our view has to be that people are rewarded for
contributing towards what we achieve. As long as contracts are
structured in that way then everyone wins.’ That year, Liverpool went
on to enjoy one of their highest finishes in the Premier League.

Commission
Commission is a bonus earned on top of a basic salary, usually in line with a
specific achievement, such as meeting a sales target. It might be that a member
of staff is expected to generate £80,000 of sales a year, and for every £1,000
above that total a commission will be paid of £50. That 5 per cent rate of
commission might enable the individual to boost income considerably by the
end of the year.
Commission is used widely to incentivise staff in clothes shops, furniture
shops and other outlets where it can take effort and skill to clinch a sale. Note
that it would be incorrect to write about commission as a ‘motivator ’. In
Professor Herzberg’s terms, commission is simply a hygiene factor.
Bonus
According to Professor Herzberg, ‘the best way to pay people is a salary’. He
considered every attempt to ‘motivate’ people through financial incentives
doomed to fail – simply because people would be incentivised to do the wrong
thing – again and again. This proved true in the 2008/2009 financial crisis,
when the mayhem in the financial sector was often the result of faulty bonus
structures that encouraged excessive short-term risk-taking. Quite simply, City
traders knew that risks that paid off gave them bonuses (measured perhaps in
hundreds of thousands of pounds) but risks that failed cost the bank money.
Ultimately their risk-taking cost banks so much money that taxpayers had to
bail the banks out. In December 2009, the National Audit Office announced that
UK banks had been bailed out to the tune of £850 billion (yes, I have checked
that extraordinary sum!).
Even after these events, banks in Britain (and many politicians) try to suggest
that bonuses are an important, positive part of remuneration. In late 2014,
British banks were still complaining about an EU ruling that no bank should
pay a bonus greater than double a person’s salary (a very wise rule).
Relatively small-scale bonuses can act as a nice thank-you for a job done well.
When they are large enough to become the focus of an individual’s working
life, they distort behaviour and potentially turn an employee into a money-
seeking robot. Just as paying a striker a huge goal bonus would eliminate team
play, the same is true in the ordinary business world.

Profit share
As financial rewards go, this is a relatively sensible one. It gives a sense of
involvement to staff, and may affect behaviour favourably. If staff receive
some share of the profits, they may be slightly warmer towards customers and
a little more likely to turn off the lights when leaving a room. Sainsbury’s, in
2014, distributed an £80 million profit share among its 161,000 staff. That
makes an average of £500. However, when you check on the customer service
rankings of the supermarket chains, Sainsbury’s doesn’t seem to provide any
better a customer experience than Asda or any of the other supermarkets.
An annual profit share is a fine thing, but day by day, if you’re not enjoying
your job, few would look forward to £500 in a year ’s time and say: it’ll all be
worth it. Good employers realise that motivation comes from the satisfaction –
pleasure, even – of doing a good job. A profit share is a lovely thank-you, but
no more than that.

Performance-related pay
Performance-related pay (PRP) is a financial reward to staff whose work is
considered above average. It is used for employees whose work achievements
cannot be assessed simply through numerical measures (such as units produced
or sold). PRP awards are usually made after an appraisal process has evaluated
the performance of staff during the year.
The usual method is outlined below.
1 Establish targets for each member of staff/management at an appraisal
interview.
2 At the end of the year, discuss the individual’s achievements against those
targets.
3 Those with outstanding achievements are given a Merit 1 pay rise or bonus
worth perhaps 6 per cent of salary; others receive between 0 per cent and 6
per cent.

Lack of evidence for benefits of PRP

Despite the enthusiasm they have shown for it, employers have rarely been able
to provide evidence of the benefits of PRP. Indeed, the Institute of Personnel
Management concluded in a report that:
‘It was not unusual to find that organisations which had introduced merit
pay some years ago were less certain now of its continued value… it was
time to move on to something more closely reflecting team achievement
and how the organisation as a whole was faring.’
This pointed to a fundamental problem with PRP: rewarding individuals does
nothing to promote teamwork. Furthermore, it could create unhealthy rivalry
between managers, with each going for the same Merit 1 spot.

Other problems for PRP systems

Other problems for PRP systems include the following.
• Perceived fairness/unfairness: staff often suspect that those awarded the
maximum are being rewarded not for performance but out of favouritism;
this may damage working relations and team spirit.
• Whether they have a sound basis in human psychology: without question,
Professor Herzberg would be very critical of any attempt to influence work
behaviour by financial incentives; a London School of Economics study of
Inland Revenue staff found that only 12 per cent believed that PRP had raised
motivation at work, while 76 per cent said it had not; Herzberg would
approve of the researchers’ conclusion that: ‘The current system has not
succeeded in motivating staff to any significant degree, and may well have
done the reverse.’
As the last point illustrates, a key assumption behind PRP is that the chance to
be paid a bit more than other employees will result in a change in individual
behaviour, in increased motivation to work. A survey for the government
publication Employment in Britain found that ‘pay incentives were thought
important for hard work by fewer than one in five [employees], and for quality
standards by fewer than one in ten’.

Why do firms continue with PRP?

So why do firms continue to pursue PRP systems? There are two possible
reasons:
1 to make it easier for managers to manage/control their staff (using a carrot
instead of a stick)
2 to reduce the influence of collective bargaining and therefore trade unions.

Real business
Performance-related pay does not encourage
performance
The clue ought to be in the name. Performance-related pay is pay for
performance, and the better performance you turn in and the harder
you work, the more you will get to take home. Except that academics
are now suggesting, more often than not, the opposite may be the
case.
New research by the London School of Economics (LSE) has argued
that, far from encouraging people to strive to reach great heights,
performance-related pay often does the opposite and encourages
people to work less hard.
An analysis of 51 separate experimental studies of financial incentives
in employment relations found what the school has described as
‘overwhelming evidence’ that these incentives could reduce an
employee’s natural inclination to complete a task and derive pleasure
from doing so.
The findings are, of course, deeply controversial, given the depths of
anger still felt by many over the role of performance-related pay in
causing or contributing to the current economic crisis.
‘We find that financial incentives may indeed reduce intrinsic motivation
and diminish ethical or other reasons for complying with workplace
social norms such as fairness’, argued Dr Bernd Irlenbusch, from the
LSE’s Department of Management.
‘As a consequence, the provision of incentives can result in a negative
impact on overall performance’, he added.
Companies therefore need to be aware that the provision of
performance-related pay could result in a net reduction of motivation
across a team or organisation, he suggested.
Source: www.management-issues.com

21.3 Empowering employees

Empowerment
Empowerment is a modern term for delegation. There is only one difference
between the two. The empowered worker has not only the authority to manage
a task, but also some scope to decide what that task should be. An IKEA store
manager has power delegated to him or her, but head office rules may be so
rigid that the manager has little scope for individual judgement. An
empowered store manager would be one who could choose a range of stock
suited to local customers, or a staffing policy that differs from the national
store policy.
Empowerment means having more power and control over your working life,
and having the scope to make significant decisions about how to allocate your
time and how to move forward. It is a practical application of the theories of
Maslow and Herzberg. It may lead to greater risks being taken, but can also
lead to opportunities being identified and exploited. Above all else, it should
aid motivation.

Delegation
Delegation means passing the authority for a task down to junior staff. In
theory, the person who has delegated the task remains responsible (to
shareholders, perhaps), but the junior manager can decide how to set the
process. To be effective, the boss has to:
• trust the junior staff member
• provide extra training, if needed
• provide the resources that will be needed, e.g. a budget
• stay interested, but not intervene or ‘micromanage’.
When effective, delegation should be motivating to the staff member, as it is
great to be trusted and great to tackle a new challenge. Effective delegation of
substantial tasks is a sign of democratic leadership, as it passes decision
making down the hierarchy.

Consultation
Consultation means asking the views of the staff you manage, then taking them
into account in the decisions you make. Effective consultation requires that the
boss:
• consults on important issues (some bosses take big decisions without
discussion, but bring trivial things up in meetings; this irritates staff)
• consults widely and deeply, so that all full-time staff feel they have had their
say, no matter how junior (it is very hard to consult with part-timers as they
may only be at work in the evenings or weekends)
• takes those views into account when making decisions…
• …and explains how they have been taken into account, including when they
have been considered but rejected.
When carried through intelligently, consultation helps boost team working and
morale. People want to be able to express their views and – occasionally – find
those views have made a difference. Effective consultation is a sign of high-
quality paternalistic leadership.

21.4 Team working

Team working is the attempt to maximise staff satisfaction and involvement by
organising employees into relatively small teams. These teams may be
functional (the ‘drive-thru crew’ at a McDonald’s) or geographic. The key
features of such teams are that they should be:
• multi-skilled, so that everyone can do everyone else’s job
• working together to meet shared objectives, such as to serve every customer
within a minute or produce a fault-free gearbox
• encouraged to think of the future as well as the present, in a spirit of kaizen
(continuous improvement).
From a theoretical point of view, team working fits in well with Maslow’s
findings on the importance of social needs. In practical terms, modern
managers like team working because of the flexibility it implies. If worker A is
absent, there are plenty of others used to dealing with the job. Therefore, there
is no disruption. Team working also gives scope for motivating influences,
such as job enrichment and quality circles.
Professor Charles Handy suggests in his book Inside Organisations that ‘a
good team is a great place to be, exciting, stimulating, supportive, successful.
A bad team is horrible, a sort of human prison.’ It is true that the business will
not benefit if the social norms within the team discourage effort. Nevertheless,
team working has proved successful in many companies in recent years.

21.5 Flexible working

Aspects of workforce flexibility that could help staff performance include
those that make it possible for talented staff to work effectively, even though
they have other issues or responsibilities. Flexitime is an example, as it gives
parents of small children and employees with disabilities the scope to arrive
and leave later or earlier than others. This would allow a wheelchair-bound
employee to avoid the rush hour, or a dad to take the kids to school before
coming to work. The same positive aspects of flexible working come from
methods such as:
• term-time only working
• job sharing
• occasional home-working.
Flexible working is covered fully in Chapter 17.

21.6 Job enlargement

Research into workplace engagement often shows that people feel trapped
within the limitations of their job. They are bored. So researchers look for
ways to increase the scope of the job. This is called job enlargement.
Job enlargement is a general term for anything that increases the scope of a
job. There are two ways of doing this:
1 Job rotation: increasing a worker ’s activities by switching between tasks of a
similar level of difficulty. This does not increase the challenge, but may
reduce the boredom of a job. This is shown in Figure 21.1. It can be argued
that this horizontal job enlargement will do little more than relieve the
boredom. The individual is still quite likely to see work as a chore.
2 Job enrichment: this enlargement of the scope of the job involves extra
responsibilities and challenges, as well as extra activities/workload.

Professor Herzberg defines job enrichment as ‘giving people the

opportunity to use their ability’. A full explanation of his theory is outlined
in Chapter 20. How can job enrichment be put into practice? The key thing
is to realise the enormity of the task. It is not cheap, quick or easy to enrich
the job of the production line worker or the supermarket checkout operator.
The first thought may be to add more variety to the work. The supermarket
operator could switch between the checkout, shelf-stacking and working in
the warehouse. Known as job rotation, this approach reduces repetition but
still provides the employee with little challenge. Herzberg’s definition of
job enrichment implies giving people ‘a range of responsibilities and
activities’. Job rotation only provides a range of activities. To provide job
enrichment, workers must have a complete unit of work (not a repetitive
fragment) and responsibility for quality and for self-checking, and must be
given the opportunity to show their abilities. In Figure 21.2, you can see that
a supermarket operator could be given responsibility for a section of the
store – taking on supervisory as well as mundane tasks. That combination of
horizontal and vertical enlargement is job enrichment.
Figure 21.1 Job rotation

Figure 21.2 Job enrichment: vertical enlargement

Five whys and a how

21.7 Motivation in practice – evaluation
When writing about financial incentives, there is a serious risk of over-
simplification. The reality is that using money to try to motivate people often
proves a dreadful mistake (as Herzberg always made clear). Exaggerated
commissions or performance-related pay can lead sales staff to oversell goods
or services, such as cosmetic surgery or questionable investments, which may
cause customers huge difficulties later on. Also, within the workplace, serious
problems can arise: bullying to ‘motivate’ staff into working harder, or
creating a culture of overwork, which leads to stress.
Fortunately, there are many businesses in which the management of motivation
is treated with respect: companies which know that quick fixes are not the
answer. Successful motivation in the long term is a result of careful job design,
employee training and development, honesty and trust. It may be possible to
supplement this with an attractive financial reward scheme, but money will
never be a substitute for motivation.

Key terms
Flexitime: giving staff flexibility over their arrival and leaving times as
long as the right numbers of hours are completed (and usually there’s a
mandatory period, e.g. 10.30–3.30).
Kaizen: continuous improvement, usually achieved by workforce
engagement and involvement (as opposed to automation).
Motivation: to Professor Herzberg, it means doing something because
you want to do it; most business leaders think of it as prompting
people to work hard.
Quality circles: discussion groups in which staff discuss an operational
problem with a view to recommending a solution to management.
Remuneration: all the financial rewards received by an employee: pay,
pension contributions, bonuses and any ‘fringe benefits’, such as a
company car.

21.8 Workbook
Revision questions
(35 marks; 35 minutes)
1 Identify three advantages to an employee of working in a team.
(3)
2 Look at the famous saying by Lee Iacocca on page 131. Explain in
your own words what he meant by this.
(3)
3 How should a manager deal with a mistake made by a junior
employee?
(4)
4 State three reasons why job enrichment should improve staff
motivation.
(3)
5 Distinguish between job rotation and job enrichment.
(4)
6 Explain in your own words how ‘empowerment’ differs from
‘delegation’.
(3)
7 State two advantages and two disadvantages of offering staff
performance-related pay.
(4)
8 What could be the implications of providing a profit share to senior
 managers but not to the workforce generally?
(5)
9 What problems may result from a manager bullying staff to
‘motivate’ them?
(6)
Data response 1
Link pay to pupil progress, over half of teachers polled
say
Over half of teachers in state schools in England support the
government’s plan to link pay to pupils’ progress and results, suggests
a survey. The National Foundation for Educational Research polled
over 1,000 teachers for the charity Sutton Trust.
Of those surveyed, 55 per cent of primary teachers and 52 per cent of
secondary teachers said incremental pay rises should depend at least
in part on performance. But almost half favoured the old system of
linking pay to length of service. From September 2014, the
government requires schools to link pay progression, for teachers in
the first five years of their career, to classroom performance.
Professor Steven Higgins, of Durham University’s School of
Education, casts doubt on this new policy by referring to research
conducted in America. He told the Education Media Centre that:
‘The evidence is not convincing that linking teacher pay to the
performance of their pupils is effective in improving learning
outcomes, either in the short, medium or long term… Attracting the
best teachers and retaining them, for which pay may be a significant
component, is more important than rewarding teachers on the basis
of their pupils’ recent test scores or their observed lesson
performance.’
Professor Higgins also said research suggested observing lessons is
‘not a reliable way of identifying teacher effectiveness, so any system
which relies only on observation or test scores or even a combination
is likely to be flawed’.
Christine Blower, general secretary of the National Union of Teachers,
opposes performance-related pay for teachers on the grounds that it is
less transparent and open to biased judgements.
Source: adapted from Sutton Trust press release, 6 June 2014, and
other sources
Questions (40 marks; 45 minutes)
1 Explain why the government appears to believe that teachers are
motivated by money.
(4)
2 Apart from money, assess two other factors which might motivate
teachers.
(8)
3 Assess two ways the government might measure the individual
performance of teachers.
(8)
4 Evaluate the benefits of the government’s proposal to scrap pay
increases based on length of service in favour of performance-
related pay.
(20)
Data response 2
An October 2013 study finds ‘emotional factors’ are
strongest motivators in the workplace
Bonuses are not the top motivator for employees, according to a
study into what makes workers most productive by the Institute of
Leadership and Management (ILM).
The survey of more than 1,000 workers found that only 13 per cent of
people agreed that a bonus would have an effect on their motivation;
however having a good basic salary and pension was viewed as an
important incentive by almost half of the respondents.
In fact, the top motivator was ‘job enjoyment’ according to 59 per cent
of respondents, while other emotional factors such as good working
relationships and fair treatment also rated highly in the survey. More
than two-fifths of the respondents cited ‘getting on with colleagues’ as
a key motivator, while just over a fifth agreed that ‘how well they are
treated by their managers’ affected motivation, with a further fifth
saying that higher levels of autonomy motivated them.
The ILM said the findings suggested that the £36.9 billion spent on
performance bonuses in the UK last year had ‘no impact on the
motivation and commitment levels of the vast majority of recipients’.
The survey highlights how important good managers are to ensuring
happy and motivated staff. When asked to identify one thing that
would motivate them to do more, 31 per cent of employees said ‘better
treatment from their employer’, ‘more praise’ and ‘a greater sense of
being valued’. However, while the majority of managers (69 per cent)
said they are ‘always giving feedback’ to their staff, just 23 per cent of
employees agreed.
‘Understanding your employees and what makes them tick is vital in
having a happy and motivated workforce,’ said Charles Elvin, chief
executive of the ILM. ‘In the past year UK companies have collectively
spent an astronomical amount on financial incentives for their staff.
But this report is telling us there are far more effective, and cost-
effective, ways to motivate people. These include giving regular
feedback, allowing people to have autonomy in a role, the opportunity
to innovate and improved office environments.’
Source: www.cipd.co.uk
Questions (30 marks; 35 minutes)
1 From the passage:
a) Outline three points that fit into the category called ‘motivators’ by
Herzberg.
(6)
b) Outline two points that fit into the category called ‘hygiene factors’
by Herzberg.
(4)
2 The ILM implies that the £36.9 billion spent on performance
bonuses was a waste of money. Assess two possible reasons why
businesses might persist with staff bonuses despite the evidence
provided here.
 (8)
3 Use the evidence provided in the text to assess how a manager
might improve the workplace performance of one of the following: a
school cleaner; a full-time employee at Tesco; or a bus driver.
(12)
Extended writing
1 Evaluate the view that there is no one ideal method to motivate
staff, because everyone is different.
(20)
2 Evaluate the importance of financial reward systems in the
motivation of young, part-time staff at a business such as Nando’s,
McDonald’s or KFC.
(20)
Section 1.4 Managing people

22 Leadership
Definition
Leadership, at its best, means inspiring staff to achieve demanding
goals.

Linked to: Motivation in theory, Ch 20; Motivation in practice,

Ch 21, Moving from entrepreneur to leader, Ch 28.

22.1 Leaders and managers

It is important to understand that the role of the leader is not the same as that of
the manager. Management guru Peter Drucker once said that: ‘Managers do
things right; leaders do the right thing.’
In other words, an effective manager is someone who can put an idea or policy
into action, and get the details right. By contrast, the leader is good at
identifying the key issues facing the business, setting new objectives, and then
deciding what should be done, by when and by whom. It is also argued that a
leader needs to inspire staff. This is often confused with charismatic leadership
– that is, when the personal charisma of the leader inspires staff to give
something extra or work a bit harder. Although some successful leaders such
as Ghandi, Churchill and Mandela had charisma, many others had success
despite quite dull personalities. The great British Prime Minister Clement
Attlee ‘had a lot to be modest about’, according to Churchill. Liverpool FC’s
long period as Britain’s top club began with the charismatic Bill Shankly; yet
the huge haul of trophies came later, under the leadership of the shy, slightly
bumbling Bob Paisley.
The main differences between managers and leaders can be summarised as
follows:
1 The job role: leaders have to avoid being bogged down in short-term ‘fire-
fighting’ (solving today’s problems); they should be looking ahead to see
new opportunities as well as threats. So a key difference is the timescale
 within which they operate. A second aspect of the job role is that the
manager will be working within tight resource constraints (e.g. a staffing
budget and an expense account). By contrast, the leader is in a position to
find the money or resources for whatever is needed, by re-jigging other
budgets.
2 The person: leaders need to have steely qualities when needed – for example,
to fire someone who is simply not fitting in; a manager may get away with
ducking difficult decisions. Although leaders do not need to have natural
charisma, they have to have qualities that make people willing to follow
them. Roy Hodgson (England manager at the time of writing) has no
obvious charisma, but he has managed to make many sets of players trust in
him and his judgement. He has proved to be a successful leader.
Table 22.1 Response of leaders and managers to different
circumstances

22.2 Types of leadership style

The way in which managers deal with their employees is known as their
management style. For example, some managers are quite strict with workers.
They always expect deadlines to be met and targets to be hit. Others are more
relaxed and understanding. If there is a good reason why a particular task has
not been completed by the deadline, they will be willing to accept this and give
the employee more time. Although the way in which everyone manages will
vary slightly from individual to individual, their styles can be categorised
under three headings: autocratic, democratic and paternalistic. A further type
(laissez-faire) is best understood as a subset of democratic.

Autocratic managers
Autocratic managers are authoritarian: they tell employees what to do and do
not listen much to what workers themselves have to say. Autocratic managers
know what they want doing and how they want it done. They tend to use one-
way, top-down communication. They give orders to workers and do not want
feedback.

Democratic managers
Democratic managers, by comparison, like to involve their workers in
decisions. They tend to listen to employees’ ideas and ensure people contribute
to the discussion. Communication by democratic managers tends to be two-
way. Managers put forward an idea and employees give their opinion. A
democratic manager would regularly delegate decision-making power to
junior staff.
The delegation of authority, which is at the heart of democratic leadership, can
be approached in one of two main ways: management by objectives and
laissez-faire.

Management by objectives
In this situation, the leader agrees clear goals with staff, provides the necessary
resources and allows day-to-day decisions to be made by the staff in question;
this approach was advocated by management guru Peter Drucker.

Laissez-faire
Meaning ‘let it be’, this occurs when managers are so busy, or so lazy, that they
do not take the time to ensure that junior staff know what to do or how to do it.
Some people may respond very well to the freedom to decide how to spend
their working lives; others may become frustrated. It is said that Bill Gates, in
the early days of Microsoft, hired brilliant students and told them no more than
to create brilliant software. Was this a laissez-faire style or management by
objectives? Clearly the dividing line can be narrow.

Figure 22.1 Manager and employee

Paternalistic managers
A paternalistic manager thinks and acts like a father. He or she tries to do
what is best for their staff/children. There may be consultation to find out the
views of the employees, but decisions are made by the head of the ‘family’.
This type of manager believes employees need direction but thinks it is
important that they are supported and cared for properly. Paternalistic
managers are interested in the security and social needs of staff. They are
interested in how workers feel and whether they are happy in their work.
Nevertheless, it is quite an autocratic approach.

Table 22.2 Assumptions and approaches of the three types of leader

22.3 McGregor’s Theory X and Y
In the 1950s, Douglas McGregor undertook a survey of managers in America
and identified two styles of management, which he labelled Theory X and
Theory Y (see Table 22.3). Theory X managers tend to distrust their
subordinates; they believe employees do not really enjoy their work and that
they need to be controlled. In McGregor ’s own words, many managers believe
that ‘the average human being has an inherent dislike of work and will avoid it
if he can’. Note that McGregor is not putting this forward as a theory about
workers, but about managers. In other words, Theory X is about the view
managers have of their workforce.
Theory Y managers, by comparison, believe that employees do enjoy work
and that they want to contribute ideas and effort. A Theory Y manager is,
therefore, more likely to involve employees in decisions and give them greater
responsibility. The managerial assumptions identified by McGregor as Theory
Y included those set out in the box below.

Evaluation
Managerial assumptions identified by McGregor as
Theory Y
‘Commitment to objectives is a function of the rewards associated
with their achievement.’
‘The average human being learns, under proper conditions, not only
to accept but to seek responsibility.’
‘The capacity to exercise a relatively high degree of imagination,
ingenuity and creativity in the solution of organizational problems is
widely, not narrowly, distributed in the population.’
Source: D. McGregor (1987) The Human Side of Enterprise, Penguin
Books (first published 1960).

It is clear that Theory Y managers would be inclined to adopt a democratic

leadership style. Their natural approach would be to delegate authority to meet
specific objectives.
The Theory X approach is likely to be self-fulfilling. If you believe people are
lazy, they will probably stop trying. Similarly, if you believe workers dislike
responsibility, and you fail to give them a chance to develop, they will
probably stop showing interest in their work. They will end up focusing purely
on their wage packet because of the way you treat them.
In his book The Human Side of Enterprise, McGregor drew upon the work of
Maslow and Herzberg. It need be no surprise that there are common features to
the theories of these three writers. McGregor ’s unique contribution was to set
issues of industrial psychology firmly in the context of the management of
organisations. So whereas Herzberg’s was a theory of motivation, McGregor ’s
concerned styles of management (and thereby leadership).
So, which is the ‘right’ approach? Clearly a Theory Y manager would be more
pleasant and probably more interesting to work for. A Theory X approach can
work, however, and is especially likely to succeed in a business employing
many part-time, perhaps student, workers, or in a situation where a business
faces a crisis.

Real business
Manchester United’s Moyes’ mistake
When Alex Ferguson became manager of Manchester United in 1986,
he promised that he would ‘knock Liverpool right off their [insert
expletive] perch!’ Ferguson did exactly that, winning trophy after
trophy. Ferguson is probably best described as being a paternalistic
leader. He established a family atmosphere at the club based on equal
status. Tea ladies, cleaners, cooks, all were treated as valued
members of the team. Players such as Giggs, Beckham and De Gea
have all described Ferguson as being ‘a father figure’. Sir Alex made all
the decisions, but unlike an autocrat he believed that his decisions
were based on doing what would be best for his family – the football
club.
In 2011, United won the championship for the nineteenth time,
overhauling Liverpool’s total of 18 league titles: mission accomplished!
Two years later, after winning the title yet again, Sir Alex decided to
retire. His final act as manager was to appoint David Moyes as his
successor. Unfortunately for United, the appointment proved to be a
disaster. Moyes was more of an autocrat than a paternalist. For
example, without consulting anyone, he sacked all of Ferguson’s
backroom staff. He inherited a playing squad that had won the league
the previous season by 11 points. With virtually the same group of
players, United ended up in seventh place and Moyes was promptly
sacked.

Table 22.3 Theory X v. Theory Y managers

22.4 Charismatic leadership

Charismatic leaders are people who are able to connect with an audience and
who can get others to buy into their ideas. History is littered with charismatic
leaders. Some of these leaders have used their communication skills and ability
to motivate others to do good things that have benefited the world. There is
perhaps no better example of this than Nelson Mandela, who almost single-
handedly inspired South Africa into abandoning apartheid. In business, Steve
Jobs used his charisma to turn around the fortunes of Apple Computers.
According to research carried out by the University of Lausanne, charismatic
leaders create impact with their audience by: setting optimistic goals; and by
using analogies, rhetorical questions and by contrasting between ‘right’ and
‘wrong’ during their speeches.
Unfortunately, charisma can have a downside. The combination of charisma
and early success as a leader can result in too much praise and not enough
friendly criticism. On many occasions in business and in history, the result can
be hubris leading to nemesis. Napoleon and Hitler are historical examples; in
business, the same has proved true of leaders of Royal Bank of Scotland
(RBS/NatWest), of Lloyds Bank and of Tesco.
Figure 22.2 Logic ladder: the risk of hubris

Leadership
Famous sayings
‘As for the best leaders, the people do not notice their existence.
The next best, the people honour and praise. The next, the people
fear; and the next, the people hate… When the best leader’s work is
done the people say, “We did it ourselves”.’
Lao-Tsu, quoted in R. Townsend and M. Joseph, Further up the
Organization, Michael Joseph.
‘…the capacity to create a compelling vision and translate it into
action and sustain it’.
Warren Bennis
‘A leader is like a shepherd. He stays behind the flock, letting the
most nimble go out ahead, whereupon the others follow, not
realizing that all along they are being directed from behind.’
Nelson Mandela
‘You do not lead by hitting people over the head – that’s assault, not
leadership.’
Dwight Eisenhower, US President
Source: Stuart Crainer (1997) The Ultimate Book of Business
Quotations, Capstone Publishing

22.5 What is the best style of leadership?

Each style of leadership can work well in different situations. If there is a
crisis, for example, people often look for a strong leader to tell them what to
do. Imagine that sales have unexpectedly fallen by 50 per cent, causing
uncertainty, even panic, within the organisation. The boss needs to take control
quickly and put a plan into action. An autocratic style might work well at this
moment. In a stable situation, where employees are trained and able to do their
work successfully, a more democratic leadership style might be more
appropriate. Countries elect very different types of leaders when there is a
threat of war or economic instability compared with when the country is doing
well. Similarly, think about how people react when they are learning to drive.
The best style depends on an enormous range of factors, such as the
personalities and abilities of the leader, of the workers, and the nature of the
task. Imagine a confident boss who knows her job well but is faced with an
unusually difficult problem. If the staff are well trained and capable, the leader
might consult on what to do next. If the staff are largely part-time and
temporary (think Sports Direct), an autocratic style of leadership is the only
realistic option.

Figure 22.3 Factors affecting leadership style

Leadership style should therefore change according to the particular situation
and the people involved. It will also vary with the time and degree of risk
involved. If a decision has to be made urgently and involves a high degree of
risk, the leader is likely to be quite autocratic. If there is plenty of time to
discuss matters and only a low chance of it going wrong, the style may well be
more democratic.

Five whys and a how

22.6 Leadership – evaluation
All firms seek effective managers. Good managers make effective use of the
firm’s resources and motivate staff; they provide vision and direction, and are
therefore a key element of business success. Look at any successful company
and you will usually find a strong management team. The problem is knowing
what it is that makes a good manager and what is the ‘best’ management style.
Even if we thought we knew the best style, could we train anyone to adopt this
approach, or does it depend on personality?
There are, of course, no easy answers to such questions. The ‘right’ style of
management will depend on the particular circumstances and the nature of the
task, and while it is possible to help someone to develop a particular style, it
will also depend on the individual’s personality. However, there are plenty of
autocratic managers who also succeed.

Key terms
Autocratic manager: autocratic managers keep most of the authority
to themselves; they do not delegate much or share information with
employees. Autocratic, or authoritarian, managers tend to tell
employees what to do.
Democratic manager: democratic managers take the views of their
subordinates into account when making decisions. Managers discuss
what needs to be done and employees are involved in the decision.
Hubris: overweening arrogance leading to excessive self-confidence
and therefore blindness to the risks being taken (‘pride comes before
the fall’).
Nemesis: divine punishment for wrongdoing or presumption; in other
words, the fall that comes after pride.
Paternalistic manager: a paternalistic manager believes he or she
knows what is best for employees. Paternalistic managers tend to tell
employees what to do, but will often explain their decisions. They are
also concerned about the social needs of employees.

22.7 Workbook
Revision questions
(40 marks; 40 minutes)
1 Distinguish between autocratic and paternalistic management.
(4)
2 Identify two features of democratic management.
(2)
3 Outline one advantage and one disadvantage of an autocratic
management approach.
(4)
4 Distinguish between McGregor’s Theory X and Theory Y.
(4)
5 Why is it ‘clear that Theory Y managers would be inclined to adopt a
democratic leadership style’?
(4)
6 Is there one correct leadership style for running a football team or a
supermarket chain?
(4)
7 Explain why autocratic managers may be of more use in a crisis than
democratic ones.
(4)
8 Explain a circumstance in which an authoritarian approach to
leadership may be desirable.
(4)
9 Many managers claim to have a democratic style of leadership.
Often, their subordinates disagree. Outline two ways of checking the
actual leadership style of a particular manager.
(4)
10 Analyse the leadership style adopted by your teacher/tutor.
(6)
Data response
Fred ‘the Shred’ Goodwin
Fred Goodwin was one of Britain’s most famous bosses. Before
becoming a banker, he trained as an accountant. After a successful
stint at Clydesdale Bank, he joined RBS (Royal Bank of Scotland) in
1998. Goodwin rapidly gained promotion by making redundancies to
reduce RBS’s costs. His ruthlessness earned him the nickname ‘Fred
the Shred’. At the tender age of 37, he became chief executive.
As praise (and a knighthood) was heaped upon him, Goodwin steadily
became more and more dominating within RBS. In his book, published
in May 2014, Shredded: Inside RBS, Ian Fraser describes how
Goodwin took great pleasure in humiliating colleagues in front of their
peers in so-called ‘morning beatings’. He ruled by fear, keeping a little
black book in which he noted down the names of employees who
annoyed him. Names written down in pencil were ‘on the borderline’,
while those penned in ink were in serious trouble. A culture of target-
setting at the bank indicated that Goodwin believed in the power of
performance-related pay as a motivating force. He clearly enjoyed his
own corporate luxuries, getting oranges flown in from Paris every
morning on expenses.
According to former colleagues, he was a control obsessive who
micromanaged RBS. He made all the decisions, even relatively
unimportant issues, such as the colour of office carpets and RBS’s
company cars. Goodwin even stipulated that filing cabinets must have
rounded tops because he disliked seeing piles of paper left on top of
filing cabinets. Under his leadership, RBS grew rapidly, buying out 26
rivals. He was uncomfortable with discussion, which he usually saw as
a challenge to his leadership. Eventually, Goodwin started making
mistakes, the biggest of which was paying £49 billion for the ABN
AMRO bank, which proved to be riddled with bad debts. As a direct
consequence, RBS made a loss of £24.1 billion in 2008 – the biggest
in UK corporate history. And RBS had to be bailed out by the British
government, i.e. the taxpayer.
Questions (25 marks; 30 minutes)
1 Explain whether Fred the Shred was an autocratic or a paternalistic
leader.
(5)
2 Explain two weaknesses of Goodwin’s style of leadership.
(8)
3 Assess whether the democratic approach is always superior to other
styles of leadership.
(12)
Activity
An investigation into a leader
1 Arrange to interview an employee. Preferably this person should be
a full-timer who has worked for at least a year. The employee could
be a manager but should not be a director.
2 Your objective is to gain a full understanding of the leadership style
prevailing at the employee’s workplace, and the style employed by
the individual’s own manager.
3 Devise your own series of questions in advance, but make sure to
include the following themes.
a) How open are communications within the business?
b) Are staff encouraged to apply a questioning or critical approach?
c) Are there any forums for discussion or debate on important policy
issues affecting staff?
d) What does the organisational hierarchy look like? Where is your
employee on that diagram? How powerful or powerless does she
or he feel?
e) How exactly does the employee’s boss treat him or her? Is there
delegation? Is there consultation? How effective is communication
between the two of them?
Write at least 600 words summarising your findings and drawing
conclusions about how well the experience conforms to the
leadership theory dealt with in this unit.
Extended writing
1 Evaluate the view that autocratic leadership has no place in today’s
business world.
(20)
2 ‘Great leaders are born, not made.’ Evaluate this view.
(20)
3 Evaluate whether it can ever be right to pay a business leader 1,000
times more than the lowest-paid employee in the organisation.
(20)
Section 1.5 Entrepreneurs and leaders

23 Role of an entrepreneur
Definition
An entrepreneur takes a restless look at the business opportunities
that exist and then turns a business idea into action.

Linked to: Entrepreneurial motives and characteristics, Ch 24;

Forms of business, Ch 26; Moving from entrepreneur to leader,
Ch 28.

23.1 Introduction
The personal qualities of entrepreneurs are dealt with in Chapter 24. This
chapter looks at the practical issues: what entrepreneurs actually do – and what
can hold them back.
Unlike the media image, most entrepreneurs are middle-aged, not young. That
is inevitable because starting a business is likely to cost thousands, so young
entrepreneurs are likely to come from wealthy backgrounds. The middle-aged
entrepreneur comes with huge advantages, but often some drawbacks. Yes, they
have money and usually they have a business idea that stems from the business
they once worked in. But going from a middle manager in a large business to
starting up your own business strips you of some important help: the IT
department, the accounting department and so on. Suddenly you have to make
decisions about a wide range of different aspects of business: a marketing
expert one minute, an accountant the next – and then there’s the toilet that needs
a clean.

23.2 Creating and setting up a business

Generating business ideas

At the heart of successful entrepreneurship is spotting a good business idea.
This is usually based on a good understanding of consumer tastes and/or the
needs of the retail trade. Both qualities were shown by Martyn Dawes, who
spotted the opportunity for machines that could automatically make high-
quality coffee. His ‘Coffee Nation’ machines in motorway service stations and
Tesco Express made him a multi-millionaire when Costa decided to buy the
business.
The main sources of business ideas are set out below.
• Observation: Martyn Dawes had seen similar machines in New York delis
and saw their potential use in Britain.
• Brain-storming: this is where two or more people are encouraged to come
up with ideas, without criticising each other ’s, no matter how bizarre; the
appraisal process comes later.
• Thinking ahead: perhaps about the new opportunities that will arise if the
weather continues to get warmer (for example, air conditioning, ice cream,
and so on).
• Ideas from personal or business experience: for example, ‘there are no ice
cream parlours for miles around’ or ‘in my company we need quality
sandwiches delivered at lunchtime’.
• Innovations: these may come from new science, such as Pilkington’s self-
cleaning glass (used in skyscrapers worldwide), or from clever re-workings
of existing knowledge, such as the Apple iPad
‘It’s really rare for people to have a successful start-up in this industry
without a breakthrough product. It has to be something where, when people
look at it, at first they say, “I don’t get it, I don’t understand it. I think it’s
too weird, I think it’s too unusual”.’
Marc Andreesen, software engineer and entrepreneur

Spotting an opportunity
It would be easy to become gloomy and to think that all the great business ideas
and opportunities have already gone: the hamburger chain, the fizzy cola, and
so on. In fact, this is completely wrong. Society changes constantly, with
different attitudes or fads marking out the generations. All today’s online
business opportunities will give way to new ones as computing power gets
ever greater. ‘Wearable technology’ has been around as an idea for nearly ten
years, but now computing power has made it a meaningful business
opportunity.
In addition to new technology, other ways to spot new business opportunities
include the following:
• Think about changes to society: for example, is there now more concern
about the body beautiful? If so, what effect will this have on the demand for
cosmetic surgery, anti-ageing creams and fashion clothing?
• Think about changes to the economy: will a continuing boom in China give
opportunities for British brands such as Burberry, Jaguar and Superdry?
• Think about the local housing market: are people moving into or out of your
area? Are prices moving up or down? Many local business opportunities
may rise or fall depending on these factors.
• Use the techniques outlined below: small budget research and careful market
mapping.

Small budget research

Even before spending money on market research, good entrepreneurs take the
time to gain a general understanding of the market. Someone thinking about
buying into a Subway franchise for Brighton, for example, may do the
following:
• Walk around the town, mapping where sandwich bars and other fast food
outlets are located (this is called geographical mapping). See Figure 23.1 to
see how plotting the existing suppliers can help to identify a suitable place to
start up.
• While doing so, check on prices, special deals, student discounts, and so on
• Arrange to spend a day with Subway at their franchise in a nearby town, to
help understand the customer and the way the service is provided
• Based on the knowledge gained by the above, produce a market map (for
more on market mapping, see Chapter 4) of fast food in Brighton; this will
help to identify whether Subway will have a market niche to itself.
Small budget research may also point towards new business opportunities. The
Grocer magazine provides many useful insights. Each week, it highlights one
consumer marketplace. For example, the 4 October 2014 issue highlighted that
sales of Christmas novelty chocolate products had risen 53 per cent in the past
12 months. This information could provide the basis for a new small company
launching into this market sector – perhaps aiming to establish an upmarket
chocolate novelty product.

Figure 23.1 Geographical mapping of sandwich bars in Brighton centre

23.3 Running and expanding a business

For a first-time entrepreneur, running the business can be as daunting
psychologically as starting it. The start-up may be scary, but at least it is bathed
in optimism about the future. It’s thrilling. But the day-to-day running of the
business may be much less so. We have all seen shop proprietors standing in
their doorway looking wistfully for customers. They must know that no-one
will walk in while they’re there, but they can’t bear to sit around any longer.
Restaurants on Mondays and Tuesdays, snack bars after the lunchtime rush and
toy shops in February – all suffer the same punishment of too few customers.
Apart from psychology, there are many practical issues that matter hugely
when running a business. For most businesses, success depends upon customer
satisfaction – delight, even. This requires a clever combination of flair and
warmth in customer service with meticulous organisation. A friendly smile is
not enough if a restaurant has forgotten that Table 27 is a birthday celebration
– and a cake is sent with the chef’s compliments to Table 14 but not 27. This is
why it is so hard to be a successful entrepreneur. Start-up is about flair, vision
and energy; running the business is about establishing systems that don’t fail.
Few people are equally strong at these very different qualities.
To run a business successfully:
• you need the ability to obtain and listen to objective measures of its
performance; if your business is your baby, it’s easy to listen to compliments
and shut out criticisms (business TV series such as Kitchen Nightmares and
Hotel Inspector tend always to come back to this problem)
• you need an obsessive eye for detail, whether in the service a customer gets
or in the accounting details of the business finances
• you need to be able to step back from day-to-day issues and think
strategically – about the long-term plans for the company
• you need to love what you’re doing and love making customers happy (see
Real Business).
‘Make every detail perfect and limit the number of details to perfect.’
Jack Dorsey, Twitter co-founder

Real business
In Wimbledon, South London, Paneteria Italiana has been providing
bread, Italian-style, for more than 40 years. Proprietor Salvatore
Falcone needs to make a profit, but cares passionately about the
bread he bakes. Why is the crust on his granary loaf relatively soft?
Well, because he makes the bread so that it stays fresh for 2–3 days.
Is that wise, when it would surely be nice to have customers who need
to buy bread every day? Well, he answers: ‘I like to make bread the
right way.’

Successful expansion
It may be no surprise that Paneteria Italiana has never expanded beyond the
single small bakery. Others need to expand. It may even be that the business
model relies on expansion because one outlet will never be able to generate
enough profit to keep the shareholders happy.
To expand a business, there are three broad issues that have to be covered:
establishing that the extra demand exists, ensuring that the finance is in place
and ensuring that the people are in place – especially any new leaders. When
Scoop ice cream opened its second outlet, the proprietor tried to be store
manager in two places at once. Not good. Later he taught himself the art of
delegation. In more detail, then, the three factors are as follows:
• Establishing that extra demand exists. This may seem obvious but can cause
problems. An all-business airline called MaxJet started with three staff in
America in 2003, flying New York to London. By 2007, it had expanded to
400 staff and several transatlantic routes – to Paris and London, to
Washington, Los Angeles and others. It grew by raising more capital from
shareholders, always claiming that it would make profits once it had a big
enough network. In 2007, it ran out of money, having never made a profit.
Passengers were stranded and staff redundant.
• Ensure the finance is in place. The most perfect form of finance is profit
generated within the business; it has no interest charges and doesn’t need to
be repaid to anyone. So ‘reinvested’, sometimes called ‘ploughed-back’,
profit is the goal. After all, if you’re not making profit now, why do you
want to expand? Sometimes the answer is that the opportunities are so huge
that you want to expand more quickly than your profit level allows. This is
often true of start-up digital businesses, from Instagram to ASOS. In this
case, the business will have to find some external finance, perhaps borrowed
from the bank or invested by shareholders. See Chapter 30 for more details.
• Ensure the people are in place. First-time entrepreneurs tend to think the
toughest aspects of business are finding a market and finding the finance.
More experienced business leaders say the biggest problems concern people.
Rapid expansion quickly stretches the human resources of the business: new
layers of hierarchy are needed and new line managers must be
appointed/promoted, trained and grow into the job.
Figure 23.2 Logic chain: successful expansion

Real business
Richard Branson’s tips for expanding a business
1 Know your mission.
2 Get the basic structure right: the back office, relations with
suppliers, etc.
3 Get the right team at the top.
4 A strong purpose and a sense of ethics give a solid foundation.
5 No matter how big you are, details count.
6 Listen to your customers and act on what you hear.
Source: www.entrepreneur.com

23.4 Intrapreneurship: innovation within a business

An intrapreneur has the personal characteristics of an entrepreneur, but works
within a large organisation. Typically, then, they think creatively (‘outside the
box’), are willing to take risks and show leadership in making things happen.
Some organisations have learnt to recognise and celebrate such people. Others
treat them as slightly wayward executives who need to be checked up on. The
factors that determine the differences between companies that celebrate and
those that mistrust intrapreneurs are:
• high tech v. low tech: high technology companies need bright, even
‘disruptive’ ideas to keep them one step ahead in a fast-changing
environment; famously, Google gives each member of staff 20 per cent free
working time to work on their own ideas; this consciously fosters
intrapreneurship by building an entrepreneurial workplace culture
• stage in the company’s life cycle: companies in an early growth stage want
 bright new ideas to keep growth going; when companies have become big
and rather static (maturity stage), they are more likely to want to avoid
mistakes – that is, to keep making lots of money in just the way they are
already doing; large companies tend to get bureaucratic, with every decision
needing to be signed off by several higher layers of management; that is the
opposite of an entrepreneurial culture
• leadership: the personal characteristics of the overall business leader can be
very important; some go out of their way to encourage younger staff to have
responsibility and some freedom; more autocratic leaders prefer to keep all
major decisions at the top – so intrapreneurship is unwelcome.

Real business
The Facebook Hackathon
From early in its life (born: 2004), workers at Facebook organised all-
night innovation sessions that came to be called Hackathons. In the
early days, founder Mark Zuckerberg was a keen participant. The
Hackathons would happen once every six weeks and the only rule was
that no-one could work on their day job. In the days leading up to the
all-nighter, emails would suggest project ideas and individuals might opt
in to someone else’s idea, or just experiment with something. The ‘Like’
button, one of the most important innovations in the company’s
history, was the product of a Hackathon.

23.5 Barriers to entrepreneurship

Entrepreneurs get praised for their risk-taking, but it is important to remember
that some are risking a lot more than others. If, like Richard Branson or Philip
Green, you come from a wealthy family, there’s a risk that a new business
might fail, but probably no risk that failure will hurt you financially. By
contrast, some people invest their life savings or borrow on the strength of
their family home; this is real risk and real pressure. An obvious barrier to
entrepreneurship, then, is lack of personal finance; a good chef can’t open a
restaurant unless the good chef has great savings. Some get round this by
starting on a market stall (famously, Julian Dunkerton, founder of
Superdry/Supergroup plc started on Cheltenham market with £40), but this is
not a realistic option for many types of business.
A parliamentary report published in 2012 made the following key findings
with regards to barriers to entrepreneurship in the UK:
• Since the 2009 financial crisis, banks have become much less willing to lend
to small firms; they regard this business as risky and unprofitable; the report
says: ‘Banks increasingly tend not to lend to businesses without asset backing
and this especially impacts upon SMEs [small and medium-sized enterprises]
and specifically deters business start-ups.’
• Government research shows that 29 per cent of entrepreneurs are women.
The report argues that if women had full 50/50 representation, 150,000
additional start-ups would be created each year. Despite this, other evidence
shows that the rate of business start-up is rising faster among women than
men, so perhaps this problem will resolve itself over time
• Another key finding was that employees in the public sector struggle to
understand or even trust the motives of entrepreneurs. There is a tendency to
assume that people running small businesses are motivated by greed and the
desire to avoid tax. In fact, says the report, small businesses tend to pay
proportionately higher rates of tax than large firms, which not only seems
unfair, but may be a barrier to entrepreneurship.
‘Most start-up companies fail and it is smart public policy to help
entrepreneurs increase their odds of succeeding. But the biggest loss to our
economy is not all the start-ups that didn’t make it: it’s the ones that might
have been created but weren’t.’
Eric Ries, business author

23.6 Anticipating risk and uncertainty in the

business environment
In August 2014, New Look announced that it was putting on hold its expansion
into Russia. In early November, it announced it was pulling out altogether. That
was well-timed, as the Russian economy imploded soon after. This is a good
example of assessing risk and acting before the overall business is affected by
uncertainty.
Entrepreneurs pride themselves on their sensitivity to the market. This is
because they are usually in daily, face-to-face contact with customers. So they
pick up changing trends or moods among consumers. In autumn 2008, just
before the 2009 recession, most firms knew things looked worrying. Yet in
Wimbledon an entrepreneur spent over £150,000 opening a French restaurant
at just the wrong time. He lasted six months before closing down. He showed
no understanding of the risks involved in that specific business environment.
To anticipate risk, it is important to try to quantify it, so that the risks can be
compared with the potential rewards. With uncertainty, wise businesspeople see
this as the natural state of affairs. They accept that tomorrow’s trade may be
completely different from yesterday’s. So it is vital to keep some capital in
hand to cover the day-to-day fluctuations in finances.

Five whys and a how

23.7 Role of an entrepreneur – evaluation

Within the economy as a whole, entrepreneurs provide two marvellous
functions. First, they provide a wide array of competitors to the big companies
that would otherwise be able to enjoy safe markets and therefore complacent
service and business thinking. Wall’s claims a 66 per cent share of the UK
market for hand-held ice cream; just think how easy the company’s life would
be if it wasn’t for all the independent ice cream parlours or vans. So the
consumer stands to benefit considerably from the work of entrepreneurs.
Their second key function is innovation. This is especially obvious in the IT
sector, where established firms want to keep things just as they are (e.g. social
media consisting solely of Facebook and Twitter). New entrepreneurs, though,
keep coming up with new ideas, such as Instagram and Snapchat. The bright
new ideas then force the existing firms to try to catch up with or beat the new
competition. Once again, the consumer is the winner.
‘Get big quietly, so you don’t tip off potential competitors.’
Chris Dixon, angel investor

Key terms
Franchise: a business that sells the rights to the use of its name and
trading methods to local businesses.
Geographical mapping: plotting on a map the locations of all the
existing businesses in your market, in order to show where all your
competitors are.
Innovations: new ideas brought to the market.
Line manager: a manager responsible for meeting specific business
targets and responsible for specific staff.
Market map: a grid plotting where each existing brand sits on scales
based on two important features of a market; for example, in the car
market: luxury/economy and green/gas guzzling.
Market niche: a gap in the market – that is, no one else is offering
what you want to offer.

23.8 Workbook
Revision questions
(35 marks; 35 minutes)
1 Explain how ‘observation’ could help a business-minded person to
come up with a great new idea for starting a firm.
(3)
2 Have you spotted any business opportunities recently? If yes, set
out your idea in no more than three sentences. If no, decide now
what you believe to be the best opportunity in your local high street
or shopping centre. Again, set it out in no more than three
sentences.
(6)
3 Explain in your own words the purpose of geographical mapping.
(3)
4 Which one of Richard Branson’s top tips (see page 148) do you
think is the most important? Explain your reasoning.
(6)
5 Explain why it might be wise for a small firm to turn down a large
order from a national supermarket chain.
(4)
6 Firms may worry that an intrapreneur wants to leave and become an
entrepreneur. Outline two barriers that may prevent the individual
from proceeding.
(4)
7 You are thinking of starting a new online travel agency focused on
extreme sports. Examine three factors that will determine whether
or not the business succeeds.
(9)
Data response 1
Cara Phelps has worked in Sainsbury’s personnel department for eight
years and is getting bored. She owns her own flat in Leeds, has
managed to save £22,000 and wants to start her own business. Her
passion is shoes (she has 70 pairs!) so she wants to start a shoe
shop. She has been eyeing a site close to Harvey Nichols, as she
wants to target those willing to pay £80–£200 a pair. She has found a
super shop for which she must pay £5,000 up front for a five-year
lease, and then £24,000 a year as the annual rent.
Figure 23.3 shows a profile of Cara, drawn up by a friend who is a
business consultant.
Figure 23.3 A profile of Cara Phelps; ‘10’ = perfect.
Questions (40 marks; 45 minutes)
1 Assess two pieces of small budget research Cara should carry out
before taking things any further with her upmarket shoe shop in
Leeds.
(8)
2 Assess whether an entrepreneur such as Cara should be given
financial help by the government in the early stages of her start-up.
(12)
3 Use the text and Figure 23.3 to evaluate whether Cara is likely to
succeed with her new shoe shop.
(20)
Data response 2
Share Radio
Figure 23.4 Gavin Oldham
4 November 2014 was the launch day for a new radio station: ‘Share
Radio’. This digital-only channel is Britain’s first station devoted solely
to money – to personal finance. It broadcasts 24/7 and a typical day
would see coverage of the economic and business news, discussion
about new savings plans or bank accounts, and coverage of the day’s
events in markets such as shares, exchange rates, oil and gold.
Share Radio is the brainchild of Gavin Oldham, the sole investor in
Share Radio. Mr Oldham made his fortune as the founder of the stock-
market-listed ‘Share plc’. He and his family retain a 76 per cent stake in
the business, which the stock market values at around £50 million.
Share Radio will require deep pockets because radio start-ups are
notoriously cash-hungry. The costs will have started building up from
spring 2014, as the central London offices and studios were acquired
and staff began to be hired. The second to arrive was Lexi Diggins,
recruited as business development manager, but who now also serves
as the station’s weather forecaster! By November, there were 25 staff,
implying a wage bill of almost £1 million a year.
And where does a new radio station get income from? Eventually
audience numbers should rise to the point that advertisers get
interested in placing commercials. But at the start it is hard for
advertisers to care. Realistically, even if Share Radio does well in
building up its listener base, it will take at least three years to break
even.
Questions (20 marks; 25 minutes)
1 Assess two possible reasons why staff may enjoy working in a start-
up such as Share Radio.
(8)
2 Assess Mr Oldham’s probable role in the start-up of Share Radio.
(12)
Extended writing
1 Outline a new business that you might like to start. Evaluate the
benefits and drawbacks to you personally of starting that business.
(20)
2 Although he has a personal fortune of around £500 million, Stelios
(founder of easyJet) keeps starting up other businesses, including
Fastjet – Africa’s first low-cost airline. Evaluate the possible motives
of a serial entrepreneur such as Stelios.
(20)
Section 1.5 Entrepreneurs and leaders

24 Entrepreneurial motives and

characteristics
Definition
The motives of entrepreneurs are often rooted in psychology rather
than ambition. Many had disappointing school careers, making them
determined to prove themselves. Entrepreneurial characteristics are
the traits that mark them out from others, including determination and
the ability to cope with (and even embrace) risk.

Linked to: Role of an entrepreneur, Ch 23; Forms of business,

Ch 26; Moving from entrepreneur to leader, Ch 28.

24.1. Introduction
Entrepreneurs see the opportunities that others see, but they also have the
courage and initiative to act quickly. The past 15 years have seen two clear
trends: an increasing desire for travel and more and more thrill-seeking, such
as extreme sports. Many people could see that both trends pointed to a gap for
a new service: space tourism – that is, individuals going into outer space, just
for the fun of it. Richard Branson saw the same opportunity and started Virgin
Galactic, which plans to charge £150,000 per trip. Despite a tragic setback in
2014, it still hopes to make its first flight in 2016.
‘I’m convinced that about half of what separates the successful
entrepreneurs from the non-successful ones is pure perseverance.’
Steve Jobs, founder of Apple Inc
A successful entrepreneur needs the following characteristics:
• understanding of the market – to know what customers want and to see how
well or badly current companies are serving them
• determination – to see things through even if there are difficulties
• passion – not just to make money, but to achieve something, such as to
design a more efficient solar panel, or to transform rooms from shabby into
bright and freshly painted ones
• resilience – that is, the ability to bounce back when things are against you
(weaker people retreat into their shell or waste time trying to find others to
blame)
• the ability to cope with risk.

Real business
Nancy’s Nails

Figure 24.1 Scented top coat ‘Got to be Strawberry’

Liberty is London’s most unusual, fashion-orientated department
store. In summer 2014, it held an open day in which anyone who
wanted to supply to Liberty could come and do a three-minute
presentation. Arriving at 4.00 in the morning, determined to be first in
the queue, was 22-year-old Nancy. Her proposition was ‘scented nail
polish’ in a bottle branded Nancy’s Nails. Attracted by in a unique new
idea, the store showed great interest and helped Nancy with the final
pack and display designs. Even more remarkably, Liberty agreed to pay
for their first order in advance because Nancy had used up all her
savings on the project so far. In the autumn of 2014, Nancy’s Nails
were on display in Liberty. Nancy’s determination had paid off.

24.2 Risk-taking
Business decisions are always about the future; therefore, they always involve
uncertainty. Supermarket giant Tesco’s management had a wonderful
reputation until it was damaged by a series of corporate failings in 2013 and
2014. 2013 saw embarrassment from the horsemeat scandal and an
ignominious withdrawal from China and America. 2014 was even worse, with
humiliation in the marketplace at the hands of Lidl and Aldi, and concerns
about fraud when Tesco’s profits proved to be overstated by more than £250
million.
Good entrepreneurs consider not only what they think will happen, but also
what could happen differently. Someone opening a restaurant may expect 60
customers a day, each spending £25. In fact, one month after opening, there
may just be 40 customers spending £20 each. Receiving just £800 instead of
£1,500 may make it hard for the restaurant to survive financially; there may be
a risk of closure. This possibility should have been foreseen so that plans
could be made.
An entrepreneur looks at the risks, compares them with the possible rewards
and makes a considered decision. If there is a good chance of making £1,000 a
week, but also a (small) chance of losing £500 a week, it is worth carrying on.
Risk-takers accept that sometimes they will take a loss; that is part of business.
See Table 24.1 for details of what makes a good entrepreneur.
‘A pessimist sees the difficulty in every opportunity; an optimist sees the
opportunity in every difficulty.’
Winston Churchill, wartime Prime Minister

24.3 Skills required to be a successful entrepreneur

Whereas characteristics are part of what we are born with, skills can be
learned. They range from skills with finance to skills at dealing with people.
They include:
• financial skills, including the ability to read and understand key documents,
such as a cash flow forecast
• persuasive abilities – entrepreneurs need to persuade others to do things like
provide planning permission, supply goods on credit or work harder/faster
to get things completed on time; they also may need to persuade staff to take
a chance by joining a brand new, risky venture
• problem-solving skills, perhaps based on the ability to investigate possible
causes and then to work out the most satisfactory solution
• networking skills: to be able to turn acquaintances into business friends and
therefore benefit from network-based crowdfunding or social media
endorsement.
‘Every worthwhile accomplishment, big or little, has its stages of drudgery
and triumph: a beginning, a struggle and a victory.’
Mahatma Ghandi, leader, Indian Independence

Table 24.1 Characteristics of good and bad entrepreneurs

24.4 Motives for becoming an entrepreneur

Although 20 per cent of entrepreneurs have money as their prime motive, most
are looking for more than financial gain. Typically they are looking for ‘a
challenge’ or ‘to prove myself’. In other words, people are looking for greater
satisfaction than they can get from a regular job. A NatWest Bank survey of
1,400 entrepreneurs named the top start-up motive as ‘to gain more control
and avoid being told what to do’. Just 6 per cent said that they started their
venture ‘to make money’. Some of the key motivators for entrepreneurs are set
out in Figure 24.2.
Figure 24.2 Key motivators for entrepreneurs
In some cases, starting a business can be hugely challenging, satisfying,
absorbing and profitable. An example is Matteo Pantani, whose passion for ice
cream led him to start Scoop ice cream parlour in 2007, opening his second
London outlet in 2010 and third in spring 2012 (dreadful weather in the two
years to spring 2014 put further expansion on hold). Yet some people deceive
themselves about enterprise. They assume it is more satisfying, glamorous and
profitable than it often is. Many shopkeepers work very long hours for quite
poor rewards. Many small builders speak bitterly about their experiences in
dealings with customers, suppliers and employees; they feel it would be easier
to just earn a wage. Furthermore, government figures show that 30 per cent of
new businesses fail within their first three years.

24.5 Financial motives for becoming an

entrepreneur

Profit maximisation
As mentioned above, 20 per cent of those starting a business have profit as
their major motivation. It is fair to assume that, of those, most will be thinking
of how to maximise that profit. This would make business sense if the market
conditions force the entrepreneur to focus on the short term. An example
would be someone who has bought a £150,000 flat in a Spanish seaside town
and needs to rent it out to pay the mortgage. Realistically, July and August are
the only months when meaningful rentals can be charged; therefore, there can
be only one logical approach: short-term profit maximisation. Unfortunately,
also coming into this category are all the ‘cowboy builders’ and other business
scams that attempt to extract as much short-term profit as possible from each
customer. In such cases the ‘business model’ is to treat each customer as a one-
off opportunity to extract cash – there is no thought for repeat purchase,
customer loyalty or long-term branding.
For businesses that are thinking about the long term, the best way to maximise
profit may be to satisfice in the short term (see below). In this context, that
means accepting a lower profit now in order to make a higher profit in the
future. Sony launched its PS4 at a relatively low price, knowing that if it could
build up enough loyal customers the real profits would come later, from
software purchases.

Profit satisficing
To satisfice means to find the ideal blend between different pressures. In this
case it is to find the ‘right’ profit rather than the biggest. In 1998, after years of
profit growth, Marks & Spencer made record profits of £1,155 million. Its net
profit margin of 14 per cent was the wonder of the retail world. After that point
came an implosion, as shoppers revolted against the company’s overpriced
products. Nearly 20 years later, it has never regained that level of profit. It had
been foolish enough to profit maximise when a business in that position should
always satisfice – because it should always be thinking about its long-term
future. The story is shown nicely in Figure 24.3, which compares profits at
Next plc with those of Marks & Spencer between 1998 and 2014.
Figure 24.3 Perils of profit maximising – annual pre-tax profits: M&S v.
Next
For new, small businesses especially, if they want to build a successful
operation for the long term, profit satisficing makes far more sense than short-
term maximisation.

24.6 Non-financial motives for becoming an

entrepreneur

Independence
Some young people crave independence from the start of their working life,
making them desperate to create a business rather than working for others. But
vibrant stories about young entrepreneurs risk masking the evidence that the
average British entrepreneur sets up in business at the age of 52! In their case,
it is likely to be that, after a long career for a large employer, they feel the
need (and the confidence; and have the savings/capital) to do something for
themselves.
The issue of independence tends to be especially important for immigrants and
their families. In Britain, whereas only 10.4 per cent of Britons have ever
started a business, 17.2 per cent of non-UK nationals have done so (and they
start at a younger age). A March 2014 report found that immigrant
entrepreneurs have founded 464,527 businesses that employ 8.3 million
people. For immigrants, there is a tendency to mistrust fair career prospects
working in large organisations – hence the drive for independence.
So independence can be a psychological need or a practical response to actual
or perceived unfairness or discrimination. It is notable that among British
entrepreneurs there seems to be a disproportionate number with dyslexia or
other issues that dented their self-esteem while at school. Perhaps people like
Richard Branson felt something akin to discrimination – and perhaps that led
to the same desire for independence felt by many immigrants.

Real business
From sixth-form college to squillionaire
Aged 17, Andrew Michael turned an A level project into an internet
business start-up. When he sold the company, he received a cheque
for just over £46 million. His business was Fasthosts, which provided
email and other services for small companies. It grew rapidly, earning a
listing in The Sunday Times as the second fastest-growing technology
company in Britain.
Fasthosts was famous for the parties Andrew threw for his staff. At
different Christmases, he hired Girls Aloud, The Darkness and The
Sugababes. After selling Fasthosts, he started a cloud computing
business, Livedrive. This grew to provide revenues of £25 million a
month before it was sold in early 2014 to a US IT company, J2 Global.
Andrew’s slice of the sale has not been published, but it is reasonable
to expect that it was more than the cheque from Fasthosts.

Home-working
Independence can also be a requirement for someone who needs to be at home
as a parent or carer. In other words, some need the practical flexibility of
home-working because they are unable to physically go to work. Sadly, there
are many employers who see this need as an opportunity to get work done at
below normal market rates – including below the legal minimum wage. Home-
workers often have to accept piece rate terms that give no security of income
and can work out as a low hourly income.
This is why some who need to work from home try to set up their own
business. In an online world, starting a business in a bedroom is quite
plausible. Needless to say, such an enterprise will work hugely better if the
entrepreneur has some strong IT skills, making website design easier and
therefore being able to start up without paying out cash to a third party.

Ethical stance
Some entrepreneurs find it difficult to accept the ethical environment within a
large business organisation. Recent mis-selling scandals affecting the banking
and insurance sectors are a reminder that modern firms may be good at talking
about ethics, but some fail to practise what they preach. As a result, some with
strong ethical convictions prefer to start up a business for themselves, in which
moral questions are entirely within the individual’s control. So, if a repressive
government wishes to place an order, the answer can be a straight ‘no’.
Running their own business gives individuals a remarkable amount of control
– as long as they are happy to trade their ethical stance off against profit (and
family income).
Figure 24.4 Logic chain: ethics can be good business

Social entrepreneurship
Whereas ‘ethics’ has a clear meaning, social entrepreneurship does not. Many
companies claim to be ‘doing good’ and therefore say they are social
enterprises. But it all depends on your point of view. A US company called
Hampton Creek launched ‘Just Mayo’, charging a premium price for a product
claiming to have health benefits. In fact, it was an egg-free product pretending
(according to a lawsuit from Unilever, owners of Hellman’s) to be a
mayonnaise. The food category ‘free from’ has become important in the UK
and US. Many companies boast about dairy-free milk (Alpro) or egg-free
mayo, making it seem as if there are health benefits. The suppliers often claim
to be social enterprises. But far more people buy these foods than need to for
health reasons – so they are paying price premiums unnecessarily. The concept
of social entrepreneurship is in the eye of the business owner, when it should
be in the eye of the beholder.

Five whys and a how

24.7 Entrepreneurial motives and characteristics –
evaluation
Starting a business can mean taking a huge gamble with family savings,
perhaps made worse still by racking up personal debt. In such circumstances,
the entrepreneur is either foolhardy or is driven by a powerful psychological
driving force. Usually this force is to prove that she or he has qualities and
skills that no-one has ever acknowledged. Interwoven with this is the need for
independence that allows the entrepreneur to take all credit for the success (or
failure) of the business. The typical entrepreneur sees the business as an
extension of him or herself. It is their baby.
‘I knew that if I failed I wouldn’t regret that, but I knew the one thing I
might regret is not trying.’
Jeff Bezos, founder of Amazon
In these highly personal circumstances, it is understandable that some think
they are fulfilling a social enterprise role when, objectively, they are just
finding a profitable niche in a complex market. Just because a business says it
is socially aware or ethically sound, it doesn’t mean that its decisions and
actions will bear this out. When an organisation such as the Co-op Bank can
claim ethical soundness when it is being fined for mis-selling financial
products to its own customers, you know that the modern business world is a
complex one.

Key terms
Crowdfunding: obtaining external finance from many individual, small
investments, usually through a web-based appeal.
Entrepreneur: someone who makes a business idea happen, either
through their own effort or by organising others to do the work.
Piece rate: paying workers per piece they produce (for example, £2 per
pair of jeans made).

24.8 Workbook
Revision questions
(25 marks; 25 minutes)
1 Why is ‘initiative’ an important quality in an entrepreneur?
(2)
2 Section 24.1 lists the characteristics needed to be a successful
entrepreneur. Which two from this list seem of greatest importance
to:
a) a new firm facing a collapse in demand due to flooding locally
 b) a 19-year-old entrepreneur wanting to start her own airline?
(4)
3 Section 24.2 mentions a restaurant that expects to receive 60
customers per day spending £25 each, but actually gets 40
customers spending £20. Calculate the shortfall in revenue that will
result from these differences.
(3)
4 Explain two actions the government could take to encourage more
people to become entrepreneurs.
(4)
5 Briefly explain one argument for and one against saying that
entrepreneurs are born, not made.
(5)
6 Having read this chapter, explain briefly how successful or
unsuccessful you think you would be as an entrepreneur. Take care
to explain your reasoning.
(7)
Data response 1
Travis Sporland is a surfer who believes he has created a revolutionary
design for surfboards. His father was made redundant from a Devon
boatyard two years ago, so Travis thinks they can start up a small
manufacturing business together. The Travis surfboard is designed for
children up to the age of 11. He believes the size of the world market
may be as high as 1.5 million. Some of his forecasts about the
business are set out in Table 24.2.
Questions (20 marks; 20 minutes)
1 If you were to advise Travis, identify four questions you would like to
ask him about his business plans.
(8)
2 Explain your reasoning behind one of those questions.
(4)
3 Assess two main factors you think he should also consider before
 going ahead.
(8)

Table 24.2 Forecasts for new business

Data response 2
Naked Pizza
In 2006, a pizza takeaway opened in New Orleans. It was called ‘The
World’s Healthiest Pizza’. It attracted attention but, as co-founder Jeff
Leach puts it, ‘people thought it would taste like the side of a tree’.
The business struggled. Then a local advertising specialist advised a
name change. He recommended ‘Naked Pizza’. Since then, sales have
risen dramatically and – in 2009 – two wealthy backers invested in
making the business grow. In a country obsessed by food, Naked
Pizza’s message is ‘keep buying the pizza you love, but buy ours
because it’s better for you’.
The thinking behind the business was to do ‘an Activia’ in the pizza
market. In other words, create probiotic pizza dough that can be
friendly towards stomachs. Leach and partner Randy Crochet said they
spent $750,000 on research and experimentation to find the perfect
dough. It is made from 12 different whole grains and contains probiotic
bacteria – just like Activia. Leach says that until Naked Pizza was
introduced the usual American pizza was ‘nothing more than a
doughnut with tomato sauce’. Sceptics have questioned whether these
friendly small bacteria can survive a 400° pizza oven, but Leach is sure
they can.
Figure 24.5 Naked Pizza
In August 2010, the first all-new Naked Pizza outlet opened in Florida.
The company claimed in early 2010 that ‘the race is on to open 400
Naked Pizza (franchise) stores between August and December 2010’.
In fact, by the end of 2014, there were just nine stores in the US (and
six in the Middle East). But founder Jeff Leach remains hugely
motivated by the desire to get people eating a healthier pizza.
The Naked Pizza website suggests that an investment of $250,000 is
required per franchisee, but it is not clear what fee and royalty Naked
Pizza will demand. In its day, many early franchisees in McDonald’s
became millionaires. The same hopes will be true in this case.
Although there’s not yet a Naked Pizza in Britain, there may yet be a
rush to become a franchisee. Recent years have seen the rise of
Subway. Perhaps it is time for something new on the high street.
Questions (30 marks; 35 minutes)
1 Give two characteristics of successful entrepreneurs shown by the
founders of Naked Pizza.
(2)
2 Assess two probable motives behind Jeff Leach and Randy
Crochet’s establishment of their Naked Pizza business.
 (8)
3 Between August 2010 and 2014, the business was developing quite
rapidly. Assess two possible risks that may undermine the success
of this expansion.
(8)
4 In Britain, Domino’s charges £10.49 for a delivered medium pizza
such as the Meat Combo and Papa John’s charges £12.49. Assess
the prices you believe that Naked Pizza should set for delivered
pizzas in the UK market.
(12)
Extended writing
1 Motor car pioneer Henry Ford once said that ‘a business that makes
nothing but money is a poor business’. Evaluate that statement.
(20)
2 This chapter started by saying that ‘The motives of entrepreneurs
are often rooted in psychology rather than ambition.’ Evaluate
whether ambition is likely to create a more successful and profitable
business.
(20)
Section 1.5 Entrepreneurs and leaders

25 Business objectives
Definition
Business objectives are the goals set for the business as a whole, also
known as corporate objectives. They derive from the mission and aims
set by the directors.

Linked to: Leadership, Ch 22; Entrepreneurial motives and

characteristics, Ch 24; Forms of business, Ch 26; Moving from
entrepreneur to leader, Ch 28.

25.1 Introduction to business objectives

Business is best looked at from the boss’s point of view. The boss (perhaps the
founder or entrepreneur) has an idea or mission. The chief executive of
Sainsbury’s may decide that a chain of supermarkets in India represents the
next big step forward. This is the mission – Sainsbury’s succeeding in India.
This can then form the basis for setting targets or objectives, such as to open
the first ten Sainsbury’s supermarkets in India by the end of 2018.
After the chief executive has set that objective, Sainsbury’s senior managers
must then figure out how to make this happen. What will be needed is a
strategy that leads to a plan of action – that is, to set out exactly what needs to
happen, and by when. That strategy will have to involve the four main business
functions: marketing, people, finance and operations (see Table 25.1).
The chief executive will expect the leaders of each of these four functions to
come up with their own plan for meeting the overall objective, so there will be
a marketing plan, a financial plan and so on. How these things relate to each
other can be seen in Figure 25.1
Figure 25.1 How business works
Having established their own plans, the four functional leaders will now need
to meet to make sure that everything fits together. It is no good if marketing
decides on an image of Sainsbury’s Super-value (a kind of Aldi/Lidl idea)
while operations chooses to build stores targeting India’s rich elite. Each of the
functions must talk to each other and trust each other (see Figure 25.2).

Table 25.1 The business functions

Figure 25.2 How business works (2)
Important though it is to understand the internal workings of a business as
shown in Figure 25.2, there are many added complications. Much as a chief
executive may wish to set optimistic objectives, a series of outside factors can
get in the way of success. Most obviously, competitors may have their own
ideas; if Sainsbury’s finds that the massive Walmart is fighting for every
suitable property site in India, opening ten stores will become a lot harder.
Figure 25.3 gives an overview of the process of running a business, taking into
account external as well as internal factors.
Figure 25.3 How business works (3)

Real business
Sainsbury’s plc is one of the UK’s leading companies, with a 16.5 per
cent share of the market for groceries. In 2014, its sales revenue was
£26,353 million and profits came to £798 million. Despite these
impressive-sounding numbers, Figure 25.4 shows how they compare
with one of the world’s monster businesses – Walmart (which owns
Asda). As you can see, Walmart makes more than 20 times more profit
per year than Sainsbury’s. If Sainsbury’s chooses to develop in India, it
will probably end up head-to-head with Walmart. That would be tricky.
Figure 25.4 Sainsbury’s v. Walmart

25.2 Mission and objectives

Mission is the aim for the business that is settled upon by the boss (in a small
firm) or by the Board of Directors in a large one. An aim is a general
statement of where the business is heading; mission usually takes that statement
and makes it sound more evangelical or motivational. An aim might be ‘to be
Number 1 in the market for advanced engines’. When dressed up as a mission,
this becomes: ‘to provide the finest, most technologically advanced power
systems’ (Rolls-Royce).
The reason to turn the aim into a motivational statement is to try to excite
customers and staff alike – to make them feel part of the project, just as
customers once felt that buying Innocent smoothies was helping to ‘make the
world a little fruitier ’. Without doubt, if a business has an exciting aim, it is
great to express it as a motivating mission. Often, though, dull aims are jazzed
up as ‘mission statements’ that mean little or nothing to the staff.
Table 25.2 Good and bad mission statements
From the aims or mission will come the objectives. These will usually be
SMART – that is, Specific, Measureable, Achievable, Realistic and Timebound.
For ASOS, an example of a SMART objective might be ‘to become one of the
Top 3 online clothing sellers in China by 1 January 2017’. Ideally this
objective would seem challenging but achievable – and should sit neatly as a
stepping stone towards the mission of becoming ‘the world’s Number 1’.
Objectives are set because if you are the boss of 21,300 people running Rolls-
Royce, you cannot make every decision. Therefore, you have to give more
junior staff the authority to get on and make middle-ranking decisions, perhaps
without letting you know. If managers are clear on the overall objectives, they
can feel confident in making decisions that contribute towards achieving those
goals.
‘Objectives are not fate; they are direction. They are not commands; they
are commitments. They do not determine the future; they are means to
mobilise the resources and energies of the business for the making of the
future.’
Peter Drucker, business guru

25.3 Common business objectives

1 Survival. This will be a priority for new, start-up businesses – one third of
new businesses fail to survive the first three years. With survival as the
objective, managers may avoid actions that look highly profitable yet have a
high risk attached to them (such as launching a new product).
Survival is also a priority for businesses that:
• are caught out by a sudden change in the economy: a sudden recession or
 (for a business such as Iceland or Poundland) an unexpected consumer boom
• have over-expanded, probably using bank finance and therefore are
struggling under the weight of interest payments (a rise in interest rates
would be a further twist of the knife)
• have been hit by a competitive whirlwind, such as a price war or a new,
wealthy, direct competitor.
‘Business is like a bicycle. Either you keep moving or you fall down.’
John David Wright
2 Profit maximisation. This is the attempt by a business to make as much profit
as possible, probably as fast as possible. Big companies may follow this
approach when they suspect a rival is about to try to buy them out. The
higher the profit they can show, the higher the price the company will fetch.
The same is likely to be the case for companies about to ‘float’ their shares
onto the stock market.

Small firms may also be trying to make as much profit as possible, with no
concern for the long-term future. Such businesses may end up on TV
programmes such as the BBC’s Watchdog, which has been uncovering poor
business practice for 35 years.
‘Growth is a by-product of the pursuit of excellence and is not itself a
worthy goal.’
Robert Townsend, Avis chief executive and business author

Real business
When Candy Crush owner King Digital Entertainment decided to float
the business, it had nine months to maximise its profit before the
flotation took place. Therefore, when the spring 2014 float happened,
it was possible to claim such high profits that a very high share price
was justified. The final price of $22.50 per share valued the company
at $7 billion. Within six months of the float, the shares had lost 40 per
cent of their value as King announced that revenues from Candy Crush
were lower than expected. The share buyers were certainly crushed.

3 Sales maximisation. The importance of online business has placed growth as

one of the most common business objectives. The logic is often to say
 ‘there can only be one giant in this market, so we must make sure it’s us’.
Therefore decisions are made that focus on rising customer/user numbers
instead of rising profits. The assumption is often made that, if you get the
growth today, the profits will come tomorrow. This is famously true in the
console business, in which selling hardware rarely makes a profit – it is the
software and the add-ons that bring profits later.
4 Market share. Gillette has a 70 per cent share of the UK market for razors
and blades. That gives it £250 million of sales at comfortably high profit
margins. Having a high market share is not only good business today – it
puts a company in a marvellous position to feel secure about its future. If
Gillette launches a new product, every supermarket and chemist will stock it
– and most consumers will try it. And it is very rare for new companies to
try to break in to a market so dominated by one business. Everyone knows
that Gillette would fight ferociously to stop a newcomer from making
serious inroads into its market-leading position.
5 Cost efficiency. This is important for large firms, but critical for small ones,
especially business start-ups. If the objective is to minimise costs, it will be
vital that everyone in the business is practising the same approach. So even
quite junior staff who have been given some decision-making power
(through delegation) should be aware of the importance of cost
minimisation. This is especially the case for businesses that operate in
markets where product differentiation is low. At the time of writing, Tata
Steel is planning to sell off its UK steel business because it has struggled to
get costs low enough to compete in the world market.
Figure 25.5 Logic chain: cost efficiency and profit
6 Employee welfare. On the face of it, the only business organisation that
would place staff as a central business objective would be a workers’ co-
operative, such as the John Lewis Partnership. Happily there are others who
appreciate that good customer service comes from motivated staff. Greggs
plc has long been a good example of this. Employee welfare is also
important in businesses such as JCB and Jaguar Land Rover, when
underlying shortages of skilled engineers force managers to care hugely
about staff retention. In 2013/2014, staff retention at Jaguar Land Rover
was a remarkable 98 per cent – a tribute to its employee welfare.
Unfortunately, there are other companies where the cliché ‘staff are our
most important asset’ rings hollow, with managers resorting to wage-
cutting devices such as outsourcing and zero-hours contracts.
7 Customer satisfaction. As with employee welfare, customer satisfaction is a
goal, but rarely a corporate objective. It is necessary but not sufficient for
success. In recent years, companies have used the term ‘customer delight’ to
denote the need for something more active than ‘satisfaction’. The real
essence of customer satisfaction is that it should be at a sufficiently high
level to generate customer loyalty, or even commitment (think Apple or the
 love of a football fan for his club).
8 Social objectives. These are easy to find on company websites; whether they
have any significant influence over business decisions is less clear. All
through the period that banks were mis-selling service after service to
customers, their websites boasted their ethical purity. Ultimately, social and
ethical objectives only mean something if the business is willing to sacrifice
some profit or some market share. Arguably, Tesco did just this in May
2014 when it volunteered to remove sweets from near its checkouts (though
perhaps it was following Lidl’s example, as the German firm did the same
earlier in the year). It is fair to be sceptical about whether social and ethical
objectives are ever much more than image-related add-ons. Financial
objectives remain the overwhelming priority for most businesses. Ethical
businesses, such as One Water, do exist – but are relatively rare.

Five whys and a how

25.4 Business objectives – evaluation
Managing a business is a challenge because there are so many variables that
can get in the way of success. If the pound rises in value, different executives
within a company may come to different judgements about what to do next. In
such a situation, the business objectives should help keep everyone pointing in
the same direction. If the goal is profit maximisation, the higher pound’s
impact on import prices can be enjoyed as higher profit levels. If sales
maximisation or market share are the goals, lower import prices can feed
through to price cuts and therefore higher sales.
A problem can be that, despite staff knowing the official objectives, some
believe there are other, unstated but more important, goals. In 2010, at a time
when it advertised itself as the ‘ethical bank’, the Co-op Bank was guilty of
mis-selling financial products to its customers. Clearly the sales staff believed
that the real goal was profit, not the social objectives claimed by the business.

Key terms
Budgets: an agreed ceiling on the monthly spending by any department
or manager.
Corporate objectives: targets for the whole business, such as profits
to rise by 20 per cent a year for the next three years.
Delegation: passing authority down the hierarchy, to allow more junior
employees some decision-making power.
Entrepreneur: someone who makes a business idea happen, either
through their own effort or by organising others to do the work.
Mission: a business aim expressed to make it seem especially
purposeful and motivating.
Mission statement: a short, powerfully expressed sentence or two that
explains the business aims clearly yet motivationally.
Objectives: targets precise enough to allow praise or blame for the
person in charge.
Shareholder value: the mix of shareholder dividends and a rising share
price that stem from high and rising profits.
Staff retention: literally retaining (keeping) staff, usually measured as
staff still remaining at the end of the year as a percentage of the total
workforce.
Strategy: a medium-to-long term plan for meeting your objectives.

25.5 Workbook
Revision questions
(25 marks; 25 minutes)
1 Explain two differences between a mission and objectives.
(4)
2 State whether each of the following statements is a mission or an
objective:
a) to become the world’s favourite car rental business
b) to bring healthy eating to Wigan
c) to achieve a 40 per cent market share by the end of 2018.
(3)
3 Outline two possible risks if a business such as Sainsbury’s sets
itself the objective of sales maximisation.
(4)
4 Outline why ‘survival’ might be the wisest objective for a brand new
start-up business.
(3)
5 Why might a business suffering bad publicity emphasise a new set of
social objectives?
(3)
6 Read John David Wright’s quotation (see page 162). Explain its
meaning in your own words.
(4)
7 Outline one strength and one weakness of a business such as Aston
Villa FC setting itself objectives for the coming season.
(4)
Data response
Snapchat
In late autumn 2013, two 23-year-old Californians were each offered
$750 million in cash by Facebook’s Mark Zuckerberg. And they turned
it down. Evan Spiegel and Bobby Murphy launched Snapchat in July
2011. By 2013 Facebook wanted to buy the business for $3,000
million. The founders had each retained a 25 per cent stake in the
business, hence the $750 million figure.
Snapchat began late one night at Stanford University when Reggie
Brown stepped into fellow student Spiegel’s room groaning about a
photo he regretted sending. He then said something like ‘I wish there
was an app to send disappearing photos’. Spiegel saw the potential,
calling Brown’s remark ‘a million dollar idea’. This conversation is now
part of a billion dollar lawsuit, as Brown claims his share of the
Snapchat goldmine.
Spiegel developed the app as part of a university project. When he
presented it, the feedback was, roughly, who wants a disappearing
photo? And when it debuted (under the brand name Picaboo) in the
Apple App Store on 13 July 2011, no-one noticed. Luckily, a bust-up
over the share split in August 2011 made Spiegel and Murphy cut
Brown out – including the Picaboo name that Brown had put forward.
The new name was Snapchat. User uptake remained painfully slow
until high school students in California started using it at school – as
Facebook had been banned. Then the take-off was spectacular, as
shown in Table 25.3.
Table 25.3 The rise of Snapchat
Having turned $3 billion down in 2013, it was perhaps a relief to the
founders that Chinese web giant Alibaba talked in August 2014 about
an investment that would value Snapchat at $10 billion. This would be
an amazing valuation as Snapchat had, at that time, never generated a
dollar of revenue. But Snapchat’s huge appeal came from demography.
Facebook users were now an average of nearly 40 years old, whereas
Snapchat’s core target market was 12–24 year olds, with an average
age below 18. Facebook might be the present, but Snapchat looked
like the future.
The other major issue for Spiegel and Murphy was Brown’s huge
lawsuit, demanding his fair share of the company. A similar thing
happened with Facebook, making it easy to forecast that lawyers will
get rich arguing this case – but it will probably be settled out of court
for a very large sum.
Questions (40 marks; 45 minutes)
1 Explain the importance of ‘funding’ to Snapchat.
(4)
2 Explain the term ‘target market’ in the context of Snapchat.
(4)
3 Assess whether profit or sales maximisation was the most
appropriate business objective for Snapchat in its early years.
(12)
4 From your own knowledge of Snapchat, evaluate whether the
business could ever generate advertising or other revenue to make
it worth billions of dollars.
(20)
Extended writing
1 You have been appointed chief executive of Marks & Spencer. Your
mission is ‘to restore M&S as the clothing store of choice for
women over the age of 30’. Evaluate how you will set about this
task.
(20)
2 Morrisons supermarket chain has decided to reposition itself as ‘the
ethical grocer’. Evaluate whether they could achieve this while still
making a profit.
(20)
Section 1.5 Entrepreneurs and leaders

26 Forms of business
Definition
The legal structure of a business determines the financial impact on
the business owners if things go wrong. It also affects the ease with
which the business can finance growth.

Linked to: Sources of finance, Ch 30; Liability and finance, Ch

31; Business failure, Ch 39.

26.1 Businesses with unlimited liability

Unlimited liability means that the finances of the business are treated as
inseparable from the finances of the business owner(s). So if the business loses
£1 million, the people owed money (the creditors) can get the courts to force
the individual owners to pay up. If that means selling their houses, cars, and so
on, so be it. If the owner(s) cannot pay, they can be made personally bankrupt.
Two types of business organisation have unlimited liability: sole traders and
partnerships.
(For more detail on limited v. unlimited liability, see Chapter 31.)

Sole traders
A sole trader is an individual who owns and operates his or her own business.
Although there may be one or two employees, this person makes the final
decisions about the running of the business. A sole trader is the only one who
benefits financially from success, but must face the burden of any failure. In the
eyes of the law, the individual and the business are the same. This means that
the owner has unlimited liability for any debts that result from running the
firm. If a sole trader cannot pay his or her bills, the courts can allow personal
assets to be seized by creditors in order to meet outstanding debts. For
example, the family home or car may be sold. If insufficient funds can be
raised in this way, the person will be declared bankrupt.
Despite the financial dangers involved, the sole trader is the most common
form of legal structure adopted by UK businesses. In some areas of the
economy, this kind of business dominates, particularly where little finance is
required to set up and run the business and customers demand a personal
service. Examples include trades such as builders and plumbers, and many
independent shopkeepers.
There are no formal rules to follow when establishing as a sole trader, or
administrative costs to pay. Complete confidentiality can be maintained because
accounts are not published. As a result, many business start-ups adopt this
structure.
The main disadvantages facing a sole trader are the limited sources of finance
available, long hours of work involved and the difficulty of running the
business during periods of ill health (plus unlimited liability).

Partnerships
Partnerships exist when two or more people start a business without forming a
company. Like a sole trader, the individuals have unlimited liability for any
debts run up by the business. Because people are working together but are
unlimitedly liable for any debts, it is vital that the partners trust each other. As a
result, this legal structure is often found in professions such as medicine and
law.
The main difference between a sole trader and a partnership is the number of
owners.

26.2 Businesses with limited liability

Limited liability means that the legal duty to pay debts run up by a business
stays with the business itself, not its owner/shareholders. If a company has £1
million of debts that it lacks the cash to repay, the courts can force the business
to sell all its assets (cars, computers, etc.). If there is still not enough money,
the company is closed down, but the owner/shareholders have no personal
liability for the remaining debts.
To gain the benefits of limited liability, the business must go through a legal
process to become a company. The process of incorporation creates a
separate legal identity for the organisation. In the eyes of the law, the owners of
the business and the company itself are now two different things. The business
can take legal action against others and have legal action taken against it. In
order to gain separate legal status, a company must be registered with the
Registrar of Companies.

Advantages of forming a limited company

• Shareholders experience the benefits of limited liability, including the
confidence to expand.
• A limited company is able to gain access to a wider range of borrowing
opportunities than a sole trader or partnership.

Disadvantages of forming a limited company

• Limited companies must make financial information available publicly at
Companies House. Small firms are not required to make full disclosure of
their company accounts, but they have to reveal more than would be the case
for a sole trader or partnership.
• Limited companies have to follow more and more expensive rules than
unlimited liability businesses – for example, audited accounts and holding an
annual general meeting of shareholders; these things add several thousands
of pounds to annual overhead costs.

Real business
One Water
In 2003, Duncan Goose quit his job and founded One Water. He
wanted to finance water projects in Africa from profits made selling
bottled water in Britain. The particular water project was ‘Playpumps’:
children’s roundabouts plumbed into freshly dug water wells. As the
children play, each rotation of the roundabout brings up a litre of fresh,
clean water.
Duncan thought of forming a charity, but felt that the regulations
governing charities might force them to be inefficient. So, for the sum
of £125, he founded a limited company, Global Ethics Ltd. This
enabled him to set the rules – for instance, that the shareholders
receive no dividends and the directors receive no fees. But, of course,
it ensured that he and other volunteers who put time into One Water
were protected, should something go wrong and big debts build up.
Today, One Water is a major business trading internationally. It has
raised more than £10 million, funding more than 900 Playpumps and
providing clean water to more than two million people, permanently.

Figure 26.1 Logic chain: sole trader or limited company?

26.3 Private limited companies

For a private limited company, the start-up capital will often be £100, which
can be wholly owned by the entrepreneur, or other people can be brought in as
investors. The shares of a private limited company cannot be bought and sold
without the agreement of the other directors. This means the company cannot
be listed on the stock market. As a result, it is possible to maintain close
control over the way the business is run. This form of business is often run by
a family or small group of friends. It may be very profit focused or, like
Global Ethics Ltd, have wholly different objectives than maximising profit.
‘I couldn’t be more thrilled to have control over my own destiny in a way
that is not possible as a public company.’
Michael Dell, after paying $25 billion to take Dell Computers private in
2013
A legal requirement for private companies is that they must state ‘Ltd’ after the
company name. This warns those dealing with the business that the firm is
relatively small and has limited liability. Remember, limited liability protects
shareholders from business debts, so there is a risk that ‘cowboy’
businesspeople might start a company, run it into the ground and then walk
away from its debts. Therefore, the cheques of a limited company are not as
secure as ones from an unlimited liability business. This is why many petrol
stations have notices saying ‘No company cheques allowed’.
Some of the factors that may determine when a business should start up as a
sole trader and when as a private limited company are outlined in Table 26.1.

Table 26.1 Factors influencing choice between starting a new business

as a sole trader or private limited company

26.4 Growth to plc and stock market flotation

When a private limited company expands to the point of having share capital of
more than £50,000, it can convert to a public limited company (plc). Then it
can be floated on the stock market, which allows any member of the general
public to buy shares. This increases the company’s access to share capital,
which enables it to expand considerably. The term ‘plc’ will appear after the
company name – for example, Marks & Spencer plc or Tesco plc.
The principal differences between private and public limited companies are as
follows:
• A public company can raise capital from the general public, while a private
limited company is prohibited from doing so.
• The minimum capital requirement of a public company is £50,000. There is
no minimum for a private limited company.
• Public companies must publish far more detailed accounts than private
limited companies.
Most large businesses are plcs. Yet the process of converting from a private to
a public company can be difficult. Usually, successful small firms grow
steadily, perhaps at a rate of 10 or 15 per cent a year. Even that pace of growth
causes problems, but good managers can cope. The problem of floating on the
stock market is that it provides a sudden, huge injection of cash. This sounds
great, but it forces the firm to try to grow more quickly (otherwise the new
shareholders will say: ‘what are you doing with our cash?’). Note that the
media increasingly uses the US term IPO (initial public offering) instead of the
British term ‘flotation’.

Real business
Poundland
From its origins as a Lincolnshire market stall in the 1990s, on 12
March 2014, Poundland was floated on the London stock market at a
valuation of £750 million. The sellers of the shares included a private
equity investor and Poundland’s senior management, which reduced its
combined holding from 24 per cent to 10 per cent of the shares. One
person who gained no benefit was Poundland’s founder, Steve Smith,
who sold his entire stake in the business for £50 million in 2004. If he
felt aggrieved at missing out on the flotation riches, at least he could
do so from the comfort of his 13-bedroom mansion.

‘When the operations of capitalism come to resemble the casino, ill fortune
will be the lot of many.’
John Maynard Keynes, economist

26.5 Other forms of business

Franchising
Starting a new business with a new idea requires a huge amount of planning,
skill and perhaps luck on the part of the businessperson. Many of these
problems can be avoided if entrepreneurs go for a situation that is a ‘half-way
house’ towards running their own business: a franchise. NatWest Bank suggests
that 93 per cent of franchises survive their first three years, compared with
slightly under 70 per cent for businesses generally.
For example, if you start up an independent optician, you have to:
• design and decorate a store that will create the right customer image
• create systems for staff training, stock control and accounting
• do your own advertising to bring in customers and create a brand strong
enough to justify the high prices charged by high street opticians.
Alternatively, you could start up your own, independent limited company, and
sign up for a Specsavers franchise. This would mean, for example, access to
the specially written Specsavers store management software. From a scan of a
sold pair of glasses, the software ensures that all the necessary stock ordering
and accounting actions are taken. The franchise owner (Specsavers) also
provides full training for the franchisee (the entrepreneur), plus advice and
supplier contacts for store decoration and display and, of course, the huge
marketing support from a multi-million pound TV advertising campaign. If
you start up J. Bloggs Opticians, how many people will come through the
doors? If you open up Specsavers, customers will trust the business from day
one.

Real business
Specsavers
Specsavers was started by Doug and Mary Perkins in Guernsey in
1984. They opened branches in Devon and Cornwall, each run by a
manager within their own Specsavers chain. In 1988, the company
decided to speed up its growth by getting individuals to open their own
Specsavers franchise outlets. The finance needed to open each new
branch (approximately £140,000) would come from the franchisee, not
Doug and Mary. Also, the founders would no longer have to manage
each store on a day-to-day basis. Each franchisee has every incentive
to run his or her store well because all the outlet’s revenues are kept
locally – apart from the royalty rate of 5 per cent that must be paid to
Specsavers’ head office. Doug and Mary also receive a start-up fee
from each new franchisee, which is a sum of between £25,000 and
£50,000 depending upon the location.
This approach has allowed Specsavers to develop into the largest
privately owned optician in the world, with more than 1,500 branches.
Annual turnover for 2010 is estimated at more than £1,300 million.

Pitfalls of running a franchise

It is important to be clear that really independent-minded people may hate
being franchisees; after all, they may want to ‘be their own boss’. A franchisee
is the boss of the business, but without the normal freedoms of decision
making. This could be very frustrating. It will also be important to choose the
right franchise. On the fringes of franchising are some dubious businesses that
sell the promises of training and advertising support, but supply very little
after they have pocketed the franchise fee. As with anything in business, careful
research is essential; better franchise operators are members of the British
Franchise Association, the BFA. It should also be borne in mind that the
franchise owner ’s slice of your income may make it difficult to make good
profits from ‘your ’ business.

Benefits of running a franchise

A young businessperson could treat being a franchisee as wonderful training
towards becoming a full entrepreneur. ‘Today I’ll open a Subway; in five years
I’ll sell it and open my own restaurant.’ Very few people have the range of
skills required of the independent business owner. Who is expert at: marketing,
buying, store design, window display, staff management, sales, stock control
and accounting? This is why the failure rate for new independent businesses is
higher than for franchise businesses.
Due to the different failure rates, the attitude of bankers is very different when
you seek finance for a franchise start-up. Ask NatWest for £100,000 to start J.
Bloggs sandwich shop, and the door will quickly be closed; ask for the same
amount to help finance a Subway franchise and the response will be far more
positive. Franchisees find finance easier and cheaper to get. The interest rate
charged by a bank for a potential Subway franchisee will be lower than the rate
they would charge to the founder of an independent business start-up.

Social enterprise
Whereas ‘private limited company’ is a legal term with specific rules, ‘social
enterprise’ sounds great but promises little. It actually means nothing more
than ‘we claim to do good’ – but good for whom is not stated. Duncan Goose,
founder of the genuine social enterprise One Water, says that a rival water
business claims to give all profits to African clean-water charities, but the
directors pay themselves so generously that there is little profit left at the end
of the year. Note that One Water is legally a private limited company (not a
charity), yet the business uses all profit for charitable purposes. Duncan says
that registering as a charity would mean that lots of potential donations would
be sucked up in bureaucracy (to meet Charity Commission rules).
A specific type of potentially social enterprise is the co-operative. Co-
operatives can be worker-owned, such as John Lewis/Waitrose, or customer-
owned, such as the retail Co-op. Co-operatives have the potential to offer a
more united cause for the workforce than the profit of shareholders. Workers
at John Lewis can enjoy annual bonuses of 20 per cent of their salary, as their
share of the company’s profits. The Co-op has been less successful, though its
focus on ethical trading has helped it become relevant to today’s shoppers.

Lifestyle businesses
Some entrepreneurs start a business based on their own or their family’s needs.
A young couple might start a surf school by the sea as a way to earn while
enjoying their passion for the surf. Less glamorously, a family-run bed-and-
breakfast may be a great way to keep a small farm going – and to keep the
family together. With a lifestyle business, usual rules about objectives and
strategies might not apply. For example, the surfer-entrepreneurs might target
plenty of customers above plenty of revenue, therefore setting lower prices
than would any profit-seeking business.

Online businesses
Online businesses are so common today that they hardly need a separate
category. They have to decide on a limited or unlimited liability structure like
any other. All that marks online businesses out is the different balance between
risk and reward. With ordinary ‘bricks’ businesses, such as a restaurant, there
has to be a heavy financial outlay before the business begins trading. With
online, the heavy investment is usually in time, not money. So a university
student can programme an app and test it online – and therefore be pretty
certain of success before risking much capital at all. Better still, the
‘scalability’ of online businesses is usually quite limitless. In June 2014, the
taxi service ‘Uber ’ was valued at $18 billion by financiers, less than five years
after it started. Such upsides are far more likely with ‘click’ than ‘brick’
businesses. So the financial risks are lower and potential rewards are higher.
Go figure.

Five whys and a how

26.6 Forms of business – evaluation
Business organisation is a dry, technical subject. It does contain some
important business themes, however, two of which are particularly valuable
sources of evaluative comment.
1 The existence of limited liability has had huge effects on business. Some
have been unarguably beneficial. How could firms become really big if the
owners felt threatened by equally big debts? Limited liability helps firms to
take reasonable business risks. It also, however, gives scope for dubious
business practices. For example, it is possible to start a firm, live a great
lifestyle, then go into liquidation, leaving the customers/creditors out of
pocket, and then start again. All too often this is the story told by
programmes such as the BBC’s Watchdog. Companies Acts lay down
legislation that tries to make this harder to do, but it still happens. Such
unethical behaviour is why government intervention to protect the consumer
can always be justified.
2 Short-termism is a curse for effective business decision making. There is no
proof that a stock exchange listing leads to short-termism, only the
suspicion that in many cases it does. Massive companies such as Unilever,
Nestlé and Shell may be above the pressures for short-term performance. In
many other cases, though, it seems that British company directors focus too
much on the short-term share price. Could this be because their huge
bonuses depend on how high the share price is? Worries about shareholder
pressures or takeover bids may distract managers from building a long-
term business in the way that companies such as BMW and Toyota have
done.
‘Too many companies, especially large ones, are driven more and more
narrowly by the need to ensure that investors get good returns and to justify
executives’ high salaries. Too often, this means they view employees as
costs.’
Hillary Clinton, US politician

Key terms
Bankrupt: when an individual is unable to meet personal liabilities,
some or all of which can be as a consequence of business activities.
Creditors: those owed money by a business – for example, suppliers
and bankers.
Franchisee: an independent business that has bought the rights to use
a better-known firm’s logos and trading practices within a specified
area.
Incorporation: establishing a business as a separate legal entity from
its owners, and therefore giving the owners limited liability.
Limited liability: owners are not liable for the debts of the business;
they can lose no more than the sum they invested.
Registrar of Companies: the government department which can allow
firms to become incorporated. It is located at Companies House,
where Articles of Association, Memorandums of Association and the
annual accounts of limited companies are available for public scrutiny.
Sole trader: a one-person business with unlimited liability.
Unlimited liability: owners are liable for any debts incurred by the
business, even if this requires them to sell all their assets and
possessions and become personally bankrupt.

26.7 Workbook
Revision questions
(30 marks; 30 minutes)
1 Explain two differences between a sole trader and a partnership.
(4)
2 In your own words, try to explain the importance of establishing a
separate legal entity to separate the business from the individual
owner.
(4)
3 You can start a business today. All you have to do is tell HM
Revenue & Customs (the taxman). Outline two risks of starting in
this way.
(4)
4 Briefly discuss whether each of the following businesses should
 start as a sole trader, a partnership or a private limited company.
a) A clothes shop started by Claire Wells with £40,000 of her own
money plus £10,000 from the bank. It is located close to her
home in Wrexham.
(3)
b) A builder’s started by Jim Barton and Lee Clark, who plan to
become the number one for loft extensions in Sheffield. They have
each invested £15,000 and are borrowing £30,000 from the bank.
(3)
5 Explain the possible risks to a growing business of making the jump
from a private limited company to ‘going public’, then floating its
shares on the stock market.
(5)
6 Why are good franchise owners keen to inspect their franchisees
regularly, even though they have no ownership stake in the
franchise businesses?
(3)
7 Why should a potential franchisee be very careful to research fully
the background of the franchise owner?
(4)
Data response 1
UK business categories
In 2013, the Federation of Small Businesses estimated that there were
five million businesses in the UK. Use this information plus Figure 26.2
to answer the questions below.
Figure 26.2 UK business organisations (source: Office of National
Statistics, October 2013)
Questions (30 marks; 30 minutes)
1 a) Calculate the number of sole traders in the UK; then calculate the
number of limited companies.
(3)
b) Assess two possible reasons why there are so many more sole
traders than companies.
(8)
2 Calculate how many British businesses operate with unlimited
liability.
(3)
3 Research conducted at Warwick Business School shows that one in
five businesses is principally owned by a woman, 93 per cent of
business owners are white and 7 per cent are from ethnic minorities.
a) Assess two possible reasons why women are so much less likely
to own a business than men.
(8)
b) The percentage figures for ethnic minorities show business
ownership to be below representation in the population (around 13
per cent). Assess two reasons that may explain this.
 (8)
Data response 2
Starting a new business
Forming a limited company can be time-consuming. According to the
World Bank, the number of actions required to get started varies from
one in New Zealand to 13 in Brazil and China. As a result of the
different processes, the number of days it takes to start up varies from
one day in New Zealand (the world’s quickest) to 144 days in
Venezuela (the world’s slowest).
Figure 26.3 provides data selected from the World Bank’s 2013–2014
‘Global Competitiveness Report’.

Figure 26.3 Time required to start a business (days) (source: Global

Competitiveness Report 2013–2014)
Questions (20 marks; 20 minutes)
1 Explain the implications for starting a business in Nigeria of the
following two factors in business start-up:
a) cash flow – that is, the daily flows of cash into and out of the
business
b) hiring and training new staff.
(8)
2 A sole trader can start a business straight away, whereas forming a
limited company takes the time shown in Figure 26.3. Assess
whether an entrepreneur should be influenced by this data when
deciding whether to form a company or act as a sole trader.
(12)
Extended writing
1 Social enterprises such as charities and co-operatives run
businesses including shops and banks. Evaluate whether you should
expect better value for money from a social enterprise than from an
ordinary limited company.
(20)
2 Sunil Mittal, an Indian software entrepreneur, once said: ‘We want
to manage and grow our companies ourselves. If we give up 51 per
cent we might as well get out of the business.’ Evaluate whether he
is right to feel that way.
(20)
Section 1.5 Entrepreneurs and leaders

27 Business choices
Definition
Business choices must be made bearing in mind opportunity cost. This
is the cost of missing out on the next best alternative when making a
decision. For example, the opportunity cost of not going to university
may be to risk missing out of an (200,000 of extra lifetime earnings
(according to government data). Similarly, trade-offs look at what you
have to give up in order to get what you want most.

Linked to: Business objectives, Ch 25; Stock control, Ch 43.

27.1 Introduction to opportunity cost

This concept will be useful throughout the A level Business course. It is at the
heart of every business decision, from small to multinational companies.
Every business faces the same issue: limited resources mean that hiring a
marketing manager leaves less money to spend on a marketing campaign. For
a start-up business, spending lots of money on a flash opening party means
there is less money to pay for staff training.
For a new business, the two most important resources are money and time.
Both have an opportunity cost. Time spent by an entrepreneur in creating a
pretty website could mean too little time is left for recruiting and training staff,
or too little time to sit back to reflect on priorities. The same issue arises with
money: it can only be spent once.
It follows that every business decision has an opportunity cost, measured in
time, money, and often both. The same is true in other walks of life. A prime
minister focused on foreign adventures may lose sight of the key issues
affecting people at home. A chancellor who spends an extra £10 billion on
education may have to cut back on healthcare.
For a new business start-up, the most important opportunity cost issues are as
follows.
• Do not tie up too much capital in stock (inventory), as this cash could be used
more productively elsewhere in the business.
• Do not overstretch yourself: good decisions take time, so make sure you are
not doing too much yourself.
• Take care with every decision that uses up cash; at the start of a business, it is
hard to get more of it, but more is always needed.

27.2 Opportunity costs in developing a business idea

Personal opportunity costs

Starting your first business is likely to be tough. Long hours and highly
pressured decisions may cause stress, but the biggest problems are beyond
psychology. A difficult cash flow position is quite normal, yet places a huge
strain on the business and its owner(s).
The owner of a first business will probably have come from a background as a
salary earner, possibly a very well-paid one. So the first opportunity cost is
missing out on the opportunity to earn a regular income. As it could take six
months or more to get a business going, this is a long period of financial
hardship.
Then comes the investment spending itself, such as the outlay on a lease, on
building work, on fixtures and fittings, on machinery and then on the human
resources (staff) to make everything work with a human face. All this is using
money that could otherwise be used on the proprietor ’s house, holidays, and so
on. The personal opportunity costs add up massively.
The wear and tear on the family must also be considered. Starting a business is
a hugely time-consuming and wholly absorbing activity. The restaurant owner
might easily spend 80 hours a week on site in the early days, then take further
paperwork home. An American business psychologist has said: ‘Even when
you are home, you’re still thinking about the business – it’s easy for a spouse
to feel neglected, even jealous.’
‘Perpetual devotion to what a man calls his business is only to be sustained
by perpetual neglect of many other things.’
Robert Louis Stevenson, writer
Despite this, research by a US investment business has shown that, although 32
per cent of new entrepreneurs said that the experience had caused marriage
difficulties, 42 per cent of chief executives in fast-growing new firms said that
the pressures and exhilarations made their marriages stronger.

The opportunity costs of developing one business

idea as opposed to another
When 30-year-old Mike Clare opened his first Sofabed Centre in 1985, he
could raise only £16,000 of capital, even though his estimates showed that
£20,000 to £25,000 was needed. Fortunately, hard work plus a great first
month’s sales brought in the cash he needed to get the business going properly.
At that time, none of the banks would lend him any money. In the lead-up to
Mike Clare’s first store opening, he spent time organising public relations
events (to get coverage in the local newspaper), helping with the building
work, wrangling with suppliers over credit terms and making decisions about
pricing and display. When the store opened, he spent 18 hours a day ‘doing
everything’. When the first store took £30,000 in month 1, he started looking
for a second location, which was open within six months. Quite clearly, there
was no possibility of starting more than one business at a time.
Later he built up a bedding business called Dreams, which he sold in 2008 for
£170 million. Sadly, Dreams collapsed in 2013, in the aftermath of the great
recession. Mike Clare, though, had turned £16,000 into £170 million. Given
how short of money he was at the start, it would have been impossible for him
to have chosen to launch two different businesses at the same time. He had to
choose one. Fortunately, he chose wisely.
Given the need for focus, the main opportunity cost arises when an
entrepreneur has two ideas. One should be chosen and one rejected. This is
possible if the entrepreneur is ruthless. After evaluating the two options
carefully, the weaker of the two should be stopped completely. The reason is
simple: opening one business is tough enough; two would be impossible.
Figure 27.1 Logic chain: opportunity costs of new product launch

27.3 Deciding between opportunities

Successful businesspeople are those who can make successful decisions. The
three founders of Innocent Drinks wanted to start a business together, but had
no idea what type of business to start. As friends at university, they had already
run nightclub events together, and two ran an annual music festival in west
London. They could have developed a successful festival business, but
stumbled upon the idea of a business that made all-fruit smoothies. On finding
an investor, in 1999, who could help turn their dream into a reality, they left
their salaried jobs, gave up their other business opportunities and concentrated
on building the Innocent brand. The 2010 sale of a majority of the Innocent
shares to Coca-Cola for £75 million showed the success of this start-up.
‘Alice came to a fork in the road. “Which road do I take?” she asked.
“Where do you want to go?” responded the Cheshire cat.
“I don’t know”, Alice answered.
“Then,” said the cat “it doesn’t matter.”
Lewis Caroll, Alice in Wonderland
When deciding between business start-up opportunities, certain factors are
crucial.

Estimating the potential sales that could be achieved

by each idea
This is hugely difficult, both in the short term and – even more – in the longer
term. Innocent’s first-year sales were £0.4 million. Who could have guessed
that, eight years later, its sales would be more than 300 times greater? Yet
estimates must be made, either by the use of market research or by using the
expertise of the entrepreneur. Mike Clare of Dreams had previously worked as
an area manager for a furniture retailer, so he had a reasonable idea about what
the sales might be. Inside knowledge is, of course, hard to beat.

Considering carefully the cash requirements of each

idea
The Innocent trio were very lucky to find an American investor who put
£250,000 into the start of the business in return for a 20 per cent stake. Some
new businesses are very hungry for cash (such as setting up a new restaurant in
London, which costs over £1 million); other new business ideas (such as a new
website) can be started from a back bedroom, keeping initial costs very low.

Deciding whether the time is right

Innocent’s launch fitted wonderfully with a time of luxury spending plus
growing concern about diet. In the same year, a small business started in west
London, focusing on customising cars: ‘souping up’ the engines to make the
cars go faster and give the engines a ‘throaty roar ’. As rising fuel prices
became a greater concern, the business was squeezed out. Five years earlier, it
might have made a lot of money, but it no longer did so.

Deciding whether the skills needed fit your own set

of skills
Running a restaurant requires a mix of organisational skills, discipline and
meticulous attention to detail. Does that describe you? Or are you better suited
to running an online business that can be handled in a relaxed way behind the
scenes?

27.4 Choices and trade-offs

In business, there are many occasions when one factor has to be traded off
against another. An entrepreneur might get huge help at the start from friends,
yet realise that these same friends lack the professionalism to help the business
grow. The needs of the business may have to be traded off against the
friendships. Can a softie be a real business success? Probably not: some inner
toughness is clearly important.
Other trade-offs may include:
• when starting in the first place, trading off the start-up against a year ’s
international travel (perhaps with friends); or trading the start-up against
going to university
• trading off the aspects of the business you most enjoy doing against those
that prove most profitable for the business; the chef/owner may love
cooking, yet find the business works far better when she or he has the time to
mix with the customers, motivate the waiting staff and negotiate hard with
suppliers
• trading off time today and time tomorrow; the entrepreneur ’s ambition may
be to ‘retire by the time I’m 40’; that may sound great in the long term but, in
the short term, her or his spouse and children may see little of them.
Overall, the key to success will be to be clear about what you and your family
want from the business. It may be to become outrageously rich, no matter what,
or – more likely – to find a balance between the freedom and independence of
running your own business and the need to find time for the family. Books on
business success assume that success can be measured only in money. Many
people running their own small businesses would tell a different story; the
independence alone may be the key to their personal satisfaction.
‘Strategy is about making choices, trade-offs; it’s about deliberately
choosing to be different.’
Michael Porter, business author/guru

Five whys and a how

27.5 Business choices – evaluation

A level Business exam papers are laced with big questions about decision
making, strategy and problem solving. Ultimately, all of these questions boil
down to one thing – what is our best option given the objectives we have and
the circumstances we are in? In every case, a crucial line of analysis is to
consider the alternatives and therefore the opportunity cost of the decision. The
risk is that the significance of the opportunity cost will not be emphasised
sufficiently because it will be underestimated. If Topshop has traded-off
America against China in its (slow) move to open stores in the US in 2013 and
2014, that is surely a mistake. Senior management often seem to focus on
pursuing a strategy without real consideration of the opportunity cost.

Key terms
Opportunity cost: the cost of missing out on the next best alternative
when making a decision (or when committing resources).
Trade-off: accepting less of one thing to achieve more of another (for
example, slightly lower quality in exchange for cheapness).

27.6 Workbook
Revision questions
(20 marks; 20 minutes)
1 Explain in your own words why time is an important aspect of
opportunity cost.
(3)
2 Give two ways of measuring the opportunity cost to you of doing
this homework.
(2)
3 Examine one opportunity cost to a restaurant chef/owner of
opening a second restaurant.
(5)
4 Explain the trade-offs that may exist in the following business
situations. Choose the two contexts you feel most comfortable with.
a) Levi’s pushes its workers to produce more pairs of jeans per hour.
b) A chocolate producer, short of cash, must decide whether to cut
its advertising spending or cut back on its research and
development into new product ideas.
c) A football manager decides to double the number of training
sessions per week.
d) A celebrity magazine must decide whether or not to run photos
that will generate huge publicity, but probably make the celebrity
unwilling to co-operate with the magazine in future.
(6)
5 According to the Robert Louis Stevenson quote on page 175, what
is the opportunity cost of devotion to business?
(4)
Data response
In 2002, a co-operative agreement between coffee farmers in 250
Ugandan villages broke down. It had taken years to put together, but
disagreements made it collapse. The prize for a successful co-
operative was to produce organic coffee beans grown to Fairtrade
standards for partners such as Cafédirect. This would ensure getting
significantly higher prices for the raw coffee beans and also much
better credit terms (being paid quickly to help with cash flow).
Over the next two years, countless hours of work were put into
forming a new co-operative. In early 2004, the new Gumutindo coffee
co-operative was Fairtrade certified. By 2014, 7,000 farmers had
joined the Gumutindo co-operative. They receive a guaranteed price of
$1.26 per pound of coffee beans, whereas the world price has been as
low as $0.80 over the last eight years. The extra (and stable) income
helps the farmers, of whom only 25 per cent have running water and 79
per cent live in mud huts with iron sheet roofing. The Fairtrade
organisation has supported the co-operative in starting up its own
production plant, converting the raw coffee into packs of coffee ready
for sale. Ongoing investments include motorised pulpers and a major
investment in solar panels to create electricity in the home as well as
the production plant.
Sources: www.fairtrade.org.uk and www.gumutindocoffee.coop
Questions (30 marks; 35 minutes)
1 Explain the opportunity cost of the farmers who put ‘countless
hours of work’ into forming a new co-operative.
(4)
2 Assess one risk for the farmers and one risk for the Fairtrade
organisation in forming a new co-operative with high guaranteed
prices for coffee beans.
(8)
3 Some commentators have suggested that Waitrose should make all
 its coffee ‘Fairtrade’, therefore getting rid of brands such as Nescafé
Gold Blend. Assess two trade-offs Waitrose management would
have to consider before making any such decision.
(8)
4 Assess whether producing coffee ready for sale would definitely
increase the income levels of the 7,000 members of the co-
operative.
(10)
Extended writing
1 Examine the different opportunity costs involved in the decisions
made by a business leader such as Dave Lewis, chief executive of
Tesco plc. Evaluate which might be the most important for the
business.
(20)
2 In the 1990s, the chairman of Samsung started to send the
company’s best and brightest young staff to live abroad for a year,
to learn about American and European lifestyles. Some directors
complained that this was a waste of their time and talent. Evaluate
whether the chairman was right to trade off management time
against consumer knowledge.
(20)
Section 1.5 Entrepreneurs and leaders

28 Moving from entrepreneur to

leader
Definition
An entrepreneur has ambition, initiative and a need to control rather
than be controlled. This can make it hard to become an effective
leader of a large business – because entrepreneurs are wary of
delegation.

Linked to: Forms of business Ch 26; Sources of finance, Ch 30;

Planning and cash flow, Ch 32; Business failure, Ch 39.

28.1 Small business growth

Although start-up is the hardest time for an entrepreneur, many small firms
find themselves struggling during periods of rapid growth. It is hard to keep
on top of the financial and the organisational pressures of expansion. For
example, in the first stage in the rapid growth of Instagram (the social photo
site that launched in 2010 and was bought for $1 billion 18 months later), the
founders frequently found themselves working through the night when the site
crashed through overuse. On the first day, there were 25,000 users and within
three months it hit one million. This stunning growth took the business from
small to major in no time at all. Luckily for the founders, the enthusiasm at the
time for all things digital ensured that it was easy to raise extra external finance
when needed.
‘Growth stresses systems.’
Larry McFadin, businessman

28.2 Business effects of forecast rapid growth

In certain circumstances, managers can anticipate a period of rapid growth.
This may be temporary (such as the effect of a change in the law) or may seem
likely to be permanent (such as the rise of a new social network). The most
successful firms will be those that devise a plan that is detailed enough to help
in a practical way, but flexible enough to allow for the differences between
forecasts and reality.
When rapid growth has been forecast, firms can:
• compare the sales estimate with the available production capacity
• budget for any necessary increases in capacity and staffing
• produce a cash flow forecast to anticipate any short-term financing shortfall
• discuss how to raise any extra capital needed.
Timescales remain important, though. The forecast may cover the next three
months; but increasing capacity may involve building a factory extension,
which will take eight months, in which case there may be five months of excess
demand to cope with (perhaps by subcontracting). In 2014, Center Parcs
opened a new site near London. It opened exactly ten years after management
made the decision to open it, and at a cost of £250 million!
However accurate the forecast, there remains a lot of scope for error. The
starting point is the increased workload on staff. Extra sales may put pressure
on the accounting system, the warehouse manager and the delivery drivers.
With everyone being kept busy, things can start to go wrong. Invoices are sent
out a little later, unpaid bills are not chased as quickly and stock deliveries are
not checked as carefully. Suddenly the cash flow position worsens and costs
start to rise. A strong, effective manager could retrieve this but, to paraphrase
the Peter Principle (see below), many have been promoted to ‘their level of
incompetence’. Once they start to go wrong, plans are hard to sort out.

The Peter Principle

In their book The Peter Principle, Laurence Peter and Raymond Hull
suggested that: ‘in a hierarchy every employee tends to rise to their
level of incompetence’. The logic is that staff gain promotions every so
often as long as they work competently. When they reach a level at
which they are starting to struggle, the promotions cease. Therefore,
in time, everyone ends up working at their level of incompetence. The
Peter Principle is an argument against large, tall organisations and can
be thought of as a practical example of diseconomies of scale.
28.3 The risks of overtrading
Overtrading refers to the situation where a business expands at a rate that
cannot be sustained by its capital base. A sudden surge in orders may tempt
firms to buy additional stock on credit. However, if customers are slow to pay,
the business may run into liquidity problems. Inadequate funding is one of the
most common reasons why apparently successful businesses end up failing.
Adequate finance means having access to sufficient levels of funding to meet
the firm’s needs, as and when they occur. Established firms will need to pay
workers, suppliers and other expenses on time, regardless of whether enough
cash has been generated from sales to cover such expenses. They will also
need to replace equipment and machinery when it wears out or becomes
obsolete. Few businesses are faced with totally predictable demand. Therefore,
adequate resources (including finance) need to be available to respond to an
unexpected upsurge in orders, as well as coping with an unwanted fall in sales.
Ensuring access to adequate funding is especially important for firms looking
to expand. Such firms will require capital not only for the purchase of new
assets, but also to cover additional day-to-day capital requirements in the form
of increased materials, wages and fuel. Overtrading is the business equivalent
of the cliché: ‘Don’t run before you can walk’.
Figure 28.1 Logic chain: how overtrading happens

28.4 Problem of adjustment from entrepreneur to

leader/manager
The typical creator of a successful new business is lively, energetic, creative,
often impatient and always a risk-taker. Such a person will have a strong
personality, and quite possibly an autocratic and charismatic leadership style.
When the business started, their own speed of decision making, attention to
detail and hard work were fundamental to the firm’s success.
With success comes a problem. How to cope with the additional workload? At
first, the entrepreneur works ever harder; then she or he takes on more junior
staff. Then comes the crunch. Is she or he willing to appoint a senior manager
with real decision-making power? Or will a weak manager be appointed who
always has to check decisions with the boss?
‘Owner-run companies are often run in an arbitrary, dictatorial way. Often,
that is what limits their growth.’
 Andy Grove, chief executive, Intel
Staff will always find it hard to accept a new manager because everyone will
know that it is really the boss’s business. It is said that, ten years after Walt
Disney died, managers were still rejecting ideas on the basis that ‘Walt
wouldn’t have done it that way.’ How much harder if the founder is still there:
James Dyson at Dyson and Larry Page and Sergey Brin at Google.
The boss must make the break, however. No longer should she or he attend
every key meeting or demand regular reports on day-to-day matters.
Delegation is necessary. In other words, authority should be passed down the
hierarchy to middle managers without interference from above. And instead of
looking for the next great opportunity, the boss may have to focus on getting
the right management structure to ensure a smooth-running business.
Even if the founder of the company is able to adjust to managing a large
organisation, there remains the problem of motivation. Will the new staff be as
‘hungry’ as the small team that built the business? Usually the answer is no.
‘He who stands on tiptoe does not stand firm.’
Lao-Tzu, ancient Chinese philosopher

Change in management structure or hierarchy

As a business grows, the management structure has not only to grow too, but
also to change. New layers of management may be needed and completely new
departments may be founded, such as personnel or public relations. And all the
time, as the business grows, new staff are being recruited, inducted and trained.
So there is constant change in personnel and their responsibilities. This can be
disconcerting for customers and suppliers. Strong relationships are hard to
build, making customer loyalty tough to achieve.
Even more important, though, is the internal effect of these personnel changes.
With new staff appearing frequently, and managerial changes occurring
regularly, team spirit may be hard to achieve. Junior and middle managers may
spend too much of their time looking upwards to the promotion prospects
instead of concentrating on their own departments. The potential for
inefficiency, or even chaos, is clear. Too many new staff may mean too many
mistakes. If customer relations are relatively weak, the result could easily be
loss of business.
These unpleasant possibilities can largely be set aside if a good example is set
from the top. If the founder of the business continues to be involved –
especially on customer service – all may still be well. The leader needs to
make sure staff keep sight of the qualities that brought the business its success
in the first place. If new management structures threaten to create
communication barriers, the leader should set an example by visiting staff,
chatting to them and acting on their advice. The leader must fight against being
cut off from the grassroots: the staff and the customers.

Risk of loss of direction and control

Each year, Templeton College Oxford produces data on what it calls the Fast
Track 100. These are the fastest-growing 100 small companies in Britain. The
December 2014 survey showed that the top ten of these firms enjoyed three-
year growth rates of:
• sales turnover +200 per cent per year
• employees +120 per cent per year.
The typical Fast Track 100 firm had gone from 15 to 80 staff in the past three
years. No wonder, then, that the key challenges faced by these companies were
managing the growth in staff and infrastructure (source: www.fasttrack.co.uk).
The entrepreneurs who get swamped by the success of the business are those
whose firms will fail to sustain their growth. They may become side-tracked
by the attractions of expense account living; or – the other extreme – become
so excited by their own success that they start opening up several different
businesses. They assume that their golden touch will ensure success in
whatever they do. Instead, just as their core business becomes harder to handle,
they are looking at a different venture altogether. Problems may then hit from
several directions at once.
The key message is, therefore: focus on what you are good at.

Five whys and a how

28.5 Moving from entrepreneur to leader –
evaluation
One of Britain’s best-known businesspeople, Alan (Lord) Sugar now runs little
more than a property business. Once he was the head of Amstrad, a company
he founded. But Amstrad grew so rapidly that it became increasingly hard for
Sugar to make all the decisions. Being Alan Sugar, he was incapable of
delegating so the business hit the buffers with a series of poor new product
launches and quality problems. Sugar later admitted that he was one of nature’s
entrepreneurs, not bosses.
‘No person will make a great business who wants to do it all himself or get
all the credit.’
Andrew Carnegie, businessman (1835–1919)
Often, then, the founder of a business will hand over to others – or be forced to
by outside shareholders. Famously, some bosses who were forced out came
back later – older, wiser and more capable of delegating. Steve Jobs at Apple
and Howard Schulz at Starbucks are good examples. Most business founders
find that ‘letting go of their baby’ is a huge challenge. That’s why it is so
impressive that people like Facebook’s Mark Zuckerberg have made the
transition so effectively.

Key terms
Delegation: passing authority down the hierarchy, to allow more junior
employees some decision-making power.
Liquidity: the ability of a business to pay its bills on time, which all
depends upon having enough cash in the bank.
Overtrading: when a business expands at a rate that cannot be
sustained by its capital base.

28.6 Workbook
Revision questions
(30 marks; 30 minutes)
1 Explain one factor that could cause rapid growth at a new food
manufacturing business.
(4)
2 Explain why rapid growth can cause problems for a company’s:
a) cash flow
b) management control.
(6)
3 Explain why there may be a problem in adjusting from ‘entrepreneur’
to ‘leader/manager’.
(4)
4 Identify three problems for a fast-growing firm caused by changes in
the management structure.
(3)
5 Explain how a growing company might make sure that it doesn’t
suffer from overtrading.
(4)
6 Give two reasons why it may be hard to grow from 15 staff to 80 in
one year.
(2)
7 Explain why it may be hard for young, inexperienced managers of a
successful business start-up to cope effectively with an unexpected,
dramatic change.
(4)
 8 Explain the meaning of the quote from Andrew Carnegie on page
182.
(3)
Data response
Lush profits
In 2012, the cosmetics producer and retailer Lush was able to declare
dividends of £5.8 million from its annual profits of £26.2 million. This
was a wonderful reward for founders Mark and Mo Constantine, who
still own 60 per cent of the shares. Founded in 1994, the business has
830 stores in 51 countries. Growth has been dramatic and the
business now supports over 4,000 jobs.
When it was founded, in 1990, Body Shop was the store to beat. Now,
Lush’s indulgent, attractive cosmetics are starting to overshadow Body
Shop. Lush also benefits from the enthusiasm of its staff for the
company’s backing for ethical causes such as banning foxhunting, or
demanding legal representation for the Guantanamo Bay detainees.
Body Shop, bought by multinational L’Oréal in 2006, no longer stands
out as the ethical retailer.
Growing sales from £0 to £360 million (2014) in 20 years inevitably
involves problems. When Lush had grown to £50 million of sales, the
manufacturing staff noticed that products made from essential oils
(that can cost £3,000 per kg) were ‘behaving’ wrongly. After some
weeks of panic, Lush decided to get a chemist to analyse the oils. It
emerged that suppliers had been adulterating the oils with as much as
70 per cent synthetic chemicals. This problem led to the establishment
of a professional buying team, together with a quality control manager.
Questions (40 marks; 35 minutes)
1 a) Assess why Lush is likely to have had a significant increase in the
number of layers of hierarchy within its business over recent years.
(12)
b) Assess two ways in which an increase in the layers of hierarchy
might harm operational performance at Lush.
(8)
2 If Lush appointed a new chief executive, evaluate the advantages
and disadvantages of the business now being run by a successor to
the Constantines – the founders.
(20)
Extended writing
1 Choose one of these three business contexts: extreme sportswear,
travel agency or a private school. Evaluate the likely reasons why a
small company specialising in that market might be able to expand
successfully.
(20)
2 ASOS plc has grown at a rate of 30–50 per cent per year for nearly
a decade. Outline the problems this may cause. Evaluate the most
effective way for management to tackle them.
(20)
Theme 2

Managing business activities

Section 2.1 Raising finance

29 Introduction to finance
Definition
Finance has two main aspects: it can provide the numbers that help
managers to make better decisions, and it can count what is happening
and what has happened. Here the focus is on finance for decision
making.

Linked to: Role of an entrepreneur, Ch 23; Moving from

entrepreneur to leader, Ch 28; Sources of finance, Ch 30;
Planning and cash flow, Ch 32; Sales forecasting, Ch 33; Sales,
revenue and costs, Ch 34; Budgets, Ch 36.

29.1 Finance and start-up

Of the 60 per cent of new restaurants that close within three years, almost all
die because the business has run out of cash. As the crisis point starts to draw
near, the staff will notice irate suppliers ‘dropping by’ to demand payment. Key
supplies may not arrive, as the suppliers get increasingly tough about payment.
So it is crucial to keep cash spending under tight control.
The main underlying problem is that people get starry-eyed about the process
of business start-up. They start to believe their own publicity, and assume that
their restaurant is going to be ‘hot’ from day one, or their nightclub is going to
be ‘cool’. The consequence of this is that too much of the start-up capital is tied
up in fixed assets, such as interior design and equipment. Far too little is left
for the day-to-day running of the business: the working capital.
‘Entrepreneurship is “risky” mainly because so few of the so-called
entrepreneurs know what they are doing.’
Peter Drucker, global management guru
The problem is an obvious one. To be an entrepreneur, you have to be an
optimist; but optimists do not look for the downside. They expect business to
be fantastic from week one, ignoring the evidence that most businesses find it
hard to establish a loyal base of customers at the start. For most new
businesses, it is wise to set aside half the start-up capital as working capital.
That will be the money used in the early weeks of operation, to pay the wages,
pay the rent and pay upfront when suspicious suppliers demand to be paid with
cash, not credit. Once the weekly takings are high enough, the money coming
in will pay for all the costs that have to be paid out, but that may take time.
Look at Table 29.1; among small business start-ups in south London, this
shows how long it took until weekly cash in started to exceed weekly cash
outflows.

Table 29.1 Small business start-ups in south London: weeks until cash
drain ceased

29.2 Working capital

The key is to keep on top of the working capital. The top priority is to keep an
everyday check on costs, credit transactions and cash payments. This can be
hard if you have several people working for you. Each could expect to be
given the authority to make a decision, such as to buy a pizza oven from
supplier X rather than supplier Y. But if lots of people are spending your
money, it will be virtually impossible to keep track of everything.
New entrepreneurs often choose one person to be the ‘moneybags’, the person
with sole control over spending. Clever entrepreneurs make sure to give the
job to someone else. Then even the business owner has to work at justifying
why exactly he wants brand new kitchen equipment instead of second-hand.
In addition to keeping a check on a firm’s day-to-day finance – its working
capital – managers need to:
• identify the costs involved in making a product; this can be the first step in
deciding the selling price
• work out how many products they need to sell to make a profit
• find out how much capital they will need in the coming months, and then
decide on the best way to obtain this extra finance
• keep tight control over the way in which the firm’s money is spent.

Figure 29.1 Logic chain: working capital in practice

29.3 Key financial concerns for new business start-

ups
The starting point is to work out the following three things.
1 How much it will cost to get from a business idea to opening the doors on
the first day (the start-up costs). For a new clothes shop, this will include a
huge range of items and could reach a figure such as £40,000.
2 How much the running costs will be (the costs week by week when the
business is operating fully). These will come in two parts: the costs that will
be fixed, no matter whether the business is going well or badly, such as the
rent, heating and lighting and staff salaries; in addition, there will be costs
that vary in line with sales, such as the cost of purchasing the items you are
selling (the dress sold for £80 may cost you £40 to buy from the dress
designer). Every entrepreneur needs a solid understanding of the firm’s
fixed costs and variable costs. (Broader coverage of this topic is provided
in Chapter 34.)
3 How much revenue can you expect from the customers you serve? Broadly,
this is a simple calculation of customers served multiplied by the amount
they spend. Although the calculation is simple, it is very hard to anticipate
what the figures will be. In August 2010, there were rumours that Microsoft
was starting to research the Xbox One, to be launched in 2014/2015. So
many years in advance, who could know the likely selling price or how
many would be sold? Market research could help in making a sales forecast,
but as only one in seven new products proves a success, six out of every
seven new products must come with an incorrect sales forecast (no one
would launch a new product that was forecast to flop, so presumably there
was a faulty forecast). For new small businesses, the problem is always the
same: how can we forecast the number of loyal customers we can expect?
(This issue is tackled in Chapter 33.)
‘Accountants focus on the past rather than the future, because that alone can
be accurately measured… Their training regards risk, uncertainty and the
unknown as undesirable.’
Charles Handy, Britain’s only management guru

29.4 Raising finance

When a business is operating fully and successfully, cash coming in from
customers will provide all the finance necessary for effective operation. Until
then, raising finance is an important issue, especially for young entrepreneurs
with little personal capital. Table 29.2 lists the sources of finance available to
firms.

Table 29.2 Sources of business finance

Real business
Financing Facebook
Facebook was started in February 2004 by college student Mark
Zuckerberg. That summer he was introduced to a wealthy co-founder
of PayPal, who invested $500,000 in establishing Facebook as a
limited company. Within a month, Zuckerberg was offered $10 million
for the business, but turned it down. Two years later, in 2006, Yahoo
offered $1,000 million, but was also rejected!
In Facebook’s early years, there was no doubting the growth in users,
but lots of doubt about how to turn users into cash. Fortunately for
Zuckerberg, people kept investing. A big break came in 2007 when
Microsoft handed over $240 million for just 1.6 per cent of the share
capital. This valued Facebook at a then-amazing $15 billion ($15,000
million).
In 2012, Facebook decided to float as a public company on the US
stock market. Its valuation of $65 billion set the value of Zuckerberg’s
shares at $12 billion. The shares performed poorly at first, but by late
November 2014 Facebook’s market capitalisation (the value of all its
shares) was £204 billion.

29.5 Financial management for an established

business
Companies that stay small tend to keep focused on cash. Bigger businesses find
a developing disconnect between the revenue and the cost aspects of the
business. Marketing people boast about rising sales while factory managers
fret about ‘costs being out of control’. Often, the solution is to bring in a
budgetary control system. This used to be a bit of a nightmare, but modern
software makes it relatively easy to set and monitor spending. A system of
budgeting can make sure that the marketing department’s efforts at boosting
sales are kept related to the costs being incurred to manufacture and distribute
the products – therefore making sure that profits are made. Chapter 36 covers
budgets and budgeting in detail.
The other big consideration for an established business is how to respond if
sales start to boom, perhaps because a strong trend is moving in the firm’s
direction. Booms sound great, but are actually extremely difficult to handle.
Rapid expansion requires a lot of cash to finance extra staff, more or bigger
premises and perhaps a bigger advertising campaign. Budgeting is helpful, but
cash flow forecasting is even more important. (See Chapter 32.)

Real business
Scoop
Scoop Gelato had a great 2014, based on good weather and plenty of
tourists. Boss Matteo makes the ice cream (all 24 flavours) in the
basement of the Covent Garden branch, from where the ice cream is
delivered to two other Scoops in central London. The strong 2014
demand put serious pressure on the ice-cream-making capacity, so the
shareholders agreed to sanction a double expansion for 2015: moving
ice cream production to a larger factory unit in west London and
opening one more Scoop outlet. The boom in sales therefore forced
Scoop to find around £100,000 to finance this expansion – cash that
must be invested in advance of the extra sales income flowing through
to Scoop’s profit and loss account. Booms need to be handled with
care.

Five whys and a how

29.6 Introduction to finance – evaluation
Reliability is a key issue when looking at any financial statement. Management
accounts, such as cash flow forecasts, are predictions. In other words, they are
not statements of fact but educated guesses. This means that they should be used
only as a guideline. Questions need to be asked, such as who drew up the
figures and do they have an interest in making the accounts point in a particular
direction? For example, have forecasts been produced to try to persuade
outsiders to invest, or are they produced by managers for their own use? In the
first case, it may be that the desire to squeeze finance out of a bank or venture
capital firm encourages an excessively optimistic set of forecasts.
A second key point to remember is how finance fits into the big picture of
business. Feel the weight of this book. There are several units dedicated to
finance, but many more covering other areas of business activity. Accounts are
good at dealing with quantitative information, but qualitative factors may be
more important, such as whether the business is building strong customer
loyalty. Today’s high sales may collapse tomorrow if they are based only on
special offers, not on repeat purchase.
‘Business is not financial science, it’s about trading… buying and selling.
It’s about creating a product or service so good that people will pay for it.’
Anita Roddick, founder of Body Shop

Key terms
Fixed costs: those that do not change as the number of sales change
(for example, rent or salaries).
Variable costs: those that change in line with the amount of business
(for example, the cost of buying raw materials).
Working capital: the finance available for the day-to-day running of the
business.

29.7 Workbook
Revision questions
(30 marks; 30 minutes)
1 Outline two possible reasons why a new restaurant could run out of
cash.
 (4)
2 Explain what is meant by working capital.
(3)
3 Give two examples of situations in which a small bakery business
could use each of the following sources of finance:
a) short-term
b) medium-term
c) long-term.
(6)
4 Reread ‘Real business: Scoop’ on page 189.
a) Outline two possible sources of finance for Scoop’s £100,000
expansion.
(4)
b) Pick the one you think would be most suitable. Explain why.
(4)
5 Explain one advantage and one disadvantage to a firm of having
large sums of cash for a long period of time.
(6)
6 Explain how a seaside hotel business might benefit from budgeting.
(3)
Data response
Starting up Moneysupermarket.com
Moneysupermarket.com was started in 1999 by 32-year-old Simon
Nixon. The site was designed to provide people with easy-to-compare
information on, for example, the interest charges on different credit
cards. The start-up costs were ‘around £100,000’, all of which came
from the sale of an earlier online business. Nixon’s earlier experience
made sure that he pursued a ‘no frills’ policy to his start-up, focusing
most of the start-up capital on public relations (PR). He employed a
City of London PR firm to contact financial journalists regularly. The
journalists came to use the site as an easy source of data, referencing
all their articles to ‘Source: Moneysupermarket.com’. Spreading the
name in this way encouraged increasing usage by ordinary customers,
providing a hit rate of 50,000 customers a month by the end of its first
year.
Nixon built the business up steadily and by 2006 he could afford his
first TV advertising campaign. In the first half of 2007, visitors to the
group’s websites rose by 58 per cent, helping sales revenue to rise
from £48 million to £78 million. So although the advertising spending
rose from £2.7 million to £9.8 million between 2006 and 2007, overall
operating profits went up by £14 million.
Although Nixon managed to build the business largely through internal
finance (reinvested profit), by 2007 he decided to sell up by floating the
shares on the London stock market. On 31 July 2007, shares in
Moneysupermarket.com were floated at 170p. This netted Nixon over
£100 million in cash, but also gave the company over £50 million for
expansion. Not long after, the shares plunged to 38p during the 2009
recession, but by December 2014 had recovered to over 200p. In a
world of competition with Comparethemarket.com and many others,
Moneysupermarket.com has done remarkably well.
Questions (25 marks; 30 minutes)
1 Explain why Simon Nixon was able to limit the start-up costs of
Moneysupermarket.com to £100,000.
(4)
2 a) Calculate the percentage increase in sales revenue between the
first half of 2006 and the first half of 2007.
(3)
b) Assess two factors that may have led to this sales increase.
(8)
3 Simon Nixon is a fabulously wealthy man today, apparently ‘worth’
£400 million. Assess whether the entrepreneurial skills he showed
are a justification for becoming that rich.
(10)
Extended writing
1 Billionaire inventor James Dyson says that business is not about
finance, it is about designing and producing great products.
 Evaluate whether Dyson is right in relation to all businesses.
(20)
2 ‘Companies succeed because of great marketing management; they
fail because of bad financial management.’ Evaluate whether this old
business saying is still true today.
(20)
Section 2.1 Raising finance

30 Sources of finance: internal and

external
Definition
All businesses need money. Where the money comes from is known as
‘sources of finance’.

Linked to: Forms of business, Ch 26; Liability and finance, Ch

31; Planning and cash flow, Ch 32; Liquidity, Ch 38.

30.1 The need for finance

Starting up
New businesses starting up need money to invest in long-term assets such as
buildings and equipment. They also need cash to purchase materials, pay wages
and pay the day-to-day bills, such as water and electricity. Inexperienced
entrepreneurs often underestimate the capital needed for the day-to-day
running of the business. Generally, for every £1,000 required to establish the
business, another £1,000 is needed for the day-to-day needs.

Growing
Once the business is established, there will be income from sales. If this is
greater than the operating costs, the business will be making a profit. This
should be kept in the business and used to help finance growth. Later on, the
owners can draw money out, but at this stage as much as possible should be left
in. Even so, there may not be enough to allow the business to grow as fast as it
would like to. It may need to find additional finance and this will probably be
from external sources such as bank loans.
Other situations
Businesses may also need finance in other circumstances, such as a cash flow
problem. A major customer may refuse to pay for the goods, causing a huge
gap in cash inflows. Or there may be a large order, requiring the purchase of
additional raw materials. In all these cases, businesses will need to find
additional funding.
Finance for business comes from two main sources:
1 inside the business: known as internal finance
2 outside the business: known as external finance.

30.2 Internal finance

Capital can be generated from within the business in three ways:
1 Retained profit. Nothing soothes a difficult cash situation better than profit. It
is also the best (and most common) way to finance investment into a firm’s
future. Research shows that over 60 per cent of business investment comes
from reinvested profit. Logically, then, the higher a firm’s profit the more
likely it is that it can finance its expansion from within.
2 Sale of assets. In autumn 2014, Tesco was in need of more capital. It could
have raised some from external shareholders, or it could sell assets. Some
were non-core businesses such as Dobbies Garden Centre and Giraffe
restaurants. Others were property assets now considered surplus to
requirements as there was suddenly no appetite for opening new
hypermarkets. By selling these assets, Tesco would easily be able to raise
the £2 billion widely seen as necessary to give new boss Dave Lewis an
effective financial fighting fund.
3 Improved management of working capital. Existing capital can be made to
stretch further. The business may be able to negotiate to pay its bills later or
work at getting cash in earlier from customers; the average small firm waits
75 days to be paid; if that period of time could be halved, it would provide a
huge boost to cash flow. Working capital is dealt with in greater detail in
Chapter 38.
One other form of finance can be regarded as internal: the personal savings of
the owner; these can be invested in the form of share capital or lent to the
business, perhaps as a director ’s loan.
30.3 External sources of finance
If the business is unable to generate sufficient funds from internal sources then
it may need to look to external sources. There are two sources of external
capital: loan capital (debt) and share capital (equity). Loan capital carries
specific annual interest charges and must be repaid to an agreed time schedule.
Share capital is usually rewarded by annual dividend payments, but the
directors have the flexibility to cut or scrap those payments in a difficult year.
There is also no agreed timescale for repaying share capital, so it can be kept
within the business indefinitely.
Sources of finance include the following.

Family and friends

Family and friends can provide share capital (taking an equity stake in the
business and its profits) or can lend money. Despite the rise of crowdfunding,
the overwhelming majority of businesses start with a combination of owner ’s
capital and family and friends’. Banks, in particular, provide start-up capital to
far fewer businesses than their TV advertisements claim.

Banks
Two recent research reports give very different figures for the percentage of
businesses that were able to get a bank loan to help start the business. A
company called Amigo Loans said that 20 per cent of its 200 sample achieved
a start-up loan, while PeoplePerHour found a figure of just 3 per cent. Either
way, it is clear that a start-up loan is a rarity.
If you can get a loan, the bank will insist on rock-solid collateral. If the loan is
to buy a five-year lease on a shop, that lease will be the collateral. If the
business is starting up without property assets, the collateral will be personal,
such as the deeds to the owner ’s house or flat. Banks are not interested in
sharing the risks involved when starting a business. They want to provide
finance, not become a partner.
‘The old saying holds. Owe your banker £1,000 and you are at his mercy;
owe him £1 million and the position is reversed.’
John Maynard Keynes, British economist and author
Peer-to-peer funding
The reluctance of banks to lend following the 2009 recession created an
opportunity for online matching platforms to match individuals who want to
lend (at a relatively high rate of interest) to individual business borrowers.
These websites cut out the bank middleman and therefore allow lenders and
borrowers to get a better deal – as long as the loan doesn’t go sour.
Peer-to-peer funding seems to work well if there is an attractive-sounding
business, such as a new restaurant; for duller businesses, investors seem less
inclined to bother.

Business angels
The term ‘angels’ has long been used for individuals who invest in West End
plays and musicals. Most lose their money, but the 500 who each put £10,000
into ‘Cats’ received £20,000 a year for more than 25 years. That’s a £500,000
return on a £10,000 investment.
The BBC series Dragons’ Den has always presented itself as a matter of
venture capital investment. In fact, it would be truer to call most of the
proposals ‘angel’ rather than dragon investments because they are at a very
early stage. Angel investors take huge risks in the hope of the occasional
blockbuster success. In reality, in the UK, the only businesspeople likely to find
an angel investor are those whose families move in wealthy circles. For
ordinary people, an angel investment is even more unlikely than a bank loan.

Real business
3D finance
The 18-year-old entrepreneur Josh Valman started MiProto in 2012
while still doing his A levels. He began with £2,500 of start-up funding
from the seedcorn capital business run by former Dragon James
Caan. Then, in June 2013 four ‘angel’ investors put in £40,000, topped
up by a further £160,000 of venture capital finance in summer 2013. In
all cases, the investors loved the business concept: a one-stop shop
for turning ideas into physical prototypes using 3D printing technology.
MiProto can turn an idea into a design and then a design into a printed
product that can then be tested on retail buyers or on a sample of
consumers. It is a marvellous example of new technology being
brought alive by a bright young businessperson.
Sources: MiProto website and James Caan’s article in The Guardian,
18 December 2013

Crowdfunding
Crowdfunding is a way of getting small investors to put money into a new
business – often with an incentive such as to get a sample product or service in
return for their investment. It works via the internet and works most effectively
when the sponsors use social media to promote their business. In the UK,
Seedrs and Kickstarter are two of the best-known sponsors of crowdfunding.

Other businesses
Some companies allocate a chunk of their capital to ‘seedcorn’, early-stage
investments. The companies hope to get the occasional winner from among a
number of duds. In Silicon Valley, USA, this type of investment is
commonplace, but not in the UK.

30.4 External methods of finance

Loans
The most usual way is through borrowing from a bank. This may be in the
form of a bank loan or an overdraft. A loan is usually for a set period of time.
It may be short term – one or two years; medium term – three to five years; or
long term – more than five years. The loan can be repaid either in instalments
over time or at the end of the loan period. The bank will charge interest on the
loan. This can be fixed or variable. The bank will demand collateral to provide
security in case the loan cannot be repaid.
An overdraft is a very short-term loan. It is a facility that allows the business to
be ‘overdrawn’. This means that the account is allowed to go ‘into the red’.
The length of time that this runs for will have to be negotiated. The interest
charges on overdrafts are usually much higher than on loans. Fortunately, the
interest charges only apply to actual debts instead of the facility itself. For
firms that use the overdraft as a way of smoothing short-term cash variations,
the interest payments can be quite small.

Share capital
As an alternative to debt, if the business is a limited company, it may look for
additional share capital. This could come from private investors or venture
capital funds. Venture capital providers are interested in investing in businesses
with dynamic growth prospects. They are willing to take a risk on a business
that may fail, or may do spectacularly well. They believe that if they make ten
investments, five can flop and four do ‘OK’ as long as one does fantastically.
Peter Theil, the original investor in Facebook, turned his $0.5 million
investment into just over $1,000 million, making a profit of 199,900 per cent
between 2004 and 2012!
Once it has become a public limited company (plc), the firm may consider
floating on the stock exchange. For smaller UK businesses, this will usually be
on the Alternative Investment Market (AIM).
Figure 30.1 The value of share capital

Real business
Financing growth
How do rapidly growing small firms finance their growth? To find an
answer to this question, Hamish Stevenson from Templeton College,
Oxford, looks each year at 100 of the fastest growing UK firms. One
of these is The Gym Group, which offers low-cost memberships for 24-
hour gyms. Its sales grew from £1 million in 2008/2009 to £22.6 million
in 2012/2013. The business started in 2007 with venture capital
backing. Founder John Treharne had already built and sold a profitable
chain of health clubs. Therefore, he was able to persuade venture
capital company Bridges Ventures to provide £20 million of start-up
equity in exchange for a substantial share stake. When the business
required more capital to fulfil a plan of growing from 38 to 74 gyms by
the end of 2015, another venture capital group invested a further £50
million in June 2013.
The Gym Group’s easy access to capital contrasts with many others.
As many as 54 of the 100 fastest-growing firms financed all their early
growth from a combination of personal savings and reinvested profits –
that is, with no external funding at all.

Venture capital
This is a way of getting outside investment for businesses that are unable to
raise finance through the stock market or from banks. Venture capitalists
invest in smaller, riskier companies. To compensate for the risks, venture
capital providers usually require a substantial part of the ownership of the
company. They are also likely to want to contribute to the running of the
business. This dilutes the owner ’s control but brings in new experience and
knowledge. Typically, venture capital houses put money into businesses that
have survived the early stages and are looking to grow. In 2013, the venture
capital association announced that its members’ average investment amounted
to £800,000. This emphasises that venture capital investment is rarely about
start-up.
‘One thing I’m so grateful for is sidestepping the usual venture capital,
 private equity route. My friends who have gone that way are many times
beholden to their boards of directors, to “sell” ideas to a team.’
Blake Mycoskie, founder of Toms Shoes

Overdrafts
An overdraft is a facility that allows a company to spend up to an agreed
negative balance on its current account – for example, minus £3,000. When the
bank balance is negative, the company is overdrawn and must pay interest
calculated on a daily basis – for example, 1/365th of 12 per cent (if 12 per cent
is the bank’s overdraft interest rate). Because the business can dip in and out of
‘the red’, its interest bill at the end of the year will usually be quite a lot lower
than with a bank loan. As shown in Table 30.1, overdrafts are the main form of
external finance for small firms.
Although overdrafts are flexible and well matched to the ups and downs of
small company cash flows, their risk-level should not be underestimated. All
overdrafts are on 24-hour recall. In other words, the bank can cancel them at
any time, often leaving the business unable to repay the negative balance – and
forcing the business into administration. This was one of the features of the
early stages of the recent recession. As mentioned in the Daily Mail on 29
October 2009: ‘Thousands of small businesses were suddenly refused credit
by banks.’ A sudden drama such as this cannot happen with a bank loan, which
is a legal agreement for a fixed period of time (e.g. three years).

Table 30.1 Principal sources of external finance for small and medium-
sized enterprises (SMEs) (source: BDRC Continental, SME Finance
Monitor, August 2013)

Leasing
For small or fast-growing businesses, keeping cash flow positive is a huge
challenge. A constant problem is having to spend chunks of cash buying new
assets, such as delivery vans, computer networks or machinery. A solution is to
lease instead of buying the assets. Leasing the asset means agreeing to pay a
fixed monthly rental for a fixed period, such as three years. Instead of buying
an asset for £5,000, you may pay £200 a month. £200 a month means paying
£200 × 36 months = £7,200 over the three years. Pricey, perhaps, but at least
you are keeping cash in your own bank account at the start of the period.
In Figure 30.2, you can see that buying an asset hits short-term cash flow hard.
In the longer term, it is better to buy than lease, but for many firms short-term
needs outweigh long-term wishes. In the graph, the assumption has been made
that the £5,000 asset yields a contribution of £250 a month over the three-year
period.

Figure 30.2 Cash flow position: buying versus leasing an asset

Trade credit
This is the simplest form of external financing. The business obtains goods or
services from another business but does not pay for these immediately. The
average credit period is two months. It is a good way of boosting day-to-day
finance. A disadvantage could be that other businesses may be reluctant to trade
with the business if they do not get paid in good time.

Grants
Grants are, in effect, hand-outs to small firms, perhaps from a local authority
or central government. A grant may be given to encourage a start-up or a
relocation that is considered valuable – probably because banks have refused
to lend. However, a recent report (SME Finance Monitor, August 2013)
showed that just 1 per cent of small and medium-sized enterprises (SMEs)
obtained finance from grants. Governments love to boast about how much help
they give small firms, but it rarely amounts to much. Within that 1 per cent
would also be any grants received from the Prince’s Trust, which, again,
makes relatively small sums of money go a long way in terms of publicity.
Table 30.1 provides more data on external finance. Note that only 41 per cent
of firms use any external finance. Small firms would prefer to finance their
start-up and growth from within.

Five whys and a how

30.5 Sources of finance – evaluation

Raising finance is a perfect example of the different skills required by
businesspeople. When starting out, the personality of the entrepreneur is likely
to be of critical importance, as angel investors must decide in part on whether
they want to work with this person. Later on, when the start-up has progressed
to the point of needing more capital for expansion, the need is for an organised
person with thorough records of cash flow and profit. At first, charisma
counts; now it is competence that matters. Not many people have both qualities,
so it is important to hire wisely, and to delegate to someone who has skills you
lack.
Whatever the situation, debt should still be taken as a threat to any business.
Advisors tell firms to borrow more when times are good, but good turns to
bad amazingly quickly, which can leave over-stretched companies floundering.
Debt always means risk; but of course some risks may be worth taking.

Key terms
Angel investors: investors who back a business before it has opened
its doors, taking a full equity risk, i.e. if it fails the angel investor will
lose everything invested.
Collateral: an asset used as security for a loan. It can be sold by a
lender if the borrower fails to pay back a loan.
Crowdfunding: obtaining external finance from many individual, small
investments, usually through a web-based appeal.
Public limited company (plc): a company with limited liability and shares,
which are available to the public. Its shares can be quoted on the stock
market.
Seedcorn capital: the early stage (sowing a seed) finance that might
come from an angel investor.
Share capital: business finance that has no guarantee of repayment or
of annual income, but gains a share of the control of the business and
its potential profits.
Stock market: a market for buying and selling company shares. It
supervises the issuing of shares by companies. It is also a second-
hand market for stocks and shares.
Venture capital: high-risk capital invested in a combination of loans and
shares, usually in a small, dynamic business.
30.6 Workbook
Revision questions
(30 marks; 30 minutes)
1 Describe the problem caused to a company if a major customer
refuses to pay a big bill.
(3)
2 Why do banks demand collateral before they agree to provide a
bank loan?
(2)
3 Outline two ways in which businesses can raise money from internal
sources.
(4)
4 What information may a bank manager want when considering a
loan to a business?
(4)
5 Read ‘Real business: 3D finance’ on page 192. Explain why it may
have been difficult for a business such as this to get a bank loan.
(4)
6 Outline two sources of finance that can be used for long-term
business development.
(4)
7 Explain why a new business could find it difficult to get external
funding for its development.
(5)
8 Outline one advantage and one disadvantage of using an overdraft.
(4)
Data response 1
Indian in China?
‘Hi everyone, I am from India and wish to open a quick takeaway and a
small restaurant or café but with Indian snacks and food in Nanjing,
near the International University. I would like to know about:
1 the rules and regulations
2 the approximate budget
3 the minimum area requirement
4 the real estate prices in an area like Shanghai Lu, Nanjing.
Please contact me by leaving a comment here.
Thank you, Karishma’
‘Hi Karishma,
You have to know that the life expectancy of a new foreign restaurant
on Nanjing Road is between three and six months, in 50 per cent of
cases. Many foreigners open restaurants without complying with all the
rules… Be ready to have enough funds to survive for one year
minimum without any revenues. If you want I could give you contacts
with very good companies that could help you for all legal aspects.
Good luck, and I will come to your restaurant!
Paul Martin’
Source: posting to www.chinasuccessstories.com
Questions
(30 marks; 35 minutes)
1 Explain to Karishma two implications of Paul Martin’s reply for her
plans for start-up finance.
(8)
2 Assess the circumstances in which Karishma should proceed with
her idea, if she were able to obtain the start-up finance.
(10)
3 Assuming this information is widely known, assess the probable
attitude of any Chinese banks that Karishma approaches.
(12)
Data response 2
Kickstarter
In recent years, ‘crowdfunding’ has become an alternative to traditional
market research and also a different way to finance a start-up. The
Kickstarter website helps a creative business idea to be put to the
public, asking for start-up capital in exchange for a free ‘taste’ of the
product.
One successful 2014 start-up was Chivote, a producer of leather bags
and accessories. It raised £20,000 through Kickstarter by offering
products in exchange for investment. A £7 investment received a
leather nametag in return, while £240 yielded a ‘Boombox’ bag.

Figure 30.3 The Boombox bag

Crowdfunding uses online technology and social media to replace the
traditional role of banks.
Chivote has another unusual aspect to its business. It sources its
leather goods from a small partnership of craftsmen who work as
partners instead of suppliers to Chivote. This is another way to help
minimise the capital needed to start up the business. Usually a new
business would have to pay cash up front for supplies; the partnership
ensures that normal credit terms can smooth the cash flow
requirements.
Questions
(30 marks; 35 minutes)
1 A weakness of crowdfunding might be that it is effective only with
consumer-friendly, attractive products or services. Examine whether
that is really a problem.
(6)
2 Explain the benefit to your cash flow of having a supplier who offers
credit terms instead of cash only.
(4)
3 Evaluate the benefits of crowdfunding compared with traditional
venture capital funding when starting a business such as Chivote.
(20)
Extended writing
1 While at university, you develop a game for mobiles based on
tractors, farms, rabbits and foxes – and everyone loves it. Your
parents lend you £4,000 and you have £2,000 but you estimate
that it will cost about £20,000 simply to get the game ready for use
and to give it some publicity. Evaluate the best way to finance the
start-up of your business.
(20)
2 For the founder of a rapidly growing small business, evaluate
whether it is better to keep at least 51 per cent of the share capital
or to finance growth in the safest way for the long-term health of
the company.
(20)
Section 2.1 Raising finance

31 Liability and finance

Definition
Every potential entrepreneur needs to know the financial risks being
run when starting up. Debts are liabilities that can overwhelm a
business owner’s personal as well as business finances.

Linked to: Business objectives, Ch 25; Forms of business, Ch

26; Sources of finance, Ch 30.

31.1 Implications of unlimited liability

Unlimited liability means that the finances of the business are treated as
inseparable from the finances of the business owner(s). So if the business loses
£1 million, the people owed money (the creditors) can get the courts to force
the individual owners to pay up. If that means selling their houses, cars, and so
on, so be it. If the owner(s) cannot pay, they can be made personally bankrupt.
Two types of business organisation have unlimited liability: sole traders and
partnerships. They were covered in Chapter 26.
In Britain, the great majority of businesses have unlimited liability. Even
though that means avoiding certain accounting costs, it still seems
extraordinary that people are willing to take even a slight chance of
bankruptcy.
‘There are few experiences in life as painful and brutal as the failure of a
small business. For a small business conceived and nurtured by its owner is
like a living, breathing child. Its loss is no less traumatic than losing a
loved one.’
William Manchee, business author

Real business
In 2012, Creative Learning Software closed down. It had enjoyed ten
years as a profitable business, designing and selling software to
schools. Because its finances had always been cash flow positive, the
proprietor never worried about limited liability. He had often said: ‘I
wouldn’t give the accountants the satisfaction’ (of auditing the
published ltd accounts).
Unfortunately, the proprietor had not thought about all the potential
liabilities. In 2011, a school sued the business because it claimed that
Creative Learning Software had damaged the entire school computer
network. The school demanded £100,000 compensation. But the small
supplier couldn’t afford that and therefore the proprietor became
personally liable for the huge debts.

31.2 Implications of limited liability

Limited liability means that the legal duty to pay debts run up by a business
stays with the business itself, not its owner/shareholders. If a company has £1
million of debts that it lacks the cash to repay, the courts can force the business
to sell all its assets (cars, computers, etc.). If there is still not enough money,
the company is closed down, but the owner/shareholders have no personal
liability for the remaining debts.
The key implication is that limited liability can give owners the confidence to
push their business forward to the next level. Expansion can be financed by
bank loans without threatening the well-being of the owners’ families. Without
the legal protections of limited liability, economies would struggle to grow.
Despite this strength, limited liability has a downside. It gives huge scope for
fraud. Proprietors can start a business, take customers’ money, enjoy a fantastic
lifestyle, then put the company into liquidation before customers receive the
service they paid for. If such actions could be proved to be deliberate, they
would constitute fraud. But there is little doubt that many scams go unpunished
because it is hard to distinguish between fraud (illegal) and business
incompetence (legal). This factor explains why most petrol stations display a
sign saying ‘company cheques not accepted’.
Figure 31.1 Logic chain: liability and stress

31.3 Finance appropriate for unlimited liability

businesses
Unlimited liability businesses are, by definition, not companies. Therefore,
they have no access to share capital (equity). So a sole trader or a partnership
must be financed in one of the following ways:
• Owners’ capital: in the case of a partnership, an agreement might be drawn
up basing the proportionate ownership of the business on the amount of
capital invested by each partner.
• Bank finance, either loan or overdraft: it is often easier for an unlimited
liability business to obtain bank finance because even if the business fails, the
bank can recoup its cash from the personal assets of the individual owners.
• Leasing: signing an agreement to rent a specific asset for a specific period
 (perhaps three years), therefore avoiding the cash drain caused by purchase.
• Trade credit: as with bank finance, supplier companies would often prefer to
deal with a sole trader or partnership, as they know they can recoup any
debts from the individual owners if the business fails.
It should never be forgotten, though, that the most important form of capital
comes from within the business: from trading profit.

31.4 Finance appropriate for limited liability

businesses
Companies have access to more types of finance than unlimited liability
businesses. Both private and public limited companies have access to the
following forms of finance:
• Share capital, part of which may be under the control of the founder and part
sold on to family and friends (ltd) or more widely to the general public (plc).
• Bank finance: bank loans would typically need to be backed by specific
collateral, especially for small companies (banks are wary of limited
liability). Overdrafts will also need to be backed by security; for new small
companies, it is highly likely that a bank would demand a personal guarantee
by the founder shareholder.
• Angel or venture capital investment, both of which tend to be a combination
of share and loan capital: so the founder suffers dilution of control over the
business and the company will probably find that the loan capital is at a much
higher interest rate than an ordinary bank loan.
• Peer-to-peer or crowdfunding: both these sources tend to keep control more
effectively in the hands of the founder.
• Leasing and trade credit are both open to limited liability companies.
For limited companies, even giant plcs, the biggest source of capital for
expansion comes from within the business: from trading profit.

Five whys and a how

31.5 Liability – evaluation
There is a case for placing limited liability among the key factors that have led
to the wealth of the western world. Without that legal protection, the industrial
revolution of the nineteenth century could not have happened. Therefore, it is
usually the case that unlimited liability businesses are small and plan to stay
small, whereas those that are formed into companies have greater ambitions.
Ultimately, the businesses that in recent times have gone from start-up to
billion-dollar sale in a year or two have all been limited liability companies.
‘Capitalism without bankruptcy is like Christianity without hell.’
Frank Borman, airline chief executive
For those dealing with businesses, either as a supplier or as a banker/lender,
the advantages of a company structure are offset by a huge downside: the risk
of the company putting itself into voluntary liquidation – leaving the creditors
with nothing. As elsewhere in business, morality matters. Some businesspeople
lack the moral compass needed to ensure that they are being fair to everyone
they deal with.

Key terms
Bankrupt: when an individual is unable to meet personal liabilities,
some or all of which can be as a consequence of business activities.
Creditors: those owed money by a business – for example, suppliers
and bankers.
Limited liability: owners are not liable for the debts of the business;
they can lose no more than the sum they invested.
Sole trader: a one-person business with unlimited liability.
Unlimited liability: owners are liable for any debts incurred by the
business, even if it requires them to sell all their assets and
possessions and become personally bankrupt.

31.6 Workbook
Revision questions
(25 marks; 25 minutes)
1 Explain in your own words the risks involved in starting a business
that has unlimited liability.
(4)
2 Outline why the liabilities involved as a business partner might be
even more of a worry than for a sole trader.
(4)
3 Outline two circumstances in which a supplier might give credit to a
newly formed limited company.
(4)
4 Explain why a sole trader cannot raise share capital.
(4)
5 From your general knowledge, give three examples of public limited
companies.
(3)
6 An aunt is about to start a business and asks you to advise on
whether to start as a sole trader or a private limited company.
Please do so.
(6)
Data response
A recent report to parliament shows the remarkable growth in business
start-ups in recent years. Figure 31.2 shows the net growth in start-
ups (births minus deaths) per year, plus the percentage of small
businesses that employ other people. In 2001, 33 per cent of small
businesses were employers; by 2014, this figure had fallen to 24 per
cent. In 2014, then, 76 per cent of small businesses were sole
proprietors (in effect, self-employed). The data for businesses
employing other people is measured using the graph’s right-hand scale
(rhs).
The report did not provide information on how many of the new
business were sole traders, partnerships or private limited companies.
Questions
(20 marks; 25 minutes)

Figure 31.2 Net growth in UK business start-ups (source:

Parliamentary report, November 2014)
1 Assess two possible reasons why the rate of net new business
start-ups jumped in 2014.
(8)
2 Assess the importance to the UK of the decline in the percentage of
 small firms that employ any staff.
(12)
Extended writing
1 As part of your plan to open a new restaurant, you establish Prime
Ribz Ltd as a private limited company. Examine the financial issues
that may arise in your first year and evaluate which issue might
prove the most difficult.
(20)
2 Your parents have decided to open a greengrocer selling only
organic produce. They plan on making it a 50/50 partnership.
Evaluate whether this business idea is wise.
(20)
Section 2.1 Raising finance

32 Planning and cash flow

Definition
Planning a firm’s financial requirements is helped by a clear, detailed
business plan. Cash flow is the flow of money into and out of a
business in a given time period.

Linked to: Sources of finance, Ch 30; Profit, Ch 37.

32.1 The relevance of a business plan in obtaining

finance
A good plan should be persuasive to an outside investor and useful to the
entrepreneur. It should explain what makes the business special and help the
entrepreneur to focus on what she or he is trying to achieve. The plan will also
help the outsider understand the risks and rewards involved in the proposal.
The outsider might be a bank or a ‘Dragon’ type of investor interested in an
ownership stake in the business. A bank’s main concern is that the start-up will
be a safe investment, whereas a ‘Dragon’ is mainly interested in the upside
potential – that is, the chance of making a huge profit. Either type of financier
will want to see a carefully prepared plan with a well-considered proposal for
the sums of money needed.
The heart of the business plan should be based around competitive advantage;
this means identifying the features of your own product or service that will
make it succeed against competitors. This may be based on a unique idea, a
better product or service or the protection provided by a patent or copyright.
On the other hand, a business may decide to strip a product or service down, to
make it possible to be the cheapest in the market.
Business plans usually contain the following sections:
1 Executive summary: this should be short, but compelling enough to
persuade the busy banker to want to read on. It should say who you are, what
the customer ’s ‘pain’ is and how you will ‘relieve’ it, why your team is ideal
 for the task, how much capital you need for the start-up, and how much you
are putting in yourself.
2 The product/service: explain it from the customer ’s point of view; for
example, when describing smoothies, do not say ‘we’ll crush fruit and put it
in bottles’, but ‘it’ll provide busy people with two portions of fruit in an
enjoyable, unmessy way’. If others already offer the service, you must
explain what is different about your idea.
3 The market: focus on market trends rather than market size, such as whether
the market is growing and, if so, how rapidly. Also there is a need to
provide a brief analysis of key competitors.
4 Marketing plan: who are you targeting and how do you plan to communicate
to them? How expensive will this be? Within this section, there should be an
explanation and justification for the prices you plan to set plus a forecast of
likely sales per month for the first two years.
5 Operational plan: how will the product or service be produced and
delivered? This could involve production in China, in which case you will
need to have already made contacts with willing suppliers.
6 Financial plan: the heart of this will be a cash flow forecast – that is, a
prediction of monthly cash out and cash in from the start of the business
until at least two years after the firm has started trading. This will give an
idea of the bank balances over the start-up period, and therefore the
financing needs.
7 Conclusion: this will include some idea of the longer-term plans for the
business, including any ‘exit strategy’ – for example, a plan to sell the
business within five years.

Real business
Estimating financial needs
Tom Doyle worked as a motor auctioneer for ten years before, at the
age of 28, he decided to set up his own car dealership. He would
specialise in German cars, especially BMWs, Audis and Volkswagen.
He knew all the local garages and felt confident that he could get cars
serviced, painted and valeted in order to maximise the value added.
The business model was simple: buy slightly run-down German cars at
the auction, make them look good to potential purchasers and then
sell them at a higher price. He thought that he could make £300–£500
net profit per car.
Tom wrote up his plans with care, using a blank business plan from
NatWest Bank. He made his sales forecasts, his cash flow projections
and committed himself to putting in half of the £100,000 to start up
the business. When he went to see the regional business bank
manager, the conversation went well until it came to the financial
needs. The bank manager thought Tom had underestimated the
finance needed to run the business day by day. Tom was turned down
because he had asked for £20,000 too little!

32.2 Interpreting a cash flow forecast

A cash flow forecast is carried out by estimating all the money coming into
and out of the business, month by month. These flows of money are then set
onto a grid showing the cash movements in each month – and how those
movements affect the overall cash holdings (the closing balance).
Table 32.1 shows a new business starting up in March with £30,000 of capital.
The key headings to be aware of are as follows.

Cash inflow
These are the sums expected to arrive each month, either from financial
sources or from customers. In Table 32.1, sales start to generate cash from
May onwards, and then start to grow impressively each month.

Cash outflow
These are the planned payments per month, such as wages, paying suppliers
and paying the landlord. Here, a big outlay of £27,000 is needed in March to
pay the start-up costs of the business, such as decoration and equipment.
The cash flow forecast is completed by calculating the following.

Monthly balance
This is cash inflow for the month minus cash outflow. It shows each month if
there is a positive or a negative movement of cash. When outflow is greater
than inflow. the monthly balance will be negative. This is shown in brackets to
indicate that it is a minus figure.

Table 32.1 Example of a cash flow forecast

Opening and closing balance

This is like a bank statement. It shows what cash the business has at the
beginning of the month (opening balance) and what the cash position is at the
end of the month (closing balance). The closing balance is the opening balance
plus the monthly balance. For example, the business starts with £3,000 in the
bank in April; a net £8,500 flows out during the month, so the closing bank
balance is (£5,500).
The closing balance shows the overall state of the bank account at the end of
the month. Table 32.1 shows a negative cash balance from April onwards,
though the accumulated position (the closing balance) is improving from the
end of June.
As there is no such thing as negative money, the cash flow forecast shows that
action is needed to avoid problems in the early months. The easiest remedy
would be to negotiate a bank overdraft.
Figure 32.1 Daily cash balances for a firm with a £25,000 overdraft

Real business
Cash problems at Debenhams?
On 16 December 2013, department store chain Debenhams shocked
its suppliers by sending them an email saying that sums owed would be
reduced by 2.5 per cent. In other words, Debenhams would be going
back on negotiated, agreed terms – and simply chopping an extra 2.5
per cent off the bills. And this would continue into the future. Several
newspapers responded by questioning whether Debenhams was
suffering a cash flow crisis, given that a pre-Christmas announcement
such as this would inevitably generate bad publicity. Retail
commentator Bill Grimsey said, ‘It means they have financial issues… a
cash flow issue, a profit issue – or both.’

32.3 Calculations based on changes in cash flow

forecasts
In Table 32.2, you can see a cash flow forecast for a small firm. It looks very
comfortable and stable, with no negative balances.
Table 32.2 Cash flow forecast
But what if the cash inflow expected for March is from a single buyer – let’s
say Tesco? And what if Tesco decide to hold up the March payment because
they say they are unhappy with three deliveries that arrived late at Tesco
stores? The result would be to throw the cash flow position of the business into
the red (and remember, a negative cash balance is only possible if you have an
overdraft agreement with your bank; otherwise your payments will bounce).
See Table 32.3.

Table 32.3 Cash flow forecast (2)

If the dispute with Tesco can be resolved and the payment made in April, the
final cash flow position will look like this (Table 32.4)
Table 32.4 Cash flow forecast (3)
Other calculations that may come up in exams:
• An unexpected payment is needed, such as a big fine for health and safety
failings: this increases the cash outflow, which worsens the monthly balance,
which then worsens the closing balance for that month – and all the
following opening and closing balances.
• A customer decides they’ll take an extra month’s credit period – for example,
paying you 60 days after the invoice date instead of 30 days. That delay by
one month would actually have the effect shown in Table 32.3 – that is, you
would lose a month’s cash inflow (you’ll get the money later on, but that
doesn’t help you now).

32.4 Analysis of cash flow forecasts

There are three main ways to analyse a cash flow forecast:
1 Calculate the difference between the closing balance at the end of the period
and the opening balance at the start. This gives a sense of what is happening
over time. If the overall cash balances are building up, then cash inflows are
greater than cash outflows and the situation is comfortable. If the balance is
declining, urgent action may be necessary.
2 Use the monthly closing balance to assess trends in the data. If the closing
balance from Table 32.1 is turned into a graph, it helps highlight that the
short-term plunge into the red seems, by July, to be stabilising into a steady
recovery in the cash position of the business (see Figure 32.1).
Figure 32.2 Closing balance from Table 32.1
3 Analyse the timings of cash inflows and outflows. Although some firms sell
goods for cash, most provide customers with interest-free credit (e.g.
Cadbury selling to Tesco). The longer the customers take to pay, the longer
the seller is without their cash. So any method of speeding up customer
payments can boost a firm’s cash flow. The sum of money outstanding from
customers is known as ‘receivables’. Logically, firms should want this
figure to be as low as possible.
Firms not only have customers, they also have suppliers. When buying goods
on credit, the longer the credit period you can negotiate from suppliers, the
longer your cash will be sitting in your bank account. As it sits in your bank
account, this money owed is known as ‘payables’.
‘An important thing in business is to look after your suppliers. They must
look after you, but you need them, so I always pay my bills on time.’
Duncan Bannatyne, Dragon investor
If a company has customers who pay in 30 days and suppliers who are paid in
30 days, businesses call this a ‘cash-to-cash’ figure of zero (which is fantastic).
If customers take 60 days to pay but suppliers have to be paid in cash, that is a
cash-to-cash figure of 60 – which would put a strain on any business’s cash
flow position.
Figure 32.3 Cash flow

32.5 Uses and limitations of a cash flow forecast

If a business forecasts a period of negative cash flow, it can work to improve
its positions in several ways.
• Getting goods to the market in the shortest possible time: the sooner goods
reach the customer, the sooner payment is received. Production and
distribution should be as efficient as possible.
• Getting paid as quickly as possible: the ideal arrangement is to get paid cash
on delivery. Most business, though, works on credit. Even worse, it is
interest-free credit, so the customer has little incentive to pay up quickly.
Early payment should be encouraged by offering incentives, such as
discounts for early payment.
• Keeping stocks of raw materials to a minimum. Good stock management
such as a just-in-time system means that the business is not paying for stocks
before it needs them for production.
‘A wise business owner once said: “Happiness is positive cash flow”.’
Quoted at www.freetaxquotes.com
Cash flow can also be improved by keeping cash in the business. Minimising
short-term spending on new equipment keeps cash in the business. Things that
the business can do include:
• leasing rather than buying equipment; this increases expenses but conserves
capital
• renting rather than buying buildings; this also allows capital to remain in the
business
• postponing expenditure – for example, on new company cars.
Cash flow forecasts have their limitations, however:
• They are only as good as the raw data put in. Entrepreneurs have to be
optimistic by nature, so they may overestimate sales and underestimate
operational difficulties (and therefore cash outflows).
• They risk giving the impression of certainty where none exists; especially at
start-up, who knows how long business customers will take to pay? Tesco
may say they will pay in 60 days, but if it proves to be 90, what can a small
firm do? Threaten to walk away from 30 per cent of the market?
• Because of these things it is vital to allow for contingencies – that is, things
that can wrong. So a clever cash flow forecast includes a planned
overstatement of costs, to allow for unexpected problems.

Five whys and a how

32.6 Planning and cash flow – evaluation

At the heart of any attempt to raise start-up capital is a business plan. And at its
heart is a cash flow forecast. For a new business, cash flow forecasting helps to
answer key questions:
• Is the venture viable?
• How much capital is needed?
• Which are the most dangerous months?
For an existing business, the cash flow forecast identifies the amount and
timing of any cash flow problems in the future. It is also useful for evaluating
new orders or ventures.
Nevertheless, completing a cash flow forecast does not ensure survival. And
whereas ‘estimates’ sounds impressive, businesspeople admit that many are
‘guesstimates’: not just the amounts but also the timings. When preparing cash
flow forecasts, managers need to ask themselves ‘what if?’ A huge mistake is
to only look at one forecast. It is far better to look at best case and worst case
possibilities. In addition, every firm needs to be continually aware of the
economic and market climate and its current cash position.
‘There’s nothing more important than cash flow. I lost my computer
business when I was 29 because I gave credit to firms I didn’t investigate
(credit check).’
Peter Jones, Dragon investor (worth £475 million, Sunday Times Rich List
2014)

Key terms
Best case: an optimistic estimate of the best possible outcome – for
example, if sales prove much higher than expected.
Business plan: a document setting out a business idea and showing
how it is to be financed, marketed and put into practice.
Cash flow forecast: estimating future monthly cash inflows and
outflows, to find out the net cash flow.
Just-in-time: ordering stock so that it arrives just before it is needed,
just in time, i.e. having no stockpiles to cover for late deliveries.
Overdraft: short-term borrowing from a bank. The business only
borrows as much as it needs to cover its daily cash shortfall.
Worst case: a pessimistic estimate assuming the worst possible
outcome – for example, sales are very disappointing.

32.7 Workbook
Revision questions
(40 marks; 40 minutes)
1 Identify two circumstances in which a new business might decide not
to write a business plan.
 (2)
2 What is meant by ‘cash flow’?
(2)
3 Why is it important to manage cash flow?
(4)
4 What is a cash flow forecast?
(3)
5 Explain two limitations of cash flow forecasts.
(4)
6 Give two reasons why a bank manager may want to see a cash flow
forecast before giving a loan to a new business.
(2)
7 How could a firm benefit from delaying its cash outflows?
(3)
8 What problems could a firm face if its cash flow forecast proved
unreliable?
(3)
9 How could a firm benefit from constructing its cash flow forecasts
on a computer spreadsheet?
(4)
10 Explain why ‘good management of cash flow starts with good
forecasting’.
(3)
11 Outline two problems that may arise if a firm is operating with very
poor cash flow.
(4)
12 Outline three ways in which a business can improve its cash flow
situation.
(6)
Data response 1
Cash flow
(18 marks; 20 minutes)
A business is to be started up on 1 January next year with £40,000 of
share capital. It will be opening a designer clothes shop. During
January, it plans to spend £45,000 on start-up costs (buying a lease,
buying equipment, decorating, and so on). On 1 February, it will open
its doors and gain sales over the next five months of: £12,000,
£16,000, £20,000, £25,000 and £24,000, respectively. Each month it
must pay £10,000 in fixed overheads (salaries, heat, light, telephone,
and so on) and its variable costs will amount to half the revenue.
Draw up a cash flow table as per Table 32.5 to find out:
1 the company’s forecast cash position at the end of June
2 the maximum level of overdraft the owners will need to negotiate
with the bank before starting up.

Table 32.5 Cash flow (all figures in £000s)

Data response 2
Cash problems at a pound store
PoundLandline was quickly a media success after opening day publicity
due to a row between the online start-up and the long-established
Poundland retail chain. As the row spread over social media, opening
day sales through PoundLandline were eight times higher than the
budget. At 3.00pm, the site crashed – incapable of dealing with all the
hits to its website. Founders Sonia and Colin had set the site up with
an expectation of selling 8,000 items a day at £1 each, leading to
annual revenue of £2.8 million but with slim gross margins and
therefore gross profit of £420,000. With fixed overheads of £200,000
(covering the warehouse rental and other costs), they anticipated a
very satisfactory net profit.
The problem now was the cost of fixing the website crash. They
needed extra bandwidth and a more robust site. Although Colin was a
very good programmer, he needed to hire extra expertise. Their budget
had ‘been too tight for contingency allowances’, according to Sonia, so
this was a strain on cash flow. A second issue was that high sales
would mean speedy purchasing of extra stock – and paying for it.
There was much to be done.
An underlying problem faced by the two entrepreneurs had been the
unhelpful attitude of the banks. Despite TV advertisements boasting
how much banks help small firms, Sonia and Colin had found them
unwilling to commit to the slightest risk. Therefore, they refused to give
bank loans and would only provide an overdraft when guaranteed by
the security of Sonia’s flat. If things went wrong, even though the
business was PoundLandline Ltd, Sonia could end up homeless. As
shown in the cash flow forecast, the pair had needed to invest
£54,000 to get the business up and running. That was the limit of their
financial resources.
So now, with customers desperate to shop at the first online pound
store, the entrepreneurs had a cash flow problem – on day one of
month one! The carefully constructed cash flow forecast was already
being disrupted.
Figure 32.4 Cash flow forecast for PoundLandline Ltd
Questions
(35 marks; 40 minutes)
1 a) Explain the day one cash flow problems at PoundLandline Ltd.
(5)
b) Assess whether Sonia and Colin could be blamed for these
causes of the cash flow difficulties.
(10)
2 Given the situation the business was in by the end of day one,
evaluate the actions the entrepreneurs might take to overcome their
cash flow problems.
(20)
Extended writing
1 Evaluate the importance of cash flow forecasting for a new retail
business.
(20)
2 ‘Cash flow management is important for small companies but not for
large companies.’ Evaluate this statement.
(20)
Section 2.2 Financial planning

33 Sales forecasting
Definition
Forecasting is the art and science of estimating future sales or costs
with accuracy.

Linked to: Market research, Ch 3; Demand, Ch 5; Income

elasticity of demand, Ch 9; Planning and cash flow, Ch 32;
Business failure, Ch 39.

33.1 Purpose of sales forecasts

It is very important for managers to look ahead. They need to think about what
is likely to happen in their industry and prepare accordingly in all areas of the
business. One of the most important forecasts that needs to be made is the sales
forecast. This forms the basis of most of the other plans within the
organisation. For example:
• the human resource plan will need to be based on the expected level of sales;
a growth in sales may require more staff
• the cash flow forecast will depend on projected sales
• profit forecasts will depend on the level of revenue predicted
• production scheduling will depend on the level of output required.
The sales forecast therefore drives many of the other plans within the business
and is an essential element of effective management planning.
When a business starts up, it is extremely difficult to interpret its sales data. An
ice cream parlour that starts up in April may find that sales double in May,
again in June and again in July. Excited by the business success, the
entrepreneurs may rush to open a second outlet. Yet a wet August may see sales
knocked back followed by a sales slump in the autumn. The business may be
overstretched and in liquidation by February.
As long as a business can survive the first year or two, managers can start to
interpret the sales data. Managers need to understand the trend in product sales
and compare it to the market as a whole.
‘Entrepreneurs can’t forecast accurately because they are trying something
fundamentally new. So they will often be laughably behind plan – yet on the
brink of success.’
Eric Ries, business author

Real business
Booths has reduced the amount of fresh stock wastage by 20 per cent
since adopting new forecasting software. This saved ‘a six-figure sum’
in the ten months since it was introduced. The 30-strong supermarket
chain has faced the same competitiveness pressures as every other
grocer in 2014, so the cost saving is a great help. The forecasting
system analyses historic sales and weather data to identify demand
patterns for individual products, stores and events (such as the FA Cup
Final). The greater accuracy of the sales forecasts has not only
allowed Booths to hold lower stock levels but has also boosted
product availability. Both these factors will help profitability.

33.2 Factors affecting sales forecasts

Consumer trends
Consumer tastes and habits change over time. The changes can be quite
dramatic. Sales of fruit juice were growing steadily until worries about the
(natural) sugar in fruit made sales fall away in the last few years. And the
desire for greater personal convenience and freedom has boosted sales of a
wide range of products, from crisps to mobile phones.
A natural way for a forecaster to deal with this is to plot the past (historic)
trends and then consider what the likely future pattern will look like. An
interesting case is that of Beechams Powders, a long-established remedy for
colds. As shown in Figure 33.1, sales were rising until 2009 but have been
sliding ever since. This is in line with the general market for ‘winter
remedies’. The actual data is from 2006 to 2014, but an Excel sales forecast
based on the polynomial trend (don’t worry about this technicality) suggests
that sales will have fallen from £27.7 million in 2014 to £21 million in 2016.
Of course, data such as this is affected by more than consumer trends.
Although people are no more likely to catch a cold or flu in a cold winter,
consumers buy more remedies when it is cold. So a particularly bad winter in
2015/2016 could help sales to buck the trend.

Figure 33.1 Sales of Beechams cold products (source: The Grocer

magazine)
Factors that affect medium-to-long term consumer trends:
• changing tastes and habits, such as concern for body shape and image, or the
trend for time-saving devices, eating and lifestyle
• demographics, such as the ageing of the population; the over-80s category is
expected to double in Britain by 2025; this creates huge new business
opportunities
• globalisation, both as a force in business and due to more adventurous
holidaymaking; not long ago Mexican food was niche; now it’s mass market
• affluence; the idea of buying water was unthinkable in the past; now it is a
£750 million market – and still growing.

Economic variables
Many products, such as Marmite, chocolate, toothpaste, umbrellas and paint,
have sales that are largely proof against changes in the economy. Others are
highly sensitive because their income elasticity is high. In other words, their
sales are heavily dependent on changes in consumers’ real incomes. In the first
half of 2014, with the UK’s growth rate at 3 per cent, sales of Rolls-Royce cars
rose by 33 per cent, implying an income elasticity of +11.
Other economic variables that could affect a sales forecast include:
• a sharp fall in the pound, making imports to the UK more expensive, which
might help boost the sales of UK produced products (as imported ones price
themselves out of the market); so the sales forecast for a UK manufacturer
might prove overly cautious
• a sharp rise in taxation, such as the 2010 coalition government’s VAT
increase from 17.5 to 20 per cent; this hit sales of many items, especially
‘big ticket’ ones such as cars and carpets
• inflation; this can be a factor if price rises are not being matched by rises in
household incomes – consumers will suffer a fall in the spending power as
their real incomes decline.

Actions of competitors
In the period 2010–2013, Samsung could do no wrong in the market for
mobile phones. Its Galaxy models outsold Apple’s iPhone. At the beginning of
2014, Samsung looked forward to a successful year boosted by the launch of
its Galaxy 5 phone. In fact, Chinese manufacturers such as Huawei (which saw
sales jump from 10.4 million to 20.3 million units) took the Samsung market
share from the bottom of the market, while the iPhone 6 saw Apple retake
market share at the top end. Samsung’s share of the global smartphone market
fell from 32.3 per cent in 2013 to 25.2 per cent in 2014, causing actual sales
volumes to decline. The actions of its competitors undermined Samsung’s
sales forecast.
Figure 33.2 Logic balance: factors in successful forecasting

33.3 Difficulties of sales forecasting

The simplest way of predicting the future is to assume that it will be just like
the past. For the immediate future, this may be realistic. It is unlikely (though
not impossible) that the economy or demand will change dramatically
tomorrow. Therefore, it is reasonable to assume that the pattern of near-term
future sales will continue to follow recent trends.
Forecasting based on the continuation of past trends is known as extrapolation.
It is overwhelmingly the most common form of forecasting and is the basis of
almost all economic forecasts. Unfortunately, by definition, it will only be
correct if the future does continue to be like the past. Sometimes that will work;
at other times it will be disastrously wrong.
‘It’s tough to make predictions, especially about the future.’
Yogi Berra, legendary baseball coach
When Branston launched tomato ketchup, sales grew rapidly between 2006 and
2010. It would have been fair, on the basis of the data, to forecast a great future
for the brand – see Figure 33.3.

Figure 33.3 Branston Ketchup sales, 2005–2010, with extrapolated

future sales
In fact, what happened after 2010 was that sales of the brand collapsed.
Retailers had been stocking it as a rival to Heinz, but consumer sales were too
weak to support it. So it started to lose distribution. The extrapolated forecast
suggested sales of £15 million by 2012. As Figure 33.4 shows, the actual sales
were no more than £3.5 million in 2012. 2010 proved to be the sales peak
rather than a stepping stone towards a higher peak. This illustrates the
difficulties of making a sales forecast.
Figure 33.4 Actual Branston Ketchup sales, 2005–2013
‘There are known knowns. These are things we know that we know. There
are known unknowns. That is to say, there are things that we know we don’t
know. But there are also unknown unknowns. There are things we don’t
know we don’t know.’
Donald Rumsfeld, US politician

Real business
When a young couple decided to open a brand new fish and chip shop
in Nottingham, they made a sales forecast based on the average sales
turnover of established outlets across the country. On the ‘Federation
of Fish Fryers’ website, they found that the British eat £1.2 billion
worth of fish and chips a year, and there are 10,500 chip shops.
Therefore, the average chippie has sales of £1.2 billion / 10,500 =
£114,286 a year (£2,200 a week). They then assumed that it would
take a while to get established, so they used the following sales
forecast:
Week 1: £1,600
Week 2: £1,800
Week 3: £2,000
Week 4 and thereafter: £2,200
At the time of writing, their finance is in place but they haven’t opened
yet. So the accuracy of the forecast is unknown.

Five whys and a how

33.4 Sales forecasting – evaluation
Sales forecasts are important to every business because so many other plans
rely on them. They determine how many people to employ, how much to
produce and decisions on future production capacity. They may not always be
accurate, but they can provide important guidelines for planning.
A badly run business will find itself in a crisis because its forecast proves
inaccurate. An intelligent manager tries hard to predict with precision, but
thinks about the effect of sales being unexpectedly high or low. Nothing
demoralises staff more than a sudden lurch by management (hiring one
minute, firing the next). So the future needs to be thought through carefully,
with contingency plans in case things turn out rather differently from forecast.
‘You don’t want to influence the same system you are trying to forecast.’
Nate Silver, US forecasting guru

Key terms
Contingency plans: plans held in reserve in case things go wrong – for
example, a cash flow forecast based on sales being 10 per cent lower
than expected.
Real incomes: changes in household incomes after allowing for
changes in prices, i.e. percentage change in household income minus
inflation = real income.
Sales forecast: a method of predicting future sales using statistical
methods.
Trend: the general path that a series of values (for example, sales)
follows over time, disregarding variations or random fluctuations.

33.5 Workbook
Revision questions
(30 marks; 30 minutes)
1 What is a sales forecast?
(2)
2 Explain how you can show the trend in a series of data.
(4)
3 Explain how two of the following Heinz managers could be helped by
two weeks’ warning that sales are forecast to rise by 15 per cent:
a) the operations manager
b) the marketing manager, Heinz Beans
c) the human resource manager
d) the chief accountant.
(8)
4 Trends are important in sales forecasting, and can be affected by
fashion. Outline two factors that might lead to a product falling out
of fashion.
(4)
5 Marks & Spencer is forecasting a sales increase of 2 per cent in the
coming year. Explain how two possible actions by rivals Next and
John Lewis might cause actual sales to perform less well than this.
(6)
6 What is meant by an ‘economic variable’?
(2)
7 Explain briefly how Superdry’s brand owner, Supergroup plc, might
make use of contingency planning.
(4)
Data response
Bikes from India
In the 1960s, the British motorcycle industry was wiped out by
competition from Japan: Honda, Yamaha Suzuki and Kawasaki. An
important part of Britain’s motorcycle heritage was Royal Enfield,
which went bust, though the brand ended up in the hands of an Indian
company: the Eicher Group. This group built a substantial business in
India based on the brand Royal Enfield. In 2013, around 175,000
Royal Enfield bikes were produced (more than double the entire UK
motorbike market).

Figure 33.5 Royal Enfield motorbike

With plans to expand output to 250,000 in 2014, the Eicher Group
was eyeing the UK market. It wanted to export 5,000 bikes to Britain,
which would mean taking a 6 per cent market share. It believes that its
market potential is rooted in the fastest growing UK biker
demographic: oldie bikers – that is, those aged 55+. Today younger
people are more likely to ride a bike than a motorbike. Fears of
accidents have made motorbikes a tough sell to younger people.
Eicher Motor’s chief executive, Siddhartha Lal, says that, following
secondary research, his group is targeting ‘a nostalgic population of
older and wealthier leisure riders’. With a price tag set at £5,200 for
the October 2013 launch of the Royal Enfield Continental GT, the pitch
certainly was at the wealthier end of the market.

Figure 33.6 Annual UK motorbike sales, 2006–2013 (source:

www.mcia.co.uk)
In the UK, the most obvious direct competitor to the Enfield bike is the
rival heritage brand Triumph, the UK’s top-selling bike. Although these
bikes are made in Thailand, the brand owner has successfully
recreated a British image to the Triumph brand, which adds value. The
Royal Enfield is priced at £1,000 below the equivalent Triumph, but it
has yet to be seen whether British bikers will trust in the quality
standards of bikes from India.
There is another demographic that is not yet being targeted by Eicher.
According to a 24-year-old British biker who rented a Royal Enfield
during a year-long stay in India, the bikes: ‘occupy cult status in India.
Countless heroes of Bollywood films have been shown riding them…
The look and feel of the thing, the rawness of the engine, the noise:
everyone is obsessed by that.’ So perhaps there are also prospects
among wealthier Indians living in Britain. Fortunately for Eicher, 56 per
cent growth in revenues in 2012 to £120 million gave the group a
degree of financial solidity, which makes success in the UK launch
desirable but not essential.
One other factor that Eicher will need to face in Britain is the highly
seasonal nature of bike sales. In January, people think of warm coats,
not bikes, so the sales season is limited to the summer months.

Figure 33.7 Monthly sales of motorbikes in the UK, January 2012–

August 2013 (source: www.mcia.co.uk)
All in all, the future of this UK launch seems uncertain. An early review
of the Continental GT raises doubts about the ‘build compromises’,
even though it praises the road handling and general modernity of the
bike. Siddhartha Lal is hoping that UK success will kickstart a global
push by Royal Enfield into export markets. It remains to be seen.
Questions (40 marks; 45 minutes)
1 Use Figure 33.6 to assess one reason in favour and one reason
against launching into the UK market for motorbikes in 2013.
(8)
2 Assess how a British motorcycle producer might use the sales trend
information provided in Figures 33.6 and 33.7.
(10)
3 Use Figure 33.7 to assess the possible difficulties created for a
motorbike manufacturer from the strongly seasonal sales pattern in
the UK market.
(10)
4 Assess whether Eicher is right to price the Royal Enfield CT at
£1,000 below the equivalent Triumph bike.
(12)
Extended writing
1 Evaluate this statement: ‘Since we can never know the future, it is
pointless trying to forecast it.’
(20)
2 ‘Quantitative sales forecasting techniques have only limited use.
Qualitative judgements are needed in a constantly changing world.’
Evaluate this statement.
(20)
Section 2.2 Financial planning

34 Sales, revenue and costs

Definition
Revenue is the value of total sales made by a business within a period,
usually one year. Costs are the expenses incurred by a firm in
producing and selling its products, such as wages and raw materials.

Linked to: Sales forecasting, Ch 33; Break-even, Ch 35; Profit,

Ch 37.

34.1 Sales
There are two ways to measure sales: by volume and by value. Sales volume is
simply the number of units sold – for example, Toyota’s global sales of ten
million cars in 2014 (the world’s number one producer). Sales revenue is what
those units were sold for – in other words, volume × price. If the average
Toyota sold for £15,000, that would put the value of its 2014 sales at the
stunning figure of £150 billion.
Sales volume × Price = Sales revenue
Toyota: 10 million cars × £15,000 = £150,000 million
Jaguar Land Rover: 430,000 cars × £45,000 = £19,350 million
(2013/2014)
For companies, calculating volume sales is easy. But sales revenue can be
more difficult. Many products are sold on credit, so although the sale has been
made, until the payment arrives there is scope for uncertainty. When La Senza
went into liquidation in 2014, millions of pounds owed to suppliers went
unpaid. Those supplier companies had to ‘write-off’ the sales revenue they
thought they had achieved. Infuriating.

34.2 Business revenues

The revenue received by a firm as a result of trading activities is a critical
factor in its success. Entrepreneurs start their financial planning by assessing
the revenue that they are likely to receive during the coming financial year. A
firm seeking to increase its revenue can plan to sell more or aim to sell at a
higher price. Some firms may maintain high prices even though this policy
depresses sales. Such companies, perhaps selling fashion and high-technology
products, believe that in the long run this approach will lead to higher revenue
and higher profits.

Real business
Blackberry’s falling revenue
In the three months ending 30 November, Blackberry saw its revenue
plunge from £1,660 million in 2012 to £730 million in 2013. The reason
for the 56 per cent fall in revenue was a collapse in phone sales from
3.7 million to 1.9 million, plus a fall in the average price charged per
Blackberry. The company had pinned everything on a new range of
phones based on a new operating system – but it proved unable to
dent sales of the iPhone and the Samsung Galaxy. As a consequence
of the revenue decline, Blackberry made losses of £2.7 billion in its
third quarter of 2013.

The other way to boost revenue is to charge a low price in an attempt to sell as
many units as possible. The high sales volumes may lead to high revenues and
profits. Firms following this approach are likely to be operating in markets in
which the goods are fairly similar and consumers do not exhibit strong
preferences for any brand. This is true of the market for young holidaymakers
going to Spain or Thailand. Price competition is fierce as businesses seek to
maximise their revenue.
Traditionally, companies printed price lists that might run for 12 months.
These days online purchasing makes variable pricing more common – that is,
allowing prices to rise and fall depending on demand and supply conditions.
This is a way to maximise revenue, by charging high prices when demand is at
its highest, but much more modestly during periods of low demand. Football
teams such as West Ham do something similar, offering ‘Kids for a Quid’
when their home game is against an unfashionable opponent, such as Stoke
City.

Evaluation
Price manipulation for maximised revenue
In a world increasingly dominated by online purchasing, businesses
have the ability to vary prices to maximise revenue. This is quite open
with airline prices – for example, the easyJet Sunday 11.40am flight to
Barcelona was priced at £108.99 for 28 December 2014, £44.99 for 25
January 2015 and £149.99 for 15 February 2015 (prices as at 20
December 2014). But it is less clear-cut with online purchasing of
insurance, where the same car might cost £475 to insure in the
morning and £650 in the afternoon, as the sellers try to reward those
who can be bothered to spend time shopping around. As the saying
goes: let the buyer beware!

‘Today, recorded music is more a marketing tool than a revenue source.’

Irving Azoff, manager to Christine Aguilera and The Eagles

34.3 The costs of production

Costs are a critical element of the information necessary to manage a business
successfully. Managers need to be aware of the costs of all aspects of their
business for a number of reasons:
• They need to know the cost of production to assess whether it is profitable to
supply the market at the current price.
• They need to know actual costs to allow comparisons with their forecasted
(or budgeted) figures. This will allow them to make judgements concerning
the cost efficiency of different parts of the business.
‘Watch the costs and the profits will look after themselves.’
Andrew Carnegie, US steel magnate (at one time, the world’s second
richest man)

Fixed and variable costs

This is an important classification of the costs encountered by businesses. This
classification has a number of uses. For example, it is the basis of calculating
break-even, which is covered in Chapter 35.
Fixed costs
Fixed costs are any costs that do not vary directly with the level of output.
These costs are linked to time rather than to level of business activity. Fixed
costs exist even if a business is not producing any goods or services. An
example of a fixed cost is rent, which is usually calculated monthly, but will
remain the same whether business is great or awful that month. The landlord
doesn’t care; s/he just wants to be paid!
If a manufacturer can double output from within the same factory, the amount
of rent will not alter, thus it is a fixed cost. In the same way, a seaside hotel has
mortgage and salary costs during the winter, even though there may be very
few guests. Given that fixed costs are inevitable, it is vital that managers work
hard at bringing in customers to keep the fixed costs covered.

Figure 34.1 Fixed costs of £50,000 per year

In Figure 34.1, you can see that the firm faces fixed costs of £50,000
irrespective of the level of output.
Other examples of fixed costs include the uniform business rate (local taxes),
management salaries, interest charges and depreciation.
In the long term, fixed costs can alter. The manufacturer referred to earlier
may decide to increase output significantly. This may require renting
additional factory space and negotiating loans for additional capital equipment.
Thus rent will rise, as may interest payments. We can see that in the long term
fixed costs may alter, but that in the short term they are – as their name
suggests – fixed.

Variable costs
Variable costs are those costs which vary directly with the level of output.
They represent payments made for the use of inputs such as labour, fuel and
raw materials. If a manufacturer doubled output, then these costs would double.
A doubling of the sales of Innocent Strawberry Smoothies would require twice
the purchasing of strawberries and bananas. There would also be extra costs
for the packaging, the wage bill and the energy required to fuel the production
line.

Figure 34.2 Variable costs of £8 per unit

The graph in Figure 34.2 shows a firm with variable costs of £8 per unit of
production. This means that variable costs rise steadily with, and
proportionately to, the level of output. Thus a 10 per cent rise in output will
increase total variable costs by the same percentage.
However, it is not always the case that variable costs rise in proportion to
output. Many small businesses discover that, as they expand, variable costs do
not rise as quickly as output. A key reason for this is that, as the business
becomes larger, it is able to negotiate better prices with suppliers. Its suppliers
are likely to agree to sell at lower unit prices when the business places larger
orders.
Examples of some variable, fixed and hard-to-classify costs are given in Table
34.1.

Table 34.1 Some costs are easy to classify; some are hard

Total costs
When added together, fixed and variable costs give the total costs for a
business. This is, of course, a very important element in the calculation of the
profits earned by a business.
The relationship between fixed, variable and total costs is straightforward to
calculate but has some important implications for a business. If a business has
relatively high fixed costs as a proportion of total costs, then it is likely to seek
to maximise its sales to ensure that the fixed costs are spread across as many
units of output as possible. In this way, the impact of high fixed costs is
lessened.
Figure 34.3 Logic chain: cutting costs
‘On the internet, companies are scale businesses, characterised by high
fixed costs and relatively low variable costs.’
Jeff Bezos, founder of Amazon

Real business
Paying the costs
In 2012, Scoop opened its third London ice cream parlour. The
company intended to continue making all the ice cream at the original
Covent Garden store, but deliver ice cream daily to the new branch at
Gloucester Road (two miles away). This meant that all the fixed
production costs would remain unchanged (rent on the floor space, the
machinery and the professional ice cream maker’s salary). Variable
costs would increase by around 50 per cent, as long as the new
parlour’s sales matched the first two. These costs would be the
ingredients, especially milk, cream and sugar; plus the cost of the
electricity to run the ice cream-making machines. There would also be
some brand new fixed costs: an extra refrigerated van, plus the rent
and the staff at the new premises. Overall, owner Matteo Pantani
knew that he could increase his revenue by 50 per cent, while total
costs should increase by no more than 30 per cent. This should boost
profit considerably.

Five whys and a how

34.4 Sales, revenue and costs – evaluation
One important issue for evaluation in relation to revenues and costs for a new
enterprise is to judge the likely accuracy of the forecast figures and the degree
of reliance that can be placed upon them. This is an important judgement for a
number of people who may have an interest in the new business. Investors will
look closely at any forecast figures before committing money to the
enterprise, and suppliers will want to be assured of payment before agreeing to
supply any raw materials.
Ultimately, the test of management is whether it can keep revenues rising faster
than costs. This might be quite easy when the economy is on the up, but
extremely hard when a recession is underway. So it is always wise to reflect on
the circumstances of the business.

Key terms
Fixed costs: those that do not change as the number of sales change
(for example, rent or salaries).
Piece-rate labour: paying workers per item they make – that is, without
regular pay.
Sales revenue: the number of units sold in a time period multiplied by
the average selling price of those units.
Sales volume: the number of units sold in a time period, e.g. a year.
Total costs: all the costs of producing a specific output level, i.e. fixed
costs plus total variable costs.
Total variable costs: all the variable costs of producing a specific
output level – that is, variable costs per unit multiplied by the number
of units sold.
Variable costs: those that change in line with the amount of business
(for example, the cost of buying raw materials).

34.5 Workbook
Revision questions
(25 marks; 25 minutes)
1 Why may a business initially receive relatively low revenues from a
 product newly introduced to the market?
(3)
2 State two circumstances in which a company may be able to charge
high prices for a new product.
(2)
3 For what reasons may a firm seek to maximise its sales revenue?
(3)
4 If a business sells 4,000 units of Brand X at £4 each and 2,000
units of Brand Y at £3 each, what is its total revenue?
(4)
5 State two reasons why firms have to know the costs they incur in
production.
(2)
6 Distinguish, with the aid of examples, between fixed and variable
costs.
(4)
7 Explain why fixed costs can only alter in the long term.
(3)
8 Examine the view that ‘cost-cutting is a short-sighted approach to
business’.
(4)
Calculation practice questions
(25 marks; 25 minutes)
1 During the summer weeks, Devon Ice Cream has average sales of
4,000 units a week. Each ice cream sells for £1 and has variable
costs of 25p. Fixed costs are £800.
a) Calculate the total weekly costs for the business in the summer
weeks.
(3)
b) Calculate Devon Ice Cream’s weekly revenue in the summer.
 (2)
2 a) If a firm sells 200 Widgets at £3.20 and 40 Squidgets at £4,
calculate its total revenue.
(3)
b) Each Widget costs £1.20 to make, while each Squidget costs
£1.50. Calculate the firm’s total variable costs.
(3)
3 ‘Last week our sales revenue was £12,000, which was great. Our
price is £2 a unit, which I think is a bit too cheap.’
a) Calculate how many unit sales were made last week.
(2)
b) If a price rise to £2.25 cuts sales to 5,600 units, calculate the
change in the firm’s revenue.
(4)
c) Express that change in revenue as a percentage.
(3)
4 At full capacity output of 24,000 units, a firm’s costs are as follows:
• managers’ salaries: £48,000
• materials: £12,000
• rent and rates: £24,000
• piece-rate labour: £36,000.
Calculate the firm’s total costs at 20,000 units.
(5)
Data response
Chalfont Computer Services Ltd
Robert has decided to give up his job with BT and to work for himself
offering computer services to local people. He has paid off his
mortgage and owns his house outright, so feels this is the time to take
a risk. Robert has no experience of running a business, but is skilled in
repairing computers and solving software problems. In the past, Robert
has repaired computers belonging to friends and family and is aware of
the costs involved in providing this service. He believes that with the
increase in internet usage there will be plenty of demand for his
services. Robert has spoken to a few people in his local pub and this
has confirmed his opinion. Robert needs to raise £10,000 to purchase
equipment for his business and to pay for a new vehicle and intends to
ask his bank for a loan.
The work Robert has already done allows him to forecast that the
average revenue from each customer will be £40, while the variable
costs will be £15. His monthly fixed costs will be £1,000. Table 34.2
gives Robert’s estimates of the number of customers he expects to
have.

Table 34.2 Estimates of number of customers

Questions (25 marks; 30 minutes)
1 What is meant by the term ‘variable costs’? Give an example.
(2)
2 Robert estimates that if he cut his prices by 10 per cent, he would
have 20 per cent more customers each month.
a) Calculate the outcome of these changes.
(3)
b) Assess whether this change would benefit Robert.
(10)
3 Assess the case for and against a bank lending Robert £10,000 on
the basis of his forecast profits.
(10)
Extended writing
1 In 2014, Tesco plc suffered a slide in its sales, with weekly data
showing a 4 per cent decline compared with 2013. Evaluate how a
supermarket chain such as Tesco could set about rebuilding its sales
revenue.
(20)
2 When a rival surfing school opened next door, ‘Jo’s Surf School’ saw
a sharp fall in sales. Evaluate the most important actions it should
take to rebuild its sales revenue.
(20)
Section 2.2 Financial planning

35 Break-even
Definition
Break-even compares a firm’s revenue with its fixed and variable costs
to identify the minimum level of sales needed to cover costs. So break-
even is the point at which total fixed costs + total variable costs = total
revenue.

Linked to: Sales, revenue and costs, Ch 34; Profit, Ch 37.

35.1 Introduction
Businesses need to know how many products they have to produce and sell in
order to cover all of their costs. This is particularly important for new
businesses with limited experience of their markets.
Look at Table 35.1, which shows forecast revenue and cost figures for a new
business.
Table 35.1 Forecast revenue and cost figures for a new business ltd
You can easily identify that 400 is the number of sales that must be achieved
each week to break even. If sales are only 200 units, the business will be
making losses of a punishing £5,000 a week, so the break-even analysis is
providing vital data.
To calculate the break-even point, we need information on both costs and
prices. Break-even can be shown on a graph or, more quickly, calculated as in
the following section.

35.2 Calculating the break-even point

Calculating the break-even point for a product requires knowledge of:
• the selling price of the product
• its fixed costs
• its variable costs per unit.
Fixed costs are expenses which do not change in response to changing demand
or output, such as rent and salaries. Variable costs will alter in relation to
changes in demand and therefore output. A doubling of demand will double
variable costs, but leave fixed costs the same.
The break-even output level can be calculated by the following formula:

Worked example:
Igloo ice cream costs 50p per unit to make and is sold for £2.50. The fixed
costs of running the production process and the shop amount to £2,000 per
week. Therefore, the break-even output level is:
So although a £2 surplus per ice cream seems a lot of profit, it is only the
1001st that really makes £2. Before getting to the break-even point, each ice
cream sold is simply reducing the losses.
‘[HMV] is now in danger of failing to break even in the full-year.’
Nick Bubb, retail analyst (in December 2011, not long before the company
collapsed into administration)

35.3 Contribution
In the above formula for break-even, price minus variable costs is known as
contribution. It is the surplus of £2 between the £2.50 selling price and the
variable costs of 50p per unit.
Contribution per unit = selling price minus variable costs per unit
Total contribution = contribution per unit × quantity sold
So, in the above example, if 1,200 ice creams were sold, the total contribution
would be:

Total contribution is a useful short-cut way to calculate profit, as:

Total contribution − Fixed costs = Profit
So:

35.4 Break-even charts

A break-even chart is a graph showing the revenue and costs for a business at
all possible levels of demand or output. The break-even chart uses the
horizontal axis to represent the output per time period for the business – for
example, between 0 and 1,000 units a month. The vertical axis represents costs
and sales in pounds.
Figure 35.1 Logic chain: boosting total contribution

Real business
Example: Berry & Hall Ltd
Berry & Hall Ltd manufactures confectionery. The company is planning
to launch a new sweet called Aromatics at a price of £5 per kg. The
variable cost of production per kg is forecast at £3 and the fixed costs
associated with this product are estimated to be £50,000 a year. The
company’s maximum output of Aromatics will be 50,000kg per year.
First, put scales on the axes. The horizontal output scale has a range
from zero to the company’s maximum output of 50,000kg. The vertical
axis records values of costs and revenues. For the maximum vertical
value, multiply the maximum output by the selling price and then place
values on the axis up to this figure. In this case, it will have a maximum
value on the axis of £250,000 (£5 per kg × 50,000kg).
Having drawn the axes and placed scales upon them, the first line we
enter is fixed costs. Since this value does not change with output, it is
simply a horizontal line drawn at £50,000.
Figure 35.2 Fixed costs for Aromatics
Next, add variable costs to the fixed costs to arrive at total costs.
Total costs start from the left hand of the fixed costs line and rise
diagonally. To see where they rise to, calculate the total cost at the
maximum output level. In the case of Aromatics, this is 50,000kg per
year. The total cost is fixed costs (£50,000) plus variable costs of
producing 50,000kg (£3 × 50,000 = £150,000). The total cost at this
level of output is £50,000 + £150,000 = £200,000.
This point can now be marked on the chart; that is, £200,000 at an
output level of 50,000kg. This can be joined by a straight line to total
costs at zero output: £50,000. This is illustrated in Figure 35.3.
Figure 35.3 Fixed, variable and total costs for Aromatics
Finally, sales revenue must be added. For the maximum level of
output, calculate the sales revenue and mark this on the chart. In the
case of Aromatics, the maximum output per year is 50,000kg;
multiplied by the selling price, this gives £250,000 each year. If Berry &
Hall does not produce and sell any Aromatics, it will not have any sales
revenue. Thus zero output results in zero income. A straight diagonal
line from zero to £250,000 represents the sales revenue (see Figure
35.4).
Figure 35.4 Break-even output for Aromatics
This brings together costs and revenues for Aromatics. A line drawn
down from the point at which total costs and sales revenue cross
shows the break-even output. For Aromatics, it is 25,000kg per year.
This can be checked using the formula method explained earlier.

35.5 Using break-even charts

Various pieces of information can be taken from break-even charts such as that
shown in Figure 35.4. As well as the level of break-even output, it also shows
the level of profits or losses at every possible level of output. Many
conclusions can be reached, such as:
• Any level of output lower than 25,000kg per year will mean the product is
making a loss. The amount of the loss is indicated by the vertical distance
between the total cost and the total revenue line.
• Sales in excess of 25,000kg of Aromatics per year will earn the company a
profit. If the company produces and sells 30,000kg of Aromatics annually, it
will earn a profit of £10,000.
• The margin of safety: this is the amount by which demand can fall before the
firm starts making losses. It is the difference between current sales and the
break-even point. If annual sales of Aromatics were 40,000kg, with a break-
 even output of 25,000kg, then the margin of safety would be 15,000kg.
margin of safety = sales minus break-even point
margin of safety = 40,000 − 25,000 = 15,000 kg
The higher the margin of safety, the less likely it is that a loss-making situation
will develop. The margin of safety is illustrated in Figure 35.5.

Figure 35.5 Margin of safety

Table 35.2 shows how changes in business circumstances affect the break-even
chart.
Table 35.2 How changes in business circumstances affect the break-
even chart

35.6 The effects of changes in price, output and cost

On its own, a limitation of the break-even chart is that it is a static model. It
does not show sales trends over time. Fortunately, it can be a useful method for
showing when changes are planned – for example, when the business is
considering a price increase.
The main changes to consider are:
1 the impact on revenue, profits and break-even of a change in price
2 the impact on revenue and profits of change in demand, perhaps because the
product has become more or less fashionable
3 the effect of a rise or fall in variable costs, such as raw materials
4 the effect of a rise or fall in fixed costs, perhaps when a business chooses to
‘downsize’ to smaller, cheaper head office premises.

Price rise
If a company increases its prices, its revenue line will rise more steeply than
before. The line will start at the same point as before (0 sales = 0 revenue) but
will rise to a higher revenue point at maximum output. This steepening of the
revenue line will increase the profit potential at each level of output and lower
the break-even point. So if you charge more, you don’t need to sell as many to
break even. This is shown in Figure 35.6.

Figure 35.6 A rise in price

A rise or fall in demand

A change in demand has no effect on the lines of the break-even chart. It is
simply that you have to read the change off the chart by drawing a line
vertically up from the new sales quantity.

Rise in variable costs

Between March and November 2013, the price of cocoa beans rose from
$2,150 per tonne to $2,700. This 25 per cent increase would make the variable
costs line rise more steeply, though it will start from the same point (zero).
Naturally, if the variable costs rise, the total costs must also be affected. So if
an exam question asks you to show the effect on a break-even chart of a rise in
variable costs, you must also adjust the total cost line. This is shown in Figure
35.7 – though in relation to Aromatics, not cocoa beans.

Figure 35.7 A rise in variable costs

Fall in fixed costs

If a company’s sales are falling, it may be necessary to cut fixed costs in order
to lower the break-even point. The fall in fixed costs will cut the total costs. All
these things are indicated in Figure 35.8.
Figure 35.8 A fall in fixed costs

Evaluation
Summary of possible changes to the break-even chart to look out for
in an exam:
1 Prices can go up or down. If a price is increased, the revenue line
starts in the same place but rises more steeply.
2 Fixed costs can rise or fall, so you may have to draw a new
horizontal line. But remember that a change to fixed costs will also
affect the total cost line.
3 Variable costs can rise or fall. An increase will make the variable cost
line rise more steeply, though it will still start at the same point – at
the fixed cost line. A change in variable costs will change the total
costs line as well.
Note that each of these three changes will alter the break-even point.

‘Because break-even points shift as conditions change, break-even analyses

should be performed regularly, preferably on a quarterly basis.’

35.7 Interpretation of break-even charts

Break-even analysis is simple to understand; it is particularly useful for small
and newly established businesses, where the managers may not be able to
employ more sophisticated techniques. Businesses can use break-even to:
• estimate the future level of output they will need to produce and sell in order
to meet given profit objectives
• assess the impact of planned price changes upon profit and the level of
output needed to break even
• take decisions on whether to produce their own products or components or
whether to purchase from external sources.
Key factors in interpreting break-even charts include:
• understanding that profit can be estimated as the vertical difference between
the revenue line and the total costs line at any single level of output
• acknowledging that no company really has static sales – that is, the same
sales level per month or per year – yet this is what the break-even chart
assumes; it is important to remember that the chart is just a snapshot of a
point in time, when sales happen to be at a particular level.

35.8 Limitations of break-even analysis

The limitations of break-even analysis are set out below.
• The model is a simplification. It assumes that variable costs increase
constantly, which ignores the benefits of bulk buying. If a firm negotiates
lower prices for purchasing larger quantities of raw materials, then its total
cost line will no longer be straight.
• Similarly, break-even analysis assumes the firm sells all its output at a single
price. In reality, firms frequently offer discounts for bulk purchases.
• A major flaw in the technique is that it assumes that all output is sold. In times
of low demand, a firm may have difficulty in selling all that it produces.
• The most important practical limitation, though, is that it is a static model. It
does not take sales trends into account, so it is only true at a point in time. If
the horizontal axis represented time instead of quantity, one could show sales
trends and therefore have an idea about possible future profits or losses.

Five whys and a how

35.9 Break-even – evaluation
There is a risk in exams of assuming that break-even charts tell you ‘facts’.
Break-even analysis seems simple to conduct and understand. That assumes the
business knows all its costs and can break them down into variable and fixed.
Coca-Cola certainly can, but not every business is as well managed. Football
clubs such as Sheffield Wednesday, Portsmouth and Darlington have hit
financial problems partly because of ignorance of their financial
circumstances. Similarly, few NHS hospitals could say with confidence how
much it costs to provide a heart transplant.
Break-even analysis is of particular value when a business is first established.
Having to work out the fixed and variable costs will help the managers to make
better decisions, for example, on pricing. As long as the figures are accurate,
break-even becomes especially useful when changes occur, such as rising raw
material costs. The technique can allow for changing revenues and costs and
gives a valuable guide to potential profitability.

Key formulae

Contribution per unit: Selling price – Variable costs per unit

Margin of safety: Sales volume – Break-even output
Total contribution: Contribution per unit × unit sales

Key terms
Break-even chart: a line graph showing total revenues and total costs
at all possible levels of output or demand from zero to maximum
capacity.
Contribution: this is total revenue less variable costs. The calculation
of contribution is useful for businesses that are responsible for a range
of products.
Fixed costs: those that do not change as the number of sales change
(for example, rent or salaries).
Margin of safety: the amount by which current output exceeds the level
of output necessary to break-even.
Variable costs: those that change in line with the amount of business
(for example, the cost of buying raw materials).

35.10 Workbook
Revision questions
(25 marks; 25 minutes)
1 What is meant by the term ‘break-even point’?
(2)
2 State three reasons why a business may conduct a break-even
analysis.
(3)
3 List the information necessary to construct a break-even chart.
(4)
4 How would you calculate the contribution made by each unit of
production that is sold?
(2)
5 A business sells its products for £10 each and the variable cost of
producing a single unit is £6. If its monthly fixed costs are £18,000,
how many units must it sell to break even each month?
(3)
6 Explain why the variable cost and total revenue lines commence at
the origin of a break-even chart.
(3)
7 What point on a break-even chart actually illustrates break-even
output?
(2)
8 Explain how, using a break-even chart, you would illustrate the
amount of profit or loss made at any given level of output.
(2)
9 Why might a business wish to calculate its margin of safety?
(2)
10 A business is currently producing 200,000 units of output annually,
and its break-even output is 120,000 units. What is its margin of
safety?
(2)
Data response 1
An entrepreneur’s first hotel
Paul Jarvis is an entrepreneur and about to open his first hotel. He has
forecast the following costs and revenues:
• Maximum number of customers per month: 800
• Monthly fixed costs: £10,000
• Average revenue per customer: £110
• Typical variable costs per customer: £90
Some secondary market research has suggested that Paul’s prices
may be too low. He is considering charging higher prices, though he is
nervous about the impact this might have on his forecast sales. Paul
has found his break-even chart useful during the planning of his new
business, but is concerned that it might be misleading too.
Questions (45 marks, 45 minutes)
1 a) Construct the break-even chart for Paul’s planned business.
(9)
b) State, and show on the graph, the profit or loss made at a
monthly sales level of 600 customers.
(4)
c) State, and show on the graph, the margin of safety at that level of
output
(4)
2 Paul’s market research shows that in his first month of trading he
can expect 450 customers at his hotel.
a) If Paul’s research is correct, calculate the level of profit or loss he
will make.
(5)
b) Illustrate this level of output on your graph and show the profit or
loss.
(3)
3 Paul has decided to increase his prices to give an average revenue
per customer of £120.
 a) Draw the new total revenue line on your break-even chart to show
the effect of this change.
(3)
b) Mark on your diagram the new break-even point.
(1)
c) Calculate Paul’s new break-even number of customers to confirm
the result shown on your chart.
(6)
4 Paul is worried that his break-even chart may be ‘misleading’. Do
you agree with him? Justify your view.
(10)
Data response 2
The Successful T-Shirt Company
Shelley has recently launched the Successful T-Shirt Company. It sells
a small range of fashion t-shirts. The shirts are available in a range of
colours and contain the company’s logo, which is becoming
increasingly desirable for young fashion-conscious people.
The shirts are sold to retailers for £35 each. They cost £16.50 to
manufacture and the salesperson receives £2.50 commission for each
item sold to retailers. The distribution cost for each shirt is £1.00 and
current sales are 1,000 per month. The fixed costs of production are
£11,250 per month.
The company is considering expanding its range of t-shirts and has
approached its bank for a loan. The bank has requested that the
company draw up a business plan including a cash flow forecast and
break-even chart.
Questions (30 marks, 30 minutes)
1 What is meant by the term ‘break-even chart’?
(2)
2 Calculate the following:
a) the variable cost of producing 1,000 t-shirts
b) the contribution earned through the sale of one t-shirt.
 (6)
3 Shelley has decided to manufacture the shirts in Poland. As a result,
the variable cost per t-shirt (including commission and distribution
costs) will fall to £15 per t-shirt. However, fixed costs will rise to
£12,000.
a) Calculate the new level of break-even for Shelley’s t-shirts.
b) Calculate the margin of safety if sales are 1,000 t-shirts per
month.
(10)
4 Assess whether Shelley should rely on break-even analysis when
taking business decisions. Justify your view.
(12)
Data response 3
Start-up break-even analysis
On 27 September 2013, Mary’s Garden opened in Raynes Park, south
London. Mary’s Garden is a Japanese restaurant. It opened without
any fanfare; without even putting a menu outside for passers-by. This
was because, as at 1.30 that afternoon, ‘we haven’t decided on the
prices yet’. Amazingly, at 7.30 that evening, every table was taken.
The premises had been unused for more than a year, since an Indian
restaurant closed down. Accordingly, Mary’s had been able to
negotiate a stunningly low rent: £1,000 per month; business rates of
£500 a month must be added, however. By Monday 30 September,
Mary had been able to estimate a probable average spend of £40 per
customer, of which £15 goes on food costs and another £5 on other
variable costs. With staffing costs of £5,000 a month and other
monthly fixed costs amounting to £1,500, Mary’s Garden has most of
the information required for a break-even chart.
There remains one difficult issue, though: what is the maximum
capacity level of the restaurant? Amazingly, the current opening times
are from 9.00am to 11.00pm; it surely is the only Japanese restaurant
in suburbia offering a breakfast menu. The restaurant itself is small,
with just 25 seats. Theoretically, it could fill them lots of times in 14
hours, but it seems wise to bet on a maximum of just 50 customers per
day, six days a week, so 1,200 a month.
For break-even analysis, the above is sufficient, but for real business
insight there is one more critical variable: the actual level of customer
demand. In conversation with Mary’s son, it emerged that no research
has been done into this. My own local knowledge suggests that it
should be full on Friday and Saturday evenings, a third full on Monday–
Thursday and gain a smattering of breakfast and lunchtime customers
(until this loss-making approach is stopped). Overall, my estimate is for
500 customers a month.
Questions (20 marks; 25 minutes)
1 Calculate the total:
a) monthly fixed costs
b) variable costs per customer
c) contribution per customer.
(3)
2 Calculate the monthly:
a) break-even number of customers
b) margin of safety based on estimated customer numbers.
(5)
3 Outline three ways in which Mary’s Garden’s margin of safety could
be expanded.
(6)
4 a) Calculate the monthly profit based on the estimated number of
customers.
(3)
b) Calculate the monthly profit if customer numbers prove to be 50
per cent higher.
(3)
Extended writing
1 Evaluate the different ways in which break-even analysis might
benefit a new small business offering Thai food for takeaway and
delivery.
 (20)
2 Evaluate the extent to which break-even analysis might be of value
when running a business such as Primark, or any other business you
have researched.
(20)
Section 2.2 Financial planning

36 Budgets
Definition
A budget is a target for costs or revenue that a firm or department
must aim to reach over a given period of time. An income budget sets
a floor, i.e. a minimum target, while an expenditure budget sets a
ceiling, e.g. a maximum target for costs.

Linked to: Planning and cash flow, Ch 32; Sales forecasting, Ch

33.

36.1 The purpose of budgets

Budgeting is used:
• to ensure that no department or individual spends more than the company
expects, thereby preventing unpleasant surprises
• to provide a yardstick against which a manager ’s success or failure can be
measured (and rewarded)
For example, a store manager may have to meet a monthly sales budget of
£25,000 at a maximum operating cost of £18,000. As long as the budget
holder believes this target is possible, the attempt to achieve it will be
motivating. The company can then provide bonuses for achieving or beating
the profit target.
• to enable spending power to be delegated to local managers, who are in a
better position to know how best to use the firm’s money; this should
improve and speed up the decision-making process and help to motivate the
local budget holders
Management expert Peter Drucker refers to ‘management by self-control’.
He regards this as the ideal approach. Managers should have clear targets,
clear budgets and the power to decide how to achieve them. Then they will
try their hardest to succeed.
• to motivate the staff in a department – budget figures can be used as a clear
basis for assessing staff performance; then staff know what they must
achieve in order to be considered successful.
‘The budget is our guide. It tells us what we’re supposed to do for the year.
We couldn’t get along without it.’
Jim Bell, US factory manager

Figure 36.1 Budget holders

Real business
The BP disaster
On 23 March 2005, a huge explosion at BP’s Texas oil refinery killed
15 people and injured more than 180. Most were the company’s own
staff. After an inquiry, the chairwoman of the US Chemical Safety
Board reported that ‘BP implemented a 25 per cent cut on fixed costs
from 1998 to 2000 that adversely impacted maintenance expenditures
at the refinery’. The report stated that ‘BP’s global management [the
British head office] was aware of problems with maintenance spending
and infrastructure well before March 2005’. Yet they did nothing about
it. The chairwoman delivered the final critique: ‘Every successful
corporation must contain its costs. But at an ageing facility like Texas
City, it is not responsible to cut budgets related to safety and
maintenance without thoroughly examining the impact on the risk of a
catastrophic accident.’ BP confirmed that its own internal investigation
had findings ‘generally consistent with those of the CSB’.
In 2010, there was an echo of this disaster when an explosion on a BP
well in the Gulf of Mexico killed 11 people and caused the biggest oil
spill in American history. By 2014, the costs associated with this had
forced BP to sell off more than $42 billion of assets, wiping out a fifth
of the value of the company. Cost cutting can be costly.
Source: adapted from Topical Cases, www.a-zbusinesstraining.com

36.2 How to construct a budget

Budgeting is the process of setting targets, covering all aspects of costs and
revenues. It is a method for turning a firm’s strategy into reality. Nothing can
be done in business without money; budgets tell individual managers how
much they can spend to achieve their objectives. For instance, a football
manager may be given a transfer expenditure budget of £20 million to buy
players. With the budget in place, the transfer dealing can get under way.
A budgeting system shows how much can be spent per time period and gives
managers a way to check whether they are on track. Most firms use a system of
budgetary control as a means of supervision. The process is as follows:
1 Make a judgement of the likely sales revenues for the coming year.
2 Set a cost ceiling that allows for an acceptable level of profit.
3 The budget for the whole company’s costs is then broken down by division,
department or by cost centre.
4 The budget may then be broken down further so that each manager has a
budget and therefore some spending power.
In a business start-up, the budget should provide enough spending power to
finance vital needs such as building work, decoration, recruiting and paying
staff, and marketing. If a manager overspends in one area, she or he knows that
it is essential to cut back elsewhere. A good manager gets the best possible
value from the budgeted sum.

36.3 Types of budget

Historical budget
Setting budgets is not an easy job. How do you decide exactly what level of
sales are likely next year, especially for new businesses with no previous
trading to rely on? Furthermore, how can you plan for costs if the cost of your
raw materials tends to fluctuate? Most firms treat last year ’s budget figures as
the main determinant of this year ’s budget. Minor adjustments will be made for
inflation and other foreseeable changes.
As a new school year approaches, a Head of Business will be told the
department’s budget for the coming year. Usually it will just be last year ’s plus
a percentage or two for inflation, but if a new syllabus is coming in (as in
2015) there should be a budget increase to allow for new textbooks and other
resources to be purchased.

Zero-based budget
An alternative approach is zero-based budgeting. This sets each department’s
budget at zero and demands that budget holders, in setting their budget, justify
every pound they ask for. This helps to avoid the common phenomenon of
budgets creeping upwards each year.
The only serious drawback to zero budgeting is that it takes a long time to
find good reasons to justify why you need a budget of £150,000 instead of
£110,000. As it is so time-consuming for managers, it is sensible to use zero
budgeting every few years, rather than every year. Figure 36.2 shows the
benefits of this approach.
Figure 36.2 The benefits of zero budgeting
The best criteria for setting budgets are:
• to relate the budget directly to the business objective; if a company wants to
increase sales and market share, the best method may be to increase the
advertising budget and thereby boost demand
• to involve as many people as possible in the process; people will be more
committed to reaching the targets if they have had a say in how the budget
was set.

Simple budget statements

A simple example of a budget statement is shown in Table 36.1.
Table 36.1 Example of a budget statement
This information is only of value if it proves possible for a manager to believe
that these figures are achievable. Only then will she or he be motivated to try to
turn the budgets into reality.
‘Any jackass can draw up a balanced budget on paper.’
Lane Kirkland, US trade union president

36.4 Variance analysis

Variance is the amount by which the actual result differs from the budgeted
figure. It is usually measured each month, by comparing the actual outcome
with the budgeted one. It is important to note that variances are referred to as
adverse or favourable – not positive or negative. A favourable variance is one
that leads to higher than expected profit (revenue up or costs down). An
adverse variance is one that reduces profit, such as costs being higher than the
budgeted level. Table 36.2 shows when variances are adverse or favourable.

Table 36.2 Adverse or favourable variance?

The value of regular variance statements is that they provide an early warning.
If a product’s sales are slipping below budget, managers can respond by
increasing marketing support or by cutting back on production plans. In an
ideal world, slippage could be noted in March, a new strategy put into place by
May and a recovery in sales achieved by September. Clearly, no firm wishes to
wait until the end-of-year to find out that things went badly. An early warning
can lead to an early solution.

36.5 Analysing budgets and variances

When significant variances occur, management should first consider whether
the fault was in the budget or in the actual achievement. In January 2014,
Nintendo apologised to shareholders that it was cutting the sales budget for its
Wii U from 9 million units to 2.8 million in the period to the end of March
2014. That is a cut of about 70 per cent! Nintendo’s management decided that
its budget was at fault and it would not therefore blame its marketing
managers. The launch of the PS4 had been known about, but Nintendo never
expected it to be so successful.
When adverse variances occur, senior managers are likely to want to hear an
explanation from the responsible ‘line manager ’. He or she will need to have a
clear explanation about what has gone wrong. Clearly, if recession has hit sales
throughout a market, it will be easy to explain adverse income variances. Far
tougher is when the blame lies with falling market share rather than market
size.
Figure 36.3 Logic chain: making variance analysis more effective

36.6 Difficulties of budgeting

Budgeting is used very widely in organisations – corporate and in the public
sector. But it isn’t always appropriate. Chessington World of Adventures uses
budgeting for its catering outlets and its shops. But the overwhelming factor
determining sales is outside the control of the managers: the weather. So a
manager given a target of boosting sales in June by 5 per cent may quickly
find that rain has made that impossible, in which case, the budget becomes
either an irritation or a source of stress.
‘[Budgets] must not be prepared on high and caste as pearls before swine.
They must be prepared by the operating divisions.’
Robert Townsend, the original business guru
Businesses need to decide whether designing and implementing a budgeting
system will cost more in terms of time and money than it could save, in other
words assess the opportunity costs. In the often chaotic world of a small
business start-up, it is easy to see how time spent talking to customers and
suppliers would be more valuable than working on a spreadsheet.

Five whys and a how

36.7 Budgets – evaluation

The sophistication of budgeting systems is usually directly linked to the size of
a business. Huge multinationals have incredibly complex budgeting systems.
For a small business start-up, any budgeting system will be quite simple. Most
will rely on a rough breakdown of how the start-up budget is to be divided
between the competing demands. There is, however, no doubt that budgeting
provides a more effective system of controlling a business’s finances than no
system at all.
Budgets are a management tool. The way in which they are used can tell you a
lot about a firm’s culture. Firms with a culture of bossy management will tend
to use a tightly controlled budgetary system. Managers will have budgets
imposed upon them and variances will be watched closely by supervisors.
Organisations with a more open culture will use budgeting as an aid to
discussion and empowerment. Whatever the culture, if a manager is to be held
accountable for meeting a budget, she or he should be given influence over
setting it, and control over reaching it.

Key terms
Adverse variance: a difference between budgeted and actual figures
that is damaging to the firm’s profit (for example, costs up or revenue
down).
Criteria: yardsticks against which success (or the lack of it) can be
measured.
Delegation: passing authority down the hierarchy, to allow more junior
employees some decision-making power.
Expenditure budget: setting a maximum figure on what a department
or manager can spend over a period of time; this is to control costs.
Favourable variance: a difference between budgeted and actual figures
that boosts a firm’s profit (for example, revenue up or costs down).
Income budget: setting a minimum figure for the revenue to be
generated by a product, a department or a manager.
Zero budgeting: setting all future budgets at £0, to force managers to
have to justify the spending levels they say they need in future.

36.8 Workbook
Revision questions
(45 marks; 45 minutes)
1 Explain the meaning of the term ‘budgeting’.
(3)
2 List three advantages that a budgeting system brings to a company.
(3)
3 Why is it valuable to have a yardstick against which performance can
be measured?
(3)
4 What are the advantages of a zero-based budgeting system?
(4)
5 Briefly explain how most companies actually set next year’s budgets.
(3)
6 Why should budget holders have a say in the setting of their
budgets?
(4)

Table 36.3 A budget statement

7 Copy and complete the budget statement shown in Table 36.3 by
filling in the gaps.
(8)
8 How could a firm respond to an increasingly adverse variance in
labour costs?
(4)
9 Explain what is meant by a ‘favourable cost variance’.
(3)
10 Look at Table 36.4, then answer the following questions.

Table 36.4 Budgeted and actual figures for May and June
a) Calculate the budgeted and actual profit figures for both months.
(2)
b) Identify a month with:
i) a favourable revenue variance
ii) an adverse variable cost variance
iii) a favourable fixed cost variance
iv) an adverse total cost variance
v) an adverse revenue variance
vi) a favourable total cost variance
vii) an adverse profit variance
viii) a favourable profit variance.
(8)
Data response 1
Table 36.5 Variance analysis (all figures in £000s)
B budgeted,
A actual,
V variance.
Questions (25 marks; 25 minutes)
1 Give the five numbers missing from the variance analysis shown in
Table 36.5.
(5)
2 Assess one financial strength and two weaknesses in these data,
from the company’s viewpoint.
(12)
3 Assess two ways in which a manager might set about improving the
accuracy of a sales budget.
(8)
Data response 2
Table 36.6 Budget data for Clinton & Collins Ltd (£000s)
Questions (25 marks; 25 minutes)
1 Use the data given in Table 36.6 to explain why February’s profits
were worse than expected.
(5)
2 Explain why Clinton & Collins Ltd may have chosen to set monthly
budgets.
(4)
3 Explain how the firm could have set these budgets.
(4)
4 The directors of Clinton & Collins Ltd knew that the recession was
causing problems for the firm but were unsure as to whether things
were improving or worsening. Assess the extent to which the data
suggests an improvement.
(12)
Data response 3
Chessington World of Adventures
In April 2014, Chessington World of Adventures opened up for its
summer season. The newly appointed merchandise manager (in charge
of all non-food sales) was given his sales budget for the year. It had
been set 4 per cent higher than for 2013. He thought the budget was
quite ambitious, especially when a wet April and May meant that there
were fewer visitors in the early part of the season. Then the period
July to August saw hot, dry weather and the turnstiles were ‘buzzing’
again. As a hot day at Chessington can boost crowds by 50 per cent,
the merchandise manager did not need to make any effort to meet his
budget.
Questions (20 marks; 25 minutes)
1 Explain two other ways in which management might have
constructed the sales budget for 2014.
(4)
2 On a particularly hot week in August, the actual sales figures were
41 per cent higher than the budget. Did the merchandise manager
deserve a bonus?
(4)
3 Assess whether budgets have a purpose in a business such as
Chessington.
(12)
Extended writing
1 ‘Budgeting systems can often be demotivating for middle managers.’
Evaluate the extent to which this might be true.
(20)
2 Evaluate whether it is true to suggest that budgets are the most
important financial documents for most managers.
(20)
Section 2.3 Managing finance

37 Profit
Definition
Profit is the difference between revenue and all the costs involved in
generating that revenue. It is the food that enables the business to
grow.

Linked to: Sources of finance, Ch 30; Sales, revenue and costs,

Ch 34; Break-even, Ch 35; Liquidity, Ch 38.

37.1 Calculating gross profit, operating profit and

profit for the year
Profit can be calculated in many different ways. For most business purposes,
though, it is enough to know gross profit, operating profit and net profit (the
after-tax profit for the year).
Each type of profit is calculated after allowing for different types of cost. This
is useful to the business because it can help identify where things are going
wrong (or right). For example, coffee bars charge £s for coffee that costs
pence to make. So their gross profit level is huge. Unfortunately, spacious
seating in expensive high street locations means big rents and therefore more
modest operating profits. Table 37.1 sets out the calculations and implications,
based on the annual accounts of a small, independent bakery.
Table 37.1 Annual accounts of an independent bakery

37.2 Statement of comprehensive income (profit and

loss account)
Large businesses established as public limited companies (plcs) are required to
state their annual profits in a document called a ‘statement of comprehensive
income’. Most businesspeople call this the ‘profit and loss account’ or ‘P&L’.
The document sets out the revenues generated in the year together with many
lines of detail about the costs incurred. From this can be read a series of
different types of profit. The most important are the gross profit, the operating
profit and the after-tax net profit. The last shows how much the directors can
pay out in shareholder dividends and how much will be left to reinvest in the
growth of the business.
‘Market leadership can translate directly to higher revenue, higher
profitability, greater capital velocity, and correspondingly stronger returns
on invested capital.’
Jeff Bezos, founder of Amazon
Table 37.2 shows a simplified version of Ted Baker plc’s 2014 statement of
comprehensive income, to help show how these three levels of profit are
calculated.
Table 37.2 Ted Baker plc’s 2014 statement of comprehensive income
Figure 37.1 Logic chain: difficult to increase profit

37.3 Measuring profitability

The gross profit of a business is an absolute number (e.g. £10,000). The
number is calculated by deducting direct costs from sales revenue. Is £10,000 a
good level of profit or not? To find out, it is helpful to measure the profit in
relation to the sales revenue. This gives a relative measure of profit known as
profitability. Marks & Spencer makes far more profit than Ted Baker, but so it
should – it has far, far more shops and staff. When you calculate their profits
as a percentage of sales, Ted Baker makes about twice as much per £ of sales
as M&S. So Marks & Spencer makes more profit, but Ted Baker is more
profitable.
Profitability can be measured for each of the three types of profit identified
earlier in the chapter: gross, operating and net.
This is the gross profit margin:

For example, if the gross profit is £10,000 and the sales are £40,000, the
gross profit margin is:

Having turned the profit figure into a percentage, a comparison can be made
with the profitability achieved by other companies. Comparing fashion
retailers Ted Baker plc and Supergroup plc, for example: the former made a
2014 gross margin of 61.5 per cent, while Supergroup’s margins were 59.7
per cent. Both figures are remarkably high, confirming the strength of the Ted
Baker and SuperDry brand names. Needless to say, Ted Baker ’s is a little more
impressive than Supergroup’s – and both are hugely better than the original
calculation of 25 per cent.

Operating profit margin

When City and media analysts are evaluating companies, the number they
focus on is operating profit. And then they take that as a percentage of revenue
to calculate the operating profit margin:

For example, if the operating profit is £3,000 and the sales are £40,000 the
operating margin is:

Having turned the profit figure into a percentage, a comparison can be made
with the profitability achieved by other companies, or looking at one company
over time. In 2014, Ted Baker plc had an operating margin of 12.3 per cent.
Sainsbury’s, by contrast, had a 2014 operating margin of just 3.3 per cent. As
the businesses operate in different types of retailing, it would be unfair to
conclude that Ted Baker is better run than Sainsbury’s. Nevertheless, the
management of Sainsbury’s would be interested in such findings (for example,
it may make Sainsbury’s determined to boost their sales of clothing).

Real business
If a business cannot make a reasonable operating profit, it has no
chance of long-term survival. A good example is Blockbuster UK. In its
2010 financial year, it made an operating profit that was less than 1
per cent of its sales. Since then, with sales falling as the DVD market
declined, operating profits of £1.7 million slipped to losses of £8.5
million in 2011 and £11.2 million in 2012 before collapse in 2013. The
final Blockbuster stores closed by early 2014.

Net profit margin

For example, if the profit after tax is £2,000 and the sales are £40,000, the net
profit margin is:

Although this percentage figure can be compared with the profitability

achieved by other companies, it is hard to interpret the findings. A company
might have a relatively high net margin because it has been aggressive in tax
avoidance. If, the following year, the tax authorities closed the loophole being
used by the company, their tax bill would rise and net profits fall – perhaps
sharply. This is why media analysis of company profits focuses on profit
before tax – this is operating profit margins.

37.4 The value of measuring profit margins

The calculation of profit margins allows questions to be asked, and sometimes
answered. Table 37.3 provides data on Tesco plc over time, and then shows
Tesco versus Sainsbury’s and Morrisons. Over time, it is clear that Tesco’s
profitability has fallen steadily. Nevertheless, in 2014, despite Sainsbury’s
steady improvement in its operating profit margin, Tesco remained
significantly more profitable. As for Morrisons, in 2014 it made operating
losses rather than profits. So, up until 2014, there were positives in Tesco’s
profitability as well as (well publicised) negatives.

Table 37.3 Trading profit margins in the UK grocery market

‘I generally disagree with most of the very high margin opportunities.
Why? Because it’s a business strategy tradeoff: the lower the margin you
take, the faster you grow.’
Vinod Khosla, Indian billionaire entrepreneur

37.5 Ways to improve profits

To increase profits a business must:
1 increase revenue
2 decrease costs
3 do a combination of 1 and 2.
To increase revenue, a business may want to consider its marketing mix.
Changes to the product may mean that it becomes more appealing to
customers. Better distribution may make it more available. Changes to
promotion may make customers more aware of its benefits. However, the
business needs to be careful that rising costs do not swallow up the rise in sales
revenues.
To reduce costs, a business may examine many of the functional areas (such as
marketing, operations, people and finance):
• Could the firm continue with fewer staff?
• Could money be saved by switching suppliers?
• Do the firm’s sales really benefit from sponsoring the opera?
• Are there ways of reducing wastage?
Essentially, a business should look for ways of making the product more
efficiently (for example, with better technology) by using fewer inputs or
paying less for the inputs being used. However, a business must be careful that,
when it reduces costs, the quality of service is not reduced. After all, this might
lead to a fall in sales and revenue. Cutting staff in your coffee shop may cut
costs, but if long queues form it may also reduce the number of customers and
your income. Managers must weigh up the consequences of any decision to
reduce costs.

Real business
Vietnam as a production base
Average wages in Vietnam are lower than those of two of its
neighbours: Thailand and China. Vietnamese factory workers earn just
two-thirds of what their colleagues in China take home (about 65p an
hour compared with £1 in China).
Companies such as Foxconn, which assembles consumer electronics
and phones for big-brand companies like Apple and Sony, operate on
very low profit margins and so try to find the lowest cost location they
can. This makes Vietnam very attractive as a production base. Even
high profit-margin businesses such as Nike are shifting production to
Vietnam, simply to keep costs down and therefore margins up.

37.6 Ways to improve profitability

Profitability (as opposed to ‘profits’) is a relative term. It is mainly measured
using the operating profit margin. To increase operating profits in relation to
sales, a business could do the following.

Increase the price

Increasing the price would boost the profit per sale, but the danger is that the
sales overall may fall so much that the overall profits of the business are
reduced. (Notice the important difference again between the operating profit
margin and the overall level of profits; you could make a high level of profit
on one can of beans relative to its price, but if you only sell one can your total
profits are not that impressive!) The impact of any price increase will depend
on the price elasticity of demand; the more price elastic demand is, the greater
the fall in demand will be, and the less likely it is that a firm will want to put up
its prices.

Cut costs
If cutting costs can be done without damaging the quality in any significant
way, then this clearly makes sense. Better bargaining to get the supply prices
down or better ways of producing may lead to higher profits per sale.
However, as we saw above, the business needs to be careful to ensure that
reducing costs does not lead to a deterioration of the service or quality of the
product.

Real business
The UK energy industry
In 2013, energy firms in the UK were being criticised for their high
profit margins by the government body that regulates the energy
industry (called Ofgem). Because the energy companies offer a vital
product and have such power, the government monitors them to see
how they behave in relation to customers. Even though the price at
which these companies buy the energy themselves (the wholesale
price) has fallen, these savings have not led to lower prices for
households. This means the energy companies have been benefiting
from increasing profit margins.

37.7 Distinction between profit and cash

A year ago, a busy bar in Wimbledon closed down. Regulars were surprised,
shocked even, that such a successful business had failed. The business was
operating profitably, but the owners had become too excited by their success.
Their investment into two new bars elsewhere in London had drained too much
cash from the business, and the bank had panicked over the mounting debts. It
forced the business to close. A profitable business had run out of cash.
 ‘Revenue is vanity… profit is sanity… cash is King.’
Anon
To understand how cash differs from profit, the key is to master profit. On the
face of it, profit is easy: total revenue minus total costs. Common sense tells
you that revenue = money in, and costs = money out. Unfortunately, that is far
too much of a simplification.
To understand the difference, it is helpful to look separately at the two
components.

Distinguishing revenue from cash inflow

Revenue is not the same as money in. Revenue is the value of sales made over a
specified period: a day, a month or a year. For example, the takings at a
Topshop outlet last Saturday: £450 of cash sales, £2,450 on credit cards and
£600 on the Topshop store card (£3,500 in total). Note that the cash inflow for
the day is just £450, so revenue is not the same as ‘cash in’. See Figure 37.2.

Figure 37.2 Saturday takings at a clothing outlet

Whereas revenue comes from just one source (customers), cash inflow can
come from many sources. It is not limited to trading. Selling an old warehouse
for £600,000 does not generate revenue, but it does bring in cash. Similarly,
taking out a bank loan could not be classed as revenue, but it does put cash into
your bank current account.
So cash inflows can be part of the revenue, but they do not have to be.
Therefore, cash and revenue are not the same. Examples of differences
between cash inflows and revenue are given in Table 37.4.

Table 37.4 Differences between cash inflows and revenue

Distinguishing costs from cash outflow

The same distinction applies to costs and cash outflows. There are many
reasons why a firm might pay out cash. Paying for the business costs is only
one of them. For example, the firm may pay out dividends to its shareholders,
or it may repay a bank loan, or it may buy a piece of land as an investment.
In the case of the Wimbledon bar, the £200,000 annual profit gave the owners
the confidence to buy leases on two new premises. They put together a business
plan for expansion and received a £90,000 bank loan plus an £80,000
overdraft facility from a high street bank. They then hired architects and
builders to turn the premises into attractive bars. Unfortunately, building
hitches added to costs while delaying the opening times. The first of the new
bars opened without any marketing support (there was no spare cash) and with
the second of the bars still draining the business of cash, the bank demanded to
have its overdraft repaid. As there was no way to repay the overdraft, the
business went into liquidation.
‘Every calculation of net profit reflects choices from competing theories
 of accounting… Profit is an opinion, cash is a fact.’
Alex Pollock, American Enterprise Institute

Five whys and a how

37.8 Profit – evaluation

A difficulty with questions about poor profits is that many suggestions made in
exams are too obvious. Sainsbury’s has a significantly lower profit margin
than Tesco. But is it worth pointing out to Sainsbury’s that it could look for
bulk-buying discounts on its supplies? Surely it will be doing that already. A
good exam answer needs to look beyond the obvious to consider, perhaps, that
Sainsbury’s may have to address its head office (fixed overhead) costs in order
to boost its margins to match those of Tesco.

Key terms
Corporation tax: a levy on the incomes of companies, i.e. you pay a
percentage of your pre-tax profit.
Dividends: annual payments made to shareholders.
Fixed overheads: the indirect costs that have to be paid however the
business is performing, e.g. rent and salaries.

37.9 Workbook
Revision questions
(40 marks; 40 minutes)
1 What is meant by ‘revenue’?
(2)
2 What is meant by ‘operating profit’?
(2)
3 Does an increase in price necessarily increase revenue? Explain
your answer.
(5)
4 How could a company jeopardise its future by paying out generous
dividends to shareholders?
(4)
5 Is profitability measured in pounds or percentages?
(1)
6 What is the formula for the operating profit margin?
(2)
7 Explain two ways of increasing profits.
(6)
8 Explain why cutting costs might end up reducing profits.
(5)
9 Explain one way in which operating profit might be affected by a
decision within:
a) the marketing function
b) the operations function.
(8)
10 Give two reasons why a profitable business could run out of cash
when it expands too rapidly.
(2)
11 Identify whether each of the following business start-ups would be
cash-rich or cash-poor in the early years of the business:
 a) a pension fund, in which people save money in return for later
pay-outs
b) building a hotel
c) starting a vineyard (grapes only pickable after 3–5 years).
(3)
Data response
SOFA-SOGOOD Ltd is a retailer of sofas. It had been experiencing a
‘very slow’ summer. Revenues had been falling but costs had been
pushed up by pay increases, higher rent costs and higher interest
payments on debts. As a result, net profits had fallen by 20 per cent
on last year. Renis, the managing director, was very disappointed that
revenue had fallen because he had cut prices by 5 per cent and had
expected customer numbers to increase sharply. Once it became clear
that this discounting policy was not working, he imposed a pay freeze
on everyone in the company and a policy of non-recruitment. If any
staff member left, she or he would not be replaced.
Questions (30 marks; 30 minutes)
1 What is meant by:
a) revenue
b) costs
c) net profit?
(6)
2 Explain why a fall in price might not have led to an increase in
revenue.
(4)
3 Apart from the methods mentioned in the text, assess two other
actions SOFA-SOGOOD could take to improve its profitability.
(8)
4 Assess the advantages and disadvantages to the business of the
staff cost-saving actions taken by Renis.
(12)
Extended writing
1 When recession hits, wise financial managers focus more on cash
flow and less on profit. Evaluate why that might be the case.
(20)
2 In 2014, Snapchat boosted user numbers to more than 200 million
people, but had not found a way to generate revenue, let alone
profit. Evaluate the difficulties for a new app in turning usage into
profit.
(20)
Section 2.3 Managing finance

38 Liquidity
Definition
Liquidity measures the ability of a firm to find the cash to pay its bills.
The cash needs to be available in a current bank account or close to
being available, such as a payment promised for next week.

Linked to: Sources of finance, Ch 30; Profit, Ch 37; Business

failure, Ch 39.

38.1 Statement of financial position

Each year, every limited company must send a statement of its financial
position to Companies House. That statement is widely known as a balance
sheet. This is an accounting statement that shows an organisation’s assets and
liabilities on the last day of the financial year.
In effect, the balance sheet answers the question: ‘How rich are you?’ To find
out how rich someone is, you would need to find out what they own and what
they owe. The balance sheet does this for a business, adding up the totals on the
last day of the financial year. Balance sheets show the wealth, or the
indebtedness, of the business – vital information for shareholders, managers,
financiers and suppliers.
‘Our liquidity is fine. As a matter of fact, it’s better than fine. It’s strong.’
Kenneth Lay, boss of Enron (shortly before Enron collapsed)

38.2 Measuring liquidity

A balance sheet contains a great deal of financial and therefore numerical
information. Liquidity concerns just one issue: can the company pay the bills it
will receive in the next 12 months? If the answer is no, further, serious
questions must be asked about how the company is going to survive.
To measure a firm’s liquidity, the first thing is to identify the bills – that is,
liabilities – that will need to be paid in the next 12 months; these are called
current liabilities. In the case of Mulberry plc, Table 38.1 shows their position
on 31 March 2014, the final day of their 2013/2014 financial year.

Table 38.1 Current liabilities of Mulberry plc, 2013/2014

So Mulberry owed £30 million to their suppliers and to the government, and
the fact that they were current liabilities shows that the bills needed to be paid
within 12 months.
So what finance did Mulberry have available to pay these bills? The answer is
found in the current assets section of their balance sheet, as shown in Table
38.2.

Table 38.2 Current assets of Mulberry plc, 2013/2014

So although they had £30 million of short-term liabilities, they held more than
£70 million of current (short-term) assets. They couldn’t quite pay the bills
from cash alone, but within the next 12 months they could expect to sell stocks
to customers, thereby turning assets into cash.
As long as a company has enough current assets to cover their current
liabilities, their liquidity is sound. But how much is enough? That question is
tackled through the use of accounting ratios.

38.3 Calculating liquidity ratios

A ratio relates one number to another, to show the relative position, e.g. 2:1.
The value of this is to give a warning about when the current liabilities are
getting too high in relation to the current assets. There are two liquidity ratios
used commonly: the current ratio and the acid test.

Current ratio
This ratio looks at the relationship between current assets and current
liabilities. It examines the liquidity position of the firm. It is given by the
formula:

This is expressed as a ratio, such as, for example, 2:1 or 3:1.

Example
Mulberry plc has current assets of £70.5 million and current liabilities of £30
million:

Interpretation
The above worked example shows that Mulberry has more than twice as many
current assets as current liabilities. This means that, for every £1 of short-term
debts owed, it has £2.35 of assets to pay them. This is a comfortable position.
Accountants suggest the ‘ideal’ current ratio should be approximately 1.5:1
(that is, £1.50 of assets for every £1 of debt). Any higher than this and the
organisation can be criticised for having too many resources tied up in
unproductive assets; these could be invested more profitably (or the cash could
be handed back to shareholders). A low current ratio means a business may not
be able to pay its debts. It is possible that the result may well be something like
0.8:1. This shows the firm has only 80p of current assets to pay every £1 it
owes.
The current ratios of a selection of public companies in 2014 are shown in
Table 38.3. As this table shows, it would be wrong to panic about a liquidity
ratio of less than 1. Huge firms such as Tesco have often had spells when their
liquidity levels were less than 1.

Acid test ratio

This ratio also examines the business’s liquidity position by comparing current
assets and liabilities, but it omits stock from the total of current assets. The
reason for this is that stock is the most illiquid current asset (the hardest to turn
into cash without a loss in its value). It can take a long time to convert stock
into cash. Furthermore, stock may be old or obsolete and thus unsellable.
By omitting stock, the ratio provides a tougher measure of a firm’s liquidity. It
is given by the formula:

Again, it is expressed in the form of a ratio, such as 2:1.

Example
Mulberry plc has highly liquid assets of £36.9 million and current liabilities of
£30 million:

Interpretation
Accountants recommend that an ‘ideal’ result for this ratio should be
approximately 1:1, thus showing that the organisation has £1 of highly liquid
assets for every £1 of short-term debt. A result below this (for example, 0.5:1)
indicates that the firm may have difficulties meeting short-term payments.
Clearly, Mulberry is in a very comfortable position, with strong liquidity.
The acid test ratios of a selection of public companies in 2014 are shown in
Table 38.4. It can be seen that the 2014 liquidity position of Morrisons looks
very uncomfortable.

Table 38.3 The current ratios of a selection of public companies in 2014

Table 38.4 The acid test ratios of a selection of public companies in

2014
Figure 38.1 Logic chain: liquidity

38.4 Ways to improve liquidity

If the ratio is so low that it is becoming hard to pay the bills, the company will
have to try to bring more cash into the balance sheet. This could be done by:
• selling under-used fixed assets
• raising more share capital
• increasing long-term borrowings
• postponing planned investments.
One further way to improve liquidity is to work hard at improving the
management of working capital.

38.5 Working capital and its management

Working capital is the finance available for the day-to-day running of the
business. All businesses need money; it is required for the purchase of
machinery and equipment. This expenditure on fixed assets is known as capital
expenditure. The business also needs money to buy materials or stock and to
pay wages and the day-to-day bills, such as electricity and telephone bills. This
money is known as working capital.
Managing working capital is about ensuring that the cash available is sufficient
to meet the cash requirements at any one time. If the bills cannot be paid on
time, there are serious consequences. In the worst situation, the business may
fail. Insufficient working capital is the commonest cause of business failure.
Managing working capital is therefore a vital business activity.

The working capital cycle

Managing working capital is a continuous process. When a business starts up,
it takes time to generate income. Money to pay for stock and the running costs
will need to be found from the initial capital invested in the business. As the
business cycle gets going, income from customers will be available to pay for
expenditure.
The firm needs to ensure that there is always sufficient cash to meet daily
requirements. If the business is expanding or takes on a special order, extra
care needs to be taken. Sufficient funds are needed to pay for the additional
expenditure until the revenue arrives. This continuous process is shown in
Figure 38.2.
Figure 38.2 The working capital cycle
As can be seen from Figure 38.2, managing working capital is about two
things:
1 ensuring the business has enough finance to meet its needs
2 keeping cash moving rapidly through the cycle, so there is enough to meet
future orders.
Each business will have its own distinct cycle. Businesses will also be subject
to unexpected events and need to be able to cope with these. Therefore, it is
helpful to have a generous overdraft limit, which can be drawn upon when
needed.
Examples of unexpected events include the following:
• A major customer gets into financial difficulties and is therefore unable to
pay its bills on time.
• The cost of materials rises quickly, as with the 50 per cent increase in the
price of beef in the year to October 2014.

Uncertainty and working capital

A business needs to take into account both the timing and the amounts involved
when working out its working capital requirements. It also needs to include an
allowance for uncertainty. An extra 10 per cent on top of the expected cash
requirement would be the very minimum required. For a new, small firm such
as a new restaurant, though, a bigger safety net can be wise. It can take months
for word to spread sufficiently to push a business above its break-even point.
Figure 38.3 shows the need for contingency finance; in other words, the
financial back-up to allow for the unexpected. In recent years, Somerset has
been hit several times by flooding, with thousands of home evacuated. Think of
the hit that would have been inflicted on small businesses in the flooded areas.
They could have faced sales revenue down by, perhaps, 30 per cent as residents
moved away to temporary accommodation. For a new business with little cash
in the bank, the position would have threatened its survival. Figure 38.3 shows
the role of contingency finance, such as an agreed overdraft facility.

Figure 38.3 The need for contingency finance

‘Many financial measurements which are useful and valid in static
situations are strategic traps in growth situations.’
Bruce Henderson, chief executive, Boston Consulting Group

How should a business manage its working capital?

Intelligent working capital management is centred on the following aspects.

Control cash used

Businesses can control the amount of cash used by:
• minimising stock levels
• keeping customer credit as low as possible (without pushing customers
away)
• trying to get as much credit from suppliers as you can
• getting goods to the market in the shortest possible time; the sooner goods
reach the customer, the sooner payment is received.

Minimise spending on fixed assets

Minimising spending on fixed assets keeps cash in the business. The business
must balance its need for cash and its need for fixed assets. A compromise is to
lease rather than buy equipment. This increases expenses but conserves
working capital.

Plan ahead by estimating cash needed

Planning ahead by estimating the amount of cash needed next month and
beyond means that cash shortfalls can be anticipated and planned for. If the next
two months look problematic, perhaps that purchase of the boss’s new BMW
should be delayed for a while.
‘A small loan makes a debtor; a great one, an enemy.’
Pubilius Syrus, 42 BC

38.6 The importance of cash

Working capital is a technical term used widely in business, but ultimately it is
a posh way of looking at cash. Businesses fail when bills cannot be paid – that
is, the cash runs out. In addition to the downside risks of being short of cash, it
is important to be aware of missed opportunities that may arise. If working
capital is too tight and cash is short, the business may not be able to buy
supplies in bulk. This may result in variable costs per unit being higher than
competitors’. Perhaps even more importantly, a company may have to refuse a
large order because it cannot finance the extra working capital requirement.
In the longer term, shortage of cash means that no funds are available for
development. The business will not be able to grow. In a world where
technological and other developments are so rapid, ‘not being able to grow’
may be a step towards the long-term demise of the business.
‘The only thing that matters is cash flow… where it’s coming from and
where it’s going and how much is left over.’
William McGowan, company chairman

Five whys and a how

38.7 Liquidity – evaluation
Managing liquidity is very important for every business. As in many other
areas of business, it is about getting the balance right. Too much working
capital may be wasteful; too little can be disastrous. Businesses need to
consider working capital requirements right from the outset. Most new
businesses underestimate these needs, allowing only £20 of working capital
for every £100 of fixed capital. Accountants advise a 50:50 ratio. Shortage of
working capital will mean a shortage of liquidity.
Managing liquidity is not just about managing cash flow. The timing and
amounts of cash flow are important, but liquidity management goes beyond
that. It is about managing the whole business. In this respect, it is an integrated
activity. It involves each aspect of the company. Efficient production keeps
costs to a minimum and turns raw inputs into finished goods in the shortest
possible time. Effective management of stock can have considerable impact on
liquidity. Effective marketing ensures that the goods are sold and that demand
is correctly estimated. This avoids wasted production. Cash then flows in from
sales. Efficient distribution gets the goods to the customer quickly. The
accounting department can help to control costs. Effective credit control
improves cash flow. Each of these can reduce the need for cash and therefore
ensure that cash is available to keep liquidity stable.

Key terms
Contingency finance: planning for the unexpected by either keeping a
cash cushion in the firm’s current account or keeping an overdraft
facility little-used.
Credit period: the length of time a supplier allows a buyer to wait
before paying, e.g. 60 days after the bill has been sent.
Liquidation: closing the business down by selling off all the assets,
paying debts and returning what is left to the shareholders.
Liquidity: the ability of a business to pay its bills on time, which all
depends upon having enough cash in the bank.
Working capital cycle: how long it takes for a complete cycle from cash
out (buying stock) to cash back in from a customer payment. It could
vary from one day (for example, for a fruit and veg stall) to one year
(for example, a house builder).

38.8 Workbook
Revision questions
(30 marks; 30 minutes)
1 What is working capital?
(2)
2 What is capital expenditure?
(2)
3 What is working capital used for? Give two examples.
(4)
4 What problems could arise if a firm is operating with very low
working capital?
(4)
5 Why may a business be unable to get a loan or overdraft if it has
working capital difficulties?
(4)
6 On 1 February, JG Co received an order for £20,000 worth of office
furniture. Between 15 February and 20 March, the company spent
£11,000 on materials and labour. Between 20 March and 31 March,
a further £4,000 was contributed to fixed costs such as quality
control. The finished order was delivered on 1 April, together with an
invoice requiring payment in 60 days. On 1 June, the payment of
£20,000 was received. How long is JG Co’s working capital cycle?
(4)
7 Outline three ways in which a business can improve its working
capital situation.
(6)
8 How does better stock management help a firm to control its
working capital requirements?
(4)
Data response
Life and death
Managing cash flow effectively is really a matter of life and death for a
new business. Government figures show that small businesses are
owed as much as £17 billion from customers at any one time, and that
10,000 UK businesses fail each year because of late payment from
customers.
Ironically, one of the reasons for cash flow problems is that small,
growing businesses can find themselves ‘overtrading’ (i.e. sales may be
strong, but the company lacks the cash to buy more stock or pay its
bills).
A previous client of mine was worth over £1 million, yet was at the end
of its bank overdraft limit simply because one customer was too large
for its business. It used all its working capital supplying this one
customer! In addition, though the client was paying its own bills
immediately, it wasn’t being firm about collecting money from its own
customers.
To put the situation right, the firm first had to walk away from its large
customer and focus on smaller ones, and then actively chase late
payments. Chasing invoices is perfectly acceptable, and in fact some
businesses will never pay until chased. Finally, the company also
negotiated better terms with its own suppliers.
I recommend a number of important cash flow rules.
• Make payment terms a central part of the contract and enforce
them.
• Invoice as soon as possible.
• Chase invoices the moment they become due.
• Walk away from bad payers.
• Do a cash flow forecast and reforecast regularly – at least every
month.
• Cash cheques as soon as you receive them.
Source: adapted from an article by Jeff Maplin at
http://startups.co.uk
Questions
(25 marks; 30 minutes)
1 Explain why late payment from customers can be such a serious
matter.
(4)
2 Explain the difficulties that may arise for a business that uses all its
working capital supplying one customer.
(4)
3 Outline one advantage and one disadvantage involved in chasing
late payers.
(7)
4 Assess what you see as the three main themes that come through
from the ‘important cash flow rules’.
(10)
Extended writing
1 Evaluate the extent to which working capital management is vital for
the future of any business.
(20)
2 Evaluate the following statement: ‘Managing working capital is not
just the business of the finance department; it is the responsibility of
everyone in the business.’
(20)
Section 2.3 Managing finance

39 Business failure
Definition
Business failure can be defined as the inability to keep the business
going, either because of inability to keep up with the bills/liabilities or
because the profits being made are too meagre to be worth
continuing.

Linked to: Liability and finance, Ch 31; Planning and cash flow,
Ch 32; Profit, Ch 37; Liquidity, Ch 38.

39.1 Introduction to business failure

The failure of any business has a tinge of tragedy. When La Senza collapsed
(again) in 2014, hundreds of people lost their jobs. Most were low-paid,
therefore having few savings, and most received no financial compensation at
all. Even harsher can be a failure by an entrepreneur, who might have invested
personal or family savings into a business flop. This situation can put pressure
on family relationships as well as on the self-confidence of the failed
entrepreneur. In America, a failed start-up can be seen as a badge of honour
(especially if a subsequent enterprise succeeds), but in Britain it is more likely
to be seen as a mistake.
‘We can afford almost any mistake once.’
Lewis Lehr, chairman of the vast 3M company
Recently, Forbes magazine published an article by a US entrepreneur setting
out the five reasons new businesses fail. They are interesting, partly because
some are not obvious:
1 Not really in touch with customers through deep dialogue. Tweets won’t do;
the entrepreneur needs to ‘walk 1,000 miles in the shoes of customers’.
2 No real differentiation (lacking a unique value proposition): too little that is
unique and different from others in the marketplace.
3 Failure to communicate your unique proposition in a concise and
compelling way – that is, you have the right business idea, but fail to
communicate it to the right target market.
4 Leadership breakdown at the top: a dysfunctional leader who is perhaps too
aggressive or too weak to lead the business towards success.
5 Inability to nail a profitable business model with sufficient revenue streams.
Source: Eric T. Wagner, Forbes magazine
It is striking that the five factors have little to do with finance. They are more
about the business/marketing strategy behind the business (plus the character of
the entrepreneur/leader). This seems right. In 2014, Tesco was publicly
humiliated by a £260 million overstatement of its profits. But far more
important was its underlying marketing failure: shoppers were leaving Tesco
to go to Aldi, Lidl and Waitrose.

39.2 Internal causes of business failure

In the 2014/2015 football season, suffering from inconsistent performances
and results, the managers of Arsenal and Manchester City both gave the same
quote to reporters: ‘We have to look to ourselves.’ In other words, don’t blame
others; look for internal causes of failure. This seems right. When retailers
blame the weather for poor trading, stock market analysts groan. They want to
see the management take responsibility for their actions and their
disappointments.
When businesses fall into administration, the same key internal reasons are
usually to blame:
1 A marketing failure. In September 2014, Phones4U suddenly announced it
was going into administration because it had lost its supply contracts with
EE and Vodafone. Although the cause was external, such a big company
(more than 5,000 staff) should have foreseen the threat to its business and
found a marketing solution – that is. finding new products or services to
meet the needs of today’s customers.
2 A financial failure. In April 2014, food manufacturer Fabulous Bakin’ Boys
collapsed, owing more than £3.5 million to its suppliers and the taxman. It
had over-expanded by investing too much in new machinery at a time when
declining sales suggested the brand’s strength was weakening. Sales had
fallen from £17.7 million in 2012 to £14.6 million in 2013. In May, the
 administrators announced that suppliers would receive between 5 and 17 per
cent of what they were owed – that is, have to withstand huge losses. The
business collapsed due to bad management.
3 A systems failure. Ultimately, businesses run on information, on data. If a
new IT system causes confusion rather than certainty, the result can be
disastrous. Stock ordering may go wrong, leaving some shelves empty
while others overflow. This seems to have been the problem behind the
2014 collapse of Bloom.fm, a UK music streaming business with 1.2
million users.

39.3 External causes of business failure

In November 2014, the wave power firm Pelamis called in the administrators,
with the potential loss of 56 jobs. Pelamis was a world leader in renewable
energy, but energy companies such as E.ON had stopped funding the business.
As it had not yet reached break-even in its commercial operations, it simply
ran out of cash and had to close.
Among the main external causes of business failure are:
1 A fundamental change in technology which gives a rival (or a new entrant) a
competitive advantage that is too great to be matched. Effectively this is
what happened to Nokia when the Apple iPhone arrived. Nokia’s share of
the global smartphone market collapsed from 40 per cent to 4 per cent
within two years.
2 The arrival of a competitor who is so effective at acquiring and keeping
customers that others fall by the wayside. Amazon had (and has) this effect
on the world’s bookshops. In Britain, there were 1,535 independent
bookshops in the country; by the end of 2013, the number had fallen to 987.
So around 550 businesses were wiped out in this way.
3 Economic change. In 2009, production of cars in Britain fell 35 per cent in
response to the world recession. For manufacturers of car parts, such as
spark plugs, this collapse in demand threatened to wipe out several
longstanding companies. The US company Visteon closed its factories in
Enfield and Basildon with the loss of 565 jobs. Although one could urge
companies to have a balanced product portfolio, including some products
that will sell well in hard times, economic shocks such as 2009 caught out
many well-run businesses.
4 The behaviour of banks. Banks such as Lloyds and NatWest love running TV
 commercials showing their warm, friendly backing of small firms. But RBS
(owner of NatWest) has been accused of running a division that was set up
to make a profit out of client companies in financial difficulties. More than
1,000 companies were dealt with in ways that included forced closure so
that RBS could sell off company assets at a profit. In August 2014, RBS
closed the unit down, following huge pressure from the government and the
Bank of England. In November 2014, Vince Cable, government Secretary of
State, told the BBC Panorama programme: ‘Good companies appear to
have been put at risk or in some cases destroyed by banks.’
‘The old saying holds. Owe your banker £1,000 and you are at his mercy;
owe him £1 million and the position is reversed.’
John Maynard Keynes, British economist and author

39.4 Financial causes of business failure

There are two triggers to financial failure: one is the inability to pay the bills –
i.e. run out of cash – which is a liquidity crisis; the other is a matter of
insolvency, meaning that liabilities outweigh assets, leaving the business with
no legal alternative to closure. The latter could happen as a result of a big
investment going spectacularly wrong. So there may be a profitable business
still operating, yet the bad investment could have wiped out the value of the
firm’s assets. This is largely what happened to RBS in the 2009 financial crisis;
because it spent over £50 billion on a bank that proved worthless, the bank’s
capital was wiped out, forcing the government to rescue this private sector
business.
Most financial collapses, though, are due to running out of cash. This can
come about because:
1 The business may have been running below break-even for some period of
time. The lossmaking drains the business of its cash, as cash outflows
regularly exceed cash inflows. If the business cannot be returned to profit,
cash will run out at some point. This is the regular life of most of Britain’s
professional football clubs – always needing a new investor to inject more
cash than sense.
2 A cash flow crisis may occur, perhaps quite unexpectedly. Tesco has 28 per
cent of the UK grocery market, so there are many small food companies
who have managed to get distribution through Tesco but are now horribly
 dependent on this one supermarket chain. If Tesco is unhappy and argues
about a large bill, the clock could be ticking on the small supplier running
out of the cash to pay its own bills; if the small firm turns to its bank for
help, the bank may choose to protect itself by insisting that an overdraft
facility is repaid within 24 hours; this makes things worse, with too little
cash to cope, and the bank may call in the administrators.
3 Overtrading. As mentioned in Chapter 28, if a rise in demand encourages a
business to pursue rapid sales growth, the strain on cash flow can prove too
great, causing the company to collapse. Overtrading is one of the most
common causes of business collapse.

39.5 Non-financial causes of business failure

Apart from finance, the two things most likely to cause a business to fail are a
sudden lurch in sales towards competitors or a steady drip-drip of sales decline
as the business loses its long-term competitiveness. A fusion between these two
was seen at HMV, where the steady loss of competitiveness compared with
online music distribution was compounded by the highly aggressive stance
taken by Amazon, in DVDs as well as CDs. HMV’s market was pulled from
under its feet.
Although both these points sound like marketing problems, it is important to
remember that the underlying difficulty could have stemmed from people
management or resource management. Unhappy staff may have stopped giving
customers an enjoyable experience, so sales steadily slide towards a rival. Or
repeated IT failures make the customer experience so frustrating that they turn
elsewhere. Ultimately, business failure can be caused by poor management of
people or operations, not just marketing and finance.
‘In Britain the quickest way to riches is to fail at the top. Sign a three-year
contract and then fail in the first six months, walk away with a million
pounds for six months’ work.’
Charles Handy, management thinker
Figure 39.1 Logic ladder: overcoming financial crisis

Five whys and a how

39.6 Business failure – evaluation

When, in 2014, Tesco admitted overstating its profit by over £260 million, it
became clear that even the biggest companies can struggle to keep on top of
their costs. For small firms, this can be even more the case. A business may
believe itself to be more profitable than it really is. This year, a publisher sells
one million textbooks at £20 each; it deducts £17 million of costs and pays out
much of the £3 million profit to the taxman and its shareholders. But next year
WHSmith sends a lorry with 100,000 books and demands £2 million back; it
shows a small clause in the contract saying, in effect, ‘If they don’t sell, we will
return them and will get our money back.’
Business is interesting precisely because it is so hard to be sure that everything
is going well; Samsung’s glorious 2013 turned into an awful 2014, as did
Snickers’, which had enjoyed a 10 per cent sales boost in 2013 (‘Get some
nuts!’) followed by a 30 per cent sales collapse in 2014. All that is certain
about business finance is that clever firms keep healthy cash balances just in
case things go wrong. One day, they will.

Key terms
Administration: when the directors of a business feel forced by the
threat of insolvency to hand over management control to an
administrator (usually an accountant), who may try to sell the business,
or perhaps close it down and sell off the assets.
Business model: the underlying plan of how the business is going to
make a profit in the long term.

39.7 Workbook
Revision questions
(35 marks; 35 minutes)
1 Briefly look again at Forbes magazine’s ‘five reasons new businesses
fail’ on page 247. Which do you think is the single most important
reason and why?
(5)
2 Explain how a change in technology might harm the position of a
small driving school in a rural area.
(4)
3 Explain what Lewis Lehr meant by his quote on page 247.
(4)
4 Explain in detail the effect a sudden loss of a big customer might
have on the cash flow of a small company.
 (4)
5 In your own words, explain the meaning of the term ‘overtrading’.
(3)
6 Explain how each of the following might damage the financial
position of a new small firm:
a) a rise in interest rates
b) fewer customers arriving than had been forecast.
(6)
7 Must a business failure always have a personal failure at its heart?
Explain your thinking.
(6)
8 Explain what John Maynard Keynes meant by his quote on page
248.
(3)
Data response 1
Bad banking
The following is an extract from the Tomlinson Report into banks’
‘Treatment of Businesses in Distress’ (published on behalf of HM
Government in 2013).
‘The cases and experiences of businesses we received can be
categorised as part of an overall process as follows:
1 The bank artificially distresses an otherwise viable business and
through their actions puts them on a journey towards
administration, receivership and liquidation.
2 Once transferred into the business support division of the bank the
business is not supported in a manner consistent with good
turnaround practice and this has a catalytic effect on the business’
journey to insolvency.
3 The insolvency process lacks fairness and accountability leading to
financial implications and biased outcomes to the detriment of the
business owner.
This report considers each part of this “process” separately and the
mechanisms adopted by the bank. From the evidence that we
received, it was apparent that, while each case is different and has its
own characteristics, when taken as a whole the pattern soon clearly
emerges. Many of the businesses who submitted evidence have done
so in confidence.
Not all of the cases that we heard about go through the full process
from stage 1–3 and some relate to specific parts of the process
outlined above. However, it became very clear, very quickly that this
process is systematic and institutional. Conversations with whistle
blowers, experts and lawyers have also confirmed that it is often, in
fact, the better businesses that enter such a path as there is more to
be gained by the bank from this than from a less asset-rich business.
This suggests an element of intent in the bank’s decision to distress
these businesses.’
Later, in evidence to a parliamentary committee, senior RBS
executives denied that they treated their ‘business support division’ as
a profit centre. Within a month, they retracted that evidence, admitting
that RBS did seek to make a profit out of businesses that were
struggling to survive.
Questions
(30 marks; 35 minutes)
1 a) Explain what might be meant by the phrase ‘artificially distresses
an otherwise viable business’.
(4)
b) Explain one action a bank could take that would distress a
business customer.
(4)
2 Assess the possible impact on the business owner of being put on a
‘journey towards administration, receivership and liquidation’
(10)
3 Assess whether the short extract from the report proves its case
that there was ‘an element of intent in the bank’s decision to
distress these businesses’.
(12)
Data response 2
Ninety jobs lost as Tinsley Special Products enters
administration
Trailer engineers Tinsley Special Products have gone into
administration with the loss of 90 jobs, just months after securing £3.5
million in Regional Growth Fund money.
Just this year the County Durham-based manufacturer of trailer
vehicles acquired Marshall Aerospace and Defence Group’s Mildenhall
operations in Suffolk, and in January they bought Tanfield Engineering
Systems Ltd out of administration.
Administrators Ian Kings and Allan Kelly from Baker Tilly were
appointed to Tinsley early this month and confirmed 90 redundancies
across the firm’s Peterlee and Suffolk operations.
Allan Kelly, joint administrator and partner in Baker Tilly’s North East
region said:
‘Tinsley Special Products Limited has suffered from a downturn in
trade which has impacted on profit and cash flow. Unfortunately the
contract position and financial requirements of the Company left us
with little option but to cease trading shortly after appointment.
We are in the process of realising the assets and quantifying the
liabilities of the company to ascertain if a distribution can be made to
creditors. Additionally, our specialist employment team are assisting
the employees in making the relevant claims for any outstanding
wage arrears, holiday pay and other claims from the Redundancy
Payments Service.’
Source: The Journal, 24 November 2014
Questions
(30 marks; 35 minutes)
1 Assess what might cause a ‘downturn in trade’ for a small
manufacturer such as Tinsley Special Products.
(10)
2 Assess two factors that may have ‘impacted’ on cash flow so
 negatively as to cause the collapse of the business.
(8)
3 Tinsley Special Products was based mainly in the North East of
England, where income levels are among the lowest in the country.
Assess whether the business should therefore have been propped
up with central government funding.
(12)
Extended writing
1 A pizza company’s sales go through the roof when it advertises a
‘low-carb pizza’. Evaluate the possible reasons why this business
might still face financial failure within the next few years.
(20)
2 A fashion clothing retailer has made losses for the past two years
and its bank is discussing whether the business should close down.
Evaluate the ways in which the retailer might be turned back into a
profitable business.
(20)
Section 2.4 Resource management

40 Introduction to resource
management
Definition
Resource management requires planning and control at every stage in
the supply chain, from purchasing to customer delivery.

Linked to: Supply, Ch 6; Introduction to managing people, Ch

16; Production, productivity and efficiency, Ch 41; Capacity
utilisation, Ch 42; Stock control, Ch 43; Quality management,
Ch 44.

40.1 Introduction
Resource management is the central business function of creating the product
or service and delivering it to the customer (that is, meeting the customer
requirement). At Jaguar Land Rover, it means designing the cars and the
machinery for making them, ordering the supplies, manufacturing the
products, delivering them to the car showrooms and handling customer service
issues such as warranty claims. Marketing creates the demand; resource
management creates the supply to meet the demand. To achieve this, it requires
human and financial resources.
Figure 40.1 The central role of resource management
The importance of resource management is especially clear in the car industry.
Rover Cars once commanded more than a 50 per cent share of the British car
market. Its cars were well designed but poorly made. In 2005, the business
ceased to exist as a British producer. In the years of Rover ’s decline, Toyota
moved from being outside the top 20 world car producers to its current
position as number one, selling ten million cars in 2014. Toyota has never
been famous for producing stylish cars, but their quality and reliability have
built its reputation worldwide. Toyota’s business success has been built not on
marketing but on resource management. By 2014, this success brought it
annual profits of over £10 billion and a balance sheet cash cushion of £30
billion. Even though Toyota has had some quality problems in recent years, the
fundamental strength of the business (and its customer loyalty) keeps it
motoring.
Figure 40.2 A car factory

40.2 What is resource management?

Step 1: design
The process starts by designing a product or service to meet the needs or
desires of a particular type of customer (see Table 40.1 for examples). The key
at this, and every other, stage is to be clear about the customer and his/her
requirements. If a tablet computer manufacturer ’s target customer is a student,
the design of the tablet must be simple, economical and effective in order to
help keep costs low enough to provide the low prices the student wants.
‘Almost all quality improvement comes via simplification of design,
manufacturing, layout, processes and procedures.’
Tom Peters, author of In Search of Excellence
Table 40.1 Examples of designs that aim to meet customer
requirements

Step 2: establishing the supply chain

In a manufacturing process, the heart of the operation will be the factory. This
is where a collection of materials and parts will be turned into a finished
product. In the case of a car, literally thousands of parts are involved in making
each vehicle. Components that may cost little to produce, such as metal fixings
for seat belts, all combine to turn £4,000 worth of parts into a car worth
£10,000.
This does not mean, though, that the car maker receives £6,000 of profit for
every car sold; £6,000 of value has been added to the components, but at what
cost? The most obvious cost is labour (that is, the staff needed to organise and
run the factory). This will typically cost about 20 to 25 per cent of the value of
the output. There are other factors that are a clear waste of money for the
business, such as those listed below.
• Production line errors leading to ‘wastage’: if a car reaches the end of the
production line and, when tested, fails to start, labour time is wasted finding
the fault, and more time and components involved in correcting the problem.
Modern companies try to eliminate all activities that waste time, but failing
to take care over quality can never make sense for any company that wants to
build a long-term future.
• Breakdowns, perhaps due to faulty maintenance, or just due to wear and tear:
a well-run business uses preventative maintenance – checking machinery and
replacing worn parts before a breakdown occurs.
Having established a well-run factory, the business can establish the other key
parts of the supply chain, as indicated in Figure 40.3.
Figure 40.3 The supply chain

Step 3: working with suppliers

Very few businesses produce 100 per cent of a product or service. Almost all
use suppliers. In some cases, suppliers may do most of the operational work.
Companies that ‘bottle’ Coca-Cola buy in: the aluminium cans, already printed
with the can design; the water; the carbon dioxide used to create the fizz; and
the secret Coke syrup (sent from the Coca-Cola factory in America). They may
also get a distribution company such as Exel to make all the deliveries to
wholesale and retail customers. So what does the Coca-Cola bottler actually
do? Well, not a huge amount, clearly. But it must still be responsible for the co-
ordination of all the suppliers and the quality of their work. If Waitrose
ordered a container load of Coke Zero to reach its Bracknell depot at 10.00am
on a Tuesday morning, did it turn up on time? If not, why not?
For many companies, working with suppliers is a key to success. A homemade
ice cream parlour may do all the production operations on-site, but still relies
on suppliers of: fresh fruit, fresh milk and cream, grocery items such as sugar,
wafer biscuits and cones, paper cups and plastic spoons, and so on. To run the
parlour successfully, all the operations have to be carried out successfully. If
you have run out of cones, the best ice creams will remain unsold.
A company must therefore select suppliers that can deliver the right goods
reliably and must negotiate low enough prices for the supplies to make it
possible to run the business economically.

Step 4: managing quality

Quality is not easy to define. It is a combination of real factors plus
psychological ones. A haircut may be carried out very expertly, yet the
customer may go away and cry! A less expert hairdresser may produce a
technically worse cut, yet the effect may be just what the customer wants. In this
case, providing quality means providing what the customer wants (that is,
delivering customer satisfaction).
Effective resource management requires certain quality objectives:
• The product/service must do what the customer has been promised.
• It must arrive on time, in good condition.
• It must last at least as long as the customer expects.
• Customer service should be effective (for example, phones answered
quickly).
• After-sales service should also be effective (for example, speedy repair if
something goes wrong).
These are the basics; on top of these should come the psychological factors
that can mean a huge amount, such as service with a warm smile. Modern
business theory suggests that, to stand out, a company needs to achieve
‘customer delight’ not just customer satisfaction. The easiest way to delight a
customer is to be genuinely welcoming.
‘I consider a bad bottle of Heineken to be a personal insult to me.’
Freddy Heineken, founder of Heineken
Figure 40.4 Logic circle: effective resource management

Step 5: achieving high levels of efficiency

Chapter 41 shows the importance of efficiency in business. This comes partly
from using resources fully, such as a school hiring out five-a-side all-weather
pitches at the weekends. It also comes from high-productivity processes,
probably backed by regularly updated equipment and technology. According to
Moore’s law, computing power doubles every two years. Technological
advances in IT can speed up existing production processes hugely. In some
cases, technology can substitute for labour, reducing costs. However, the most
successful firms tend to encourage staff to help re-think their processes
regularly – but especially during periods of rapid technological change.
‘Engineering is treated with disdain, on the whole. It’s considered to be
 rather boring and irrelevant, yet neither of those is true.’
James Dyson, billionaire engineer and entrepreneur
Within the resource management function, a key requirement is software that
will satisfactorily manage the day-to-day process, from supplies through to
delivery. For example, if fashion retailer Zara of Spain suddenly orders 4,000
‘Glastonbury’ jackets from your clothing factory, you need instantly to know:
• how many metres of cloth to order from your suppliers, and how many
metres of lining
• how many buttons and zips to order
• when is the earliest date that all the above can be received, and therefore the
job can begin
• how many hours of machine time will be needed
• how much overtime will be needed from staff, if the factory is already busy
• how many extra delivery vehicles will be needed and when
• when Zara can expect delivery of all 4,000 items to its Spanish headquarters.
This should all be available at the touch of a button using enterprise resource
planning (ERP) software. This software has all the details of the business
operation and provides the planning plus day-to-day monitoring of whether
things are working to schedule.

Five whys and a how

40.3 Introduction to resource management –
evaluation
Every business is different, especially in the status given to resource
management staff. In Toyota or BMW, top engineers are the stars of the
business and resource management will be at the heart of all major decisions.
In a business such as Innocent Drinks, the marketing people lead the business,
with resources changing to suit the market. Usually the importance and power
of resource staff reflect the needs and history of the business. Regrettably there
are also national characteristics to consider. The title ‘engineer ’ is prestigious
in Germany, Japan and India. In Britain, it is a struggle to find many A level
students who desperately want to be engineers. Bankers, management
consultants and media careers are much preferred. So some UK companies that
should be based on strong resource management are actually dominated by
marketing and finance executives. Therefore, decisions about the future may be
too focused on the short term. The hugely successful engineer billionaire
James Dyson once said: ‘Advertising is the British answer to everything. But
that is the way to a fast buck, not real money.’

Key terms
Enterprise resource planning (ERP): planning that logs all of a firm’s
costs, working methods and resources (machinery, labour, stocks of
materials) within a piece of software; this provides a model of the
business that can be used to answer questions such as ‘When do we
need to start working to get stocks made in time for delivery before
Christmas?’
Supply chain: the whole path from suppliers of raw materials through
production and storage on to customer delivery.

40.4 Workbook
Revision questions
(25 marks; 25 minutes)
1 Why may the quality of product design be less important for some
businesses than others?
(3)
2 Explain two key elements of resource management for:
a) a children’s shoe shop
b) a new, all-business-class airline.
 (8)
3 Choose one of the examples in Table 40.1 and outline one strength
and one weakness of that business idea.
(4)
4 Identify three ways in which staff might be at fault in production line
errors that cause wastage.
(3)
5 Examine the possible effects on a firm such as Coca-Cola of being
unreliable in delivering to a big customer like Waitrose.
(5)
6 Outline one possible benefit to a business from ‘delighting’ rather
than ‘satisfying’ its customers.
(2)
Data response
IKEA resource management
The furniture retailer IKEA was established in 1943 by a 17-year-old
Swede called Ingvar Kamprad. His aim was very similar to Henry
Ford’s: sell high-quality products at prices low enough to make them
affordable to a mass market. The business thrived because IKEA
successfully delivered products that met customer requirements.
People liked IKEA’s designs and were happy to buy into the company’s
vision that beautiful, high-quality furniture should be affordable for all.
The company grew rapidly. By 2014, IKEA was a global giant,
operating worldwide in 43 countries. Last year, its annual turnover ($38
billion) was greater than the GDP of Serbia.
IKEA’s highly effective resource management is crucial to its success.
This is because low prices will only be profitable if operating costs are
kept under control. One of IKEA’s most significant innovations was to
sell its furniture in flat packs. These take up less room than furniture
that is displayed conventionally, which means that IKEA is able to
generate high revenues per cubic metre of floor space. Staffing costs
at IKEA stores are kept low in two ways. First, customers are asked to
collect their purchases themselves from the in-store warehouse.
Second, IKEA does not have to pay staff to assemble its products; the
consumers assemble the furniture that they have bought themselves
by following instruction leaflets included inside the flat packs. Families
that buy IKEA flat packs are therefore prosumers – half consumer and
half producer.
Source: www.ikea.com/gb/en/
Questions
(40 marks; 45 minutes)
1 Outline one aspect of IKEA’S resource management that helps the
company to minimise its costs.
(2)
2 Assess whether IKEA’s highly effective resource management is the
most important factor in determining the company’s success.
(10)
3 Assess two possible weaknesses of IKEA’S resource management.
(8)
4 IKEA sources its raw materials from suppliers all over the world.
Evaluate the challenges that this might pose for IKEA’s supply chain
management.
(20)
Extended writing
1 In 2014, UK food producer Pasta Reale collapsed into
administration, costing 169 jobs. Even though its sales revenue was
£39 million in the 18 months to March 2013, the business lost
money. Evaluate how likely it is that poor resource management
was the key factor in its operating losses.
(20)
2 For a business such as Tesco, evaluate whether marketing or
resource management is more likely to be the key to improving
operational performance.
(20)
Section 2.4 Resource management

41 Production, productivity and

efficiency
Definition
Production measures the quantity of output. Productivity is a measure
of efficiency, calculated by dividing output by the inputs per time
period, e.g. labour productivity at Nissan UK: 100 cars per worker per
year.

Linked to: Supply, Ch 6; Approaches to staffing, Ch 17;

Introduction to resource management, Ch 40; Capacity
utilisation, Ch 42. .

41.1 Methods of production

Job production
This means producing a one-off item for a one-off customer. Prince Charles
gets his shoes hand-made at John Lobb Bootmaker in central London. So does
Calvin Klein. It takes five years of training to become a John Lobb shoemaker.
And the price of a pair starts at £3,500. That’s job production: tailor-made to
suit an individual’s needs. It is how everything used to be made, long ago when
labour was cheap.

Batch production
This means producing a set number of identical items – for example, 500 pairs
of size 11 army boots for the British armed forces. When producing batches of
this size, the producer would find it worthwhile to invest in some machinery to
speed up the production process. Instead of hand-stitching, up-to-date
machinery will do the job far better; there will also be a machine purchased to
stick the sole of the shoe to the upper. And whereas at John Lobb one person
performs every task required to complete the pair of shoes, batch production
usually involves division of labour – that is, dividing up the tasks between
different employees, each of whom can specialise and therefore become more
efficient. Batch production is more efficient than job production, which keeps
costs down, thereby allowing prices to fall. The 500 army boots might cost the
army £60 each.

Flow production
This is continuous production of a single item, such as cans of Heinz Baked
Beans. With 250 million cans produced each year in the UK Heinz factory, a
production line can be set up to churn out five million cans a week. It will be
highly automated, with the only human labour being to feed in materials, to
check on quality and to maintain the machines. Whereas the labour cost of John
Lobb shoes might amount to more than £1,000 per pair; the labour cost per
can of beans might be little more than 1p. Flow production is the most efficient
way to produce an item with predictable, high-volume sales.

Cell production
This means setting up a small production line or group-working process so
that items can be produced quite flexibly. A good example would be Brompton
Bikes (the UK’s biggest producer – 45,000 a year), which has the flexibility to
produce every bike to order. They can produce a bike for a customer who is
6ft 6in tall, or one with a titanium frame, or one with special gearing for going
up mountains. Brompton used to produce on a job basis, but moved to cell
production in 2010 when business started to boom. Group working allows the
company to produce to higher productivity and higher output levels.
Table 41.1 Circumstances when each production method is at its most
effective

41.2 Productivity: what is it?

Labour productivity measures the amount a worker produces over a given
time. For example, an employee might make ten pairs of jeans in an hour.
Measuring productivity is relatively easy in manufacturing where the number
of goods can be counted. In the service sector, it is not always possible to be
sure what to measure. Productivity in services can be measured in some cases:
the number of customers served, number of patients seen and the sales per
employee. But how can the productivity of a receptionist be measured?
It is important to distinguish between productivity and total output. By hiring
more employees, a firm may increase the total output, but this does not mean
that the output per employee has gone up. Similarly it is possible to have lower
production with higher productivity because of a fall in the number of
employees. Imagine, for example, 20 employees producing 40 tables a week at
a furniture company. Their productivity on average is two tables per week per
worker. If new machinery enables 10 employees to make 30 tables, the overall
output has fallen, but the output per worker has risen to three. This rise in
productivity would lower the labour cost per table. In the formula below,
‘inputs’ primarily means labour, but could also be land or capital.

41.3 The importance of productivity

The output per employee is a very important measure of a firm’s performance.
It has a direct impact on the cost of producing a unit. If productivity increases
then, assuming wages are unchanged, the labour cost per unit will fall. Imagine
that in one factory employees make five pairs of shoes per day, but in another
they make ten pairs per day; assuming the wage rate is the same, this means the
labour cost of a pair of shoes will be halved in the second factory (see Table
41.2). With lower labour costs, this firm is likely to be in a better competitive
position.
Table 41.2 Shoe factory productivity and wage costs
By increasing productivity, a firm can improve its competitiveness (ability to
equal or beat its rivals). It can either sell its products at a lower price or keep
the price as it was and enjoy a higher profit margin. This is why firms
continually monitor their productivity relative to their competitors and, where
possible, try to increase it. However, they need to make sure that quality does
not suffer in the rush to produce more. It may be necessary to set both
productivity and quality targets.

41.4 Factors influencing productivity

The level of investment in modern equipment

By investing in modern, sophisticated machines and better production
processes, it shouldn’t be hard to improve output per worker. That, in turn,
would improve individual companies’ competitiveness and help to boost the
country’s economic growth. Yet Figure 41.1 is a reminder that Britain
consistently invests less than other countries as a share of GDP – despite
repeated cuts to corporation tax that are said to encourage greater business
investment.
Figure 41.1 Investment spending: too low in UK (source: CIA Factbook,
2014)
‘Engineering is the ability to do for $1 what any damn fool can do for $5.’
Arthur Wellington, nineteenth-century US engineer

The ability level of those at work

To increase productivity, a firm may need to introduce more or better training
for its employees. A skilled and well-trained workforce is likely to produce
more and make fewer mistakes. Employees should be able to complete tasks
more quickly and will not need as much supervision or advice. They will be
able to solve their own work-related problems and may be in a better position
to contribute ideas on how to increase productivity further.
However, firms are often reluctant to invest in training because employees may
leave and work for another firm once they have gained more skills. There is a
danger that the training will not provide sufficient gains to justify the initial
investment and so any spending in this area needs to be properly costed and
evaluated. In general, UK firms do not have a particularly good record in
training; more investment here could help the UK’s productivity levels.

Improve employee motivation

Professor Herzberg once said that most people’s idea of a fair day’s work is
less than half what they can give. The key to success, he felt, was to design jobs
that contained motivators to help employees give much, much more. His
suggestions on how to provide job enrichment are detailed in Chapter 20.
There is no doubt that motivation matters. A motivated sales force may achieve
twice the sales level of an unmotivated one. A motivated computer technician
may correct twice the computer faults of an unmotivated one. And, in both
cases, overall business performance will be boosted.

Figure 41.2 Logic chain: boosting productivity through training

‘Looking for differences between the more productive and less productive
organisations, we found that the most striking difference is the number of
people who are involved and feel responsibility for solving problems.’
Michael McTague, management consultant

Real business
Motivation on the pitch
When Fulham Football Club appointed a new groundsman, few people
even noticed. The fans had always been proud of the pitch, but newly
appointed Frank Boahene was not impressed. He thought it needed a
dramatic improvement before the start of the new season in August.
With no time to reseed the pitch, he decided the best way to
strengthen the grass was to cut it three times a day. Doing so, first
thing in the morning and last thing in the afternoon, was not a problem.
But he also chose to ‘pop back’ from his home in Reading (an hour’s
drive) to do the third cut at 11.00 at night. Every day! That’s
motivation.

Figure 41.3 Motivation and the football pitch

41.5 Difficulties increasing productivity

The role of management

A serious problem for UK management is that productivity has never been a
central focus for directors. In the UK, directors focus on profits; elsewhere
they look for efficiency first, trusting that profits will follow.
Perhaps the key management role is to identify increasing productivity as a
permanent objective. The Japanese bulldozer company Komatsu set a target of
a 10 per cent productivity increase every year, until they caught up with the
world-leading American producer Caterpillar. Today Komatsu is the world
number two producer, with annual sales of £11.5 billion.
In many firms, productivity is not a direct target. The focus, day by day, is on
production, not productivity. After all, it is production which ensures customer
orders are fulfilled. An operations manager, faced with a 10 per cent increase
in orders, may simply ask the workforce to do overtime. The work gets done;
the workforce is happy to earn extra money; and it is all rather easy to do. It is
harder by far to re-organise the workplace to make production more effective.
Managers whose main focus is on the short term, therefore, think of
production not productivity.
As shown in Figure 41.4, productivity growth has been very weak in Britain
since 2007. If this continues, the economic recovery will stall.

Figure 41.4 UK productivity index, output per worker (source: ONS,

June 2014)

41.6 Link between productivity and competitiveness

Figure 41.5 shows changes in productivity among selected EU countries. In
2004, UK productivity was 16.3 per cent higher than the EU average – not too
far off the figures for Germany and France. Since then, UK productivity has
fallen significantly, to below the EU average and about 30 per cent below that
of France and Germany. Ultimately, as lower productivity inevitably causes
higher labour costs per unit, this makes UK producers less competitive with
our rivals. It makes it more likely that, in future, UK producers will have to
hold wage levels down to stay in business.

Figure 41.5 Labour productivity per hour in Europe (source: Eurostat,

September 2014)
Fortunately, competitiveness is not just about costs. Jaguar Land Rover is
enjoying a sales boom that is nothing to do with the prices of its cars. It is
simply that people want the cars – and are willing to pay top prices if
necessary. In other words, the price elasticity of JLR cars is low, and therefore
neither prices nor costs matter too much. The same is true of some other
important UK manufactures, such as Brompton bikes, JCB construction
vehicles and GKN composite materials for making fuel-efficient passenger
planes.
‘Not everything that can be counted counts, and not everything that counts
can be counted.’
Albert Einstein, the ultimate boffin

41.7 Are efficiency and productivity the same thing?

Directly, the answer is no. Productivity is output per worker per time period
(hour, month or year). That ignores some other key features of efficiency,
notably waste. One super-fast worker may produce a lot of output, but in a
wasteful manner. A decorator may paint speedily but messily, wasting 20 per
cent of the paint. So productivity may be high but overall efficiency no better
than average. And a company may produce chemicals with high productivity,
but create pollution locally (waste products leaking out of the chimney,
perhaps). Again this would not be efficient. Despite this, labour productivity is
regarded by business as one of the most important tests of management
efficiency.

41.8 Production at minimum average cost

By definition, the most efficient production level is the one at which total unit
costs are as low as possible. Figure 41.6 shows this point, with its implication
that average unit costs don’t simply fall for ever – they fall at first but then rise
as cost inefficiencies kick in. Note that this diagram shows the short-term
position for a company; ‘minimum average costs’ are at the point marked as
‘minimum level of unit costs’.

Figure 41.6 Production at minimum average cost

Factors influencing efficiency include:
• level of wastage in the production process (as explained in Section 41.7)
• whether the right technology is being used – for example, is the production
process utilising the very latest methods?
When Nestlé started packing four-finger KitKats into a ‘flow’ plastic
wrapper (instead of the old-style silver foil with a paper cover) they claimed
 that the efficiency gains would be ‘substantial’ as it would speed up the
production line.
• whether managers have achieved the right balance between the variable
factors that affect efficiency. For example a supermarket may have all the
latest equipment to make it efficient, yet recruit too few staff at the peak
shopping hours to cope with the customer volumes; this might lead to long
queues and, ultimately, fewer returning customers.

41.9 Capital and labour intensity

A further factor affecting production efficiency concerns the balance struck
between capital- and labour-intensive production. Measuring up a bride-to-be
and then making a wedding dress by hand is the ultimate in labour-intensive
production. However hard the dressmaker works, his/her productivity will be
very low. This is because so little can be mechanised or automated. By contrast,
a dress designer for Topshop may be able to order 10,000 identical size 10
dresses to be distributed across the Topshop stores. This batch of 10,000 can
be produced largely by machine (that is, through capital- rather than labour-
intensive production).
The importance of this topic is that it points to a huge opportunity for small
firms. In almost every industry, there is scope for some labour-intensive
production. This is because there are always some people who want – and can
afford – an entirely individual product. In addition, there are businesses where
labour-intensive production is inevitable, such as plumbing, advertising
(creating and producing commercials), legal advice and running a school.
Starting a new car manufacturing firm will be massively expensive and make
you compete head-on with huge firms. Starting a new advertising agency has
neither problem.

Labour-intensive production
Labour-intensive production:
• means that labour costs form a high percentage of total costs
• has low financial barriers to entry because it is cheap to start up production
• makes it necessary for management to focus on the cost of labour (making it
especially attractive to switch production to a low-cost country such as
Cambodia)
• has the advantage of being highly flexible, making it possible for a small
firm to operate successfully without direct competition from a large one.
‘When a man tells you that he got rich through hard work, ask him whose.’
Don Marquis, author and playwright

Capital-intensive production
Capital-intensive production:
• has a large percentage of its total costs tied up in the fixed costs of
purchasing and operating machinery
• has high financial barriers to entry
• may be able to keep producing in a high-cost country because labour costs
are such a small proportion of the total costs (for example, mass production
of Coca-Cola or Heinz Beans)
• can be inflexible, both in terms of switching from one product to another and
in the ability to tailor a product to an individual customer.
‘Capital intensive production is great on the way up, but trouble on the way
down.’
Anon

Figure 41.7 Labour- versus capital-intensive production

Five whys and a how

41.10 Production, productivity and efficiency –
evaluation
Greater labour productivity can lead to greater efficiency and higher
profitability. This is because, other things being equal, it lowers the labour cost
per unit. However, productivity is only one factor that contributes to a firm’s
success. A firm must also ensure it produces a good-quality product, that it is
marketed effectively and that costs are controlled. There is little point
increasing productivity by 20 per cent if at the same time you pay your staff 30
per cent more. Similarly, there is no point producing more if there is no actual
demand. Higher productivity, therefore, contributes to better performance but
needs to be accompanied by effective decision making throughout the firm.
The importance of productivity to a firm depends primarily on the level of
value added. Top-price perfumes such as Chanel have huge profit margins.
Production costs are a tiny proportion of the selling price. Therefore, a 10 per
cent productivity increase might have only a marginal effect on profit and
virtually none on the competitiveness of the brand. For mass market products
in competitive markets, high productivity is likely to be essential for survival.
A 5 per cent cost advantage might make all the difference. Therefore, when
judging an appropriate recommendation for solving a business problem, a
judgement is required as to whether boosting productivity is a top priority for
the business concerned.

Key terms
Barrier to entry: factors that make it hard for new firms to break into
an existing market (for example, strong brand loyalty to the current
market leaders).
GDP: gross domestic product is the value of all the goods and
services produced in a country in a year.
Job enrichment: giving people the opportunity to use their ability
(Professor Herzberg’s definition).
Lean production: focusing on minimising wastage of resources
throughout the supply process, e.g. minimum stock levels and minimum
wastage through poor quality.

41.11 Workbook
Revision questions
(40 marks; 40 minutes)
1 What is meant by the term ‘productivity’?
(3)
2 Why may it be hard to measure the productivity of staff who work
in service industries?
(4)
3 How does productivity relate to labour costs per unit?
(4)
4 Explain how a firm may be able to increase its employees’
productivity.
(4)
5 How can increased investment in machinery help to boost
productivity?
(3)
6 Identify two factors which help and two factors which limit your
productivity as a student.
(4)
7 Outline the likely effect of increased motivation on the productivity
of a teacher.
(5)
8 Calculate the change in productivity at BDQ Co (see Table 41.3)
 since last year.
(4)

Table 41.3 Productivity at BDQ Co

9 Explain how motivation and productivity may be linked.
(4)
10 Explain how productivity can be linked to unit labour costs.
(5)
Data response 1
In developing countries, labour is often wasted by employers because
it is relatively cheap. The result is workers being profitably employed in
low productivity activities such as shoe-cleaning, street vending and
sandwich boards (a human, walking advertising poster).
Real wages in the UK have fallen sharply over the last decade. This
has encouraged some British firms to adopt some of the same
methods used by employers in developing countries. Cheap British
labour is now being employed in activities that are profitable, but where
productivity is very low.
A good example is Domino’s pizza.
Figure 41.8 A Domino’s ‘wobble boarder’
In recent years, the take-away chain has used some of its employees
to act as human advertisements. Workers are asked to wave and
dance at passing motorists on busy street corners while wearing giant
pizza boxes featuring the company’s brand and details of special
promotional prices. The company has defended their use of ‘wobble
boarding’ by claiming that ‘it is a key part of our marketing activity’. The
use of wobble boards to boost sales of pizza has attracted criticism. In
Cambridge, local residents wrote letters of complaint arguing that it
was demeaning and degrading for young people, including graduates,
to be paid minimum wages to act as little more than walking
advertisements. Others criticised the adverts on the grounds that they
could distract motorists, causing accidents. Presumably, Domino’s
uses wobble boards because the extra revenue generated from this
form of advertising exceeds the wages paid to wobble boarders.
Questions
(30 marks; 35 minutes)
1 Explain how the manager of a Domino’s pizza outlet might measure
the productivity of their wobble boarders.
(4)
2 The manager of a Pizza Express estimates that a team of five
wobble boarders working for eight hours daily will boost the
restaurant’s gross profit by £500 per day. According to the local job
centre, there will be plenty of people willing to undertake this work at
the national minimum wage of £6.50 per hour. On the basis of these
figures, calculate whether it would be profitable for Pizza Express to
employ the wobble boarders.
(4)
3 Assess the view that low productivity always leads to low
profitability.
(10)
4 Assess whether it is ethical to employ graduates to act as human
advertisements.
(12)
Data response 2
Going potty
Farah Stewart was trying to explain the need to boost productivity to
the employees at her ceramics factory, FS Ltd. Relations between
Farah and her staff had not been good in recent years. The company
was not doing well and she blamed the workers.
‘On average you work eight hours a day at £8 an hour and produce
around 160 pots each. Meanwhile at Frandon, I am told, they
produce 280 pots a day. Can’t you see that this makes it cheaper for
them and if things go on like this we’ll be out of business? You need
to work much harder to get our unit costs down! I know you are
expecting to get a pay rise this year, but I cannot afford it until you
produce more; then we’ll think about it.’
Jeff Battersby, the spokesperson for the employees, was clearly
annoyed by Farah’s tone.
 ‘Firstly, Ms Stewart, have you ever considered that if you paid us
more we might produce more for you? I’m not surprised productivity
is higher at Frandon – they get about £80 a day. There’s no point
demanding more work from us if you are not willing to pay for it –
we’re not slaves you know. If you paid us £10 an hour, like Frandon,
I reckon we could increase productivity by 50 per cent. However,
that’s not the only issue: they’ve got better equipment. It’s not our
fault if the kilns don’t work half the time and take an age to heat up.
Sort out the equipment and our pay and you’ll soon see productivity
improve. Why not ask us next time instead of jumping to
conclusions?’
Questions
(60 marks; 75 minutes)
1 a) FS Ltd employs 50 pot makers while Frandon Ltd employs 30
people in production. Calculate the total output for each of the
two companies.
(4)
b) With reference to FS Ltd and Frandon Ltd, explain the difference
between ‘total output’ and ‘productivity’.
(4)
2 a) Calculate the average labour cost per pot at FS Ltd if employees
are paid £8 an hour and their daily output is 160 pots each.
(4)
b) Calculate the wage cost per pot at Frandon (assume an eight-
hour day).
(4)
c) Assess the short- and long-term benefits to Frandon of its lower
labour costs per unit.
(10)
d) Jeff Battersby claims that if the employees at FS Ltd were paid
£10 an hour their productivity would increase by 50 per cent.
Calculate what the unit wage cost would be then.
(4)
3 Assess whether Farah should increase the pay of her employees to
£10 an hour.
(10)
4 Evaluate the possible gains from involving employees in discussions
about how to improve productivity.
(20)
Extended writing
1 Faced with falling sales and sharply falling market share, the boss at
Morrisons supermarkets decides to implement a 12-month
Productivity Improvement Programme (PIP). Evaluate how the boss
should set about this task.
(20)
2 New competition from Chinese-made cars is undercutting the prices
of British-made cars by 35 per cent. Evaluate the possible impact of
a sustained programme by management to boost labour productivity
at a British car factory.
(20)
Section 2.4 Resource management

42 Capacity utilisation
Definition
Capacity utilisation measures a firm’s output level as a percentage of
the firm’s maximum output level. A football stadium is at full capacity
when all the seats are filled.

Linked to: Approaches to staffing, Ch 17; Introduction to

resource management, Ch 40; Production, productivity and
efficiency, Ch 41.

42.1 The importance of capacity

Few products have completely predictable sales (perhaps baked beans or
Marmite?) and therefore these is a fine balance to be struck between using your
factory capacity fully and therefore efficiently – yet having the wiggle room to
meet unexpectedly high orders. So it is vital to have sufficient spare capacity to
cope with higher demand, while keeping capacity low enough to keep costs
down. A fine balance.

42.2 Why and how to change capacity

In growth markets, capacity may need to be increased regularly. If an
individual firm decides against increasing its own capacity, it will lose market
share if it cannot meet demand. Yet capacity increases can take years to put into
practice. The risk, then, is that the decision to increase capacity looks foolish
when – a year or two later – the bigger factory or huge new office block opens
at a time when boom has turned to bust. Clever businesses make sure that they
anticipate changes in demand, so that capacity increases are managed. A little at
a time is greatly preferable to a great leap forward.

Real business
India’s railways are crumbling, due to a lack of investment over many
years. At the same time, the demand for passenger and freight
transport in India has been increasing. This is mostly due to economic
growth, which has pushed up commuter numbers and the amount of
raw materials and goods that have to be moved around the country.
The combination of rising demand and static capacity has caused
overcrowding on many routes – bottlenecks on routes cause delays,
which slow journeys. A shortage of space on trains means that
passengers frequently have to stand in very crowded conditions,
indicating that capacity utilisation is well above 100 per cent.

Figure 42.1 India’s overcrowded railways

In January 2014, the Indian government announced a $10 billion plan
to reduce overcrowding by investing in new trains and by building new
rail lines and stations. This will not go far within such a vast country.

42.3 How is capacity utilisation measured?

Capacity utilisation is measured using the formula:

What does capacity depend upon? A firm’s maximum output level is

determined by the quantity of buildings, machinery and labour it has available.
Maximum capacity is achieved when the firm is making full use of all the
buildings, machinery and labour available – that is, 100 per cent capacity
utilisation.
For a service business, the same logic applies, though it is much harder to
identify a precise figure. This is because it may take a different time to serve
each customer. Many service businesses cope with fluctuating demand by
employing temporary or part-time staff. These employees provide a far
greater degree of flexibility to employers. Part-time hours can be increased, or
extra temporary staff can be employed to increase capacity easily. If demand
falls, temporary staff can be laid off without redundancy payments, or part-
time staff can have their hours reduced, thus reducing capacity easily and
cheaply.

Figure 42.2 How flexible staffing (C) can reduce wastage implied by
having under-used full-time staff (A)

42.4 Implications of under-utilisation of capacity

Fixed costs are fixed in relation to output. This means that whether capacity
utilisation is 50 per cent or 100 per cent, fixed costs will not change. So if a
football club invests in an expensive playing staff (whose salaries are a fixed
cost) but matches are played to a half-empty stadium, the fixed costs will
become a huge burden. This is because the very fact that fixed costs do not
change in total as output changes means that they do change per unit of
output/demand. A half-empty stadium means that the fixed costs per unit are
double the level at maximum capacity (see Table 42.1).

Table 42.1 Fixed costs and capacity

When the stadium capacity utilisation is at 50 per cent, £30 of the ticket price is
needed for the players’ wages alone. The many other fixed and variable costs
of running a football club would be on top of this, of course.
The reason why capacity utilisation is so important is that it has an inverse
(opposite) effect upon fixed costs per unit. In other words, when utilisation is
high, fixed costs are spread over many units. This cuts the cost per unit, which
enables the producer either to cut prices to boost demand further or to enjoy
large profit margins. If utilisation is low, fixed costs per unit become
punishingly high. In June 2014, a newspaper in Zimbabwe reported that
manufacturing capacity utilisation had fallen in the last year by 10 per cent to
30 per cent. According to the report, firms had reduced output in response to
falling demand. This would make fixed costs per unit three times higher than
necessary, which is an almost impossible situation.

42.5 Implications of over-utilisation of capacity

There are two key concerns about operating at maximum capacity for long,
however. These are the risks that:
• if demand rises further, you will have to turn it away, enabling your
competitors to benefit
• you will struggle to service the machinery and train/retrain staff; this may
prove costly in the long term, and will increase the chances of production
breakdowns in the short term.
And is it possible to have a capacity utilisation rate of 105 or 110 per cent?
Yes, in the service sector. If the business was a hotel or airline, then
‘overbooking’ will mean disappointed customers, ‘bumped’ off the flight they
had chosen. For a shop, though, it might mean an uncomfortably overcrowded
store, or queues having to form outside (as was true of Ugg Boots outlets when
they were hugely trendy).
The ideal, therefore, is a capacity utilisation of around 90 per cent.

Real business
In 2014, suffering from a sharp downturn in sales at its biggest stores,
Tesco re-evaluated the size of its car parks. Their average utilisation
rate had fallen to an all-time low. In response, it invited Avis car hire to
take over sections of the big-store car parks. For Avis, it could be a
winner: ‘We think this will work really well for customers who want a
convenient place to pick up their hire car and do a quick shop before
heading off on their travels.’ For Tesco, it reduces the waste involved
in empty car spaces. It increases Tesco’s capacity utilisation and
therefore (slightly) reduces costs per customer.

42.6 Ways of improving capacity utilisation

If a firm’s capacity utilisation is an unsatisfactory 45 per cent, how could it be
increased to a more acceptable level of around 90 per cent? There are two
possible approaches, as discussed below.

Increase demand (in this case, double it!)

Demand for existing products could be boosted by extra promotional
spending, price cutting or – more fundamentally – devising a new strategy to
reposition the products into growth sectors. If supermarket own-label products
are flourishing, perhaps offer to produce under the Tesco or Sainsbury’s
banner. If doubling of sales is needed, it is unlikely that existing products will
provide the whole answer. The other approach is to launch new products. This
could be highly effective, but implies long-term planning and investment.

Cut capacity
If your current factory and labour force is capable of producing 10,000 units a
week, but there is demand for only 4,500, there will be a great temptation to
cut capacity to 5,000. This may be done by cutting out the night shift (that is,
making those workers redundant). This would avoid the disruption and
inflexibility caused by the alternative, which is to move to smaller premises.
Moving will enable all fixed costs to be cut (rent, rates, salaries, and so on), but
may look silly if, six months later, demand has recovered to 6,000 units when
your new factory capacity is only 5,000.

How to select the best option

A key factor in deciding whether to cut capacity or boost demand is the
underlying cause of the low utilisation. It may be the result of a known
temporary demand shortfall, such as a seasonal low point in the toy business.
Or it may be due to an economic recession, which (on past experience) may hit
demand for around 18–24 months. Either way, it could prove to be a mistake in
the long run to cut capacity. Nevertheless, if a firm faces huge short-term
losses from its excess fixed costs, it may have to forget the future and
concentrate on short-term survival.
Figure 42.3 Logic chain: improving capacity utilisation

Five whys and a how

42.7 Capacity utilisation – evaluation
Most firms will aim to operate close to full capacity, but probably not at 100
per cent. A small amount of spare capacity is accepted as necessary, bringing a
certain degree of flexibility in case of need. In this way, sudden surges of
demand can be coped with in the short run by increasing output, or downtime
can be used for maintenance. Spare capacity can be a good thing.
Firms operating close to full capacity are those that may be considering
investing in new premises or machinery. Building new factories takes time, as
well as huge quantities of money. Can the firm afford to wait 18 months for its
capacity to be expanded? Perhaps the firm would be better served
subcontracting certain areas of its work to other companies, thus freeing
capacity.
Capacity utilisation also raises the difficult issue of cutting capacity by
rationalisation and, often, redundancy. This incorporates many issues of
human resource management, motivation and social responsibility. There are
fewer more important tests of the skills and far-sightedness of senior
managers.
‘You cannot endow even the best machine with initiative.’
Walter Lippmann, journalist and writer
When tackling this type of case study, it is important that you take a step back,
to consider the cause and the effect. Is excess capacity the problem or an
indicator of another problem, such as declining market share? By showing the
broader picture in this way, you can also show the skill of evaluation.

Key terms
Downtime: any period when machinery is not being used in production;
some downtime is necessary for maintenance, but too much may
suggest incompetence.
Excess capacity: when there is more capacity than justified by current
demand (that is, utilisation is low).
Rationalisation: reorganising in order to increase efficiency. This often
implies cutting capacity to increase the percentage utilisation.
Subcontracting: where another business is used to perform or supply
certain aspects of a firm’s operations.

42.8 Workbook
Revision questions
(30 marks; 30 minutes)
1 What is meant by the phrase ‘100 per cent capacity utilisation’?
(3)
2 At what level of capacity utilisation will fixed costs per unit be lowest
for any firm? Briefly explain your answer.
(4)
3 What formula is used to calculate the capacity utilisation of a firm?
(2)
4 How can a firm increase its capacity utilisation without increasing
output?
(3)
5 If a firm is currently selling 11,000 units per month and this
represents a capacity utilisation of 55 per cent, what is its maximum
capacity?
(4)
6 Use the information given in Table 42.2 to calculate profit per week
at 50 per cent, 75 per cent and 100 per cent capacity utilisation.
 (7)

Table 42.2 A firm’s data

7 Briefly explain the risks of operating at 100 per cent capacity
utilisation for any extended period of time.
(3)
8 Outline two ways you might be able to tell that a supermarket was
over-utilising its capacity.
(4)
Data response 1
R. Sivyer & Co was founded 50 years ago. It has a successful history
of manufacturing high-quality bicycle chains, which are supplied direct
to retailers. In recent years, orders from retail customers have fallen,
meaning that the firm is now manufacturing and selling only 12,000
chains per month.
The cost information given in Table 42.3 has been made available.
Table 42.3 Cost information for R. Sivyer & Co
The finance manager has called the other two managers to a meeting
to discuss the firm’s future. She puts forward two alternative courses
of action:
1 Make four shop-floor and two other staff redundant, thus cutting the
firm’s fixed costs, and reducing maximum capacity to 12,000 units
per month.
2 Sign a contract to supply a large bicycle manufacturer with a fixed
quantity of 8,000 chains per month at £5.80 each for the next four
years; breaking the contract will lead to heavy financial penalties.
Questions (30 marks; 35 minutes)
1 Calculate the firm’s current monthly profit.
(4)
2 Calculate the monthly profit that would result from each of the two
options.
(8)
3 Assess the advantages and disadvantages of each option.
 (10)
4 State which of the two options you would choose, and explain any
other information you would need before making the final decision.
(8)
Data response 2
Ryanair load factors
The Irish low-cost airline Ryanair carried over 81 million passengers in
2013, making it the world’s most popular airline. The company’s
success is based on highly efficient operations management. The low
fares charged by Ryanair will only generate profit if the company can
minimise its costs. To that end, the airline operates with only one type
of plane, the Boeing 737. This decision enables the company to benefit
from a range of economies of scale. Some airlines operate with leased
planes; others, like Ryanair, buy outright. In July 2014, a Boeing 737
could be leased for $463,000 per month or bought outright for $81
million; either way, the fixed costs are significant. In these
circumstances, load factors (the phrase used in the aviation business
for capacity utilisation) must be kept very high in order to dilute the
punishing fixed costs. The tactics used by Ryanair to achieve high load
factors include:
• charging low prices
• reducing seat pitch – by removing some leg room, extra rows of
seats can be crammed into each plane
• fast turnarounds in-between flights, ensuring that each plane spends
as much time in the air as possible earning revenue.
According to the Centre for Aviation in March 2014, the number of
passengers carried by Ryanair grew by over 7 per cent compared with
the previous year and their load factor averaged 78 per cent.
Questions (35 marks; 40 minutes)
1 a) A Boeing 737 can accommodate 213 passengers when full.
Calculate the load factor of a flight carrying 150 passengers.
(4)
b) The operating cost of flying a 737 is approximately £7,000 per
 hour. Calculate the average cost per passenger of a two-hour
flight to Ibiza, assuming a load factor of 70 per cent.
(5)
c) Calculate the new average cost per passenger for the same flight
if the load factor can be increased to 95 per cent?
(4)
2 Other than price, assess the tactics Ryanair could employ in order
to increase its load factors.
(10)
3 In recent years, Ryanair has been on the receiving end of bad
publicity regarding the quality of its customer service. Assess
whether this could be due to the airline’s high load factors/capacity
utilisation.
(12)
Extended writing
1 Evaluate the implications of a decision by Arsenal FC to increase its
stadium capacity from 60,000 to 80,000. (By all means substitute
Arsenal for any other sports club with which you are familiar.)
(20)
2 Owing to a significant change in shopping habits, Tesco finds that its
huge Tesco Extra shops are 40 per cent under-utilised. Evaluate
what might be the right strategy for dealing with this.
(20)
Section 2.4 Resource management

43 Stock control
Definition
Because few businesses can match supply to minute-by-minute
demand, most need stock to avoid disappointing their customers.

Linked to: Markets and equilibrium, Ch 7; Sales forecasting,

Ch 33; Liquidity, Ch 38; Production, productivity and
efficiency, Ch 41.

43.1 Types of stock

Manufacturing firms hold three types of stock. These are:
• raw materials and components: these are the stocks the business has
purchased from outside suppliers; they will be held by the firm until it is
ready to process them into its finished output
• work in progress: at any given moment, a manufacturing firm will have some
items it has started to process, but that are incomplete; this may be because
they are presently moving through the production process; it may be because
the firm stores unfinished goods to give it some flexibility to meet consumer
demand
• finished goods: once a product is complete, the firm may keep possession of
it for some time; this could be because it sells goods in large batches or no
buyer has yet come in for the product; for producers of seasonal goods, such
as toys, most of the year ’s production may be building stock in preparation
for the pre-Christmas sales rush, a process known as producing for stock, or
stockpiling.
The firm’s costs increase if it holds more stock. However, this needs to be set
against the opportunity cost of keeping too little stock, such as not being able
to meet customer demand. One theory is that a firm should try to keep as little
stock as possible at all times. This system, known as just-in-time, is covered
later in this chapter.
43.2 Stock control charts
One way in which a firm analyses its stock situation is by using a control chart.
This line graph looks at the level of stock in the firm over time. Managers can
see how stock levels are changing and act quickly if slow sales have led to
excessive stock levels.
A typical stock control chart looks like Figure 43.1. The chart shows four lines
which represent the levels described below.
• Stock levels: this line shows how stock levels have changed over this time
period. As the stock is used up, the level of stock gradually falls from left to
right. When a delivery is made, however, the stock level leaps upwards in a
vertical line. The greater the rise in the vertical line, the more stock has been
delivered.
• Maximum stock level: this shows the largest amount that the firm is either
willing or able to hold in stock.
• Re-order level: this is a ‘trigger ’ quantity. When stocks fall to this level, a
new order will be sent in to the supplier. The re-order level is reached some
time before the delivery (shown by the vertical part of the stock level line).
This is because the supplier will need some ‘lead time’ to process the order
and make the delivery.
• Minimum stock level: this is also known as the buffer stock. The firm will
want to keep a certain minimum level of stock so that it will have something
to fall back on if supplies fail to arrive on time or if there is a sudden
increase in demand.
Figure 43.1 Stock control chart
Diagrams such as this, showing a neat and regular pattern to stockholding, will
not happen in reality. Orders may arrive late and may not always be of the
correct quantity. The rate of usage is unlikely to be constant. The slope of the
stock level line may be steeper, showing more stock being used than normal,
or shallower, showing a slower use of stock.
However, stock control charts such as these give managers a clear picture of
how things have changed, and show them what questions need to be asked. For
example, perhaps suppliers are regularly delivering late. Managers would then
know to ask if suppliers were taking longer than the agreed lead time, or if
orders were being placed too late.
Figure 43.2 shows a more realistic stock control graph. It is based on actual
sales of Nestlé Lion Bars at a newsagent in south-west London.
Figure 43.2 Monthly sales of Lion Bars at one newsagent

43.3 Implications of poor stock control

A firm can hold too much or too little stock. Both cases will add to the costs of
the firm. Too much stock can lead to:
• opportunity cost: holding the firm’s wealth in the form of stock prevents it
using its capital in other ways, such as investing in new machinery or
research and development on a new product; this may dent its
competitiveness
• cash flow problems: holding the firm’s wealth as stock may cause problems
if it proves slow moving; there may be insufficient cash to pay suppliers
• increased storage costs: as well as the rental cost of the space needed to hold
the stocks, the higher the stock value, the higher the cost of insurance against
fire and theft
• increased finance costs: if the capital for the extra stock needs to be
borrowed, the cost of that capital (the interest rate) will be a significant
added annual overhead
• increased stock wastage: the more stock that is held, the greater the risk of it
going out of date.
Figure 43.3 Logic chain: how destocking boosts cash
This does not, however, mean that the business is free to carry very low stocks.
There are potential costs from holding too few stocks, including:
• lost orders, if urgent customer orders cannot be met because there is too
little finished goods stock
• worker downtime, if essential components have been delayed in arriving
from suppliers (and the very low buffer has been used up already)
• the loss of the firm’s reputation and any goodwill it has been able to build up
with its customers.
The total stockholding cost will therefore be a combination of these factors.
As stock levels rise, the costs of holding the stock increases, but the costs of
being out of stock decrease. The cost of holding stock will therefore look like
Figure 43.4.
Figure 43.4 The cost of stockholding
For a firm, the optimum level of stock is where the total costs of holding stock
are the lowest.

Real business
RFID at Carlsberg
Brewers such as Carlsberg sell most of their beer and cider to pubs in
36 gallon aluminium kegs. The kegs are supposed to be sent back to
the brewery by the pubs when they are empty. Unfortunately, in many
cases, they are not returned promptly, or they go missing.
In the past, Carlsberg overcame this problem by purchasing extra kegs
from their supplier. The problem with this cautious, just-in-case
approach is cost. Each empty beer keg costs Carlsberg nearly £75. In
early 2013, Carlsberg began fitting RFID (radio-frequency
identification) tags to its latest product – Somersby Cider. The tags
send digital information back to Carlsberg HQ. The tags have helped
Carlsberg in two ways. First, fewer barrels are now going missing
because Carlsberg now knows the precise locations of all its barrels.
Second, the tags also tell Carlsberg how much cider is left in each
barrel. This enables Carlsberg to better match supply with demand,
ensuring that pubs don’t run out of stock.

43.4 Just-in-time
Just-in-time (JIT) is a Japanese system of stock control that has been popular
with UK firms over recent decades. JIT is the attempt to operate with a zero
buffer stock. At the same time, a system must be developed so that the costs and
risks of running out of stock are avoided by the firm.
Establishing a JIT system is not something that can or should be achieved
overnight. The risks of running out of stock are too great. Figure 43.5 shows
how a firm might set out to achieve a JIT system in a carefully planned way.
The diagram shows five phases, after which the firm would intend to continue
with phases six, seven and thereafter, until it could get as close as possible to
zero buffer stock. The five phases are as follows:
1 The firm orders 20,000 units of stock to arrive every third week.
2 Suppliers are asked to move to weekly deliveries; therefore only one-third
of the quantity is ordered.
3 As phase two has proved successful, there is no longer any need for such a
high buffer stock. Stock levels are allowed to fall to a new, lower level.
4 With phase three complete, the firm now moves to receiving deliveries twice
a week. Therefore, the order level is halved.
5 The suppliers have proved reliable enough to allow the buffer to be cut
again…
Figure 43.5 Step-by-step progress towards JIT stock control
‘Stock in work-in-progress hides inefficiencies. It’s better to expose them
by removing buffer stock.’
J.K. Liker, business author

43.5 Waste minimisation

When the idea of just-in-time spread from Japan, most western companies
looked to the benefits from lower working capital and potentially greater
profitability. When companies tried the new approach, they suddenly found
inefficiencies they hadn’t known before. A late delivery from a supplier might
leave workers idle on the shop floor, if there was no longer any buffer stock.
And a faulty component could also cause the factory to shut down.
JIT puts pressure on managers to demand much higher quality standards and
more efficiency from everyone involved in the business. Years ago, a
supermarket’s stockroom held huge stocks – including some forgotten
stockpiles that might go out of date before they had made it to the shop floor.
JIT reduced such levels of wastage and has helped grocers to become among
the greenest of modern businesses – as measured by the reduction in their
greenhouse gas emissions.

43.6 Competitive advantage from lean production

Lean production aims to produce more using less, by eliminating all forms of
waste (‘waste’ being defined as anything that does not add value to the final
product). The rise of the Japanese approach to lean production has been
unstoppable. It is based upon a combined focus by management and workers
on minimising the use of the key business resources: materials, manpower,
capital, floor space and time. Largely originated by Toyota, lean production
works by a process of continuous refinement that:
• maximises the input from staff
• focuses attention upon the quality of supplies and production
• minimises wasted resources in stock through just-in-time
• focuses upon the competitive advantage represented by speed.
For Toyota, a focus in new product development was to shorten the time
between product conception and product launch. With its ability to be ‘first-to-
market’ and its terrific reputation for quality, in 2013 Toyota became the
world’s number one car producer.
Lean production:
• creates higher levels of labour productivity; therefore, it uses less labour
• requires less stock, less factory space and less capital equipment than a mass
producer of comparable size; the lean producer therefore has substantial cost
advantages over the mass producer
• creates substantial marketing advantages: first, it results in far fewer defects,
improving quality and reliability for the customer; second, lean production
requires fewer engineering hours to develop a new product; this means that
the lean producer can speedily develop a wide range of new products.
‘To be competitive, we have to look for every opportunity to improve
efficiencies and productivity while increasing quality. Lean manufacturing
principles have improved every aspect of our processes.’
Cynthia Fanning, general manager, General Electric

Real business
Lean production ideas are starting to influence modern biotech
companies. Innovative R&D is no longer enough; business success
requires manufacturing efficiency. So biotech companies are
implementing lean principles on the equipment and labour aspects of
their business.
A US producer of proteins, Aldevron, has hired researchers from the
University of Wisconsin to study the company’s manufacturing
processes and outline a strategy for improving efficiency. The company
hopes to shrink the facility’s product delivery timeline by at least 25 per
cent – shaving a week or two off a typical four-to-five-week process.
‘Because our labour force is more expensive, we’ve got to figure out
how to do things faster’, said Aldevron’s vice president. The
productivity gains from lean manufacturing could help Aldevron fend off
overseas manufacturers that provide the same services at cheaper
rates.

Five whys and a how

43.7 Stock control – evaluation

Stock control is at the heart of many business operations. For retailers such as
Zara, Topshop and Primark, the desire for a constant flow of new, fashion-
orientated stock means huge pressure to clear away old stock. Therefore, a JIT
approach is ideal, with little or no buffer stock. In some cases, it is quite
helpful commercially to run out of stock, if it means that, next Saturday,
shoppers come earlier to make sure they can get the must-have item. The only
thing that will not work is when customers go to a clothes shop and see tired,
over-fingered stock that is outdated.
Making a just-in-time approach work requires close collaboration between
purchasers and suppliers. The purchasing firm needs to bring the supplier into
discussions on product development. Advice may be needed on components
and materials as well as gaining the supplier ’s commitment to the new project.
This Japanese way of doing business has taken off in Britain, making it much
easier to provide customers with what they need.
Yet there are still firms that believe mass production plus high inventories is
the only way to be efficient. If that is what Cadbury says about making
chocolate – even the highly seasonal Creme Egg – it would be arrogant to
argue. So it is always important to keep an open mind about what is right for a
specific company.

Key terms
Buffer stock: the desired minimum stock level held by a firm just in case
something goes wrong.
Competitive advantage: a feature that gives one business an edge
over its rivals.
Competitiveness: the extent to which a firm can stand up to – or beat
– its rivals.
Opportunity cost: the cost of missing out on the next best alternative
when making a decision (or when committing resources).
Stockholding cost: the overheads resulting from the stock levels held
by a firm.

43.8 Workbook
Revision questions
(35 marks; 35 minutes)
1 Why may it be important to maintain good relationships with
suppliers?
(3)
2 State the three main categories of stock.
(3)
3 Outline two factors that might lead to a fall in stockholding costs.
 (4)
4 Explain the difference between lead time and re-order level.
(4)
5 Sketch a typical stock control chart.
(6)
6 State three costs associated with holding too much stock.
(3)
7 Give three costs associated with running out of stock.
(3)
8 What is meant by just-in-time stock control?
(3)
9 Explain the meaning of the sentence: ‘The purchaser’s reputation is
placed in the hands of the external supplier.’
(3)
10 Why is stock control of particular importance to an ice cream
seller?
(3)
Activities
(35 marks; 40 minutes)
1 A firm sells 40,000 units a month. It receives monthly deliveries. Its
maximum stock level is 50,000 and minimum (buffer) stock is
10,000. After two months (eight weeks), it decides to switch to
weekly deliveries.
a) Sketch a 12-week stock control graph to illustrate this situation.
Assume the firm starts the first week with 50,000 units of stock.
(10)
b) What short-term problems may the firm face in switching to
weekly deliveries?
(6)
c) Consider the long-term benefits that may result from the change.
 (9)
2 Sketch a graph to show the impact upon stock levels of a downturn
in demand for a product for which a company has a non-cancellable
fixed order from its suppliers. Fully label the graph to explain what
happens when.
(10)
Data response 1
Ann Brennan established a bakery in Wigan 20 years ago. Although
the firm is profitable, Ann is considering the introduction of modern
techniques to help the company develop. In particular, she wishes to
introduce information technology to improve communications between
her five shops and the central bakery, and to help her manage her
stock of raw materials more effectively.
Stocks of raw materials at the business are currently purchased in
response to usage. For example, the bakery uses on average 500kg of
flour per week. The most Ann wishes to hold at any time is 2,000kg.
She would be worried if the stock fell below 500kg. An order takes one
week to arrive, so Ann always re-orders when her stock falls to
1,000kg.
Questions (30 marks; 35 minutes)
1 What is meant by the following terms:
a) re-order level
b) buffer stock
c) lead time?
(6)
2 a) Draw a stock control graph for flour at Brennan’s Bakery over a
six-week period.
(6)
b) Draw a second graph showing the situation if twice the normal
amount of flour were used in the fourth week.
(6)
3 Explain how information technology might be used to improve
communication between Ann’s shops and between the bakery and
 its suppliers.
(4)
4 Assess two possible effects of a ‘stock-out’ on Brennan’s Bakery.
(8)
Data response 2
Is JIT always the best option?
In March 2011, a devastating earthquake and tsunami hit Japan. The
effects of this natural disaster were arguably amplified by the
widespread use of just-in-time production in Japan, whereby firms
operate with very little, if any, buffer stock. This means that a whole
production line will grind to a halt if just one component or raw material
fails to be delivered by a supplier. The globalised nature of modern
supply chains also meant that firms as far away as Britain and America
suffered from the natural disaster in Japan. For example, Honda’s
factory in Britain quickly ran out of imported components from Japan
causing car production to halt in Swindon.
Fujitsu is one of the leading suppliers of semi-conductors in Japan.
One of its Japanese factories was badly damaged by the 2011
earthquake, which reduced output. Despite this, Fujitsu was able to
bounce back quickly. In less than three months, production was back
up to the pre-earthquake level. The key to Fujitsu’s success was
planning. Three years earlier, in response to another earthquake, the
company developed an emergency response strategy. The strategy
was based on creating additional capacity in other Fujitsu factories
located in areas less susceptible to earthquakes. In 2011, Fujitsu
wasted no time in implementing its plan, which worked.
Aside from acts of nature and war, manufacturers who want to be
successful with JIT need to prepare for demand spikes. (A demand
spike is a sudden, unexpected upsurge in demand.) Both Nintendo and
Sony Corp. have had out-of-stock issues with their console systems,
notably the PS4 in 2014. ‘Just-in-time is OK, but if all of a sudden
there is a surge in demand, you may not have the flexibility available to
meet the demand’, says one noted business analyst.
Questions (26 marks; 30 minutes)
1 Explain the weakness of JIT that was revealed by the 2011
earthquake and tsunami in Japan.
(4)
2 A noted business analyst has said that ‘JIT is about meticulous
planning’. How well did Fujitsu stand up to that test? Explain your
answer.
(5)
3 a) Explain why manufacturing businesses hold stock.
(3)
b) Explain one benefit to a business from operating JIT with a zero
buffer stock level.
(4)
4 Assess whether a JIT approach to stock management is appropriate
to a business with demand ‘spikes’, such as Sony.
(10)
Extended writing
1 In November 2014, a mystery shopper went to five different stores
and found the following level of products out of stock: Asda, 10 per
cent; Morrisons, 15.6 per cent; Sainsbury’s, 6.2 per cent; Tesco, 9.1
per cent; and Waitrose, 3.1 per cent. Evaluate the implications of
this for two of the businesses concerned.
(20)
2 Primark has decided to launch its first five shops in China. Up until
now, it has had no presence in the country. Evaluate the challenges
it will face in establishing an efficient system of stock management.
(20)
Section 2.4 Resource management

44 Quality management
Definition
Quality means providing what the customer wants at the right time, to
the right standard of product and service, and therefore yielding high
customer satisfaction.

Linked to: Product and service design, Ch 10; Marketing

strategy, Ch 15; Introduction to resource management, Ch 40..

44.1 The importance of quality

W. Edwards Deming, the American quality guru, said that ‘quality is defined by
the customer ’. The customer may insist on certain specifications, or demand
exceptional levels of customer comfort. Another definition of quality is ‘fit for
use’. Although hard to define, there is no doubt that customers are very aware
of quality. Their perception of quality is an important part of the buying
decision.
Customers will accept some trade-off between price and quality. There is,
however, a minimum level of quality that is acceptable. The customer wants the
product to work (be fit for use), regardless of the price. If the customers think
that the quality is below a minimum level, they will not buy. Above the
minimum level of acceptable quality, customers will expect to get more as they
pay more.
The importance of quality is related to the level of competitiveness in the
market. When competition is fierce, the quality of the product can tip the
balance in the customer ’s decision making. For all customers, quality is about
satisfying their expectations. The customer will take into account the total
buying experience. Customer service and after-sales service may be as
important as the product itself. The way the product is sold, even where it is
sold, all contribute to the customer ’s feelings about the quality of the product.
Real business
Ryanair
Between 1991 and 2013, Ryanair boss Michael O’Leary built up the
airline from almost nothing to become Europe’s largest carrier. In all
that time, O’Leary focused on three things: low costs to make low
prices possible, plus two aspects of quality – on-time arrivals and
fewest bags lost. By 2005, Ryanair was the best in Europe on both
these measures of customer quality. Yet in 2013 O’Leary announced
that, in future, Ryanair would be more sensitive to other aspects of
customer quality – above all else, being friendlier, smilier and keener to
give customers a more pleasant flying experience. Customers’ quality
needs had changed, and quality had become more important in
customers’ purchasing decisions.

Quality quotes
‘Reducing the cost of quality is in fact an opportunity to increase
profits without raising sales, buying new equipment, or hiring new
people.’
Philip Crosby, American quality guru
‘Quality is remembered long after the price is forgotten.’
Gucci slogan
‘Quality has to be caused, not controlled.’
Philip Crosby
‘Quality is our best assurance of customer allegiance, our strongest
defence against foreign competition, and the only path to sustained
growth and earnings.’
Jack Welch, General Electric chief
Source: Stuart Crainer (1997) The Ultimate Book of Business
Quotations, Capstone Publishing
Figure 44.1 Logic chain: quality is different things to different people

44.2 Methods of improving quality

Quality control
Quality control (QC) is the traditional way to manage quality, and is based on
inspection. Workers get on with producing as many units as possible, and
quality control inspectors check that the output meets minimum acceptable
standards. This might be done by checking every product; for example, starting
up every newly built car and driving it from the factory to a storage area. Or it
might be done by checking every 200th KitKat coming off the end of the
factory’s production line. If one KitKat is faulty, inspectors will check others
from the same batch and – if concerned – may scrap the whole batch. The
problem with this system is that faulty products can slip through, and it stops
staff from producing the best quality: they just focus on products ‘good
enough’ to pass the checks. Total quality management (below) is therefore a
superior approach.

Quality assurance
Quality assurance (QA) is a system that assures customers that detailed systems
are in place to govern quality at every stage in production. It would start with
the quality-checking process for newly arrived raw materials and components.
Companies have to put in place a documented quality assurance system. This
should operate throughout the company, involving suppliers and
subcontractors. The main criticism of QA is that it is a paper-based system and
therefore encourages staff to tick boxes rather than care about the customer
experience.

Total quality management

Total quality management (TQM) was introduced by W. Edwards Deming. He
worked with Japanese firms, and his techniques are said to be one of the
reasons for the success of businesses such as Honda and Toyota. TQM is not a
management tool: it is a philosophy. It is a way of looking at quality issues. It
requires commitment from the whole organisation, not just the quality control
department. The business considers quality in every part of the business
process – from design right through to sales. TQM is about building-in rather
than inspecting-out. For it to be successful, it should be woven in to the
organisational culture.

44.3 Other quality initiatives

Quality circles
A quality circle is a group of employees who meet together regularly for the
purpose of identifying problems and recommending adjustments to the
working processes. This is done to improve the product or process. It is used
to address known quality issues such as defective products. It can also be useful
for identifying better practices that may improve quality. In addition, it has the
advantage of improving staff morale through employee involvement. It takes
advantage of the knowledge of operators.

Zero defects
The aim is to produce goods and services with no faults or problems. This is
vital in industries such as passenger aircraft production or the manufacture of
surgical equipment. For many firms, zero defects is a target to move towards
without any realistic expectation of getting there. For others, it is a deadly
serious goal because a fault can be a life-and-death matter.
To achieve zero defects, in addition to a perfectionist approach to quality from
all staff, there is likely to be a two-stage system for quality control – perhaps
inspection by machine and then again by a quality inspector.

Table 44.1 Pros and cons of TQM, QC and QA

Real business
Boeing ‘Dreamliner’
In January 2013, all of Boeing’s new 787 ‘Dreamliner’ aircraft were
grounded. With each plane having a list price of over $200 million, this
was a huge and costly embarrassment for the American plane maker
and its global airline customers.
The specific problem was a battery on the plane that overheated and
sometimes caught fire. In fact, though, the Dreamliner had already
suffered far more teething problems than would usually be expected
from Boeing.
The reason proved to be the way Boeing had organised the huge
operation of developing and engineering the production process. Due
to lack of production capacity, 60 per cent of the design and
production of key components had been outsourced to suppliers from
around the world. Because Boeing’s own quality standards had not
been applied uniformly, the company’s quality assurance and quality
control systems struggled to cope.

44.4 Continuous improvement (kaizen)

Kaizen is a Japanese term meaning continuous improvement. Staff at firms like
Toyota generate thousands of new ideas every year, each aimed at improving
productivity or quality. Over time, these small steps forward add up to
significant improvements in competitiveness.
There are two key elements to kaizen:
1 Most kaizen improvements are based around people and their ideas rather
than investment in new technology.
2 Each change on its own may be of little importance. However, if hundreds of
small changes are made, the cumulative effects can be substantial.
According to the Kaizen Institute, the goal of any kaizen programme should be
to convince all employees that they have two jobs to do: doing the job and then
looking for ways of improving it. The kaizen culture is based on the belief that
the production line worker is the real expert. The worker on the assembly line
does the job day in, day out. This means knowing more about the causes of
problems and their solutions than the highly qualified engineer who sits in an
office.
To operate kaizen successfully, employees cannot be allowed to work as
isolated individuals. Team working is vital to the process of continuous
improvement. These teams are composed of employees who work on the same
section of the production line as a self-contained unit. Each team is often
referred to as a ‘cell’. The members of a cell are responsible for the quality of
the work in their section. Over time, the cell becomes expert about the
processes within its section of the production line.
Once the necessary kaizen apparatus is in place, good ideas and the resulting
improvements should continue. The number of suggestions made each month
should improve over time once employees see the effects of their own
solutions.
‘Continuous improvement is better than delayed perfection.’
Mark Twain, famous American writer
‘If there’s a way to do it better… find it.’
Thomas Edison, inventor

44.5 Competitive advantage from quality

management
The traditional belief was that high quality was costly: in terms of materials,
labour, training and checking systems. Therefore, managements should beware
of building too much quality into a product (the term given to this was ‘over-
engineered’). The alternative approach, put forward by the American writer
Philip Crosby, is that ‘quality is free’. The latter view suggests that getting
things right first time can save a huge amount of time and money.
In addition to cost advantages from high-quality production, there are potential
benefits from adding value to the customer experience and therefore price tag.
High-quality standards have disproportionate impacts upon reputation and
therefore potential price levels. At the time of writing, Waitrose has
champagne at prices from £20 to £255 for a bottle. At the upper end, brand
image matters greatly, but is heavily underpinned by a reputation for high
quality.
Where the consumer has choice, quality is vital. A reputation for good quality
brings competitive advantages. A good-quality product will:
• generate a high level of repeat purchase, and therefore a longer product life
cycle
• allow brand building and marketing benefits that can spread from one brand
to others, e.g. Cadbury Twirl benefiting from the reputation of Cadbury
Dairy Milk
• allow a price premium (this is often greater than any added costs of quality
improvements; in other words, quality adds value and additional profit)
• make products easier to place (retailers are more likely to stock products
with a good reputation).

Five whys and a how

44.6 Quality management – evaluation
In recent years, there has been a change in the emphasis on quality. The quality
business has itself grown. The management section of any book shop will
reveal several titles dedicated to quality management. The growth of initiatives
such as TQM and continuous improvement goes on. With an increase in the
international awareness of quality, British businesses will have to ensure that
they continue to be competitive.
This growth in emphasis on quality has undoubtedly brought benefits to
business. Increased quality brings rewards in the marketplace. Companies have
also found that the initiatives, especially where they are people-based, have
brought other advantages: changes in working practices have improved
motivation and efficiency, and have reduced waste and costs.

Key terms
Competitiveness: the extent to which a firm can stand up to – or beat
– its rivals.
Right first time: avoiding mistakes and therefore achieving high quality
with no wastage of time or materials.
Trade-off: accepting less of one thing to achieve more of another (for
example, slightly lower quality in exchange for cheapness).
Zero defects: eliminating quality defects by getting things right first
time.

44.7 Workbook
Revision questions
(35 marks; 35 minutes)
1 State two reasons why quality management is important.
(2)
2 How important is quality to the consumer?
(3)
3 Suggest two criteria customers may use to judge quality at:
 a) a budget-priced hotel chain
b) a Tesco supermarket
c) a McDonald’s.
(6)
4 Why has there been an increase in awareness of the importance of
improving the quality of products?
(3)
5 Give two marketing advantages that come from a quality reputation.
(2)
6 What costs are involved if the firm has quality problems?
(3)
7 What are the four stages of quality management?
(4)
8 What is total quality management?
(4)
9 Outline two benefits of adopting quality circles to a clothing chain
such as Topshop.
(4)
10 Outline two additional costs that may be incurred in order to
improve quality.
(4)
Data response 1
Horsemeat and food quality in 2013
In January 2013, supermarkets were hit by an extraordinary scandal as
it emerged that foods made of processed ‘beef’ actually contained
horsemeat. Tesco was quickly forced to admit that one of its products
contained 30 per cent horsemeat. Discounter Aldi also had to endure
some tough headlines. Broadly, higher-priced retailers such as
Waitrose, Sainsbury’s and Marks & Spencer came out of the saga
pretty well; Tesco, Asda and Morrisons fared worse. In the 12 weeks
to 17 February, Tesco’s market share slipped below 30 per cent for the
first time in several years.
So how could it happen?
Amazingly, most supermarkets do not check the meat when it arrives
at their depots. This task is outsourced (‘farmed out’) to companies
approved by the British Retail Consortium. The inspectors go once to
the source of supply, acting on behalf of all retailers. But according to
Paul Smith, a recently retired food inspector:
‘The suppliers can select which “approved inspection body” they use.
They also pay for the audit. Yes, they can pick which audit company,
the alleged policeman, they wish. In practice they also pick the
individual auditor by heaping praise and requesting the same
individual for the next visit.’
Source: evidence to a government committee, February 2013
‘Throughout the world, our customers want safe, affordable
products. Many also want to know that what they buy is sourced to
robust ethical and environmental standards.
‘We believe it is possible to provide for all our customers, whatever
their needs, whilst upholding strong standards across our business
and in our supply chains.’
Source: Tesco Social Responsibility Report
So despite the claims it makes in its Social Responsibility Report,
Tesco does nothing to check on its food supplies. Other companies
such as Waitrose may well do so, as they had no problem with
horsemeat contamination.
The consequence of this slack approach to quality was clear in the
impact of the scandal on food sales. In the four weeks after the
scandal first hit, sales of frozen burgers were down (nationally) by over
40 per cent and sales of all ready meals were down by 12 per cent.
So what should Tesco be doing? First, it should switch its focus from
public relations to quality management. Tesco shoppers probably
believed that tough Tesco buyers went to suppliers, checked the
quality standards, then negotiated toughly on price. Clearly the
checking part may be a bit of a myth. To clear the air, the company
should bring in a new policy of checking at the producer, then checking
as products arrive at Tesco. In effect this would be a full quality
assurance regime. Having set the new policy up, it is then time to tell
the consumer.
Tesco knows perfectly well that government inspection of food has
been run down in recent years (see below), so it should have been
making greater efforts to protect its customers (and its own
reputation). It seems to have been very short-sighted in its approach
to quality. It is likely to keep feeling the impact on its market share.
‘The meat inspection workforce managed by the Food Standards
agency has shrunk from a high point of 1700 – during the BSE and
e-Coli crises in the 1990s – to around 800 today. This has been a
direct consequence of the deregulatory policies of both the
European Commission and UK government to hand over more and
more meat inspection duties to the meat industry and dispense with
proper independent inspection.’
Source: Unison (trade union)

Questions (20 marks; 25 minutes)

1 Assess Tesco’s performance at choosing effective suppliers.
(10)
2 Assess the importance of quality to a business such as Tesco.
(10)
Data response 2
Manufacturing defects – producer comparisons: PcNow
PcNow is a small computer manufacturer based in the East Midlands.
It tailor-makes computers and accessories based on customers’ own
specifications. Although business grew steadily initially, it is now
worried about falling sales. It believes it is losing sales to Japanese and
American companies that have set up manufacturing facilities in
Europe, as well as to other European and UK-based firms. An industry
survey has produced data on industry levels of production defects. It
has added its own figures and produced the chart shown in Figure
44.2.
Figure 44.2 Manufacturing defects: producer comparisons
The firm realises that survival depends upon addressing the quality
problems. It has decided to employ a quality manager, Cara
Davenport, to address the issues. Her first suggestion is to get
together workers from each department to discuss the problems and
issues. Following a survey of the factory, she has also suggested that
the layout of the production facilities should be changed. This will be
an expensive exercise, and management is reluctant to make the
changes as they will require production to stop for a week and there
will need to be investment in new equipment. The firm’s weak cash flow
position makes it hard for the owners to accept new capital spending.
The other area that Cara has identified is a problem with one particular
component. She has suggested that a new supplier should be found,
or that she should work with the existing supplier to improve the quality
of the component.
Questions (40 marks; 45 minutes)
1 Explain what Figure 44.2 shows.
(4)
2 From the case study, give two reasons for the quality problems
experienced by PcNow.
 (2)
3 Assess two marketing implications for PcNow of the data in Figure
44.2.
(8)
4 Assess the advantages PcNow may achieve from the discussion
group formed to discuss the quality problems.
(10)
5 Explain how Cara might convince the firm’s management to change
the layout of the production facilities.
(4)
6 Once these changes have been made, the firm needs to ensure that
quality is maintained and improved. Assess the implications for the
firm of implementing a total quality management initiative.
(12)
Extended writing
1 ‘Quality control is about building quality in, not inspecting it out.’
Evaluate this statement.
(20)
2 Evaluate whether quality management is solely a matter for the
resource management function.
(20)
3 Evaluate the extent to which quality is a major competitive issue in
service businesses.
(20)
Section 2.5 External influences

45 Economic influences
Definition
Economic influences deal with changes in the economy as a whole
(sometimes known as the ‘macro’ economy) and how they affect
different businesses.

Linked to: Demand, Ch 5; Supply, Ch 6; Income elasticity of

demand, Ch 9; Role of an entrepreneur, Ch 23.

45.1 What is ‘the economy’?

Each of us goes about our business in our own way. A teacher receives a
monthly salary paid directly into the bank, and draws out the cash needed to
buy the shopping, buy petrol and give the children some pocket money. The
children may spend this on chocolate, Coca-Cola and packets of crisps.
Although, as individuals, we ‘do our own thing’, the actions and decisions
taken by millions of people and businesses make up ‘the economy’.
Collectively, chocolate purchases in Britain add up to £3,500 million per year.
This, in turn, provides the income for chocolate producers and shopkeepers,
who employ tens of thousands of staff.
If the value of all spending on all products bought in the UK is added together,
it comes to an annual figure of over £1.5 trillion (a thousand billion). This
spending provides the vast revenues that companies need in order to pay for
Britain’s 30 million workers, and enough profit left over to pay for business
growth.
The key thing to remember is that the economy is intertwined. Cadbury is
successful only if families have enough cash to be able to buy chocolate bars.
So, if there was a big cutback in consumer spending, perhaps in the wake of
government spending cutbacks, many firms would struggle, including
Cadbury.
When times are bad, almost every business suffers; this, in turn, can lead to job
losses. When the economy is recovering, things get better for almost all firms.

45.2 Current economic climate

Business thrives on confidence. Confident consumers are willing to dip into
their savings for a holiday, or to borrow to buy a new carpet or car. Confident
investors are willing to put more money into businesses in return for shares.
And the companies themselves will spend to invest in their future: new factory
buildings, new machinery and new computer systems. All this spending can
create an upsurge in economic activity.
The reverse also applies: gloom can spread doom. Therefore, the economic
climate is important. The sections that follow give an idea of the factors that
help to create an economic climate, either of optimism or of pessimism. These
factors include:
• the business cycle
• changes in inflation
• changes in interest rates
• changes in exchange rates
• changes in taxation and government spending.

45.3 The business cycle

The business cycle is the pattern of boom then slowdown that has been a
feature of the UK economy for more than 150 years. When the economy is
growing rapidly (around 3 per cent a year), consumers and companies have
the confidence to spend and invest. This extra boost to output risks creating an
unsustainable boom, which may lead to a bust, such as the one in 2009.
Figure 45.1 shows the tricky period for the UK economy between the start of
recession in 2008 and the second quarter of 2014, when the economy finally
returned to its pre-recession peak. The straight black line shows the GDP trend
excluding the recession and the unprecedentedly slow recovery. The graph also
shows the normal progress of the UK economy. For more than 200 years, it
has grown at an average of just under 2.5 per cent per annum – that is, growth
is normal. Therefore, the general expectation is that the underlying market
conditions will be positive, with the size of markets expanding on a regular
basis.

Figure 45.1 UK gross domestic product, 1995–2014; chained volume

measures, quarterly figures, seasonally adjusted (source: ONS)
When market conditions are as tough, as in 2008/2009, there are likely to be
failures as businesses run out of cash (Woolworths, La Senza and many others
went under). There may also be huge pressures placed on company
workforces, as people are forced to choose between redundancy and real wage
cuts. In the recessions of 1980 and 1990, job losses pushed unemployment up
above three million. The recent recession saw instead a huge squeeze on
people’s real incomes, meaning that the pain was shared more fairly across the
population. Government statistics show that between July 2008 and March
2014 earnings rose 8.6 per cent while prices rose 16.9 per cent. This made
people 7.1 per cent worse off (even worse if the tax to be paid on the extra
earnings is included). In addition to this squeeze on incomes, Figure 45.2
shows why consumer confidence was hard hit in 2009, with people worried
whether they would be next for a redundancy notice. No wonder that, at times,
even products like chocolate and chewing gum saw falls in sales volume as
market conditions tightened.
Figure 45.2 UK redundancies per quarter (source: ILO, quoted by UK
Office of National Statistics)
‘There’s no evidence that the business cycle has been repealed.’
Alan Greenspan, former chairman of the US central bank
‘Never has so much money been owed by so few to so many.’
Mervyn King, governor of the Bank of England, on the £1,000 billion bail-
out from taxpayers to Britain’s banks

45.4 Inflation
Inflation measures the percentage annual rise in the average price level. For
consumers, inflation increases the cost of living. The rate of inflation is
measured monthly, but presented as a year-on-year figure. So September 2014
inflation of 1.2 per cent meant that the prices of the average household’s
shopping basket were 1.2 per cent higher than in September 2013.
Does this matter? Traditionally, it mattered most to those with cash savings,
such as pensioners. Steady inflation erodes the spending power of money and
therefore makes each £1,000 of cash savings worth less. In the period between
2009 and 2015, it mattered because the weakness of the labour market meant
that earnings were hardly rising at all, year on year. Therefore, every 1 per
cent of inflation meant a 1 per cent reduction in the value of employees’
earnings. In turn, that meant squeezed living standards.
The most widely quoted index for measuring inflation is the Consumer Prices
Index (CPI). This data series is produced by the government’s statistical office
each month. It selects 700 items that we buy most often, then measures changes
in the price charged for this shopping basket in thousands of different stores
and locations. The data is then converted into an index to make it easier to
understand and use by students, journalists and others.
An index means converting a series of data into figures that all relate to a base
period where the data = 100. This allows users of the data to see at a glance the
percentage changes and trends. In Table 45.1, column A shows the total price
of buying the shopping basket. Column B converts that data into an index. This
starts by saying ‘let £402 = 100’, then all the other figures in column A are
related to that base figure of 100. For example, the figure for 2014 is
£514.15/£402 × 100 = 127.9. Column C then calculates the percentage change
each year based on the data in column A (or column B – it should give the
same figure).
Table 45.1 Measuring inflation, 2005–2015
The advantage of index numbers is that you can see quickly that, for example,
inflation amounted to 27.9 per cent between 2005 and 2014. So index numbers
help you understand trends rather more easily. Their other huge benefit is that
they enable direct comparisons to be made between different data series. In the
case of inflation, the interesting recent comparison would be with earnings.
This data is shown in Table 45.2 and Figure 45.3. It shows average earnings
outstripping prices in 2006 and 2007, but then being dragged back until – from
2011 – they were well behind the rise in prices.
Table 45.2 Consumer Price Index v. Earnings Index, 2005–2015

Figure 45.3 Consumer Price Index v. Earnings Index, 2005–2015

(source: Office of National Statistics, October 2014)

Effects of inflation on businesses

1 Firms with large loans benefit from inflation because inflation erodes the
real value of the money owed. So when they have to repay the loan, it
doesn’t feel as painful because of the fall in the value of money. As an
extreme example, a house in south London has just been sold for £1.2
million. When bought, 20 years ago, its price was £80,000. It was bought
with a £50,000 mortgage. Repaying a £50,000 mortgage seems a lot easier
now that the sale has provided £1.2 million of cash.
2 But inflation can damage profitability, especially for firms that have fixed-
price contracts that take a long time to complete. For example, a local
building company might agree a £5 million price for an extension to a local
private school, which is expected to take three years to finish. If inflation is
higher than expected, profit could be wiped out by the unexpectedly high
cost increases created by the unexpectedly high rates of inflation.
3 If costs in Britain are rising faster than prices elsewhere, UK companies will
find that they are losing their ability to compete effectively with foreign
firms. Renault has launched a new small car for India priced at £2,200. That
would hardly pay the labour costs if the car was produced in Britain.

45.5 Interest rates

The interest rate is the price charged by a bank per year for lending money or
for providing credit. Individual banks decide for themselves about the rate they
will charge on their credit cards or for the overdrafts they provide. But they
are usually influenced by the interest rate that the central bank charges high
street banks for borrowing money: the bank rate. In Britain, this is set each
month by a committee of the Bank of England. As shown in Figure 45.4, the
standard rate of interest in the UK has generally been around 4 –5 per cent. In
March 2009, though, the rate was cut to its lowest point in the Bank of
England’s history – 0.5 per cent. And it remained there as a way of helping to
revive an economy hit very hard by the 2009 recession.
Figure 45.4 UK bank interest rates, 2000–2014 (source:
www.bankofengland.co.uk)
The Bank of England committee is asked to set interest rates at a level that
should ensure UK prices rise by around 2 per cent per year. If the committee
members decide that the economy is growing so strongly that prices may rise
faster than 2 per cent, it will increase interest rates. Then people will feel
worried about borrowing more (because of the higher repayment cost) and
may cut their spending. This should help to discourage firms from increasing
their prices.
For firms, the level of interest rates is very important because:
• it affects consumer demand, especially for goods bought on credit, such as
houses and cars; the higher the rate of interest, the lower the sales that can be
expected
• the interest charges affect the total operating costs (that is, the higher the
interest rate, the higher the costs of running an overdraft, and therefore the
lower the profit)
• the higher the rate of interest, the less attractive it is for a firm to invest
money into the future of the business (because of the opportunity cost – the
high interest rates available for keeping money safely in the bank);
therefore, there is a risk of falling demand for items such as lorries,
computers and factory machinery.
If interest rates fall, the opposite effects occur, to the benefit of both companies
and the economy as a whole.

Figure 45.5 Logic chain: effect on costs and revenues of rising interest
rates

45.6 Exchange rates

The exchange rate measures the quantity of foreign currency that can be
bought with one unit of domestic currency. Movements in the exchange rate
can dramatically affect profitability because the exchange rate affects prices of
imported and exported goods. In exams, the value of the pound (£) is usually
considered only in relation to the US dollar ($) or the euro (€).
Appreciation of the pound occurs when the value of the pound rises. This
means each pound can buy more dollars or euros. Depreciation means a fall in
the value of the pound. It can buy fewer dollars or euros. Table 45.3 gives a
numerical example of appreciation and depreciation.

Table 45.3 Summary of effects of exchange rate changes

The impact of a high exchange rate

On firms with large export markets

UK firms that sell a high proportion of their output overseas will prefer a low
exchange rate (that is, a weak pound). Why is this so? The best way of
explaining is via a numerical example.
America is an important export market for Morgan Cars. Morgan charges its
UK customers £25,000 for a basic two-seater Roadster.
Figure 45.6 Morgan Roadster
To achieve the same profit margin in America, Morgan has to charge a price
in US dollars that will convert into £25,000. If the exchange rate against the US
dollar is £1 = $1.60, Morgan has to charge its American customers:

If the pound appreciates to be worth $2, to generate the same £25,000 of export
revenue per car, Morgan must charge its American customers:

In other words, Morgan would have to increase the US price of its cars by
$10,000 to maintain the current profit made on each car sold. The price
increase would be off-putting to car buyers, so sales would fall.

On firms that import most of their raw materials or

stock
Retailers such as Sports Direct, which import much of their stock, like a strong
pound. A high exchange rate reduces the cost of buying goods from abroad.
For example, Nike trainers are imported from the American producer. If the
US price of a pair of trainers is $40, the price paid by Sports Direct is as
follows.
If the exchange rate is £1 = $1.60, the trainers will cost Sports Direct:

However, if the exchange rate goes up to £1 = $2, the same trainers cost £20
($40/$2 = £20). A high exchange rate benefits Sports Direct because it buys
imports more cheaply, allowing it to make more profit per pair of imported
trainers sold to UK customers.

The impacts of a low exchange rate

The impacts of a weak exchange rate are the reverse of the impacts of a strong
exchange rate. Exporters, especially manufacturers, can be damaged by a
strong pound. Exporters love to see the pound depreciate in value.
On the other hand, companies such as Sports Direct are damaged by a low
exchange rate because their imported stock costs them more. If Sports Direct
reacts to the falling exchange rate by raising its prices, the company could lose
customers. If the company does nothing, it will make less profit on each sale of
an imported item.

45.7 Taxation and government spending

In addition to economic change, businesses can be affected by economic policy
decisions taken by government. If worried about inflation, a government could
decide to increase income tax. This would take spending power out of the
pockets of consumers, softening the upward pressure on prices, but cutting
demand for the products and services produced by businesses. What might be
right for the economy as a whole could be damaging for individual businesses.
Why would any government take actions that could damage businesses and
therefore threaten jobs? The answer is simple: because ministers may believe
that short-term pain may be necessary for long-term gain. This might be
correct, but it will be no consolation to any business squeezed out of business
by an unexpected tax rise.
The other main weapon government can use to achieve its policy goals is to
change the level of government (known as ‘public’) spending. At present, just
over 40 per cent of the British economy is generated by public spending. The
rest is mainly generated by private consumers (you and me). The government
spends huge sums on the health service, defence, roads and much else. If the
government was concerned about rising prices, it could consider cutting back
on its own spending. This would reduce the income of businesses involved in
education, road-building, and so on. They, in turn, may have to make
redundancies, thereby dampening down consumer spending, which should help
to keep prices from rising so sharply.
‘The last thing you want to do is raise taxes in the middle of the recession.’
Barack Obama, US President
It follows, therefore, that sensible businesspeople keep an eye on government
activity. Years ago, the government announced its tax and spending plans in the
Spring Budget, which was always kept secret until the government announced
it. Today, an ‘Autumn Statement’ announces, six months in advance, the
government’s public spending plans. This ensures that firms can anticipate the
tax decisions that will be announced in the spring.
Table 45.4 shows how a government could use its power over taxation and
spending to tackle different economic problems.

Table 45.4 The impact of a change in taxation and government

spending

45.8 The effect of economic uncertainty on the

business environment
In late 2013, investment bankers Goldman Sachs made their forecast for oil
prices for the coming year. They expected a price rise to $105, with $115 a
distinct possibility. In fact, by December 2014, the world oil price was below
$60 a barrel. Some very highly paid bankers got it all wrong. This, in turn,
would mean that airlines would have paid too much for their fuel, and that
suppliers of sustainable energy such as wind power would now be under
severe economic pressure.
This gives an idea of what economic uncertainty looks like. If it is extremely
difficult to forecast the level of supply and demand in the oil business (and
therefore the price), how much harder is it to forecast the level of demand
throughout an economy? It verges on the impossible. Therefore, every
business has to make its plans for the coming year with little certainty about the
overall state of the economy, and even less certainty about certain economic
variables that are especially prone to big ups and downs. These include:
• the value of the pound; in the ten years from 2005 to 2014, the value of the
pound against the euro fluctuated between £1 = €1.02 and £1 = €1.52; that
variation of 50 per cent adds huge uncertainty to the plans of UK exporters
• the rate of economic growth; in that same ten-year period, UK annual growth
varied between +3.2 per cent and −5.0 per cent
• the value of oil; between 2005 and 2014, the world oil price varied between
$41 and $133 once again, making planning extremely difficult.
The lesson businesses need to take from the uncertain economic environment
is to always be prepared for changing times around the corner. In good times,
make sure your cash balances are being built up sufficiently to cope with a
sudden worsening of your position. And in bad times, keep alert to the
opportunities that may soon be about to open up.

Five whys and a how

45.9 Economic influences – evaluation
When companies publish their annual results, commentators groan if the boss
blames disappointing results on external factors such as the weather or the
weakness of the economy. Business journalists admire chief executives who
achieve their targets no matter what. Yet that may not be realistic. If you are
running Coca-Cola, you have huge control over your pricing and therefore
can probably find a way to boost profits to meet analysts’ expectations. Not
long ago, people assumed that Tesco was in a similar position. The squeeze on
household spending, the rise of Aldi and Lidl and a series of strategy mistakes
by Tesco make it look very different now.
In truth, it is always the case that firms are vulnerable to external factors. Even
monopolies (when a single firm dominates a market) are subject to changing
consumer habits, as Microsoft and even Apple have found in recent years. If
things seem to be going wonderfully well – and every commentator thinks
your business is bulletproof – it is probably time to worry. The one-time boss
of monopolist microchip supplier Intel, Andy Grove, once said that ‘only the
paranoid survive’. That remains grimly true.

Key terms
Consumer demand: the levels of spending by consumers in general
(not just the demand from one consumer).
Discretionary income: a person’s income after deducting taxes and
fixed payments such as rent and utility bills.
Economic climate: the atmosphere surrounding the economy (for
example, gloom and doom or optimism and boom).
GDP: gross domestic product is the value of all the goods and
services produced in a country in a year.
Real: changes in money (for example, wages) excluding the distorting
effect of changes in prices. So a fall in real wages might be that wages
are unchanged, but prices have risen.
Recession: two or more quarters of negative economic growth.

45.10 Workbook
Revision questions
(35 marks; 35 minutes)
1 Explain why a fall in spending in London could have a knock-on
effect on the economy in Bradford, Plymouth, Norwich or anywhere
else in the country.
(3)
2 Explain whether the Bank of England should raise or cut interest
rates in the following circumstances:
a) A sharp recession has hit the UK economy.
(3)
b) House prices have risen by 16 per cent in each of the last two
years.
(3)
c) Household incomes and spending have been rising rapidly.
(3)
3 Outline how an economic downturn could affect the level of
unemployment.
(5)
4 a) Outline a change in government spending or taxation that could
boost sales at Mothercare.
(3)
 b) Explain the possible impact on a supermarket chain of an increase
in inflation.
(4)
5 What is meant by ‘an appreciation’ in an exchange rate?
(1)
6 A British detective agency has been hired by a French woman to tail
a man. The fee is €500 per week. After four weeks, the sum of
€2,000 is due to be paid, but the rate for the pound against the
euro has fallen from 1.30 to 1.15.
a) What sum will the detective agency receive in pounds for this four
weeks’ work?
(3)
b) What may stop the agency from simply putting the euro price up?
(3)
7 Outline two possible reasons why a UK manufacturer of chemicals
might be concerned if the value of the pound depreciated.
(4)
Data response
External pressures on the grocery market
The booming discount supermarket chain Aldi is on the verge of
overtaking upmarket Waitrose to become the UK’s sixth biggest
supermarket as the German-owned grocer continues to open new
stores and steal customers from its bigger rivals. Industry data show
that, while Tesco and Morrisons continue to decline, Aldi’s share of
grocery till receipts rose to 4.8 per cent in the 12 weeks to 20 July
2014. A year previously, the discounter’s market share was 3.7 per
cent, according to figures from retail analysts Kantar Worldpanel.
Over the same period, Waitrose’s market share edged up to 4.9 per
cent from 4.8 per cent last year, while Tesco dropped to 28.9 per cent
from 30.3 per cent. The data confirm the trend of shoppers
abandoning mid-market players in favour of more upmarket rivals and
the discounters, with increasing numbers of shoppers cherry-picking
from both ends of the market. ‘Waitrose has continued to resist
pressure from the competition, testament to its policy of maximum
differentiation, and has grown sales by 3.4 per cent. This figure is well
above the market average and thereby has lifted its market share.’
Despite this positivity, The Grocer magazine has questioned whether
Waitrose is now starting to suffer. Its profit margins at 5.4 per cent are
well above industry averages, and perhaps shoppers are starting to
query its value for money. Partly because of its high prices, Waitrose
offers free delivery to online grocery shoppers. With online sales
booming, it may be that Waitrose profits start to get squeezed by the
free delivery, given that picking and delivery is far from free from the
shop’s point of view.
The numbers come against a backdrop of a challenging market. Kantar
says grocery price inflation has fallen for the tenth successive period
and now stands at just 0.4 per cent – its lowest level since prices were
first measured in 2006. As a result, market growth has fallen to 0.9 per
cent.
Tim Vallance, head of retail at property group JLL, said:
‘The figures highlight the impact that the big four’s response to the
rise of the discount retailers is having on the grocery sector, with
vicious price cutting leading to shrinking market growth. As shoppers
continue to demand a more convenient offer in an increasingly digital
world, supermarkets need to think about how and where their
customers shop and need to focus on choice, provenance, quality,
service and convenience to differentiate from the discounter
offering.’
Sources: adapted from www.4traders.com, 30 July 2014, and The
Grocer, 9 August 2014
Questions (40 marks; 45 minutes)
1 Assess the possible implications for Waitrose of a fall in ‘grocery
price inflation’ to 0.4 per cent a year.
(10)
2 At this time in mid-2014, the rate of interest had been 0.5 per cent
for five years. Assess how the position of Waitrose might have been
affected by an increase in interest rates.
 (10)
3 Evaluate whether Waitrose would have been wise, at this time, to
have differentiated itself further by switching entirely to Fairtrade
supplies.
(20)
Extended writing
1 Jaguar Land Rover exports 80 per cent of all the 500,000+ cars it
produces in Britain. Evaluate the most probable response from the
company if the pound appreciated sharply against other currencies.
(20)
2 In the last recession, Tata Steel closed one of its Scunthorpe
steelworks, making hundreds redundant. Evaluate the strategies
Tata could have adopted to prepare for recession.
(20)
Section 2.5 External influences

46 Legislation
Definition
Legislation is defined as laws initiated by government but passed by
parliament that relate to business operations and therefore employees,
the general public and the environment.

Linked to: Introduction to managing people, Ch 16; Business

objectives, Ch 25; Economic influences, Ch 45.

46.1 Introduction to legislation

UK businesses are subject to laws (legislation) passed by both the UK
parliament and the European parliament. Since both UK and EU law are passed
by parliaments, laws are affected by party politics. Conservative governments
suggest they interfere as little as possible with the workings of business. In
other words, they claim to take a laissez-faire approach. This means trusting
businesses to do their best for their customers and employees – in other words,
let the market regulate business activities.
‘The most enlightened judicial policy is to let people manage their own
business in their own way.’
Oliver Wendell Holmes, nineteenth-century author
Labour governments are more suspicious that businesses may act in their
shareholders’ interests, not those of their customers. Therefore, there is a
greater temptation to bring in laws to regulate business activity. Before the
Labour government established the National Minimum Wage in 1999,
employers could, and did, pay as little as £3 an hour. The 2014 rate of £6.50
per hour is not riches, but provides some protection for the lower paid.
There are five main areas in which the law affects businesses:
1 consumer protection
2 employee protection
3 environmental protection
4 competition policy
5 health and safety.

46.2 Consumer protection

Consumer protection law is designed to ensure that consumers are treated
fairly by the companies from which they buy. This covers issues such as
whether a product does what it claims to do, whether products are correctly
labelled and measured out and the rights of the consumers to refunds or
exchanges of faulty goods. Consumer protection legislation should ensure that
no firm can gain an unfair competitive advantage by taking short-cuts in how
their products are made. If all products and services must meet a minimum
legal standard, companies cannot use unsafe/cheaper materials to gain a
competitive edge.
Two Acts of Parliament are especially important:
1 The Sale of Goods Act. First passed in 1893 and updated in 1979, this is the
law that says ‘goods must be fit for the purpose for which they are sold’.
Before this law, nineteenth-century crooks sold ‘cures’ for ‘bad blood’ or
cancer – and customers had no right to demand their money back. Today, if
you buy shoes and holes appear in the soles within weeks, the Sale of Goods
Act makes sure you can get your money back.
2 The Trade Descriptions Act. This was introduced in 1968 and updated in
2008. It forces companies to ensure that every claim and statement about a
product is true. Before it, a beer producer could proclaim in advertising that
‘Guinness is good for you’. In recent years, Danone has repeatedly been
forced to back down on over-claims about the health virtues of products
such as Activia.
The effect of consumer protection law on business has been to create more of
a ‘level playing field’ in which competition has to be more on the basis of real
product benefits, not simply on imagination and willingness to deceive. At
every stage, companies have argued against new laws, suggesting that they will
undermine competition. There is little evidence for this.

46.3 Employee protection

Employment law sets out, and aims to protect, the rights of employees at work.
These rights include the right to fair pay, sick leave, maternity and paternity
leave, employment contracts being honoured, relationships with trade unions,
the ability of employers to shed staff and the responsibilities of employers who
make staff redundant. Of these, the easiest to remember (and to see the
implications of) is the National Minimum Wage legislation that was introduced
in 1999. Table 46.1 sets out the implications of employment legislation for
businesses.
Table 46.1 Implications of employment legislation
As a general rule, businesses like to have minimal legal constraints on their
activities. A business craves flexibility in the way it deals with its staff;
legislation tends to impose certain restrictions on how staff are dealt with. UK
business leaders argue that more employment legislation makes them
uncompetitive relative to their international rivals. Yet UK employment
legislation is not as tight as that in major rivals such as France and Germany. In
its 2014–2015 report on global competitiveness, the World Economic Forum
ranked the UK fifth in the world for ‘labour market efficiency’. Yet there are
still politicians who try to claim that Britain’s labour market is over-regulated.
‘Morality cannot be legislated, but behaviour can be regulated. Judicial
decrees may not change the heart, but they can restrain the heartless.’
Martin Luther King, civil rights leader

46.4 Environmental protection

Laws governing the impact of business on the environment are a key area
today, given the increased acceptance of the need to legislate to protect the
environment. A wide range of laws governs issues as diverse as the materials
that firms must use for certain products, the processes firms are allowed to use
in manufacturing and the extent to which firms must ensure their products are
recyclable at the end of their lives. Environmental protection laws, perhaps
more than any others, seem to most firms to be a source of additional cost
without much of an upside. Firms in the UK are also subject to EU laws; this is
an area in which several EU directives have led to increased expectations of
businesses. Of course, all these firms feel a sense of injustice that they are
competing against non-EU countries with less stringent environmental laws.
The reality is, though, that companies such as Dyson have succeeded in Japan
and America precisely because consumers in those countries want well-
designed, environmentally friendly products.

Real business
Hoover panic
Towards the end of August 2014, UK newspapers reported on panic
buying of vacuum cleaners. New EU rules were to start on 1
September making it unlawful to sell vacuum cleaners with an engine
with more than 1,600 watts of power. Although James Dyson made it
clear that the power of the engine was barely related to its efficiency,
media scare stories created a sales surge amounting to a 400 per cent
increase. The EU’s concern was to halt a 6 per cent annual rise in
electricity usage on household electric goods – as part of Europe’s
promise to cut carbon emissions by 20 per cent by 2020. UK
newspapers treated the story as another opportunity to bash the
European Union; in fact, vacuums sold today are every bit as efficient
as before – with better design compensating for smaller engines.

Among the various pieces of environmental legislation, especially important

ones include the following:
1 Landfill tax, which was introduced in the UK in 1996 following a European
Union ‘directive’. It forces businesses to pay £80 per tonne to deposit
‘active waste’ in landfill sites (council rubbish dumps). This adds to
business costs and therefore can be said to damage international
competitiveness. The other way to look at it is that it encourages businesses
to minimise and then recycle waste instead of dumping it.
2 The Environmental Protection Act 1990 (updated in 2008), which sets out
the structure of waste management and emissions control for the UK.
Perhaps its most notorious feature is the requirement for ‘risk assessments’
– that is, full analyses by companies of the possible environmental risks
from different aspects of their business. This is time-consuming and
bureaucratic, but has probably helped in the significant reduction of river
pollution in the UK. In 1990, a swim in the Thames was a suicide mission.
Today fish, at least, have returned to the river.

46.5 Competition policy

Even the strongest believers in laissez-faire see the value in government
intervention to boost competition. The need becomes most obvious when one
company tries to buy up a rival. If Cadbury (with about 33 per cent of the UK
chocolate market) bought Mars UK (which has about 20 per cent), the resulting
giant would surely find it easy to push prices up and consumer choice down.
In 2014, the new Competition and Markets Authority (CMA) took on the
functions of the now-closed Competition Commission and Office of Fair
Trading. The government-funded CMA is responsible for:
• investigating takeovers and mergers
• investigating possible anti-competitive practices
• bringing criminal proceedings against individuals who commit cartel
offences.
If the CMA is completely successful, UK consumers will benefit from real
competition between companies doing their best to win market share. Sadly
price-fixing remains surprisingly common, as evidenced by the number of
companies ‘busted’ for this illegal activity.
‘If there were no bad people there would be no good lawyers.’
Charles Dickens, novelist

Real business
In October 2013, the UK’s cement industry was forced to change its
practices by the competition authorities. The industry (dominated by
three multinational companies) would no longer be allowed to share
sales and production data, and the largest producer was forced to sell
off one of its biggest cement factories. The competition authorities
suggested that over-charging had cost the struggling construction
sector £180 million over the period 2009–2013.
Figure 46.1 Logic circle: functions of the CMA

46.6 Health and safety

Health and safety legislation is designed to ensure the safety of employees and
customers within the workplace. The Health & Safety at Work Act 1974 places
the major burden on employers. They have to provide a safe working
environment for their staff. The main areas covered by the legislation include
the physical conditions in which staff are required to work, precautions that
firms are required to take when planning their work and the way in which
hazardous substances must be treated in the workplace.
The job of the Health and Safety Executive is to identify and prosecute any
serious lapses by companies. In its 2014 annual report, the Executive
prosecuted a scaffolding company that was found guilty and fined £300,000
(plus £124,000 in costs) after an employee was killed by an overturned skip
lorry.
Despite the tight laws in Britain, there are still a worrying number of deaths at
work. The annual toll is set out in Table 46.2. Even more striking is that there
are as many as 230,000 workplace injuries a year. Health and safety cannot be
taken for granted.

Table 46.2 Deaths at work, 2013–2014 (source: Health and Safety

Commission)

Five whys and a how

46.7 Legislation – evaluation
Legislation seeks to ensure that all firms compete on a ‘level playing field’.
This is a noble goal because one country’s legislation can only create a level
playing field in the home market. Super-tough laws, perhaps on the
environment, add to costs and therefore may make it hard for UK firms to win
contracts overseas. Although that could be a price worth paying, it may be
better still for all developed trading countries to agree common standards.
This is what happens within the European Union.
For those who argue that laws are unnecessary because market forces will
drive unscrupulous firms out of business, there is a disappointing lack of
evidence to suggest that this argument is valid. Though plenty of businesses are
convicted of breaking the law, it is a real challenge to find just one example of
a firm that has been forced to close as a result of doing so. Is the incentive to
avoid prosecution strong enough?

Key terms
Cartel: an agreement between producers to control supply and thereby
control prices. This is illegal, but not unusual.
Laissez-faire: literally means ‘let it be’, implying leaving businesses free
to choose their own policies and practices: trusting in the free market.

46.8 Workbook
Revision questions
(30 marks; 30 minutes)
1 a) Explain, in your own words, the meaning of the term ‘laissez-faire’.
(3)
b) Explain what a follower of laissez-faire might think about
governments setting a National Minimum Wage.
(4)
2 From the chapter, explain one advantage and one disadvantage to
UK businesses of being based in the European Union.
(6)
3 Briefly describe the main aims of the following legislation:
a) employment laws
b) consumer protection law
c) health and safety law.
(6)
4 Explain two possible consequences of a tightening of environmental
protection laws for one of the following:
a) a supermarket
b) a chemical manufacturer
c) a bank.
(6)
5 Briefly explain why many UK firms would welcome a relaxation of
environmental protection legislation.
(5)
Data response
Forbes Bricks
Maintaining a legal factory is a lot harder than you might expect – just
ask Dave Maisey, managing director of Forbes Bricks Ltd. Forbes is
one of a handful of bespoke brick makers left in the UK. It can tailor-
make any shape, size, colour or material of brick; this feature explains
its lasting popularity among those looking for bricks to restore or
maintain older properties. A medium-sized firm, Forbes owns a single
factory in Kent, with a loyal workforce of skilled and semi-skilled staff.
Dave, however, has the look of a tired man. Charged with managing
most aspects of the business, he is also ultimately responsible for the
firm’s compliance with the legislation affecting the business. His biggest
headache, he says, is health and safety: ‘They just don’t seem to
understand that making bricks is a dusty business. You can’t make
bricks without dust, and the inspector we had round the other week
was measuring dust levels all round the shop floor, tutting as she
went.’
The inspector from the HSE (Health and Safety Executive) was at the
plant to measure the level of dust particles in the air and to assess the
measures taken by the firm to ensure that staff suffered no long-term
respiratory damage from the dusty working conditions.
Dave continued: ‘I’d only just finished a full risk assessment on the new
kiln we’ve bought, so luckily I managed to impress her with that. The
inspector went over the accident record book, and our whole Health
and Safety manual. I spent the whole day with her, time I could have
spent out on the road finding new business, or working with the boys
to find a better solution to some of the stockholding issues we’ve had
recently.’
Two weeks after the inspector’s visit, Dave called a meeting of the
firm’s directors to discuss the recommendation from the HSE: to
spend an extra £105,000 on extractor units to reduce the dust levels
in the air to standards acceptable under UK and EU law. Dave was
also about to find out what purchasing director Andy Hemmings
discovered when he visited a similar factory in China recently. Dave
feared that Andy had found a factory with poor working conditions,
paying well below Forbes’ rates to staff and offering similar bricks at
half the price.
Questions (30 marks; 35 minutes)
1 Outline two reasons why Dave seems unhappy about the legislation
affecting Forbes Bricks Ltd.
(6)
2 Explain Dave’s general responsibilities to his staff according to UK
health and safety law.
(4)
3 Evaluate whether the case study proves that different legal
standards make it impossible to have fair competition between firms
from different countries.
(20)
Extended writing
1 A laissez-faire ‘think-tank’ has recommended that the government
should allow small firms to be exempt from all employment
legislation. Evaluate the value of that recommendation to UK
businesses.
(20)
2 An important objective of business-related legislation is a ‘level
playing field’. Evaluate the extent to which this is possible in a
globalised world.
(20)
Section 2.5 External influences

47 The competitive environment

Definition
A competitive environment involves measuring the directness and
toughness of the competition within a market or sector within a
market.

Linked to: Demand, Ch 5; Price elasticity of demand, Ch 8;

Pricing strategies, Ch 12.

47.1 What is a competitive market?

Markets used to be physical places where buyers and sellers met in person to
exchange goods or to haggle over price. Street markets are still like that. In
online or digital markets, there is no face-to-face negotiation, but the
potentially huge number of buyers and sellers makes transactions highly
competitive.
A competitive market features intense rivalry between producers of a similar
good or service. The number of firms operating within a market influences the
intensity of competition; the more firms there are, the greater the level of
competition. However, the respective size of the firms operating in the market
should also be taken into account. A market consisting of 50 firms may not be
particularly competitive, if one of the firms holds a 60 per cent market share
and the 40 per cent is shared between the other 49. Similarly, a market
composed of just four firms could be quite competitive if they are of a similar
size.
Consumers benefit from competitive markets. Not so the firms themselves. In
competitive markets, prices and profit margins tend to be squeezed. As a result,
firms operating in competitive markets try hard to minimise competition,
perhaps by creating a unique selling point (USP) or using predatory pricing.
It could be argued that marketing is vital no matter what the level of
competition. Firms that fail to produce goods and services that satisfy the needs
of their target consumers will find it hard to succeed in the long term.
Ultimately, consumers will not waste their hard-earned cash on products that
disappoint.

47.2 The degree of competition within a market

One dominant business

Some markets are dominated by one large business. Economists use the word
‘monopoly’ to describe a market where there is a single supplier, and therefore
no competition. In practice, pure textbook monopolies rarely exist; even
Microsoft does not have a 100 per cent share of the office software market
(though it does have a 90 per cent share). The UK government’s definition of a
monopoly is somewhat looser. According to the Competition and Markets
Authority, a monopoly is a firm that has a market share of 25 per cent and
above.
Monopolies are bad for consumers. They restrict choice, and tend to drive
prices upwards. For that reason, most governments regulate against
monopolies and near monopolies that exploit consumers by abusing their
dominant market position.
Deciding whether a firm has, or does not have, a monopoly is far from being a
straightforward task. First of all, the market itself has to be accurately defined.
For example, Camelot has been granted a monopoly to run the National
Lottery. However, it could be argued that Camelot does not have a dominant
market position because there are other forms of gambling, such as horse
racing and football ‘in-play’ betting, available to consumers in the UK. Second,
national market share figures should not be used in isolation because some
firms enjoy local monopolies. A good example of a dominant local market
position was the airport operator BAA. The company used to own three of
London’s four airports. Acting on complaints made by airlines, the
government forced BAA to sell off Gatwick airport in December 2009 and
Stansted in 2013. Increased competition should lead to improved customer
service and lower landing fees (and therefore air fares).
Companies work hard to try to create monopoly positions for themselves. This
might be achieved by technical innovations that make it harder for new entrants
to break into the market. Apple spends millions of dollars on research and
development in order to produce cutting-edge products. Apple’s 14-year-old
iPod is still the market leader in MP3s with a 70 per cent share of the massive
US market. In 2014, Apple sold $14 billion of iPods. To ensure that Apple
maintains its dominant market position, new product launches involve
innovations that make it hard for competitors to keep up.

Figure 47.1 iPad

Competition among a few giants

The UK supermarket industry is a good example of a market that is dominated
by a handful of very large companies. Economists call markets like this
oligopolies. The rivalry that exists within such markets can be very intense.
Firms know that any gains in market share will be at the expense of their rivals.
The actions taken by one firm affect the profits made by the other firms that
compete within the same market.
In markets made up of a few giants, firms tend to focus on non-price
competition when designing the marketing mix. Firms in these markets are
reluctant to compete by cutting price. They fear that the other firms in the
industry will respond by cutting their prices too, creating a costly price war in
which no firm wins.
The fiercely competitive market
Fiercely competitive markets tend to be fragmented; made up of hundreds of
relatively small firms who each compete actively against other. In some of
these markets, competition is amplified by the fact that firms sell near-identical
products called commodities; these are products such as flour, sugar or blank
DVDs, which are hard to differentiate. Rivalry in commodity markets tends to
be intense. In such markets, firms have to manage their production costs very
carefully because the retail price is the most important factor in determining
whether the firm’s product sells or not. If a firm cannot cut its costs, it will not
be able to cut its prices without cutting into profit margins. Without price cuts,
market share is likely to be lost.
In fiercely competitive markets, firms will try, where possible, to create
product differentiation. For example, the restaurant market in Croydon, Surrey,
is extremely competitive. There are over 70 outlets within a two-mile radius of
the town centre. To survive without having to compete solely on price, firms in
markets like this must find new innovations regularly because points of
differentiation are quickly copied.

47.3 Competition and market size

Big markets
In 2014, British consumers spent £2,700 million on ‘bagged snacks’. Walkers
regular crisps was the market leader, with sales of £475 million. More money
was spent on Walkers crisps in the UK than the entire worldwide revenues of
Manchester United football club. But even though brand owner PepsiCo had 14
of the 25 top sellers in the market for bagged snacks (think Doritos, Quavers,
Sensations and many more), it still faced serious competition. Although the
market number two (Pringles) had sales of ‘just’ £180 million, Pringles gives
Walkers serious competition, forcing the market leader to have to keep
innovating in order to stay at number one. Walkers also faces competition
from niche brands such as Kettle Chips. Started in 1988, it took the brand until
2004 to reach £35 million of annual sales. In 2014, its sales had nearly trebled
to £98 million. A market share of 3.6 per cent may seem trivial, but Kettle’s
adult niche allows it to be one of the most profitable brands in bagged snacks.
Small markets
The market for dishwasher powder is less than a tenth of that for bagged
snacks. At £250 million a year, there is only room for two brands: Finish,
which once dominated this sector and still has a 52 per cent market share, and
Fairy, with 25 per cent of the market. The remainder consists of other brands
and supermarket own labels. In such a market, it would be hugely difficult for
any other brand to break in. Both Finish and Fairy are backed by generous
advertising budgets, which act as a barrier to others entering the market.

Changes in the competitive environment

The number of firms operating within a market can change over time. If new
competitors enter, a market will become more competitive. New entrants are
usually attracted into a new market by the high profits or the rapid growth
achieved by the existing firms. After the Europe-wide success of airlines such
as easy Jet and Ryanair, a huge number of imitators came into the airline
business, including Air Berlin and Wizz Air. Although most of these have
struggled to be profitable, their lower prices have unquestionably benefited the
traveller.
In markets that are suffering from low or negative profitability, firms tend to
exit, leaving the market less competitive than it was. In 2014, many UK
‘payday’ lenders withdrew from the market after the Financial Conduct
Authority placed restrictions on the level of interest rates they were allowed to
charge.

Key quotations
‘People of the same trade seldom meet together, even for merriment
and diversion, but the conversation ends in a conspiracy against the
public, or in some contrivance to raise prices.’
Adam Smith, The Wealth of Nations, 1776
‘Competition is not only the basis of protection to the consumer, but
is the incentive to progress.’
Herbert Hoover, US President, 1929–1933
‘Like many businessmen of genius he learned that free competition
 was wasteful, monopoly efficient. And so he simply set about
achieving that efficient monopoly.’
Mario Puzo, The Godfather, 1969

47.4 Responses of businesses to a changing

competitive environment
In a market that has become more competitive, firms may be forced into the
following actions in order to defend market share.

Price cutting
Many firms attempt to fight off a competitor by cutting price. If the
competition can be under-cut, consumers will hopefully remain loyal to the
company that has cut its prices. Firms that use price-cutting as a way of
fighting off the competition will normally try to cut their costs in line with the
price cut in an attempt to preserve profit margins. If profit margins are already
tight and costs have already been cut as much as possible, it probably will not
be possible to respond to a new competitor by cutting prices.

Increase product differentiation

Product differentiation is the degree to which consumers perceive a brand to
be different from, and in some way superior to, other brands of the same type
of product. Some firms may be apprehensive about responding to a
competitive threat by cutting price because the long-term result could be a
deteriorating brand image that could hinder, rather than help, sales. Many
consumers still associate price with product quality. If product differentiation
can be increased, consumers will be less likely to switch to products supplied
by the competition. To a degree, differentiation helps a firm to insulate itself
from competitive pressure. Firms that want to increase differentiation can do
so in the following ways.

Design
An eye-catching design that is aesthetically pleasing can help a firm to survive
in a competitive market. By using design as a unique selling point, British
manufacturers can compete on quality rather than on price, making them less
vulnerable to competition from China and India. Good-looking design can add
value to a product. For example, the BMW Mini relies upon its retro 1960s
styling to command its price premium within the small car market.

Unique product features

In markets that are highly competitive, some firms react by redesigning their
products to ensure that they possess the latest must-have feature. For example,
in the car market, Toyota’s hybrid drive technology has appealed to consumers
who are interested in buying an environmentally friendly car with very low
emissions.

Collusion
If faced with a real threat to the survival of the business, some managements
take the apparently easy way out and try to do deals with their supposed
competitors. In other words, they get in touch to fix prices, cut promotional
expenditures or find any other way to boost profitability. If two or more
companies feel equally threatened by the level of competition, there is every
reason to agree to this in the short term. With much tougher legislation these
days, it has become more difficult to make this work in the longer term,
because there are strong incentives for one cheating firm to whistleblow (‘rat’)
on the others. The first one to whistleblow gets 100 per cent immunity and
therefore no fines or any other form of punishment.

Five whys and a how

47.5 The competitive environment – evaluation
The best way a business can ensure its survival in a competitive world is to
find something it is good at, and stick with it. Cadbury is great when it
concentrates on making chocolate; Heinz is brilliant at making and marketing
baked beans or ketchup. Even if the massive Hershey Corporation brings its
chocolate from America, Cadbury need not fear.
The hard thing is to get to the stage at which customers are subconsciously
looking for your brand on the shelf, and buying it without thinking too much
about price and quality. They want Nike on their feet and Apple in their hand. In
2014, in the UK, Pepsi added £33 million of sales while Coca-Cola suffered a
£25 million sales decline – despite the huge and expensive launch of Coke Life.
That is a reminder that ‘do nothing’ can sometimes be the right course of
action. Instead of panicking about the possible impact of Coke Life upon Pepsi
Max, Pepsi stayed confident in its product range. Clever stuff.

Key terms
Collusion: when managers from different firms get together to discuss
ways to work together to restrict supply and/or raise prices.
Non-price competition: all competitive strategies other than price, such
as branding, product design and technological innovation.
Oligopolies: markets dominated by a few large companies.
Predatory pricing: pricing low with the deliberate intention of driving a
competitor out of business.

47.6 Workbook
Revision questions
(35 marks; 35 minutes)
1 What is a monopoly?
(2)
2 Explain two reasons why monopolies exist.
(4)
3 How may an increase in competition within the UK banking market
affect shareholders of banks such as Lloyds and HSBC?
(3)
4 Analyse two factors which could decrease the level of competition
within the car market.
(6)
5 Outline two reasons why a supermarket such as Waitrose may be
concerned if Mars and Cadbury merged into one business.
(6)
6 Explain how product differentiation may help a firm to adjust to a
more competitive market.
(4)
7 Explain why many large firms prefer to buy out smaller rivals, rather
than competing against them head-to-head.
(4)
8 Discuss whether it is right for some firms to use tactics such as
predatory pricing to influence market structure.
(6)
Data response 1
BA bosses accused of price-fixing by Virgin
‘whistleblowers’
In 1993, British Airways found itself in court accused of using anti-
competitive tactics in an attempt to force a much smaller new airline,
called Virgin Atlantic, out of business. The so-called ‘dirty tricks’ used
by BA included spreading malicious rumours about Virgin’s solvency, in
order to deprive the company of credit. After a bitter legal battle in the
High Court, BA apologised and agreed to pay Virgin over £600,000 in
compensation.
How times change. Nearly 20 years later, the same two companies
stood accused of collusion. In April 2010, BA managers were
summoned to appear in court to answer allegations that they had met
with their rivals at Virgin to agree on a common fuel duty surcharge to
impose on both BA and Virgin consumers. Over a period of a year and
a half, both airlines increased the fuel surcharges paid by passengers
on long-haul routes from £5 to £60.
In the UK, the Competition Commission was then responsible for
investigating alleged cases of anti-competitive behaviour.
Unfortunately, anti-competitive behaviour such as price-fixing is still
very common in the UK, despite the fact that it is illegal. One of the
main problems faced by the new Competition and Markets Authority is
the difficulty faced in acquiring the necessary evidence needed to
prove that anti-competitive behaviour has taken place. The Authority
now offers so-called ‘whistleblowers’ immunity from prosecution in
exchange for information that enables a prosecution to take place. In
this case, the evidence used to convict BA came from their co-
conspirators. Virgin’s chief executive stood as the main witness for the
prosecution!
Questions (30 marks; 35 minutes)
1 What is meant by the following terms:
a) anti-competitive tactics
b) ‘whistleblowers’
c) ‘collusion’?
(6)
2 Explain why anti-competitive behaviour such as price-fixing is illegal.
(4)
3 Assess two possible reasons why anti-competitive behaviour
persists despite the fact that it is illegal.
(8)
4 Assess whether the Competition and Markets Authority was right to
offer Virgin immunity from prosecution.
(12)
Data response 2
The prices of consumer electronics, such as toasters, satellite TV set-
top boxes and MP3 players, have tumbled in recent years.
Supermarket chains like Tesco now sell DVD players that previously
cost hundreds of pounds for less than £10. So, why have the prices of
these goods fallen? In part, the price falls reflect the falling price of the
components that go into consumer electronics. Low prices also reflect
the fact that there is now more competition in the market. In the past,
consumers typically bought items such as TVs and computers from
specialist retailers – for example, Currys and Comet. Today, the
situation is somewhat different; in addition to these specialist retailers,
consumers can now buy electrical goods over the internet and from
supermarkets. Some industry analysts also believe that some of the
supermarket chains are using set-top boxes and DVD players as loss
leaders.
In today’s ultra-competitive environment, manufacturers of consumer
electronics face intense pressure from retailers to cut costs so that
retail prices can be cut without any loss of profit margin. To cut prices
without compromising product quality, manufacturers such as the
Dutch giant Phillips have transferred production from the Netherlands
to low-cost locations like China.
Questions (35 marks; 40 minutes)
1 Describe two characteristics of a highly competitive market.
(4)
2 Explain why the market for consumer electronics has become more
competitive.
(4)
3 Examine three factors that would affect the competitiveness of a
 manufacturer of DVD players.
(9)
4 a) Use a dictionary or A-Z to find out the meaning of the term ‘loss
leader’.
(3)
b) Why do supermarkets use this tactic?
(3)
5 Assess whether, in today’s competitive market for consumer
electronics, firms must constantly cut costs and prices if they are to
survive.
(12)
Extended writing
1 Evaluate the benefits to mobile phone buyers of the fierce
competition between Samsung and Apple.
(20)
2 With the demise of Rangers F.C., Celtic has a monopoly in Scottish
club football. Evaluate whether this proves that monopoly is
something no business should wish for.
(20)
Edexcel A level Business Year 1

48 Quantitative skills for Business

Definition
Quantitative skills are needed to calculate, interpret and analyse
business data, whether numerical or graphical.

Linked to every chapter in the book.

48.1 Introduction
Unlike the other chapters of the book, this purely provides questions (the
answers can be found at the back of the book). It is to help you test your
knowledge and understanding of an important aspect of the subject. Page 37 of
the Edexcel Specification sets out the exact skill requirement for AS level
exams. The questions in this chapter match page 37 precisely, making it perfect
for revision.

Table 48.1 Chewing gum sales, top ten, 2013 (source: The Grocer, 21
December 2013)
48.2 Calculate, use and understand ratios, averages
and fractions
Look at Table 48.1 then answer the questions that follow.
1a) Calculate the average 2013 sales figure among the top five in the UK
market for chewing gum.
(3)
b) Why may that figure be less valuable than many averages?
(4)
2 What fraction of the total market was represented by the sales of Wrigley’s
Extra Gum (be willing to round the numbers to provide a simple fraction)?
(4)
3a) In 2013, Maynards Fruit Gums outsold Orbit Chewing Gum 5:1. Use that
ratio and the data provided to give the 2013 sales figure for Maynards
Fruit Gums.
(4)
b) In the UK market for chocolate, brands outsell supermarket own labels in
a ratio of 12:1. In the case of sugar confectionery, the ratio is 4.5:1.
Explain two possible reasons for this.
(8)

48.3 Calculate, use and understand percentages and

percentage changes
Table 48.2 shows unit sales of Apple’s three main products.
Table 48.2 Unit sales of Apple’s three main products (figures in 000s)
4a) Calculate the percentage change in iPod sales between quarter 2 of 2013
and the same quarter of 2014.
(3)
b) Calculate the percentage change in iPhone sales between quarter 2 of 2013
and the same quarter of 2014.
(3)
c) If iPhone enjoys a 12 per cent sales increase between quarter 2 of 2014
and quarter 2 of 2015, what will its new sales level be?
(3)
d) In quarter 2 of 2014, what percentage of the sales of all Apple’s three
products came from the iPad?
(3)

48.4 Construct and interpret a range of standard

graphical forms
A line graph is a great way to show trends over time in comparative data.
Figure 48.1 shows UK exports to four developing countries over the period
1998–2013. Look at the graph and then answer the questions below.
Figure 48.1 UK exports, 1998–2013 (source: Office of National
Statistics)
5a) Explain two important features of the data shown on the graph.
(6)
b) Estimate the £ms increase in UK exports to China between 2007 and 2012.
(2)
c) Calculate the percentage change in UK exports to China between 1998 and
2013. Then do the same for the percentage change in exports to South
Africa.
(5)
d) Explain two possible reasons why the figure for China is so much greater.
(8)
Another type of data that needs illustrating is proportions. This is often done
by pie charts, though Figure 48.2 does the equivalent, using a stacked bar chart.
This makes it easy to show changing proportions, in this case of the different
consumer electronic products sold by Apple Inc.
Figure 48.2 Global sales of Apple products (000 units) (source: Apple
quarterly accounts)
6a) Explain two important features of the data shown in Figure 48.2.
(8)
b) Calculate the percentage increase in total unit sales of Apple’s products
between 2010 and 2014.
(3)
c) Assess what use Apple might have been able to make out of the data shown
in Figure 48.2.
(8)

48.5 Interpret index numbers

In business, data series are often converted into index numbers. It makes the
data easier to interpret and far easier to compare with data that might be
correlated.
Look at the graph showing trends in UK manufacturing (Figure 48.3) and then
answer question 7.
7 a) i) Explain what is meant by ‘Index 2010 = 100’.
(4)
ii) Outline two possible reasons why this data has been presented in Index
form.
(4)
b) Assess the trend in car manufacturing with production of aircraft and
spacecraft.
(8)
c) The black line shows the trend in total UK manufacturing between 1997
and 2014. Assess the main features of this data over the period.
(8)

Figure 48.3 Trends in UK manufacturing September 2014 (source:

Office of National Statistics)
48.6 Calculate cost, revenue, profit and break-even
A small bakery specialises in French bread. Each loaf is priced at £1.20 and has
a variable cost of 40p. Weekly fixed costs are £600 and 1,200 loaves are sold
per week.
8a) Calculate the total costs of producing 1,200 loaves in a week.
(3)
b) Calculate the total revenue per week.
(3)
c) Calculate the weekly profit.
(2)
d) Calculate the break-even point and the margin of safety for the bakery.
(6)
e) Calculate the weekly profit if a price rise to £1.40 cuts demand to 1,100
loaves.
(5)
(Quantitative skill 6 only applies to second-year A level and will be dealt with
in Edexcel Business A level Year 2 by Marcousé, Hammond and Watson, 2016.)

48.7 Interpret values of price and income elasticity

of demand
In the year to June 2014, Wrigley put the price of its ‘Hubba Bubba’ brand up
by 10 per cent. The result was a 9 per cent fall in sales volume. Therefore, its
price elasticity of demand was −0.9.
9a) What would have been the effect on Hubba Bubba sales revenue of this 10
per cent price rise?
(3)
b) What would the effect be on the brand’s profit level (in the short term)?
(3)
c) Why might the long-term effect of this price rise be more worrying than
the short-term effect?
(5)
In January–June 2014, the UK economy grew at 3 per cent. Across the whole
UK car market, income elasticity is estimated at +3.5.
10a) Calculate the percentage increase in UK car sales that could be expected
in January–June 2014.
(3)
b) With an income elasticity of +3.5, what term could be used to describe
cars as a product category?
(1)
c) Based on the above information, explain what might happen to UK car
sales if there is ever a repeat of the 2009 recession, with its 6 per cent fall
in GDP.
(4)

48.8 Use and interpret quantitative and non-

quantitative information in order to make decisions
In 2014, a total of 912 new confectionery products hit the market. Within that
total, the highest category for launches was ‘seasonal chocolate’, with 178 new
products. These launches were attracted by the strength of this category, with
sales rising 15.1 per cent to £580 million, even though the market as a whole
was static. Quite apart from selling £58 million of its market leading Creme
Eggs, Cadbury saw sales double in 2014 for its ‘Dairy Milk Egg and Spoon’.
Ferrero and Mars are among the companies trying hard to win a bigger share
of this high profit-margin sector (source: The Grocer, 4 October 2014).
11a) Explain two reasons why seasonal chocolate saw such a high number of
new product launches in 2014.
(8)
b) i) Calculate Creme Egg’s share of this market sector.
(3)
ii) What is the implication of a brand being the market leader with that
level of market share? Explain your thinking.
(4)
c) A key Mars brand is Maltesers – which has annual sales of £120 million
but quite a small share of the seasonal chocolate sector. Assess how the
 Malteser brand might be used to boost Mars sales within this sector.
(8)

48.9 Interpret, apply and analyse information in

written, graphical and numerical forms
The final set of questions on quantitative skills relates to Table 48.3 and Figure
48.4. The data is based on the best estimates available in November 2014 of the
sales performance of the Sony PS4 console compared with its rival Microsoft
Xbox One.

Table 48.3 Launch sales estimates for PS4 and others

12a) From the data in Table 48.3, what conclusions can Sony draw so far?
(4)
b) On the basis of Table 48.3, what sales forecast might Sony make for Oct–
Dec 2014? Give an estimate and explain your reasoning.
(6)
c) Figure 48.4 shows the cumulative sales figures for each console. Assess
whether this information is more or less useful than the ordinary
quarterly sales figures shown in Table 48.3.
(6)
Figure 48.4 Cumulative launch sales: PS4 v. Xbox One v. PS3
(sources: various, including company press releases)
d) Assess how Microsoft might react to the sales data provided.
(8)
All the answers to these questions are on pages 316–317, at the end of the
book.
Edexcel A level Business Year 1

49 How to revise for Business exams

Good revision can add as much as two grades to your A level result. The aim
of this unit is to help you to appreciate what makes up a quality revision
programme.

49.1 Aims and objectives

A good revision programme should be aimed at achieving specific targets that
will maximise your chances of success in the exam. How should these targets
be set?
The basis for setting revision targets can be found in three places:
1 the specification (syllabus)
2 past papers (unfortunately, these are in short supply at the start of the life of
a specification)
3 examiners’ reports.

The specification
The specification tells you the knowledge and skills the examiner is looking
for. Knowing the skills the examiner is looking for will help you to produce
better-quality answers in an exam. However, like all skills these can be
developed only through practice, so it is important to start your revision early.
In fact, you should try to review your work every few weeks to make sure
there are no gaps in your notes and that your files are well organised. This way
it becomes easier to revise at the end of the course because everything is in
place.

Definitions of higher academic skills

Higher academic skills include: analysis, synthesis and evaluation.
Analysis (breaking down)
This is:
• identification of cause, effect and interrelationships
• the appropriate use of theory or business cases/practice to investigate the
question set
• breaking the material down to show underlying causes or problems
• use of appropriate techniques to analyse data.
Analysis involves a chain of argument linking ideas and concepts, and showing
the relationship between them. You may analyse why something happened or
the consequence of something occurring.
Look back at previous answers you have written and try to find examples of
how you could extend your responses. Were there any occasions when you
could have used business theory such as elasticity, motivation or break-even to
strengthen your arguments and provide a higher level of analysis?

Synthesis (bringing together)

This is:
• building the points/themes within the answer into a connected whole
• logical sequencing of argument
• clarity through summarising an argument.
This skill is particularly important when you have a piece of extended writing
such as a report or an essay. In a good essay, for example, each paragraph will
have a clear purpose. The arguments will be well organised and lead to a
logical conclusion that builds on the earlier analysis. In some exams, the
synthesis marks may be awarded separately; in others, they will be part of an
overall mark for an answer.

Evaluation (judgement)
This is:
• judgement shown in weighing up the relative importance of different points
or sides of an argument, in order to reach a conclusion
• informed comment on the reliability of evidence
• distinguishing between fact and opinion
• judgement of the wider issues and implications
• conclusions drawn from the evidence presented
• selectivity: identifying the material that is most relevant to the question.

Past papers
Previous exam papers are very important in helping you to prepare for your
exam. They will show you exactly what sort of questions you will face and the
number of marks available. They will also give you a feel for the type of
words used in the question. It goes without saying that exam questions must be
read carefully. However, there will be key words used in the questions that tell
you how to answer them. There is, for example, a great difference in the
answers expected for the following two questions.
1 Assess the key elements of ABC plc’s marketing strategy.
2 Evaluate the key elements of ABC plc’s marketing strategy.
Unless you know what is expected from these two questions, you are unlikely
to know how much detail is required or how your answer ought to be
structured.

Examiners’ reports
These are available for each examination and can be found on
www.edexcel.com. They are written by the principal examiner of each exam
and provide an insight into what candidates did well or struggled with. By
looking at these reports, you will learn candidates’ weak areas of subject
knowledge and common problems in interpreting questions.

49.2 Resources
The following list contains items that will be of value in preparing for an
exam. They should all be familiar to you before you begin revising, and
should have played a constant part in your studies throughout the course.
1 Class notes
2 A copy of the specification
3 Past exam papers, mark schemes and examiners’ reports
4 A revision plan
5 Newspapers/cuttings files of relevant stories
6 This textbook
7 Access to your teacher
8 Other students

Class notes
Since these are the product of your work and a record of your activities, they
will form a vital part of your understanding of the subject. They should contain
past work you have done on exam-style questions and model answers that will
help to prepare you for the exam. As you make notes, try to make sure these
will be legible and useful later on in your revision. Make sure you keep them
in the right order as you go; having to sort them out later is much more of a
challenge.

A copy of the specification

The specification tells you several important things:
• what knowledge you could be tested on
• what skills the examiner will be looking for
• how the marks will be allocated
• what you will be expected to do in each exam paper you sit.

Past exam papers, mark schemes and examiners’

reports
By working from past papers, you will develop a feel for the type of question
you will be asked and the sorts of responses you will be expected to give.
Examiners’ reports will give you an insight into what they thought worked well
and what surprised them in terms of the responses. This in turn will give you
some idea of how and what they want to assess in the future.
A revision plan
As described in the previous section, this will help to keep you on target to
achieve everything that you need to cover before the exam.

Newspapers/cuttings files
Since Business is a real-life subject, the ability to bring in relevant examples
will boost your answers and grades. By studying what is happening in the
business world, you will be able to apply your answers much more effectively;
this is because you will develop a better understanding of the key issues in
different markets and industries. It will also help you to draw comparisons
between different types of business, which can lead to good evaluation.
Keeping some form of ‘business diary’, where you track at least one story a
week, is a good way of keeping up to date with what is happening. When
making notes about your story, try to highlight the underlying business issues
and relate it to theory rather than just describe it. This will help you to analyse
cases and business situations.

This textbook
In this textbook, focus especially on the ‘Five whys and a how’ and
‘Evaluation’ sections at the end of each chapter.

Access to your teacher

Asking your teacher for help is vital. She or he is able to give you useful
advice and insights, to quell sudden panics and suggest ways to improve your
performance. Don’t hold back – ask! Whenever you get a piece of work back
where the mark is disappointing, make sure you know what you need to do
differently next time. Read any comments on your work and try to improve in
the specific areas mentioned in the next piece of work.

Other students
Talk to other students to help discuss points and clarify ideas. Learning from
each other is a very powerful way of revising. Studies often show that you
remember something much more when you have to explain it to someone else.
Why not agree as a group to revise some topics? Study them individually and
then get together to test each other ’s understanding. This works very well.
Remember you can all get A*s if you are good enough, so there is no problem
helping others to improve their performance (as long as it is all their own
work in the exam) and you will almost certainly benefit yourself from working
with others.

49.3 Learning the language of the subject

Clear definitions of business terms are essential for exam success. The
Complete A–Z Business Studies Handbook (see Further reading), is very
helpful for this. They count for much more than the odd two-mark question
here or there. By showing the examiner that you understand what a term means,
you are reassuring her that your knowledge is sound; this is likely to help your
marks for other skills as well. If the examiner is not convinced that you
understand what a concept actually means, then they are less likely to reward
the other skills at a high level. Even on very high-mark questions, it is
important to define your terms.
For revising business definitions, you could use:
• definition cards
• past papers
• business crosswords and brainteasers.
There are many possible sources of good definitions of business terms. In this
book, key terms have been highlighted and given clear and concise definitions.
Your definitions should be written without using the word in question. (‘Market
growth is the growth in the market’ is not a very good definition, for
example!)
It is important, then, that you can produce high-quality definitions in an exam.
This can be done only through learning and practice. Possible ways to achieve
this are as follows.

Definition cards
Take a pack of index cards or postcards, or similar-sized pieces of thick paper.
On each one, write a particular term or phrase that you can find in the
specification document. Remember to include things like motivation theories
where a clear definition or description can give an excellent overview. It is
extremely unlikely that you will be asked to know a precise definition for any
term that is not specifically in the specification.
On the back of each card write an appropriate definition. This could come
from your class notes, a textbook or a dictionary such as The Complete A–Z
Business Studies Handbook. Make sure that the definition you write:
• is concise
• is clear
• does not use the word being defined in the definition.
Learn them by continual repetition. Put a tick or cross on each card to show
whether or not you came up with an acceptable effort. Over time, you should
see the number of ticks growing.
Shuffle the cards occasionally so that you are not being given clues to some
definitions because of the words or phrases preceding them.
Try doing the exercise ‘back to front’, by looking at the definitions and then
applying the correct word or phrase.

Past papers
By using as many past papers as possible, you can find out exactly what type of
definition questions are asked. More importantly, you can see how many marks
are available for them, which will tell you exactly how much detail you need to
go into in your answer.
If possible, get hold of examiners’ mark schemes. These will again give you a
clear idea of what is being looked for from your answer.

Business crosswords and brainteasers

You will be able to find many examples of word games in magazines such as
Business Review. By completing these, you are developing your business
vocabulary and linking words with their meanings.

49.4 Numbers
All business courses contain aspects of number work, which can be
specifically tested in exams. It must be remembered, however, that there are
two clear aspects to numbers:
1 calculation
2 interpretation.
The calculation aspects of business courses are one area where practice is by
far the best approach. Each numerical element has its own techniques that you
will be expected to be able to demonstrate. The techniques can be learnt, and by
working through many examples they can become second nature. Even if
mathematics is not your strong point, the calculations ought not to cause
problems to an A level student. Something that at first sight appears complex,
such as break-even, requires only simple techniques, such as multiplying,
adding and subtracting. Going through the ‘Workbook’ sections of this book
will provide invaluable practice. Ask your teacher for a photocopy of the
answers available in the Teacher’s Guide.
Once calculated, all business numbers need to be used. It is all very well to
calculate the accounting ratios, for example, but if the numbers are then unused
the exercise has been wasted. You must attempt to follow each calculation by
stating what the numbers are saying and their implications for the business.

49.5 General tips for revision

1 Start early.
2 Know the purpose of your revision.
3 Work more on weaker areas.
4 Use past papers as far as is possible.
5 Keep a clear perspective.
Finally, do no more revision on the night before the exam; it won’t help and
can only cause you anxiety. Eat well and get a good night’s sleep. That way you
will be in good physical shape to perform to the best of your abilities in the
exam.

Further reading
Business Review (available from Hodder Education, see
www.hoddereducation.co.uk/magazines).
Lines, D., Marcousé, I. and Martin, B. (2009) The Complete A–Z Business
Studies Handbook (6th edn), Hodder Education.
Answers to the questions in Chapter
48
1a) Add £186.4 + £35.0 + …. Then divide by 5 = £49.52m.
b) Because the top seller is so much more than the others (the fifth – Five
Gum – only has £5m of sales, so bears little relation to the average)

2 £186.4m/£271.6m = 0.686, rounded to 7/10.

3a) £12.8 × 5 = £64, so Maynards had sales of £64m.

b) 1 Adults are more likely than children to eat chocolate, and know/care
more about brand/quality and can afford to pay more.
2 There is more differentiation with chocolate, with more powerful,
historic brand names like Cadbury and Galaxy.

4a) % change = change/original × 100

So it is 2,926 − 4,569 = −1,643 / 4,569 × 100 = −36%
b) 35,203 − 31,241 = 3,962 / 31,241 × 100 = +12.68%
c) 35,203 × 112 / 100 = 39,427.36
d) 13,276 / (13,276 + 35,203 + 2,926) × 100
= 13,276 / 51,405 × 100 = 25.8%

5a) 1 It shows change in value of UK exports to four selected countries,

misses out many others; what was the basis for the selection?
2 It shows that exports to China have increased disproportionately to
the others on the graph.
b) £10,500 − £3,900 = £6,600ms
c) China: £12,402 − £845 = £11,557
£11,557 / £845 × 100 = +1,367.7%
South Africa: 2,582 − 1,497 = 1,085
1,085 / 1,497 × 100 = + 72.5%
d) 1 China has grown exceptionally rapidly in recent years.
2 Perhaps Britain has grown its market share in China.
6a) 1 By 2014, iPhone had become the most important product by far for
Apple.
2 Total Apple sales have increased hugely since 2010, despite the
collapse of iPod sales.
b) 2010 total: 3,270 + 8,398 + 9,406 = 21,074 (000s)
2014 total: 13,276 + 35,203 + 2,926 = 51,405 (000s)
% increase = (51,405 − 21,074) / 21,074 × 100 = +143.9%
c) They may have to plan for when to discontinue the iPod. They may need a
completely new product to reduce their dependence on the iPhone. (Will
the Apple Watch do that? Surely not.)

7a) i) All the other years’ data is in proportion to 2010 – the base year.
ii) 1 The different data sets will all have their own scales, perhaps in units
with millions of cars per year, but only 20 or so airplanes. Indexing
the data brings it onto a common scale, making comparisons
possible.
2 It shows trends at a glance.
b) Aircraft has grown more or less steadily with minor dips in 2002 and
2009, whereas car manufacturing has been erratic, with a major fall in
2009, and steady recovery since.
c) Manufacturing output remained very flat between 1997 and 2007, but then
plunged in the 2009 recession. It still hadn’t recovered its previous peak
by the second quarter of 2014.
8a) £480 variable + £600 fixed = £1,080
b) 1,200 × £1.20 = £1440
c) £1,440 − £1,080 = £360
d) Break-even = Fixed costs / Selling price – variable costs p.u.
£600 / £1.20 − 40p = 750 loaves
Margin of safety = 1,200 − 750 = 450 loaves
e) New profit = (£1.40 × 1,100) minus (£600 + 1,100 × 40p)
= £1,540 − £1,040 = £500

9a) It would have risen slightly (approx. 1 per cent) as the percentage price
increase is higher than the percentage sales decline.
b) It would rise (as the fall in sales would cut total costs; so revenue up, costs
down).
 c) In the longer term, the loss of sales volume might provide space for new
entrants to the market, and might lead to reductions in distribution levels,
as retailers are always short of space.

10a) Economy + 3% × Income elasticity + 3.5 = 10.5% sales increase

b) Luxury
c) A fall of 6% × 3.5 = 21%

11a) 1 The upward trend in this category that has seen a 15.1 per cent increase
to £580m.
2 The mention at the end about it being a ‘high profit-margin sector ’.
b) i) 10 per cent
ii) With just 10 per cent, it would seem quite an open market, so other
brands may try to break into the market.
c) They could either go for Malteser versions of existing seasonal products,
such as Malteser Father Christmases, or else try to work at newer
‘seasons’, such as Halloween or Mothers’ Day.

12a) 1 Post-launch sales for Jan–Sep 2014 for PS4 were 200 per cent of
launch compared to 215 per cent for PS3 and 150 per cent for XBox
One.
2 More importantly, it looks as if PS4’s sales are set to outdo PS3’s,
perhaps by a significant margin.
b) They could expect nearly 12m of unit sales in Oct–Dec 2014 if one year
from launch matches increase in PS3. Workings: 5.0 / 1.6 = +263%
PS4 4.5m × 263% = 11.835 million
c) The cumulative figures give a sense of the progress of ongoing sales,
perhaps giving rise to concern for Microsoft’s One, which seems to be
flagging in mid-2014.
d) 1 They might feel they have to attack PS4 aggressively, using price
and promotions (free games, perhaps) to claw their way back.
2 Or they may already be thinking of bringing forward the
development and launch of Xbox Two.