Introduction to Business

Introduction to Business

Lawrence J. Gitman, Carl McDaniel, Amit Shah, Monique Reece, Linda Koffel, Bethann Talsma, and James C. Hyatt

OpenStax Introduction to Business

Contents

1

Preface

Welcome to Introduction to Business, an OpenStax resource. This textbook was written to increase student access to high-quality learning materials, maintaining highest standards of academic rigor at little to no cost.

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Format

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About Introduction to Business

Introduction to Business is designed to meet the scope and sequence requirements of foundational business courses. The textbook presents business principles and emerging trends in fields including management, leadership, production, marketing, and finance. Through this content, students will acquire the knowledge, skills, and competencies to prepare for the competitive workplace.

Coverage and scope

Introduction to Business covers the scope and sequence of most introductory business courses. The book provides detailed explanations in the context of core themes such as ethics, entrepreneurship, customer satisfaction, global business, and managing change. Introduction to Business includes hundreds of current business examples from a range of industries, geographic locations, and featuring a variety of individuals. The outcome is a balanced approach to the theory and application of business concepts, with attention to the knowledge and skills necessary for student success in this course and beyond.

Pedagogical foundation

Consistent, integrated learning. Targeted learning outcomes are listed at the beginning of each chapter and then repeated throughout the chapter. The learning outcomes connect to the text and the additional resources that accompany Introduction to Business. After reading each section, students can test their retention by answering the questions in the Concept Checks. Every learning goal is further reinforced by a summary.

Hundreds of business examples to bring concepts to life. This book is designed to speak to the typical student. We have done a lot of research about student needs, abilities, experiences, and interests, and then we have shaped the text around them. We have used experiences both inside and outside the classroom to enrich a book that is both readable and enjoyable. We believe that the real business applications found throughout every chapter set the standard for readability and understanding of key concepts.

Learning business terminology, made easy. As students begin to study business, they will explore new words and concepts. To help them learn this language of business, we define each new term in the chapter, display the terms in bold, and offer a complete glossary at the end of the book.

Engaging business themes

Ethics. Business presents outstanding opportunities to do good. Through responsible business practices and the development and distribution of helpful products and services, businesspeople can positively affect their community. A paramount theme of this text is that business must be conducted in an ethical and socially responsible manner. Chapter 2, Making Ethical Decisions and Managing a Socially Responsible Business, is completely devoted to business ethics and social responsibility. We discuss techniques for setting personal ethical standards, how managers influence organizational ethics, tools for creating employee ethical awareness, and the concept of individual and corporate responsibility. Introduction to Business also features ethics activities at the end of each chapter. All ethical dilemmas are taken right out of today’s business world.

Customer satisfaction and quality. Because customer satisfaction and quality are the foundation of all business principles, these important topics are addressed in most chapters within Introduction to Business. Each chapter stresses that satisfied customers who experience high-quality products and services become loyal customers. A box in every chapter called “Customer Satisfaction and Quality” demonstrates how these concepts are applied in actual companies.

Managing change. Change in the business or consumer environment can lead to failures like Kodak’s and successes like Apple’s. The Managing Change boxed feature describes how companies have recognized and responded to changes in technology, competition, economic forces, demographics, and culture.

Entrepreneurship and small business management. Because many students will either open their own businesses or go to work for small organizations, entrepreneurship and small business principles are covered throughout the text. Chapter 5, Entrepreneurship: Starting and Managing Your Own Business, delivers interesting discussions on starting and managing a small business and the associated advantages and disadvantages. In addition, a feature called “Catching the Entrepreneurial Spirit” offers practical insights into the challenges and rewards of actually owning and managing a small business.

Global business economy. In Chapter 3, Competing in the Global Marketplace, we discuss why global trade is important to the United States, why nations trade, barriers to international trade, how companies enter the global marketplace, and a host of other international concepts and topics. The Trends section of each chapter frequently includes a discussion of how globalization will affect specific business activities. In addition, our Global Business box demonstrates how businesses are expanding their workforce, products, and customer base throughout the world in order to grow.

Features

Rather than provide a dry recitation of facts, we illustrate concepts with contemporary examples. In addition to the in-text examples, we have several boxed features that provide more extensive examples in areas of importance in today’s business environment. Each of the boxed features described below includes a series of critical thinking questions to prompt the student to consider the implications of each business strategy.

Ethics in Practice. Ethics in Practice features demonstrate how businesses are responsible not only to the bottom line, but to providing goods and services in a responsible manner.

Customer Satisfaction and Quality. Because customer satisfaction and quality are essential to attracting and keeping customers, the Customer Satisfaction and Quality box addresses how these concepts are illustrated and applied in actual companies.

Expanding Around the Globe. Upon entering today’s workplace, you are very likely to conduct business with colleagues, clients, and vendors from around the world. The Expanding Around the Globe feature offers insights into the global economy and highlights the strategies firms take to expand their business and improve their productivity by utilizing global resources.

Managing Change. The turbulent business climate requires companies to adapt their business strategies in response to a variety of economic, social, competitive, and technological forces. The Managing Change feature highlights how businesses have altered their business strategies in response to these forces.

Catching the Entrepreneurial Spirit. This feature highlights the challenges and opportunities available in small businesses and other entrepreneurial ventures.

Activities and cases that put knowledge to work

Introduction to Business helps students develop a solid grounding in the skills that they can apply in the workplace. These skill-building activities and resources help build and polish competencies that future employers will value.

Preparing for tomorrow’s workplace skills and team activities. These activities are designed to help build students’ business skills and to help them practice teamwork. We have developed assignments focused on five important workplace competencies: using and allocating resources, working with others, acquiring and using information, understanding systems, and working with technology. Team activities in every chapter give students an opportunity to work together, building communication skills and interpersonal skills.

Ethics activities. Ethics activities at the end of each chapter present real-world ethical challenges and prompt students to choose the most ethical course of action.

Working the net activities. These activities guide students through a step-by-step analysis of actual e-business practices and give them opportunities to build online research skills.

Creative thinking cases. The Creative Thinking case in each chapter invites students to explore business strategies of various companies, analyze business decisions, and prepare comments.

Additional resources

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To reach the Community Hubs, visit www.oercommons.org/hubs/OpenStax.

Student and instructor resources

We’ve compiled additional resources for both students and instructors, including Getting Started Guides, an instructor’s manual, test bank, and image slides. Instructor resources require a verified instructor account, which you can apply for when you log in or create your account on OpenStax.org. Take advantage of these resources to supplement your OpenStax book.

Comprehensive instructor’s manual. Each component of the instructor’s manual is designed to provide maximum guidance for delivering the content in an interesting and dynamic manner. The instructor’s manual includes an in-depth lecture outline, which is interspersed with lecture “tidbits” that allow instructors to add timely and interesting enhancements to their lectures. Authored by Linda Hefferin, Elgin Community College.

Test bank. With nearly 2,000 true/false, multiple-choice, fill-in-the-blank, and short answer questions in our test bank, instructors can customize tests to support a variety of course objectives. The test bank is available in Word format. Authored by Amit Shah, Frostburg State University.

PowerPoint lecture slides. The PowerPoint slides provide images and descriptions as a starting place for instructors to build their lectures.

Technology partners

As allies in making high-quality learning materials accessible, our technology partners offer optional low-cost tools that are integrated with OpenStax books. To access the technology options for your text, visit your book page on OpenStax.org.

About the authors

Senior contributing authors

Lawrence J. Gitman, San Diego State University – Emeritus

Lawrence J. Gitman is a prolific author, with over fifty published articles and a number of best-selling college textbooks (some with coauthors). In addition to this book, his works include Personal Financial Planning, Fourteenth Edition (2017), PFIN 6 (2018), Fundamentals of Investing, Thirteenth Edition, (2017), Principles of Managerial Finance, Fourteenth Edition (2015), and Principles of Managerial Finance, Brief, Seventh Edition (2015). His books have been used by more than two million college students. Dr. Gitman is a CFP® and has served as a member of the Certified Financial Planner Board of Standards and as an associate editor of several academic journals. He has also served as president of a number of academic organizations, including the Academy of Financial Services, the Midwest Finance Association, and the Financial Management Association National Honor Society. Professor Gitman earned degrees from Purdue University (B.S. in Industrial Management), the University of Dayton (MBA), and the University of Cincinnati (PhD in Finance).

Carl McDaniel, University of Texas, Arlington

Carl McDaniel’s career has spanned more than 40 years, during which he was the recipient of several awards for outstanding teaching. He was the chair of the University of Texas at Arlington marketing department for 32 year, and now teaches executive MBA courses locally and in China. McDaniel’s research has appeared in such publications as the Journal of Marketing, Journal of Business Research, Journal of the Academy of Marketing Science, and California Management Review. He has also authored over 50 textbooks in marketing and business. He has a bachelor’s degree from the University of Arkansas and a master’s degree and doctorate from Arizona State University.

Amit Shah, Frostburg State University

Amit Shah is professor of management and director of the Center for Community Partnerships at Frostburg State University (FSU) in Maryland. He has over 20 years of experience in industry and academia. Dr. Shah has taught a variety of business courses including management, strategic management, and international business. He has published over 60 referreed articles in various journals and published proceedings and has conducted training for various organizations in the area of business and strategy. In his capacity as Center director, he works with various small-to-medium-size organizations — for profit, nonprofit, and government agencies — in organizing management development workshops and training. He has received several awards including Frostburg State University’s Outstanding Faculty Service Award, the FSU College of Business’s Outstanding Faculty Research Award, and Outstanding SAM Student Chapter Advisor Award. He has also served as president of the Southeastern Chapters of the Decision Sciences Institute and president of the Institute for Operations Research and Management Sciences. When he is not in his classroom or engaged in community service, Dr. Shah enjoys being an entrepreneur serving coffee at Mountain City Coffeehouse and Creamery, which he owns with his wife.

Monique Reece

Monique Reece is the founder and CEO of MarketSmarter, a marketing consulting and training firm that helps companies improve strategy and implement real-time business planning processes to develop a culture of execution. She has more than 20 years of marketing and executive management experience working with both Fortune 100 companies and fast-growing entrepreneurial businesses. Professor Reece formerly served as Executive Vice President at Jones Knowledge and as Director of Global Market Development at Avaya. Monique has served as an Executive Education faculty member at the Daniels College of Business, University of Denver, and as an Adjunct Professor at the Institute for Leadership and Organizational Performance where she taught marketing and customer experience in the Executive MBA program. She has published hundreds of articles and is the author of four books. Monique is also a frequent speaker for industry conferences such as the American Marketing Association and Inc. Magazine.

Linda Koffel, Houston Community College

Linda Koffel has been teaching at Houston Community College. She is a winner of the Consortium of Community Colleges for Innovation, a prestigious NISOD award for teaching.  She taught in the Goldman Sachs 10,000 Small Businesses program; is a certified Ice House Entrepreneurial Program professor; and has her own business.  Linda Koffel played a key role in the design and development of cutting-edge marketing and entrepreneurial curriculum at Houston Community College.

Bethann Talsma, Davenport University and Grand Rapids Community College

Bethann Talsma is the founder of Platinum Properties, an income property business that provides housing in Grand Rapids, Michigan. She has more than 15 years of experience managing all operations including property procurement, tenant interaction, project management, and administration. Under her leadership the business has experienced steady growth and increased profits. Bethann also serves as an adjunct instructor at both Grand Rapids Community College and Davenport University where she teaches general business courses and Microsoft Office applications, bringing real-life examples to the classroom. In addition, Bethann facilitates corporate trainings for Microsoft Office and Google applications.

James C. Hyatt, University of The Cumberlands

Professor Hyatt serves the University of the Cumberlands teaching graduate courses for the School of Computer and Information Sciences, Executive Programs. He has served as an Assistant Professor at Fort Hays State University and Ashford University, where he taught Business, Technology and Analytics Courses. He has published in Business, Technology and Leadership journals and serves on International Committees. Professor Hyatt has extensive experience in Business, Technology and Analytics consulting. Professor Hyatt received his Ph.D. in Information Systems Management from Walden University and also holds degrees from Fort Hays State University and Southern Utah University.

Reviewers

Maria Zak Aria, Camden County College

Joseph H. Atallah, Devry Institute of Technology

Herm Baine, Broward Community College

Dennis R. Brode, Sinclair Community College

Harvey Bronstein, Oakland Community College

Mark Camma, Atlantic Cape Community College

Bonnie R. Chavez, Santa Barbara City College

M. Bixby Cooper, Michigan State University

Linda Davenport, Klamath Community College

Evelyn Delaney, Daytona Beach Community College

Kathryn E. Dodge, University of Alaska, Fairbanks

Jonas Falik, Queensborough Community College

Janice M. Feldbauer, Austin Community College Northridge

Dennis Foster, Northern Arizona University

James Giles, Bergen Community College

Mary E. Gorman, University of Cincinnati

Gina Hagler

Carnella Hardin, Glendale College

Elizabeth Hastings, Middlesex Community College

Frederic H. Hawkins, Westchester Business Institute

Melvin O. Hawkins, Midlands Technical College

Charlane Bomrad Held, Onondaga Community College

Merrily Joy Hoffman, San Jacinto College

Ralph F. Jagodka, Mount San Antonio College

Andrew Johnson, Bellevue Community College

Connie Johnson, Tampa College

Jerry Kinskey, Sinclair Community College

Raymond T. Lamanna, Berkeley College

Carol Luce, Arizona State University

Tom McFarland, Mt. San Antonio College

Carl Meskimen, Sinclair Community College

Andrew Miller, Hudson Valley Community College

H. Lynn Moretz, Central Piedmont Community College

Linda M. Newell, Saddleback College

Joseph Newton, Bakersfield College

Brandy Nielsen, Great Basin College

David Oliver, Edison College

Teresa Palmer, Illinois State University

Jim Pennypacker

Karli Peterson, Colorado State University

Raymond Pfang, Tarrant County College Connect Campus

Jude A. Rathburn, University of Wisconsin–Milwaukee

Jodell Raymond Monroe Community College

Robert F. Reck, Western Michigan University

Matthew Rivaldi, San Diego City College

Carol Rowey, Community College of Rhode Island

Ann Squire, Blackhawk Technical College

Carolyn Stevenson, Kaplan University

Richard E. T. Strickler, Sr., McLennan Community College

Linda Tancs

Susan Thompson, Palm Beach Community College

David L. Turnipseed, Indiana University-Purdue University Fort Wayne

Maria Vitale, Chaffey College

Valerie Wallingford, Bemidji State University

Ron Weidenfeller, Grand Rapids Community College

I

Understanding Economic Systems and Business

1

Introduction

An aerial photograph shows houses on a tropical hillside with solar panels on their roofs.

Exhibit 1.1 (Credit: Marco Verch /flickr / Attribution 2.0 Generic (CC BY 2.0))

Learning Outcomes

After reading this chapter, you should be able to answer these questions:

  1. How do businesses and not-for-profit organizations help create our standard of living?
  2. What are the sectors of the business environment, and how do changes in them influence business decisions?
  3. What are the primary features of the world’s economic systems, and how are the three sectors of the U.S. economy linked?
  4. How do economic growth, full employment, price stability, and inflation indicate a nation’s economic health?
  5. How does the government use monetary policy and fiscal policy to achieve its macroeconomic goals?
  6. What are the basic microeconomic concepts of demand and supply, and how do they establish prices?
  7. What are the four types of market structure?
  8. Which trends are reshaping the business, microeconomic, and macroeconomic environments and competitive arena?

Exploring Business Careers

Team Rubicon: Disaster Relief and a Sense of Purpose

Accounting for a substantial amount of economic activity in the United States, not-for-profits are an undeniable force in the business world, even though their focus on goals other than profit falls outside the traditional model of a for-profit business. But it is this shift away from a focus on profit that allows them to pursue missions of social improvement and contributions to society as a whole. To be truly effective in a not-for-profit organization, a person must share the organization’s vision.

The vision for Team Rubicon was shaped by its cofounders, Jake Wood and William McNulty, who saw the devastation caused by the Haiti earthquake in 2010 and sprang into action. Both marines, Wood and McNulty knew they could do something to help in this devastating and chaotic situation. Within 24 hours, they enlisted the help of six other military veterans and first responders, gathered donations and supplies from friends and family, and made their way to Haiti to help with disaster relief, and Team Rubicon was born.

A man wearing a Team Rubicon hat and shirt.

Exhibit 1.2 Team Rubicon (Credit: Bureau of Land Management Oregon and Washington/flickr/ Attribution 2.0 Generic (CC BY 2.0))

The organization gets its name from the Rubicon, a river in northern Italy that Julius Caesar and his troops crossed on their epic march to Rome, with the river marking the point of no return. The name underscores the cofounders’ experiences during the Haitian disaster, where despite advice from government officials and other aid organizations not to proceed, their small team crossed into Haiti from the Dominican Republic carrying crucial gear and medical supplies to thousands of earthquake victims.

Seven years later, Team Rubicon’s mission is twofold: to pair the skills and experiences of military veterans with first responders to hit the ground running in any type of disaster and to provide a sense of community and accomplishment to veterans who have served their country proudly but may be struggling as a result of their war experiences.

According to the organization’s mission statement, Team Rubicon seeks to provide veterans three things they sometimes lose after leaving the military: a purpose, gained through disaster relief; a sense of community, built by serving with others; and a feeling of self-worth from recognizing the impact one individual can make when dealing with natural disasters.

Headquartered in the Los Angeles area, Team Rubicon is staffed by more than 60 employees who work in 10 regions around the country, along with more than 40,000 volunteers ready to deploy within 24 hours. Similar to company operations in for-profit organizations, staff positions at Team Rubicon include regional administrators; field operations (including membership and training); marketing, communications, and social media; fundraising and partnership development; finance and accounting; and people operations.

Team Rubicon’s staff members bring professional and/or military experience to their daily jobs, but they all share the organization’s vision. Many staff members started as volunteers for Team Rubicon while working in for-profit careers, while others took advantage of the organization’s strong internship program to become familiar with its mission and focus on disaster relief.

In 2016, Team Rubicon trained 8,000 military veterans and first responders in disaster relief and responded to 46 disasters, which required more than 85,000 volunteer hours. In addition to donations from individuals and corporations, Team Rubicon relies on its partnerships with other organizations, such as Southwest Airlines, which supplies hundreds of free plane tickets each year to fly volunteers to disaster sites.

Team Rubicon actively engages its nationwide community at every level of the organization, from volunteer to board member, and every step of its operation: from training to planning to implementation to seeking donations and volunteers to help with any type of disaster relief. Over the past several years, Team Rubicon has been recognized as one of the top nonprofits to work for by The NonProfit Times, based on employee surveys and business partners’ input about the organization’s work environment.

The not-for-profit world may not be for everyone, but if its growth is any indication within the overall economy, it does appeal to many. With a resolve to assist those in need, including both disaster victims and returning military personnel, Team Rubicon offers opportunities for those interested in nonprofit careers as well as those passionate about helping others.

Sources: Company website, “Our Mission” and “Staff & Board,” https://teamrubiconusa.org, accessed May 29, 2017; Mark Hrywna, “2017 NPT Best Nonprofits to Work,” The NonProfit Times, http://thenonprofittimes.com, accessed May 27, 2017; Mark Hrywna, “2016 NPT Best Nonprofits to Work,” The NonProfit Times, http://thenonprofittimes.com, accessed May 27, 2017; Kyle Dickman, “The Future of Disaster Relief Isn’t the Red Cross,” Outside, https://www.outsideonline.com, August 25, 2016.

This module provides the basic structures upon which the business world is built: how it is organized, what outside forces influence it, and where it is heading. It also explores how the world’s economies and governments shape economic activity. Each day in the United States, thousands of new businesses are born. Only a rare few will become the next Apple, Google, or Amazon. Unfortunately, many others will never see their first anniversary. The survivors are those that understand that change is the one constant in the business environment. Those organizations pay attention to the business environment in which they operate and the trends that affect all businesses and then successfully adapt to those trends. In this module, we will meet many businesses, both large and small, profit and not-for-profit, that prosper because they track trends and use them to identify potential opportunities. This ability to manage change is a critical factor in separating the success stories from the tales of business failure.

We begin our study of business by introducing you to the primary functions of a business, the relationship between risk and profits, and the importance of not-for-profit organizations. We’ll also examine the major components of the business environment and how changing demographic, social, political and legal, and competitive factors affect all business organizations. Next, we’ll explore how economies provide jobs for workers and also compete with other businesses to create and deliver products to consumers. You will also learn how governments attempt to influence economic activity through policies such as lowering or raising taxes. Next, we discuss how supply and demand determine prices for goods and services. Finally, we conclude by examining key trends in the business environment, economic systems, and the competitive environment.

2

The Nature of Business

  1. How do businesses and not-for-profit organizations help create our standard of living?

Take a moment to think about the many different types of businesses you come into contact with on a typical day. As you drive to class, you may stop at a gas station that is part of a major national oil company and grab lunch from a fast food chain such as Taco Bell or McDonald’s or the neighborhood pizza place. Need more cash? You can do your banking on a smartphone or other device via mobile apps. You don’t even have to visit the store anymore: online shopping brings the stores to you, offering everything from clothes to food, furniture, and concert tickets.

A business is an organization that strives for a profit by providing goods and services desired by its customers. Businesses meet the needs of consumers by providing medical care, autos, and countless other goods and services. Goods are tangible items manufactured by businesses, such as laptops. Services are intangible offerings of businesses that can’t be held, touched, or stored. Physicians, lawyers, hairstylists, car washes, and airlines all provide services. Businesses also serve other organizations, such as hospitals, retailers, and governments, by providing machinery, goods for resale, computers, and thousands of other items.

Thus, businesses create the goods and services that are the basis of our standard of living. The standard of living of any country is measured by the output of goods and services people can buy with the money they have. The United States has one of the highest standards of living in the world. Although several countries, such as Switzerland and Germany, have higher average wages than the United States, their standards of living aren’t higher, because prices are so much higher. As a result, the same amount of money buys less in those countries. For example, in the United States, we can buy an Extra Value Meal at McDonald’s for less than $5, while in another country, a similar meal might cost as much as $10.

Businesses play a key role in determining our quality of life by providing jobs and goods and services to society. Quality of life refers to the general level of human happiness based on such things as life expectancy, educational standards, health, sanitation, and leisure time. Building a high quality of life is a combined effort of businesses, government, and not-for-profit organizations. In 2017, Vienna, Austria, ranked highest in quality of life, followed by Zurich, Switzerland; Auckland, New Zealand; and Munich, Germany. It may come as a surprise that not one of the world’s top cities is in the United States: seven of the top 10 locations are in western Europe, two are in Australia/New Zealand, and one is in Canada. At the other end of the scale, Baghdad, Iraq, is the city scoring the lowest on the annual survey.“Mercer 2017 Quality of Life Rankings,” http://mercer.com/qol, May 15, 2017. Creating a quality of life is not without risks, however. Risk is the potential to lose time and money or otherwise not be able to accomplish an organization’s goals. Without enough blood donors, for example, the American Red Cross faces the risk of not meeting the demand for blood by victims of disaster. Businesses such as Microsoft face the risk of falling short of their revenue and profit goals. Revenue is the money a company receives by providing services or selling goods to customers. Costs are expenses for rent, salaries, supplies, transportation, and many other items that a company incurs from creating and selling goods and services. For example, some of the costs incurred by Microsoft in developing its software include expenses for salaries, facilities, and advertising. If Microsoft has money left over after it pays all costs, it has a profit. A company whose costs are greater than revenues shows a loss.

When a company such as Microsoft uses its resources intelligently, it can often increase sales, hold costs down, and earn a profit. Not all companies earn profits, but that is the risk of being in business. In U.S. business today, there is generally a direct relationship between risks and profit: the greater the risks, the greater the potential for profit (or loss). Companies that take too conservative a stance may lose out to more nimble competitors who react quickly to the changing business environment.

Take Sony, for example. The Japanese electronics giant, once a leader with its Walkman music player and Trinitron televisions, steadily lost ground—and profits—over the past two decades to other companies by not embracing new technologies such as the digital music format and flat-panel TV screens. Sony misjudged what the market wanted and stayed with proprietary technologies rather than create cross-platform options for consumers. Apple, at the time an upstart in personal music devices, quickly grabbed the lion’s share of the digital music market with its iPods and iTunes music streaming service. By 2016, Sony restructured its business portfolio and has experienced substantial success with its PlayStation 4 gaming console and original gaming content.Rob Fahey, “Sony’s Entire Future Now Rests on PlayStation,” http://www.gamesindustry.biz, July 1, 2016.

Not-for-Profit Organizations

Not all organizations strive to make a profit. A not-for-profit organization is an organization that exists to achieve some goal other than the usual business goal of profit. Charities such as Habitat for Humanity, the United Way, the American Cancer Society, and the World Wildlife Fund are not-for-profit organizations, as are most hospitals, zoos, arts organizations, civic groups, and religious organizations. Over the last 20 years, the number of nonprofit organizations—and the employees and volunteers who work for them—has increased considerably. Government is our largest and most pervasive not-for-profit group. In addition, more than 1.5 million nongovernmental not-for-profit entities operate in the United States today and contribute more than $900 billion annually to the U.S. economy.“Quick Facts about Nonprofits,” National Center for Charitable Statistics, http://nccs.urban.org, accessed May 15, 2017; Brice S. McKeever, “The Nonprofit Sector in Brief 2015,” Urban Institute, http://www.urban.org, accessed May 15, 2017.

Like their for-profit counterparts, these groups set goals and require resources to meet those goals. However, their goals are not focused on profits. For example, a not-for-profit organization’s goal might be feeding the poor, preserving the environment, increasing attendance at the ballet, or preventing drunk driving. Not-for-profit organizations do not compete directly with one another in the same manner as, for example, Ford and Honda, but they do compete for talented employees, people’s limited volunteer time, and donations.

Rescue boat
Following Hurricane Irma affected The island of Puerto Rico, the Kentucky and Haraii National Guard assisted storm victims by donating to disaster relief efforts. Some not-for-profit charities focused aid toward the people of the region, but others delivered care to a different group of sufferers: animals and pets. Although most animal hospitals are not normally a refuge for displaced animals, many facilities opened their doors to pet owners affected by the torrential rains. Why are tasks such as animal rescue managed primarily through not-for-profit organizations? (Credit: Hawaii and Kentucky National Guard /flickr /Attribution 2.0 Generic (CC BY))


A photograph shows a group of men wearing military fatigues, using heavy duty strapping to secure a large pallet stacked with cargo.

The boundaries that formerly separated not-for-profit and for-profit organizations have blurred, leading to a greater exchange of ideas between the sectors. As discussed in detail in the ethics chapter, for-profit businesses are now addressing social issues. Successful not-for-profits apply business principles to operate more effectively. Not-for-profit managers are concerned with the same concepts as their colleagues in for-profit companies: developing strategy, budgeting carefully, measuring performance, encouraging innovation, improving productivity, demonstrating accountability, and fostering an ethical workplace environment.

In addition to pursuing a museum’s artistic goals, for example, top executives manage the administrative and business side of the organization: human resources, finance, and legal concerns. Ticket revenues cover a fraction of the museum’s operating costs, so the director spends a great deal of time seeking major donations and memberships. Today’s museum boards of directors include both art patrons and business executives who want to see sound fiscal decision-making in a not-for-profit setting. Therefore, a museum director must walk a fine line between the institution’s artistic mission and financial policies. According to a survey by The Economist, over the next several years, major art museums will be looking for new directors, as more than a third of the current ones are approaching retirement.Julia Halperin, “As a Generation of Directors Reaches Retirement, Fresh Faces Prepare to Take Over US Museums,” The Art Newspaper, http://www.russellreynolds.com, June 2, 2015; “Museum Succession in America: Onwards and Upwards,” The Economist, www.economist.com, May 9, 2015.

Factors of Production: The Building Blocks of Business

To provide goods and services, regardless of whether they operate in the for-profit or not-for-profit sector, organizations require inputs in the form of resources called factors of production. Four traditional factors of production are common to all productive activity: natural resources, labor (human resources), capital, and entrepreneurship. Many experts now include knowledge as a fifth factor, acknowledging its key role in business success. By using the factors of production efficiently, a company can produce more goods and services with the same resources.

Commodities that are useful inputs in their natural state are known as natural resources. They include farmland, forests, mineral and oil deposits, and water. Sometimes natural resources are simply called land, although, as you can see, the term means more than just land. Companies use natural resources in different ways. International Paper Company uses wood pulp to make paper, and Pacific Gas & Electric Company may use water, oil, or coal to produce electricity. Today urban sprawl, pollution, and limited resources have raised questions about resource use. Conservationists, environmentalists, and government bodies are proposing laws to require land-use planning and resource conservation.

Labor, or human resources, refers to the economic contributions of people working with their minds and muscles. This input includes the talents of everyone—from a restaurant cook to a nuclear physicist—who performs the many tasks of manufacturing and selling goods and services.

The tools, machinery, equipment, and buildings used to produce goods and services and get them to the consumer are known as capital. Sometimes the term capital is also used to mean the money that buys machinery, factories, and other production and distribution facilities. However, because money itself produces nothing, it is not one of the basic inputs. Instead, it is a means of acquiring the inputs. Therefore, in this context, capital does not include money.

Entrepreneurs are the people who combine the inputs of natural resources, labor, and capital to produce goods or services with the intention of making a profit or accomplishing a not-for-profit goal. These people make the decisions that set the course for their businesses; they create products and production processes or develop services. Because they are not guaranteed a profit in return for their time and effort, they must be risk-takers. Of course, if their companies succeed, the rewards may be great.

Today, many individuals want to start their own businesses. They are attracted by the opportunity to be their own boss and reap the financial rewards of a successful firm. Many start their first business from their dorm rooms, such as Mark Zuckerberg of Facebook, or while living at home, so their cost is almost zero. Entrepreneurs include people such as Microsoft cofounder Bill Gates, who was named the richest person in the world in 2017, as well as Google founders Sergey Brin and Larry Page.Kerry A. Dolan, “Forbes 2017 Billionaires List: Meet the Richest People on the Planet,” Forbes, https://www.forbes.com, March 20, 2017.

Many thousands of individuals have started companies that, while remaining small, make a major contribution to the U.S. economy.

CATCHING THE ENTREPRENEURIAL SPIRIT

StickerGiant Embraces Change

Entrepreneurs typically are not afraid to take risks or change the way they do business if it means there is a better path to success. John Fischer of Longmont, Colorado, fits the profile.

The drawn-out U.S. presidential election in 2000 between Bush and Gore inspired Fischer to create a bumper sticker that claimed, “He’s Not My President,” which became a top seller. As a result of this venture, Fischer started an online retail sticker store, which he viewed as possibly the “Amazon of Stickers.” Designing and making stickers in his basement, Fischer’s start-up would eventually become a multimillion-dollar company, recognized in 2017 by Forbes as one of its top 25 small businesses.

The StickerGiant online store was successful, supplying everything from sports stickers to ones commemorating rock and roll bands and breweries. By 2011, the business was going strong; however, the entrepreneur decided to do away with the retail store, instead focusing the business on custom orders, which became StickerGiant’s main product.

As the company became more successful and added more employees, Fischer once again looked to make some changes. In 2012 he decided to introduce a concept called open-book management, in which he shares the company’s financials with employees at a weekly meeting. Other topics discussed at the meeting include customer comments and feedback, employee concerns, and colleague appreciation for one another. Fischer believes sharing information about the company’s performance (good or bad) not only allows employees to feel part of the operation, but also empowers them to embrace change or suggest ideas that could help the business expand and flourish.

Innovation is also visible in the technology StickerGiant uses to create miles and miles of custom stickers (nearly 800 miles of stickers in 2016). The manufacturing process involves digital printing and laser-finishing equipment. Fischer says only five other companies worldwide have the laser-finishing equipment StickerGiant uses as part of its operations. Because of the investment in this high-tech equipment, the company can make custom stickers in large quantities overnight and ship them to customers the next day.

This small business continues to evolve with an entrepreneur at the helm who is not afraid of making changes or having fun. In 2016, StickerGiant put together Saul the Sticker Ball, a Guinness World Records winner that weighed in at a whopping 232 pounds. Fischer and his employees created Saul when they collected more than 170,000 stickers that had been lying around the office and decided to put them to good use. With $10 million in annual sales and nearly 40 employees, StickerGiant continues to be a successful endeavor for John Fischer and his employees almost two decades after Fischer created his first sticker.

Questions for Discussion
  1. How does being a risk-taker help Fischer in his business activities?
  2. If you were a small business owner, would you consider sharing the company’s financial data with employees? Explain your reasoning.

Sources: “All About StickerGiant,” https://www.stickergiant.com, accessed May 29, 2017; Bo Burlingham, “Forbes Small Giants 2017: America’s Best Small Companies,” Forbes, http://www.forbes.com, May 9, 2017; Karsten Strauss, “Making Money and Breaking Records in the Sticker Business,” Forbes, http://www.forbes.com, January 26, 2016; Emilie Rusch, “StickerGiant Does Big Business in Tiny Town of Hygiene,” Denver Post, April 19, 2016, http://www.denverpost.com; Eric Peterson, “StickerGiant,” Company Week, https://companyweek.com, September 5, 2016.

A number of outstanding managers and noted academics are beginning to emphasize a fifth factor of production—knowledge. Knowledge refers to the combined talents and skills of the workforce and has become a primary driver of economic growth. Today’s competitive environment places a premium on knowledge and learning over physical resources. Recent statistics suggest that the number of U.S. knowledge workers has doubled over the last 30 years, with an estimated 2 million knowledge job openings annually. Despite the fact that many “routine” jobs have been replaced by automation over the last decade or outsourced to other countries, technology has actually created more jobs that require knowledge and cognitive skills.Caroline Beaton, “Why Knowledge Workers Are Bad at Making Decisions,” Forbes, http://www.forbes.com, January 23, 2017; Josh Zumbrun, “The Rise of Knowledge Workers Is Accelerating Despite the Threat of Automation,” The Wall Street Journal, http://www.wsj.com, May 4, 2016.

 

  1. Explain the concepts of revenue, costs, and profit.
  2. What are the five factors of production?
  3. What is the role of an entrepreneur in society?

Summary of Learning Outcomes

  1. How do businesses and not-for-profit organizations help create our standard of living?

Businesses attempt to earn a profit by providing goods and services desired by their customers. Not-for-profit organizations, though not striving for a profit, still deliver many needed services for our society. Our standard of living is measured by the output of goods and services. Thus, businesses and not-for-profit organizations help create our standard of living. Our quality of life is not simply the amount of goods and services available for consumers but rather the society’s general level of happiness.

Economists refer to the building blocks of a business as the factors of production. To produce anything, one must have natural resources, labor (human resources), capital, and entrepreneurship to assemble the resources and manage the business. Today’s competitive business environment is based upon knowledge and learning. The companies that succeed will be those that learn fast, use knowledge efficiently, and develop new insights.

Glossary

business
An organization that strives for a profit by providing goods and services desired by its customers.
capital
The inputs, such as tools, machinery, equipment, and buildings, used to produce goods and services and get them to the customer.
costs
Expenses incurred from creating and selling goods and services.
entrepreneurs
People who combine the inputs of natural resources, labor, and capital to produce goods or services with the intention of making a profit or accomplishing a not-for-profit goal.
factors of production
The resources used to create goods and services.
goods
Tangible items manufactured by businesses.
knowledge
The combined talents and skills of the workforce.
knowledge workers
Workers who create, distribute, and apply knowledge.
not-for-profit organization
An organization that exists to achieve some goal other than the usual business goal of profit.
profit
The money left over after all costs are paid.
quality of life
The general level of human happiness based on such things as life expectancy, educational standards, health, sanitation, and leisure time.
revenue
The money a company receives by providing services or selling goods to customers.
risk
The potential to lose time and money or otherwise not be able to accomplish an organization’s goals.
services
Intangible offerings of businesses that can’t be held, touched, or stored.
standard of living
A country’s output of goods and services that people can buy with the money they have.

3

Understanding the Business Environment

  1. What are the sectors of the business environment, and how do changes in them influence business decisions?

Businesses do not operate in a vacuum but rather in a dynamic environment that has a direct influence on how they operate and whether they will achieve their objectives. This external business environment is composed of numerous outside organizations and forces that we can group into seven key subenvironments, as (Figure) illustrates: economic, political and legal, demographic, social, competitive, global, and technological. Each of these sectors creates a unique set of challenges and opportunities for businesses.

Business owners and managers have a great deal of control over the internal environment of business, which covers day-to-day decisions. They choose the supplies they purchase, which employees they hire, the products they sell, and where they sell those products. They use their skills and resources to create goods and services that will satisfy existing and prospective customers. However, the external environmental conditions that affect a business are generally beyond the control of management and change constantly. To compete successfully, business owners and managers must continuously study the environment and adapt their businesses accordingly.

Other forces, such as natural disasters, can also have a major impact on businesses. While still in the rebuilding stage after Hurricane Katrina hit in 2005, the U.S. Gulf Coast suffered another disaster in April 2010 as a result of an explosion on the Deepwater Horizon oil-rig, which killed 11 workers and sent more than 3 million barrels of oil into the Gulf of Mexico. This event, which played out for more than 87 days, severely affected the environment, businesses, tourism, and people’s livelihoods. Global oil conglomerate BP, which was responsible for the oil spill, has spent more than $60 billion in response to the disaster and cleanup. Seven years after the explosion, tourism and other businesses are slowly recovering, although scientists are not certain about the long-term environmental consequences of the oil spill.

Environmental Defense Fund, “Seven Years Later: What’s Ahead for the Gulf,” http://www.edf.org, accessed May 15, 2017; “Oil Spills Fast Facts,” CNN, http://www.cnn.com, February 9, 2017; Steven Mufson, “BP’s Big Bill for the World’s Largest Oil Spill Reaches $61.6 Billion,” Washington Post, https://www.washingtonpost.com, July 14, 2016; Debbie Elliott, “5 Years after BP Oil Spill, Effects Linger and Recovery Is Slow,” NPR, http://www.npr.org, April 20, 2015.

The Dynamic Business Environment
(Attribution: Copyright Rice University, OpenStax, under CC-BY 4.0 license)


The diagram is a circle, with a core that is labeled, and sections surrounding the core that are labeled. Outside of the circle is the external environment, which affects the contents of the circle. The core is labeled as, Internal Environment; entrepreneurs, managers, workers, and customers. The sections surrounding the core are as follows; technological, and economic, and political slash legal, and demographic, and social, and competitive, and global. All these sections have arrows pointing inward to the core internal environment.

No one business is large or powerful enough to create major changes in the external environment. Thus, managers are primarily adapters to, rather than agents of, change. Global competition is basically an uncontrollable element in the external environment. In some situations, however, a firm can influence external events through its strategies. For example, major U.S. pharmaceutical companies have been successful in getting the Food and Drug Administration (FDA) to speed up the approval process for new drugs.

Melissa Healy, “Speed Up Drug Approvals at FDA? It’s Already Faster Than Europe’s Drug Agency,” Los Angeles Times, http://www.latimes.com, April 6, 2017.

In recent years, the five largest companies in the S&P Index—Google, Facebook, Amazon, Microsoft, and Apple—have spent close to $50 million on lobbying activities in the nation’s capital in an effort to help policy makers understand the tech industry and the importance of innovation and an “open” internet.

Hamza Shaban, “Google for the First Time Outspent Every Other Company to Influence Washington in 2017,” Washington Post, https://www.washingtonpost.com, January 23, 2018; Saleha Mohsin, “Silicon Valley Cozies Up to Washington, Outspending Wall Street 2–1,” Bloomberg, http://www.bloomberg.com, October 18, 2016.

Let’s now take a brief look at these varied environmental influences.

Economic Influences

This category is one of the most important external influences on businesses. Fluctuations in the level of economic activity create business cycles that affect businesses and individuals in many ways. When the economy is growing, for example, unemployment rates are low, and income levels rise. Inflation and interest rates are other areas that change according to economic activity. Through the policies it sets, such as taxes and interest rate levels, a government attempts to stimulate or curtail the level of economic activity. In addition, the forces of supply and demand determine how prices and quantities of goods and services behave in a free market.

Political and Legal Influences

The political climate of a country is another critical factor for managers to consider in day-to-day business operations. The amount of government activity, the types of laws it passes, and the general political stability of a government are three components of political climate. For example, a multinational company such as General Electric will evaluate the political climate of a country before deciding to locate a plant there. Is the government stable, or might a coup disrupt the country? How restrictive are the regulations for foreign businesses, including foreign ownership of business property and taxation? Import tariffs, quotas, and export restrictions also must be taken into account.

In the United States, laws passed by Congress and the many regulatory agencies cover such areas as competition, minimum wages, environmental protection, worker safety, and copyrights and patents. For example, Congress passed the Telecommunications Act of 1996 to deregulate the telecommunications industry. As a result, competition increased and new opportunities arose as traditional boundaries between service providers blurred. Today the dramatic growth in mobile technology has changed the focus of telecommunications, which now faces challenges related to broadband access and speed, content streaming, and much-needed improvements in network infrastructure to address ever-increasing data transmissions.

“CIO Journal: 2017 Telecommunications Outlook,” The Wall Street Journal, http://deloitte.wsj.com, March 1, 2017.

Federal agencies play a significant role in business operations. When Pfizer wants to bring a new medication for heart disease to market, it must follow the procedures set by the Food and Drug Administration for testing and clinical trials and secure FDA approval. Before issuing stock, Pfizer must register the securities with the Securities and Exchange Commission. The Federal Trade Commission will penalize Pfizer if its advertisements promoting the drug’s benefits are misleading. These are just a few ways the political and legal environment affect business decisions.

States and local governments also exert control over businesses—imposing taxes, issuing corporate charters and business licenses, setting zoning ordinances, and similar regulations. We discuss the legal environment in greater detail in a separate appendix.

Demographic Factors

Demographic factors are an uncontrollable factor in the business environment and extremely important to managers. Demography is the study of people’s vital statistics, such as their age, gender, race and ethnicity, and location. Demographics help companies define the markets for their products and also determine the size and composition of the workforce. You’ll encounter demographics as you continue your study of business.

Demographics are at the heart of many business decisions. Businesses today must deal with the unique shopping preferences of different generations, which each require marketing approaches and goods and services targeted to their needs. For example, the more than 75 million members of the millennial generation were born between 1981 and 1997. In 2017 they surpassed baby boomers as America’s largest generation.

Richard Fry, “Millennials Overtake Baby Boomers as America’s Largest Generation,” Pew Research Center, http://www.pewresearch.org, April 25, 2016.

The marketing impact of millennials continues to be immense. These are technologically savvy and prosperous young people, with hundreds of billions of dollars to spend. And spend they do—freely, even though they haven’t yet reached their peak income and spending years.

Ashley Lutz, “Everything You Know about Millennial Spending Is about to Change,” Business Insider, http://www.businessinsider.com, October 1, 2016.

Other age groups, such as Generation X—people born between 1965 and 1980—and the baby boomers—born between 1946 and 1964—have their own spending patterns. Many boomers nearing retirement have money and are willing to spend it on their health, their comforts, leisure pursuits, and cars. As the population ages, businesses are offering more products that appeal to middle-aged and senior markets.

Geoff Gross, “5 Ways to Effectively Market to Baby Boomers,” Entrepreneur, http://www.entrepreneur.com, June 1, 2016.

In addition, minorities represent more than 38 percent of the total population, with immigration bringing millions of new residents to the country over the past several decades. By 2060 the U.S. Census Bureau projects the minority population to increase to 56 percent of the total U.S. population.

U.S. Census Bureau, “Projections of the Size and Composition of the U.S. Population: 2014 to 2060,” http://www.census.gov, accessed May 15, 2017.

Companies recognize the value of hiring a diverse workforce that reflects our society. Minorities’ buying power has increased significantly as well, and companies are developing products and marketing campaigns that target different ethnic groups.

Social Factors

Social factors—our attitudes, values, ethics, and lifestyles—influence what, how, where, and when people purchase products or services. They are difficult to predict, define, and measure because they can be very subjective. They also change as people move through different life stages. People of all ages have a broader range of interests, defying traditional consumer profiles. They also experience a “poverty of time” and seek ways to gain more control over their time. Changing roles have brought more women into the workforce. This development is increasing family incomes, heightening demand for time-saving goods and services, changing family shopping patterns, and impacting individuals’ ability to achieve a work-life balance. In addition, a renewed emphasis on ethical behavior within organizations at all levels of the company has managers and employees alike searching for the right approach when it comes to gender inequality, sexual harassment, and other social behaviors that impact the potential for a business’s continued success.

Balancing Comes Easy at H&R Block

In an industry driven by deadlines and details, it’s hard to imagine striking a balance between work and everyday life for full-time employees and seasonal staff. Fortunately, the management team at H&R Block not only believes in maintaining a strong culture, it also tries to offer flexibility to its more than 70,000 employees and seasonal workers in 12,000 retail offices worldwide.

Based in Kansas City, Missouri, and built on a culture of providing exceptional customer service, H&R Block was recently named the top U.S. business with the best work-life balance by online job search site Indeed. Analyzing more than 10 million company reviews by employees, Indeed researchers identified the top 20 firms with the best work-life balance. H&R Block headed the 2017 list, followed by mortgage lender Network Capital Funding Corporation, fast food chain In-N-Out Burger, Texas food retailer H-E-B, and health services company Kaiser Permanente, among others.

According to Paul Wolfe, Indeed’s senior vice president of human resources, empathy on the part of organizations is a key factor in helping employees achieve balance. Wolfe says companies that demonstrate empathy and work diligently to provide personal time for all employees tend to take the top spots on the work-life balance list. “Comments we have seen from employee reviews for these companies indicate ‘fair’ and ‘flexible work environments,’” he says. Surprisingly, none of the tech companies known for their generous work perks made the top 20 list in 2017.

In this 24/7 world, when no one is far from a text or tweet, finding time for both family and work can be difficult, especially in the tax services industry, which is so schedule driven for a good part of the year. Making a commitment to help workers achieve a healthy work-life balance not only helps its employees, but it also helps H&R Block retain workers in a tight labor market where individuals continue to have choices when it comes to where and for whom they want to work.

Questions for Discussion
  1. How does management’s support of employee work-life balance help the company’s bottom line?
  2. What can other organizations learn from H&R Block when it comes to offering employee perks that encourage personal time for workers even during the busy tax season?

Sources: “Career Opportunities,” https://www.hrblock.com, accessed May 25, 2017; “About Us,” http://newsroom.hrblock.com, accessed May 25, 2017; Abigail Hess, “The 20 Best Companies for Work-Life Balance,” CNBC, http://www.cnbc.com, May 4, 2017; Kristen Bahler, “The 20 Best Companies for Work-Life Balance,” Money, http://time.com, April 20, 2017; Rachel Ritlop, “3 Benefits Companies Can Provide to Boost Work-Life Balance,” Forbes, http://www.forbes.com, January 30, 2017.

Technology

The application of technology can stimulate growth under capitalism or any other economic system. Technology is the application of science and engineering skills and knowledge to solve production and organizational problems. New equipment and software that improve productivity and reduce costs can be among a company’s most valuable assets. Productivity is the amount of goods and services one worker can produce. Our ability as a nation to maintain and build wealth depends in large part on the speed and effectiveness with which we use technology—to invent and adapt more efficient equipment to improve manufacturing productivity, to develop new products, and to process information and make it instantly available across the organization and to suppliers and customers.

Many U.S. businesses, large and small, use technology to create change, improve efficiencies, and streamline operations. For example, advances in cloud computing provide businesses with the ability to access and store data without running applications or programs housed on a physical computer or server in their offices. Such applications and programs can now be accessed through the internet. Mobile technology allows businesses to communicate with employees, customers, suppliers, and others at the swipe of a tablet or smartphone screen. Robots help businesses automate repetitive tasks that free up workers to focus on more knowledge-based tasks critical to business operations.

“Why Move to the Cloud? 10 Benefits of Cloud Computing,” http://www.salesforce.com, accessed May 15, 2017; Jim Rock, “How Robots Will Reshape the U.S. Economy,” Tech Crunch, http://techcrunch.com, March 21, 2016.

  1. Define the components of the internal and the external business environments.
  2. What factors within the economic environment affect businesses?
  3. Why do demographic shifts and technological developments create both challenges and new opportunities for business?

Summary of Learning Outcomes

  1. What are the sectors of the business environment, and how do changes in them influence business decisions?

The external business environment consists of economic, political and legal, demographic, social, competitive, global, and technological sectors. Managers must understand how the environment is changing and the impact of those changes on the business. When economic activity is strong, unemployment rates are low, and income levels rise. The political environment is shaped by the amount of government intervention in business affairs, the types of laws it passes to regulate both domestic and foreign businesses, and the general political stability of a government. Demographics, or the study of people’s vital statistics, are at the heart of many business decisions. Businesses today must deal with the unique preferences of different generations, each of which requires different marketing approaches and different goods and services. The population is becoming increasingly diverse: currently minorities represent more than 38 percent of the total U.S. population, and that number will continue to increase over the next several decades. Minorities’ buying power has increased significantly as well, and companies are developing products and marketing campaigns that target different ethnic groups. Social factors—our attitudes, values, and lifestyles—influence what, how, where, and when people purchase products. They are difficult to predict, define, and measure because they can be very subjective. They also change as people move through different life stages.

Glossary

demography
The study of people’s vital statistics, such as their age, gender, race and ethnicity, and location.
productivity
The amount of goods and services one worker can produce.
technology
The application of science and engineering skills and knowledge to solve production and organizational problems.

4

How Business and Economics Work

  1. What are the primary features of the world’s economic systems, and how are the three sectors of the U.S. economy linked?

A business’s success depends in part on the economic systems of the countries where it is located and where its sells its products. A nation’s economic system is the combination of policies, laws, and choices made by its government to establish the systems that determine what goods and services are produced and how they are allocated. Economics is the study of how a society uses scarce resources to produce and distribute goods and services. The resources of a person, a firm, or a nation are limited. Hence, economics is the study of choices—what people, firms, or nations choose from among the available resources. Every economy is concerned with what types and amounts of goods and services should be produced, how they should be produced, and for whom. These decisions are made by the marketplace, the government, or both. In the United States, the government and the free-market system together guide the economy.

You probably know more about economics than you realize. Every day, many news stories deal with economic matters: a union wins wage increases at General Motors, the Federal Reserve Board lowers interest rates, Wall Street has a record day, the president proposes a cut in income taxes, consumer spending rises as the economy grows, or retail prices are on the rise, to mention just a few examples.

Global Economic Systems

Businesses and other organizations operate according to the economic systems of their home countries. Today the world’s major economic systems fall into two broad categories: free market, or capitalism; and planned economies, which include communism and socialism. However, in reality many countries use a mixed market system that incorporates elements from more than one economic system.

The major differentiator among economic systems is whether the government or individuals decide:

  • How to allocate limited resources—the factors of production—to individuals and organizations to best satisfy unlimited societal needs
  • What goods and services to produce and in what quantities
  • How and by whom these goods and services are produced
  • How to distribute goods and services to consumers

Managers must understand and adapt to the economic system or systems in which they operate. Companies that do business internationally may discover that they must make changes in production and selling methods to accommodate the economic system of other countries. (Figure) summarizes key factors of the world’s economic systems.

The Basic Economic Systems of the World
Capitalism Communism Socialism Mixed Economy
Ownership of Business Businesses are privately owned with minimal government ownership or interference. Government owns all or most enterprises. Basic industries such as railroads and utilities are owned by government. Very high taxation as government redistributes income from successful private businesses and entrepreneurs. Private ownership of land and businesses but government control of some enterprises. The private sector is typically large
Control of Markets Complete freedom of trade. No or little government control. Complete government control of markets. Some markets are controlled, and some are free. Significant central-government planning. State enterprises are managed by bureaucrats. These enterprises are rarely profitable. Some markets, such as nuclear energy and the post office, are controlled or highly regulated.
Worker Incentives Strong incentive to work and innovate because profits are retained by owners. No incentive to work hard or produce quality products. Private-sector incentives are the same as capitalism, and public-sector incentives are the same as in a planned economy. Private-sector incentives are the same as capitalism. Limited incentives in the public sector.
Management of Enterprises Each enterprise is managed by owners or professional managers with little government interference. Centralized management by the government bureaucracy. Little or no flexibility in decision-making at the factory level. Significant government planning and regulation. Bureaucrats run government enterprises. Private-sector management similar to capitalism. Public sector similar to socialism.
Forecast for 2020 Continued steady growth. No growth and perhaps disappearance. Stable with probable slight growth. Continued growth.
Examples United States Cuba, North Korea Finland, India, Israel Great Britain, France, Sweden, Canada

Capitalism

In recent years, more countries have shifted toward free-market economic systems and away from planned economies. Sometimes, as was the case of the former East Germany, the transition to capitalism was painful but fairly quick. In other countries, such as Russia, the movement has been characterized by false starts and backsliding. Capitalism, also known as the private enterprise system, is based on competition in the marketplace and private ownership of the factors of production (resources). In a competitive economic system, a large number of people and businesses buy and sell products freely in the marketplace. In pure capitalism, all the factors of production are owned privately, and the government does not try to set prices or coordinate economic activity.

A capitalist system guarantees certain economic rights: the right to own property, the right to make a profit, the right to make free choices, and the right to compete. The right to own property is central to capitalism. The main incentive in this system is profit, which encourages entrepreneurship. Profit is also necessary for producing goods and services, building manufacturing plants, paying dividends and taxes, and creating jobs. The freedom to choose whether to become an entrepreneur or to work for someone else means that people have the right to decide what they want to do on the basis of their own drive, interest, and training. The government does not create job quotas for each industry or give people tests to determine what they will do.

Competition is good for both businesses and consumers in a capitalist system. It leads to better and more diverse products, keeps prices stable, and increases the efficiency of producers. Companies try to produce their goods and services at the lowest possible cost and sell them at the highest possible price. But when profits are high, more businesses enter the market to seek a share of those profits. The resulting competition among companies tends to lower prices. Companies must then find new ways of operating more efficiently if they are to keep making a profit—and stay in business.

McDonald’s China
Since joining the World Trade Organization in 2001, China has continued to embrace tenets of capitalism and grow its economy. China is the world’s largest producer of mobile phones, PCs, and tablets, and the country’s over one billion people constitute a gargantuan market. The explosion of McDonald’s and KFC franchises epitomizes the success of American-style capitalism in China, and Beijing’s bid to host the 2022 Winter Olympics is a symbol of economic openness. This McCafe is an example of changing Western products to suit Chinese tastes. This is an example of changing Western products to suit Chinese tastes. Do you think China’s capitalistic trend can continue to thrive under the ruling Chinese Communist Party that opposes workers’ rights, free speech, and democracy? (Credit: Marku Kudjerski/ flickr/ Attribution 2.0 Generic (CC BY 2.0)


A photograph shows the entrance to a Mc Cafe that is ornately decorated in a traditional Chinese style.

Communism

The complete opposite of capitalism is communism. In a communist economic system, the government owns virtually all resources and controls all markets. Economic decision-making is centralized: the government, rather than the competitive forces in the marketplace, decides what will be produced, where it will be produced, how much will be produced, where the raw materials and supplies will come from, who will get the output, and what the prices will be. This form of centralized economic system offers little if any choice to a country’s citizens. Early in the 20th century, countries that chose communism, such as the former Soviet Union and China, believed that it would raise their standard of living. In practice, however, the tight controls over most aspects of people’s lives, such as what careers they can choose, where they can work, and what they can buy, led to lower productivity. Workers had no reasons to work harder or produce quality goods, because there were no rewards for excellence. Errors in planning and resource allocation led to shortages of even basic items.

These factors were among the reasons for the 1991 collapse of the Soviet Union into multiple independent nations. Recent reforms in Russia, China, and most of the eastern European nations have moved these economies toward more capitalistic, market-oriented systems. North Korea and Cuba are the best remaining examples of communist economic systems. Time will tell whether Cuba takes small steps toward a market economy now that the United States reestablished diplomatic relations with the island country a few years ago.

“What the Future Holds for U.S.–Cuba Relations,” Knowledge@Wharton, http://knowledge.wharton.upenn.edu, April 11, 2017.

Socialism

Socialism is an economic system in which the basic industries are owned by the government or by the private sector under strong government control. A socialist state controls critical, large-scale industries such as transportation, communications, and utilities. Smaller businesses and those considered less critical, such as retail, may be privately owned. To varying degrees, the state also determines the goals of businesses, the prices and selection of goods, and the rights of workers. Socialist countries typically provide their citizens with a higher level of services, such as health care and unemployment benefits, than do most capitalist countries. As a result, taxes and unemployment may also be higher in socialist countries. For example, in 2017, the top individual tax rate in France was 45 percent, compared to 39.6 percent in the United States. With both countries electing new presidents in 2017, tax cuts may be a campaign promise that both President Macron and President Trump take on as part of their overall economic agendas in the coming years.

France Accountants, “French Tax Summary 2017,” http://www.franceaccountants.com, accessed May 15, 2017; “2017 Tax Brackets,” http://www.bankrate.com, accessed May 15, 2017.

Many countries, including the United Kingdom, Denmark, India, and Israel, have socialist systems, but the systems vary from country to country. In Denmark, for example, most businesses are privately owned and operated, but two-thirds of the population is sustained by the state through government welfare programs.

Mixed Economic Systems

Pure capitalism and communism are extremes; real-world economies fall somewhere between the two. The U.S. economy leans toward pure capitalism, but it uses government policies to promote economic stability and growth. Also, through policies and laws, the government transfers money to the poor, the unemployed, and the elderly or disabled. American capitalism has produced some very powerful organizations in the form of large corporations, such as General Motors and Microsoft. To protect smaller firms and entrepreneurs, the government has passed legislation that requires that the giants compete fairly against weaker competitors.

Canada, Sweden, and the UK, among others, are also called mixed economies; that is, they use more than one economic system. Sometimes, the government is basically socialist and owns basic industries. In Canada, for example, the government owns the communications, transportation, and utilities industries, as well as some of the natural-resource industries. It also provides health care to its citizens. But most other activity is carried on by private enterprise, as in a capitalist system. In 2016, UK citizens voted for Britain to leave the European Union, a move that will take two or more years to finalize. It is too early to tell what impact the Brexit decision will have on the UK economy and other economies around the world.

Simon Kennedy, “Brexit Timeline: From the Referendum to Article 50,” Bloomberg, http://www.bloomberg.com, March 20, 2017.

The few factors of production owned by the government in a mixed economy include some public lands, the postal service, and some water resources. But the government is extensively involved in the economic system through taxing, spending, and welfare activities. The economy is also mixed in the sense that the country tries to achieve many social goals—income redistribution and retirement pensions, for example—that may not be attempted in purely capitalist systems.

Macroeconomics and Microeconomics

The state of the economy affects both people and businesses. How you spend your money (or save it) is a personal economic decision. Whether you continue in school and whether you work part-time are also economic decisions. Every business also operates within the economy. Based on their economic expectations, businesses decide what products to produce, how to price them, how many people to employ, how much to pay these employees, how much to expand the business, and so on.

Economics has two main subareas. Macroeconomics is the study of the economy as a whole. It looks at aggregate data for large groups of people, companies, or products considered as a whole. In contrast, microeconomics focuses on individual parts of the economy, such as households or firms.

Both macroeconomics and microeconomics offer a valuable outlook on the economy. For example, Ford might use both to decide whether to introduce a new line of vehicles. The company would consider such macroeconomic factors as the national level of personal income, the unemployment rate, interest rates, fuel costs, and the national level of sales of new vehicles. From a microeconomic viewpoint, Ford would judge consumer demand for new vehicles versus the existing supply, competing models, labor and material costs and availability, and current prices and sales incentives.

Economics as a Circular Flow

Another way to see how the sectors of the economy interact is to examine the circular flow of inputs and outputs among households, businesses, and governments as shown in (Figure). Let’s review the exchanges by following the red circle around the inside of the diagram. Households provide inputs (natural resources, labor, capital, entrepreneurship, knowledge) to businesses, which convert these inputs into outputs (goods and services) for consumers. In return, households receive income from rent, wages, interest, and ownership profits (blue circle). Businesses receive revenue from consumer purchases of goods and services.

The other important exchange in (Figure) takes place between governments (federal, state, and local) and both households and businesses. Governments supply many types of publicly provided goods and services (highways, schools, police, courts, health services, unemployment insurance, social security) that benefit consumers and businesses. Government purchases from businesses also contribute to business revenues. When a construction firm repairs a local stretch of state highway, for example, government pays for the work. As the diagram shows, government receives taxes from households and businesses to complete the flow.

Changes in one flow affect the others. If government raises taxes, households have less to spend on goods and services. Lower consumer spending causes businesses to reduce production, and economic activity declines; unemployment may rise. In contrast, cutting taxes can stimulate economic activity. Keep the circular flow in mind as we continue our study of economics. The way economic sectors interact will become more evident as we explore macroeconomics and microeconomics.

Economics as a Circular Flow
(Attribution: Copyright Rice University, OpenStax, under CC-BY 4.0 license)


The diagram is a circle, with a labeled core. There is a band surrounding the core, and an outer band surrounding both the core and inner band. The outward flow of the outer band is labeled as follows. Money income, such as rent, wages, and interest profits, goes into households. Money is then spent by consumers in product markets. This flows into business revenues, which flows into costs, then into resource markets. Next is the inner band, which is labeled as follows. The resource markets outputs, such goods and services, flows into inputs, such as natural resources, labor, capital, and entrepreneurship. In the center of the core is labeled Government, federal, state and local. Arrows pointing inward and outward are in pairs and are labeled. From the resource markets, In arrow, inputs; out arrow revenues. From the households, In arrow taxes; out arrow public goods and services. From the product markets, in arrow outputs; out arrow revenues. From businesses, in arrow taxes; out arrow public goods and services, business revenues.

  1. What is economics, and how can you benefit from understanding basic economic concepts?
  2. Compare and contrast the world’s major economic systems. Why is capitalism growing, communism declining, and socialism still popular?
  3. What is the difference between macroeconomics and microeconomics?

Summary of Learning Outcomes

  1. What are the primary features of the world’s economic systems, and how are the three sectors of the U.S. economy linked?

Economics is the study of how individuals, businesses, and governments use scarce resources to produce and distribute goods and services. Today there is a global trend toward capitalism. Capitalism, also known as the private enterprise system, is based upon marketplace competition and private ownership of the factors of production. Competition leads to more diverse goods and services, keeps prices stable, and pushes businesses to become more efficient.

In a communist economy, the government owns virtually all resources, and economic decision-making is done by central government planning. Governments have generally moved away from communism because it is inefficient and delivers a low standard of living. Socialism is another centralized economic system in which the basic industries are owned by the government or by the private sector under strong government control. Other industries may be privately owned. The state is also somewhat influential in determining the goals of business, the prices and selection of products, and the rights of workers. Most national economies today are a mix of socialism and capitalism.

The two major areas in economics are macroeconomics, the study of the economy as a whole, and microeconomics, the study of households and firms. The individual, business, and government sectors of the economy are linked by a series of two-way flows. The government provides public goods and services to the other two sectors and receives income in the form of taxes. Changes in one flow affect the other sectors.

Glossary

capitalism
An economic system based on competition in the marketplace and private ownership of the factors of production (resources); also known as the private enterprise system.
circular flow
The movement of inputs and outputs among households, businesses, and governments; a way of showing how the sectors of the economy interact.
communism
An economic system characterized by government ownership of virtually all resources, government control of all markets, and economic decision-making by central government planning.
economic system
The combination of policies, laws, and choices made by a nation’s government to establish the systems that determine what goods and services are produced and how they are allocated.
economics
The study of how a society uses scarce resources to produce and distribute goods and services.
macroeconomics
The subarea of economics that focuses on the economy as a whole by looking at aggregate data for large groups of people, companies, or products.
microeconomics
The subarea of economics that focuses on individual parts of the economy, such as households or firms.
mixed economies
Economies that combine several economic systems; for example, an economy where the government owns certain industries but others are owned by the private sector.
socialism
An economic system in which the basic industries are owned either by the government itself or by the private sector under strong government control.

5

Macroeconomics: The Big Picture

  1. How do economic growth, full employment, price stability, and inflation indicate a nation’s economic health?

Have you ever looked at CNN’s Headline News on a mobile device or turned on the radio and heard something like, “Today the Labor Department reported that for the second straight month unemployment declined”? Statements like this are macroeconomic news. Understanding the national economy and how changes in government policies affect households and businesses is a good place to begin our study of economics.

Let’s look first at macroeconomic goals and how they can be met. The United States and most other countries have three main macroeconomic goals: economic growth, full employment, and price stability. A nation’s economic well-being depends on carefully defining these goals and choosing the best economic policies for achieving them.

Striving for Economic Growth

Perhaps the most important way to judge a nation’s economic health is to look at its production of goods and services. The more the nation produces, the higher its standard of living. An increase in a nation’s output of goods and services is economic growth.

The most basic measure of economic growth is the gross domestic product (GDP). GDP is the total market value of all final goods and services produced within a nation’s borders each year. The Bureau of Labor Statistics publishes quarterly GDP figures that can be used to compare trends in national output. When GDP rises, the economy is growing.

The rate of growth in real GDP (GDP adjusted for inflation) is also important. Recently, the U.S. economy has been growing at a slow but steady rate of between 3 and 4 percent annually. This growth rate has meant a steady increase in the output of goods and services and relatively low unemployment. When the growth rate slides toward zero, the economy begins to stagnate and decline.

One country that continues to grow more rapidly than most is China, whose GDP has been growing at 6 to 7 percent per year. Today few things in the global marketplace are not or cannot be made in China. The primary contributor to China’s rapid growth has been technology. For example, most tablets and laptops are manufactured in China.

The level of economic activity is constantly changing. These upward and downward changes are called business cycles. Business cycles vary in length, in how high or low the economy moves, and in how much the economy is affected. Changes in GDP trace the patterns as economic activity expands and contracts. An increase in business activity results in rising output, income, employment, and prices. Eventually, these all peak, and output, income, and employment decline. A decline in GDP that lasts for two consecutive quarters (each a three-month period) is called a recession. It is followed by a recovery period when economic activity once again increases. The most recent recession began in December 2007 and ended in June 2009.

Businesses must monitor and react to the changing phases of business cycles. When the economy is growing, companies often have a difficult time hiring good employees and finding scarce supplies and raw materials. When a recession hits, many firms find they have more capacity than the demand for their goods and services requires. During the most recent recession, many businesses operated at substantially lower than capacity. When plants use only part of their capacity, they operate inefficiently and have higher costs per unit produced. Let’s say that Mars Corp. has a huge plant that can produce one million Milky Way candy bars a day, but because of a recession Mars can sell only half a million candy bars a day. The plant uses large, expensive machines. Producing Milky Ways at 50 percent capacity does not efficiently utilize Mars’s investment in its plant and equipment.

Keeping People on the Job

Another macroeconomic goal is full employment, or having jobs for all who want to and can work. Full employment doesn’t actually mean 100 percent employment. Some people choose not to work for personal reasons (attending school, raising children) or are temporarily unemployed while they wait to start a new job. Thus, the government defines full employment as the situation when about 94 to 96 percent of those available to work actually have jobs. During the 2007–2009 recession in the United States, the unemployment rate peaked at 10 percent in October 2009. Today, that rate hovers at about 4 percent.

Maggie McGrath, “Unemployment Rate Holds Steady at 4.1% as U.S. Adds 148,000 Jobs in December,” Forbes, https://www.forbes.com, January 5, 2018; Bureau of Labor Statistics, “Spotlight on Statistics: The Recession of 2007–2009,” http://www.bls.gov/spotlight, accessed May 15, 2017.

Maintaining low unemployment levels is of concern not just to the United States but also to countries around the world. For example, high youth unemployment rates (for workers 25 years of age and younger) in Spain, Italy, and Greece continue to cause protests in these European countries as elected officials struggle with how to turn around their respective economies and put more people, particularly young people, back to work. The UK’s impending exit from the European Union may also have an effect on unemployment rates, as global companies move jobs out of Britain to central European countries such as Poland.

Marcus Bensasson, “Youth Unemployment Shows Euro-Area Recovery Not Working for All,” Bloomberg Markets, http://www.bloomberg.com, April 3, 2017; Dorota Bartyzel and Konrad Krasuski, “Brexit Flight to Shift 30,000 Jobs to Poland, Minister Says,” Bloomberg Politics, http://www.bloomberg.com, January 23, 2017.

Measuring Unemployment

To determine how close we are to full employment, the government measures the unemployment rate. This rate indicates the percentage of the total labor force that is not working but is actively looking for work. It excludes “discouraged workers,” those not seeking jobs because they think no one will hire them. Each month the U.S. Department of Labor releases statistics on employment. These figures help us understand how well the economy is doing.

Types of Unemployment

Economists classify unemployment into four types: frictional, structural, cyclical, and seasonal. The categories are of small consolation to someone who is unemployed, but they help economists understand the problem of unemployment in our economy.

Frictional unemployment is short-term unemployment that is not related to the business cycle. It includes people who are unemployed while waiting to start a better job, those who are reentering the job market, and those entering for the first time, such as new college graduates. This type of unemployment is always present and has little impact on the economy.

Structural unemployment is also unrelated to the business cycle but is involuntary. It is caused by a mismatch between available jobs and the skills of available workers in an industry or a region. For example, if the birthrate declines, fewer teachers will be needed. Or the available workers in an area may lack the skills that employers want. Retraining and skill-building programs are often required to reduce structural unemployment.

Cyclical unemployment, as the name implies, occurs when a downturn in the business cycle reduces the demand for labor throughout the economy. In a long recession, cyclical unemployment is widespread, and even people with good job skills can’t find jobs. The government can partly counteract cyclical unemployment with programs that boost the economy.

In the past, cyclical unemployment affected mainly less-skilled workers and those in heavy manufacturing. Typically, they would be rehired when economic growth increased. Since the 1990s, however, competition has forced many American companies to downsize so they can survive in the global marketplace. These job reductions affected workers in all categories, including middle management and other salaried positions. Firms continue to reevaluate workforce requirements and downsize to stay competitive to compete with Asian, European, and other U.S. firms. After a strong rebound from the global recession of 2007–2009, when the auto industry slashed more than 200,000 hourly and salaried workers from their payrolls, the automakers are now taking another close look at the size of their global workforces. For example, as sales steadily rose after the recession, Ford Motor Company’s workforce in North America increased by 25 percent over the past five years. As car sales plateaued in 2017, the company recently announced it would cut approximately 10 percent of its global workforce in an effort to reduce costs, boost profits, and increase its stock value for shareholders.

Bureau of Labor Statistics, “Employees in Motor Vehicle and Parts Industry,” https://data.bls.gov, data extracted on May 19, 2017; Christina Rogers, “Ford Aims to Cut Global Workforce by Roughly 10%,” The Wall Street Journal, http://www.wsj.com, May 15, 2017.

The last type is seasonal unemployment, which occurs during specific times of the year in certain industries. Employees subject to seasonal unemployment include retail workers hired for the holiday shopping season, lettuce pickers in California, and restaurant employees in ski country during the summer.

Keeping Prices Steady

The third macroeconomic goal is to keep overall prices for goods and services fairly steady. The situation in which the average of all prices of goods and services is rising is called inflation. Inflation’s higher prices reduce purchasing power, the value of what money can buy. Purchasing power is a function of two things: inflation and income. If incomes rise at the same rate as inflation, there is no change in purchasing power. If prices go up but income doesn’t rise or rises at a slower rate, a given amount of income buys less, and purchasing power falls. For example, if the price of a basket of groceries rises from $30 to $40 but your salary remains the same, you can buy only 75 percent as many groceries ($30 ÷ $40) for $30. Your purchasing power declines by 25 percent ($10 ÷ $40). If incomes rise at a rate faster than inflation, then purchasing power increases. So you can, in fact, have rising purchasing power even if inflation is increasing. Typically, however, inflation rises faster than incomes, leading to a decrease in purchasing power.

Inflation affects both personal and business decisions. When prices are rising, people tend to spend more—before their purchasing power declines further. Businesses that expect inflation often increase their supplies, and people often speed up planned purchases of cars and major appliances.

From the early 2000s to April 2017, inflation in the United States was very low, in the 0.1 to 3.8 percent range; for 2016 it was 1.3 percent. For comparison, in the 1980s, the United States had periods of inflation in the 12 to 13 percent range.

“Historical Inflation Rates: 1914–2017,” http://www.usinflationcalculator.com, accessed May 19, 2017.

Some nations have had high double- and even triple-digit inflation in recent years. As of early 2017, the monthly inflation rate in Venezuela was an astounding 741 percent, followed by the African country of South Sudan at 273 percent.

Trading Economics, “Inflation Rate by Country,” http://www.tradingeconomics.com, accessed May 19, 2017.

Nespresso
Buyers of Nespresso coffee, KitKat chocolate bars, and Purina pet food are paying more for these items as global food giant Nestlé raises prices. Increasing input costs, such as costs of raw materials, have been hard on food businesses, raising the price of production, packaging, and transportation. How might fluctuations in the producer price index (PPI) affect the consumer price index (CPI) and why? (Credit: Kārlis Dambrāns/ flickr/ Attribution 2.0 Generic (CC BY 2.0))


A photograph shows a display of all the small, plastic coffee pods made by Nespresso.

Types of Inflation

There are two types of inflation. Demand-pull inflation occurs when the demand for goods and services is greater than the supply. Would-be buyers have more money to spend than the amount needed to buy available goods and services. Their demand, which exceeds the supply, tends to pull prices up. This situation is sometimes described as “too much money chasing too few goods.” The higher prices lead to greater supply, eventually creating a balance between demand and supply.

Cost-push inflation is triggered by increases in production costs, such as expenses for materials and wages. These increases push up the prices of final goods and services. Wage increases are a major cause of cost-push inflation, creating a “wage-price spiral.” For example, assume the United Auto Workers union negotiates a three-year labor agreement that raises wages 3 percent per year and increases overtime pay. Carmakers will then raise car prices to cover their higher labor costs. Also, the higher wages will give autoworkers more money to buy goods and services, and this increased demand may pull up other prices. Workers in other industries will demand higher wages to keep up with the increased prices, and the cycle will push prices even higher.

How Inflation Is Measured

The rate of inflation is most commonly measured by looking at changes in the consumer price index (CPI), an index of the prices of a “market basket” of goods and services purchased by typical urban consumers. It is published monthly by the Department of Labor. Major components of the CPI, which are weighted by importance, are food and beverages, clothing, transportation, housing, medical care, recreation, and education. There are special indexes for food and energy. The Department of Labor collects about 80,000 retail price quotes and 5,000 housing rent figures to calculate the CPI.

The CPI sets prices in a base period at 100. The base period, which now is 1982–1984, is chosen for its price stability. Current prices are then expressed as a percentage of prices in the base period. A rise in the CPI means prices are increasing. For example, the CPI was 244.5 in April 2017, meaning that prices more than doubled since the 1982–1984 base period.

Changes in wholesale prices are another important indicator of inflation. The producer price index (PPI) measures the prices paid by producers and wholesalers for various commodities, such as raw materials, partially finished goods, and finished products. The PPI, which uses 1982 as its base year, is actually a family of indexes for many different product categories, including crude goods (raw materials), intermediate goods (which become part of finished goods), and finished goods. For example, the PPI for finished goods was 197.7 in April 2017, a 3.9-point increase, and for chemicals was 106.5, up 3.8 points since April 2016. Examples of other PPI indexes include processed foods, lumber, containers, fuels and lubricants, metals, and construction. Because the PPI measures prices paid by producers for raw materials, energy, and other commodities, it may foreshadow subsequent price changes for businesses and consumers.

The Impact of Inflation

Inflation has several negative effects on people and businesses. For one thing, inflation penalizes people who live on fixed incomes. Let’s say that a couple receives $2,000 a month retirement income beginning in 2018. If inflation is 10 percent in 2019, then the couple can buy only about 91 percent (100 ÷ 110) of what they could purchase in 2018. Similarly, inflation hurts savers. As prices rise, the real value, or purchasing power, of a nest egg of savings deteriorates.

  1. What is a business cycle? How do businesses adapt to periods of contraction and expansion?
  2. Why is full employment usually defined as a target percentage below 100 percent?
  3. What is the difference between demand-pull and cost-push inflation?

Summary of Learning Outcomes

  1. How do economic growth, full employment, price stability, and inflation indicate a nation’s economic health?

A nation’s economy is growing when the level of business activity, as measured by gross domestic product (GDP) is rising. GDP is the total value of all goods and services produced in a year. The goal of full employment is to have a job for all who can and want to work. How well a nation is meeting its employment goals is measured by the unemployment rate. There are four types of unemployment: frictional, structural, cyclical, and seasonal. With price stability, the overall prices of goods and services are not moving very much either up or down. Inflation is the general upward movement of prices. When prices rise, purchasing power falls. The rate of inflation is measured by changes in the consumer price index (CPI) and the producer price index (PPI). There are two main causes of inflation. If the demand for goods and services exceeds the supply, prices will rise. This is called demand-pull inflation. With cost-push inflation, higher production costs, such as expenses for materials and wages, increase the final prices of goods and services.

Glossary

business cycles
Upward and downward changes in the level of economic activity.
consumer price index (CPI)
An index of the prices of a “market basket” of goods and services purchased by typical urban consumers.
cost-push inflation
Inflation that occurs when increases in production costs push up the prices of final goods and services.
cyclical unemployment
Unemployment that occurs when a downturn in the business cycle reduces the demand for labor throughout the economy.
demand-pull inflation
Inflation that occurs when the demand for goods and services is greater than the supply.
economic growth
An increase in a nation’s output of goods and services.
frictional unemployment
Short-term unemployment that is not related to the business cycle.
full employment
The condition when all people who want to work and can work have jobs.
gross domestic product (GDP)
The total market value of all final goods and services produced within a nation’s borders each year.
inflation
The situation in which the average of all prices of goods and services is rising.
producer price index (PPI)
An index of the prices paid by producers and wholesalers for various commodities, such as raw materials, partially finished goods, and finished products.
purchasing power
The value of what money can buy.
recession
A decline in GDP that lasts for at least two consecutive quarters.
seasonal unemployment
Unemployment that occurs during specific seasons in certain industries.
structural unemployment
Unemployment that is caused by a mismatch between available jobs and the skills of available workers in an industry or region; not related to the business cycle.
unemployment rate
The percentage of the total labor force that is not working but is actively looking for work.

6

Achieving Macroeconomic Goals

  1. How does the government use monetary policy and fiscal policy to achieve its macroeconomic goals?

To reach macroeconomic goals, countries must often choose among conflicting alternatives. Sometimes political needs override economic needs. For example, bringing inflation under control may call for a politically difficult period of high unemployment and low growth. Or, in an election year, politicians may resist raising taxes to curb inflation. Still, the government must try to guide the economy to a sound balance of growth, employment, and price stability. The two main tools it uses are monetary policy and fiscal policy.

Monetary Policy

Monetary policy refers to a government’s programs for controlling the amount of money circulating in the economy and interest rates. Changes in the money supply affect both the level of economic activity and the rate of inflation. The Federal Reserve System (the Fed), the central banking system of the United States, prints money and controls how much of it will be in circulation. The money supply is also controlled by the Fed’s regulation of certain bank activities.

When the Fed increases or decreases the amount of money in circulation, it affects interest rates (the cost of borrowing money and the reward for lending it). The Fed can change the interest rate on money it lends to banks to signal the banking system and financial markets that it has changed its monetary policy. These changes have a ripple effect. Banks, in turn, may pass along this change to consumers and businesses that receive loans from the banks. If the cost of borrowing increases, the economy slows because interest rates affect consumer and business decisions to spend or invest. The housing industry, business, and investments react most to changes in interest rates.

As a result of the 2007–2009 recession and the global financial crisis that ensued, the Fed dropped the federal funds rate—the interest rate charged on overnight loans between banks—to 0 percent in December 2008 and kept the rate at zero until December 2015, when it raised the rate to 0.25 percent. This decision marked the first increase in the federal-funds rate since June 2006, when the federal funds rate was 5.25 percent. As the U.S. economy continues to show a slow but steady expansion, the Fed subsequently increased the federal funds rate to a range of 0.75 to 1 percent in March 2017. As expected, this change has a ripple effect: the regional Federal Reserve Banks increase the discount rate they charge commercial banks for short-term loans, many commercial banks raise the interest rates they charge their customers, and credit card companies increase the annual percentage rate (APR) they charge consumers on their credit card balances.

Binyamin Appelbaum, “Fed Raises Interest Rates for Third Time Since Financial Crisis,” The New York Times, http://www.nytimes.com, March 15, 2017; Lauren Lyons Cole, “How the Fed’s Interest-Rate Hike Affects Consumers,” Consumer Reports, http://www.consumerreports.org, March 15, 2017.

As you can see, the Fed can use monetary policy to contract or expand the economy. With contractionary policy, the Fed restricts, or tightens, the money supply by selling government securities or raising interest rates. The result is slower economic growth and higher unemployment. Thus, contractionary policy reduces spending and, ultimately, lowers inflation. With expansionary policy, the Fed increases, or loosens, growth in the money supply. An expansionary policy stimulates the economy. Interest rates decline, so business and consumer spending go up. Unemployment rates drop as businesses expand. But increasing the money supply also has a negative side: more spending pushes prices up, increasing the inflation rate.

Powell
As chair of the Board of Governors of the Federal Reserve System, Jerome (Jay) Powell is considered the face of U.S. monetary policy. Powell took over the chair in February 2018 from Janet Yellen, the first woman ever to be appointed Fed chair. What are the responsibilities of the chair of the Board of Governors of the Federal Reserve System? (Credit: Federalreserve/ flickr/ US Government Works)


A photograph shows Fed Chairperson Jay Powell speaking at a podium.

Fiscal Policy

The other economic tool used by the government is fiscal policy, its program of taxation and spending. By cutting taxes or by increasing spending, the government can stimulate the economy. Look again at (Figure). The more government buys from businesses, the greater the business revenues and output. Likewise, if consumers or businesses have to pay less in taxes, they will have more income to spend for goods and services. Tax policies in the United States therefore affect business decisions. High corporate taxes can make it harder for U.S. firms to compete with companies in countries with lower taxes. As a result, companies may choose to locate facilities overseas to reduce their tax burden.

Nobody likes to pay taxes, although we grudgingly accept that we have to. Although most U.S. citizens complain that they are overtaxed, we pay lower taxes per capita (per person) than citizens in many countries similar to ours. In addition, our taxes represent a lower percentage of gross income and GDP compared to most countries.

Taxes are, of course, the major source of revenue for our government. Every year, the president prepares a budget for the coming year based upon estimated revenues and expenditures. Congress receives the president’s report and recommendations and then, typically, debates and analyzes the proposed budget for several months. The president’s original proposal is always modified in numerous ways. (Figure) shows the sources of revenue and expenses for the U.S. budget.

Revenues and Expenses for the Federal Budget
Source: U.S. Treasury, “Final Monthly Treasury Statement of Receipts and Outlays of the United States Government for Fiscal Year 2016,” https://www.fiscal.treasury.gov, accessed May 23, 2017.


The pieces of the revenue pie chart, and percentages are as follows. Corporate income taxes, 9 percent. Other taxes and duties, 9 percent. Individual income taxes, 48 percent. Social security and other payroll taxes, 34 percent. The pieces of the expense pie chart, and percentages are as follows. Defense, 16 percent. Social security, 24 percent. Medicare, 15 percent. Interest on debt, 6 percent. Other expenses, 39 percent. Other expenses are labeled with an asterisk. The asterisk definition reads as follows. This category includes both mandatory spending, such as spending for veterans' benefits and administration of justice, and discretional spending, such as expenditures for education, community development, agriculture, science, and commerce.

Whereas fiscal policy has a major impact on business and consumers, continual increases in government spending raises another important issue. When government takes more money from business and consumers (the private sector), a phenomenon known as crowding out occurs. Here are three examples of crowding out:

  1. The government spends more on public libraries, and individuals buy fewer books at bookstores.
  2. The government spends more on public education, and individuals spend less on private education.
  3. The government spends more on public transportation, and individuals spend less on private transportation.

In other words, government spending is crowding out private spending.

If the government spends more for programs (social services, education, defense) than it collects in taxes, the result is a federal budget deficit. To balance the budget, the government can cut its spending, increase taxes, or do some combination of the two. When it cannot balance the budget, the government must make up any shortfalls by borrowing (just like any business or household).

In 1998, for the first time in a generation, there was a federal budget surplus (revenue exceeding spending) of about $71 billion. That budget surplus was short lived, however. By 2005, the deficit was more than $318 billion. In the fiscal year of 2009, the federal deficit was at an all-time high of more than $1.413 trillion. Six years later, at the end of the 2015 fiscal year, the deficit decreased to $438 billion.

Mike Patton, “U.S. Government Deficit Is Rising Again,” Forbes, http://www.forbes.com, April 28, 2016.

The U.S. government has run budget deficits for many years. The accumulated total of these past deficits is the national debt, which now amounts to about $19.8 trillion, or about $61,072 for every man, woman, and child in the United States. Total interest on the debt is more than $2.5 trillion a year.

“Quantifying the National Debt,” http://www.justfacts.com, accessed May 23, 2017; “U.S. National Debt Clock: U.S. Total Interest Paid,” http://usdebtclock.org, accessed May 23, 2017.

To cover the deficit, the U.S. government borrows money from people and businesses in the form of Treasury bills, Treasury notes, and Treasury bonds. These are federal IOUs that pay interest to their owners.

The national debt is an emotional issue debated not only in the halls of Congress, but by the public as well. Some believe that deficits contribute to economic growth, high employment, and price stability. Others have the following reservations about such a high national debt:

  • Not Everyone Holds the Debt: The government is very conscious of who actually bears the burden of the national debt and keeps track of who holds what bonds. If only the rich were bondholders, then they alone would receive the interest payments and could end up receiving more in interest than they paid in taxes. In the meantime, poorer people, who held no bonds, would end up paying taxes that would be transferred to the rich as interest, making the debt an unfair burden to them. At times, therefore, the government has instructed commercial banks to reduce their total debt by divesting some of their bond holdings. That’s also why the Treasury created savings bonds. Because these bonds are issued in relatively small denominations, they allow more people to buy and hold government debt.
  • It Crowds Out Private Investment: The national debt also affects private investment. If the government raises the interest rate on bonds to be able to sell them, it forces private businesses, whose corporate bonds (long-term debt obligations issued by a company) compete with government bonds for investor dollars, to raise rates on their bonds to stay competitive. In other words, selling government debt to finance government spending makes it more costly for private industry to finance its own investment. As a result, government debt may end up crowding out private investment and slowing economic growth in the private sector.
  1. What are the two kinds of monetary policy?
  2. What fiscal policy tools can the government use to achieve its macroeconomic goals?
  3. What problems can a large national debt present?

Summary of Learning Outcomes

  1. How does the government use monetary policy and fiscal policy to achieve its macroeconomic goals?

Monetary policy refers to actions by the Federal Reserve System (the Fed) to control the money supply. When the Fed restricts the money supply, interest rates rise, the inflation rate drops, and economic growth slows. By expanding the money supply, the Fed stimulates economic growth. The government also uses fiscal policy— changes in levels of taxation and spending—to control the economy. Reducing taxes or increasing spending stimulates the economy; raising taxes or decreasing spending does the opposite. When the government spends more than it receives in tax revenues, it must borrow to finance the deficit. Some economists favor deficit spending as a way to stimulate the economy; others worry about our high level of national debt.

Glossary

contractionary policy
The use of monetary policy by the Fed to tighten the money supply by selling government securities or raising interest rates.
crowding out
The situation that occurs when government spending replaces spending by the private sector.
expansionary policy
The use of monetary policy by the Fed to increase, or loosen, the growth of the money supply.
federal budget deficit
The condition that occurs when the federal government spends more for programs than it collects in taxes.
Federal Reserve System (the Fed)
The central banking system of the United States.
fiscal policy
The government’s use of taxation and spending to affect the economy.
monetary policy
A government’s programs for controlling the amount of money circulating in the economy and interest rates.
national debt
The accumulated total of all of the federal government’s annual budget deficits.
savings bonds
Government bonds issued in relatively small denominations.

7

Microeconomics: Zeroing in on Businesses and Consumers

  1. What are the basic microeconomic concepts of demand and supply, and how do they establish prices?

Now let’s shift our focus from the whole economy to microeconomics, the study of households, businesses, and industries. This field of economics is concerned with how prices and quantities of goods and services behave in a free market. It stands to reason that people, firms, and governments try to get the most from their limited resources. Consumers want to buy the best quality at the lowest price. Businesses want to keep costs down and revenues high to earn larger profits. Governments also want to use their revenues to provide the most effective public goods and services possible. These groups choose among alternatives by focusing on the prices of goods and services.

As consumers in a free market, we influence what is produced. If Mexican food is popular, the high demand attracts entrepreneurs who open more Mexican restaurants. They want to compete for our dollars by supplying Mexican food at a lower price, of better quality, or with different features, such as Santa Fe Mexican food rather than Tex-Mex. This section explains how business and consumer choices influence the price and availability of goods and services.

Galaxy Note 7
Samsung’s strategy to take on Apple’s iPhone domination hit a terrible snag in 2016, when its Galaxy Note 7 mobile phone was recalled and the product eliminated. Defective batteries in the Note 7 made them catch fire and cause serious damage. Samsung eventually killed the entire line of Note 7 phones, recalling nearly 3 million phones, which cost the company more than $5 billion. How do businesses determine the optimum quantity of products or services to make available to consumers? (Credit: Paul Sullivan/ flickr/ Attribution-NoDerivs 2.0 Generic (CC BY-ND 2.0))


A photograph shows a large display of the Samsung Galaxy note smart phone, with a stylus pen touching the screen.

The Nature of Demand

Demand is the quantity of a good or service that people are willing to buy at various prices. The higher the price, the lower the quantity demanded, and vice versa. A graph of this relationship is called a demand curve.

Let’s assume you own a store that sells jackets for snowboarders. From past experience, you know how many jackets you can sell at different prices. The demand curve in (Figure) depicts this information. The x-axis (horizontal axis) shows the quantity of jackets, and the y-axis (vertical axis) shows the related price of those jackets. For example, at a price of $100, customers will buy (demand) 600 snowboard jackets.

In the graph, the demand curve slopes downward and to the right because as the price falls, people will want to buy more jackets. Some people who were not going to buy a jacket will purchase one at the lower price. Also, some snowboarders who already have a jacket will buy a second one. The graph also shows that if you put a large number of jackets on the market, you will have to reduce the price to sell all of them.

Understanding demand is critical to businesses. Demand tells you how much you can sell and at what price—in other words, how much money the firm will take in that can be used to cover costs and hopefully earn a profit. Gauging demand is difficult even for the very largest corporations, but particularly for small firms.

Demand Curve for Jackets for Snowboarders
(Attribution: Copyright Rice University, OpenStax, under CC-BY 4.0 license)


The Nature of Supply

Demand alone is not enough to explain how the market sets prices. We must also look at supply, the quantity of a good or service that businesses will make available at various prices. The higher the price, the greater the number of jackets a supplier will supply, and vice versa. A graph of the relationship between various prices and the quantities a business will supply is a supply curve.

We can again plot the quantity of jackets on the x-axis and the price on the y-axis. As (Figure) shows, 800 jackets will be available at a price of $100. Note that the supply curve slopes upward and to the right, the opposite of the demand curve. If snowboarders are willing to pay higher prices, suppliers of jackets will buy more inputs (for example, Gore-Tex® fabric, dye, machinery, labor) and produce more jackets. The quantity supplied will be higher at higher prices, because manufacturers can earn higher profits.

Supply Curve for Jackets for Snowboarders
(Attribution: Copyright Rice University, OpenStax, under CC-BY 4.0 license)


The horizontal x axis is labeled quantity, and is labeled from left to right, 0 to 1,400 in increments of 200. The vertical y axis is labeled price, and is labeled, from bottom to top, 0 dollars to 200 dollars in increments of $25. Points are plotted on the graph, and connected with a solid line. The points are plotted at approximately 275, $40, and 450, $60, and 700, $80, and 800, $100, and 975, $120, and 1100, $135, and 1325, $155. A dashed horizontal line extends from 100 dollars on the y axis, and a vertical dashed line extends from 800 on the x axis and meet at the plotted point 800, $100.

How Demand and Supply Interact to Determine Prices

In a stable economy, the number of jackets that snowboarders demand depends on the jackets’ price. Likewise, the number of jackets that suppliers provide depends on price. But at what price will consumer demand for jackets match the quantity suppliers will produce?

To answer this question, we need to look at what happens when demand and supply interact. By plotting both the demand curve and the supply curve on the same graph in (Figure), we see that they cross at a certain quantity and price. At that point, labeled E, the quantity demanded equals the quantity supplied. This is the point of equilibrium. The equilibrium price is $80; the equilibrium quantity is 700 jackets. At that point, there is a balance between the quantity consumers will buy and the quantity suppliers will make available.

Market equilibrium is achieved through a series of quantity and price adjustments that occur automatically. If the price increases to $160, suppliers produce more jackets than consumers are willing to buy, and a surplus results. To sell more jackets, prices will have to fall. Thus, a surplus pushes prices downward until equilibrium is reached. When the price falls to $60, the quantity of jackets demanded rises above the available supply. The resulting shortage forces prices upward until equilibrium is reached at $80.

Equilibrium Price and Quantity for Jackets for Snowboarders
(Attribution: Copyright Rice University, OpenStax, under CC-BY 4.0 license)


The x axis is labeled quantity, and the y axis is labeled price. The quantity demanded line, labeled D, falls from the upper left of the graph from approximate point 275, $160, to the bottom right of the graph at approximate point 1225, $45. The quantity supplied line, labeled S, rises from lower left to upper right, from approximate point 275, $40, to the upper right point 1200, $160. These lines intersect at a point labeled E, the point of equilibrium between supply and demand. Point E is at approximately 700, $80. Above point E, in between lines D and S, is labeled surplus at $160. Below point E, between lines D and S is labeled shortage at $60.

The number of snowboard jackets supplied and bought at $80 will tend to rest at equilibrium unless there is a shift in either demand or supply. If demand increases, more jackets will be purchased at every price, and the demand curve shifts to the right (as illustrated by line D2 in (Figure)). If demand decreases, less will be bought at every price, and the demand curve shifts to the left (D1). When demand decreased, snowboarders bought 500 jackets at $80 instead of 700 jackets. When demand increased, they purchased 800.

Changes in Demand

A number of things can increase or decrease demand. For example, if snowboarders’ incomes go up, they may decide to buy a second jacket. If incomes fall, a snowboarder who was planning to purchase a jacket may wear an old one instead. Changes in fashion or tastes can also influence demand. If snowboarding were suddenly to go out of fashion, demand for jackets would decrease quickly. A change in the price of related products can also influence demand. For example, if the average price of a snowboard rises to $1,000, people will quit snowboarding, and jacket demand will fall.

Another factor that can shift demand is expectations about future prices. If you expect jacket prices to increase significantly in the future, you may decide to go ahead and get one today. If you think prices will fall, you will postpone your purchase. Finally, changes in the number of buyers will affect demand. Snowboarding is a young person’s sport, and the number of teenagers will increase in the next few years. Therefore, the demand for snowboard jackets should increase.

Shifts in Demand for Jackets for Snowboarders
(Attribution: Copyright Rice University, OpenStax, under CC-BY 4.0 license)


The graph shows 3 lines, each falls down and slightly left before hooking back to the right. The line labeled D is in the middle, and falls through the point 700, $80. The line to the left, labeled D 1, falls through the point 500, $80. This is labeled as decrease in demand. The line to the right, labeled D 2 falls through the point 800, $80. This is labeled as increase in demand.

Changes in Supply

Other factors influence the supply side of the picture. New technology typically lowers the cost of production. For example, North Face, a supplier of ski and snowboard jackets, purchased laser-guided pattern-cutting equipment and computer-aided pattern-making equipment. Each jacket was cheaper to produce, resulting in a higher profit per jacket. This provided an incentive to supply more jackets at every price. If the price of resources such as labor or fabric goes up, North Face will earn a smaller profit on each jacket, and the amount supplied will decrease at every price. The reverse is also true. Changes in the prices of other goods can also affect supply.

Let’s say that snow skiing becomes a really hot sport again. The number of skiers jumps dramatically, and the price of ski jackets soars. North Face can use its machines and fabrics to produce either ski or snowboard jackets. If the company can make more profit from ski jackets, it will produce fewer snowboard jackets at every price. Also, a change in the number of producers will shift the supply curve. If the number of jacket suppliers increases, they will place more jackets on the market at every price. If any suppliers stop making jackets available, the supply will naturally decrease. Taxes can also affect supply. If the government decides, for some reason, to tax the supplier for every snowboard jacket produced, then profits will fall, and fewer jackets will be offered at every price. (Figure) summarizes the factors that can shift demand and supply curves.

To better understand the relationship between supply and demand across the economy, consider the impact of 2005’s Hurricane Katrina on U.S. energy prices. Oil and gas prices were already at high levels before Hurricane Katrina disrupted production in the Gulf Coast. Most U.S. offshore drilling sites are located in the Gulf of Mexico, and almost 30 percent of U.S. refining capacity is in Gulf States that were hit hard by the storm. Prices rose almost immediately as supplies fell while demand remained at the same levels.

The storm drove home the vulnerability of the U.S. energy supply to not only natural disasters, but also terrorist attacks and price increases from foreign oil producers. Many energy policy experts questioned the wisdom of having such a high concentration of oil facilities—about 25 percent of the oil and natural gas infrastructure—in hurricane-prone states. Refiners were already almost at capacity before Katrina’s devastation.

Kimberly Amadeo, “Hurricane Katrina Facts: Damage and Costs,” The Balance, http://www.thebalance.com, February 9, 2017.

Factors That Cause Demand and Supply Curves to Shift
Shift Demand
Factor To the Right If To the Left If
Buyers’ incomes Increase Decrease
Buyers’ preferences/tastes Increase Decrease
Prices of substitute products Increase Decrease
Expectations about future prices Will rise Will fall
Number of buyers Increases Decreases
Shift Supply
To the Right If To the Left If
Technology Lowers cost Increases cost
Resource prices Fall Rise
Changes in prices of other products that can be produced with the same resources Profit of other product falls Profit of other product rises
Number of suppliers Increases Decreases
Taxes Decreases Increases

High energy prices affect the economy in many ways. With oil at the time costing $50 to $60 a barrel—more than double the 2003 price—both businesses and consumers across the United States felt the pinch in their wallets. Midwestern agricultural businesses export about 70 percent of their grain production through Gulf of Mexico port facilities. With fewer usable docking spaces, barges couldn’t unload and return for more crops. The supply of both transportation services and grain products was inadequate to meet demand, pushing up transportation and grain costs. Higher gas prices also contributed to rising prices, as 80 percent of shipping costs are related to fuel.

More than a decade after Katrina, U.S. gas prices have fluctuated dramatically, with the cost of a gallon of regular gas peaking in 2014 at $3.71, dropping as low as $1.69 in early 2015, and moderating to $2.36 in mid-2017. Recent research by JP Morgan Chase revealed that consumers spend roughly 80 percent of their savings from lower gas prices, which helps the overall economy.

“18-Month Average Retail Price Chart (2015–2017),” http://www.gasbuddy.com, accessed May 23, 2017; JPMorgan Chase Institute, “How Falling Gas Prices Fuel the Consumer,” https://www.jpmorganchase, accessed May 23, 2017.

  1. What is the relationship between prices and demand for a product?
  2. How is market equilibrium achieved? Describe the circumstances under which the price for gasoline would have returned to equilibrium in the United States after Hurricane Katrina.
  3. Draw a graph that shows an equilibrium point for supply and demand.

Summary of Learning Outcomes

  1. What are the basic microeconomic concepts of demand and supply, and how do they establish prices?

Demand is the quantity of a good or service that people will buy at a given price. Supply is the quantity of a good or service that firms will make available at a given price. When the price increases, the quantity demanded falls, but the quantity supplied rises. A price decrease leads to increased demand but a lower supply. At the point where the quantity demanded equals the quantity supplied, demand and supply are in balance. This equilibrium point is achieved by market adjustments of quantity and price.

Glossary

demand
The quantity of a good or service that people are willing to buy at various prices.
demand curve
A graph showing the quantity of a good or service that people are willing to buy at various prices.
equilibrium
The point at which quantity demanded equals quantity supplied.
supply
The quantity of a good or service that businesses will make available at various prices.
supply curve
A graph showing the quantity of a good or service that businesses will make available at various prices.

8

Competing in a Free Market

  1. What are the four types of market structure?

One of the characteristics of a free-market system is that suppliers have the right to compete with one another. The number of suppliers in a market defines the market structure. Economists identify four types of market structures: (1) perfect competition, (2) pure monopoly, (3) monopolistic competition, and (4) oligopoly. (Figure) summarizes the characteristics of each of these market structures.

Perfect Competition

Characteristics of perfect (pure) competition include:

  • A large number of small firms are in the market.
  • The firms sell similar products; that is, each firm’s product is very much like the products sold by other firms in the market.
  • Buyers and sellers in the market have good information about prices, sources of supply, and so on.
  • It is easy to open a new business or close an existing one.
Comparison of Market Structures
Characteristics Perfect Competition Pure Monopoly Monopolistic Competition Oligopoly
Number of firms in market Many One Many, but fewer than perfect competition Few
Firm’s ability to control price None High Some Some
Barriers to entry None Subject to government regulation Few Many
Product differentiation Very little No products that compete directly Emphasis on showing perceived differences in products Some differences
Examples Farm products such as wheat and corn Utilities such as gas, water, cable television Retail specialty clothing stores Steel, automobiles, airlines, aircraft manufacturers

In a perfectly competitive market, firms sell their products at prices determined solely by forces beyond their control. Because the products are very similar and each firm contributes only a small amount to the total quantity supplied by the industry, price is determined by supply and demand. A firm that raised its price even a little above the going rate would lose customers. In the wheat market, for example, the product is essentially the same from one wheat producer to the next. Thus, none of the producers has control over the price of wheat.

Perfect competition is an ideal. No industry shows all its characteristics, but the stock market and some agricultural markets, such as those for wheat and corn, come closest. Farmers, for example, can sell all of their crops through national commodity exchanges at the current market price.

Pure Monopoly

At the other end of the spectrum is pure monopoly, the market structure in which a single firm accounts for all industry sales of a particular good or service. The firm is the industry. This market structure is characterized by barriers to entry—factors that prevent new firms from competing equally with the existing firm. Often the barriers are technological or legal conditions. Polaroid, for example, held major patents on instant photography for years. When Kodak tried to market its own instant camera, Polaroid sued, claiming patent violations. Polaroid collected millions of dollars from Kodak. Another barrier may be one firm’s control of a natural resource. DeBeers Consolidated Mines Ltd., for example, controls most of the world’s supply of uncut diamonds.

Public utilities, such as gas and water companies, are pure monopolies. Some monopolies are created by a government order that outlaws competition. The U.S. Postal Service is currently one such monopoly.

Monopolistic Competition

Three characteristics define the market structure known as monopolistic competition:

  • Many firms are in the market.
  • The firms offer products that are close substitutes but still differ from one another.
  • It is relatively easy to enter the market.

Under monopolistic competition, firms take advantage of product differentiation. Industries where monopolistic competition occurs include clothing, food, and similar consumer products. Firms under monopolistic competition have more control over pricing than do firms under perfect competition because consumers do not view the products as perfect substitutes. Nevertheless, firms must demonstrate product differences to justify their prices to customers. Consequently, companies use advertising to distinguish their products from others. Such distinctions may be significant or superficial. For example, Nike says “Just Do It,” and Tylenol is advertised as being easier on the stomach than aspirin.

Oligopoly

An oligopoly has two characteristics:

  • A few firms produce most or all of the output.
  • Large capital requirements or other factors limit the number of firms.

Boeing and Airbus Industries (aircraft manufacturers) and Apple and Google (operating systems for smartphones) are major players in different oligopolistic industries.

With so few firms in an oligopoly, what one firm does has an impact on the other firms. Thus, the firms in an oligopoly watch one another closely for new technologies, product changes and innovations, promotional campaigns, pricing, production, and other developments. Sometimes they go so far as to coordinate their pricing and output decisions, which is illegal. Many antitrust cases—legal challenges arising out of laws designed to control anticompetitive behavior—occur in oligopolies.

The market structure of an industry can change over time. Take, for example, telecommunications. At one time, AT&T had a monopoly on long-distance telephone service nationwide. Then the U.S. government divided the company into seven regional phone companies in 1984, opening the door to greater competition. Other companies such as MCI and Sprint entered the fray and built state-of-the-art fiber-optic networks to win customers from the traditional providers of phone service. The 1996 Telecommunications Act changed the competitive environment yet again by allowing local phone companies to offer long-distance service in exchange for letting competition into their local markets. Today, the broadcasting, computer, telephone, and video industries are converging as companies consolidate through merger and acquisition.

  1. What is meant by market structure?
  2. Compare and contrast perfect competition and pure monopoly. Why is it rare to find perfect competition?
  3. How does an oligopoly differ from monopolistic competition?

Summary of Learning Outcomes

  1. What are the four types of market structure?

Market structure is the number of suppliers in a market. Perfect competition is characterized by a large number of buyers and sellers, very similar products, good market information for both buyers and sellers, and ease of entry into and exit from the market. In a pure monopoly, there is a single seller in a market. In monopolistic competition, many firms sell close substitutes in a market that is fairly easy to enter. In an oligopoly, a few firms produce most or all of the industry’s output. An oligopoly is also difficult to enter, and what one firm does will influence others.

Glossary

barriers to entry
Factors, such as technological or legal conditions, that prevent new firms from competing equally with an existing firm.
market structure
The number of suppliers in a market.
monopolistic competition
A market structure in which many firms offer products that are close substitutes and in which entry is relatively easy.
oligopoly
A market structure in which a few firms produce most or all of the output and in which large capital requirements or other factors limit the number of firms.
perfect (pure) competition
A market structure in which a large number of small firms sell similar products, buyers and sellers have good information, and businesses can be easily opened or closed.
pure monopoly
A market structure in which a single firm accounts for all industry sales of a particular good or service and in which there are barriers to entry.

II

Making Ethical Decisions and Managing a Socially Responsible Business

10

Introduction


A photograph shows a street that branches into 2 paths; one going left, and one going right.

Learning Outcomes

After reading this chapter, you should be able to answer these questions:

  1. What philosophies and concepts shape personal ethical standards?
  2. How can organizations encourage ethical business behavior?
  3. What is corporate social responsibility?
  4. How do businesses meet their social responsibilities to various stakeholders?
  5. What are the trends in ethics and corporate social responsibility?
Playing with a Purpose at Hasbro

Hasbro is a global play and entertainment company that takes corporate social responsibility (CSR) very seriously. Founded nearly a century ago in Rhode Island, Hasbro integrates its CSR efforts throughout the organization with the goal of helping to make the world a better place for children of all ages.

In 2017, the company achieved the number one spot in the “100 Best Corporate Citizens” rankings, published annually by Corporate Responsibility magazine. Hasbro is no stranger to this achievement; over the past five years, Hasbro has consistently been in the top five spots on this prestigious list—and that is no accident.

Hasbro’s Monopoly game
(Credit: Ben Tsai/ Flickr/ Public Domain)


With more than 5,000 employees, Hasbro relies heavily on its strategic brand blueprint to guide its efforts in CSR, innovation, philanthropy, and product development. With a business portfolio that includes such well-known brands as Nerf, Play-Doh, Transformers, Monopoly, and The Game of Life, the company focuses its CSR efforts on four key areas: product safety, environmental sustainability, human rights and ethical sourcing, and community.

According to the company, product safety is its highest priority. Hasbro uses a five-step quality assurance process that starts with design and then moves to engineering, manufacturing, and packaging. Another key part of product safety at Hasbro is incorporating continuous feedback from both consumers and retailers and insisting that these high standards and quality processes apply to all third-party factories worldwide that manufacture its products.

Hasbro is also committed to finding new ways to reduce its environmental footprint. Over the past several years, the company has reduced energy consumption, cut greenhouse gas emissions, and reduced water consumption and waste production in its production facilities. In addition, Hasbro has totally eliminated the use of wire ties in all of its product packaging, saving more than 34,000 miles of wire ties—more than enough to wrap around the earth’s circumference.

Human rights and ethical sourcing remains a key ingredient of Hasbro’s CSR success. Treating people fairly is a core company value, as is working diligently to make great strides in diversity and inclusion at all levels of the organization. Company personnel work closely with third-party factories to ensure that the human rights of all workers in the Hasbro global supply chain are recognized and upheld.

Philanthropy, corporate giving, and employee volunteering are key components of the Hasbro community. Through its various charitable programs, Hasbro made close to $15 million in financial contributions and product donations in 2016, which reached close to an estimated 4 million children around the globe. Several years ago the company started an annual Global Day of Joy as a way of engaging its employees worldwide in community service. In a recent year, more than 93 percent of Hasbro’s employees participated in service projects in more than 40 countries.

Hasbro is in the business of storytelling, and its CSR efforts tell the story of an ethical, responsible organization whose mission is to create the world’s best play experiences. Its ability to be accountable for its actions and to help make the world a better place one experience at time continues to make it a highly successful company.

Sources: Brian Goldner, “Who Are You Really?—Brian Goldner, President & CEO for Hasbro, Inc.,” http://insights.ethisphere.com, accessed June 29, 2017; “CSR Fact Sheet,” https://csr.hasbro.com, accessed June 23, 2017; “The World’s Biggest Public Companies: Hasbro,” Forbes, https://www.forbes.com, accessed June 23, 2017; “2016 Global Philanthropy & Social Impact,” https://csr.hasbro.com, accessed June 23, 2017; Elizabeth Gurdus, “Hasbro CEO Reveals the Magic Behind the Toymaker’s Earnings Beat,” CNBC, http://www.cnbc.com, April 24, 2017; Jade Burke, “Hasbro Reaches Top Spot in CSR Listing,” Toy News, http://www.toynews-online.biz, April 21, 2017; Kathrin Belliveau, “CSR at Hasbro: What It Means to Play with Purpose,” LinkedIn, https://www.linkedin.com, April 20, 2017.

Every day, managers and business owners make business decisions based on what they believe to be right and wrong. Through their actions, they demonstrate to their employees what is and is not acceptable behavior and shape the moral standard of the organization. As you will see in this module, personal and professional ethics are important cornerstones of an organization and shape its ultimate contributions to society in the form of corporate social responsibility. First, let’s consider how individual business ethics are formed.

11

Understanding Business Ethics

  1. What philosophies and concepts shape personal ethical standards?

Ethics is a set of moral standards for judging whether something is right or wrong. The first step in understanding business ethics is learning to recognize an ethical issue. An ethical issue is a situation where someone must choose between a set of actions that may be ethical or unethical. For example, Martin Shkreli, former CEO of Turing Pharmaceuticals, raised the price of a drug used for newborns and HIV patients by more than 5000 percent, defending the price increase as a “great business decision.”

Renae Merle, “‘Pharma Bro’ Martin Shkreli Goes on Trial, Where He Finds Another Kind of Limelight,” Washington Post, https://www.washingtonpost.com, June 27, 2017.

Few people would call that ethical behavior. But consider the actions of the stranded, hungry people in New Orleans who lost everything in the aftermath of Hurricane Katrina. They broke into flooded stores, taking food and bottled water without paying for them. Was this unethical behavior? Or what about the small Texas plastics manufacturer that employed over 100 people and specialized in the Latin American market? The president was distraught because he knew the firm would be bankrupt by the end of the year if it didn’t receive more contracts. He knew that he was losing business because he refused to pay bribes. Bribes were part of the culture in his major markets. Closing the firm would put many people out of work. Should he start paying bribes in order to stay in business? Would this be unethical? Let’s look at the next section to obtain some guidance on recognizing unethical situations.

Recognizing Unethical Business Activities

Researchers from Brigham Young University tell us that all unethical business activities will fall into one of the following categories:

  1. Taking things that don’t belong to you. The unauthorized use of someone else’s property or taking property under false pretenses is taking something that does not belong to you. Even the smallest offense, such as using the postage meter at your office for mailing personal letters or exaggerating your travel expenses, belongs in this category of ethical violations.
  2. Saying things you know are not true. Often, when trying for a promotion and advancement, fellow employees discredit their coworkers. Falsely assigning blame or inaccurately reporting conversations is lying. Although “This is the way the game is played around here” is a common justification, saying things that are untrue is an ethical violation.
  3. Giving or allowing false impressions. The salesperson who permits a potential customer to believe that cardboard boxes will hold the customer’s tomatoes for long-distance shipping when the salesperson knows the boxes are not strong enough has given a false impression. A car dealer who fails to disclose that a car has been in an accident is misleading potential customers.
  4. Buying influence or engaging in a conflict of interest. A conflict of interest occurs when the official responsibilities of an employee or government official are influenced by the potential for personal gain. Suppose a company awards a construction contract to a firm owned by the father of the state attorney general while the state attorney general’s office is investigating that company. If this construction award has the potential to shape the outcome of the investigation, a conflict of interest has occurred.
  5. Hiding or divulging information. Failing to disclose the results of medical studies that indicate your firm’s new drug has significant side effects is the ethical violation of hiding information that the product could be harmful to purchasers. Taking your firm’s product development or trade secrets to a new place of employment constitutes the ethical violation of divulging proprietary information.
  6. Taking unfair advantage. Many current consumer protection laws were passed because so many businesses took unfair advantage of people who were not educated or were unable to discern the nuances of complex contracts. Credit disclosure requirements, truth-in-lending provisions, and new regulations on auto leasing all resulted because businesses misled consumers who could not easily follow the jargon of long, complex agreements.
  7. Committing improper personal behavior. Although the ethical aspects of an employee’s right to privacy are still debated, it has become increasingly clear that personal conduct outside the job can influence performance and company reputation. Thus, a company driver must abstain from substance abuse because of safety issues. Even the traditional company holiday party and summer picnic have come under scrutiny due to the possibility that employees at and following these events might harm others through alcohol-related accidents.
  8. Abusing power and mistreating individuals. Suppose a manager sexually harasses an employee or subjects employees to humiliating corrections or reprimands in the presence of customers. In some cases, laws protect employees. Many situations, however, are simply interpersonal abuse that constitutes an ethical violation.
  9. Permitting organizational abuse. Many U.S. firms with operations overseas, such as Apple, Nike, and Levi Strauss, have faced issues of organizational abuse. The unfair treatment of workers in international operations appears in the form of child labor, demeaning wages, and excessive work hours. Although a business cannot change the culture of another country, it can perpetuate—or stop—abuse through its operations there.
  10. Violating rules. Many organizations use rules and processes to maintain internal controls or respect the authority of managers. Although these rules may seem burdensome to employees trying to serve customers, a violation may be considered an unethical act.
  11. Condoning unethical actions. What if you witnessed a fellow employee embezzling company funds by forging her signature on a check? Would you report the violation? A winking tolerance of others’ unethical behavior is itself unethical.
    Arthur Schwartz, “The 5 Most Common Unethical Behaviors in the Workplace,” Philadelphia Business Journal, http://www.bizjournals.com, January 26, 2015; Marianne Moody Jennings, Case Studies in Business Ethics, 2nd edition (St. Paul: West Publishing Company, 1996), pp. xx–xxii.

After recognizing that a situation is unethical, the next question is what do you do? The action that a person takes is partially based upon his or her ethical philosophy. The environment in which we live and work also plays a role in our behavior. This section describes personal philosophies and legal factors that influence the choices we make when confronting an ethical dilemma.

Justice—The Question of Fairness

Another factor influencing individual business ethics is justice, or what is fair according to prevailing standards of society. We all expect life to be reasonably fair. You expect your exams to be fair, the grading to be fair, and your wages to be fair, based on the type of work being done.

Today we take justice to mean an equitable distribution of the burdens and rewards that society has to offer. The distributive process varies from society to society. Those in a democratic society believe in the “equal pay for equal work” doctrine, in which individuals are rewarded based on the value the free market places on their services. Because the market places different values on different occupations, the rewards, such as wages, are not necessarily equal. Nevertheless, many regard the rewards as just. A politician who argued that a supermarket clerk should receive the same pay as a physician, for example, would not receive many votes from the American people. At the other extreme, communist theorists have argued that justice would be served by a society in which burdens and rewards were distributed to individuals according to their abilities and their needs, respectively.

Utilitarianism—Seeking the Best for the Majority

One of the philosophies that may influence choices between right and wrong is utilitarianism, which focuses on the consequences of an action taken by a person or organization. The notion that people should act so as to generate the greatest good for the greatest number is derived from utilitarianism. When an action affects the majority adversely, it is morally wrong. One problem with this philosophy is that it is nearly impossible to accurately determine how a decision will affect a large number of people.

Another problem is that utilitarianism always involves both winners and losers. If sales are slowing and a manager decides to fire five people rather than putting everyone on a 30-hour workweek, the 20 people who keep their full-time jobs are winners, but the other five are losers.

A final criticism of utilitarianism is that some “costs,” although small relative to the potential good, are so negative that some segments of society find them unacceptable. Reportedly, the backs of animals a year are deliberately broken so that scientists can conduct spinal cord research that could someday lead to a cure for spinal cord injuries. To a number of people, however, the “costs” are simply too horrible for this type of research to continue.

Following Our Obligations and Duties

The philosophy that says people should meet their obligations and duties when analyzing an ethical dilemma is called deontology. This means that a person will follow his or her obligations to another individual or society because upholding one’s duty is what is considered ethically correct. For instance, people who follow this philosophy will always keep their promises to a friend and will follow the law. They will produce very consistent decisions, because they will be based on the individual’s set duties. Note that this theory is not necessarily concerned with the welfare of others. Say, for example, a technician for Orkin Pest Control has decided that it’s his ethical duty (and is very practical) to always be on time to meetings with homeowners. Today he is running late. How is he supposed to drive? Is the technician supposed to speed, breaking his duty to society to uphold the law, or is he supposed to arrive at the client’s home late, breaking his duty to be on time? This scenario of conflicting obligations does not lead us to a clear ethically correct resolution, nor does it protect the welfare of others from the technician’s decision.

Individual Rights

In our society, individuals and groups have certain rights that exist under certain conditions regardless of any external circumstances. These rights serve as guides when making individual ethical decisions. The term human rights implies that certain rights—to life, to freedom, to the pursuit of happiness—are bestowed at birth and cannot be arbitrarily taken away. Denying the rights of an individual or group is considered to be unethical and illegal in most, though not all, parts of the world. Certain rights are guaranteed by the government and its laws, and these are considered legal rights. The U.S. Constitution and its amendments, as well as state and federal statutes, define the rights of American citizens. Those rights can be disregarded only in extreme circumstances, such as during wartime. Legal rights include the freedom of religion, speech, and assembly; protection from improper arrest and searches and seizures; and proper access to counsel, confrontation of witnesses, and cross-examination in criminal prosecutions. Also held to be fundamental is the right to privacy in many matters. Legal rights are to be applied without regard to race, color, creed, gender, or ability.

  1. How are individual business ethics formed?
  2. What is utilitarianism?
  3. How can you recognize unethical activities?

Summary of Learning Outcomes

  1. What philosophies and concepts shape personal ethical standards?

Ethics is a set of moral standards for judging whether something is right or wrong. A utilitarianism approach to setting personal ethical standards focuses on the consequences of an action taken by a person or organization. According to this approach, people should act so as to generate the greatest good for the greatest number. Every human is entitled to certain rights such as freedom and the pursuit of happiness. Another approach to ethical decision-making is justice, or what is fair according to accepted standards.

Glossary

deontology
A philosophy in which a person will follow his or her obligations to an individual or society because upholding one’s duty is what is ethically correct.
ethical issue
A situation where a person must choose from a set of actions that may be ethical or unethical.
ethics
A set of moral standards for judging whether something is right or wrong.
justice
What is considered fair according to the prevailing standards of society; an equitable distribution of the burdens and rewards that society has to offer.
utilitarianism
A philosophy that focuses on the consequences of an action to determine whether it is right or wrong; holds that an action that affects the majority adversely is morally wrong.

12

How Organizations Influence Ethical Conduct

  1. How can organizations encourage ethical business behavior?

People choose between right and wrong based on their personal code of ethics. They are also influenced by the ethical environment created by their employers. Consider the following headlines:

As these actual stories illustrate, poor business ethics can create a very negative image for a company, can be expensive for the firm and/or the executives involved, and can result in bankruptcy and jail time for the offenders. Organizations can reduce the potential for these types of liability claims by educating their employees about ethical standards, by leading through example, and through various informal and formal programs.

Leading by Example

Employees often follow the examples set by their managers. That is, leaders and managers establish patterns of behavior that determine what’s acceptable and what’s not within the organization. While Ben Cohen was president of Ben & Jerry’s ice cream, he followed a policy that no one could earn a salary more than seven times that of the lowest-paid worker. He wanted all employees to feel that they were equal. At the time he resigned, company sales were $140 million, and the lowest-paid worker earned $19,000 per year. Ben Cohen’s salary was $133,000, based on the “seven times” rule. A typical top executive of a $140 million company might have earned 10 times Cohen’s salary. Ben Cohen’s actions helped shape the ethical values of Ben & Jerry’s.

Offering Ethics Training Programs

In addition to providing a system to resolve ethical dilemmas, organizations also provide formal training to develop an awareness of questionable business activities and practice appropriate responses. Many companies have some type of ethics training program. The ones that are most effective, like those created by Levi Strauss, American Express, and Campbell Soup Company, begin with techniques for solving ethical dilemmas such as those discussed earlier. Next, employees are presented with a series of situations and asked to come up with the “best” ethical solution. One of these ethical dilemmas is shown in (Figure). According to a recent survey by the Ethics Resource Center, more than 80 percent of U.S. companies provide some sort of ethics training for employees, which may include online activities, videos, and even games.

Dori Meinert, “Creating an Ethical Workplace,” Society for Human Resource Management, https://www.shrm.org, accessed June 23, 2017; Jeff Kauflin, “The World’s Most Ethical Companies 2017,” Forbes, http://www.forbes.com, March 14, 2017.

An Ethical Dilemma Used for Employee Training
Bill Gannon was a middle manager of a large manufacturer of lighting fixtures in Newark, New Jersey. Bill had moved up the company ladder rather quickly and seemed destined for upper management in a few years. Bill’s boss, Dana Johnson, had been pressuring him about the semiannual reviews concerning Robert Talbot, one of Bill’s employees. Dana, it seemed, would not accept any negative comments on Robert’s evaluation forms. Bill had found out that a previous manager who had given Robert a bad evaluation was no longer with the company. As Bill reviewed Robert’s performance for the forthcoming evaluation period, he found many areas of subpar performance. Moreover, a major client had called recently complaining that Robert had filled a large order improperly and then had been rude to the client when she called to complain.
Discussion Questions
  1. What ethical issues does the situation raise?
  2. What courses of action could Bill take? Describe the ethics of each course.
  3. Should Bill confront Dana? Dana’s boss?
  4. What would you do in this situation? What are the ethical implications?

Establishing a Formal Code of Ethics

Most large companies and thousands of smaller ones have created, printed, and distributed codes of ethics. In general, a code of ethics provides employees with the knowledge of what their firm expects in terms of their responsibilities and behavior toward fellow employees, customers, and suppliers. Some ethical codes offer a lengthy and detailed set of guidelines for employees. Others are not really codes at all but rather summary statements of goals, policies, and priorities. Some companies have their codes framed and hung on office walls, included as a key component of employee handbooks, and/or posted on their corporate websites.

Examples of company codes of ethics:
  • Costco http://phx.corporate-ir.net/phoenix.zhtml?c=83830&p=irol-govhighlights
  • Starbucks https://www.starbucks.com/about-us/company-information/business-ethics-and-compliance
  • AT&T https://www.att.com/gen/investor-relations?pid=5595

Do codes of ethics make employees behave in a more ethical manner? Some people believe that they do. Others think that they are little more than public relations gimmicks. If senior management abides by the code of ethics and regularly emphasizes the code to employees, then it will likely have a positive influence on behavior.

The “100 Best Corporate Citizens” as ranked by Corporate Responsibility magazine are selected based on seven categories, including employee relations, human rights, corporate governance (including code of ethics), philanthropy and community support, financial performance, environment, and climate change.

“The 2017 100 Best Corporate Citizens,” Corporate Responsibility, http://www.thecro.com, accessed June 23, 2017; Karsten Strauss, “America’s 100 Best Corporate Citizens in 2017,” Forbes, http://www.forbes.com, May 11, 2017.

The top corporate citizens in 2017 were:

  1. Hasbro, Inc.
  2. Intel Corp.
  3. Microsoft Corp.
  4. Altria Group, Inc.
  5. Campbell Soup Company
  6. Cisco Systems, Inc.
  7. Accenture
  8. Hormel Foods Corp.
  9. Lockheed Martin Corp.
  10. Ecolab, Inc.
Campbell’s Adds CSR to Its Recipe

The Campbell Soup Company is no longer just about traditional cans of processed soup. Under the guidance of its management team, particularly its former CEO Denise Morrison (Morrison retired from Campbell’s in July of 2018), Campbell’s has undergone a transformation that includes a strong emphasis on organics and fresh food—and a large serving of corporate citizenship.

Named one of the Best Corporate Citizens by Corporate Responsibility magazine in 2017, Campbell’s is working to make sustainability and transparency part of its business DNA, and this culture shift has had an important influence on the company’s business strategies.

Morrison, who took over as CEO in 2011, is a firm believer in the company’s central vision: real food that matters for life’s moments. “We can make a profit and make a difference, and we are doing both through our business . . . in a way that’s authentic, that’s transparent, and that truly matters,” she explains.

Under Morrison’s watch, the company recently acquired several fresh food and organic companies, including Bolthouse Farms, one of the largest suppliers of fresh carrots in the United States, and Garden Fresh Gourmet, which produces a top line of fresh salsa and hummus. Tracking the strong change in consumer preference for healthier food, Campbell’s also recently acquired Plum Organics, a line of organic baby food products, which should help solidify the company’s reputation for fresh ingredients with millennials and their families.

The company’s transformation from a processed food giant to a major competitor in the fresh food business has also had a positive influence on the company’s bottom line. Campbell’s shareholders have to be pleased with the 20 percent increase in the company’s stock price over the past two years, as the markets, competitors, and consumers take notice of the company’s strong commitment to sustainability.

Inherent in the company’s reinvention is the strong emphasis on corporate citizenship—doing good and giving back seem to be top priorities for Campbell’s. In addition to acquiring sustainable and fresh food companies, Campbell’s has also made a conscious decision to support the communities where their employees live and work. For example, the company launched a healthy communities initiative in Camden, New Jersey, where Campbell’s is headquartered—an urban city that has seen its share of economic and social challenges in the past. In partnership with several local organizations, this initiative has helped fund community gardens, food pantries, nutrition education, and cooking classes that help build healthy communities. The Camden experience has been so successful that the company has expanded the program to other cities where it operates, including Detroit, Michigan, and Norwalk, Connecticut.

The company’s ongoing commitment to fresh food, community involvement, and corporate social responsibility has helped change the narrative when it comes to being a sustainable and ethical organization.

Questions for Discussion
  1. How does Campbell Soup Company’s recent business acquisitions help support its CSR strategies?
  2. Provide examples of how the company’s transformation from a processed food giant to a purveyor of fresh ingredients can help attract a new group of customers.

Sources: “Corporate Responsibility and Sustainability Are Good for Business,” https://www.campbellsoupcompany.com, accessed June 27, 2017; “Campbell Soup Wants to Make You a Personal Eating Plan (video),” Fortune, http://fortune.com, May 2, 2017; Don Seiffert, “Campbell Soup CEO Makes 3 Predictions about the Future of Food,” Boston Business Journal, http://www.bizjournals.com, April 13, 2017; Aaron Hurst, “How Denise Morrison Took Processed Food Icon Campbell’s on a Fresh Food Buying Spree,” Fast Company, https://www.fastcompany.com, March 2, 2017; Abigail Stevenson, “Campbell Soup CEO: Stunning Disruption in the Ecosystem of Food,” CNBC, http://www.cnbc.com, July 21, 2016.

Making the Right Decision

In many situations, there may be no simple right or wrong answers. Yet there are several questions you can ask yourself, and a couple of self-tests you can do, to help you make the right ethical decision. First, ask yourself, “Are there any legal restrictions or violations that will result from the action?” If so, take a different course of action. If not, ask yourself, “Does it violate my company’s code of ethics?” If so, again find a different path to follow. Third, ask, “Does this meet the guidelines of my own ethical philosophy?” If the answer is “yes,” then your decision must still pass two important tests.

The Feelings Test

You must now ask, “How does it make me feel?” This enables you to examine your comfort level with a particular decision. Many people find that, after reaching a decision on an issue, they still experience discomfort that may manifest itself in a loss of sleep or appetite. Those feelings of conscience can serve as a future guide in resolving ethical dilemmas.

The Newspaper or Social Media Test

The final test involves the front page of the newspaper or social media posts. The question to be asked is how an objective reporter would describe your decision in a front-page newspaper story, an online media site, or a social media platform such as Twitter or Facebook. Some managers rephrase the test for their employees: How will the headline read if I make this decision, or what will be the reaction of my social media followers? This test is helpful in spotting and resolving potential conflicts of interest.

Making an ethical decision might come down to how you feel about the decision or to the newspaper or social media post test. The question to ask yourself is how the decision would make you feel if an objective reporter described the decision on the front page of a newspaper or via a social media post on Twitter or Facebook—all of which would be viewed by many, many people. Speaking of social media, it plays a pivotal role in ethical decision-making today, when people use the medium to share critical comments about friends as well as employers, business colleagues, and competitors. Should companies view employees’ social media pages on a regular basis, or is that information off-limits to employers? (Credit: Mike MacKenzie/ Flickr/ Attribution 2.0 Generic (CC BY 2.0))


A photograph shows a cell phone screen, with many apps, including Facebook, Skype, Twitter, LinkedIn, and Instagram.

  1. What is the role of top management in organizational ethics?
  2. What is a code of ethics?

Summary of Learning Outcomes

  1. How can organizations encourage ethical business behavior?

Top management must shape the ethical culture of the organization. They should lead by example, offer ethics-training programs, and establish a formal code of ethics.

Glossary

code of ethics
A set of guidelines prepared by a firm to provide its employees with the knowledge of what the firm expects in terms of their responsibilities and behavior toward fellow employees, customers, and suppliers.

13

Managing a Socially Responsible Business

  1. What is corporate social responsibility?

Acting in an ethical manner is one of the four components of the pyramid of corporate social responsibility (CSR), which is the concern of businesses for the welfare of society as a whole. It consists of obligations beyond those required by law or union contract. This definition makes two important points. First, CSR is voluntary. Beneficial action required by law, such as cleaning up factories that are polluting air and water, is not voluntary. Second, the obligations of corporate social responsibility are broad. They extend beyond investors in the company to include workers, suppliers, consumers, communities, and society at large.

(Figure) portrays economic responsibility as the foundation for the other three responsibilities. At the same time that a business pursues profits (economic responsibility), however, it is expected to obey the law (legal responsibility); to do what is right, just, and fair (ethical responsibility); and to be a good corporate citizen (philanthropic responsibility). These four components are distinct but together constitute the whole. Still, if the company doesn’t make a profit, then the other three responsibilities won’t matter.

Many companies continue to work hard to make the world a better place to live. Recent data suggests that Fortune 500 companies spend more than $15 billion annually on CSR activities. Consider the following examples:

Understanding Social Responsibility

Peter Drucker, the late globally respected management expert, said that we should look first at what an organization does to society and second at what it can do for society. This idea suggests that social responsibility has two basic dimensions: legality and responsibility.

The Pyramid of Corporate Social Responsibility
(Attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license.)


The base of the pyramid is labeled, Economic Responsibility, and the description is as follows. Because a corporation must be profitable to survive, its economic responsibilities form the base of the pyramid. The next level up in the pyramid is labeled Legal Responsibilities, and the description is as follows. Corporations must, of course, follow the law. The second level of the pyramid recognizes that legal considerations are also necessary for a corporation's success. The next level up in the pyramid is labeled, Ethical Responsibilities, and the description is as follows. Resting on the foundation set by economic and legal responsibilities are ethical responsibilities. A corporation can turn its attention to ethical matters only after ensuring its economic and legal position. The highest level of the pyramid, forming the peak, is labeled Philanthropic Responsibilities, and the description is as follows. The highest level of the pyramid, philanthropic responsibilities can be considered only after economic, legal, and ethical responsibilities.

Illegal and Irresponsible Behavior

The idea of corporate social responsibility is so widespread today that it is hard to conceive of a company continually acting in illegal and irresponsible ways. Nevertheless, such actions do sometimes occur, which can create financial ruin for organizations, extreme financial hardships for many former employees, and general struggles for the communities in which they operate. Unfortunately, top executives still walk away with millions. Some, however, will ultimately pay large fines and spend time in prison for their actions. Federal, state, and local laws determine whether an activity is legal or not. The laws that regulate business are discussed later in this module.

Irresponsible but Legal Behavior

Sometimes companies act irresponsibly, yet their actions are legal. For example, the Minnesota-based company that makes MyPillow was recently fined $1 million by the state of California for making unsubstantiated claims that the “most comfortable pillow you’ll ever own” could help alleviate medical conditions such as snoring, fibromyalgia, migraines, and other disorders. The company’s CEO countered that the claims were actually made by customers; these testimonials were posted on the company’s website but later removed. In addition to the fine, the company faced several class-action lawsuits, and the Better Business Bureau has revoked MyPillow’s accreditation.

John Ewoldt, “Better Business Bureau Revokes MyPillow Accreditation over Ad Dispute,” Minneapolis Star Tribune, http://www.startribune.com, January 4, 2017; Herb Weisbaum, “Full of Fluff? MyPillow Ordered to Pay $1M for Bogus Ads,” NBC News, http://www.nbcnews.com, November 3, 2016.

Badger Company Founder Walks the Walk

As a carpenter, Bill Whyte was always looking for a solution to his dry, cracked hands, especially in the harsh New Hampshire winters. After trying many commercial lotions that didn’t really work, Whyte experimented with olive oil and beeswax to come up with a soothing balm to help heal rough hands. Mixing up the concoction at home, Whyte came up with a product that seemed to work and was made from natural ingredients.

Originally called Bear Paw, the lotion became known as Badger Balm after a friend found a competing product already named Bear Paw. Whyte set up a production line at home to fill the tins. Soon he was pounding the pavement in the town of Gilsum, trying to sell the new product to hardware stores, lumber yards, and health food stores.

Fast-forward a little more than 20 years from his early days of experimentation, and Whyte (affectionately known as the “head badger”) runs W.S. Badger Company with the same goals and passions he started with back in the mid-1990s. The company uses only organic plant extracts, exotic oils, beeswax, and minerals to make the most effective products to soothe, heal, and protect the body. And the natural ingredients come from all over the world—for example, organic extra virgin olive oil from Spain, organic rose essential oil from Bulgaria, and bergamot oil from southern Italy.

Badger’s homey culture is no accident. In fact, in the early days, Whyte made soup every Friday for the small staff. Today, Whyte and family members, including his wife Kathy, chief operating officer; daughter Rebecca, head of sustainability and innovation; and daughter Emily, head of sales and marketing, all embrace the ethical and social principles of this family business that have made the company a success.

To reinforce the commitment of being socially responsible and demonstrating transparency, W.S. Badger Company became a Certified Benefit Corporation, or B Corp for short. This certification requires companies to meet rigorous standards for transparency, accountability, and social and environmental performance. (Benefit Corporations are discussed in more detail later in this module.)

Becoming a B Corp. has helped the company organize how it operates. For example, pay for the highest-paid full-time employee is capped at five times that of the lowest paid, which is now $15 an hour (more than double New Hampshire’s minimum wage); a portion of company profits flows to employees via profit sharing, and all employees participate in a bonus plan; and new parents are encouraged to bring their babies to work, a program that has helped foster a new style of teamwork for the entire organization, as well as increase employee morale. In addition, Badger donates 10 percent of its pre-tax profits annually to nonprofit organizations that focus on the health and welfare of children, matches employee contributions to charitable causes (up to $100 per employee), and donates an additional $50 to a nonprofit chosen by each employee on their birthday.

Badger staff, which now number more than 100, enjoy a living wage, great benefits, and a socially responsible work environment thanks to a visionary who found an eco-friendly way to soothe his rough hands and created an ethical business as part of his journey.

Questions for Discussion
  1. How does Badger’s approach to social responsibility help attract and retain employees?
  2. Does the company’s certification as a Benefit Corporation provide Badger with a competitive advantage? Explain your reasoning.

Sources: “Badger’s History & Legend,” “Babies at Work Policy,” and “2016 Annual Impact Report,” https://www.badgerbalm.com, accessed June 27, 2017; “About Badger,” https://www.bcorporation.net, accessed June 27, 2017; “Badger ‘Still In’ on Climate Action, Asks New Hampshire Businesses, State Officials, and Local Leaders to Join Forces in Honoring Paris Agreement,” http://www.prweb.com, June 22, 2017; Amy Feldman, “Badger Balm Creator Once Dismissed Being a B Corp as ‘Just Marketing.’ Now He’s a True Believer,” Forbes, http://www.forbes.com, May 9, 2017.

Legal and Responsible Behavior

The vast majority of business activities fall into the category of behavior that is both legal and responsible. Most companies act legally, and most try to be socially responsible. Research shows that consumers, especially those under 30, are likely to buy brands that have excellent ethical track records and community involvement. Outdoor specialty retailer REI, for example, recently announced that it gave back nearly 70 percent of its profits to the outdoor community. A member cooperative, the company invested a record $9.3 million in its nonprofit partners in 2016.

“REI Co-op Gives Back Nearly 70 Percent of Profits to the Outdoor Community after Year of Record Revenues in 2016,” http://newsroom.rei.com, March 15, 2017.

  1. What are the four components of social responsibility?
  2. Give an example of legal but irresponsible behavior.

Summary of Learning Outcomes

  1. What is corporate social responsibility?

Corporate social responsibility is the concern of businesses for the welfare of society as a whole. It consists of obligations beyond just making a profit and goes beyond what is required by law or union contract. Companies may engage in illegal and irresponsible behavior, irresponsible but legal behavior, or legal and responsible behavior. The vast majority of organizations act legally and try to be socially responsible.

Glossary

corporate social responsibility (CSR)
The concern of businesses for the welfare of society as a whole; consists of obligations beyond those required by law or contracts.

14

Responsibilities to Stakeholders

  1. How do businesses meet their social responsibilities to various stakeholders?

What makes a company be admired or perceived as socially responsible? Such a company meets its obligations to its stakeholders. Stakeholders are the individuals or groups to whom a business has a responsibility. The stakeholders of a business are its employees, its customers, the general public, and its investors.

Responsibility to Employees

An organization’s first responsibility is to provide a job to employees. Keeping people employed and letting them have time to enjoy the fruits of their labor is the finest thing business can do for society. Beyond this fundamental responsibility, employers must provide a clean, safe working environment that is free from all forms of discrimination. Companies should also strive to provide job security whenever possible.

Enlightened firms are also empowering employees to make decisions on their own and suggest solutions to company problems. Empowerment contributes to an employee’s self-worth, which, in turn, increases productivity and reduces absenteeism.

Each year, in collaboration with Great Place to Work®, Fortune conducts an extensive employee survey of the best places to work in the United States. For 2017, the top companies included Google, Wegmans Food Markets, Edward Jones, Genentech, Salesforce, Acuity, and Quicken Loans. Some companies offer unusual benefits to their employees. For example, biotech company Genentech offers employee compensation for taking alternative methods of transportation to work at its South San Francisco campus. Employees can earn $12 per day for walking or biking to work, and those who drive a carpool or vanpool can earn $8 and $16, respectively. In addition, the company offers free commuter bus service for all employees via 27 routes around the Bay Area.

“The 100 Best Companies to Work For 2017,” Fortune, http://fortune.com, accessed June 23, 2017; “Genentech Perks and Programs,” http://reviews.greatplacetowork.com, accessed June 23, 2017.

Responsibility to Customers

To be successful in today’s business environment, a company must satisfy its customers. A firm must deliver what it promises, as well as be honest and forthright in everyday interactions with customers, suppliers, and others. Recent research suggests that many consumers, particularly millennials, prefer to do business with companies and brands that communicate socially responsible messages, utilize sustainable manufacturing processes, and practice ethical business standards.

Sarah Landrum, “Millennials Driving Brands to Practice Socially Responsible Marketing,” Forbes, http://www.forbes.com, March 17, 2017.

Responsibility to Society

A business must also be responsible to society. A business provides a community with jobs, goods, and services. It also pays taxes that go to support schools, hospitals, and better roads. Some companies have taken an additional step to demonstrate their commitment to stakeholders and society as a whole by becoming Certified Benefit Corporations, or B Corps for short. Verified by B Lab, a global nonprofit organization, B Corps meet the highest standards of social and environmental performance, public transparency, and legal accountability and strive to use the power of business to solve social and environmental problems via an impact assessment that rates each company on a possible score of 200 points. To become certified as a Benefit Corporation, companies need to reach a score of at least 80 and must be recertified every two years. There are more than 2,000 companies worldwide that have been certified as B Corps, including Method, W.S. Badger Company, Fishpeople Seafood, LEAP Organics, New Belgium Brewing Company, Ben & Jerry’s, Cabot Creamery Co-op, Comet Skateboards, Etsy, Patagonia, Plum Organics, and Warby Parker.

“Why B Corps Matter,” https://www.bcorporation.net, accessed June 27, 2017; Suntae Kim, Matthew J. Karlesky, Christopher G. Meyers, and Todd Schifeling, “Why Companies Are Becoming B Corporations,” Harvard Business Review, https://hbr.org, June 17, 2016.

Environmental Protection

Business is also responsible for protecting and improving the world’s fragile environment. The world’s forests are being destroyed fast. Every second, an area the size of a football field is laid bare. Plant and animal species are becoming extinct at the rate of 17 per hour. A continent-size hole is opening up in the earth’s protective ozone shield. Each year we throw out 80 percent more refuse than we did in 1960; as a result, more than half of the nation’s landfills are filled to capacity.

To slow the erosion of the world’s natural resources, many companies have become more environmentally responsible. For example, Toyota now uses renewable energy sources such as solar, wind, geothermal, and water power for electricity to run its facilities. When its new $1 billion North American headquarters opened in Plano, Texas, in May 2017, Toyota said the 2.1 million square-foot campus would eventually be powered by 100% clean energy, helping the auto giant move closer to its goal of eliminating carbon emissions in all of its operations.

Becky May, “Creating One Toyota,” American Builders Quarterly, http://americanbuildersquarterly.com, accessed June 23, 2017; Jessica Lyons Hardcastle, “Toyota Headquarters Will Use 100% Renewable Energy,” Environmental Leader, https://www.environmentalleader.com, June 10, 2016.

This Fish Story Has a Tasting Ending

Duncan Berry has always been an environmentalist at heart. Brought up on the Oregon coast, he was a sea captain at an early age, spending nearly two decades on the ocean before going on to become a successful entrepreneur in the organic cotton industry. After selling the textile business at the age of 50, he retired back to the Oregon coast to work on a state initiative to preserve marine habitats.

He quickly discovered that the state’s commercial fishing industry had gone into major disrepair since his seafaring adventure years earlier. Berry learned the majority of seafood consumed in the United States was being imported from other countries and more than 90 percent of U.S. seafood was being exported. In addition, great harm was being done to the ocean because it was being overfished.

Although several groups were already working to improve the commercial fishing industry, he observed that one key group was not part of the discussion: consumers. Berry decided a key component of change had to be involving consumers in the process. He spent more than a year meeting with everyone involved in the Oregon fishing industry—from fishermen to processors, distributors, truck drivers, chefs, and consumers—to gain perspective on why the industry was failing. His “aha” moment occurred when he realized the majority of fish is consumed in restaurants because consumers think preparing fish at home is too difficult and time-consuming. That’s when he co-founded Fishpeople Seafood.

Started in 2012, Fishpeople has a mission of changing the way people think about seafood by being transparent about where the seafood comes from, how it is processed, and how it is handled. Berry believes the company’s transparency helps consumers understand how the process translates into sustainable food that tastes good and is good for you. The company makes shelf-stable, ready-to-eat restaurant-quality seafood in the form of soups, meal kits, and fresh and frozen filets, complete with farm-to-table ingredients. On every package there is a code consumers can enter at the company’s website that will tell them everything about the seafood’s origin, down to the fisherman who caught it. Fishpeople also operates a processing plant in Toledo, Oregon, where workers are paid a livable wage and receive health insurance—benefits typically unheard of in the fishing industry.

Fishpeople’s products are available in more than 5,000 stores nationwide, including Walmart, Whole Foods, Costco, Kroger, and other grocery stores and markets. Recently the company announced a merger with Ilwaco Landing Fishermen, which will help further the two groups’ shared vision of supporting local fishermen and providing sustainable seafood to consumers.

Questions for Discussion
  1. How does Fishpeople’s transparency contribute to the company’s success?
  2. What responsibility, if any, does Fishpeople have to the local fishing industry?

Sources: Company website, https://fishpeopleseafood.com, accessed June 27, 2017; J. David Santen, Jr., “Adding Value to Oregon Seafood,” Built Oregon, http://builtoregon.com, accessed June 27, 2017; Elizabeth Crawford, “Fishpeople Wants to Fix the ‘Fundamentally Broken’ Seafood Industry with Increased Transparency,” Food Navigator, http://www.foodnavigator-usa.com, May 25, 2017; Fishpeople Seafood Announces Merger with Ilwaco Landing Fishermen,” Tillamook County Pioneer, https://www.tillamookcountypioneer.net, May 22, 2017; Leigh Buchanan, “Why This Entrepreneur Ditched Fashion for the ‘Hunting and Gathering’ Business,” Inc., https://www.inc.com, April 2017 issue; Kate Harrison, “This Former Green Textile Maven Is Making Microwaved Seafood Sustainable,” Forbes, http://www.forbes.com, August 25, 2015.

Corporate Philanthropy

Companies also display their social responsibility through corporate philanthropy. Corporate philanthropy includes cash contributions, donations of equipment and products, and support for the volunteer efforts of company employees. Recent statistics suggest U.S. corporate philanthropy exceeds more than $19 billion annually.

“Charitable Giving Statistics,” National Philanthropic Trust, https://www.nptrust.org, accessed June 23, 2017.

American Express is a major supporter of the American Red Cross. The organization relies almost entirely on charitable gifts to carry out its programs and services, which include disaster relief, armed-forces emergency relief, blood and tissue services, and health and safety services. The funds provided by American Express have enabled the Red Cross to deliver humanitarian relief to victims of numerous disasters around the world.

“American Express Company Corporate Social Responsibility: Philanthropy 2016,” http://about.americanexpress.com, accessed June 23, 2017.

When Hurricane Katrina hit the Gulf Coast, Bayer sent 45,000 diabetes blood glucose monitors to the relief effort. Within weeks of the disaster, Abbott, Alcoa, Dell, Disney, Intel, UPS, Walgreens, Walmart, and others contributed more than $550 million for disaster relief.

Ryan Scott, “How Hurricane Katrina Changed Corporate Social Responsibility Forever,” The Huffington Post, http://www.huffingtonpost.com, accessed June 23, 2017; Del Jones, “Corporate Giving for Katrina Reaches $547 Million,” USA Today, http://www.usatoday.com, September 12, 2005.

Hybrid cars and all-electric vehicles such as Tesla models are turning heads and changing the way the world drives. Electric vehicles are more eco-friendly, but they are also more expensive to own. Analysts project that after charging, insurance, and maintenance costs, electric cars cost thousands of dollars more than conventional vehicles. Do the environmental benefits associated with electric cars justify the higher cost of ownership? (Credit: Steve Jurvetson/ Flickr/ Attribution 2.0 Generic (CC BY 2.0))


A photograph shows a large crowd cheering on a line of Tesla cars driving down a red carpet path.

Responsibilities to Investors

Companies’ relationships with investors also entail social responsibility. Although a company’s economic responsibility to make a profit might seem to be its main obligation to its shareholders, some investors increasingly are putting more emphasis on other aspects of social responsibility.

Some investors are limiting their investments to securities (e.g., stocks and bonds) that coincide with their beliefs about ethical and social responsibility. This is called social investing. For example, a social investment fund might eliminate from consideration the securities of all companies that make tobacco products or liquor, manufacture weapons, or have a history of being environmentally irresponsible. Not all social investment strategies are alike. Some ethical mutual funds will not invest in government securities because they help to fund the military; others freely buy government securities, with managers noting that federal funds also support the arts and pay for AIDS research. Today, assets invested using socially responsible strategies total more than $7 trillion.

Nellie S. Huang, “7 Great Socially Responsible Mutual Funds,” Kiplinger’s Personal Finance, http://www.kiplinger.com, accessed June 23, 2017.

Perhaps partly as the result of the global recession of 2007–2009, over the last several years companies have tried to meet responsibilities to their investors as well as to their other stakeholders. Recent research suggests that now more than ever, CEOs are being held to higher standards by boards of directors, investors, governments, media, and even employees when it comes to corporate accountability and ethical behavior. A recent global study by PwC reveals that over the last several years, there has been a large increase in the number of CEOs being forced out due to some sort of ethical lapse in their organizations. Strategies to prevent such missteps should include establishing a culture of integrity to prevent anyone from breaking the rules, making sure company goals and metrics do not create undue pressure on employees to cut corners, and implementing effective processes and controls to minimize the opportunity for unethical behavior.

Per-Ola Karlsson, DeAnne Aquirre, and Kristin Rivera, “Are CEOs Less Ethical Than in the Past?” Strategy + Business, https://www.strategy-business.com, accessed June 27, 2017; Emily C. Bianchi and Aharon Mohliver, “CEOs Who Began Their Careers During Booms Tend to Be Less Ethical,” Harvard Business Review, https://hbr.org, May 12, 2017.

  1. How do businesses carry out their social responsibilities to consumers?
  2. What is corporate philanthropy?
  3. Is a company’s only responsibility to its investors to make a profit? Why or why not?

Summary of Learning Outcomes

  1. How do businesses meet their social responsibilities to various stakeholders?

Stakeholders are individuals or groups to whom business has a responsibility. Businesses are responsible to employees. They should provide a clean, safe working environment. Organizations can build employees’ self-worth through empowerment programs. Businesses also have a responsibility to customers to provide good, safe products and services. Organizations are responsible to the general public to be good corporate citizens. Firms must help protect the environment and provide a good place to work. Companies also engage in corporate philanthropy, which includes contributing cash, donating goods and services, and supporting volunteer efforts of employees. Finally, companies are responsible to investors. They should earn a reasonable profit for company owners.

Glossary

corporate philanthropy
The practice of charitable giving by corporations; includes contributing cash, donating equipment and products, and supporting the volunteer efforts of company employees.
social investing
The practice of limiting investments to securities of companies that behave in accordance with the investor’s beliefs about ethical and social responsibility to encourage businesses to be more socially responsible.
stakeholders
Individuals or groups to whom a business has a responsibility; include employees, customers, the general public, and investors.

III

Competing in the Global Marketplace

16

Introduction

(Credit: Xiquinho Silva /Flickr/ Attribution 2.0 Generic (CC BY 2.0))


A photograph shows a port city skyline, where the buildings all appear to be very new, and very sleek.

Learning Outcomes

After reading this chapter, you should be able to answer these questions:

  1. Why is global trade important to the United States, and how is it measured?
  2. Why do nations trade?
  3. What are the barriers to international trade?
  4. How do governments and institutions foster world trade?
  5. What are international economic communities?
  6. How do companies enter the global marketplace?
  7. What threats and opportunities exist in the global marketplace?
  8. What are the advantages of multinational corporations?
  9. What are the trends in the global marketplace?
Mike Schlater Domino’s Pizza

Domino’s Pizza has more than 14,000 stores worldwide. As executive vice president of Domino’s Pizza’s international division, Mike Schlater is president of Domino’s Canada with more than 440 stores. Originally from Ohio, Schlater started his career with Domino’s as a pizza delivery driver and worked his way up into management. Schlater saved his earnings, and with some help from his brother, he was able to accept the opportunity to have the first international Domino’s franchise in Winnipeg, Manitoba, in 1983. Within weeks, Schlater’s store in Canada reached higher sales than his previous store in Ohio had ever attained. However, it was not an easy start. Schlater had to identify the international suppliers and get them approved to sell their products to Domino’s. This shows one of the challenges that organizations face when entering new global markets. To meet quality standards designed to protect a brand, companies must undertake an extensive review of potential new suppliers to ensure consistent product quality. By 2007, Schlater and a partner unified all of the franchises under one corporate umbrella, and Schlater is now president of Domino’s of Canada, Ltd., which operates more than 440 stores located in every province, as well as the Yukon and Northwest Territories.

Domino’s store. (Credit: Mr. Blue Mau Mau/ Flickr/ Attribution 2.0 Generic (CC BY 2.0))


Such an impressive career path might seem like luck to some, but Schlater achieved his success due to determination and attention to detail. Luck did play a role in a recent event in his live, though. Schlater manages dough in his business but also came into “dough” by winning $250,000 in a lottery. Since Schlater believes in philanthropy, he donated the entire amount to Cardinal Carter High School in his hometown. Over the years, Schlater has donated millions of dollars to foundations and charities, such as The London Health Sciences Foundation, because he now has the ability to indulge after spending decades climbing the corporate ladder at Domino’s Pizza. A father of three, he moved to Essex County from Winnipeg after buying the Domino’s master franchise for Canada. He wanted to live close to the border because one of his daughters was in a private school in Ohio and another was headed to university there.

The master franchisees of Domino’s Pizza’s international business are individuals or entities who, under a specific licensing agreement with Domino’s, control all operations within a specific country. They operate their own stores, set up a distribution infrastructure to transport materials into and throughout the country, and create subfranchisees. One particular benefit of master franchisees is their local knowledge. As discussed in this chapter, a major challenge when opening a business on foreign soil is negotiating the political, cultural, and economic differences of that country. Master franchisees allow Domino’s, and the franchisee, to take advantage of their local expertise in dealing with marketing strategies, political and regulatory issues, and the local labor market. It takes local experience to know, for example, that only 30 percent of the people in Poland have phones, so carryout needs to be the focus of the business; that Turkey has changed its street names three times in the past 30 years, so delivery is much more challenging; or that, in Japanese, there is no word for pepperoni, the most popular topping worldwide. These are just a few of the challenges that Domino’s has had to overcome on the road to becoming the worldwide leader in the pizza delivery business. Under the leadership of people like Schlater, and with the help of dedicated, local master franchisees, Domino’s has been able to not only compete in but to lead the global pizza delivery market.

Sources: “Domino’s Pizza Corporate Facts,” http://phx.corporate-ir.net, accessed June 20, 2017; Domino’s Canada website, https://www.dominos.ca, accessed June 20, 2017; Trevor Wilhelm, “Domino’s CEO, who lives in Leamington, will donate $250K lotto winnings to high school,” Windsor Star, February 27, 2015.

This chapter examines the business world of the global marketplace. It focuses on the processes of taking a business global, such as licensing agreements and franchisees; the challenges that are encountered; and the regulatory systems governing the world market of the 21st century.

Today, global revolutions are under way in many areas of our lives: management, politics, communications, and technology. The word global has assumed a new meaning, referring to a boundless mobility and competition in social, business, and intellectual arenas. The purpose of this chapter is to explain how global trade is conducted. We also discuss the barriers to international trade and the organizations that foster global trade. The chapter concludes with trends in the global marketplace.

17

Global Trade in the United States

  1. Why is global trade important to the United States, and how is it measured?

No longer just an option, having a global vision has become a business imperative. Having a global vision means recognizing and reacting to international business opportunities, being aware of threats from foreign competitors in all markets, and effectively using international distribution networks to obtain raw materials and move finished products to the customer.

U.S. managers must develop a global vision if they are to recognize and react to international business opportunities, as well as remain competitive at home. Often a U.S. firm’s toughest domestic competition comes from foreign companies. Moreover, a global vision enables a manager to understand that customer and distribution networks operate worldwide, blurring geographic and political barriers and making them increasingly irrelevant to business decisions. Over the past three decades, world trade has climbed from $200 billion a year to more than $1.4 trillion.

International Trade Administration: US Department of Commerce Website, accessed August 1, 2017. http://tse.export.gov/tse/MapDisplay.aspx.

U.S. companies play a major role in this growth in world trade, with 113 of the Fortune 500 companies making over 50 percent of their profits outside the United States. Among these companies are recognizable names such as Apple, Microsoft, Pfizer, Exxon Mobil, and General Electric.

“In the Stock Market, International Is Actually First,” New York Times, May 21, 2017, Page BU6.

Starbucks Corp. is among the fastest growing global consumer brands and one of the most visible emblems of U.S. commercial culture overseas. Of Starbucks’s 24,000 total stores, almost 66 percent are international stores that contribute a substantial amount to the company’s revenues, which have grown from $4.1 billion in 2003 to $21.3 billion in 2016.

“Starbucks Coffee International,” https://www.starbucks.com, accessed June 20, 2017; Trefis Team, “How Starbucks Plans to Grow Its International Operations,” Forbes, https://www.forbes.com, January 18, 2016.

Go into a Paris McDonald’s and you may not recognize where you are. There are no Golden Arches or utilitarian chairs and tables and other plastic features. The restaurants have exposed brick walls, hardwood floors, and armchairs. Some French McDonald’s even have faux marble walls. Most restaurants have TVs with continuous music videos. You can even order an espresso, beer, and a chicken on focaccia bread sandwich. It’s not America.

Global business is not a one-way street, where only U.S. companies sell their wares and services throughout the world. Foreign competition in the domestic market used to be relatively rare but now occurs in almost every industry. In fact, U.S. makers of electronic goods, cameras, automobiles, fine china, tractors, leather goods, and a host of other consumer and industrial products have struggled to maintain their domestic market shares against foreign competitors. Toyota now has 14 percent of the U.S. auto market, followed by Honda at 9 percent and Nissan with 8 percent.

“Market Share by Manufacturer, October 2016 Data,” https://www.edmunds.com, accessed June 25, 2016.

Nevertheless, the global market has created vast new business opportunities for many U.S. firms.

The Importance of Global Business to the United States

Many countries depend more on international commerce than the United States does. For example, France, Great Britain, and Germany all derive more than 55 percent of their gross domestic product (GDP) from world trade, compared to about 28 percent for the United States.

“Trade (% of GDP),” http://data.worldbank.org, accessed June 26, 2017.

Nevertheless, the impact of international business on the U.S. economy is still impressive:

These statistics might seem to imply that practically every business in the United States is selling its wares throughout the world, but most is accounted for by big business. About 85 percent of all U.S. exports of manufactured goods are shipped by 250 companies. Yet, 98 percent of all exporters are small and medium-size firms.

“Small Business Key Players in International Trade,” https://www.sba.gov/sites/default/files/advocacy/Issue-Brief-11-Small-Biz-Key-Players-International-Trade.pdf, June 26, 2017.

The Impact of Terrorism on Global Trade

The terrorist attacks on America on September 11, 2001, and the Charlie Hebdo terrorist attacks in Paris in 2015 have changed the way the world conducts business. The immediate impacts of these events have included a short-term shrinkage of global trade. Globalization, however, will continue because the world’s major markets are too vitally integrated for globalization to stop. Nevertheless, terrorism has caused the growth to be slower and costlier.

“Globalization took hits in 2016; will 2017 lead to more?” http://www.denverpost.com/2017/01/01/globalization-2016-and-2017/, January 1, 2017.

Companies are paying more for insurance and to provide security for overseas staff and property. Heightened border inspections slow movements of cargo, forcing companies to stock more inventory. Tighter immigration policies curtail the liberal inflows of skilled and blue-collar workers that allowed companies to expand while keeping wages in check. The impact of terrorism may lessen over time, but multinational firms will always be on guard.

“How Venezuela Ruined Its Oil Industry”, https://www.forbes.com/sites/rrapier/2017/05/07/how-venezuela-ruined-its-oil-industry/#4a066087399d, May 7, 2017.

Measuring Trade between Nations

International trade improves relationships with friends and allies; helps ease tensions among nations; and—economically speaking—bolsters economies, raises people’s standard of living, provides jobs, and improves the quality of life. The value of international trade is over $16 trillion a year and growing. This section takes a look at some key measures of international trade: exports and imports, the balance of trade, the balance of payments, and exchange rates.

Exports and Imports

The developed nations (those with mature communication, financial, educational, and distribution systems) are the major players in international trade. They account for about 70 percent of the world’s exports and imports. Exports are goods and services made in one country and sold to others. Imports are goods and services that are bought from other countries. The United States is both the largest exporter and the largest importer in the world.

Each year the United States exports more food, animal feed, and beverages than the year before. A third of U.S. farm acreage is devoted to crops for export. The United States is also a major exporter of engineering products and other high-tech goods, such as computers and telecommunications equipment. For more than 60,000 U.S. companies (the majority of them small), international trade offers exciting and profitable opportunities. Among the largest U.S. exporters are Apple, General Motors Corp., Ford Motor Co., Procter & Gamble, and Cisco Systems.

Daniel Workman, “Top 10 Major Export Companies,” http://www.worldtopexports.com, accessed July 4, 2017.

Despite our impressive list of resources and great variety of products, imports to the United States are also growing. Some of these imports are raw materials that we lack, such as manganese, cobalt, and bauxite, which are used to make airplane parts, exotic metals, and military hardware. More modern factories and lower labor costs in other countries make it cheaper to import industrial supplies (such as steel) and production equipment than to produce them at home. Most of Americans’ favorite hot beverages—coffee, tea, and cocoa—are imported. Lower manufacturing costs have resulted in huge increases in imports from China.

Balance of Trade

The difference between the value of a country’s exports and the value of its imports during a specific time is the country’s balance of trade. A country that exports more than it imports is said to have a favorable balance of trade, called a trade surplus. A country that imports more than it exports is said to have an unfavorable balance of trade, or a trade deficit. When imports exceed exports, more money from trade flows out of the country than flows into it.

Although U.S. exports have been booming, we still import more than we export. We have had an unfavorable balance of trade throughout the 1990s, 2000s and 2010s. In 2016, our exports totaled $2.2 trillion, yet our imports were $2.7 trillion. Thus, in 2016 the United States had a trade deficit of $500 billion.

“U.S. Exports and Imports,” https://www.thebalance.com, accessed June 26, 2017.

America’s exports continue to grow, but not as fast as our imports: The export of goods, such as computers, trucks, and airplanes, is very strong. The sector that is lagging in significant growth is the export of services. Although America exports many services—ranging from airline trips to education of foreign students to legal advice—part of the problem is due to piracy, which leads companies to restrict the distribution of their services to certain regions. The FBI estimates that the theft of intellectual property from products, books and movies, and pharmaceuticals totals in the billions every year.

“What We Investigate: International Property Theft/Piracy,” https://www.fbi.gov, accessed June 26, 2017.

Balance of Payments

Another measure of international trade is called the balance of payments, which is a summary of a country’s international financial transactions showing the difference between the country’s total payments to and its total receipts from other countries. The balance of payments includes imports and exports (balance of trade), long-term investments in overseas plants and equipment, government loans to and from other countries, gifts and foreign aid, military expenditures made in other countries, and money transfers in and out of foreign banks.

From 1900 until 1970, the United States had a trade surplus, but in the other areas that make up the balance of payments, U.S. payments exceeded receipts, largely due to the large U.S. military presence abroad. Hence, almost every year since 1950, the United States has had an unfavorable balance of payments. And since 1970, both the balance of payments and the balance of trade have been unfavorable. What can a nation do to reduce an unfavorable balance of payments? It can foster exports, reduce its dependence on imports, decrease its military presence abroad, or reduce foreign investment. The U.S. balance of payments deficit was over $504 billion in 2016.

“International Economic Accounts,” https://www.bea.gov/International/index.htm, accessed July 17, 2017.

The Changing Value of Currencies

The exchange rate is the price of one country’s currency in terms of another country’s currency. If a country’s currency appreciates, less of that country’s currency is needed to buy another country’s currency. If a country’s currency depreciates, more of that currency will be needed to buy another country’s currency.

How do appreciation and depreciation affect the prices of a country’s goods? If, say, the U.S. dollar depreciates relative to the Japanese yen, U.S. residents have to pay more dollars to buy Japanese goods. To illustrate, suppose the dollar price of a yen is $0.012 and that a Toyota is priced at 2 million yen. At this exchange rate, a U.S. resident pays $24,000 for a Toyota ($0.012 × 2 million yen = $24,000). If the dollar depreciates to $0.018 to one yen, then the U.S. resident will have to pay $36,000 for a Toyota.

As the dollar depreciates, the prices of Japanese goods rise for U.S. residents, so they buy fewer Japanese goods—thus, U.S. imports decline. At the same time, as the dollar depreciates relative to the yen, the yen appreciates relative to the dollar. This means prices of U.S. goods fall for the Japanese, so they buy more U.S. goods—and U.S. exports rise.

Currency markets operate under a system called floating exchange rates. Prices of currencies “float” up and down based upon the demand for and supply of each currency. Global currency traders create the supply of and demand for a particular currency based on that currency’s investment, trade potential, and economic strength. If a country decides that its currency is not properly valued in international currency markets, the government may step in and adjust the currency’s value. In a devaluation, a nation lowers the value of its currency relative to other currencies. This makes that country’s exports cheaper and should, in turn, help the balance of payments.

In other cases, a country’s currency may be undervalued, giving its exports an unfair competitive advantage. Many people believe that China’s huge trade surplus with the United States is partially because China’s currency was undervalued. In 2017, the U.S. Department of Commerce issued a fact sheet detailing how it accused China of dumping steel on the U.S. market as well as providing financial assistance to Chinese companies to produce, manufacture, and export stainless steel to the United States from the People’s Republic of China.

“Fact Sheet: Commerce Finds Dumping and Countervailable Subsidies of Imports of Stainless Steel Sheet and Strip from the People’s Republic of China,” http://enforcement.trade.gov, accessed June 26, 2017.

  1. What is global vision, and why is it important?
  2. What impact does international trade have on the U.S. economy?
  3. Explain the impact of a currency devaluation.

Summary of Learning Outcomes

  1. Why is global trade important to the United States, and how is it measured?

International trade improves relations with friends and allies, eases tensions among nations, helps bolster economies, raises people’s standard of living, and improves the quality of life. The United States is still the largest importer and exporter in the world. We export a fifth of our industrial production and about a third of our farm crops.

Two concepts important to global trade are the balance of trade (the difference in value between a country’s exports and its imports over some period) and the balance of payments (the difference between a country’s total payments to other countries and its total receipts from other countries). The United States now has both a negative balance of trade and a negative balance of payments. Another important concept is the exchange rate, which is the price of one country’s currency in terms of another country’s currency. Currencies float up and down based upon the supply of and demand for each currency. Sometimes a government steps in and devalues its currency relative to the currencies of other countries.

Glossary

balance of payments
A summary of a country’s international financial transactions showing the difference between the country’s total payments to and its total receipts from other countries.
balance of trade
The difference between the value of a country’s exports and the value of its imports during a specific time.
devaluation
A lowering of the value of a nation’s currency relative to other currencies.
exports
Goods and services produced in one country and sold to other countries.
floating exchange rates
A system in which prices of currencies move up and down based upon the demand for and supply of the various currencies.
global vision
The ability to recognize and react to international business opportunities, be aware of threats from foreign competition, and effectively use international distribution networks to obtain raw materials and move finished products to customers.
imports
Goods and services that are bought from other countries.
trade deficit
An unfavorable balance of trade that occurs when a country imports more than it exports.
trade surplus
A favorable balance of trade that occurs when a country exports more than it imports.

18

Why Nations Trade

  1. Why do nations trade?

One might argue that the best way to protect workers and the domestic economy is to stop trade with other nations. Then the whole circular flow of inputs and outputs would stay within our borders. But if we decided to do that, how would we get resources like cobalt and coffee beans? The United States simply can’t produce some things, and it can’t manufacture some products, such as steel and most clothing, at the low costs we’re used to. The fact is that nations—like people—are good at producing different things: you may be better at balancing a ledger than repairing a car. In that case you benefit by “exporting” your bookkeeping services and “importing” the car repairs you need from a good mechanic. Economists refer to specialization like this as advantage.

Absolute Advantage

A country has an absolute advantage when it can produce and sell a product at a lower cost than any other country or when it is the only country that can provide a product. The United States, for example, has an absolute advantage in reusable spacecraft and other high-tech items.

Suppose that the United States has an absolute advantage in air traffic control systems for busy airports and that Brazil has an absolute advantage in coffee. The United States does not have the proper climate for growing coffee, and Brazil lacks the technology to develop air traffic control systems. Both countries would gain by exchanging air traffic control systems for coffee.

Comparative Advantage

Even if the United States had an absolute advantage in both coffee and air traffic control systems, it should still specialize and engage in trade. Why? The reason is the principle of comparative advantage, which says that each country should specialize in the products that it can produce most readily and cheaply and trade those products for goods that foreign countries can produce most readily and cheaply. This specialization ensures greater product availability and lower prices.

For example, India and Vietnam have a comparative advantage in producing clothing because of lower labor costs. Japan has long held a comparative advantage in consumer electronics because of technological expertise. The United States has an advantage in computer software, airplanes, some agricultural products, heavy machinery, and jet engines.

Thus, comparative advantage acts as a stimulus to trade. When nations allow their citizens to trade whatever goods and services they choose without government regulation, free trade exists. Free trade is the policy of permitting the people and businesses of a country to buy and sell where they please without restrictions. The opposite of free trade is protectionism, in which a nation protects its home industries from outside competition by establishing artificial barriers such as tariffs and quotas. In the next section, we’ll look at the various barriers, some natural and some created by governments, that restrict free trade.

The Fear of Trade and Globalization

The continued protests during meetings of the World Trade Organization and the protests during the convocations of the World Bank and the International Monetary Fund (the three organizations are discussed later in the chapter) show that many people fear world trade and globalization. What do they fear? The negatives of global trade are as follows:

  • Millions of Americans have lost jobs due to imports or production shifting abroad. Most find new jobs, but often those jobs pay less.
  • Millions of others fear losing their jobs, especially at those companies operating under competitive pressure.
  • Employers often threaten to export jobs if workers do not accept pay cuts.
  • Service and white-collar jobs are increasingly vulnerable to operations moving offshore.

Sending domestic jobs to another country is called outsourcing, a topic you can explore in more depth. Many U.S. companies, such as Dell, IBM, and AT&T, have set up call service centers in India, the Philippines, and other countries. Now even engineering and research and development jobs are being outsourced. Outsourcing and “American jobs” were a big part of the 2016 presidential election with Carrier’s plan to close a plant in Indianapolis and open a new plant in Mexico. While intervention by President Trump did lead to 800 jobs remaining in Indianapolis, Carrier informed the state of Indiana that it will cut 632 workers from its Indianapolis factory. The manufacturing jobs will move to Monterrey, Mexico, where the minimum wage is $3.90 per day.

Danielle Paquette, “Trump Said He Would Save Jobs at Carrier. The Layoffs Start July 20,” The Washington Post, https://www.washingtonpost.com, May 24, 2017.

Anti-globalization groups oppose America’s free-trade stance, arguing that corporate interests are hurting the U.S. economy and usurping the power of the American people. The recent protests at the G20 meetings in Hamburg, Germany, expressed anti-free-trade sentiment, supporting the idea that multinational corporations wield too much power. Are fears expressed by anti-globalization activists and nationalists justified? (Credit: fiction of reality/ Flickr/ Attribution 2.0 Generic (CC BY 2.0))


So is outsourcing good or bad? If you happen to lose your job, it’s obviously bad for you. However, some economists say it leads to cheaper goods and services for U.S. consumers because costs are lower. Also, it should stimulate exports to fast-growing countries. No one knows how many jobs will be lost to outsourcing in coming years. According to estimates, almost 2.4 million U.S. jobs were outsourced in 2015.

“Jobs Overseas Statistics,” http://www.statisticbrain.com, accessed June 26, 2017.

Benefits of Globalization

A closer look reveals that globalization has been the engine that creates jobs and wealth. Benefits of global trade include the following:

  • Productivity grows more quickly when countries produce goods and services in which they have a comparative advantage. Living standards can increase faster. One problem is that big G20 countries have added more than 1,200 restrictive export and import measures since 2008.
  • Global competition and cheap imports keep prices down, so inflation is less likely to stop economic growth. However, in some cases this is not working because countries manipulate their currency to get a price advantage.
  • An open economy spurs innovation with fresh ideas from abroad.
  • Through infusion of foreign capital and technology, global trade provides poor countries with the chance to develop economically by spreading prosperity.
  • More information is shared between two trading partners that may not have much in common initially, including insight into local cultures and customs, which may help the two nations expand their collective knowledge and learn ways to compete globally.
    Mike Collins, “The Pros and Cons of Globalization,” Forbes, https://www.forbes.com, May 6, 2015.

  1. Describe the policy of free trade and its relationship to comparative advantage.
  2. Why do people fear globalization?
  3. What are the benefits of globalization?

Summary of Learning Outcomes

  1. Why do nations trade?

Nations trade because they gain by doing so. The principle of comparative advantage states that each country should specialize in the goods it can produce most readily and cheaply and trade them for those that other countries can produce most readily and cheaply. The result is more goods at lower prices than if each country produced by itself everything it needed. Free trade allows trade among nations without government restrictions.

Glossary

absolute advantage
The situation when a country can produce and sell a product at a lower cost than any other country or when it is the only country that can provide the product.
free trade
The policy of permitting the people and businesses of a country to buy and sell where they please without restrictions.
G20
Informal group that brings together 19 countries and the European Union—the 20 leading economies in the world.
outsourcing
Sending work functions to another country, resulting in domestic workers losing their jobs.
principle of comparative advantage
The concept that each country should specialize in the products that it can produce most readily and cheaply and trade those products for those that other countries can produce more readily and cheaply.
protectionism
The policy of protecting home industries from outside competition by establishing artificial barriers such as tariffs and quotas.

19

Barriers to Trade

  1. What are the barriers to international trade?

International trade is carried out by both businesses and governments—as long as no one puts up trade barriers. In general, trade barriers keep firms from selling to one another in foreign markets. The major obstacles to international trade are natural barriers, tariff barriers, and nontariff barriers.

Natural Barriers

Natural barriers to trade can be either physical or cultural. For instance, even though raising beef in the relative warmth of Argentina may cost less than raising beef in the bitter cold of Siberia, the cost of shipping the beef from South America to Siberia might drive the price too high. Distance is thus one of the natural barriers to international trade.

Language is another natural trade barrier. People who can’t communicate effectively may not be able to negotiate trade agreements or may ship the wrong goods.

Tariff Barriers

A tariff is a tax imposed by a nation on imported goods. It may be a charge per unit, such as per barrel of oil or per new car; it may be a percentage of the value of the goods, such as 5 percent of a $500,000 shipment of shoes; or it may be a combination. No matter how it is assessed, any tariff makes imported goods more costly, so they are less able to compete with domestic products.

Protective tariffs make imported products less attractive to buyers than domestic products. The United States, for instance, has protective tariffs on imported poultry, textiles, sugar, and some types of steel and clothing, and in March of 2018 the Trump administration added tariffs on steel and aluminum from most countries. On the other side of the world, Japan imposes a tariff on U.S. cigarettes that makes them cost 60 percent more than Japanese brands. U.S. tobacco firms believe they could get as much as a third of the Japanese market if there were no tariffs on cigarettes. With tariffs, they have under 2 percent of the market.

Arguments for and against Tariffs

Congress has debated the issue of tariffs since 1789. The main arguments for tariffs include the following:

  • Tariffs protect infant industries. A tariff can give a struggling new domestic industry time to become an effective global competitor.
  • Tariffs protect U.S. jobs. Unions and others say tariffs keep foreign labor from taking away U.S. jobs.
  • Tariffs aid in military preparedness. Tariffs should protect industries and technology during peacetime that are vital to the military in the event of war.

The main arguments against tariffs include the following:

  • Tariffs discourage free trade, and free trade lets the principle of competitive advantage work most efficiently.
  • Tariffs raise prices, thereby decreasing consumers’ purchasing power. In 2017, the United States imposed tariffs of 63.86 percent to 190.71 percent on a wide variety of Chinese steel products. The idea was to give U.S. steel manufacturers a fair market after the Department of Commerce concluded their antidumping and anti-subsidy probes. It is still too early to determine what the effects of these tariffs will be, but higher steel prices are likely. Heavy users of steel, such as construction and automobile industries, will see big increases in their production costs. It is also likely that China may impose tariffs on certain U.S. products and services and that any negotiations on intellectual property and piracy will bog down.
    Wendy Wu, “China Upset at High U.S. Tariffs on Steel Imports,” South China Morning Post, http://www.scmp.com, February 4, 2017.

Nontariff Barriers

Governments also use other tools besides tariffs to restrict trade. One type of nontariff barrier is the import quota, or limits on the quantity of a certain good that can be imported. The goal of setting quotas is to limit imports to the specific amount of a given product. The United States protects its shrinking textile industry with quotas. A complete list of the commodities and products subject to import quotas is available on line at the U.S. Customs and Border Protection Agency website.

“Commodities Subject to Import Quotas,” https://www.cbp.gov, accessed June 25, 2017.

A complete ban against importing or exporting a product is an embargo. Often embargoes are set up for defense purposes. For instance, the United States does not allow various high-tech products, such as supercomputers and lasers, to be exported to countries that are not allies. Although this embargo costs U.S. firms billions of dollars each year in lost sales, it keeps enemies from using the latest technology in their military hardware.

Government rules that give special privileges to domestic manufacturers and retailers are called buy-national regulations. One such regulation in the United States bans the use of foreign steel in constructing U.S. highways. Many state governments have buy-national rules for supplies and services. In a more subtle move, a country may make it hard for foreign products to enter its markets by establishing customs regulations that are different from generally accepted international standards, such as requiring bottles to be quart size rather than liter size.

Exchange controls are laws that require a company earning foreign exchange (foreign currency) from its exports to sell the foreign exchange to a control agency, usually a central bank. For example, assume that Rolex, a Swiss company, sells 300 watches to Zales Jewelers, a U.S. chain, for US$600,000. If Switzerland had exchange controls, Rolex would have to sell its U.S. dollars to the Swiss central bank and would receive Swiss francs. If Rolex wants to buy goods (supplies to make watches) from abroad, it must go to the central bank and buy foreign exchange (currency). By controlling the amount of foreign exchange sold to companies, the government controls the amount of products that can be imported. Limiting imports and encouraging exports helps a government to create a favorable balance of trade.

  1. Discuss the concept of natural trade barriers.
  2. Describe several tariff and nontariff barriers to trade.

Summary of Learning Outcomes

  1. What are the barriers to international trade?

The three major barriers to international trade are natural barriers, such as distance and language; tariff barriers, or taxes on imported goods; and nontariff barriers. The nontariff barriers to trade include import quotas, embargoes, buy-national regulations, and exchange controls. The main argument against tariffs is that they discourage free trade and keep the principle of comparative advantage from working efficiently. The main argument for using tariffs is that they help protect domestic companies, industries, and workers.

Glossary

buy-national regulations
Government rules that give special privileges to domestic manufacturers and retailers.
embargo
A total ban on imports or exports of a product.
exchange controls
Laws that require a company earning foreign exchange (foreign currency) from its exports to sell the foreign exchange to a control agency, such as a central bank.
import quota
A limit on the quantity of a certain good that can be imported.
protective tariffs
Tariffs that are imposed in order to make imports less attractive to buyers than domestic products are.
tariff
A tax imposed on imported goods.

20

Fostering Global Trade

  1. How do governments and institutions foster world trade?

Antidumping Laws

U.S. firms don’t always get to compete on an equal basis with foreign firms in international trade. To level the playing field, Congress has passed antidumping laws. Dumping is the practice of charging a lower price for a product (perhaps below cost) in foreign markets than in the firm’s home market. The company might be trying to win foreign customers, or it might be seeking to get rid of surplus goods.

When the variation in price can’t be explained by differences in the cost of serving the two markets, dumping is suspected. Most industrialized countries have antidumping regulations. They are especially concerned about predatory dumping, the attempt to gain control of a foreign market by destroying competitors with impossibly low prices.

The United States recently imposed tariffs on softwood lumber from Canada. Canada was found guilty of pricing softwood lumber at between 7.72 and 4.49 percent below their costs. U.S. customs officers will now levy tariffs on Canadian timber exports with tax rates from 17.41 percent to 30.88 percent, depending on the business.

“Members and Observers,” https://www.wto.org, accessed June 25, 2017.

From our discussion so far, it might seem that governments act only to restrain global trade. On the contrary, governments and international financial organizations work hard to increase it, as this section explains.

Trade Negotiations and the World Trade Organization

The Uruguay Round of trade negotiations is an agreement that dramatically lowers trade barriers worldwide. Adopted in 1994, the agreement has been now signed by 148 nations. The most ambitious global trade agreement ever negotiated, the Uruguay Round reduced tariffs by one-third worldwide, a move that is expected to increase global income by $235 billion annually. Perhaps the most notable aspect of the agreement is its recognition of new global realities. For the first time, an agreement covers services, intellectual property rights, and trade-related investment measures such as exchange controls.

As a follow-up to the Uruguay Round, a negotiating round started in the capital of Qatar in 2001 is called the Doha Round. To date, the round has shown little progress in advancing free trade. Developing nations are pushing for the reduction of farm subsidies in the United States, Europe, and Japan. Poor countries say that the subsidies stimulate overproduction, which drives down global agricultural prices. Because developing nations’ primary exports are agricultural commodities, low prices mean that they cannot compete in the global marketplace. On the other hand, the United States and Europe are interested in bringing down trade barriers in services and manufacturing. The continuing talks have served as a lightning rod for protesters, who claim that the World Trade Organization (WTO) serves the interests of multinational corporations, promotes trade over preserving the environment, and treats poor nations unfairly.

https://www.wto.org/english/tratop_e/dda_e/dda_e.htm, accessed June 25, 2017.

The World Trade Organization replaces the old General Agreement on Tariffs and Trade (GATT), which was created in 1948. The GATT contained extensive loopholes that enabled countries to evade agreements to reduce trade barriers. Today, all WTO members must fully comply with all agreements under the Uruguay Round. The WTO also has an effective dispute settlement procedure with strict time limits to resolve disputes.

The WTO has emerged as the world’s most powerful institution for reducing trade barriers and opening markets. The advantage of WTO membership is that member countries lower trade barriers among themselves. Countries that don’t belong must negotiate trade agreements individually with all their trading partners. Only a few countries, such as North Korea, Turkmenistan, and Eritrea, are not members of the WTO.

“WTO Technical Notes,” https://www.wto.org/english/res_e/booksp_e/anrep_e/wtr10_tech_notes_e.pdf, accessed July 17, 2017.

Headquartered in Toulouse, France, Airbus is one of the world’s top commercial aircraft manufacturers, operating design and manufacturing facilities in Europe, Japan, China, and the United States. The airliner’s current product lineup of 12 jet-aircraft types ranging from 100 seats to 600 seats is heavy competition for Boeing, a top U.S. airline firm with which Airbus has ongoing subsidy-related disputes. What is the World Trade Organization’s role in settling disputes between competing multinational corporations? (Credit: Bartlomiej Mostek/ Flickr/ Attribution 2.0 Generic (CC BY 2.0))


A photograph shows a large, double decker airplane, with the word, Emirates, painted on the side. There is also Sanskrit painted on the side of the plane.

The United States has had mixed results in bringing disputes before the WTO. To date, it has won slightly fewer than half of the cases it has presented to the WTO. America has also won about one-third of the cases brought against it by other countries. One of America’s recent losses came in a ruling where the U.S. claimed that tuna imported from Mexico was not meeting the “dolphin safe” criteria, meaning that dolphins were not being killed during the process to catching tuna. The WTO ruled in favor of Mexico. Recently, the United States targeted Europe, India, South Korea, Canada, and Argentina to file cases against. The disputes ranged from European aviation practices to Indian trade barriers affecting U.S. automakers.

One of the biggest disputes before the WTO involved the United States and the European Union. The United States claims that Europe has given Airbus $15 billion in aid to develop airplanes. The European Union claims that the U.S. government has provided $23 billion in military research that has benefited Boeing’s commercial aircraft business. It also claimed that Washington State (the home of Boeing manufacturing) has given the company $3.2 billion in unfair tax breaks.

“EC and Certain Member States—Large Civil Aircraft,” https://www.wto.org, accessed June 25, 2017.

The World Bank and International Monetary Fund

Two international financial organizations are instrumental in fostering global trade. The World Bank offers low-interest loans to developing nations. Originally, the purpose of the loans was to help these nations build infrastructure such as roads, power plants, schools, drainage projects, and hospitals. Now the World Bank offers loans to help developing nations relieve their debt burdens. To receive the loans, countries must pledge to lower trade barriers and aid private enterprise. In addition to making loans, the World Bank is a major source of advice and information for developing nations. The United States has granted the organization millions to create knowledge databases on nutrition, birth control, software engineering, creating quality products, and basic accounting systems.

The International Monetary Fund (IMF) was founded in 1945, one year after the creation of the World Bank, to promote trade through financial cooperation and eliminate trade barriers in the process. The IMF makes short-term loans to member nations that are unable to meet their budgetary expenses. It operates as a lender of last resort for troubled nations. In exchange for these emergency loans, IMF lenders frequently extract significant commitments from the borrowing nations to address the problems that led to the crises. These steps may include curtailing imports or even devaluing the currency.

Some global financial problems do not have a simple solution. One option would be to pump a lot more funds into the IMF, giving it enough resources to bail out troubled countries and put them back on their feet. In effect, the IMF would be turned into a real lender of last resort for the world economy.

The danger of counting on the IMF, though, is the “moral hazard” problem. Investors would assume that the IMF would bail them out and would therefore be encouraged to take bigger and bigger risks in emerging markets, leading to the possibility of even deeper financial crises in the future.

  1. Describe the purpose and role of the WTO.
  2. What are the roles of the World Bank and the IMF in world trade?

Summary of Learning Outcomes

  1. How do governments and institutions foster world trade?

The World Trade Organization, established by the Uruguay Round of trade negotiations, has dramatically lowered trade barriers worldwide. For the first time, a trade agreement covers services, intellectual property rights, and exchange controls. The World Bank makes loans to developing nations to help build infrastructures. The International Monetary Fund makes loans to member nations that cannot meet their budgetary expenses. Despite efforts to expand trade, terrorism can have a negative impact on trade growth.

Glossary

dumping
The practice of charging a lower price for a product in foreign markets than in the firm’s home market.
International Monetary Fund (IMF)
An international organization, founded in 1945, that promotes trade, makes short-term loans to member nations, and acts as a lender of last resort for troubled nations.
Uruguay Round
A 1994 agreement originally signed by 117 nations to lower trade barriers worldwide.
World Bank
An international bank that offers low-interest loans, as well as advice and information, to developing nations.
World Trade Organization (WTO)
An organization established by the Uruguay Round in 1994 to oversee international trade, reduce trade barriers, and resolve disputes among member nations.

21

International Economic Communities

  1. What are international economic communities?

Nations that frequently trade with each other may decide to formalize their relationship. The governments meet and work out agreements for a common economic policy. The result is an economic community or, in other cases, a bilateral trade agreement (an agreement between two countries to lower trade barriers). For example, two nations may agree upon a preferential tariff, which gives advantages to one nation (or several nations) over others. When members of the British Commonwealth (countries that are former British territories) trade with Great Britain, they pay lower tariffs than do other nations. For example, Canada and Australia are former British territories but still members of the British Commonwealth. You will note that Queen Elizabeth still appears on Canadian currency and the Union Jack is still incorporated into the Australian flag. In other cases, nations may form free-trade associations. In a free-trade zone, few duties or rules restrict trade among the partners, but nations outside the zone must pay the tariffs set by the individual members.

North American Free Trade Agreement (NAFTA)

The North American Free Trade Agreement (NAFTA) created the world’s largest free-trade zone. The agreement was ratified by the U.S. Congress in 1993. It includes Canada, the United States, and Mexico, with a combined population of 450 million and an economy of over $20.8 trillion.

“Facts about NAFTA: Statistics and Accomplishments,” https://www.thebalance.com/facts-about-nafta-statistics-and-accomplishments-3306280, July 7, 2017.

Canada, one of the largest U.S. trading partners, entered a free-trade agreement with the United States in 1988. Thus, most of the new long-run opportunities opened for U.S. business under NAFTA are in Mexico, America’s third-largest trading partner. Before NAFTA, tariffs on Mexican exports to the United States averaged just 4 percent, and most goods entered the United States duty-free, so NAFTA’s primary impact was to open the Mexican market to U.S. companies. When the treaty went into effect, tariffs on about half the items traded across the Rio Grande disappeared. Since NAFTA came into effect, U.S.-Mexican trade has increased from $80 billion to $515 billion annually. The pact removed a web of Mexican licensing requirements, quotas, and tariffs that limited transactions in U.S. goods and services. For instance, the pact allows U.S. and Canadian financial-services companies to own subsidiaries in Mexico for the first time in 50 years.

The softwood lumber dispute between the United States and Canada that has resulted in the U.S. imposing tariffs on Canadian softwood lumber imports is one of the longest trade disputes between the two nations. The dispute is the result of disagreements about Canadian lumber production and imports between the two nations. The main contention in the softwood lumber dispute is the U.S. claim that the Canadian government is unfairly subsidizing Canadian lumber production by providing access to public land while U.S. producers harvest softwood lumber on their own property. Why do anti-free-trade groups support these tariffs when the result will be higher prices for softwood lumber? (Credit: Jesse Wagstaff/ Flickr/ Attribution-NoDerivs 2.0 Generic (CC BY 2.0))


The real test of NAFTA will be whether it can deliver rising prosperity on both sides of the Rio Grande. For Mexicans, NAFTA must provide rising wages, better benefits, and an expanding middle class with enough purchasing power to keep buying goods from the United States and Canada. That scenario seems to be working. At the Delphi Corp. auto parts plant in Ciudad Juárez, just across the border from El Paso, Texas, the assembly line is a cross section of working-class Mexico. In the years since NAFTA lowered trade and investment barriers, Delphi has significantly expanded its presence in the country. Today it employs 70,000 Mexicans, who every day receive up to 70 million U.S.-made components to assemble into parts. The wages are modest by U.S. standards—an assembly-line worker with two years’ experience earns about $2.30 an hour. But that’s triple Mexico’s minimum wage, and Delphi jobs are among the most coveted in Juárez. The United States recently notified the Canadian and Mexican governments that it intends to renegotiate aspects of the NAFTA agreement.

“Mexico Nominal Hourly Wages in Manufacturing,” https://tradingeconomics.com, accessed June 25, 2017; Julie Hirschfeld Davis, “Trump Sends NAFTA Renegotiation Notice to Congress,” The New York Times, http://www.nytimes.com, May 18, 2017; Kate Linthicum, “What Happened When Factory Jobs Moved from Warren, Ohio, to Juarez, Mexico,” Los Angeles Times, http://www.latimes.com, February 17, 2017.

The largest new trade agreement is Mercosur, which includes Peru, Brazil, Argentina, Uruguay, and Paraguay. The elimination of most tariffs among the trading partners has resulted in trade revenues that currently exceed $16 billion annually. Recent recessions in Mercosur countries have limited economic growth, even though trade among Mercosur countries has continued to grow.

Central America Free Trade Agreement

The newest free trade agreement is the Central America Free Trade Agreement (CAFTA) passed in 2005. Besides the United States, the agreement includes Costa Rica, the Dominican Republic, El Salvador, Guatemala, Honduras, and Nicaragua. The United States is already the principal exporter to these nations, so economists don’t think that it will result in a major increase in U.S. exports. It will, however, reduce tariffs on exports to CAFTA countries. Already, some 80 percent of the goods imported into the United States from CAFTA nations are tariff-free. CAFTA countries may benefit from the new permanent trade deal if U.S. multinational firms deepen their investment in the region.

The European Union

In 1993, the member countries of the European Community (EC) ratified the Maastricht Treaty, which proposed to take the EC further toward economic, monetary, and political union. Although the heart of the treaty deals with developing a unified European Market, Maastricht was also intended to increase integration among European Union (EU) members.

The EU has helped increase this integration by creating a borderless economy for the 28 European nations, shown on the map in (Figure).

https://ec.europa.eu/info/policies/eu-enlargement_en#bootstrap-fieldgroup-nav-item–details–2, June 25, 2017.

EU28 Member States: Candidate Countries:
  • Austria
  • Belgium
  • Bulgaria
  • Croatia
  • Cyprus
  • Czech Republic
  • Denmark
  • Estonia
  • Finland
  • France
  • Germany
  • Greece
  • Hungary
  • Ireland
  • Italy
  • Latvia
  • Lithuania
  • Luxembourg
  • Malta
  • The Netherlands
  • Poland
  • Portugal
  • Romania
  • Slovakia
  • Slovenia
  • Spain
  • Sweden
  • United Kingdom
  • Albania
  • Former Yugoslav Republic of Macedonia
  • Montenegro
  • Serbia
  • Turkey

European Union member states have set up common institutions to which they delegate some of their sovereignty so that decisions on specific matters of joint interest can be made democratically at the European level. This pooling of sovereignty is also called European integration. In 2016, citizens of the United Kingdom voted to leave the European Union, a plan known as Brexit, which could take several years to occur.

“Brexit: All You Need to Know About the UK Leaving the EU,” BBC, ( June 26, 2017), http://www.bbc.com/news/uk-politics-32810887, June 26, 2017.

The European Union
Source: Adapted from https://europa.eu/european-union/about-eu/countries/member-countries_en.


A map of Europe is color coded to show the E U 28 Member States, and those that are candidate countries.

One of the principal objectives of the European Union is to promote economic progress of all member countries. The EU has stimulated economic progress by eliminating trade barriers, differences in tax laws, and differences in product standards, and by establishing a common currency. A new European Community Bank was created, along with a common currency called the euro. The European Union’s single market has created 2.5 million new jobs since it was founded and generated more than $1 trillion in new wealth.

“Is Europe Outperforming the US?” World Economic Forum, https://www.weforum.org/agenda/2015/10/is-europe-outperforming-the-us/, October 30, 2015.

The opening of national EU markets has brought down the price of national telephone calls by 50 percent since 1998. Under pressure of competition, the prices of airfares in Europe have fallen significantly. The removal of national restrictions has enabled more than 15 million Europeans to go to another EU country to work or spend their retirement.

The EU is a very tough antitrust enforcer; some would say it is tougher than the United States. The EU, for example, fined Google $2.7 billion for favoring some of its own services in its search results.

Mark Scott, “Google Fined $2.7 Billion in E.U. Antitrust Case,” The New York Times, http://www.nytimes.com, June 26, 2017.

Unlike in the United States, the EU can seal off corporate offices for unspecified periods to prevent destruction of evidence and enter the homes, cars, yachts, and other personal property of executives suspected of abusing their companies’ market power or conspiring to fix prices.

Microsoft has been fighting the European Court since 2002, with no quick end in sight. The Court fined Microsoft for monopolizing internet access by offering Internet Explorer with its Windows software. The company is also appealing a Court decision requiring it to share code with “open source” companies. Another big U.S. company, Coca-Cola, settled a six-year antitrust dispute with the European Court by agreeing to strict limits on its sales tactics. Coke can’t sign exclusive agreements with retailers that would ban competing soft drinks or give retailers rebates based on sales volume. Furthermore, it must give rivals, like Pepsi, 20 percent of the space in Coke coolers so Pepsi can stock its own brands. If Coke violates the terms of the agreement, it will be fined 10 percent of its worldwide revenue (over $2 billion).

“EU Makes Coke Throw Open Fridges,” BBC, http://news.bbc.co.uk, June 22, 2005.

An entirely different type of problem facing global businesses is the possibility of a protectionist movement by the EU against outsiders. For example, European automakers have proposed holding Japanese imports at roughly their current 10 percent market share. The Irish, Danes, and Dutch don’t make cars and have unrestricted home markets; they are unhappy at the prospect of limited imports of Toyotas and Hondas. Meanwhile, France has a strict quota on Japanese cars to protect its own Renault and Peugeot. These local automakers could be hurt if the quota is raised at all.

Interestingly, a number of big U.S. companies are already considered more “European” than many European companies. Coke and Kellogg’s are considered classic European brand names. Ford and General Motors compete for the largest share of auto sales on the continent. Apple, IBM, and Dell dominate their markets. General Electric, AT&T, and Westinghouse are already strong all over Europe and have invested heavily in new manufacturing facilities there.

The European Union proposed a constitution that would centralize powers at the Union level and decrease the powers of individual member countries. It also would create a single voice in world affairs by creating a post of foreign minister. The constitution also gave the EU control over political asylum, immigration, guaranteed freedom of speech, and collective labor bargaining. In order to become law, each EU country had to ratify the constitution. The two most powerful countries in the EU, France and Germany, voted “no” in the summer of 2005. Citizens of both countries were afraid that the constitution would draw jobs away from Western Europe and to the Eastern European EU countries. These new members of the EU have lower wage rates and fewer regulations. Voters were also worried that the constitution would result in free-market reforms along American or British lines over France and Germany’s traditional social protections. Concerns over immigration also sparked the referendum vote that is leading to the United Kingdom leaving the European Union.

  1. Explain the pros and cons of NAFTA.
  2. What is the European Union? Will it ever be a United States of Europe?

Summary of Learning Outcomes

  1. What are international economic communities?

International economic communities reduce trade barriers among themselves while often establishing common tariffs and other trade barriers toward nonmember countries. The best-known economic communities are the European Union, NAFTA, CAFTA, and Mercosur.

Glossary

European integration
The delegation of limited sovereignty by European Union member states to the EU so that common laws and policies can be created at the European level.
European Union
Trade agreement among 28 European nations.
free-trade zone
An area where the nations allow free, or almost free, trade among each other while imposing tariffs on goods of nations outside the zone.
Mercosur
Trade agreement between Peru, Brazil, Argentina, Uruguay, and Paraguay.
North American Free Trade Agreement (NAFTA)
A 1993 agreement creating a free-trade zone including Canada, Mexico, and the United States.
preferential tariff
A tariff that is lower for some nations than for others.

22

Participating in the Global Marketplace

  1. How do companies enter the global marketplace?

Companies decide to “go global” for a number of reasons. Perhaps the most urgent reason is to earn additional profits. If a firm has a unique product or technological advantage not available to other international competitors, this advantage should result in major business successes abroad. In other situations, management may have exclusive market information about foreign customers, marketplaces, or market situations. In this case, although exclusivity can provide an initial motivation for going global, managers must realize that competitors will eventually catch up. Finally, saturated domestic markets, excess capacity, and potential for cost savings can also be motivators to expand into international markets. A company can enter global trade in several ways, as this section describes.

Exporting

When a company decides to enter the global market, usually the least complicated and least risky alternative is exporting, or selling domestically produced products to buyers in another country. A company, for example, can sell directly to foreign importers or buyers. Exporting is not limited to huge corporations such as General Motors or Apple. Indeed, small companies typically enter the global marketplace by exporting. China is the world’s largest exporter, followed by the United States.

https://www.cia.gov/library/publications/the-world-factbook/rankorder/2078rank.html, accessed June 25, 2017.

Many small businesses claim that they lack the money, time, or knowledge of foreign markets that exporting requires. The U.S. Small Business Administration (SBA) now offers the Export Working Capital Program, which helps small and medium-size firms obtain working capital (money) to complete export sales. The SBA also provides counseling and legal assistance for small businesses that wish to enter the global marketplace. Companies such as American Building Restoration Products of Franklin, Wisconsin, have benefited tremendously from becoming exporters. American Building is now selling its chemical products to building restoration companies in Mexico, Israel, Japan, and Korea. Exports account for more than 5 percent of the firm’s total sales.

Plenty of governmental help is available when a company decides to begin exporting. Export Assistance Centers (EAC) provide a one-stop resource for help in exporting. Over 700 EACs are placed strategically around the country. Often the SBA is located in the same building as the EAC. The SBA can guarantee loans of $50,000 to $100,000 to help an exporter grow its business. Online help is also available at http://www.ustr.gov. The site lists international trade events, offers international marketing research, and has practical tools to help with every step of the exporting process. Companies considering exporting for the first time can go to http://www.export.gov and get answers to questions such as: What’s in it for me? Am I ready for this? What do I have to do? The site also provides a huge list of resources for the first-time exporter.

Licensing and Franchising

Another effective way for a firm to move into the global arena with relatively little risk is to sell a license to manufacture its product to a firm in a foreign country. Licensing is the legal process whereby a firm (the licensor) agrees to let another firm (the licensee) use a manufacturing process, trademark, patent, trade secret, or other proprietary knowledge. The licensee, in turn, agrees to pay the licensor a royalty or fee agreed on by both parties.

International licensing is a multibillion-dollar-a-year industry. Entertainment and character licensing, such as DVD movies and characters such as Batman, is the largest single category. Trademarks are the second-largest source of licensing revenue. Caterpillar licenses its brand for both shoes and clothing, which is very popular in Europe.

U.S. companies have eagerly embraced the licensing concept. For instance, Labatt Brewing Company has a license to produce Miller High Life in Canada. The Spalding Company receives more than $2 million annually from license agreements on its sporting goods. Fruit of the Loom lends its name through licensing to 45 consumer items in Japan alone, for at least 1 percent of the licensee’s gross sales.

The licensor must make sure it can exercise sufficient control over the licensee’s activities to ensure proper quality, pricing, distribution, and so on. Licensing may also create a new competitor in the long run if the licensee decides to void the license agreement. International law is often ineffective in stopping such actions. Two common ways that a licensor can maintain effective control over its licensees are by shipping one or more critical components from the United States and by locally registering patents and trademarks in its own name.

Franchising is a form of licensing that has grown rapidly in recent years. Many U.S. franchisors operate thousands of outlets in foreign countries. More than half of the international franchises are for fast-food restaurants and business services. McDonald’s, however, decided to sell its Chinese stores to a group of outside investors for $1.8 billion, but retained 20 percent of the equity.

“McDonald’s Sells Control of China Business to Citic, Carlyle,” Bloomberg News, https://www.bloomberg.com/news/articles/2017-01-09/mcdonald-s-sells-control-of-china-business-to-citic-carlyle, January 9, 2017.

Having a big-name franchise doesn’t always guarantee success or mean that the job will be easy. In China, Home Depot closed its stores after opening 12 to serve the large Chinese population. Had they done market research, they would have known that the majority of urban dwellers live in recently built apartments and that DIY (Do It Yourself) is viewed with disdain in Chinese society, where it is seen as a sign of poverty.

“Famous Failures in China,” http://www.1421.consulting, February 2, 2016.

When Subway opened its first sandwich shop in China, locals stood outside and watched for a few days. Patrons were so confused that the franchisee had to print signs explaining how to order. Customers didn’t believe the tuna salad was made from a fish because they couldn’t see the head or tail. And they didn’t like the idea of touching their food, so they would hold the sandwich vertically, peel off the paper wrap, and eat it like a banana. Most of all, the Chinese customers didn’t want sandwiches.

It’s not unusual for Western food chains to adapt their strategies when selling in China. McDonald’s, aware that the Chinese consume more chicken than beef, offered a spicy chicken burger. KFC got rid of coleslaw in favor of seasonal dishes such as shredded carrots or bamboo shoots.

Contract Manufacturing

In contract manufacturing, a foreign firm manufactures private-label goods under a domestic firm’s brand. Marketing may be handled by either the domestic company or the foreign manufacturer. Levi Strauss, for instance, entered into an agreement with the French fashion house of Cacharel to produce a new Levi’s line, Something New, for distribution in Germany.

The advantage of contract manufacturing is that it lets a company test the water in a foreign country. By allowing the foreign firm to produce a certain volume of products to specification and put the domestic firm’s brand name on the goods, the domestic firm can broaden its global marketing base without investing in overseas plants and equipment. After establishing a solid base, the domestic firm may switch to a joint venture or direct investment, explained below.

Joint Ventures

Joint ventures are somewhat similar to licensing agreements. In a joint venture, the domestic firm buys part of a foreign company or joins with a foreign company to create a new entity. A joint venture is a quick and relatively inexpensive way to enter the global market. It can also be very risky. Many joint ventures fail. Others fall victim to a takeover, in which one partner buys out the other.

Sometimes countries have required local partners in order to establish a business in their country. China, for example, had this requirement in a number of industries until recently. Thus, a joint venture was the only way to enter the market. Joint ventures help reduce risks by sharing costs and technology. Often joint ventures will bring together different strengths from each member. In the General MotorsSuzuki joint venture in Canada, for example, both parties have contributed and gained. The alliance, CAMI Automotive, was formed to manufacture low-end cars for the U.S. market. The plant, which was run by Suzuki management, produces the Chevrolet Equinox and the Pontiac Torrent, as well as the new Suzuki SUV. Through CAMI, Suzuki has gained access to GM’s dealer network and an expanded market for parts and components. GM avoided the cost of developing low-end cars and obtained models it needed to revitalize the lower end of its product line and its average fuel economy rating. After the successful joint venture, General Motors gained full control of the operation in 2011. The CAMI factory may be one of the most productive plants in North America. There GM has learned how Japanese automakers use work teams, run flexible assembly lines, and manage quality control.

General Motors website, http://www.gmcamiassembly.ca/Facilities/public/ca/en/CAMI/about_us.html, accessed July 17, 2017.

Direct Foreign Investment

Active ownership of a foreign company or of overseas manufacturing or marketing facilities is direct foreign investment. Direct investors have either a controlling interest or a large minority interest in the firm. Thus, they stand to receive the greatest potential reward but also face the greatest potential risk. A firm may make a direct foreign investment by acquiring an interest in an existing company or by building new facilities. It might do so because it has trouble transferring some resources to a foreign operation or obtaining that resource locally. One important resource is personnel, especially managers. If the local labor market is tight, the firm may buy an entire foreign firm and retain all its employees instead of paying higher salaries than competitors.

Sometimes firms make direct investments because they can find no suitable local partners. Also, direct investments avoid the communication problems and conflicts of interest that can arise with joint ventures. IBM, in the past, insisted on total ownership of its foreign investments because it did not want to share control with local partners.

General Motors has done very well by building a $4,400 (RMB 29,800) minivan in China that gets 43 miles per gallon in city driving. The Wuling Sunshine has a quarter the horsepower of U.S. minivans, weak acceleration, and a top speed of 81 miles per hour. The seats are only a third of the thickness of seats in Western models, but look plush compared to similar Chinese cars. The minivans have made GM the largest automotive seller in China, and have made China a large profit center for GM.

Wuling Sunshine, http://media.gm.com/media/cn/en/wuling/vehicles/sunshine/2010.html, accessed June 27, 2017.

Walmart now has over 6,000 stores located outside the United States. In 2016, international sales were over $116 billion. About one-third of all new Walmart stores are opened in global markets.

“Walmart 2017 Annual Report,” http://stock.walmart.com, accessed June 27, 2017.

Not all of Walmart’s global investments have been successful. In Germany, Walmart bought the 21-store Wertkauf hypermarket chain and then 74 unprofitable and often decrepit Interspar stores. Problems in integrating and upgrading the stores resulted in at least $200 million in losses. Like all other German stores, Walmart stores were required by law to close at 8 p.m. on weekdays and 4 p.m. on Saturdays, and they could not open at all on Sundays. Costs were astronomical. As a result, Walmart left the German retail market.

Walmart has turned the corner on its international operations. It is pushing operational authority down to country managers in order to respond better to local cultures. Walmart enforces certain core principles such as everyday low prices, but country managers handle their own buying, logistics, building design, and other operational decisions.

Global firms change their strategies as local market conditions evolve. For example, major oil companies like Shell Oil and ExxonMobil had to react to dramatic changes in the price of oil due to technological advances such as more efficient automobiles, fracking, and horizontal drilling.

Managing the Drop in Oil Prices

In 2014, crude oil was $90 a barrel, but increased production due to the shale oil boom and the reluctance of OPEC countries to reduce output led to a price drop to $45–$60 throughout the first quarter of 2015. While this is terrific news for consumers, it does provide challenges to managers at both large and small companies connected to the oil industry. Companies such as Chevron, Royal Dutch Shell, and ExxonMobil saw dramatic reductions in their earnings, which were also reflected in lower stock prices.

The action taken by senior executives at Chevron was to trim their planned capital expenditures by $5 billion in 2016, resulting in the elimination of 1,500 jobs, while ExxonMobil executives Jeff Woodbury and CEO Rex Tillerson (now the former U.S. Secretary of State) were less specific; they planned several belt-tightening strategies and forecast several years of low oil prices. Likewise, Ben van Beurden, the CEO of Royal Dutch Shell, announced plans to eliminate 6,500 jobs and also predicted long-range low prices for oil.

In addition to layoffs, actions that oil company managers can employ include mergers for companies that don’t have the ability to become fully efficient themselves. They can merge with other companies that can improve overall efficiencies and operations. Contrary to the cost-cutting plans mentioned earlier, some companies might consider increasing their spending plans. Going against the reduced expenditures trend is Encana, a North American oil producer, which plans to increase its overall spending. Some of the factors that allowed Encana to increase spending was its low debt-to-equity ratio and its growth, which exceeded the industry average.

Growth is an important component of a company’s strategy, and reactive short-term strategies can often hurt long-term growth. By implementing performance-improvement programs, companies can address problems and inefficiencies within the company and allow them to focus on innovation. Another strategy that companies can use is to review and alter their supply chain by focusing on costs and efficiency. Companies can expand their supplier base, thus increasing competition and reducing costs. This also requires companies to embrace a lean manufacturing mindset.

New technology can also be used as a cost driver. New technologies such as microseismic sensors used to monitor fracking operations in drilling operations miles under the earth can boost production. Adopting new technology can also lead to changes in the workers that companies employ. New technology usually requires higher-skilled workers, while reducing the number of lower-skilled workers.

The drop in oil prices has produced a survival-of-the-fittest competition among energy companies. The companies that employ multiple strategies to improve efficiency are the ones that will survive and prosper.

Critical Thinking Questions
  1. Do you think that Royal Dutch Shell and ExxonMobil would have been more successful if they had considered strategies other than cutting spending and eliminating jobs? Why or why not?
  2. How should oil companies react if oil prices rise to the $90 to $100 per barrel level? Explain your reasoning.

Sources: Stanley Reed and Clifford Krauss, “Royal Dutch Shell Profits Continue to Fall, Prompting Layoffs,” The New York Times, http://www.nytimes.com, July 30, 2015; John Biers, “More Belt-tightening Ahead as Exxon, Chevron Profits Dive,” Yahoo! News, https://www.yahoo.com, July 31, 2015; Aisha Tejani, “How Oil Companies Are Responding to the Oil Price Drop,” http://www.castagra.com, accessed June 30, 2017.

Countertrade

International trade does not always involve cash. Today, countertrade is a fast-growing way to conduct international business. In countertrade, part or all of the payment for goods or services is in the form of other goods or services. Countertrade is a form of barter (swapping goods for goods), an age-old practice whose origins have been traced back to cave dwellers. The U.S. Commerce Department says that roughly 30 percent of all international trade involves countertrade. Each year, about 300,000 U.S. firms engage in some form of countertrade. U.S. companies, including General Electric, Pepsi, General Motors, and Boeing, barter billions of goods and services every year. Recently, the Malaysian government bought 20 diesel-powered locomotives from China and paid for them with palm oil.

  1. Discuss several ways that a company can enter international trade.
  2. Explain the concept of countertrade.

Summary of Learning Outcomes

  1. How do companies enter the global marketplace?

There are a number of ways to enter the global market. The major ones are exporting, licensing, contract manufacturing, joint ventures, and direct investment.

Glossary

contract manufacturing
The practice in which a foreign firm manufactures private-label goods under a domestic firm’s brand name.
countertrade
A form of international trade in which part or all of the payment for goods or services is in the form of other goods and services.
direct foreign investment
Active ownership of a foreign company or of manufacturing or marketing facilities in a foreign country.
exporting
The practice of selling domestically produced goods to buyers in another country.
joint venture
An agreement in which a domestic firm buys part of a foreign firm or joins with a foreign firm to create a new entity.
licensing
The legal process whereby a firm agrees to allow another firm to use a manufacturing process, trademark, patent, trade secret, or other proprietary knowledge in exchange for the payment of a royalty.

23

Threats and Opportunities in the Global Marketplace

  1. What threats and opportunities exist in the global marketplace?

To be successful in a foreign market, companies must fully understand the foreign environment in which they plan to operate. Politics, cultural differences, and the economic environment can represent both opportunities and pitfalls in the global marketplace.

Political Considerations

We have already discussed how tariffs, exchange controls, and other governmental actions threaten foreign producers. The political structure of a country may also jeopardize a foreign producer’s success in international trade.

Intense nationalism, for example, can lead to difficulties. Nationalism is the sense of national consciousness that boosts the culture and interests of one country over those of all other countries. Strongly nationalistic countries, such as Iran and New Guinea, often discourage investment by foreign companies. In other, less radical forms of nationalism, the government may take actions to hinder foreign operations. France, for example, requires pop music stations to play at least 40 percent of their songs in French. This law was enacted because the French love American rock and roll. Without airtime, American music sales suffer. In another example of nationalism, U.S.-based PPG made an unsolicited bid to acquire Netherlands-based AzkoNobel NV. There was a chorus of opposition from Dutch politicians to the idea of a foreign takeover of AzkoNobel, the Dutch paint manufacturer. The government warned that it would move to defend AzkoNobel from a hostile takeover attempt. AzkoNobel played up the sentiment, tweeting about its rejection of the hostile takeover with the hashtag #DutchPride.

Ellen Proper, “Dutch See Red Over Foreign Bid For Paint Giant,” Bloomberg News, https://www.bloomberg.com, March 10, 2017.

In a hostile climate, a government may expropriate a foreign company’s assets, taking ownership and compensating the former owners. Even worse is confiscation, when the owner receives no compensation. This happened during rebellions in several African nations during the 1990s and 2000s.

Cultural Differences

Central to any society is the common set of values shared by its citizens that determine what is socially acceptable. Culture underlies the family, educational system, religion, and social class system. The network of social organizations generates overlapping roles and status positions. These values and roles have a tremendous effect on people’s preferences and thus on marketers’ options. For example, in China Walmart holds live fishing contests on the premises, and in South Korea the company hosts a food competition with variations on a popular Korean dish, kimchee.

Language is another important aspect of culture. Marketers must take care in selecting product names and translating slogans and promotional messages so as not to convey the wrong meaning. For example, Mitsubishi Motors had to rename its Pajero model in Spanish-speaking countries because the term refers to a sexual activity. Toyota Motor’s MR2 model dropped the 2 in France because the combination sounds like a French swear word. The literal translation of Coca-Cola in Chinese characters means “bite the wax tadpole.”

Each country has its own customs and traditions that determine business practices and influence negotiations with foreign customers. For example, attempting to do business in Western Europe during the first two weeks in August is virtually impossible. Businesses close, and everyone goes on vacation at the same time. In many countries, personal relationships are more important than financial considerations. For instance, skipping social engagements in Mexico may lead to lost sales. Negotiations in Japan often include long evenings of dining, drinking, and entertaining; only after a close personal relationship has been formed do business negotiations begin. (Figure) presents some cultural dos and don’ts.

Cultural Dos and Don’ts Guidelines and Examples
DO: DON’T:
  • Always present your business card with both hands in Asian countries. It should also be right-side-up and print-side-showing so that the recipient can read it as it is being presented. If you receive a business card, accept it with gratitude and examine it carefully. Don’t quickly put it into your pocket.
  • Use a “soft-sell” and subtle approach when promoting a product in Japan. Japanese people do not feel comfortable with America’s traditional hard-selling style.
  • Understand the role of religion in business transactions. In Muslim countries, Ramadan is a holy month when most people fast. During this time everything slows down, particularly business.
  • Have a local person available to culturally and linguistically interpret any advertising that you plan to do. When American Airlines wanted to promote its new first-class seats in the Mexican market, it translated the “Fly in Leather” campaign literally, which meant “Fly Naked” in Spanish.
  • Glad-hand, back-slap, and use first names on your first business meeting in Asia. If you do, you will be considered a lightweight.
  • Fill a wine glass to the top if dining with a French businessperson. It is considered completely uncouth.
  • Begin your first business meeting in Asia talking business. Be patient. Let your clients get to know you first.

Economic Environment

The level of economic development varies considerably, ranging from countries where everyday survival is a struggle, such as Sudan and Eritrea, to countries that are highly developed, such as Switzerland and Japan. In general, complex, sophisticated industries are found in developed countries, and more basic industries are found in less developed nations. Average family incomes are higher in the more developed countries than in the least-developed markets. Larger incomes mean greater purchasing power and demand, not only for consumer goods and services but also for the machinery and workers required to produce consumer goods. (Figure) provides a glimpse of global wealth.

Business opportunities are usually better in countries that have an economic infrastructure in place. Infrastructure is the basic institutions and public facilities upon which an economy’s development depends. When we think about how our own economy works, we tend to take our infrastructure for granted. It includes the money and banking system that provide the major investment loans to our nation’s businesses; the educational system that turns out the incredible varieties of skills and basic research that actually run our nation’s production lines; the extensive transportation and communications systems—interstate highways, railroads, airports, canals, telephones, internet sites, postal systems, and television stations—that link almost every piece of our geography into one market; the energy system that powers our factories; and, of course, the market system itself, which brings our nation’s goods and services into our homes and businesses.

Where the Money Is
The Top 20 Gross National Income Per Capita* US$
* Gross National Income is the value of the final goods and services produced by a country (Gross Domestic Product) together with its income received from other countries (such as interest and dividends) less similar payments made to other countries.
Final goods are the goods ultimately consumed rather than used in the production of another good. For example, a car sold to a consumer is a final good; the components, such as tires sold to the car manufacturer, are not. They are intermediate goods used to make the final good. The same tires, if sold to a consumer, would be a final good.
Sources: Some data refers to IMF staff estimates and some are actual figures for the year 2017, made on April 12, 2017. Adapted from the World Economic Outlook Database—April 2017, International Monetary Fund, accessed on April 18, 2017.
Luxembourg 103,199
Switzerland 79,243
Norway 70,392
Ireland 62,562
Qatar 60,787
Iceland 59,629
United States 57,436
Denmark 53,744
Singapore 52,961
Australia 51,850
Sweden 51,165
San Marino 46,447
Netherlands 45,283
Austria 44,498
Finland 43,169
Canada 42,210
Germany 41,902
Belgium 41,283
United Kingdom 40,096
Japan 38,912
The Bottom Five
Madagascar 391
Central African Republic 364
Burundi 325
Malawi 295
South Sudan 233
  1. Explain how political factors can affect international trade.
  2. Describe several cultural factors that a company involved in international trade should consider.
  3. How can economic conditions affect trade opportunities?

Summary of Learning Outcomes

  1. What threats and opportunities exist in the global marketplace?

Domestic firms entering the international arena need to consider the politics, economies, and culture of the countries where they plan to do business. For example, government trade policies can be loose or restrictive, countries can be nationalistic, and governments can change. In the area of culture, many products fail because companies don’t understand the culture of the country where they are trying to sell their products. Some developing countries also lack an economic infrastructure, which often makes it very difficult to conduct business.

Glossary

infrastructure
The basic institutions and public facilities upon which an economy’s development depends.
nationalism
A sense of national consciousness that boosts the culture and interests of one country over those of all other countries.

24

The Impact of Multinational Corporations

  1. What are the advantages of multinational corporations?

Corporations that move resources, goods, services, and skills across national boundaries without regard to the country in which their headquarters are located are multinational corporations. Some are so rich and have so many employees that they resemble small countries. For example, the sales of both Exxon and Walmart are larger than the GDP of all but a few nations in the world. Multinational companies are heavily engaged in international trade. The successful ones take political and cultural differences into account.

Many global brands sell much more outside the United States than at home. Coca-Cola, Philip Morris’s Marlboro brand, Pepsi, Kellogg, Pampers, Nescafe, and Gillette, are examples.

The Fortune 500 made over $1.5 trillion in profit in 2016. In slow-growing, developed economies like Europe and Japan, a weaker dollar helps, because it means cheaper products to sell into those markets, and profits earned in those markets translate into more dollars back home. Meanwhile, emerging markets in Asia, Latin America, and Eastern Europe are growing steadily. General Electric expects 60 percent of its revenue growth to come from emerging markets over the next decade. For Brown-Forman, the spirits company, a fifth of its sales growth of Jack Daniels, the Tennessee whiskey, is coming from developing markets like Mexico and Poland. IBM had rapid sales growth in emerging markets such as Russia, India, and Brazil.

Source: “The World’s Largest Corporations,” Fortune, http://fortune.com/global500/, accessed June 30, 2017.

The largest multinational corporations in the world are shown in (Figure).

Despite the success of American multinationals abroad, there is some indication that preference for U.S. brands may be slipping.

As overseas investment grows, so does the need for global branding. The Wisconsin National Guard picked NBA star Giannis Antetokounmpo to be the face of its recruiting and marketing effort. Recognizable to NBA fans the world over, Antetokounmpo personifies a youthful, dynamic spirit that transcends cultural and geographic boundaries. Why is it increasingly important that multinational advertisers identify and sign celebrity spokespersons capable of bridging different cultures? (Credit: Erik Drost/ Flickr/ Attribution-ShareAlike 2.0 Generic (CC BY 2.0))


The Multinational Advantage

Large multinationals have several advantages over other companies. For instance, multinationals can often overcome trade problems. Taiwan and South Korea have long had an embargo against Japanese cars for political reasons and to help domestic automakers. Yet Honda USA, a Japanese-owned company based in the United States, sends Accords to Taiwan and Korea. In another example, when the environmentally conscious Green movement challenged the biotechnology research conducted by BASF, a major German chemical and drug manufacturer, BASF moved its cancer and immune-system research to Cambridge, Massachusetts.

Another advantage for multinationals is their ability to sidestep regulatory problems. U.S. drugmaker SmithKline and Britain’s Beecham decided to merge in part so that they could avoid licensing and regulatory hassles in their largest markets. The merged company can say it’s an insider in both Europe and the United States. “When we go to Brussels, we’re a member state [of the European Union],” one executive explains. “And when we go to Washington, we’re an American company.”

South Korea’s Samsung is a leading manufacturer of giant high-definition TVs. Samsung produces the largest curved ultra-high-definition (UHD) screens for the worldwide home-theater market. Samsung’s monster 110-inch curved UHD screen is among the world’s largest such screens. Unfortunately, for most of the world’s consumers, the giant Samsung TVs can be too costly, but the 88-inch version can be purchased for under $20,000. How does being a multinational corporation enable Samsung to succeed in the high-end electronics market? (Credit: Chris F/ Flickr/ Attribution 2.0 Generic (CC BY 2.0))


A photograph shows a large television with a concave screen. Above the television display is a sign that reads, Samsung U H D, the world's first curved U H D T V.

Multinationals can also shift production from one plant to another as market conditions change. When European demand for a certain solvent declined, Dow Chemical instructed its German plant to switch to manufacturing a chemical that had been imported from Louisiana and Texas. Computer models help Dow make decisions like these so it can run its plants more efficiently and keep costs down.

Source: Adapted from “The World’s Largest Corporations,” Fortune http://fortune.com/global500/, accessed June 30, 2017.
The World’s Top 11 Largest Multinational Corporations
RANK RANK COMPANY Revenues ($M) Home Country
1 Walmart $482,130 United States
2 State Grid $329,601 China
3 China National Petroleum $299,271 China
4 Sinopec Group $294,344 China
5 Royal Dutch Shell $272,156 Netherlands
6 Exxon Mobil $246,204 United States
7 Volkswagen $236,600 Germany
8 Toyota Motor $236,592 Japan
9 Apple $233,715 United States
10 BP $225,982 United Kingdom
11 Berkshire Hathaway $210,821 United States
U.S. Brands Face Global Competition

America is the cradle of the consumer goods brand. Here, a free-spending and marketing-saturated public nurtured Apple, Google, Coca-Cola, Microsoft, and countless others to maturity. Many of those brands grew up to conquer other societies, as well.

But American brands’ domination in the global marketplace is eroding. From Samsung to Toyota to Mercedes Benz to SAP, companies in Europe and Asia are turning out top-quality goods and selling them as such rather than competing on price. “There are longer-term trends toward greater competition. The United States was the only global brand country [but] that’s no longer the case,” says Earl L. Taylor, chief marketing officer of the Marketing Science Institute. “Consumers prefer brands that they take to be of higher quality” regardless of the country of origin, he notes. “Increasingly, there will be other successful global brands in the U.S. [market].”

Of the brands at the top of Interbrand’s recent list of the world’s most valuable, four of the top five still originate in the United States; the five most valuable are Apple, Google, Coca-Cola, and Microsoft, while Toyota (Japan) comes in at number five. American companies have lost the most ground in the middle tier of recognizable brand names, says George T. Haley, professor of marketing at the University of New Haven’s School of Business.

One area from which U.S. brands are feeling the pressure is the Asia-Pacific region, which harbors the fastest-growing emerging markets today. In the appliance category, two Chinese companies, Haier and Kelon, are becoming top competitors for well-known U.S. brands Whirlpool and Maytag. In fact, Haier bought GE’s appliance division in 2016. The Chinese branding trend is not confined only to hard goods. Sporting goods and sportswear brand Li Ning, well known within China, is building its international profile. While the Chinese basketball team wore Nike uniforms at the Athens Olympic Games, the Spanish team wore Li Ning apparel. The threat to U.S. brands is not confined to China, however. South Korean brands, such as Samsung, LG, and Hyundai, have emerged on the global stage in specific categories, such as smartphones, household appliances, and automobiles.

The animosity that many Europeans feel toward the United States is translated into a preference for European or even Asian brands at the expense of U.S. brands. Plus, experts say, European brands are simply becoming stronger and more consistent.

Meanwhile, European brands are gaining momentum in the areas of white goods and consumer goods, putting the pressure on such well-known U.S. brands as Bissell and Hoover, experts say. For instance, Gaggenau is a popular, high-end European kitchen appliance brand, along with Bosch and Dyson. Other European brands maintaining cachet—if not always the allure of luxury—include Absolut, Virgin, Mini (as in Cooper), Red Bull, and Ikea.

Critical Thinking Questions
  1. What can U.S. multinational firms do to regain and maintain their leadership in global branding? Are there sectors and product areas where U.S. brands are gaining share?
  2. Do you think that the quality of American products and services is declining, or that the rest of the world is just getting better? Explain your answer.

Sources: “Interbrand: Best Global Brands 2016 Rankings,” http://interbrand.com, accessed June 30, 2017; Vasileios Davvetas and Adamantios Diamantopoulos (2016), “How Product Category Shapes Preferences toward Global and Local Brands: A Schema Theory Perspective,” Journal of International Marketing, 24 (4), 61–81; Deborah Vence, “Not Taking Care of Business?” Marketing News, March 15, 2005, pp. 19–20.

Multinationals can also tap new technology from around the world. In the United States, Xerox has introduced some 80 different office copiers that were designed and built by Fuji Xerox, its joint venture with a Japanese company. Versions of the super-concentrated detergent that Procter & Gamble first formulated in Japan in response to a rival’s product are now being sold under the Ariel brand name in Europe and under the Cheer and Tide labels in the United States. Also, consider Otis Elevator’s development of the Elevonic 411, an elevator that is programmed to send more cars to floors where demand is high. It was developed by six research centers in five countries. Otis’s group in Farmington, Connecticut, handled the systems integration, a Japanese group designed the special motor drives that make the elevators ride smoothly, a French group perfected the door systems, a German group handled the electronics, and a Spanish group took care of the small-geared components. Otis says the international effort saved more than $10 million in design costs and cut the process from four years to two.

Finally, multinationals can often save a lot in labor costs, even in highly unionized countries. For example, when Xerox started moving copier-rebuilding work to Mexico to take advantage of the lower wages, its union in Rochester, New York, objected because it saw that members’ jobs were at risk. Eventually, the union agreed to change work styles and to improve productivity to keep the jobs at home.

  1. What is a multinational corporation?
  2. What are the advantages of multinationals?

Summary of Learning Outcomes

  1. What are the advantages of multinational corporations?

Multinational corporations have several advantages. First, they can sidestep restrictive trade and licensing restrictions because they frequently have headquarters in more than one country. Multinationals can also move their operations from one country to the next depending on which location offers more favorable economic conditions. In addition, multinationals can tap into a vast source of technological expertise by drawing upon the knowledge of a global workforce.

Glossary

multinational corporations
Corporations that move resources, goods, services, and skills across national boundaries without regard to the country in which their headquarters are located.

IV

Forms of Business Ownership

26

Introduction

(Credit: pxhere / Attribution CC0 Public Domain)


A dimly lit, crowded coffee shop is shown. Patrons sit at tables, and a worker attends to a customer at the counter.

Learning Outcomes

After reading this chapter, you should be able to answer these questions:

  1. What are the advantages and disadvantages of the sole proprietorship form of business organization?
  2. What are the advantages of operating as a partnership, and what downside risks should partners consider?
  3. How does the corporate structure provide advantages and disadvantages to a company, and what are the major types of corporations?
  4. What other options for business organization does a company have in addition to sole proprietorships, partnerships, and corporations?
  5. What makes franchising an appropriate form of organization for some types of business, and why does it continue to grow in importance?
  6. Why are mergers and acquisitions important to a company’s overall growth?
  7. What current trends will affect the business organizations of the future?
Jessica MacLean

Sole Proprietor In most any elementary school classroom, at least one child’s answer to the question, “What do you want to do with your life?” will be, “A lawyer.” One of the most popular careers, lawyers are powerful figures in society, shaping our laws and ensuring that we adhere to them. Their prominence and power have led to the stereotype of rich, career-driven lawyers, often leaving no room in our minds for those who truly want to bring justice to the world. However, Jessica MacLean, a lawyer focusing primarily on women’s rights, is quick to say that, as with many stereotypes, that is only one side of the story. “I know because I lived that—I was on my way to being a successful corporate lawyer. But I realized what I was doing and how different that was from why I’d started practicing. So I walked away from it all to start my own practice.”

Nervous about the prospect of private practice, she has chosen to operate as a sole proprietorship for now. Sole proprietorships are easy to set up for people who want to work on their own, prefer direct control of the business, and desire the flexibility to sell the business or close the doors at any time. “For me, it’s the best choice because I am not responsible for or to anyone else. I can easily dissolve the business if I find it is not proceeding how I’d planned. More positively, too, if it does succeed, I know that success is due to my hard work.

Indeed MacLean’s law career was not always in corporate law. She turned her sights toward law after a gender and communications professor at DePaul University suggested her argumentative style might be an asset in that profession. “She said I needed to tone it down for class—that the other students seemed afraid to speak up—but then asked if I’d ever considered being a lawyer.” MacLean, who had always been interested in issues of justice and legality surrounding women, took her professor’s advice and made the leap into law.

While in law school, she clerked for the city of Chicago in their department of personnel’s sexual harassment office and volunteered for the Cook County state’s attorney’s office in the domestic violence division. The cases she worked on were emotionally trying. Despite the difficulty of the cases, she was drawn to them, compelled by the people she helped and the change she was able to effect. After school, she continued in related practice, working first for the Cook County state’s attorney’s office.

After several years with the state’s attorney’s office, she needed a change. It was then that MacLean decided to work for a corporation, a form of business that you will learn about in this chapter. “Why did I switch to corporate law? I think I was burnt out, to some extent. It’s so hard to work on those cases, day after day. I needed to see if I would be better somewhere else.”

Having enjoyed the rewards of working with the state’s attorney’s office and a corporation and being a sole proprietor, in 2014 MacLean joined a limited liability partnership (LLP, a form of business that you will learn about in this chapter) firm in Chicago. As her needs changed, the form and type of business organization she has worked for has changed also.

This chapter discusses sole proprietorships, as well as several other forms of business ownership, including partnerships and corporations, and compares the advantages and disadvantages of each.

With a good idea and some cash in hand, you decide to start a business. But before you get going, you need to ask yourself some questions that will help you decide what form of business organization will best suit your needs.

Would you prefer to go it alone as a sole proprietorship, or do you want others to share your burdens and challenges in a partnership? Or would the limited liability protection of a corporation, or perhaps the flexibility of a limited liability company (LLC), make more sense?

There are other questions you need to consider too: Will you need financing? How easy will it be to obtain? Will you attract employees? How will the business be taxed, and who will be liable for the company’s debts? If you choose to share ownership with others, how much operating control would they want, and what costs would be associated with that?

As (Figure) illustrates, sole proprietorships are the most popular form of business ownership, accounting for 72 percent of all businesses, compared with 10 percent for partnerships and 18 percent for corporations. Because most sole proprietorships and partnerships remain small, corporations generate approximately 81 percent of total business revenues and 58 percent of total profits.

Most start-up businesses select one of these major ownership forms. In the following pages, we will discover the advantages and disadvantages of each form of business ownership and the factors that may make it necessary to change from one form of organization to another as the needs of the business change. As a company expands from small to midsize or larger, the form of business structure selected in the beginning may no longer be appropriate.

27

Going It Alone: Sole Proprietorships

  1. What are the advantages and disadvantages of the sole proprietorship form of business organization?

Jeremy Shepherd was working full-time for an airline when, at the age of 22, he wandered into an exotic pearl market in China, searching for a gift for his girlfriend. The strand of pearls he handpicked by instinct was later valued by a jeweler back in the States at 20 times what he paid for it. Jeremy cashed his next paycheck and hurried back to Asia, buying every pearl he could afford. Founded in 1996, his company Pearl Paradise was brought online in 2000. Shepherd chose the sole proprietorship form of business organization—a business that is established, owned, operated, and often financed by one person—because it was the easiest to set up. He did not want partners, and low liability exposure made incorporating unnecessary.

Fluent in Mandarin Chinese, Japanese, and Spanish and immersed in Asian culture, Shepherd believed the internet was the way to market his pearls (http://www.pearlparadise.com). Offering a wide range of pearl jewelry through 14 websites worldwide, his company sells as many as 1,000 items per day. The recent addition of an exclusive Los Angeles showroom allows celebrity customers to shop by appointment. With $20 million in sales annually, PearlParadise.com is the industry leader in terms of sales and volume.

Tara Siegel Bernard, “Building a Luxury Retail Business on the Web,” The Wall Street Journal-Small Business, July 12, 2005, p. B4; Pearl Paradise corporate website, http://www.pearlparadise.com (August 17, 2017); Jeremy Shepherd, “My Journey From Flight Attendant To CEO Of A $20 Million Company,” The Blog, Huffington Post, November 1, 2010 (accessed August 17, 2017); Syl Tang , “Rarest of pearls face a less than golden future,” Financial Times, https://www.ft.com, accessed August 17, 2017.

Source: Internal Revenue Service, as reported in Table 746, U.S. Bureau of the Census, Statistical Abstract of the United States, 2012, 131st ed. (Washington, DC: U.S. Government Printing Office, 2012), p. 492. Note: US Bureau of Census stopped collecting and publishing this data after 2012.
Comparison of Forms of Business Organization
Form Number Sales Profits
Sole Proprietorships 72 percent 4 percent 15 percent
Partnerships 10 percent 15 percent 27 percent
Corporations 18 percent 81 percent 58 percent

Advantages of Sole Proprietorships

Sole proprietorships have several advantages that make them popular:

  • Easy and inexpensive to form. As Jeremy Shepherd discovered, sole proprietorships have few legal requirements (local licenses and permits) and are not expensive to form, making them the business organization of choice for many small companies and start-ups.
  • Profits all go to the owner. The owner of a sole proprietorship obtains the start-up funds and gets all the profits earned by the business. The more efficiently the firm operates, the higher the company’s profitability.
  • Direct control of the business. All business decisions are made by the sole proprietorship owner without having to consult anyone else.
  • Freedom from government regulation. Sole proprietorships have more freedom than other forms of business with respect to government controls.
  • No special taxation. Sole proprietorships do not pay special franchise or corporate taxes. Profits are taxed as personal income as reported on the owner’s individual tax return.
  • Ease of dissolution. With no co-owners or partners, the sole proprietor can sell the business or close the doors at any time, making this form of business organization an ideal way to test a new business idea.

Disadvantages of Sole Proprietorships

Along with the freedom to operate the business as they wish, sole proprietors face several disadvantages:

  • Unlimited liability. From a legal standpoint, the sole proprietor and the company are one and the same, making the business owner personally responsible for all debts the company incurs, even if they exceed the company’s value. The owner may need to sell other personal property—their car, home, or other investments—to satisfy claims against the business.
  • Difficulty raising capital. Business assets are unprotected against claims of personal creditors, so business lenders view sole proprietorships as high risk due to the owner’s unlimited liability. Owners must often use personal funds—borrowing on credit cards, second-mortgaging their homes, or selling investments—to finance their business. Expansion plans can also be affected by an inability to raise additional funding.
  • Limited managerial expertise. The success of a sole proprietorship rests solely with the skills and talents of the owner, who must wear many different hats and make all decisions. Owners are often not equally skilled in all areas of running a business. A graphic designer may be a wonderful artist but not know bookkeeping, how to manage production, or how to market their work.
  • Trouble finding qualified employees. Sole proprietors often cannot offer the same pay, fringe benefits, and advancement as larger companies, making them less attractive to employees seeking the most favorable employment opportunities.
  • Personal time commitment. Running a sole proprietorship business requires personal sacrifices and a huge time commitment, often dominating the owner’s life with 12-hour workdays and 7-day workweeks.
  • Unstable business life. The life span of a sole proprietorship can be uncertain. The owner may lose interest, experience ill health, retire, or die. The business will cease to exist unless the owner makes provisions for it to continue operating or puts it up for sale.
  • Losses are the owner’s responsibility. The sole proprietor is responsible for all losses, although tax laws allow these to be deducted from other personal income.

The sole proprietorship may be a suitable choice for a one-person start-up operation with no employees and little risk of liability exposure. For many sole proprietors, however, this is a temporary choice, and as the business grows, the owner may be unable to operate with limited financial and managerial resources. At this point, the owner may decide to take in one or more partners to ensure that the business continues to flourish.

Work-Life Balance Important in Small Business

According to a survey released by the Wells Fargo/Gallup Small Business Index, about two-thirds of small business owners are satisfied with how they balance their personal lives and work schedules, and the New York Enterprise Report survey found that they work twice as much as regular employees. The survey also found that 33 percent of small business owners work more than 50 hours per week, while 25 percent reported working over 60 hours per week. A survey by Gallup finds 39 percent of small business owners working over 60 hours per week.

The 2016 Annual Bank of the West Small Business Growth Survey found that 62 percent of the respondents reported the stress of ownership as worse than what they had originally imagined. At the same time, the same people indicated that being a small business owner puts them in charge of their destiny, offers freedom, and is more rewarding than ever imagined. Over two-thirds of small business owners, according to a survey, said they were satisfied with their personal work-life balance, and almost 90 percent said they were satisfied with being a small business owner in general. Dennis Jacobe, chief economist at Gallup, argues, “People see the benefits more closely tied to them when they’re the owner,” he says. “Working hard and long is a natural aspect of the kind of people willing to start their own business.”

But if employees have trouble balancing work and life, odds are they will have less confidence in you as a leader, a recent study shows. The study, which polled more than 50,000 U.S. workers from various markets including professional services, consumer goods, and financial services, found that employees who strike a positive balance between home and work were 11 percent more likely to praise their leaders’ ability to set a clear direction.

The Society for Human Resource Management’s (SHRM) research also shows work-life balance has a great impact on how employees feel about their leaders. Jennifer Schramm, a manager in SHRM’s workplace trends and forecasting research department, predicts that as companies try to maximize the productivity of each employee, work-life balance and the resulting employee satisfaction will become increasingly more important. And research shows that happy employees can yield happy returns for businesses.

Critical Thinking Questions
  1. Many small business owners expect their employees to be as committed and to work as hard as they do. How would you avoid falling into that trap while still demanding the best from your workers?
  2. As a small business owner, consider some strategies to ensure an appropriate work-life balance for your employees.

Sources: Brian Sutter, “How Hard Small Business Owners Work,” SCORE, https://www.score.org, accessed August 17, 2017; The Hartford Insurance Company, “2015 Small Business Success Study,” accessed August 17, 2017; Michelle Di Gangi, “Attitude check: Small business owners say it’s all worth it,” July 26, 2016, Bank of the West; 2016 Annual Bank of the West Small Business Growth Survey, conducted by Harris Poll, July 26, 2016; Jena Wuu, “Work-Life Not an Issue for Owners,” Inc., http://www.inc.com, August 10, 2005; Christina Galoozis, “Employees View Leadership Through Lens of Work-Life Balance,Inc., http://www.inc.com, June 8, 2005.

  1. What is a sole proprietorship?
  2. Why is this a popular form of business organization?
  3. What are the drawbacks to being a sole proprietor?

Summary of Learning Outcomes

  1. What are the advantages and disadvantages of the sole proprietorship form of business organization?

The advantages of sole proprietorships include ease and low cost of formation, the owner’s rights to all profits, the owner’s control of the business, relative freedom from government regulation, absence of special taxes, and ease of dissolution. Disadvantages include owner’s unlimited liability for debts and personal absorption of all losses, difficulty in raising capital, limited managerial expertise, difficulty in finding qualified employees, large personal time commitment, and unstable business life.

Glossary

sole proprietorship
A business that is established, owned, operated, and often financed by one person.

28

Partnerships: Sharing the Load

  1. What are the advantages of operating as a partnership, and what downside risks should partners consider?

Can partnerships, an association of two or more individuals who agree to operate a business together for profit, be hazardous to a business’s health? Let’s assume partners Ron and Liz own a stylish and successful beauty salon. After a few years of operating the business, they find they have contrasting visions for their company. Liz is happy with the status quo, while Ron wants to expand the business by bringing in investors and opening salons in other locations.

How do they resolve this impasse? By asking themselves some tough questions. Whose view of the future is more realistic? Does the business actually have the expansion potential Ron believes it does? Where will he find investors to make his dream of multiple locations a reality? Is he willing to dissolve the partnership and start over again on his own? And who would have the right to their clients?

Ron realizes that expanding the business in line with his vision would require a large financial risk and that his partnership with Liz offers many advantages he would miss in a sole proprietorship form of business organization. After much consideration, he decides to leave things as they are.

For those individuals who do not like to “go it alone,” a partnership is relatively simple to set up. Offering a shared form of business ownership, it is a popular choice for professional-service firms such as lawyers, accountants, architects, stockbrokers, and real estate companies.

The parties agree, either orally or in writing, to share in the profits and losses of a joint enterprise. A written partnership agreement, spelling out the terms and conditions of the partnership, is recommended to prevent later conflicts between the partners. Such agreements typically include the name of the partnership, its purpose, and the contributions of each partner (financial, asset, skill/talent). It also outlines the responsibilities and duties of each partner and their compensation structure (salary, profit sharing, etc.). It should contain provisions for the addition of new partners, the sale of partnership interests, and procedures for resolving conflicts, dissolving the business, and distributing the assets.

There are two basic types of partnerships: general and limited. In a general partnership, all partners share in the management and profits. They co-own the assets, and each can act on behalf of the firm. Each partner also has unlimited liability for all the business obligations of the firm. A limited partnership has two types of partners: one or more general partners, who have unlimited liability, and one or more limited partners, whose liability is limited to the amount of their investment. In return for limited liability, limited partners agree not to take part in the day-to-day management of the firm. They help to finance the business, but the general partners maintain operational control.

There are also limited liability partnerships (LLP), which are similar to a general partnership except that partners are not held responsible for the business debt and liabilities. Another type is a limited liability limited partnership (LLLP), which is basically a limited partnership with addition of limited liability, hence protecting the general partner from the debt and liabilities of the partnership.

Advantages of Partnerships

Some advantages of partnerships come quickly to mind:

  • Ease of formation. Like sole proprietorships, partnerships are easy to form. The partners agree to do business together and draw up a partnership agreement. For most partnerships, applicable state laws are not complex.
  • Availability of capital. Because two or more people contribute financial resources, partnerships can raise funds more easily for operating expenses and business expansion. The partners’ combined financial strength also increases the firm’s ability to raise funds from outside sources.
  • Diversity of skills and expertise. Partners share the responsibilities of managing and operating the business. Combining partner skills to set goals, manage the overall direction of the firm, and solve problems increases the chances for the partnership’s success. To find the right partner, you must examine your own strengths and weaknesses and know what you need from a partner. Ideal partnerships bring together people with complementary backgrounds rather than those with similar experience, skills, and talents. In (Figure) you’ll find some advice on choosing a partner.
  • Flexibility. General partners are actively involved in managing their firm and can respond quickly to changes in the business environment.
  • No special taxes. Partnerships pay no income taxes. A partnership must file a partnership return with the Internal Revenue Service, reporting how profits or losses were divided among the partners. Each partner’s profit or loss is then reported on the partner’s personal income tax return, with any profits taxed at personal income tax rates.
  • Relative freedom from government control. Except for state rules for licensing and permits, the government has little control over partnership activities.
Perfect Partners
Picking a partner is both an art and a science. Someone may have all the right credentials on paper, but does that person share your vision and the ideas you have for your company? Are they a straight shooter? Honesty, integrity, and ethics are important, because you may be liable for what your partner does. Be prepared to talk about everything, and trust your intuition and your gut feelings—they’re probably right. Ask yourself and your potential partner the following questions—then see how well your answers match up:
  1. Why do you want a partner?
  2. What characteristics, talents, and skills does each person bring to the partnership?
  3. How will you divide responsibilities—from long-range planning to daily operations? Who will handle such tasks as marketing, sales, accounting, and customer service?
  4. What is your long-term vision for the business—its size, life span, financial commitment, etc.?
  5. What are your personal reasons for forming this company? Are you looking to create a small company or build a large one? Are you seeking a steady paycheck or financial independence?
  6. Will all parties put in the same amount of time, or is there an alternative arrangement that is acceptable to everyone?
  7. Do you have similar work ethics and values?
  8. What requirements will be in the partnership agreement?

Disadvantages of Partnerships

Business owners must consider the following disadvantages of setting up their company as a partnership:

  • Unlimited liability. All general partners have unlimited liability for the debts of the business. In fact, any one partner can be held personally liable for all partnership debts and legal judgments (such as malpractice)—regardless of who caused them. As with sole proprietorships, business failure can lead to a loss of the general partners’ personal assets. To overcome this problem, many states now allow the formation of limited liability partnerships (LLPs), which protect each individual partner from responsibility for the acts of other partners and limit their liability to harm resulting from their own actions.
  • Potential for conflicts between partners. Partners may have different ideas about how to run their business, which employees to hire, how to allocate responsibilities, and when to expand. Differences in personalities and work styles can cause clashes or breakdowns in communication, sometimes requiring outside intervention to save the business.
  • Complexity of profit sharing. Dividing the profits is relatively easy if all partners contribute equal amounts of time, expertise, and capital. But if one partner puts in more money and others more time, it might be more difficult to arrive at a fair profit-sharing formula.
  • Difficulty exiting or dissolving a partnership. As a rule, partnerships are easier to form than to leave. When one partner wants to leave, the value of their share must be calculated. To whom will that share be sold, and will that person be acceptable to the other partners? If a partner who owns more than 50 percent of the entity withdraws, dies, or becomes disabled, the partnership must reorganize or end. To avoid these problems, most partnership agreements include specific guidelines for transferring partnership interests and buy–sell agreements that make provision for surviving partners to buy a deceased partner’s interest. Partners can also purchase special life insurance policies designed to fund such a purchase.

Business partnerships are often compared to marriages. As with a marriage, choosing the right partner is critical. So if you are considering forming a partnership, allow plenty of time to evaluate your and your potential partner’s goals, personality, expertise, and working style before joining forces.

  1. How does a partnership differ from a sole proprietorship?
  2. Describe the four main types of partnerships, and explain the difference between a limited partner and a general partner.
  3. What are the main advantages and disadvantages of a partnership?

Summary of Learning Outcomes

  1. What are the advantages of operating as a partnership, and what downside risks should partners consider?

The advantages of partnerships include ease of formation, availability of capital, diversity of managerial skills and expertise, flexibility to respond to changing business conditions, no special taxes, and relative freedom from government control. Disadvantages include unlimited liability for general partners, potential for conflict between partners, sharing of profits, and difficulty exiting or dissolving the partnership. Partnerships can be formed as either general or limited partnerships. In a general partnership, the operations of the business are controlled by one or more general partners with unlimited liability. The partners co-own the assets and share the profits. Each partner is individually liable for all debts and contracts of the partnership. In a limited partnership, the limited partners are financial partners whose liability is limited to their investment; they do not participate in the firm’s operations.

Glossary

general partners
Partners who have unlimited liability for all of the firm’s business obligations and who control its operations.
general partnership
A partnership in which all partners share in the management and profits. Each partner can act on behalf of the firm and has unlimited liability for all its business obligations.
limited partners
Partners whose liability for the firm’s business obligations is limited to the amount of their investment. They help to finance the business but do not participate in the firm’s operations.
limited partnership
A partnership with one or more general partners, who have unlimited liability, and one or more limited partners, whose liability is limited to the amount of their investment in the company.
partnership
An association of two or more individuals who agree to operate a business together for profit.

29

Corporations: Limiting Your Liability

  1. How does the corporate structure provide advantages and disadvantages to a company, and what are the major types of corporations?

When people think of corporations, they typically think of major, well-known companies, such as Apple, Alphabet (parent company of Google), Netflix, IBM, Microsoft, Boeing, and General Electric. But corporations range in size from large multinationals with thousands of employees and billions of dollars in sales to midsize or even smaller firms with few employees and revenues under $25,000.

A corporation is a legal entity subject to the laws of the state in which it is formed, where the right to operate as a business is issued by state charter. A corporation can own property, enter into contracts, sue and be sued, and engage in business operations under the terms of its charter. Unlike sole proprietorships and partnerships, corporations are taxable entities with a life separate from their owners, who are not personally liable for its debts.

When launching her company, Executive Property Management Services, Inc., 32-year-old Linda Ravden realized she needed the liability protection of the corporate form of business organization. Her company specialized in providing customized property management services to mid- and upper-level corporate executives on extended work assignments abroad, often for three to five years or longer. Taking care of substantial properties in the million-dollar range and above was no small responsibility for Ravden’s company. Therefore, the protection of a corporate business structure, along with carefully detailed contracts outlining the company’s obligations, were crucial in providing Ravden with the liability protection she needed—and the peace of mind to focus on running her business without constant worry. Note that an LLC does not provide unlimited protection; you can still get in trouble for such things as mingling personal and business funds.

“LLC vs. S Corp.: What’s the Best Setup for Your Startup?” Young Upstarts, http://www.youngupstarts.com, August 28, 2017; “Be Careful! Structuring Your Business as an LLC Is Not a Guarantee of Liability Protection,” allBusiness, https://www.allbusiness.com, accessed September 30, 2017; Linda Ravden, based on personal interview on May 25, 2006.

Pacific Sun’s Golden Glow

It all started as a little surf shop in 1980 in Newport Beach, California. It wasn’t called PacSun then. It wasn’t even all that different from other shops carrying surfboards and wax, except for one thing. The founders had a better idea.

During Southern California’s wet, cool winters, the beaches got empty, and the surf store business went dry. Where did everyone go? To the mall, of course. Their idea—to be the first surf shop to move into California’s popular mall locations—worked. The company soon grew to 21 stores, selling such popular name brands as Billabong, Gotcha, CatchIt, Stussy, and Quiksilver, as well as its own private-label brands.

What began as a little surf shop became a leading mall-based specialty retailer in the fast-growing surf, skate, and hip-hop apparel markets. With close to a thousand stores in the United States and Puerto Rico and sales topping $1 billion, how did the founders make the leap from selling and waxing surfboards to being a major player in the youth apparel market? How has Pacific Sunwear of California, Inc. (http://www.pacsun.com) succeeded when thousands of other clothing companies failed?

“We listen and we change,” says the CEO of Pacific Sun. “The kids have the answers, so we listen to get the trends, the solutions, and find out what we are doing right.” To remain on the cutting edge of teen tastes, the company hosts an open house every Wednesday at its corporate headquarters in Anaheim, California, where vendors present their wares to PacSun’s savvy team of buyers. Being able to distinguish between short-lived fads and actual trends is important when making merchandise choices. The company’s focus on “active brand management” is what kept its sales climbing.

The founders’ philosophy had served their business well. In 1993, the 60-store company sold stock to the public. It had grown to over 1,000 stores in 50 states and Puerto Rico, with 12,000 employees. The company’s PacSun stores cater to a completely different customer than its d.e.m.o. hip-hop stores. In April 2006, PacSun launched its third concept, One Thousand Steps, a footwear store.

With changing trends and online shopping challenges facing many brick-and-mortar retailers, companies such as Wet Seal and Quicksilver filed for bankruptcy in 2015, and PacSun filed for bankruptcy in April 2016. At the time of bankruptcy filing, the company had 593 PacSun stores employing approximately 2,000 employees. In September 2016, PacSun emerged from the bankruptcy after it cut debt and closed stores. The company also turned over all of its stock to the private equity firm Golden Gate Capital, its senior lender.

As its business took off, PacSun successfully made the leap from the small sole proprietorship form of business organization to corporate retailing giant. Facing changing trends and technologies, the firm hit a bump in the road and is working hard to reestablish. The company is indeed a thousand steps away from its humble beginnings.

Critical Thinking Questions
  1. How did PacSun manage its evolution from a small, local business to a leading mall-based specialty retailer? What could be the reasons for its missteps resulting in the bankruptcy filing?
  2. What form of business organization might PacSun have chosen when it started, and what might have prompted it to change as it grew?

Sources: Marie Driscoll, “Pacific Sun’s Golden Glow,” Business Week Online, November 9, 2004, http://www.businessweek.com; Ron Ehlers (VP Information Services, Pacific Sunwear of California, Inc.) “Pacific Sunwear: Maintain a Fresh Brand by Anticipating Consumer Needs,” presentation to the Retail Systems MIX Summit, May 25, 2005, http://www.retailsystems.com; “Corporate Profile,” Pacific Sun corporate Web site, http://www.pacsun.com; Samantha Masunaga, “PacSun files for Chapter 11 bankruptcy protection, plans to go private,” Los Angeles Times, http://www.latimes.com, accessed August 17, 2017; Steven Church, “Pacific Sunwear Has ‘Retailer’s Dream’ as Bankruptcy Wraps Up,” Bloomberg, https://www.bloomberg.com, accessed August 2017.

Corporations play an important role in the U.S. economy. As (Figure) demonstrated, corporations account for only 18 percent of all businesses but generate 81 percent of all revenues and 58 percent of all profits. Company type and size vary; however, when you look at the top companies by revenue in the United States or globally, they include many familiar names that affect our daily lives.

In the United States, according to Fortune magazine, the top three corporations in the 2017 were (1) Walmart Stores (revenue: $485.9 B), (2) Berkshire Hathaway (revenue: $223.6 B), and (3) Apple (revenue: $215.6 B), whereas Forbes magazine found that the top three corporations were (1) Berkshire Hathaway (revenue: $222.9B), (2) Apple (revenue: $217.5B), and (3) JPMorgan Chase (revenue: $102.5B). By comparison, the top three companies in 2017 according to the World Economic Forum were (1) Apple, (2) Alphabet, and (3) Microsoft. These corporations rise and fall on the various lists based on their revenue in a given year and how the organizations measure revenue and the time frames that they use.

“Fortune 500 Companies 2017,” Fortune, http://www.fortune.com, accessed March 31, 2018; “America’s Top Public Companies in 2017: A Buffett Buy List”, Forbes, https://www.forbes.com, accessed March 31, 2018; Alex Gray, “These Are the World’s 10 Biggest Corporate Giants,” World Economic Forum, https://www.weforum.org, January 16, 2017.

The Incorporation Process

Setting up a corporation is more complex than starting a sole proprietorship or partnership. Most states base their laws for chartering corporations on the Model Business Corporation Act of the American Bar Association, although registration procedures, fees, taxes, and laws that regulate corporations vary from state to state.

Incorporated in 1969, Walmart is one of America’s most popular retail stores. Opened as Walmart Discount City by retailer Sam Walton in 1962, the retailer quickly established a strong brand image. Today, Walmart operates in more than 28 countries, and the Walmart icon is among the most recognizable trademarks in all of business. What steps must companies take to become incorporated? (Credit: Mike Mozart/ Flickr/ Attribution 2.0 Generic (CC BY 2.0))


A photograph shows the front entrance of a Walmart store.

A firm does not have to incorporate in the state where it is based and may benefit by comparing the rules of several states before choosing a state of incorporation. Although Delaware is a small state with few corporations actually based there, its procorporate policies make it the state of incorporation for many companies, including about half the Fortune 500. Incorporating a company involves five main steps:

  • Selecting the company’s name
  • Writing the articles of incorporation (see (Figure)) and filing them with the appropriate state office, usually the secretary of state
  • Paying required fees and taxes
  • Holding an organizational meeting
  • Adopting bylaws, electing directors, and passing the first operating resolutions

The state issues a corporate charter based on information in the articles of incorporation. Once the corporation has its charter, it holds an organizational meeting to adopt bylaws, elect directors, and pass initial operating resolutions. Bylaws provide legal and managerial guidelines for operating the firm.

Articles of Incorporation
Articles of incorporation are prepared on a form authorized or supplied by the state of incorporation. Although they may vary slightly from state to state, all articles of incorporation include the following key items:
  • Name of corporation
  • Company’s goals
  • Types of stock and number of shares of each type to issue
  • Life of the corporation (usually “perpetual,” meaning with no time limit)
  • Minimum investment by owners
  • Methods for transferring shares of stock
  • Address of the corporate office
  • Names and addresses of the first board of directors

The Corporate Structure

As (Figure) shows, corporations have their own organizational structure with three important components: stockholders, directors, and officers.

Stockholders (or shareholders) are the owners of a corporation, holding shares of stock that provide them with certain rights. They may receive a portion of the corporation’s profits in the form of dividends, and they can sell or transfer their ownership in the corporation (represented by their shares of stock) at any time. Stockholders can attend annual meetings, elect the board of directors, and vote on matters that affect the corporation in accordance with its charter and bylaws. Each share of stock generally carries one vote.

The stockholders elect a board of directors to govern and handle the overall management of the corporation. The directors set major corporate goals and policies, hire corporate officers, and oversee the firm’s operations and finances. Small firms may have as few as 3 directors, whereas large corporations usually have 10 to 15.

The boards of large corporations typically include both corporate executives and outside directors (not employed by the organization) chosen for their professional and personal expertise. Outside directors often bring a fresh view to the corporation’s activities because they are independent of the firm.

Hired by the board, the officers of a corporation are its top management and include the president and chief executive officer (CEO), vice presidents, treasurer, and secretary, who are responsible for achieving corporate goals and policies. Officers may also be board members and stockholders.

When Walt Disney cast his now-famous mouse as Steamboat Willie back in the 1920s, he had little idea that his animation project would turn into one of the largest entertainment companies in the world. The house that Walt built, with its magical theme parks, movie studios, and product lines, is overseen today by visionary directors with accomplished backgrounds in media, technology, and government. What important tasks and responsibilities are entrusted to Disney’s board of directors? (Marc Levin/ Flickr/ Attribution 2.0 Generic (CC BY 2.0))


Advantages of Corporations

The corporate structure allows companies to merge financial and human resources into enterprises with great potential for growth and profits:

  • Limited liability. A key advantage of corporations is that they are separate legal entities that exist apart from their owners. Owners’ (stockholders’) liability for the obligations of the firm is limited to the amount of the stock they own. If the corporation goes bankrupt, creditors can look only to the assets of the corporation for payment.
  • Ease of transferring ownership. Stockholders of public corporations can sell their shares at any time without affecting the status of the corporation.
  • Unlimited life. The life of a corporation is unlimited. Although corporate charters specify a life term, they also include rules for renewal. Because the corporation is an entity separate from its owners, the death or withdrawal of an owner does not affect its existence, unlike a sole proprietorship or partnership.
  • Tax deductions. Corporations are allowed certain tax deductions, such as operating expenses, which reduces their taxable income.
  • Ability to attract financing. Corporations can raise money by selling new shares of stock. Dividing ownership into smaller units makes it affordable to more investors, who can purchase one or several thousand shares. The large size and stability of corporations also helps them get bank financing. All these financial resources allow corporations to invest in facilities and human resources and expand beyond the scope of sole proprietorships or partnerships. It would be impossible for a sole proprietorship or partnership to make automobiles, provide nationwide telecommunications, or build oil or chemical refineries.
Organizational Structure of Corporations
Attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license


Illustration shows that stockholders elect the directors, and the directors hire the officers, or top management. Top management consists of secretary, treasurer, vice presidents and president.

Disadvantages of Corporations

Although corporations offer companies many benefits, they have some disadvantages:

  • Double taxation of profits. Corporations must pay federal and state income taxes on their profits. In addition, any profits (dividends) paid to stockholders are taxed as personal income, although at a somewhat reduced rate.
  • Cost and complexity of formation. As outlined earlier, forming a corporation involves several steps, and costs can run into thousands of dollars, including state filing, registration, and license fees, as well as the cost of attorneys and accountants.
  • More government restrictions. Unlike sole proprietorships and partnerships, corporations are subject to many regulations and reporting requirements. For example, corporations must register in each state where they do business and must also register with the Securities and Exchange Commission (SEC) before selling stock to the public. Unless it is closely held (owned by a small group of stockholders), a firm must publish financial reports on a regular basis and file other special reports with the SEC and state and federal agencies. These reporting requirements can impose substantial costs, and published information on corporate operations may also give competitors an advantage.

Types of Corporations

Three types of corporate business organization provide limited liability.

The C corporation is the conventional or basic form of corporate organization. Small businesses may achieve liability protection through S corporations or limited liability companies (LLCs).

An S corporation is a hybrid entity, allowing smaller corporations to avoid double taxation of corporate profits as long as they meet certain size and ownership requirements. Organized like a corporation with stockholders, directors, and officers, an S corporation is taxed like a partnership. Income and losses flow through to the stockholders and are taxed as personal income. S corporations are allowed a maximum of 100 qualifying shareholders and one class of stock. The owners of an S corporation are not personally liable for the debts of the corporation.

A newer type of business entity, the limited liability company (LLC), is also a hybrid organization. Like S corporations, they appeal to small businesses because they are easy to set up and not subject to many restrictions. LLCs offer the same liability protection as corporations as well as the option of being taxed as a partnership or a corporation. First authorized in Wyoming in 1977, LLCs became popular after a 1988 tax ruling that treats them like partnerships for tax purposes. Today all states allow the formation of LLCs.

(Figure) summarizes the advantages and disadvantages of each form of business ownership.

Advantages and Disadvantages of Major Types of Business Organization
Sole Proprietorship Partnership Corporation
Advantages
Owner receives all profits. More expertise and managerial skill available. Limited liability protects owners from losing more than they invest.
Low organizational costs. Relatively low organizational costs. Can achieve large size due to marketability of stock (ownership).
Income taxed as personal income of proprietor. Income taxed as personal income of partners. Receives certain tax advantages.
Independence. Fundraising ability is enhanced by more owners. Greater access to financial resources allows growth.
Secrecy. Can attract employees with specialized skills.
Ease of dissolution. Ownership is readily transferable.
Long life of firm (not affected by death of owners).
Disadvantages
Owner receives all losses. Owners have unlimited liability; may have to cover debts of other, less financially sound partners. Double taxation because both corporate profits and dividends paid to owners are taxed, although the dividends are taxed at a reduced rate.
Owner has unlimited liability; total wealth can be taken to satisfy business debts. Dissolves or must reorganize when partner dies. More expensive and complex to form.
Limited fundraising ability can inhibit growth. Difficult to liquidate or terminate. Subject to more government regulation.
Proprietor may have limited skills and management expertise. Potential for conflicts between partners. Financial reporting requirements make operations public.
Few long-range opportunities and benefits for employees. Difficult to achieve large-scale operations.
Lacks continuity when owner dies.
  1. What is a corporation? Describe how corporations are formed and structured.
  2. Summarize the advantages and disadvantages of corporations. Which features contribute to the dominance of corporations in the business world?
  3. Why do S corporations and limited liability companies (LLCs) appeal to small businesses?

Summary of Learning Outcomes

  1. How does the corporate structure provide advantages and disadvantages to a company, and what are the major types of corporations?

A corporation is a legal entity chartered by a state. Its organizational structure includes stockholders who own the corporation, a board of directors elected by the stockholders to govern the firm, and officers who carry out the goals and policies set by the board. Stockholders can sell or transfer their shares at any time and are entitled to receive profits in the form of dividends. Advantages of corporations include limited liability, ease of transferring ownership, unlimited life tax deductions, and the ability to attract financing. Disadvantages include double taxation of profits, the cost and complexity of formation, and government restrictions.

Glossary

board of directors
A group of people elected by the stockholders to handle the overall management of a corporation, such as setting major corporate goals and policies, hiring corporate officers, and overseeing the firm’s operations and finances.
corporation
A legal entity with an existence and life separate from its owners, who are not personally liable for the entity’s debts. A corporation is chartered by the state in which it is formed and can own property, enter into contracts, sue and be sued, and engage in business operations under the terms of its charter.
C corporation
A conventional or basic form of corporate organization.
limited liability company (LLC)
A hybrid organization that offers the same liability protection as a corporation but may be taxed as either a partnership or a corporation.
S corporation
A hybrid entity that is organized like a corporation, with stockholders, directors, and officers, but taxed like a partnership, with income and losses flowing through to the stockholders and taxed as their personal income.
stockholders (or shareholders)
The owners of a corporation who hold shares of stock that carry certain rights.

30

Specialized Forms of Business Organization

  1. What other options for business organization does a company have in addition to sole proprietorships, partnerships, and corporations?

In addition to the three main forms, several specialized types of business organization also play an important role in our economy. We will look at cooperatives and joint ventures in this section and take a detailed look at franchising in the following section.

Cooperatives

When you eat a Sunkist orange or spread Land O’Lakes butter on your toast, you are consuming foods produced by cooperatives. A cooperative is a legal entity with several corporate features, such as limited liability, an unlimited life span, an elected board of directors, and an administrative staff. Member-owners pay annual fees to the cooperative and share in the profits, which are distributed to members in proportion to their contributions. Because they do not retain any profits, cooperatives are not subject to taxes.

There are currently 2.6 million cooperatives with one billion members employing more than 12.5 million employees in more than 145 countries worldwide.

“Measuring the Size and Scope of the Cooperative Economy: Results of the 2014 Global Census on Co-operatives,” prepared by Dave Grace and Associates for the United Nation’s Secretariat Department of Economic and Social Affairs Division for Social Policy and Development, April 2014.

Cooperatives operate in every industry, including agriculture, childcare, energy, financial services, food retailing and distribution, health care, insurance, housing, purchasing and shared services, and telecommunications, among others. They range in size from large enterprises such as Fortune 500 companies to small local storefronts and fall into four distinct categories: consumer, producer, worker, and purchasing/shared services.

Cooperatives are autonomous businesses owned and democratically controlled by their members—the people who buy their goods or use their services—not by investors. Unlike investor-owned businesses, cooperatives are organized solely to meet the needs of the member-owners, not to accumulate capital for investors. As democratically controlled businesses, many cooperatives practice the principle of “one member, one vote,” providing members with equal control over the cooperative.

There are two types of cooperatives. Buyer cooperatives combine members’ purchasing power. Pooling buying power and buying in volume increases purchasing power and efficiency, resulting in lower prices. At the end of the year, members get shares of the profits based on how much they bought. Obtaining discounts to lower costs gives the corner Ace Hardware store the chance to survive against retailing giants such as Home Depot Inc. and Lowe’s.

Founded in 1924, Ace Hardware is one of the nation’s largest cooperatives and is wholly owned by its independent hardware retailer members in stores spanning all 50 states and 70 countries. In August 2017, Ace opened its 5,000th store. In 2017, the company reported its revenues in the second quarter were $1.5 billion, which was an increase of 4.6 percent from 2016’s second quarter. The net income for the second quarter of 2017 was $51.1 million.

“Ace Hardware Reports Second Quarter 2017 Results,” http://www.acehardware.com, accessed August 17, 2017.

Seller cooperatives are popular in agriculture, wherein individual producers join to compete more effectively with large producers. Member dues support market development, national advertising, and other business activities. In addition to Sunkist and Land O’Lakes, other familiar cooperatives are Calavo (avocados), Ocean Spray (cranberries and juices), and Blue Diamond (nuts). CHS Inc., the largest cooperative in the United States, sells energy, supply, food, and grain.

Cooperatives empower people to improve their quality of life and enhance their economic opportunities through self-help. Throughout the world, cooperatives are providing members with credit and financial services, energy, consumer goods, affordable housing, telecommunications, and other services that would not otherwise be available to them. There are several principles that cooperatives must follow, according to San Luis Valley REC, International Co-operative Alliance, and Daman Prakash, author of The Principles of Cooperation. They include (1) open membership, which means that cooperatives are open to all people to use its services; (2) democratic member control, which means that organizations are controlled by their members; (3) members’ economic participation, which means that members contribute equally to the capital of the cooperative; (4) autonomy, which means cooperatives are self-help organizations controlled by their members; and (5) education and training, which means that cooperatives provide education and training for their members while also electing representatives, managers, and employees.

“7 Cooperative Principles,” San Luis Valley REC, https://www.slvrec.com; “Co-operative Principles,” International Co-operative Alliance, ica.coop; and “The Principles of Cooperation,” Daman Prakash, www.uwcc.wisc.edu.

Joint Ventures

In a joint venture, two or more companies form an alliance to pursue a specific project, usually for a specified time period. There are many reasons for joint ventures. The project may be too large for one company to handle on its own, and joint ventures also afford companies access to new markets, products, or technology. Both large and small companies can benefit from joint ventures.

In 2005, South Korea’s Hyundai Motor Company announced it signed a $1.24 billion deal to form a joint venture with China’s Guangzhou Automobile Group. The arrangement gave the South Korean automaker access to the commercial vehicle market in China, where its passenger cars are already the top selling foreign brand. Each side will hold equal stakes in the new entity, named Guangzhou Hyundai Motor Company. The new plant began production in 2007 with an annual capacity of 200,000 units producing small to large trucks and buses as well as commercial vehicles. According to Reuters, Hyundai made plans to build a fifth factory in China. With five factories in operation, Hyundai’s annual Chinese production capacity will be 1.65 million vehicles.

Joyce Lee, “Hyundai Motor to Begin Production at Fifth China Factory in August,” Thomson Reuters, July 18, 2017; Jin, Hyunjoo, and Samuel Shen, “Hyundai Motor to Build Two New Plants in China Instead of One: Sources,” Thomson Reuters, accessed August 17, 2017; Seon-Jin Cha, “Hyundai Forms China Joint Venture,” The Wall Street Journal, June 22, 2005, p. B4.

  1. Describe the two types of cooperatives and the advantages of each.
  2. What are the benefits of joint ventures?

Summary of Learning Outcomes

  1. What other options for business organization does a company have in addition to sole proprietorships, partnerships, and corporations?

Businesses can also organize as limited liability companies, cooperatives, joint ventures, and franchises. A limited liability company (LLC) provides limited liability for its owners but is taxed like a partnership. These two features make it an attractive form of business organization for many small firms. Cooperatives are collectively owned by individuals or businesses with similar interests that combine to achieve more economic power. Cooperatives distribute all profits to their members. Two types of cooperatives are buyer and seller cooperatives. A joint venture is an alliance of two or more companies formed to undertake a special project. Joint ventures can be set up in various ways, through partnerships or special-purpose corporations. By sharing management expertise, technology, products, and financial and operational resources, companies can reduce the risk of new enterprises.

Glossary

buyer cooperative
A group of cooperative members who unite for combined purchasing power.
cooperative
A legal entity typically formed by people with similar interests, such as suppliers or customers, to reduce costs and gain economic power. A cooperative has limited liability, an unlimited life span, an elected board of directors, and an administrative staff; all profits are distributed to the member-owners in proportion to their contributions.
joint venture
Two or more companies that form an alliance to pursue a specific project, usually for a specified time period.
seller cooperative
Individual producers who join together to compete more effectively with large producers.

32

Mergers and Acquisitions

  1. Why are mergers and acquisitions important to a company’s overall growth?

A merger occurs when two or more firms combine to form one new company. For example, in 2016, Johnson Controls, a leading provider of building efficiency solutions, agreed to merge with Ireland’s Tyco International, a leading provider of fire and security solutions, resulting in a company that will be a leader in products, technologies, and integrated solutions for the building and energy sectors. The merger is valued at $30 billion, with new Johnson Controls PLC to be based in Ireland. Currently, AT&T and Time Warner have an $85.4 billion merger pending. “Once we complete our acquisition of Time Warner Inc., we believe there is an opportunity to build an automated advertising platform that can do for premium video and TV advertising what the search and social media companies have done for digital advertising,” AT&T’s CEO Randall Stephenson said in a prepared statement. Mergers such as this one, in a well-established industry, can produce winning results in terms of improved efficiency and cost savings.

Thomas Content, “With acquisition of Tyco, Johnson Controls will become global ‘one-stop shop’ for building controls,” Journal Sentinel, January 25, 2016, http://archive.jsonline.com, (accessed August 17, 2017); Johnson Control Media Center, http://www.johnsoncontrols.com (accessed August 17, 2017); Brian Steinberg, “AT&T Opens New Advertising Unit in Advance of Time Warner Merger,” Variety, August 4, 2017, (August 6, 2017).

In an acquisition, a corporation or investor group finds a target company and negotiates with its board of directors to purchase it. In Verizon’s recent $4.5 billion acquisition of Yahoo, Verizon was the acquirer, and Yahoo the target company.

Christina Mercer, “We List the Most Notable Tech Acquisitions of 2017, So Far,” ComputerworldUK, https://www.computeruk.com, December 12, 2017.

Worldwide merger activity in the first quarter of 2017 was mixed. The volume of deals was lower but with higher dollar value. The total number of deals fell by 17.9 percent versus the first quarter of 2016; however, the overall deal value was $678.5 billion.

Gemma Acton, “Number of Global M&A Deals Tumbles in Q1 2017 While Overall Value Rises,” CNBC, https://www.cnbc.com, accessed August 6, 2017.

We will discuss the increase in international mergers later in this chapter.

Types of Mergers

The three main types of mergers are horizontal, vertical, and conglomerate. In a horizontal merger, companies at the same stage in the same industry merge to reduce costs, expand product offerings, or reduce competition. Many of the largest mergers are horizontal mergers to achieve economies of scale. Its $1.25 billion acquisition of trucking company Overnite allowed UPS, the world’s largest shipping carrier, to step up expansion of its heavy freight–delivery business, thus expanding its product offerings.

Harry R. Webber, “UPS to Buy Trucking Company Overnight for $1.25 Billion to Expand Its Freight Business,” USA Today, May 17, 2005, p. 6B.

In a vertical merger, a company buys a firm in its same industry, often involved in an earlier or later stage of the production or sales process. Buying a supplier of raw materials, a distribution company, or a customer gives the acquiring firm more control. A good example of this is Google’s acquisition of Urchin Software Corp., a San Diego–based company that sells web analytics software and services that help companies track the effectiveness of their websites and online advertising. The move enables Google to bolster the software tools it provides to its advertisers.

Kevin J. Delaney, “Google to Buy Urchin Software, Provider of Data for Advertisers,”Wall Street Journal, March 29, 2005, p. B4.

A conglomerate merger brings together companies in unrelated businesses to reduce risk. Combining companies whose products have different seasonal patterns or respond differently to business cycles can result in more stable sales. The Philip Morris Company, now called Altria Group, started out in the tobacco industry but diversified as early as the 1960s with the acquisition of Miller Brewing Company. It diversified into the food industry with its subsequent purchase of General Foods, Kraft Foods, and Nabisco, among others. Later spinning off many businesses, current product categories include cigarettes, smokeless tobacco such as Copenhagen and Skoal, cigars, e-vapor products such as MarkTen, and wines.

A specialized, financially motivated type of merger, the leveraged buyout (LBO) became popular in the 1980s but is less common today. LBOs are corporate takeovers financed by large amounts of borrowed money—as much as 90 percent of the purchase price. LBOs can be started by outside investors or the corporation’s management. For example, the private equity firm Apollo Global Management LLC agreed to buy U.S. security company ADT Corp. in the largest leveraged buyout (LBO) of 2016.

Koh Gui Qing and Greg Roumeliotis, “Apollo Global Braves LBO Rout with $7 Billion ADT Deal,” Reuters, https://www.reuters.com, accessed August 6, 2017.

Often a belief that a company is worth more than the value of all its stock is what drives an LBO. They buy the stock and take the company private, expecting to increase cash flow by improving operating efficiency or selling off units for cash to pay off debt. Although some LBOs do improve efficiency, many do not live up to investor expectations or generate enough cash to pay their debt.

Merger Motives

Although headlines tend to focus on mega-mergers, “merger mania” affects small companies too, and motives for mergers and acquisitions tend to be similar regardless of the company’s size. The goal is often strategic: to improve overall performance of the merged firms through cost savings, elimination of overlapping operations, improved purchasing power, increased market share, or reduced competition. Oracle Corp. paid $5.85 billion to acquire Siebel Systems, its largest competitor in the sales automation programs market.

Laurie J. Flynn, “Oracle Acquiring Another Big Rival,” San Diego Union–Tribune, September 13, 2005, p. C1.

Company growth, broadening product lines, acquiring technology or management skills, and the ability to quickly acquire new markets are other motives for acquiring a company. Yahoo Inc.’s $1 billion cash purchase of a 40 percent stake in China’s biggest e-commerce firm, Alibaba.com, instantly strengthened its ties to the world’s second largest internet market.

Joe McDonald, “Yahoo Buys Stake in China’s No. 1 Web Shopping Firm,” Associated Press, San Diego Union- Tribune, August 12, 2005, p. C1.

Purchasing a company can also offer a faster, less risky, less costly option than developing products or markets in-house or expanding internationally. Amazon’s 2017 purchase of Whole Foods Market, an upscale grocery chain, for $13.7 billion was a move to enter the retail grocery sector. In addition to the new product market, this move offers Amazon opportunity to sell Amazon tech products in the grocery stores as well as access to an entirely new set of data on consumers.

Greg Petro, “Amazon’s Acquisition of Whole Foods Is About Two Things: Data and Product,” Forbes, http://www.forbes.com, accessed March 31, 2018; Kate Taylor, “Here Are All the Changes Amazon Is Making to Whole Foods,” Business Insider, www.businessinsider.com, March 2, 2018.

Another motive for acquisitions is financial restructuring—cutting costs, selling off units, laying off employees, and refinancing the company to increase its value to stockholders. Financially motivated mergers are based not on the potential to achieve economies of scale, but rather on the acquirer’s belief that the target has hidden value to be unlocked through restructuring. Most financially motivated mergers involve larger companies. In January 2018, Brookfield Business Partners, a subsidiary of Canada’s Brookfield Asset Management, announced that it plans to acquire Westinghouse Electric Co LLC, the bankrupt nuclear services company owned by Toshiba Corp., for $4.6 billion. Brookfield has a history of turning around distressed businesses.

Tom Hals and Jessica DiNapoli, “Brookfield Business Partners to Buy Westinghouse for $4.6 Billion,” Reuters, https://www.reuters.com, January 4, 2018.

Emerging Truths

Along with the technology boom of the late 1990s, merger activity also soared. Total annual transactions averaged $1.6 trillion a year. Companies were using their stock, which had been pushed to unrealistically high levels, to buy each other. When the technology bubble burst in 2000, the level of merger activity dropped as well. It fell even further after the United States was attacked on September 11, 2001. Then massive corporate wrongdoing began to surface. Stocks plummeted in reaction to these events, and merger transactions, which generally track stock market movements, fell as a result.

Today, merger activity is once again on the rise. Propelled by a solid economy, low interest rates, good credit, rising stock prices, and stockpiles of cash, 2016’s $3.84 trillion of global M&A was historically a very strong year, with several blockbuster deals.

Brad Gevurtz, “’Fasten Your Seat Belt’: There’s Going to Be a Dealmaking Bonanza in 2017,” Business Insider, www.businessinsider.com, accessed August 6, 2017.

Size is definitely an advantage when competing in the global marketplace, but bigger does not always mean better in the merger business. Study results show that heady mega-mergers can, in fact, be a bust for investors who own those shares. So companies are wise to consider their options before stuffing their dollars in the biggest merger slot machine they can find. In their eagerness to snare a deal, many buyers pay a premium that wipes out the merger’s entire potential economic gain. Often managers envision grand synergies that prove illusory or unworkable or buy a company that isn’t what it seems—not fully understanding what they are getting.

Integrating acquisitions is both an art and a science. Acquirers often underestimate the costs and logistical nightmare of consolidating the operations of merged companies with very different cultures. As a result, they may fail to keep key employees aboard, sales forces selling, and customers happy.

Companies will always continue to seek out acquisition candidates, but the fundamental business case for merging will have to be strong. So what should companies look for to identify mergers with a better-than-even chance of turning out well?

  • A purchase price that is low enough—a 10 percent premium over market as opposed to 50 percent—so the buyer doesn’t need heroic synergies to make the deal work.
  • A target that is significantly smaller than the buyer—and in a business the buyer understands. The more “transformational” the deal, such as entering a new business arena, the bigger the risk.
  • A buyer who pays in cash and not overinflated stock.
  • Evidence that the deal makes both business and financial sense and isn’t purely the brainchild of an empire-building CEO. Mergers are tough—culturally, commercially, and logistically. The most important quality a company can bring to a merger may be humility.
  1. Differentiate between a merger and an acquisition.
  2. What are the most common motives for corporate mergers and acquisitions?
  3. Describe the different types of corporate mergers.

Summary of Learning Outcomes

  1. Why are mergers and acquisitions important to a company’s overall growth?

In a merger, two companies combine to form one company. In an acquisition, one company or investor group buys another. Companies merge for strategic reasons to improve overall performance of the merged firm through cost savings, eliminating overlapping operations, improving purchasing power, increasing market share, or reducing competition. Desired company growth, broadened product lines, and the rapid acquisition of new markets, technology, or management skills are other motives. Another motive for merging is financial restructuring—cutting costs, selling off units, laying off employees, and refinancing the company to increase its value to stockholders.

There are three types of mergers. In a horizontal merger, companies at the same stage in the same industry combine for more economic power, to diversify, or to win greater market share. A vertical merger involves the acquisition of a firm that serves an earlier or later stage of the production or sales process, such as a supplier or sales outlet. In a conglomerate merger, unrelated businesses come together to reduce risk through diversification.

Glossary

acquisition
The purchase of a target company by another corporation or by an investor group typically negotiated with the target company board of directors.
conglomerate merger
A merger of companies in unrelated businesses; done to reduce risk.
horizontal merger
A merger of companies at the same stage in the same industry; done to reduce costs, expand product offerings, or reduce competition.
leveraged buyout (LBO)
A corporate takeover financed by large amounts of borrowed money; can be started by outside investors or the corporation’s management.
merger
The combination of two or more firms to form one new company.
vertical merger
A merger of companies at different stages in the same industry; done to gain control over supplies of resources or to gain access to different markets.

V

Entrepreneurship: Starting and Managing Your Own Business

34

Introduction

(Credit: Christian Heilmann / flickr / Attribution 2.0 Generic (CC BY 2.0))


A photograph shows a street sign, and the street is named Innovation

Learning Outcomes

After reading this chapter, you should be able to answer these questions:

  1. Why do people become entrepreneurs, and what are the different types of entrepreneurs?
  2. What characteristics do successful entrepreneurs share?
  3. How do small businesses contribute to the U.S. economy?
  4. What are the first steps to take if you are starting your own business?
  5. Why does managing a small business present special challenges for the owner?
  6. What are the advantages and disadvantages facing owners of small businesses?
  7. How does the Small Business Administration help small businesses?
  8. What trends are shaping entrepreneurship and small-business ownership?
Natalie Tessler, Spa Space

Natalie Tessler has always had an entrepreneurial spirit. After she graduated from New York University’s law school, she began working as a tax attorney for a large firm in Chicago. But Tessler soon realized that this left her feeling unfulfilled. She didn’t want to practice law, and she didn’t want to work for someone else. “I wanted to wake up and be excited for my day,” Tessler said. Not until one night, though, when she was having dinner with a friend who recently had begun a writing career, did she realize it was time. “I was listening to her talk about how much she loved her job. Her passion and excitement—I wanted that. I wanted something that grabbed me and propelled me through the day—and being a lawyer wasn’t it.”

She began searching for what “it” was. She had a tremendous passion and talent for hospitality, entertaining others, and presentation. Seeking an outlet for that flair, she found the spa industry, and the idea for Spa Space was born.

“People think that, owning a spa, I’m able to live this glamorous lifestyle,” she laughs. “Owning a spa is nothing like going to one—my nails always are broken from fixing equipment; my back is usually in pain from sitting hunched over a computer trying to figure out the budget or our next marketing promotion.” Tessler is a true entrepreneur, embodying the spirit and drive necessary to see her vision become a reality.

Tessler wanted to design a spa that focused on something new: creating a comfortable, personalized environment of indulgence while not neglecting the medical technology of proper skin care. “My father’s a dermatologist, so we discussed the importance of making this more than a spa where you can get a frou-frou, smell-good treatment that might actually harm your skin. We both thought it was important to create an experience that is as beneficial for people’s skin as it is for their emotional well-being.” To address this need, Spa Space has a medical advisory board that helps with product selection, treatment design, and staff training.

Armed with a vision and a plan, Tessler turned her sights toward making it a reality. Spa Space opened in 2001 and has received a great deal of national recognition for its service excellence, unique treatments and products, and its fresh approach to appealing to both men and women. But it hasn’t always been smooth sailing for Spa Space. Tessler had to steer the business through several obstacles, including the 9/11 tragedy just three months after the spa’s grand opening, and then the Great Recession. Tessler learned to adapt her strategy by refining her target market and the services Spa Space offered. Her resiliency enabled the company to not only survive difficult economic periods, but to thrive and grow 17 years later into what the press recognizes as Chicago’s best spa.

Tessler recently turned the reins over to Ilana Alberico, another entrepreneur and founder of Innovative Spa Management, a company that has been named twice to Inc. magazine’s list of fastest growing companies. When Alberico met Natalie Tessler and learned about her vision, she was inspired to invest in Spa Space. “Natalie’s vision still resonates . . . I’m inspired to champion her vision into the future.”

Sources: “Our Team,” https://spaspace.com, accessed February 1, 2018; Jennifer Keishin Armstrong, “Spa Reviews: Spa Space in Chicago,” Day Spa magazine, http://www.dayspamagazine.com, accessed February 1, 2018; “About Us,” https://ismspa.com, accessed February 1, 2018.

Typical of many who catch the entrepreneurial bug, Natalie Tessler had a vision and pursued it single-mindedly. She is just one of thousands of entrepreneurs from all age groups and backgrounds. Even kids are starting businesses and high-tech firms. College graduates are shunning the corporate world to head out on their own. Downsized employees, midcareer executives, and retirees who have worked for others all their lives are forming the companies they have always wanted to own.

Companies started by entrepreneurs and small-business owners make significant contributions to the U.S. and global economies. Hotbeds of innovation, these small businesses take leadership roles in technological change and the development of new goods and services. Just how important are small businesses to our economy? (Figure) provides insight into the role of small business in today’s economy.

You may be one of the millions of Americans who’s considering joining the ranks of business owners. As you read this chapter, you’ll learn why entrepreneurship continues to be one of the hottest areas of business activity. Then you’ll get the information and tools you need to help you decide whether owning your own company is the right career path for you. Next you’ll discover what characteristics you’ll need to become a successful entrepreneur. Then we’ll look at the importance of small businesses in the economy, guidelines for starting and managing a small business, the many reasons small businesses continue to thrive in the United States, and the role of the Small Business Administration. Finally, the chapter explores the trends that shape entrepreneurship and small-business ownership today.

35

Entrepreneurship Today

  1. Why do people become entrepreneurs, and what are the different types of entrepreneurs?

Brothers Fernando and Santiago Aguerre exhibited entrepreneurial tendencies at an early age. At 8 and 9 years old respectively, they sold strawberries and radishes from a vacant lot near their parents’ home in Plata del Mar on the Atlantic coast of Argentina. At 11 and 12, they provided a surfboard repair service from their garage. As teenagers, Fer and Santi, as they call each other, opened Argentina’s first surf shop, which led to their most ambitious entrepreneurial venture of all.

The flat-footed brothers found that traipsing across hot sand in flip-flops was uncomfortable, so in 1984 they sank their $4,000 savings into manufacturing their own line of beach sandals. Now offering sandals and footwear for women, men, and children, as well as clothing for men, Reef sandals have become the world’s hottest beach footwear, with a presence in nearly every surf shop in the United States.

Shannon McMahon, “Stepping into a Fortune,” San Diego Union-Tribune, April 5, 2005, p. C4.

Source: “Firm Size Data: 2014,” https://www.sba.gov, accessed February 1, 2018.
The Economic Impact of Small Business
Most U.S. Businesses Are Small:
  • 80% (approximately 23.8 million) of the nearly 29.7 million businesses have no employees (businesses run by individuals or small groups of partners, such as married couples).
  • 89% (approximately 5.2 million) of the nearly 5.8 million businesses with employees have fewer than 20 employees.
  • 99.6% (approximately 5.7 million) of all businesses have 0–99 employees—98% have 0–20 workers.
  • Approximately 5.8 million businesses have fewer than 500 employees.
  • Only about 19,000 businesses in the United States have more than 500 employees.
  • Companies with fewer than 50 employees pay more than 20% of America’s payroll.
  • Companies with fewer than 500 employees pay more than 41% of America’s payroll.
  • 32.5 million people (1 employee in 4) work for businesses with fewer than 50 employees.
  • These businesses also pay tens of millions of owners, not included in employment statistics.
Young Entrepreneur Living the Dream

Jack Bonneau is the quintessential entrepreneur. In the three years he has been in business, he has expanded his product line, opened multiple locations, established strategic partnerships, and secured sponsorship from several national brands. His business has garnered publicity from The New York Times, The Denver Post, The Today Show, Good Morning America, and numerous other media. He has shared his business success on several stages, speaking at TechStars and the Aspen Ideas Festival, and recently delivered the closing keynote speech at a national STEM conference. He even landed a gig on Shark Tank.

Jack Bonneau is smart, charismatic, an excellent spokesperson, and persistent in his mission. And he is only 11 years old—which also makes him very adorable.

Jack’s business was born from a need that most kids have: a desire for toys. He asked his dad, Steve Bonneau, for a LEGO Star Wars Death Star. The problem was that it cost $400. Jack’s dad said he could have it but only if he paid for it himself. This led Jack to do what a lot of kids do to earn some extra cash. He opened a lemonade stand. But he quickly learned that this would never help him realize his dream, so, with the advice and help of his father, he decided to open a lemonade stand at a local farmers market. “There were lots of people who wanted to buy great lemonade from an eight-year-old,” says Jack. In no time, Jack had earned enough to buy his LEGO Death Star. “I had sales of around $2,000, and my total profit was $900,” Jack said.

Jack realized that he was on to something. Adults love to buy things from cute kids. What if he could make even more money by opening more locations? Jack developed an expansion plan to open three new “Jack Stands” the following spring. Realizing that he would need more working capital, he secured a $5,000 loan from Young Americas Bank, a bank in Denver that specializes in loans to children. Jack made $25,000 in 2015.

The following year, Jack wanted to expand operations, so he secured a second loan for $12,000. He opened stands in several more locations, including shopping malls during the holiday season, selling apple cider and hot chocolate instead of lemonade. He also added additional shop space and recruited other young entrepreneurial kids to sell their products in his space, changing the name to Jack’s Stands and Marketplace. One of his first partnerships was Sweet Bee Sisters, a lip balm and lotion company founded by Lily, Chloe, and Sophie Warren. He also worked with 18 other young entrepreneurs who sell a range of products from organic dog treats to scarves and headbands.

Jack’s strategy worked, and the business brought in more than $100,000 last year. This year, he became the spokesperson for Santa Cruz Organic Lemonade, and he’s now looking at expanding into other cities such as Detroit and New Orleans.

Even though Jack is only 11 years old, he has already mastered financial literacy, customer service, marketing and sales, social skills, and other sound business practices—all the qualities of a successful entrepreneur.

Critical Thinking Questions
  1. What do you think enabled Jack Bonneau to start and grow a successful business at such a young age?
  2. What personal characteristics and values will Jack need to continue running his business while also attending school full-time?

Sources: “About Jack’s Stands & Marketplaces,” https://www.jackstands.com, accessed February 1, 2018; Peter Gasca, “This 11-Year-Old Founder’s Advice Is As Profound as Any You Could Receive,” Inc., https://www.inc.com, July 27, 2017; Claire Martin, “Some Kids Sell Lemonade. He Starts a Chain,” The New York Times, https://www.nytimes.com, February 26, 2016.

Christy Glass Lowe, who monitors surf apparel for USBX Advisory Services LLC, notes, “They [Reef] built a brand from nothing and now they’re the dominant market share leader.”

The Aguerres, who currently live two blocks from each other in La Jolla, California, sold Reef to VF Corporation for more than $100 million in 2005. In selling Reef, “We’ve finally found our freedom,” Fernando says. “We traded money for time,” adds Santiago. Fernando remains active with surfing organizations, serving as president of the International Surfing Association, where he became known as “Ambassador of the Wave” for his efforts in getting all 90 worldwide members of the International Olympic Committee to unanimously vote in favor of including surfing in the 2020 Olympic Games.

Dashel Pierson, “10 Things You Should Know about Surfing in the Olympics,” Surfline, http://www.surfline.com, August 5, 2016.

He has also been named “Waterman of the Year” by the Surf Industry Manufacturers Association two times in 24 years.

Steve Chapple, “Reef Brand’s Co-founder Eyes the Horizon,” San Diego Union Tribune, https://www.sandiegouniontribune.com, December 13, 2013.

Santi raises funds for his favorite not-for-profit, SurfAid. Both brothers are enjoying serving an industry that has served them so well.

The United States is blessed with a wealth of entrepreneurs such as the Aguerres who want to start a small business. According to research by the Small Business Administration, two-thirds of college students intend to be entrepreneurs at some point in their careers, aspiring to become the next Bill Gates or Jeff Bezos, founder of Amazon.com. But before you put out any money or expend energy and time, you’d be wise to check out (Figure) for some preliminary advice.

The desire to be one’s own boss cuts across all age, gender, and ethnic lines. Results of a recent U.S. Census Bureau survey of business owners show that minority groups and women are becoming business owners at a much higher rate than the national average. (Figure) illustrates these minority-owned business demographics.

Why has entrepreneurship remained such a strong part of the foundation of the U.S. business system for so many years? Because today’s global economy rewards innovative, flexible companies that can respond quickly to changes in the business environment. Such companies are started by entrepreneurs, people with vision, drive, and creativity, who are willing to take the risk of starting and managing a business to make a profit.

Sources: Jess Ekstrom, “5 Questions to Ask Yourself Before You Start a Business,” Entrepreneur, https://www.entrepreneur.com, accessed February 1, 2018; “Resources,” http://www.marketsmarter.com, accessed February 1, 2018; Monique Reece, Real-Time Marketing for Business Growth: How to Use Social Media, Measure Marketing, and Create a Culture of Execution (Upper Saddle River, NJ: FT Press/Pearson, 2010); Mike Collins, “Before You Start–Innovator’s Inventory,” The Wall Street Journal, May 9, 2005, p. R4.
Are You Ready to Be an Entrepreneur?
Here are some questions would-be entrepreneurs should ask themselves:
  1. What is new and novel about your idea? Are you solving a problem or unmet need?
  2. Are there similar products/services out there? If so, what makes yours better?
  3. Who is your target market? How many people would use your product or service?
  4. Have you talked with potential customers to get their feedback? Would they buy your product/service?
  5. What about production costs? How much do you think the market will pay?
  6. How defensible is the concept? Is there good intellectual property?
  7. Is this innovation strategic to my business?
  8. Is the innovation easy to communicate?
  9. How might this product evolve over time? Would it be possible to expand it into a product line? Can it be updated/enhanced in future versions?
  10. Where would someone buy this product/service?
  11. How will the product/service be marketed? What are the costs to sell and market it?
  12. What are the challenges involved in developing this product/service?
Sources: Robert Bernstein, “Hispanic-Owned Businesses on the Upswing, International Trade Management Division, U.S. Census, https://www.census.gov, December 1, 2016; The Kauffman Index of Main Street Entrepreneurship, https://www.kauffman.org, November 2016.
Statistics for Minority-Owned Businesses
  • The number of Hispanic-owned businesses almost tripled between 1997 (1.2 million) and 2012 (3.3 million).
  • The percentage of U.S. businesses with 1 to 50 employees owned by African Americans increased by 50% between 1996 and 2015.
  • Almost a million firms with employees are minority owned: 53% are Asian American owned, 11% are African American owned, and almost a third are Hispanic owned.
  • 19% of all companies with employees are owned by women.

Entrepreneur or Small-Business Owner?

The term entrepreneur is often used in a broad sense to include most small-business owners. The two groups share some of the same characteristics, and we’ll see that some of the reasons for becoming an entrepreneur or a small-business owner are very similar. But there is a difference between entrepreneurship and small-business management. Entrepreneurship involves taking a risk, either to create a new business or to greatly change the scope and direction of an existing one. Entrepreneurs typically are innovators who start companies to pursue their ideas for a new product or service. They are visionaries who spot trends.

Although entrepreneurs may be small-business owners, not all small-business owners are entrepreneurs. Small-business owners are managers or people with technical expertise who started a business or bought an existing business and made a conscious decision to stay small. For example, the proprietor of your local independent bookstore is a small-business owner. Jeff Bezos, founder of Amazon.com, also sells books. But Bezos is an entrepreneur: He developed a new model—web-based book retailing—that revolutionized the bookselling world and then moved on to change retailing in general. Entrepreneurs are less likely to accept the status quo, and they generally take a longer-term view than the small-business owner.

Types of Entrepreneurs

Entrepreneurs fall into several categories: classic entrepreneurs, multipreneurs, and intrapreneurs.

Classic Entrepreneurs

Classic entrepreneurs are risk-takers who start their own companies based on innovative ideas. Some classic entrepreneurs are micropreneurs who start small and plan to stay small. They often start businesses just for personal satisfaction and the lifestyle. Miho Inagi is a good example of a micropreneur. On a visit to New York with college friends in 1998, Inagi fell in love with the city’s bagels. “I just didn’t think anything like a bagel could taste so good,” she said. Her passion for bagels led the young office assistant to quit her job and pursue her dream of one day opening her own bagel shop in Tokyo. Although her parents tried to talk her out of it, and bagels were virtually unknown in Japan, nothing deterred her. Other trips to New York followed, including an unpaid six-month apprenticeship at Ess-a-Bagel, where Inagi took orders, cleared trays, and swept floors. On weekends, owner Florence Wilpon let her make dough.

In August 2004, using $20,000 of her own savings and a $30,000 loan from her parents, Inagi finally opened tiny Maruichi Bagel. The timing was fortuitous, as Japan was about to experience a bagel boom. After a slow start, a favorable review on a local bagel website brought customers flocking for what are considered the best bagels in Tokyo. Inagi earns only about $2,300 a month after expenses, the same amount she was making as a company employee. “Before I opened this store I had no goals,” she says, “but now I feel so satisfied.”

Andrew Morse, “An Entrepreneur Finds Tokyo Shares Her Passion for Bagels,” The Wall Street Journal, October 18, 2005, p. B1.

In contrast, growth-oriented entrepreneurs want their business to grow into a major corporation. Most high-tech companies are formed by growth-oriented entrepreneurs. Jeff Bezos recognized that with Internet technology he could compete with large chains of traditional book retailers. Bezos’s goal was to build his company into a high-growth enterprise—and he chose a name that reflected his strategy: Amazon.com. Once his company succeeded in the book sector, Bezos applied his online retailing model to other product lines, from toys and house and garden items to tools, apparel, music, and services. In partnership with other retailers, Bezos is well on his way to making Amazon’s vision “to be Earth’s most customer-centric company; to build a place where people can come to find and discover anything they might want to buy online.”—a reality.

Barbara Farfan, “Amazon.com’s Mission Statement”, The Balance. April 15, 2018, https://www.thebalance.com/amazon-mission-statement-4068548.

Multipreneurs

Then there are multipreneurs, entrepreneurs who start a series of companies. They thrive on the challenge of building a business and watching it grow. In fact, over half of the chief executives at Inc. 500 companies say they would start another company if they sold their current one. Brothers Jeff and Rich Sloan are a good example of multipreneurs, having turned numerous improbable ideas into successful companies. Over the past 20-plus years, they have renovated houses, owned a horse breeding and marketing business, invented a device to prevent car batteries from dying, and so on. Their latest venture, a multimedia company called StartupNation, helps individuals realize their entrepreneurial dreams. And the brothers know what company they want to start next: yours.

“About StartupNation,” https://startupnation.com, accessed February 1, 2018; Jim Morrison, “Entrepreneurs,” American Way Magazine, October 15, 2005, p. 94.

If there is one person responsible for the mainstream success of solar energy and electric vehicles in the past 10 years, it’s Elon Musk, founder and CEO of Tesla. Since the 2000s when he founded Tesla, launching innovation in solar technology, and commercial space exploration with SpaceX, Musk has pioneered countless innovations and has challenged traditional automobile, trucking, and energy companies to challenge and rethink their businesses. What entrepreneurial type best describes Elon Musk? (Credit: Steve Jurvetson/ Flickr/ Attribution 2.0 Generic (CC BY 2.0))


A photograph shows Elon Musk

Intrapreneurs

Some entrepreneurs don’t own their own companies but apply their creativity, vision, and risk-taking within a large corporation. Called intrapreneurs, these employees enjoy the freedom to nurture their ideas and develop new products, while their employers provide regular salaries and financial backing. Intrapreneurs have a high degree of autonomy to run their own minicompanies within the larger enterprise. They share many of the same personality traits as classic entrepreneurs, but they take less personal risk. According to Gifford Pinchot, who coined the term intrapreneur in his book of the same name, large companies provide seed funds that finance in-house entrepreneurial efforts. These include Intel, IBM, Texas Instruments (a pioneering intrapreneurial company), Salesforce.com, and Xerox.

Why Become an Entrepreneur?

As the examples in this chapter show, entrepreneurs are found in all industries and have different motives for starting companies. The most common reason cited by CEOs of the Inc. 500, the magazine’s annual list of fastest-growing private companies, is the challenge of building a business, followed by the desire to control their own destiny. Other reasons include financial independence and the frustration of working for someone else. Two important motives mentioned in other surveys are a feeling of personal satisfaction with their work, and creating the lifestyle that they want. Do entrepreneurs feel that going into business for themselves was worth it? The answer is a resounding yes. Most say they would do it again.

  1. Describe several types of entrepreneurs.
  2. What differentiates an entrepreneur from a small-business owner?
  3. What are some major factors that motivate entrepreneurs to start businesses?

Summary of Learning Outcomes

  1. Why do people become entrepreneurs, and what are the different types of entrepreneurs?

Entrepreneurs are innovators who take the risk of starting and managing a business to make a profit. Most want to develop a company that will grow into a major corporation. People become entrepreneurs for four main reasons: the opportunity for profit, independence, personal satisfaction, and lifestyle. Classic entrepreneurs may be micropreneurs, who plan to keep their businesses small, or growth-oriented entrepreneurs. Multipreneurs start multiple companies, while intrapreneurs work within large corporations.

Glossary

entrepreneurs
People with vision, drive, and creativity who are willing to take the risk of starting and managing a business to make a profit, or greatly changing the scope and direction of an existing firm.
intrapreneurs
Entrepreneurs who apply their creativity, vision, and risk-taking within a large corporation, rather than starting a company of their own.
small business
A business with under 500 employees that is independently managed, is owned by an individual or a small group of investors, is based locally, and is not a dominant company in its industry.

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Characteristics of Successful Entrepreneurs

  1. What characteristics do successful entrepreneurs share?

Do you have what it takes to become an entrepreneur? Having a great concept is not enough. An entrepreneur must be able to develop and manage the company that implements his or her idea. Being an entrepreneur requires special drive, perseverance, passion, and a spirit of adventure, in addition to managerial and technical ability. Entrepreneurs are the company; they tend to work longer hours, take fewer vacations, and cannot leave problems at the office at the end of the day. They also share other common characteristics as described in the next section.

The Entrepreneurial Personality

Studies of the entrepreneurial personality find that entrepreneurs share certain key traits. Most entrepreneurs are

  • Ambitious: They are competitive and have a high need for achievement.
  • Independent: They are individualists and self-starters who prefer to lead rather than follow.
  • Self-confident: They understand the challenges of starting and operating a business and are decisive and confident in their ability to solve problems.
  • Risk-takers: Although they are not averse to risk, most successful entrepreneurs favor business opportunities that carry a moderate degree of risk where they can better control the outcome over highly risky ventures where luck plays a large role.
  • Visionary: Their ability to spot trends and act on them sets entrepreneurs apart from small-business owners and managers.
  • Creative: To compete with larger firms, entrepreneurs need to have creative product designs, bold marketing strategies, and innovative solutions to managerial problems.
  • Energetic: Starting and operating a business takes long hours. Even so, some entrepreneurs start their companies while still employed full-time elsewhere.
  • Passionate. Entrepreneurs love their work, as Miho Inagi demonstrated by opening a bagel shop in Tokyo despite the odds against it being a success.
  • Committed. Because they are so committed to their companies, entrepreneurs are willing to make personal sacrifices to achieve their goals.
Ethical Choices Transform Family Business into International Brand

Ever since Apollonia Poilâne was a young girl growing up in Paris, she always knew what she wanted to do when she grew up: take over the family business. But she didn’t anticipate how quickly this would happen. When her father—Lionel Poilâne—and her mother died in a helicopter crash in 2002, France lost its most celebrated baker, and Apollonia stepped into the role. She was just 18 years old at the time with plans to matriculate to Harvard in the fall, but the moment her parents had prepared her for had come. As her Harvard admissions essay said, “The work of several generations is at stake.”

With organization and determination, Apollonia managed one of the best French bakeries in the world—based in Paris—from her apartment in Cambridge, Massachusetts. She would usually wake up an extra two hours before classes to make sure she would get all the phone calls done for work. “After classes I check on any business regarding the company and then do my homework,” she says. “Before I go to bed I call my production manager in Paris to check the quality of the bread.” Because the name Poilâne has earned a place with a very small group of prestige bakers, the 18-year-old was determined to continue the tradition of customer satisfaction and quality her grandfather established in 1932. When her grandfather suffered a stroke in 1973, his 28-year-old son, Lionel, poured his heart into the business and made the family bread into the global brand it is today. Lionel opened two more bakeries in Paris and another in London. He developed and nurtured a worldwide network of retailers and celebrities where bread is shipped daily via FedEx to upscale restaurants and wealthy clients around the world.

Experimenting with sourdough is what distinguished Poilâne’s products from bread produced by Paris’s other bakers, and it has remained the company’s signature product. It is baked with a “P” carved into the crust, a throwback to the days when the use of communal ovens forced bakers to identify their loaves, and it also ensures that the loaf doesn’t burst while it’s baking. Today, Poilâne also sells croissants, pastries, and a few specialty breads, but the company’s signature item is still the four-pound miche, a wheel of sourdough, a country bread, pain Poilâne.

“Apollonia is definitely passionate about her job,” says Juliette Sarrazin, manager of the successful Poilâne Bakery in London. “She really believes in the work of her father and the company, and she is looking at the future, which is very good.”

Apollonia’s work ethic and passion fueled her drive even when she was a student. Each day presented a juggling act of new problems to solve in Paris while other Harvard students slept. As Apollonia told a student reporter from The Harvard Crimson writing a story about her, “The one or two hours you spend procrastinating I spend working. It’s nothing demanding at all. It was always my dream to run the company.”

Her dedication paid off, and Apollonia retained control of important decisions, strategy, and business goals, describing herself as the “commander of the ship,” determining the company’s overall direction. Today, Poilâne is an $18 million business that employs 160 people. Poilâne runs three restaurants called Cuisine de Bar in Paris and in London, serving casual meals such as soups, salads, and open-faced tartines. The company ships more than 200,000 loaves a year to clients in 20 countries, including the United States, Japan, and Saudi Arabia. “More people understand what makes the quality of the bread, what my father spent years studying, so I am thrilled about that,” says Apollonia.

Critical Thinking Questions
  1. What type of entrepreneur is Apollonia Poilâne?
  2. What personal ethics drove Apollonia’s decision to take over the family business?

Sources: “About Us,” https://www.poilane.com, accessed February 1, 2018; Meg Bortin, “Apollonia Poilâne Builds on Her Family’s Legacy,” The New York Times, https://www.nytimes.com, accessed February 1, 2018; Lauren Collins, “Bread Winner: A Daughter Upholds the Traditions of France’s Premier Baking Dynasty,” The New Yorker, https://www.newyorker.com, December 3, 2012; Gregory Katz, “Her Daily Bread,” American Way magazine, July 15, 2005, p. 34; Clarel Antoine, “No Time to Loaf Around,” Harvard Crimson, http://www.thecrimson.com, October 16, 2003.

Most entrepreneurs combine many of the above characteristics. Sarah Levy, 23, loved her job as a restaurant pastry chef but not the low pay, high stress, and long hours of a commercial kitchen. So she found a new one—in her parents’ home—and launched Sarah’s Pastries and Candies. Part-time staffers help her fill pastry and candy orders to the soothing sounds of music videos playing in the background. Cornell University graduate Conor McDonough started his own web design firm, OffThePathMedia.com, after becoming disillusioned with the rigid structure of his job. “There wasn’t enough room for my own expression,” he says. “Freelancing keeps me on my toes,” says busy graphic artist Ana Sanchez. “It forces me to do my best work because I know my next job depends on my performance.”

Martha Irvine, “More 20-Somethings Are Blazing Own Paths in Business,” San Diego Union-Tribune, November 22, 2004, p. C6.

Celebrity Ashton Kutcher is more than just a pretty face. The actor-mogul is an active investor in technology-based start-ups such as Airbnb, Skype, and Foursquare with an empire estimated at $200 million dollars. What personality traits are common to successful young entrepreneurs such as Kutcher? (Credit: TechCrunch/ Flickr/ Attribution 2.0 Generic (CC BY 2.0))


A photograph shows Ashton Kutcher sitting in front of a digital screen that reads Tech Crunch, N Y 2013.

Managerial Ability and Technical Knowledge

A person with all the characteristics of an entrepreneur might still lack the necessary business skills to run a successful company. Entrepreneurs need the technical knowledge to carry out their ideas and the managerial ability to organize a company, develop operating strategies, obtain financing, and supervise day-to-day activities. Jim Crane, who built Eagle Global Logistics from a start-up into a $250 million company, addressed a group at a meeting saying, “I have never run a $250 million company before so you guys are going to have to start running this business.”

Keith McFarland, “What Makes Them Tick,” Inc. 500, October 19, 2005, http://www.inc.com.

Good interpersonal and communication skills are important in dealing with employees, customers, and other business associates such as bankers, accountants, and attorneys. As we will discuss later in the chapter, entrepreneurs believe they can learn these much-needed skills. When Jim Steiner started his toner cartridge remanufacturing business, Quality Imaging Products, his initial investment was $400. He spent $200 on a consultant to teach him the business and $200 on materials to rebuild his first printer cartridges. He made sales calls from 8.00 a.m. to noon and made deliveries to customers from noon until 5:00 p.m. After a quick dinner, he moved to the garage, where he filled copier cartridges until midnight, when he collapsed into bed, sometimes covered with carbon soot. And this was not something he did for a couple of months until he got the business off the ground—this was his life for 18 months.

Ibid.

But entrepreneurs usually soon learn that they can’t do it all themselves. Often they choose to focus on what they do best and hire others to do the rest.

  1. Describe the personality traits and skills characteristic of successful entrepreneurs.
  2. What does it mean when we say that an entrepreneur should work on the business, not in it?

Summary of Learning Outcomes

  1. What characteristics do successful entrepreneurs share?

Successful entrepreneurs are ambitious, independent, self-confident, creative, energetic, passionate, and committed. They have a high need for achievement and a willingness to take moderate risks. Good managerial, interpersonal, and communication skills, as well as technical knowledge are important for entrepreneurial success.

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Small Business: Driving America's Growth

  1. How do small businesses contribute to the U.S. economy?

Although large corporations dominated the business scene for many decades, in recent years small businesses have once again come to the forefront. Downsizings that accompany economic downturns have caused many people to look toward smaller companies for employment, and they have plenty to choose from. Small businesses play an important role in the U.S. economy, representing about half of U.S. economic output, employing about half the private sector workforce, and giving individuals from all walks of life a chance to succeed.

What Is a Small Business?

How many small businesses are there in the United States? Estimates range from 5 million to over 22 million, depending on the size limits government agencies and other groups use to define a small business or the number of businesses with or without employees. The Small Business Administration (SBA) established size standards to define whether a business entity is small and therefore eligible for government programs and preferences that are reserved for “small businesses.” Size standards are based on the types of economic activity or industry, generally matched to the North American Industry Classification System (NAICS).

U.S. Small Business Administration, “Make Sure You Meet SBA Size Standards,” https://www.sba.gov, accessed February 1, 2018.

Small businesses are defined in many ways. Statistics for small businesses vary based on criteria such as new/start-up businesses, the number of employees, total revenue, length of time in business, nonemployees, businesses with employees, geographic location, and so on. Due to the complexity and need for consistent statistics and reporting for small businesses, several organizations are now working together to combine comprehensive data sources to get a clear and accurate picture of small businesses in the United States. (Figure) provides a more detailed look at small-business owners.

Sources: “The Kauffman Index: Main Street Entrepreneurship: National Trends,” http://www.kauffman.org, November 2016; “Kauffman Index of Startup Activity, 2016 (calculations based from CPS, BDS, and BED),” http://www.kauffman.org; “America’s Entrepreneurs: September 2016,” https://www.census.gov; “Nearly 1 in 10 Businesses with Employees Are New, According to Inaugural Annual Survey of Entrepreneurs,” https://www.census.gov, September 1, 2016.
Snapshot of Small-Business Owners
  • Start-up activity has risen sharply over the last three years, from an all-time low of minus 0.87% in 2013 to positive 0.48% in 2016.
  • Between 1996 and 2011, the rate of business ownership dropped for both men and women; however, business ownership has increased every year since 2014.
  • The Kauffman Index of Startup Activity, an early indicator of new entrepreneurship in the United States, rose again slightly in 2016 following sharp increases two years in a row.
  • New entrepreneurs who started businesses to pursue opportunity rather than from necessity reached 86.3%, more than 12 percentage points higher than in 2009 at the height of the Great Recession.
  • For the first time, Main Street entrepreneurship activity was higher in 2016 than before the onset of the Great Recession. This increase was driven by a jump in business survival rates, which reached a three-decade high of 48.7%. Nearly half of new businesses are making it to their fifth year of operation.
  • 47% of U.S. businesses have been in business for 11 or more years.
  • In 2016, about 25% of all employing firms had revenues over $1 million, but 2% had revenues under $10,000.

One of the best sources to track U.S. entrepreneurial growth activity is the Ewing Marion Kauffman Foundation. The Kauffman Foundation is among the largest private foundations in the country, with an asset base of approximately $2 billion, and focuses on projects that encourage entrepreneurship and support education through grants and research activities. They distributed over $17 million in grants in 2013.

“Who We Are,” http://www.kauffman.org, accessed February 1, 2018; “Ewing Marion Kauffman Foundation,” http://en.wikipedia.org, accessed February 1, 2018.

The Kauffman Foundation supports new business creation in the United States through two research programs. The annual Kauffman Index of Entrepreneurship series measures and interprets indicators of U.S. entrepreneurial activity at the national, state, and metropolitan level. The foundation also contributes to the cost of the Annual Survey of Entrepreneurs (ASE), which is a public–private partnership between the foundation, the U.S. Census Bureau, and the Minority Business Development Agency. The ASE provides annual data on select economic and demographic characteristics of employer businesses and their owners by gender, ethnicity, race, and veteran status.

“Annual Survey of Entrepreneurs,” https://www.census.gov, accessed February 1, 2018.

The Kauffman Index of Entrepreneurship series is an umbrella of annual reports that measures how people and businesses contribute to America’s overall economy. What is unique about the Kauffman reports is that the indexes don’t focus on only inputs (as most small-business reporting has been done in the past); it reports primarily on entrepreneurial outputs—the actual results of entrepreneurial activity, such as new companies, business density, and growth rates. The reports also include comprehensive, interactive data visualizations that enable users to slice and dice a myriad of data nationally, at the state level, and for the 40 largest metropolitan areas.

“The Kauffman Index,” http://www.kauffman.org, accessed February 2, 2018.

The Kauffman Index series consists of three in-depth studies—Start-up Activity, Main Street Entrepreneurship, and Growth Entrepreneurship.

  • The Kauffman Index of Startup Activity is an early indicator of new entrepreneurship in the United States. It focuses on new business creation activity and people engaging in business start-up activity, using three components: the rate of new entrepreneurs, the opportunity share of new entrepreneurs, and start-up density.
  • The Kauffman Index of Main Street Entrepreneurship measures established small-business activity—focusing on U.S. businesses more than five years old with less than 50 employees from 1997 to 2016. Established in 2015, it takes into account three components of local, small-business activity: the rate of businesses owners in the economy, the five-year survival rate of businesses, and the established small-business density.
  • The Kauffman Growth Entrepreneurship Index is a composite measure of entrepreneurial business growth in the United States that captures growth entrepreneurship in all industries and measures business growth from both revenue and job perspectives. Established in 2016, it includes three component measures of business growth: rate of start-up growth, share of scale-ups, and high-growth company density.

Data sources for the Kauffman Index calculations are based on Current Population Survey (CPS), with sample sizes of more than 900,000 observations, and the Business Dynamics Statistics (BDS), which covers approximately 5 million businesses. The Growth Entrepreneurship Index also includes Inc. 500/5000 data).

Small businesses in the United States can be found in almost every industry, including services, retail, construction, wholesale, manufacturing, finance and insurance, agriculture and mining, transportation, and warehousing. Established small businesses are defined as companies that have been in business at least five years and employ at least one, but less than 50, employees. (Figure) provides the number of employees by the size of established business. More than half of small businesses have between one and four employees.

Source: Kauffman Foundation calculations from Business Dynamics Statistics, yearly measures. November 2016.
Number of Employees, by Percentage of Established Small Businesses
Established small businesses are defined as businesses over the age of five employing at least one, but less than 50, employees.
Number of Employees Percentage of Businesses
1–4 employees 53.07%
5–9 employees 23.23%
10–19 employees 14.36%
20–49 employees 9.33%
  1. What are three ways small businesses can be defined?
  2. What social and economic factors have prompted the rise in small business?

Summary of Learning Outcomes

  1. How do small businesses contribute to the U.S. economy?

Small businesses play an important role in the economy. They account for over 99 percent of all employer firms and produce about half of U.S. economic output. Most new private-sector jobs created in the United States over the past decade were in small firms. The Small Business Administration defines a small business as independently owned and operated, with a local base of operations, and not dominant in its field. It also defines small business by size, according to its industry. Small businesses are found in every field, but they dominate the service, construction, wholesale, and retail categories.

38

Ready, Set, Start Your Own Business

  1. What are the first steps to take if you are starting your own business?

You have decided that you’d like to go into business for yourself. What is the best way to go about it? Start from scratch? Buy an existing business? Or buy a franchise? About 75 percent of business start-ups involve brand-new organizations, with the remaining 25 percent representing purchased companies or franchises. Franchising may have been discussed elsewhere in your course, so we’ll cover the other two options in this section.

Getting Started

The first step in starting your own business is a self-assessment to determine whether you have the personal traits you need to succeed and, if so, what type of business would be best for you. (Figure) provides a checklist to consider before starting your business.

Finding the Idea

Entrepreneurs get ideas for their businesses from many sources. It is not surprising that about 80 percent of Inc. 500 executives got the idea for their company while working in the same or a related industry. Starting a firm in a field where you have experience improves your chances of success. Other sources of inspiration are personal experiences as a consumer; hobbies and personal interests; suggestions from customers, family, and friends; industry conferences; and college courses or other education.

Source: “10 Steps to Start Your Business,” https://www.sba.gov, accessed February 2, 2018.
Checklist for Starting a Business
Before you start your own small business, consider the following checklist:
  • Identify your reasons
  • Self-analysis
  • Personal skills and experience
  • Finding a niche
  • Conduct market research
  • Plan your start-up: write a business plan
  • Finances: how to fund your business

An excellent way to keep up with small-business trends is by reading entrepreneurship and small-business magazines and visiting their websites. With articles on everything from idea generation to selling a business, they provide an invaluable resource and profile some of the young entrepreneurs and their successful business ventures ((Figure)).

Adapted from “They’ve Founded Million Dollar Companies and They’re not Even 30,”https://www.inc.com/30-under-30.

Successful Entrepreneurs
Name and Age Company and Description
Philip Kimmey, 27 Kimmey’s dog-sitting and dog-walking network, Rover.com, raised almost $100 million in venture capital and was valued at $300 million in 2017.
Max Mankin, 27 Mankin cofounded Modern Electron and raised $10 million in venture capital to create “advanced thermionic energy converters” that will generate “cheap, scalable, and reliable electricity.” Modern Electron will turn every home into a power station.
Alexandra Cristin White, 28 In her early 20s, White founded Glam Seamless, which sells tape-in hair extensions. In 2016, her self-funded company grossed $2.5 million.
Steph Korey, 29; Jen Rubio, 29 Korey and Rubio founded Away, selling “first-class luggage at a coach price” in 2015. They raised $31 million in funding and grossed $12 million in sales in 2016.
Allen Gannet, 26 Gannet founded TrackMaven, a web-marketing analytics company, in 2012; by 2016, his company was grossing $6.7 million a year.
Jake Kassan, 25; Kramer LaPlante, 25 Kassan and Kramer launched their company, MVMT, through Indiegogo, raising $300,000, and in 2016 grossed $60 million, selling primarily watches and sunglasses.
Brian Streem, 29 Streem’s company, Aerobo, provides drone services to the film industry, selling “professional aerial filming and drone cinematography.” Aerobo grossed $1 million in 2016, its first full year of business.
Natalya Bailey, 30; Louis Perna, 29 Accion Systems began in 2014, raised $10 million in venture funding, and grossed $4.5 million in 2016, making tiny propulsion systems for satellites.
Jessy Dover, 29 Dover is the cofounder of Dagne Dover, a company making storage-efficient handbags for professional women. She and her cofounders grossed $4.5 million in 2016 and debuted on Nordstrom.com in 2017.

These dynamic individuals, who are already so successful in their 20s and 30s, came up with unique ideas and concepts and found the right niche for their businesses.

Interesting ideas are all around you. Many successful businesses get started because someone identifies a need and then finds a way to fill it. Do you have a problem that you need to solve? Or a product that doesn’t work as well as you’d like? Raising questions about the way things are done and seeing opportunity in adversity are great ways to generate ideas.

Choosing a Form of Business Organization

A key decision for a person starting a new business is whether it will be a sole proprietorship, partnership, corporation, or limited liability company. As discussed earlier, each type of business organization has advantages and disadvantages. The choice depends on the type of business, number of employees, capital requirements, tax considerations, and level of risk involved.

Developing the Business Plan

Once you have the basic concept for a product or service, you must develop a plan to create the business. This planning process, culminating in a sound business plan, is one of the most important steps in starting a business. It can help to attract appropriate loan financing, minimize the risks involved, and be a critical determinant in whether a firm succeeds or fails. Many people do not venture out on their own because they are overwhelmed with doubts and concerns. A comprehensive business plan lets you run various “what if” analyses and evaluate your business without any financial outlay or risk. You can also develop strategies to overcome problems well before starting the business.

Taking the time to develop a good business plan pays off. A venture that seems sound at the idea stage may not look so good on paper. A well-prepared, comprehensive, written business plan forces entrepreneurs to take an objective and critical look at their business venture and analyze their concept carefully; make decisions about marketing, sales, operations, production, staffing, budgeting and financing; and set goals that will help them manage and monitor its growth and performance.

Each year, a variety of organizations hold business plan competitions to engage the growing number of college students starting their own businesses. The University of Essex and the iLearn entrepreneurship curriculum developed by the University of Texas in Austin, which partnered with Trisakti University in Jakarta, Indonesia, and the U.S. embassy to help run an entrepreneurship course and competition are examples of such competitions. Seven students from “iLearn: Entrepreneurship” were selected as finalists to pitch their business plans to a panel of Indonesian business leaders and embassy representatives. The winning business plan, which was an ecotourism concept, earned $1,000 in seed money. What research goes into a winning business plan? (Credit: University of Essex /flickr/ Attribution 2.0 Generic (CC BY 2.0))


A photograph shows a group of people, made up of younger and older people, wearing shirts that read, Essex Startups 20 15.

The business plan also serves as the initial operating plan for the business. Writing a good business plan takes time. But many businesspeople neglect this critical planning tool in their eagerness to begin doing business, getting caught up in the day-to-day operations instead.

The key features of a business plan are a general description of the company, the qualifications of the owner(s), a description of the products or services, an analysis of the market (demand, customers, competition), sales and distribution channels, and a financial plan. The sections should work together to demonstrate why the business will be successful, while focusing on the uniqueness of the business and why it will attract customers. (Figure) describes the essential elements of a business plan.

A common use of a business plan is to persuade lenders and investors to finance the venture. The detailed information in the plan helps them assess whether to invest. Even though a business plan may take months to write, it must capture potential investors’ interest within minutes. For that reason, the basic business plan should be written with a particular reader in mind. Then you can fine-tune and tailor it to fit the investment goals of the investor(s) you plan to approach.

Sources: “7 Elements of a Business Plan,” https://quickbooks.intuit.com, accessed February 2, 2018; David Ciccarelli, “Write a Winning Business Plan with These 8 Key Elements,” Entrepreneur, https://www.entrepreneur.com, accessed February 2, 2018; Patrick Hull, “10 Essential Business Plan Components,” Forbes, https://www.forbes.com, accessed February 2, 2018; Justin G. Longenecker, J. William Petty, Leslie E. Palich, and Frank Hoy, Small Business Management: Launching & Growing Entrepreneurial Ventures, 18th edition (Mason, OH: Cengage, 2017); Monique Reece, Real-Time Marketing for Business Growth: How to Use Social Media, Measure Marketing, and Create a Culture of Execution (Upper Saddle River, NJ: FT Press/Pearson, 2010).
Key Elements of a Business Plan
Executive summary provides an overview of the total business plan. Written after the other sections are completed, it highlights significant points and, ideally, creates enough excitement to motivate the reader to continue reading.
Vision and mission statement concisely describe the intended strategy and business philosophy for making the vision happen. Company values can also be included in this section.
Company overview explains the type of company, such as manufacturing, retail, or service; provides background information on the company if it already exists; and describes the proposed form of organization—sole proprietorship, partnership, or corporation. This section should include company name and location, company objectives, nature and primary product or service of the business, current status (start-up, buyout, or expansion) and history (if applicable), and legal form of organization.
Product and/or service plan describes the product and/or service and points out any unique features, as well as explains why people will buy the product or service. This section should offer the following descriptions: product and/or service; features and benefits of the product or service that provide a competitive advantage; available legal protection—patents, copyrights, and trademarks.
Marketing plan shows who the firm’s customers will be and what type of competition it will face; outlines the marketing strategy and specifies the firm’s competitive edge; and describes the strengths, weaknesses, opportunities, and threats of the business. This section should offer the following descriptions: analysis of target market and profile of target customer; methods of identifying, attracting, and retaining customers; a concise description of the value proposition; selling approach, type of sales force, and distribution channels; types of marketing and sales promotions, advertising, and projected marketing budget; product and/or service pricing strategy; and credit and pricing policies.
Management plan identifies the key players—active investors, management team, board members, and advisors— citing the experience and competence they possess. This section should offer the following descriptions: management team, outside investors and/or directors and their qualifications, outside resource people and their qualifications, and plans for recruiting and training employees.
Operating plan explains the type of manufacturing or operating system to be used and describes the facilities, labor, raw materials, and product-processing requirements. This section should offer the following descriptions: operating or manufacturing methods, operating facilities (location, space, and equipment), quality-control methods, procedures to control inventory and operations, sources of supply, and purchasing procedures.
Financial plan specifies financial needs and contemplated sources of financing, as well as presents projections of revenues, costs, and profits. This section should offer the following descriptions: historical financial statements for the last 3–5 years or as available; pro forma financial statements for 3–5 years, including income statements, balance sheets, cash flow statements, and cash budgets (monthly for first year and quarterly for second year); financial assumptions; breakeven analysis of profits and cash flows; and planned sources of financing.
Appendix of supporting documents provides materials supplementary to the plan. This section should offer the following descriptions: management team biographies; the company’s values; information about the company culture (if it’s unique and contributes to employee retention); and any other important data that support the information in the business plan, such as detailed competitive analysis, customer testimonials, and research summaries.

But don’t think you can set aside your business plan once you obtain financing and begin operating your company. Entrepreneurs who think their business plan is only for raising money make a big mistake. Business plans should be dynamic documents, reviewed and updated on a regular basis—monthly, quarterly, or annually, depending on how the business progresses and the particular industry changes.

Owners should adjust their sales and profit projections up or down as they analyze their markets and operating results. Reviewing your plan on a constant basis will help you identify strengths and weaknesses in your marketing and management strategies and help you evaluate possible opportunities for expansion in light of both your original mission and goals, current market trends, and business results. The Small Business Administration (SBA) offers sample business plans and online guidance for business plan preparation under the “Business Guide” tab at https://www.sba.gov.

Financing the Business

Once the business plan is complete, the next step is to obtain financing to set up your company. The funding required depends on the type of business and the entrepreneur’s own investment. Businesses started by lifestyle entrepreneurs require less financing than growth-oriented businesses, and manufacturing and high-tech companies generally require a large initial investment.

Who provides start-up funding for small companies? Like Miho Inagi and her Tokyo bagel shop, 94 percent of business owners raise start-up funds from personal accounts, family, and friends. Personal assets and money from family and friends are important for new firms, whereas funding from financial institutions may become more important as companies grow. Three-quarters of Inc. 500 companies have been funded on $100,000 or less.

McFarland, “What Makes Them Tick.”

The two forms of business financing are debt, borrowed funds that must be repaid with interest over a stated time period, and equity, funds raised through the sale of stock (i.e., ownership) in the business. Those who provide equity funds get a share of the business’s profits. Because lenders usually limit debt financing to no more than a quarter to a third of the firm’s total needs, equity financing often amounts to about 65 to 75 percent of total start-up financing.

FUBU started when a young entrepreneur from Hollis, Queens, began making tie-top skullcaps at home with some friends. With funding from a $100,000 mortgage and a later investment from the Samsung Corporation, CEO Daymond John, turned his home into a successful sportswear company. The FUBU brand tops the list for today’s fashionistas who don everything from FUBU’s classic Fat Albert line to swanky FUBU suits and tuxedos. How do start-ups obtain funding? (Credit: U.S. Embasy Nairobi/ flickr/ Attribution 2.0 Generic (CC BY 2.0))


A photograph shows Daymond John sitting in a chair on stage, speaking into a microphone.

One way to finance a start-up company is bootstrapping, which is basically funding the operation with your own resources. If the resources needed are not available to an individual, there are other options. Two sources of equity financing for young companies are angel investors and venture-capital firms. Angel investors are individual investors or groups of experienced investors who provide financing for start-up businesses by investing their own money, often referred to as “seed capital.” This gives the investors more flexibility on what they can and will invest in, but because it is their own money, angels are careful. Angel investors often invest early in a company’s development, and they want to see an idea they understand and can have confidence in. (Figure) offers some guidelines on how to attract angel financing.

Sources: Guy Kawasaki, “The Art of Raising Angel Capital,” https://guykawasaki.com, accessed February 2, 2018; Murray Newlands, “How to Raise an Angel Funding Round,” Forbes, https://www.forbes.com, March 16, 2017; Melinda Emerson, “5 Tips for Attracting Angel Investors,” Small Business Trends, https://smallbiztrends.com, July 26, 2016; Nicole Fallon, “5 Tips for Attracting Angel Investors,” Business News Daily, https://www.businessnewsdaily.com, January 2, 2014; Stacy Zhao, “9 Tips for Winning over Angels,” Inc., https://www.inc.com, June 15, 2005; Rhonda Abrams, “What Does It Take to Impress an Angel Investor?” Inc., https://www.inc.com, March 29, 2001.
Making a Heavenly Deal
You need financing for your start-up business. How do you get angels interested in investing in your business venture?
  • Show them something they understand, ideally a business from an industry they’ve been associated with.
  • Know your business details: Information important to potential investors includes annual sales, gross profit, profit margin, and expenses.
  • Be able to describe your business—what it does and who it sells to—in less than a minute. Limit PowerPoint presentations to 10 slides.
  • Angels can always leave their money in the bank, so an investment must interest them. It should be something they’re passionate about. And timing is important—knowing when to reach out to an angel can make a huge difference.
  • They need to see management they trust, respect, and like. Present a competent management team with a strong, experienced leader who can explain the business and answer questions from potential investors with specifics.
  • Angels prefer something they can bring added value to. Those who invest could be involved with your company for a long time or perhaps take a seat on your board of directors.
  • They are more partial to deals that don’t require huge sums of money or additional infusions of angel cash.
  • Emphasize the likely exits for investors and know who the competition is, why your solution is better, and how you are going to gain market share with an infusion of cash.

Venture capital is financing obtained from venture capitalists, investment firms that specialize in financing small, high-growth companies. Venture capitalists receive an ownership interest and a voice in management in return for their money. They typically invest at a later stage than angel investors. We’ll discuss venture capital in greater detail when discussing financing the enterprise.

Buying a Small Business

Another route to small-business ownership is buying an existing business. Although this approach is less risky, many of the same steps for starting a business from scratch apply to buying an existing company. It still requires careful and thorough analysis. The potential buyer must answer several important questions: Why is the owner selling? Does he or she want to retire or move on to a new challenge, or are there problems with the business? Is the business operating at a profit? If not, can this be corrected? On what basis has the owner valued the company, and is it a fair price? What are the owner’s plans after selling the company? Will he or she be available to provide assistance through the change of ownership of the business? And depending on the type of business it is, will customers be more loyal to the owner than to the product or service being offered? Customers could leave the firm if the current owner decides to open a similar business. To protect against this, many purchasers include a noncompete clause in the contract of sale, which generally means that the owner of the company being sold may not be allowed to compete in the same industry of the acquired business for a specific amount of time.

You should prepare a business plan that thoroughly analyzes all aspects of the business. Get answers to all your questions, and determine, via the business plan, whether the business is a sound one. Then you must negotiate the price and other terms of purchase and obtain appropriate financing. This can be a complicated process and may require the use of a consultant or business broker.

Risky Business

Running your own business may not be as easy as it sounds. Despite the many advantages of being your own boss, the risks are great as well. Over a period of five years, nearly 50% percent of small businesses fail according to the Kauffman Foundation.

“The Kauffman Index,” http://www.kauffman.org, accessed February 2, 2018.

Businesses close down for many reasons—and not all are failures. Some businesses that close are financially successful and close for nonfinancial reasons. But the causes of business failure can be interrelated. For example, low sales and high expenses are often directly related to poor management. Some common causes of business closure are:

  • Economic factors—business downturns and high interest rates
  • Financial causes—inadequate capital, low cash balances, and high expenses
  • Lack of experience—inadequate business knowledge, management experience, and technical expertise
  • Personal reasons—the owners may decide to sell the business or move on to other opportunities

Inadequate early planning is often at the core of later business problems. As described earlier, a thorough feasibility analysis, from market assessment to financing, is critical to business success. Yet even with the best plans, business conditions change and unexpected challenges arise. An entrepreneur may start a company based on a terrific new product only to find that a larger firm with more marketing, financing, and distribution clout introduces a similar item.

The stress of managing a business can also take its toll. The business can consume your whole life. Owners may find themselves in over their heads and unable to cope with the pressures of business operations, from the long hours to being the main decision maker. Even successful businesses have to deal with ongoing challenges. Growing too quickly can cause as many problems as sluggish sales. Growth can strain a company’s finances when additional capital is required to fund expanding operations, from hiring additional staff to purchasing more raw material or equipment. Successful business owners must respond quickly and develop plans to manage its growth.

So, how do you know when it is time to quit? “Never give up” may be a good motivational catchphrase, but it is not always good advice for a small-business owner. Yet, some small-business owners keep going no matter what the cost. For example, Ian White’s company was trying to market a new kind of city map. White maxed out 11 credit cards and ran up more than $100,000 in debt after starting his company. He ultimately declared personal bankruptcy and was forced to find a job so that he could pay his bills. Maria Martz didn’t realize her small business would become a casualty until she saw her tax return showing her company’s losses in black and white—for the second year in a row. It convinced her that enough was enough and she gave up her gift-basket business to become a full-time homemaker. But once the decision is made, it may be tough to stick to. “I got calls from people asking how come I wasn’t in business anymore. It was tempting to say I’d make their basket but I had to tell myself it is finished now.”

Andrew Blackman, “Know When to Give Up,” The Wall Street Journal, May 9, 2005, p. R9.

  1. How can potential business owners find new business ideas?
  2. Why is it important to develop a business plan? What should such a plan include?
  3. What financing options do small-business owners have? What risks do they face?

Summary of Learning Outcomes

  1. What are the first steps to take if you are starting your own business?

After finding an idea that satisfies a market need, the small-business owner should choose a form of business organization. Preparing a formal business plan helps the business owner analyze the feasibility of his or her idea. The written plan describes in detail the idea for the business and how it will be implemented and operated. The plan also helps the owner obtain both debt and equity financing for the new business.

Glossary

angel investors
Individual investors or groups of experienced investors who provide financing for start-up businesses by investing their own funds.
business plan
A formal written statement that describes in detail the idea for a new business and how it will be carried out; includes a general description of the company, the qualifications of the owner(s), a description of the product or service, an analysis of the market, and a financial plan.
debt
A form of business financing consisting of borrowed funds that must be repaid with interest over a stated time period.
equity
A form of business financing consisting of funds raised through the sale of stock (i.e., ownership) in a business.
venture capital
Financing obtained from venture capitalists, investment firms that specialize in financing small, high-growth companies and receive an ownership interest and a voice in management in return for their money.

39

Managing a Small Business

  1. Why does managing a small business present special challenges for the owner?

Managing a small business is quite a challenge. Whether you start a business from scratch or buy an existing one, you must be able to keep it going. The small-business owner must be ready to solve problems as they arise and move quickly if market conditions change.

Learning How to Pivot

Most small business owners either use, or at least know of, the iconic email service MailChimp, a company that is growing by more than $120 million every year and is on track to bring in $525 million over the coming year. But Ben Chestnut, the CEO and cofounder, says it took MailChimp several years to figure out what it did well.

When Chestnut was laid off from his job at the Cox Media Group in Atlanta, he founded Rocket Science Group, a web design firm. Cofounder Dan Kurzius (who taught himself to code) joined Chestnut, and they began to focus their sales efforts on tech companies. But when the tech bubble burst, they pivoted to focus on selling to airline and travel companies. Then 9/11 hit, and they needed to change focus again, this time on the real estate market. However, both Chestnut and Kurzius discovered they didn’t enjoy sales (and they weren’t very good at it), nor did they like the bureaucracy of working with large companies. “The only companies we could relate to were small businesses, and they always asked for email marketing.”

This insight helped Chestnut to recall a product feature the Rocket Science Group had previously developed for an email greeting card project. So Chestnut and Kurzius evaluated the marketing software and began to test it with small businesses. “Our day jobs felt like going to these big organizations and pitching to them, and it was miserable,” Chestnut says. “But we really loved our nighttime jobs, which were helping the small businesses use this email marketing app.” Their passion, along with market feedback, led to their decision to completely focus on email marketing for small businesses. But it wasn’t until almost 2009 that MailChimp found its sweet spot. The founders initially wanted to give away one product that collected subscribers and then charge for another, which was sending emails, but it would have been very difficult to divide the product into two pieces. That’s when they landed on the Freemium idea. “Let’s just make the whole thing free,” said Chestnut.

The idea was that if they made it cheap and easy for small businesses to try MailChimp, their business would grow and they would be happy to pay for MailChimp services. MailChimp allows customers to send an email for free to 1,999 people at once but charges for emails sent to over 2,000 people and for premium features. MailChimp charges a monthly recurring fee starting at $10 for sending more than 12,000 emails a month.

The idea quickly proved to be a huge success. MailChimp went from a few hundred thousand users to 1 million users in a year. The next year they added another million users.

The MailChimp founders learned a lot of lessons during their 17 years in business. One of their most important lessons is knowing when to change. When you see an opportunity, don’t be afraid to pivot and change course, especially if it means focusing on a market you’re passionate about. Listening to market feedback and following their passion earned MailChimp’s founders \recognition as “2017 Business of the Year” by Inc. magazine.

Critical Thinking Questions
  1. What led MailChimp’s founders to change its focus on the customers they were selling to?
  2. What was MailChimp’s “big idea” that changed the business, and why was it so successful?

Sources: Maria Aspan, “Want Proof That Patience Pays Off? Ask the Founders of This 17-Year-Old $525 Million Email Empire,” Inc., https://www.inc.com, Winter 2017/January 2018 issue; “MailChimp: From Startup to Inc. Magazine’s Top Company,” CNBC, https://www.cnbc.com, December 12, 2017; Farhad Manjoo, “MailChimp and the Un-Silicon Valley Way to Make It as a Start-Up,” The New York Times, https://www.nytimes.com, October 5, 2016.

A sound business plan is key to keeping the small-business owner in touch with all areas of his or her business. Hiring, training, and managing employees is another important responsibility because the owner’s role may change over time. As the company grows, others will make many of the day-to-day decisions while the owner focuses on managing employees and planning for the firm’s long-term success. The owner must constantly evaluate company performance and policies in light of changing market and economic conditions and develop new policies as required. He or she must also nurture a continual flow of ideas to keep the business growing. The types of employees needed may change too as the firm grows. For instance, a larger firm may need more managerial talent and technical expertise.

Using Outside Consultants

One way to ease the burden of managing a business is to hire outside consultants. Nearly all small businesses need a good certified public accountant (CPA) who can help with financial record keeping, decision-making, and tax planning. An accountant who works closely with the owner to help the business grow is a valuable asset. An attorney who knows about small-business law can provide legal advice and draw up essential contracts and documents. Consultants in areas such as marketing, employee benefits, and insurance can be used on an as-needed basis. Outside directors with business experience are another way for small companies to get advice. Resources such as these free the small-business owner to concentrate on medium- and long-range planning and day-to-day operations.

Some aspects of business can be outsourced or contracted out to specialists. Among the more common departments that use outsourcing are information technology, marketing, customer service, order fulfillment, payroll, and human resources. Hiring an outside company—in many cases another small business—can save money because the purchasing firm buys just the services it needs and makes no investment in expensive technology. Management should review outsourced functions as the business grows because at some point it may be more cost-effective to bring them in-house.

Hiring and Retaining Employees

It is important to identify all the costs involved in hiring an employee to make sure your business can afford it. Recruiting, help-wanted ads, extra space, and taxes will easily add about 10–15 percent to their salary, and employee benefits will add even more. Hiring an employee may also mean more work for you in terms of training and management. It’s a catch-22: To grow you need to hire more people, but making the shift from solo worker to boss can be stressful.

Attracting good employees is more difficult for a small firm, which may not be able to match the higher salaries, better benefits, and advancement potential offered by larger firms. Small companies need to be creative to attract the right employees and convince applicants to join their firm. Once they hire an employee, small-business owners must make employee satisfaction a top priority in order to retain good people. A company culture that nurtures a comfortable environment for workers, flexible hours, employee benefit programs, opportunities to help make decisions, and a share in profits and ownership are some ways to do this.

Duane Ruh figured out how to build a $1.2 million business in a town with just 650 residents. It’s all about treating employees right. The log birdhouse and bird feeder manufacturer, Little Log Co., located in Sargent, Nebraska, boasts employee-friendly policies you read about but rarely see put into practice. Ruh offers his employees a flexible schedule that gives them plenty of time for their personal lives. During a slow period last summer, Ruh cut back on hours rather than lay anyone off. There just aren’t that many jobs in that part of Nebraska that his employees could go to, so when he received a buyout offer that would have closed his facility but kept him in place with an enviable salary, he turned it down. Ruh also encourages his employees to pursue side or summer jobs if they need to make extra money, assuring them that their Little Log jobs are safe.

Michelle Prather, “Talk of the Town,” Entrepreneur Magazine, February 2003, http://www.entrepreneur.com.

Going Global with Exporting

More and more small businesses are discovering the benefits of looking beyond the United States for market opportunities. The global marketplace represents a huge opportunity for U.S. businesses, both large and small. Small businesses’ decision to export is driven by many factors, one of which is the desire for increased sales and higher profits. U.S. goods are less expensive for overseas buyers when the value of the U.S. dollar declines against foreign currencies, and this creates opportunities for U.S. companies to sell globally. In addition, economic conditions such as a domestic recession, foreign competition within the United States, or new markets opening up in foreign countries may also encourage U.S. companies to export.

Like any major business decision, exporting requires careful planning. Small businesses may hire international-trade consultants or distributors to get started selling overseas. These specialists have the time, knowledge, and resources that most small businesses lack. Export trading companies (ETCs) buy goods at a discount from small businesses and resell them abroad. Export management companies (EMCs) act on a company’s behalf. For fees of 5–15 percent of gross sales and multiyear contracts, they handle all aspects of exporting, including finding customers, billing, shipping, and helping the company comply with foreign regulations.

Many online resources are also available to identify potential markets for your goods and services, as well as to decipher the complexities involved in preparing to sell in a foreign country. The Small Business Association’s Office of International Trade has links to many valuable sites. The Department of Commerce offers services for small businesses that want to sell abroad. Contact its Trade Information Center, 1-800-USA-TRADE, or its Export Center (http://www.export.gov).

  1. How does the small-business owner’s role change over time?
  2. How does managing a small business contribute to its growth?
  3. What are the benefits to small firms of doing business internationally, and what steps can small businesses take to explore their options?

Summary of Learning Outcomes

  1. Why does managing a small business present special challenges for the owner?

At first, small-business owners are involved in all aspects of the firm’s operations. Hiring and retaining key employees and the wise use of outside consultants can free up an owner’s time to focus on planning, strategizing, and monitoring market conditions, in addition to overseeing day-to-day operations. Expanding into global markets can be a profitable growth strategy for a small business.

40

Small Business, Large Impact

  1. What are the advantages and disadvantages facing owners of small businesses?

An uncertain economy has not stopped people from starting new companies. The National Federation of Independent Businesses reports that 85 percent of Americans view small businesses as a positive influence on American life. This is not surprising when you consider the many reasons why small businesses continue to thrive in the United States:

There are several cities and regions that are regarded as the best locations for start-up businesses and entrepreneurs. Among them are Tulsa, Oklahoma; Tampa, Florida; Atlanta, Georgia; Raleigh, North Carolina; Oklahoma City, Oklahoma; Seattle, Washington; Minneapolis, Minnesota; and Austin, Texas.

Forbes, “Ten Best Cities for Entrepreneurs” https://www.forbes.com/pictures/feki45igde/10-best-cities-for-young-entrepreneurs/#5bc189726058.

Why Stay Small?

Owners of small businesses recognize that being small offers special advantages. Greater flexibility and an uncomplicated company structure allow small businesses to react more quickly to changing market forces. Innovative product ideas can be developed and brought to market more quickly, using fewer financial resources and personnel than would be needed in a larger company. And operating more efficiently keeps costs down as well. Small companies can also serve specialized markets that may not be cost-effective for large companies. Another feature is the opportunity to provide a higher level of personal service. Such attention brings many customers back to small businesses such as gourmet restaurants, health clubs, spas, fashion boutiques, and travel agencies.

Steve Niewulis played in baseball’s minor leagues before an injury to his rotator cuff cut short his career. Niewulis decided to combine his love of the game with a clever idea that has elevated him to the big leagues. The fact that players had trouble keeping their hands dry while batting inspired his big idea: a sweat-busting rosin bag attached to a wristband so that a player can dry the bat handle between pitches. In less than two years, Niewulis’s Fort Lauderdale, Florida, company, Tap It! Inc., sold thousands of Just Tap It! wristbands. The product, which retails for $12.95, is used by baseball players, basketball players, tennis players, golfers, and even rock climbers. His secret to success? Find a small distribution network that allows small companies, with just one product line, to succeed.

Don Debelak, “Rookie Rules,” Business Start-Ups Magazine, http://www.entrepreneur.com, March 2, 2006.

On the other hand, being small is not always an asset. The founders may have limited managerial skills or encounter difficulties obtaining adequate financing, potential obstacles to growing a company. Complying with federal regulations is also more expensive for small firms. Those with fewer than 20 employees spend about twice as much per employee on compliance than do larger firms. In addition, starting and managing a small business requires a major commitment by the owner. Long hours, the need for owners to do much of the work themselves, and the stress of being personally responsible for the success of the business can take a toll.

But managing your company’s growing pains doesn’t need to be a one-person job. Four years after he started DrinkWorks (now Whirley DrinkWorks), a company that makes custom drinking cups, Richard Humphrey was logging 100-hour weeks. “I was concerned that if I wasn’t there every minute, the company would fall apart.” Humphrey got sick, lost weight, and had his engagement fall apart. When forced by a family emergency to leave the company in the hands of his five employees, Humphrey was amazed at how well they managed in his absence. “They stepped up to the plate and it worked out,” he says. “After that the whole company balanced out.”

McFarland, “What Makes Them Tick.”

  1. Why are small businesses becoming so popular?
  2. Discuss the major advantages and disadvantages of small businesses.

Summary of Learning Outcomes

  1. What are the advantages and disadvantages facing owners of small businesses?

Because of their streamlined staffing and structure, small businesses can be efficiently operated. They have the flexibility to respond to changing market conditions. Small firms can serve specialized markets more profitably than large firms, and they provide a higher level of personal service. Disadvantages include limited managerial skill, difficulty in raising capital needed for start-up or expansion, the burden of complying with increasing levels of government regulation, and the major personal commitment that is required by the owner.

41

The Small Business Administration

  1. How does the Small Business Administration help small businesses?

Many small-business owners turn to the Small Business Administration (SBA) for assistance. The SBA’s mission is to speak on behalf of small business, and through its national network of local offices it helps people start and manage small businesses, advises them in the areas of finance and management, and helps them win federal contracts. Its toll-free number—1-800-U-ASK-SBA (1-800-827-5722)—provides general information, and its website at http://www.sba.gov offers details on all its programs.

Much of the statistical information for the SBA section is from the Small Business Administration website at http://www.sba.gov.

Financial Assistance Programs

The SBA offers financial assistance to qualified small businesses that cannot obtain financing on reasonable terms through normal lending channels. This assistance takes the form of guarantees on loans made by private lenders. (The SBA no longer provides direct loans.) These loans can be used for most business purposes, including purchasing real estate, equipment, and materials. The SBA has been responsible for a significant amount of small-business financing in the United States. In the fiscal year ending on September 30, 2017, the SBA backed more than $25 billion in loans to almost 68,000 small businesses, including about $9 billion to minority-owned firms and $7.5 billion in loans to businesses owned by women. It also provided more than $1.7 billion in home and business disaster loans.

“SBA Lending Activity in FY 2017 Shows Consistent Growth,” https://www.sba.gov, October 13, 2017.

Other SBA programs include the New Markets Venture Capital Program, which promotes economic development and job opportunities in low-income geographic areas, while other programs offer export financing and assistance to firms that suffer economic harm after natural or other disasters.

More than 300 SBA-licensed Small Business Investment Companies (SBICs) provide about $6 billion each year in long-term financing for small businesses. The SBA’s website suggests seeking angel investors and using SBA-guaranteed loans as a way to fund the start-up. These privately owned and managed investment companies hope to earn a substantial return on their investments as the small businesses grow.

SCORE-ing with Management Assistance Programs

The SBA also provides a wide range of management advice. Its Business Development Library has publications on most business topics. Its “Starting Out” series offers brochures on how to start a wide variety of businesses—from ice-cream stores to fish farms.

Business development officers at the Office of Business Development and local Small Business Development Centers counsel many thousands of small-business owners each year, offering advice, training, and educational programs. The SBA also offers free management consulting through two volunteer groups: the Service Corps of Retired Executives (SCORE), and the Active Corps of Executives (ACE). Executives in these programs use their own business backgrounds to help small-business owners. SCORE has expanded its outreach into new markets by offering email counseling through its website (http://www.score.org). The SBA also offers free online resources and courses for small-business owners and aspiring entrepreneurs in its Learning Center, located on the SBA website under the “Learning Center” tab.

Assistance for Women and Minorities

The SBA is committed to helping women and minorities increase their business participation. It offers a minority small-business program, microloans, and the publication of Spanish-language informational materials. It has increased its responsiveness to small businesses by giving regional offices more decision authority and creating high-tech tools for grants, loan transactions, and eligibility reviews.

The SBA offers special programs and support services for socially and economically disadvantaged persons, including women, Native Americans, and Hispanics through its Minority Business Development Agency. It also makes a special effort to help veterans go into business for themselves.

  1. What is the Small Business Administration (SBA)?
  2. Describe the financial and management assistance programs offered by the SBA.

Summary of Learning Outcomes

  1. How does the Small Business Administration help small businesses?

The Small Business Administration is the main federal agency serving small businesses. It provides guarantees of private-lender loans for small businesses. The SBA also offers a wide range of management assistance services, including courses, publications, and consulting. It has special programs for women, minorities, and veterans.

Glossary

Small Business Administration (SBA)
A government agency that speaks on behalf of small business; specifically it helps people start and manage small businesses, advises them in the areas of finance and management, and helps them win federal contracts.
Small Business Investment Company (SBIC)
Privately owned and managed investment companies that are licensed by the Small Business Administration and provide long-term financing for small businesses.

VI

Management and Leadership in Today's Organizations

43

Introduction

(Credit: Urs Rüegsegger / flickr / Public Domain Mark 1.0)


A photograph shows a lighthouse sitting on a bluff near the ocean.

Learning Outcomes

After reading this chapter, you should be able to answer these questions:

  1. What is the role of management?
  2. What are the four types of planning?
  3. What are the primary functions of managers in organizing activities?
  4. How do leadership styles influence a corporate culture?
  5. How do organizations control activities?
  6. What roles do managers take on in different organizational settings?
  7. What set of managerial skills is necessary for managerial success?
  8. What trends will affect management in the future?
Jalem Getz

BuyCostumes.com/Wantable, Inc. You might ask, “How does one come to work in the world of online costume retail?” A passion for holiday make-believe and dress-up? A keen eye for business potential? The drive to capitalize on a competitive advantage? If you’re Jalem Getz, the answer is: all of these. Getz is the founder of BuyCostumes.com, an online costume and accessories retailer and, most recently, founder of Wantable, Inc.

As with most businesses, BuyCostumes.com and Wantable, Inc., are the result of careful planning. BuyCostumes.com was a response to what Getz saw as inherent flaws of resource allocation with the business model of brick-and-mortar costume retailers. “As a brick-and-mortar business, we were the gypsies of retail, which caused scale problems since we started over every year. Because we only were in a mall four or five months a year, locations we had one year often were rented the next. So we had to find new stores to rent each year. Then we had to find management to run the stores, and train employees to staff them. We also had to shuffle the inventory around each year to stock them. It’s almost impossible to grow a business like that.” By turning to the internet, however, Getz was able to bypass all of those issues. The virtual “space” was available year-round, and inventory and staff were centralized in a single warehouse location.

Getz grew BuyCostumes.com to a multimillion-dollar business before selling it, with a staff of about 600 employees during its peak season. Before Getz sold the business, it carried over 10,000 Halloween items and had upwards of 20 million visitors each holiday season. In one year, it shipped over 1 million costumes across the world, including 45 countries outside the United States. “We say that our goal is to ensure that anytime anyone buys a costume anywhere in the world, it will be from BuyCostumes.com. And, although to some extent we’re kidding, we’re also very serious.”

To keep track of all this action, Getz mixed ideals of a strong work ethic, a willingness to take risks, and an interest in having fun while making a profit. Given the size of the company, BuyCostumes.com organized its management to help keep the company focused on the corporate goal of continued growth. For Getz, his role in the management hierarchy was to “hire excellent people who have similar goals and who are motivated the same way I am and then put them in a position where they can succeed.” Beyond that? “Inspect what you expect.” This maxim is a concise way to say that, although he does not believe in constantly watching over his employees’ shoulders, he does believe in periodically checking in with them to ensure that both he and they are on the same page. By considering the process of management a conversation between himself and his employees, he exhibits a strong participative leadership style.

Getz will joke that he wishes he could say that he spent his childhood dreaming of the day he could work with costumes. The truth, though, is that he saw an opportunity, grabbed it, and hasn’t let go since. And sometimes, especially during Halloween, truth can be even more satisfying than fiction.

After selling BuyCostumes.com, Getz experimented with other digital start-ups but quickly realized he worked best with retail. In 2012, he launched Wantable, Inc., an online personal shopping service. In its first four years, Getz led the company to exceed 28,000% annual revenue growth and to hire more than 100 employees. It became profitable in 2016 and looked to double its income the following year.

Sources: “About Wantable,” http://blog.wantable.com, accessed October 27, 2017; “Wantable Surpasses 100 Employees,” http://www.prweb.com, April 3, 2017; Jeff Engel, “Jalem Getz’s Latest Retail Startup Wantable Targets Women, Fast Growth,” https://www.xconomy.com, April 21, 2014.

Today’s companies rely on managers to guide daily operations using human, technological, financial, and other resources to create a competitive advantage. For many beginning business students, being in “management” is an attractive but somewhat vague future goal. This vagueness is due in part to an incomplete understanding of what managers do and how they contribute to organizational success or failure. This chapter introduces the basic functions of management and the skills managers need to drive an organization toward its goals. We will also discuss how leadership styles influence a corporate culture and highlight the trends that are shaping the future role of managers.

44

The Role of Management

  1. What is the role of management?

Management is the process of guiding the development, maintenance, and allocation of resources to attain organizational goals. Managers are the people in the organization responsible for developing and carrying out this management process. Management is dynamic by nature and evolves to meet needs and constraints in the organization’s internal and external environments. In a global marketplace where the rate of change is rapidly increasing, flexibility and adaptability are crucial to the managerial process. This process is based in four key functional areas of the organization: planning, organizing, leading, and controlling. Although these activities are discussed separately in the chapter, they actually form a tightly integrated cycle of thoughts and actions.

From this perspective, the managerial process can be described as (1) anticipating potential problems or opportunities and designing plans to deal with them, (2) coordinating and allocating the resources needed to implement plans, (3) guiding personnel through the implementation process, and (4) reviewing results and making any necessary changes. This last stage provides information to be used in ongoing planning efforts, and thus the cycle starts over again. The four functions are highly interdependent, with managers often performing more than one of them at a time and each of them many times over the course of a normal workday.

To encourage greater collaboration between employees, Apple is investing $5 billion in the construction of its new Cupertino, CA, headquarters, which is replacing several buildings the company had outgrown. Most headquarters-based employees of Apple now share not only the same office space, but also the same technology tools and corporate culture. How do Apple’s planning and organizing decisions increase organizational efficiency and effectiveness? (Credit: Tom Pavel / flickr/ Attribution 2.0 Generic (CC BY 2.0))


A photograph shows a large building made up of mostly windows, with a security gate out front.

The four management functions can help managers increase organizational efficiency and effectiveness. Efficiency is using the least possible amount of resources to get work done, whereas effectiveness is the ability to produce a desired result. Managers need to be both efficient and effective in order to achieve organizational goals. For example in 2016, Delta, one of the most efficient network U.S. airlines, operated at revenue of 12.15 cents per seat-mile, which is the revenue the company makes on one seat (occupied or not) the distance of one mile. No other airline came close to operating this efficiently except Southwest, which flew seats that produced 12.51 cents a mile, the best performance of all U.S. airlines.

Source: US DOT Form 41 via BTS, Schedules P12 and T2.

There are many ways that airlines can manage to produce higher revenue per seat-mile. For instance, they can raise ticket prices, fill more of their seats, operate more efficient aircraft that utilize less fuel, or negotiate favorable salaries with their employees. While efficiency and effectiveness are sometimes lauded by investors, airlines also need to account for customer satisfaction, which can mean extra costs.

Matthew C. Klein, “Traders Appreciate United Airlines Commitment to ‘Cost Efficiency Targets’,” Financial Times, https://ftalphaville.ft.com, April 10, 2017; Robert Silk, “UPDATED: JetBlue Founder Neeleman Working on New Company,” Travel Weekly, http://www.travelweekly.com, July 31, 2017; Karsten Strauss, “When CEOs Get Demoted (By Companies They Founded),” Forbes, https://www.forbes.com, March 28, 2013.

To meet the demands of rapid growth, Skechers hired a new chief financial officer, John Vandemore, which allowed their existing CFO (David Weinberg) to concentrate on international expansion. Skechers CEO Robert Greenberg commented: “As international now represents more than 50 percent of our total business, we must continue to ramp up operations and infrastructure to meet the demand. David (Weinberg) understands how to do it the right way at the right speed to maintain our forward momentum. With John (Vandemore) handling CFO responsibilities, David will now have the bandwidth to travel and find opportunities to maximize our efficiencies around the globe.”

I-Chun Chen, “Sketchers Hires Former Disney and Mattel Exec as CFO,” L. A. Biz, https://www.bizjournals.com, November 15, 2017.

As these examples and (Figure) show, good management uses the four management functions to increase a company’s efficiency and effectiveness, which leads to the accomplishment of organizational goals and objectives. Let’s look more closely at what each of the management functions entails.

What Managers Do and Why
Good management consists of these four activities: Which results in And leads to
Planning
  • Set objectives and state mission
  • Examine alternatives
  • Determine needed resources
  • Create strategies to reach objectives
Leading
  • Lead and motivate employees to accomplish organizational goals
  • Communicate with employees
  • Resolve conflicts
  • Manage change
Organizing
  • Design jobs and specify tasks
  • Create organizational structure
  • Staff positions
  • Coordinate work activities
  • Set policies and procedures
  • Allocate resources
Controlling
  • Measure performance
  • Compare performance to standards
  • Take necessary action to improve performance
Leads to Organizational efficiency and effectiveness Leads to Achievement of organizational mission and objectives
  1. Define the term management.
  2. What are the four key functions of managers?
  3. What is the difference between efficiency and effectiveness?

Summary of Learning Outcomes

  1. What is the role of management?

Management is the process of guiding the development, maintenance, and allocation of resources to attain organizational goals. Managers are the people in the organization responsible for developing and carrying out this management process. The four primary functions of managers are planning, organizing, leading, and controlling. By using the four functions, managers work to increase the efficiency and effectiveness of their employees, processes, projects, and organizations as a whole.

Glossary

effectiveness
The ability to produce the desired result or good.
efficiency
Using the least amount of resources to accomplish the organization’s goals.
management
The process of guiding the development, maintenance, and allocation of resources to attain organizational goals.

45

Planning

  1. What are the four types of planning?

Planning begins by anticipating potential problems or opportunities the organization may encounter. Managers then design strategies to solve current problems, prevent future problems, or take advantage of opportunities. These strategies serve as the foundation for goals, objectives, policies, and procedures. Put simply, planning is deciding what needs to be done to achieve organizational objectives, identifying when and how it will be done, and determining who should do it. Effective planning requires extensive information about the external business environment in which the firm competes, as well as its internal environment.

There are four basic types of planning: strategic, tactical, operational, and contingency. Most of us use these different types of planning in our own lives. Some plans are very broad and long term (more strategic in nature), such as planning to attend graduate school after earning a bachelor’s degree. Some plans are much more specific and short term (more operational in nature), such as planning to spend a few hours in the library this weekend. Your short-term plans support your long-term plans. If you study now, you have a better chance of achieving some future goal, such as getting a job interview or attending graduate school. Like you, organizations tailor their plans to meet the requirements of future situations or events. A summary of the four types of planning appears in (Figure).

Strategic planning involves creating long-range (one to five years), broad goals for the organization and determining what resources will be needed to accomplish those goals. An evaluation of external environmental factors such as economic, technological, and social issues is critical to successful strategic planning. Strategic plans, such as the organization’s long-term mission, are formulated by top-level managers and put into action at lower levels in the organization. For example, when Mickey Drexler took over as CEO of J.Crew, the company was floundering and had been recently purchased by a private equity group. One of Drexler’s first moves was to change the strategic direction of the company by moving it out of the crowded trend-following retail segment, where it was competing with stores such as Gap, American Eagle, and Abercrombie and back into the preppie, luxury segment where it began. Rather than trying to sell abundant inventory to a mass market, J.Crew cultivated scarcity, making sure items sold out early rather than hit the sale rack later in the season. The company also limited the number of new stores it opened during a two-year span but planned to double the number of stores in the next five to six years. Drexler led the company through public offerings and back to private ownership before bringing on a new CEO in 2017. He remained chairman with ownership in the company.

Christina Cheddar, “Famed Retailer Mickey Drexler Leaving CEO Job at J. Crew,” CNBC, https://www.cnbc.com, June 5, 2017; John Kell, “J. Crew CEO Mickey Drexler Steps Down,” Fortune, http://fortune.com, June 5, 2017; Vanessa Friedman and Julie Creswell, “Mickey Drexler Steps Down as Chief of J. Crew, Ending an Era,” The New York Times, https://www.nytimes.com, June 5, 2017; Steven Solomon, “J. Crew Struggles with Its ‘Great Man’ Dilemma,” The New York Times, https://www.nytimes.com, June 10, 2015; Julia Boorstin. “Mickey Drexler’s Second Coming,” Fortune, May 2, 2005, p. 101.

Types of Planning
Type of Planning Time Frame Level of Management Extent of coverage Purpose and Goal Breadth of Content Accuracy and Predictability
Strategic 1–5 years Top management (CEO, vice presidents, directors, division heads) External environment and entire organization Establish mission and long-term goals Broad and general High degree of uncertainty
Tactical Less than 1 year Middle management Strategic business units Establish mid-range goals for implementation More specific Moderate degree of certainty
Operational Current Supervisory management Geographic and functional divisions Implement and activate specific objectives Specific and concrete Reasonable degree of certainty
Contingency When an event occurs or a situation demands Top and middle management External environment and entire organization Meet unforeseen challenges and opportunities Both broad and detailed Reasonable degree of certainty once event or situation occurs
Changing Strategy Can Change Your Opportunities

Since 1949, Gordon Bernard, a printing company in Milford, Ohio, focused exclusively on printing fundraising calendars for a variety of clients, such as cities, schools, scout troops, and fire departments. The company’s approximately 4,000 clients nationwide, 10 percent of which have been with the company for over 50 years, generated $4 million in revenue in 2006. In order to better serve customers, company president Bob Sherman invested $650,000 in the purchase of a Xerox iGEN3 digital color press so that the company could produce in-house a part of its calendar product that had been outsourced. The high-tech press did more for the company than simply reduce costs, however.

The new press gave the company four-color printing capability for the first time in its history, and that led the management of Gordon Bernard to rethink the company’s strategy. The machine excels at short runs, which means that small batches of an item can be printed at a much lower cost than on a traditional press. The press also has the capability to customize every piece that rolls off the machine. For example, if a pet store wants to print 3,000 direct mail pieces, every single postcard can have a personalized greeting and text. Pieces targeted to bird owners can feature pictures of birds, whereas the dog owners’ brochure will contain dog pictures. Text and pictures can be personalized for owners of show dogs or overweight cats or iguanas.

Bob Sherman created a new division to oversee the implementation, training, marketing, and creative aspects of the new production process. The company even changed how it thinks of itself. No longer does Gordon Bernard consider itself a printing firm, but as a marketing services company with printing capabilities. That change in strategy prompted the company to seek more commercial work. For example, Gordon Bernard will help clients of its new services develop customer databases from their existing information and identify additional customer information they might want to collect. Even though calendar sales accounted for 97 percent of the firm’s revenues, that business is seasonal and leaves large amounts of unused capacity in the off-peak periods. Managers’ goals for the new division were to contribute 10 percent of total revenue within a couple years of purchase.

Critical Thinking Questions
  1. What type of planning do you think Gordon Bernard is doing?
  2. Because Gordon Bernard’s strategy changed only after it purchased the iGEN3, does the shift constitute strategic planning? Why or why not?

Sources: GBC Fundraising Calendars, http://www.gordonbernard.com/, accessed September 15, 2017; Gordon Bernard Co Inc., https://www.manta.com, accessed September 15, 2017; Karen Bells, “Hot Off the Press; Milford Printer Spends Big to Fill New Niche,” Cincinnati Business Courier, July 15, 2005, pp. 17–18.

An organization’s mission is formalized in its mission statement, a document that states the purpose of the organization and its reason for existing. For example, Twitter’s mission statement formalizes both concepts while staying within its self-imposed character limit; see (Figure).

Sources: “About” and “Our Values,” https://about.twitter.com, accessed October 30, 2017; Justin Fox, “Why Twitter’s Mission Statement Matters,” Harvard Business Review, https://hbr.org, accessed October 30, 2017; Jeff Bercovici, “Mission Critical: Twitter’s New ‘Strategy Statement’ Reflects Shifting Priorities,” Inc., https://www.inc.com, accessed October 30, 2017.
Twitter’s Mission, Values, and Strategy
Mission: Give everyone the power to create and share ideas and information instantly, without barriers.
Values: We believe in free expression and think every voice has the power to impact the world.
Strategy: Reach the largest daily audience in the world by connecting everyone to their world via our information sharing and distribution platform products and be one of the top revenue generating Internet companies in the world.
Twitter combines its mission and values to bring together a diverse workforce worldwide to fulfill its strategy.
The 3 Parts of a Company Mission Statement:
  • Purpose
  • Value
  • Action

In all organizations, plans and goals at the tactical and operational levels should clearly support the organization’s mission statement.

Tactical planning begins the implementation of strategic plans. Tactical plans have a shorter (less than one year) time frame than strategic plans and more specific objectives designed to support the broader strategic goals. Tactical plans begin to address issues of coordinating and allocating resources to different parts of the organization.

Under Mickey Drexler, many new tactical plans were implemented to support J.Crew’s new strategic direction. For example, he severely limited the number of stores opened each year, with only nine new openings in the first two years of his tenure (he closed seven). Instead, he invested the company’s resources in developing a product line that communicated J.Crew’s new strategic direction. Drexler dumped trend-driven apparel because it did not meet the company’s new image. He even cut some million-dollar volume items. In their place, he created limited editions of a handful of garments that he thought would be popular, many of which fell into his new luxury strategy. For example, J.Crew now buys shoes directly from the same shoe manufacturers that produce footwear for designers such as Prada and Gucci. In general, J.Crew drastically tightened inventories, a move designed to keep reams of clothes from ending up on sale racks and to break its shoppers’ habit of waiting for discounts.

This part of the plan generated great results. Prior to Drexler’s change in strategy, half of J.Crew’s clothing sold at a discount. After implementing tactical plans aimed to change that situation, only a small percentage does. The shift to limited editions and tighter inventory controls has not reduced the amount of new merchandise, however. On the contrary, Drexler created a J.Crew bridal collection, a jewelry line, and Crew Cuts, a line of kids’ clothing. The results of Drexler’s tactical plans were impressive. J.Crew saw same-store sales rise 17 percent in one year.

Boorstin, “Mickey Drexler’s Second Coming.”

Operational planning creates specific standards, methods, policies, and procedures that are used in specific functional areas of the organization. Operational objectives are current, narrow, and resource focused. They are designed to help guide and control the implementation of tactical plans. In an industry where new versions of software have widely varying development cycles, Autodesk, maker of software tools for designers and engineers, implemented new operational plans that dramatically increased profits. Former CEO Carol Bartz shifted the company away from the erratic release schedule it had been keeping to regular, annual software releases. By releasing upgrades on a defined and predictable schedule, the company is able to use annual subscription pricing, which is more affordable for small and midsize companies. The new schedule keeps Autodesk customers on the most recent versions of popular software and has resulted in an overall increase in profitability.

Hallie Busta, “Q&A: Former Autodesk CEO Carol Bartz on the Past, Present and Future of Construction Tech,” http://www.constructiondive.com, March 29, 2017; David Bank, “Autodesk Stages Revival,” Wall Street Journal, August 19, 2005, p. B3.

The key to effective planning is anticipating future situations and events. Yet even the best-prepared organization must sometimes cope with unforeseen circumstances, such as a natural disaster, an act of terrorism, or a radical new technology. Therefore, many companies have developed contingency plans that identify alternative courses of action for very unusual or crisis situations. The contingency plan typically stipulates the chain of command, standard operating procedures, and communication channels the organization will use during an emergency.

An effective contingency plan can make or break a company. Consider the example of Marriott Hotels in Puerto Rico. Anticipating Hurricane Maria in 2017, workers at the San Juan Marriott had to shift from their regular duties to handling the needs of not only customers, but everyone who needed assistance in the wake of the hurricane that devastated the island. A contingency plan and training for events such as this were a key part of managing this crisis.

Richard Levick, “Crisis Contingency Planning, Risk Assessment Vitally Important in Today’s Climate,” Forbes, https://www.forbes.com, November 16, 2017.

The company achieved its goal of being able to cater to guest and general needs due to planning and training while having a contingency plan in place. One guest commented on TripAdvisor, “Could not believe how friendly, helpful & responsive staff were even during height of hurricane. Special thanks to Eydie, Juan, Jock, Ashley and security Luis. They kept us safe & were exemplary. Will always stay at Marriott from now on.”

Trip Advisor website, https://www.tripadvisor.com/ShowUserReviews-g147320-d149920-r526998919-San_Juan_Marriott_Resort_Stellaris_Casino-San_Juan_Puerto_Rico.html, accessed November 15, 2017.

Within one month after Hurricane Maria hit, operations were back to normal at the San Juan Marriott.

San Juan Marriott website, http://www.marriott.com/hotels/travel/sjupr-san-juan-marriott-resort-and-stellaris-casino/, accessed November 15, 2017.

Boeing Takes Off in New Direction

Boeing and Airbus have been locked in fierce competition for the world’s airplane business for decades. What characterized most of that time period was a focus on designing larger and larger airplanes. Since its development in the 1970s, Boeing revamped its pioneering B747 numerous times and at one time boasted over 1,300 of the jumbo jets in operation around the world. As part of this head-to-head competition for bragging rights to the largest jet in the air, Boeing was working on a 747X, a super-jumbo jet designed to hold 525 passengers. In what seemed to be an abrupt change of strategy, Boeing conceded the super-jumbo segment of the market to its rival and killed plans for the 747X. Instead of trying to create a plane with more seats, Boeing engineers began developing planes to fly fewer people at higher speeds. Then, as the rising price of jet fuel surpassed the airlines’ ability to easily absorb its increasing cost, Boeing again changed its strategy, this time focusing on developing jets that use less fuel. In the end, Boeing’s strategy changed from plane capacity to jet efficiency.

The new strategy required new plans. Boeing managers identified gaps in Airbus’s product line and immediately set out to develop planes to fill them. Boeing announced a new 787 “Dreamliner,” which boasted better fuel efficiency thanks to lightweight composite materials and next-generation engine design. Even though the 787 has less than half the seating of the Airbus A380, Boeing’s Dreamliner is a hit in the market. Orders for the new plane have been stronger than anticipated, forcing Boeing to change its production plans to meet demand. The company decided to accelerate its planned 787 production rate buildup, rolling out a new jet every two days or so.

Airbus was not so lucky. The company spent so much time and energy on its super-jumbo that its A350 (the plane designed to compete with Boeing’s 787) suffered. The 787 uses 15 percent less fuel than the A350, can fly nonstop from Beijing to New York, and is one of the fastest-selling commercial planes ever.

The battle for airline supremacy continues to switch between the two global giants. In 2017, Boeing beat Airbus on commercial jet orders at the Paris Air Show and continues to push forward. A spokesperson has hinted at a hybrid fuselage for midrange planes, which could carry passengers farther at lower costs. If successful, Boeing will regain market share lost to the Airbus A321.

Critical Thinking Questions
  1. What seems to be the difference in how Boeing and Airbus have approached planning?
  2. Do you think Airbus should change its strategic plans to meet Boeing’s or stick with its current plans? Explain.

Sources: Gillian Rich, “Why Boeing’s Paris Air Show Orders Are ‘Staggering’,” http://www.investors.com, June 22, 2017; Jon Ostrower, “Boeing vs. Airbus: A New Winner Emerges at the Paris Air Show,” CNN, http://money.cnn.com, June 22, 2017; Gillian Rich, “’Hybrid’ Design for New Boeing Midrange Jet Could Hit This Sweet Spot,” http://www.investors.com, June 20, 2017; Alex Taylor, III, “Boeing Finally Has a Flight Plan,” Fortune, June 13, 2005, pp. 27–28; J. Lynn Lundsford and Rod Stone, “Boeing Net Falls, but Outlook Is Rosy,” The Wall Street Journal, July 28, 2005, p. A3; Carol Matlack and Stanley Holmes, “Why Airbus Is Losing Altitude,” Business Week, June 20, 2005, p. 20; J. Lynn Lunsford, “UPS to Buy 8 Boeing 747s, Lifting Jet’s Prospects,” The Wall Street Journal, September 18, 2005, p. A2; “Airbus to Launch A350 Jet in October,” Xinhua News Agency, September 14, 2005, online; “Boeing Plans Major Change,” Performance Materials, April 30, 2001, p. 5.

  1. What is the purpose of planning, and what is needed to do it effectively?
  2. Identify the unique characteristics of each type of planning.

Summary of Learning Outcomes

  1. What are the four types of planning?

Planning is deciding what needs to be done, identifying when and how it will be done, and determining who should do it. Managers use four different types of planning: strategic, tactical, operational, and contingency planning. Strategic planning involves creating long-range (one to five years), broad goals and determining the necessary resources to accomplish those goals. Tactical planning has a shorter time frame (less than one year) and more specific objectives that support the broader strategic goals. Operational planning creates specific standards, methods, policies, and procedures that are used in specific functional areas of the organization. Contingency plans identify alternative courses of action for very unusual or crisis situations.

Glossary

contingency plans
Plans that identify alternative courses of action for very unusual or crisis situations; typically stipulate the chain of command, standard operating procedures, and communication channels the organization will use during an emergency.
mission
An organization’s purpose and reason for existing; its long-term goals.
mission statement
A formal document that states an organization’s purpose and reason for existing and describes its basic philosophy.
operational planning
The process of creating specific standards, methods, policies, and procedures that are used in specific functional areas of the organization; helps guide and control the implementation of tactical plans.
planning
The process of deciding what needs to be done to achieve organizational objectives; identifying when and how it will be done; and determining who should do it.
strategic planning
The process of creating long-range (one to five years), broad goals for the organization and determining what resources will be needed to accomplish those goals.
tactical planning
The process of beginning to implement a strategic plan by addressing issues of coordination and allocating resources to different parts of the organization; has a shorter time frame (less than one year) and more specific objectives than strategic planning.

46

Organizing

  1. What are the primary functions of managers in organizing activities?

A second key function of managers is organizing, which is the process of coordinating and allocating a firm’s resources in order to carry out its plans. Organizing includes developing a structure for the people, positions, departments, and activities within the firm. Managers can arrange the structural elements of the firm to maximize the flow of information and the efficiency of work processes. They accomplish this by doing the following:

These and other elements of organizational structure are discussed in detail elsewhere. In this chapter, however, you should understand the three levels of a managerial hierarchy. This hierarchy is often depicted as a pyramid, as in (Figure). The fewest managers are found at the highest level of the pyramid. Called top management, they are the small group of people at the head of the organization (such as the CEO, president, and vice president). Top-level managers develop strategic plans and address long-range issues such as which industries to compete in, how to capture market share, and what to do with profits. These managers design and approve the firm’s basic policies and represent the firm to other organizations. They also define the company’s values and ethics and thus set the tone for employee standards of behavior. For example, Jack Welch, the former CEO of General Electric, was a role model for his managers and executives. Admirers say that he had an extraordinary capacity to inspire hundreds of thousands of people in many countries and he could change the direction of a huge organization like General Electric as if it were a small firm. Following his leadership, General Electric’s executives turned in impressive results. During his tenure, General Electric’s average annual shareholder return was 25 percent.

Jeffery Garten, “Jack Welch: A Role Model for Today’s CEO,” Business Week (September 10, 2001).

The Managerial Pyramid
(Attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license.)


The bottom level is labeled as supervisory, or first line, management. This layer includes the supervisor, team leader, and foreman. The next level up is labeled middle management, and includes the regional manager, division manager, director, plant manager, and sales manager. The highest level, or peak of the pyramid, is labeled top management. Top management includes the C E O; C F O; C O O; C I O; the president, governor, and general director.

The second and third tiers of the hierarchy are called middle management and supervisory (first-line) management, respectively. Middle managers (such as division heads, departmental managers, and regional sales managers) are responsible for beginning the implementation of strategic plans. They design and carry out tactical plans in specific areas of the company. They begin the process of allocating resources to meet organizational goals, and they oversee supervisory managers throughout the firm. Supervisors, the most numerous of the managers, are at the bottom of the managerial pyramid. These managers design and carry out operational plans for the ongoing daily activities of the firm. They spend a great deal of their time guiding and motivating the employees who actually produce the goods and services.

  1. Explain the managerial function of organizing.
  2. What is the managerial pyramid?

Summary of Learning Outcomes

  1. What are the primary functions of managers in organizing activities?

Organizing involves coordinating and allocating a firm’s resources in order to carry out its plans. It includes developing a structure for the people, positions, departments, and activities within the firm. This is accomplished by dividing up tasks (division of labor), grouping jobs and employees (departmentalization), and assigning authority and responsibilities (delegation).

Glossary

middle management
Managers who design and carry out tactical plans in specific areas of the company.
organizing
The process of coordinating and allocating a firm’s resources in order to carry out its plans.
supervisory (first-line) management
Managers who design and carry out operation plans for the ongoing daily activities of the firm.
top management
The highest level of managers; includes CEOs, presidents, and vice presidents, who develop strategic plans.

47

Leading, Guiding, and Motivating Others

  1. How do leadership styles influence a corporate culture?

Leadership, the third key management function, is the process of guiding and motivating others toward the achievement of organizational goals. A leader can be anyone in an organization, regardless of position, able to influence others to act or follow, often by their own choice. Managers are designated leaders according to the organizational structure but may need to use negative consequences or coercion to achieve change. In the organization structure, top managers use leadership skills to set, share, and gain support for the company’s direction and strategy—mission, vision, and values, such as Jeff Bezos does at Amazon. Middle and supervisory management use leadership skills in the process of directing employees on a daily basis as the employees carry out the plans and work within the structure created by management. Top-level leadership demonstrated by Bezos was also exhibited by Jack Welch while leading General Electric and led to many studies of his approach to leadership. Organizations, however, need strong effective leadership at all levels in order to meet goals and remain competitive.

To be effective leaders, managers must be able to influence others’ behaviors. This ability to influence others to behave in a particular way is called power. Researchers have identified five primary sources, or bases, of power:

Many leaders use a combination of all of these sources of power to influence individuals toward goal achievement. While CEO of Procter & Gamble, A. G. Lafley got his legitimate power from his position. His reward power came from reviving the company and making the stock more valuable. Also, raises and bonus for managers who met their goals was another form of reward power. Lafley also was not hesitant to use his coercive power. He eliminated thousands of jobs, sold underperforming brands, and killed weak product lines. With nearly 40 years of service to the company, Lafley had a unique authority when it came to P&G’s products, markets, innovations, and customers. The company’s sales doubled during his nine years as CEO, and its portfolio of brands increased from 10 to 23. He captained the purchase of Clairol, Wella AG, and IAMS, as well as the multibillion-dollar merger with Gillette. As a result, Lafley had a substantial amount of referent power. Lafley is also widely respected, not only by people at P&G, but by the general business community as well. Ann Gillin Lefever, a managing director at Lehman Brothers, said, “Lafley is a leader who is liked. His directives are very simple. He sets a strategy that everybody understands, and that is more difficult than he gets credit for.”

Ghazal Hashemipour, “A.G. Lafley: A Look Back at the Career of the Most Successful CEO in P&G History,” Chief Executive, https://chiefexecutive.net, June 13, 2016; Jennifer Reingold, “P&G Chairman A.G. Lafley Steps Down—For Good, This Time?” Fortune, http://fortune.com, June 1, 2016; Nancy Brumback, “6. A.G. Lafley, Chairman and CEO, Procter & Gamble Company,” Supermarket News, July 25, 2005.

Leadership Styles

Individuals in leadership positions tend to be relatively consistent in the way they attempt to influence the behavior of others, meaning that each individual has a tendency to react to people and situations in a particular way. This pattern of behavior is referred to as leadership style. As (Figure) shows, leadership styles can be placed on a continuum that encompasses three distinct styles: autocratic, participative, and free rein.

Autocratic leaders are directive leaders, allowing for very little input from subordinates. These leaders prefer to make decisions and solve problems on their own and expect subordinates to implement solutions according to very specific and detailed instructions. In this leadership style, information typically flows in one direction, from manager to subordinate. The military, by necessity, is generally autocratic. When autocratic leaders treat employees with fairness and respect, they may be considered knowledgeable and decisive. But often autocrats are perceived as narrow-minded and heavy-handed in their unwillingness to share power, information, and decision-making in the organization. The trend in organizations today is away from the directive, controlling style of the autocratic leader.

Recently ranking near the top of the Forbes list of the world’s most powerful women was Sheryl Sandberg, the COO at Facebook. As Facebook’s chief operating officer since 2008, Sandberg has helped dramatically boost revenues at the social network. Sandberg also founded Lean In, a nonprofit named after her bestselling book, to support women’s empowerment. What are Sheryl Sandberg’s primary sources of power? (Credit: JD Lasica/ Flickr/ Attribution 2.0 Generic (CC BY 2.0))


A photograph shows Sheryl Sandberg.

Instead, U.S. businesses are looking more and more for participative leaders, meaning leaders who share decision-making with group members and encourage discussion of issues and alternatives. Participative leaders use a democratic, consensual, consultative style. One CEO known for her participative leadership style is Meg Whitman, former CEO at Hewlett Packard. When Whitman worked at eBay, a team in the German-based operation began a promotional “treasure hunt,” launching registration pages, clues, and an hourly countdown clock. Trouble was, the launch violated eBay’s well-established corporate project-development processes. When the treasure hunt began, 10 million contestants logged on, crashing the local servers. Rather than shut the project down, the VP in charge of the German operation allowed the promotion to be fixed and fly under the radar of corporate headquarters. Successful innovations emerged, such as an Easy Lister feature and separate registration processes for private and business sellers. When the VP shared this experience with Meg Whitman, she fostered the idea of rapid prototyping throughout the organization, which “breaks rules to get something done,” and modeled such behavior for the entire organization.

Linda Hill, Greg Brandeau, Emily Truelove, and Kent Linebeck, Collective Genius (Boston: Harvard Business Review Press, 2015).

Leadership Styles of Managers
Amount of authority held by the leader
Autocratic Style Participative Style (Democratic, Consensual, Consultative) Free-Rein (Laissez-Faire) Style
  • Manager makes most decisions and acts in authoritative manner.
  • Manager is usually unconcerned about subordinates’ attitudes toward decisions.
  • Emphasis is on getting task accomplished.
  • Approach is used mostly by military officers and some production line supervisors.
  • Manager shares decision-making with group members and encourages teamwork.
  • Manager encourages discussion of issues and alternatives.
  • Manager is concerned about subordinates’ ideas and attitudes.
  • Manager coaches subordinates and helps coordinate efforts.
  • Approach is found in many successful organizations.
  • Manager turns over virtually all authority and control to group.
  • Members of group are presented with task and given freedom to accomplish it.
  • Approach works well with highly motivated, experienced, educated personnel.
  • Approach is found in high-tech firms, labs, and colleges.
Amount of authority held by group members
Scott Stephenson: Balancing the Duality of Ethics

Whether it’s Bernie Madoff defrauding investors, Wells Fargo having to respond to creating fake accounts in the names of real customers, or Mylan N.V. imposing huge price increases on its life-saving EpiPen, it seems like there is never a shortage of ethical issues being an important aspect of business. As shown by these examples, unethical decisions permeate different parts of the business and occur for different reasons.

In the case of Bernie Madoff, it was the greed of one person using a Ponzi scheme to defraud thousands of customers. In the case of Wells Fargo, the culprits were managers putting excessive pressure on workers to meet new account quotas. The case of Mylan included the dramatic rise in the price of the EpiPen in a short time span and reports that CEO Heather Bresch and other executives received compensation that increased over 700 percent during the same time frame. Adding to the Mylan case was the fact that Bresch is the daughter of West Virginia Senator Joseph Manchin, and prior to being appointed CEO at Mylan, Bresch served as Mylan’s chief lobbyist and helped craft the Generic Drug User Fee Amendments and the School Access to Emergency Epinephrine Act.

Where does the responsibility of managing ethical behavior in organizations reside? The answer is everyone in the organization is responsible to act in an ethical manner. The primary responsibility resides, however, with the CEO and also with the chief financial officer, who has the responsibility to oversee financial compliance with laws and regulations. Scott Stephenson, the CEO of Verisk Analytics, recently commented on how he approaches the duality of what he terms a “loose–tight” approach to leadership where he provides his employees with the discretion and responsibility to make critical decisions in crisis situations where ethics might be involved. That’s the loose part. He also works on communicating and building trust in his employees so that he has the confidence they will act responsibly and make the correct decisions in crisis situations. That’s the tight part of his leadership duality.

Critical Thinking Questions
  1. Do you think Verisk Analytics, a technology company that needs innovation breakthroughs, benefits from Stephenson’s “loose–tight” approach? What if Stepheson had been an autocratic leader? Explain your reasoning.
  2. What kind of participative leader (described below) does Stephenson seem to be? Explain your choice.

Sources: Scott Stephenson, “The Duality of Balanced Leadership,” Forbes, https://www.forbes.com, November 29, 2017; Matt Egan, “Wells Fargo Uncovers Up to 1.4 Million More Fake Accounts,” CNN Money, http://money.cnn.com, August 31, 2017; Jesse Heitz, “The EpiPen Scandal and the Perception of the Washington Establishment,” The Hill, http://thehill.com, September 1, 2016; “Decade’s Top 10 Ethics Scandals,” The Wall Street Journal, https://www.wsj.com, August 9, 2010.

Participative leadership has three types: democratic, consensual, and consultative. Democratic leaders solicit input from all members of the group and then allow the group members to make the final decision through a voting process. This approach works well with highly trained professionals. The president of a physicians’ clinic might use the democratic approach. Consensual leaders encourage discussion about issues and then require that all parties involved agree to the final decision. This is the general style used by labor mediators. Consultative leaders confer with subordinates before making a decision but retain the final decision-making authority. This technique has been used to dramatically increase the productivity of assembly-line workers.

The third leadership style, at the opposite end of the continuum from the autocratic style, is free-rein or laissez-faire (French for “leave it alone”) leadership. Managers who use this style turn over all authority and control to subordinates. Employees are assigned a task and then given free rein to figure out the best way to accomplish it. The manager doesn’t get involved unless asked. Under this approach, subordinates have unlimited freedom as long as they do not violate existing company policies. This approach is also sometimes used with highly trained professionals as in a research laboratory.

Although one might at first assume that subordinates would prefer the free-rein style, this approach can have several drawbacks. If free-rein leadership is accompanied by unclear expectations and lack of feedback from the manager, the experience can be frustrating for an employee. Employees may perceive the manager as being uninvolved and indifferent to what is happening or as unwilling or unable to provide the necessary structure, information, and expertise.

No leadership style is effective all the time. Effective leaders recognize employee growth and use situational leadership, selecting a leadership style that matches the maturity and competency levels of those completing the tasks. Newly hired employees may respond well to authoritative leadership until they understand the job requirements and show the ability to handle routine decisions. Once established, however, those same employees may start to feel undervalued and perform better under a participative or free-rein leadership style. Using situational leadership empowers employees as discussed next.

Employee Empowerment

Participative and free-rein leaders use a technique called empowerment to share decision-making authority with subordinates. Empowerment means giving employees increased autonomy and discretion to make their own decisions, as well as control over the resources needed to implement those decisions. When decision-making power is shared at all levels of the organization, employees feel a greater sense of ownership in, and responsibility for, organizational outcomes.

Management use of employee empowerment is on the rise. This increased level of involvement comes from the realization that people at all levels in the organization possess unique knowledge, skills, and abilities that can be of great value to the company. For example, when Hurricane Katrina hit the Gulf Coast, five miles of railroad tracks were ripped off a bridge connecting New Orleans to Slidell, Louisiana. Without the tracks, which fell into Lake Pontchartrain, Norfolk Southern Railroad couldn’t transport products between the East and West Coasts. Before the storm hit, however, Jeff McCracken, a chief engineer at the company, traveled to Birmingham with equipment he thought he might need and then to Slidell with 100 employees. After conferring with dozens of company engineers and three bridge companies, McCracken decided to try to rescue the miles of track from the lake. (Building new tracks would have taken several weeks at the least.) To do so, he gathered 365 engineers, machine operators, and other workers, who lined up eight huge cranes and, over the course of several hours, lifted the five miles of sunken tracks in one piece out of the lake and bolted it back on the bridge.

Carol Hymowitz, “Middle Managers Are Unsung Heroes on Corporate Stage,” Wall Street Journal, September 19, 2005, p. B1.

By giving employees the autonomy to make decisions and access to required resources, Norfolk Southern was able to avoid serious interruptions in its nationwide service.

Management thought leader Peter Drucker (1909–2005) was the author of more than three dozen books, translated into almost as many languages. Most management scholars have remarked that although he was firmly associated with the human relations school of management—along with Douglas McGregor and Warren Bennis, for example—the thought leader Drucker most admired was Frederick Winslow Taylor, the father of “scientific” management. Should any one “school” of management predominate thinking, or should all approaches be considered? (Credit: IsaacMao/ Flickr/ Attribution 2.0 Generic (CC BY 2.0))


A photograph shows Peter Drucker.

Corporate Culture

The leadership style of managers in an organization is usually indicative of the underlying philosophy, or values, of the organization. The set of attitudes, values, and standards of behavior that distinguishes one organization from another is called corporate culture. A corporate culture evolves over time and is based on the accumulated history of the organization, including the vision of the founders. It is also influenced by the dominant leadership style within the organization. Evidence of a company’s culture is seen in its heroes (e.g., the late Andy Grove of Intel

Andrew S. Grove 1936-2016, Intelcom, https://newsroom.intel.com/news-releases/andrew-s-grove-1936-2016/, accessed September 16, 2017.)

, myths (stories about the company passed from employee to employee), symbols (e.g., the Nike swoosh), and ceremonies. The culture at Google, working in teams and fostering innovation, sometimes is overlooked while its employee perks are drooled over. But both are important to the company’s corporate culture. Since 2007 Google has been at or near the top of Fortune’s list of the “100 Best Companies to Work For,” an annual list based on employee survey results tabulated by an independent company: Great Place to Work®.

“How the Best Are Measured,” Great Place to Work, https://www.greatplacetowork.com, accessed October 30, 2017.

“We have never forgotten since our startup days that great things happen more frequently within the right culture and environment,” a company spokesperson said in response to the company first taking over the top spot.

Oscar Raymundo, “5 Reasons Googlers Think It’s the Best Place to Work,” Inc., https://www.inc.com, accessed November 11, 2017.

Culture may be intangible, but it has a tremendous impact on employee morale and a company’s success. Google approaches morale analytically. When it found that mothers were leaving the company in higher rates than other employee groups, the company improved its parental-leave policies. The result was a 50 percent reduction in attrition for working moms. An analytical approach along with culture-building activities such as town halls led by black employees and allies, support for transgender employees, and unconscious-bias workshops are why employees say Google is a safe and inclusive place to work.

“Fortune 100 Best Companies to Work For 2017,” Fortune.com, http://fortune.com/best-companies/google/, accessed October 30, 2017.

Clearly Google leaders recognize culture is critical to the company’s overall success.

  1. How do leaders influence other people’s behavior?
  2. How can managers empower employees?
  3. What is corporate culture?

Summary of Learning Outcomes

  1. How do leadership styles influence a corporate culture?

Leading is the process of guiding and motivating others toward the achievement of organizational goals. Managers have unique leadership styles that range from autocratic to free-rein. The set of attitudes, values, and standards of behavior that distinguishes one organization from another is called corporate culture. A corporate culture evolves over time and is based on the accumulated history of the organization, including the vision of the founders.

Glossary

autocratic leaders
Directive leaders who prefer to make decisions and solve problems on their own with little input from subordinates
coercive power
Power that is derived from an individual’s ability to threaten negative outcomes.
consensual leaders
Leaders who encourage discussion about issues and then require that all parties involved agree to the final decision.
consultative leaders
Leaders who confer with subordinates before making a decision but who retain the final decision-making authority.
corporate culture
The set of attitudes, values, and standards that distinguishes one organization from another.
democratic leaders
Leaders who solicit input from all members of the group and then allow the members to make the final decision through a vote.
empowerment
The process of giving employees increased autonomy and discretion to make decisions, as well as control over the resources needed to implement those decisions.
expert power
Power that is derived from an individual’s extensive knowledge in one or more areas.
free-rein (laissez-faire) leadership
A leadership style in which the leader turns over all authority and control to subordinates.
leadership
The process of guiding and motivating others toward the achievement of organizational goals.
leadership style
The relatively consistent way that individuals in leadership positions attempt to influence the behavior of others.
legitimate power
Power that is derived from an individual’s position in an organization.
participative leaders
Leaders who share decision-making with group members and encourage discussion of issues and alternatives; includes democratic, consensual, and consultative styles.
power
The ability to influence others to behave in a particular way.
referent power
Power that is derived from an individual’s personal charisma and the respect and/or admiration the individual inspires.
reward power
Power that is derived from an individual’s control over rewards.
situational leadership
Selecting a leadership style based on the maturity and competency level of those who will complete the task.

48

Controlling

  1. How do organizations control activities?

The fourth key function that managers perform is controlling. Controlling is the process of assessing the organization’s progress toward accomplishing its goals. It includes monitoring the implementation of a plan and correcting deviations from that plan. As (Figure) shows, controlling can be visualized as a cyclical process made up of five stages:

The Control Process
(Attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license.)


Each stage flows into the next. Stage 1 says, set performance standards and goals. Stage 2 says, measure performance. Stage 3 says, compare actual performance to established performance standards. Stage 4 says, take corrective action. Stage 5 says, use information gained from the process to set up future performance standards.

Performance standards are the levels of performance the company wants to attain. These goals are based on its strategic, tactical, and operational plans. The most effective performance standards state a measurable behavioral objective that can be achieved in a specified time frame. For example, the performance objective for the sales division of a company could be stated as “$200,000 in gross sales for the month of January.” Each individual employee in that division would also have a specified performance goal. Actual firm, division, or individual performance can be measured against desired performance standards to see if a gap exists between the desired level of performance and the actual level of performance. If a performance gap does exist, the reason for it must be determined and corrective action taken.

Feedback is essential to the process of control. Most companies have a reporting system that identifies areas where performance standards are not being met. A feedback system helps managers detect problems before they get out of hand. If a problem exists, the managers take corrective action. Toyota uses a simple but effective control system on its automobile assembly lines. Each worker serves as the customer for the process just before his or hers. Each worker is empowered to act as a quality control inspector. If a part is defective or not installed properly, the next worker won’t accept it. Any worker can alert the supervisor to a problem by tugging on a rope that turns on a warning light (i.e., feedback). If the problem isn’t corrected, the worker can stop the entire assembly line.

Why is controlling such an important part of a manager’s job? First, it helps managers to determine the success of the other three functions: planning, organizing, and leading. Second, control systems direct employee behavior toward achieving organizational goals. Third, control systems provide a means of coordinating employee activities and integrating resources throughout the organization.

  1. Describe the control process.
  2. Why is the control process important to the success of the organization?

Summary of Learning Outcomes

  1. How do organizations control activities?

Controlling is the process of assessing the organization’s progress toward accomplishing its goals. The control process is as follows: (1) set performance standards (goals), (2) measure performance, (3) compare actual performance to established performance standards, (4) take corrective action (if necessary), and (5) use information gained from the process to set future performance standards.

Glossary

controlling
The process of assessing the organization’s progress toward accomplishing its goals; includes monitoring the implementation of a plan and correcting deviations from the plan.

49

Managerial Roles

  1. What roles do managers take on in different organizational settings?

In carrying out the responsibilities of planning, organizing, leading, and controlling, managers take on many different roles. A role is a set of behavioral expectations, or a set of activities that a person is expected to perform. Managers’ roles fall into three basic categories: informational roles, interpersonal roles, and decisional roles. These roles are summarized in (Figure). In an informational role, the manager may act as an information gatherer, an information distributor, or a spokesperson for the company. A manager’s interpersonal roles are based on various interactions with other people. Depending on the situation, a manager may need to act as a figurehead, a company leader, or a liaison. When acting in a decisional role, a manager may have to think like an entrepreneur, make decisions about resource allocation, help resolve conflicts, or negotiate compromises.

Managerial Decision Making

In every function performed, role taken on, and set of skills applied, a manager is a decision maker. Decision-making means choosing among alternatives. Decision-making occurs in response to the identification of a problem or an opportunity. The decisions managers make fall into two basic categories: programmed and nonprogrammed. Programmed decisions are made in response to routine situations that occur frequently in a variety of settings throughout an organization. For example, the need to hire new personnel is a common situation for most organizations. Therefore, standard procedures for recruitment and selection are developed and followed in most companies.



The Many Roles Managers Play in an Organization
Role
Description
Example
Information Roles
Monitor

Disseminator

Spokesperson

Interpersonal Roles
Figurehead

Leader

Liaison

Decisional Roles
Entrepreneur

Disturbance handler

Resource allocator

Negotiator

Infrequent, unforeseen, or very unusual problems and opportunities require nonprogrammed decisions by managers. Because these situations are unique and complex, the manager rarely has a precedent to follow. The earlier example of the Norfolk Southern employee, who had to decide the best way to salvage a five-mile-long piece of railroad track from the bottom of Lake Pontchartrain, is an example of a nonprogrammed decision. Likewise, when Hurricane Katrina was forecast to make landfall, Thomas Oreck, then CEO of the vacuum manufacturer that bears his name, had to make a series of nonprogrammed decisions. Oreck’s corporate headquarters were in New Orleans, and its primary manufacturing facility was in Long Beach, Mississippi. Before the storm hit, Oreck transferred its computer systems and call-center operations to backup locations in Colorado and planned to move headquarters to Long Beach. The storm, however, brutally hit both locations. Oreck executives began searching for lost employees, tracking down generators, assembling temporary housing for workers, and making deals with UPS to begin distributing its product (UPS brought food and water to Oreck from Atlanta and took vacuums back to the company’s distribution center there). All of these decisions were made in the middle of a very challenging crisis environment.

Whether a decision is programmed or nonprogrammed, managers typically follow five steps in the decision-making process, as illustrated in (Figure):

  1. Recognize or define the problem or opportunity. Although it is more common to focus on problems because of their obvious negative effects, managers who do not take advantage of new opportunities may lose competitive advantage to other firms.
  2. Gather information so as to identify alternative solutions or actions.
  3. Select one or more alternatives after evaluating the strengths and weaknesses of each possibility.
  4. Put the chosen alternative into action.
  5. Gather information to obtain feedback on the effectiveness of the chosen plan.

It can be easy (and dangerous) for managers to get stuck at any stage of the decision-making process. For example, entrepreneurs can become paralyzed evaluating the options. For the Gabby Slome, the cofounder of natural pet food maker Ollie, the idea for starting the company came after her rescue dog began having trouble digesting store-bought pet food after living on scraps. Slome decided that the pet food industry, a $30 billion a year business, was ripe for a natural food alternative. She laments, however, that she let perfect be the enemy of the very good by indulging in “analysis paralysis.”

Megan Bruneau, “Overcome ‘Analysis Paralysis’ and Execute on Your Idea: 5 Tips from Ollie Cofounder Gabby Slome,” Forbes, https: www.forbes.com, November 19, 2017.

The Decision-Making Process
(Attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license.)


The five steps in the decision making process are illustrated as a staircase, with step 1 as the bottom step, and step 5 as the top step.

  1. What are the three types of managerial roles?
  2. Give examples of things managers might do when acting in each of the different types of roles.
  3. List the five steps in the decision-making process.

Summary of Learning Outcomes

  1. What roles do managers take on in different organizational settings?

In an informational role, the manager may act as an information gatherer, an information distributor, or a spokesperson for the company. A manager’s interpersonal roles are based on various interactions with other people. Depending on the situation, a manager may need to act as a figurehead, a company leader, or a liaison.

Glossary

decisional roles
A manager’s activities as an entrepreneur, resource allocator, conflict resolver, or negotiator.
informational roles
A manager’s activities as an information gatherer, an information disseminator, or a spokesperson for the company.
interpersonal roles
A manager’s activities as a figurehead, company leader, or liaison.
nonprogrammed decisions
Responses to infrequent, unforeseen, or very unusual problems and opportunities where the manager does not have a precedent to follow in decision-making.
programmed decisions
Decisions made in response to frequently occurring routine situations.

50

Managerial Skills

  1. What set of managerial skills is necessary for managerial success?

In order to be successful in planning, organizing, leading, and controlling, managers must use a wide variety of skills. A skill is the ability to do something proficiently. Managerial skills fall into three basic categories: technical, human relations, and conceptual skills. The degree to which each type of skill is used depends upon the level of the manager’s position as seen in (Figure). Additionally, in an increasingly global marketplace, it pays for managers to develop a special set of skills to deal with global management issues.

The Importance of Managerial Skills at Different Management Levels
(Attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license.)


From left to right, the first column is conceptual skills. The second column is human skills. The third column is technical skills. From top to bottom, the first row is top management. The second row is middle management. The bottom row is supervisory management. At the bottom of the table, at the left hand side, is labeled as very important. On the bottom of the right side of the table is labeled as not as important.

Technical Skills

Specialized areas of knowledge and expertise and the ability to apply that knowledge make up a manager’s technical skills. Preparing a financial statement, programming a computer, designing an office building, and analyzing market research are all examples of technical skills. These types of skills are especially important for supervisory managers because they work closely with employees who are producing the goods and/or services of the firm.

Human Relations Skills

Human relations skills are the interpersonal skills managers use to accomplish goals through the use of human resources. This set of skills includes the ability to understand human behavior, to communicate effectively with others, and to motivate individuals to accomplish their objectives. Giving positive feedback to employees, being sensitive to their individual needs, and showing a willingness to empower subordinates are all examples of good human relations skills. Identifying and promoting managers with human relations skills are important for companies. A manager with little or no people skills can end up using an authoritarian leadership style and alienating employees.

Conceptual Skills

Conceptual skills include the ability to view the organization as a whole, understand how the various parts are interdependent, and assess how the organization relates to its external environment. These skills allow managers to evaluate situations and develop alternative courses of action. Good conceptual skills are especially necessary for managers at the top of the management pyramid, where strategic planning takes place.

  1. Define the basic managerial skills.
  2. How important is each of these skill sets at the different levels of the management pyramid?

Summary of Learning Outcomes

  1. What set of managerial skills is necessary for managerial success?

Managerial skills fall into three basic categories: technical, human relations, and conceptual skills. Specialized areas of knowledge and expertise and the ability to apply that knowledge make up a manager’s technical skills. Human relations skills include the ability to understand human behavior, to communicate effectively with others, and to motivate individuals to accomplish their objectives. Conceptual skills include the ability to view the organization as a whole, understand how the various parts are interdependent, and assess how the organization relates to its external environment.

Glossary

conceptual skills
A manager’s ability to view the organization as a whole, understand how the various parts are interdependent, and assess how the organization relates to its external environment.
human relations skills
A manager’s interpersonal skills that are used to accomplish goals through the use of human resources.
technical skills
A manager’s specialized areas of knowledge and expertise, as well as the ability to apply that knowledge.

VII

Designing Organizational Structures

52

Introduction

(Credit: CDC/ Dawn Arlotta / US Government Works)


In the foreground, a man and a woman on one side of a table speak to another woman on the opposite side. In the background, some other groups speak at tables.

Learning Outcomes

After reading this chapter, you should be able to answer these questions:

  1. What are the traditional forms of organizational structure?
  2. What contemporary organizational structures are companies using?
  3. Why are companies using team-based organizational structures?
  4. What tools do companies use to establish relationships within their organizations?
  5. How can the degree of centralization/decentralization be altered to make an organization more successful?
  6. How do mechanistic and organic organizations differ?
  7. How does the informal organization affect the performance of the company?
  8. What trends are influencing the way businesses organize?
Elise Eberwein

EVP of People and Communications, American Airlines As executive vice president of people and communications at American Airlines, Elise Eberwein’s role within the structure of the organization might not be readily apparent. After all, you might ask, doesn’t corporate communications typically involve marketing? And what does that have to do with organizational structure? As it turns out, quite a bit at the world’s largest airline.

When American Airlines and US Airways finally got the U.S. government’s approval to merge in late 2013, it was no longer business as usual for Eberwein and her colleagues at the “new” airline. Until the merger, which basically produced the world’s largest airline with more than 6,000 daily flights and 102,900 employees, Eberwein was head of communications at US Airways—a position she held for nine years after various other jobs in the airline industry.

American Airlines jet. (Credit: Joao Carlos Medau/ flickr/ Attribution 2.0 Generic (CC BY 2.0))


An American Airlines plane is landing at an airport.

Communications and aviation are in Eberwein’s DNA. She worked as a flight attendant at TWA before moving on to manage communications at Denver-based Frontier Airlines. Her next communications experience was at America West, which then merged with US Airways, where Eberwein served as executive vice president of people, communications, and public affairs before she took over the chief communications job at American Airlines.

Corporation communications is no longer just about marketing. The importance of an effective communications strategy cannot be understated in today’s 24/7 business environment. Corporate communication executives have taken on an expanded role in many organizations, according to a recent survey by the Korn Ferry Institute. Of the senior communications executives from Fortune 500 companies who responded to the survey, nearly 40 percent said chief communications officers report directly to the CEO. In addition, more than two-thirds of respondents believe the most important leadership characteristic for communications professionals is having a strategic mindset that goes beyond day-to-day communications activities and looks ahead to future possibilities that can be translated into achievable corporate strategies at all levels of the organization.

In a company as large as American Airlines, even after the initial two-year integration plan, there are many departments, unions, and other employees to communicate with on a daily basis, not to mention the millions of customers they serve every day. For example, American’s social media hub consists of 30 or so team members, divided into three groups: social customer service, social engagement, and social insights. The customer service group, the largest of the three, operates around the clock to address customers’ issues, including missed flight connections and lost luggage, as well as quirky questions like why American airplanes have a specific number of stripes on their tails. Reporting to Eberwein, the social media group is empowered to reach out to any company department directly to get answers for any customer.

Eberwein believes her role includes working closely with the CEO and other managers across the globe to provide consistent, detailed information to all of its stakeholders. To accomplish this feat, Eberwein and other senior managers hold a weekly Monday morning meeting to review the previous week’s operations data, revenue results, and people engagement activities. Eberwein believes establishing this regular contact with colleagues across the organization helps reinforce American’s commitment to engagement and transparent communications, which ultimately shapes the customer’s experience as well as the entire company.

Sources: “Leadership Bios: Elise Eberwein,” https://www.aa.com, accessed July 24, 2017; “By the Numbers: Snapshot of the Airline,” http://news.aa.com, accessed July 24, 2017; Richard Marshall, Beth Fowler, and Nels Olson, “The Chief Communications Officer: Survey and Findings among the Fortune 500,” https://www.kornferry.com, accessed July 24, 2017; Elise Eberwein, “Why the Chief Communications Officer Is Pivotal to the CEO, Especially a New One,” Chief Executive, http://chiefexecutive.net, September 11, 2016; Michael Slattery, “A Visit to American Airlines Social Media Hub,” Airways magazine, https://airwaysmag.com, June 10, 2016; Diana Bradley, “American Airlines CEO Discusses Comms Strategy behind US Airways Merger,” PR Week, http://www.prweek.com, May 27, 2015.

This module focuses on the different types of organizational structure, the reasons an organization might prefer one structure over another, and how the choice of an organizational structure ultimately can impact that organization’s success.

In today’s dynamic business environment, organizational structures need to be designed so that the organization can quickly respond to new competitive threats and changing customer needs. Future success for companies will depend on their ability to be flexible and respond to the needs of customers. In this chapter, we’ll look first at how companies build organizational structures by implementing traditional, contemporary, and team-based models. Then, we’ll explore how managers establish the relationships within the structures they have designed, including determining lines of communication, authority, and power. Finally, we’ll examine what managers need to consider when designing organizational structures and the trends that are changing the choices companies make about organizational design.

53

Building Organizational Structures

  1. What are the traditional forms of organizational structure?

The key functions that managers perform include planning, organizing, leading, and controlling. This module focuses specifically on the organizing function. Organizing involves coordinating and allocating a firm’s resources so that the firm can carry out its plans and achieve its goals. This organizing, or structuring, process is accomplished by:

The result of the organizing process is a formal structure within an organization. An organization is the order and design of relationships within a company or firm. It consists of two or more people working together with a common objective and clarity of purpose. Formal organizations also have well-defined lines of authority, channels for information flow, and means of control. Human, material, financial, and information resources are deliberately connected to form the business organization. Some connections are long-lasting, such as the links among people in the finance or marketing department. Others can be changed at almost any time—for example, when a committee is formed to study a problem.

Every organization has some kind of underlying structure. Typically, organizations base their frameworks on traditional, contemporary, or team-based approaches. Traditional structures are more rigid and group employees by function, products, processes, customers, or regions. Contemporary and team-based structures are more flexible and assemble employees to respond quickly to dynamic business environments. Regardless of the structural framework a company chooses to implement, all managers must first consider what kind of work needs to be done within the firm.

Founded in 1943, Sweden retailer IKEA has grown from a small mail-order operation to a global force in home furnishings with more than 390 stores throughout Europe, North America, Africa, Australia, and Asia. Best known for its contemporary furniture designs, highly trafficked store openings, and quirky advertising, the IKEA Group consists of multiple divisions corresponding to the company’s retail, supply chain, sales, and design and manufacturing functions. What factors likely influenced the development of IKEA’s organizational structure as the company expanded over the years? (Credit: JJBers/ flickr/ Attribution 2.0 Generic (CC BY 2.0))


A photo shows a large Ikea building with cars parked beside it.

Division of Labor

The process of dividing work into separate jobs and assigning tasks to workers is called division of labor. In a fast-food restaurant, for example, some employees take or fill orders, others prepare food, a few clean and maintain equipment, and at least one supervises all the others. In an auto assembly plant, some workers install rearview mirrors, while others mount bumpers on bumper brackets. The degree to which the tasks are subdivided into smaller jobs is called specialization. Employees who work at highly specialized jobs, such as assembly-line workers, perform a limited number and variety of tasks. Employees who become specialists at one task, or a small number of tasks, develop greater skill in doing that particular job. This can lead to greater efficiency and consistency in production and other work activities. However, a high degree of specialization can also result in employees who are disinterested or bored due to the lack of variety and challenge.

Traditional Structures

After a company divides the work it needs to do into specific jobs, managers then group the jobs together so that similar or associated tasks and activities can be coordinated. This grouping of people, tasks, and resources into organizational units is called departmentalization. It facilitates the planning, leading, and control processes.

An organization chart is a visual representation of the structured relationships among tasks and the people given the authority to do those tasks. In the organization chart in (Figure), each figure represents a job, and each job includes several tasks. The sales manager, for instance, must hire salespeople, establish sales territories, motivate and train the salespeople, and control sales operations. The chart also indicates the general type of work done in each position. As (Figure) shows, five basic types of departmentalization are commonly used in organizations:

Organization Chart for a Typical Appliance Manufacturer
Attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license


At the top of the chart is the president. Three lines extend from the president; one line goes to finance, a second line goes to operations, and the third line goes to marketing. 3 lines extend from finance; one extends to manager, allocations and inventory control. The second line extends to manager, accounting. The third line extends to manager, financial planning. 3 lines extend from operations; one extends to production manager, large appliances. The second line extends to production manager, small appliances. The third line extends to director of human resources. 3 lines extend from marketing; the first line extends to sales manager. The second line extends to director of customer service. The third line extends to distribution manager.

  1. Functional departmentalization, which is based on the primary functions performed within an organizational unit (marketing, finance, production, sales, and so on). Ethan Allen Interiors, a vertically integrated home furnishings manufacturer, continues its successful departmentalization by function, including retail, manufacturing and sourcing, product design, logistics, and operations, which includes tight financial controls.
    “2016 Annual Report,” http://www.ethanallen.com, accessed July 18, 2017.

Five Traditional Ways to Organize
(Attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license.)


Functional departmentalization shows a president, with lines extending to legal, human resources, manufacturing, engineering, marketing, and finance. Product departmentalization shows an administrator and C E O, with lines extending to head of outpatient slash emergency treatment, head of pediatrics, head of cardiology, head of orthopedics, and head of obstetrics slash gynecology. Process departmentalization shows a plant superintendent with lines extending to lumber cutting and treatment, furniture assembly, furniture finishing, and shipping. Customer departmentalization shows the vice president of marketing, with lines extending to marketing manager, railroad customers; and marketing manager, aircraft customers; and marketing manager, automotive customers, and marketing manager, military customers. Geographic departmentalization shows the vice president of marketing, with lines extending to the director, U S and Canadian marketing; and director, European marketing; and director, Latin American marketing.

  1. Product departmentalization, which is based on the goods or services produced or sold by the organizational unit (such as outpatient/emergency services, pediatrics, cardiology, and orthopedics). For example, ITT is a diversified leading manufacturer of highly engineered components and customized technology solutions for the transportation, industrial, and oil and gas markets. The company is organized into four product divisions: Industrial Process (pumps, valves, and wastewater treatment equipment), Control Technologies (motion control and vibration isolation products), Motion Technologies (shock absorbers, brake pads, and friction materials), and Interconnect Solutions (connectors for a variety of markets).
    “ITT 2016 Fact Sheet V2,” https://www.itt.com, accessed July 18, 2017.

  2. Process departmentalization, which is based on the production process used by the organizational unit (such as lumber cutting and treatment, furniture finishing, and shipping). For example, the organization of Gazprom Neft, a Russian oil company, reflects the activities the company needs to perform to extract oil from the ground and turn it into a final product: exploration and research, production (drilling), refining, and marketing and distribution.
    “Our Business,” http://www.gazprom-neft.com, accessed July 18, 2017.

    Pixar, the animated-movie company now part of Disney, is divided into three parallel yet interactive process-based groups: technology development, which delivers computer-graphics tools; creative development, which creates stories and characters and animates them; and production, which coordinates the film-making process.
    “Pixar Animation Studios,” The Disney Wiki, http://disney.wiki.com, accessed July 18, 2017; Bob Gower, “Want a Creative Culture? Pixar Says Do These 3 Things,” Inc., https://www.inc.com, August 9, 2016.

  3. Customer departmentalization, which is based on the primary type of customer served by the organizational unit (such as wholesale or retail purchasers). The PNC Financial Services Group offers a wide range of services for all of its customers and is structured by the type of consumer it serves: retail banking for consumers; the asset management group, with specific focus on individuals as well as corporations, unions, municipalities, and others; and corporate and institutional banking for middle-market companies nationwide.
    “Corporate Overview,” https://www.pnc.com, accessed July 18, 2017.

Ethics in Practice

Panera’s Menu Comes Clean Making a strategic change to a company’s overall philosophy and the way it does business affects every part of the organizational structure. And when that change pertains to sustainability and “clean food,” Panera Bread Company took on the challenge more than a decade ago and now has a menu free of man-made preservatives, sweeteners, colors, and flavors.

In 2015, Ron Shaich, company founder and CEO, announced Panera’s “no-no” list of nearly 100 ingredients, which he vowed would be eliminated or never used again in menu items. Two years later, the company announced that its menu was “100 percent clean,” but the process was not an easy one.

Panera used thousands of labor hours to review the 450 ingredients used in menu items, eventually reformulating more than 120 of them to eliminate artificial ingredients. Once the team identified the ingredients that were not “clean,” they worked with the company’s 300 vendors—and in some instances, a vendor’s supplier—to reformulate an ingredient to make it preservative-free. For example, the recipe for the company’s popular broccoli cheddar soup had to be revised 60 times to remove artificial ingredients without losing the soup’s taste and texture. According to Shaich, the trial-and-error approach was about finding the right balance of milk, cream, and emulsifiers, like Dijon mustard, to replace sodium phosphate (a no-no item) while keeping the soup’s texture creamy. Panera also created a new cheddar cheese to use in the soup and used a Dijon mustard that contained unpreserved vinegar as a substitute for the banned sodium phosphate.

Sara Burnett, Panera’s director of wellness and food policy, believes that the company’s responsibility goes beyond just serving its customers. She believes that Panera can make a difference by using its voice and purchasing power to have a positive impact on the overall food system. In addition, the company’s Herculean effort to remove artificial ingredients from its menu items also helped it take a close look at its supply chain and other processes that Panera could simplify by using better ingredients.

Panera is not yet satisfied with its commitment to clean food. The food chain recently announced its goal of sourcing 100 percent cage-free eggs for all of its U.S. Panera bakery-cafés by 2020.

Critical Thinking Questions
  1. How does Panera’s approach to clean eating provide the company with a competitive advantage?
  2. What kind of impact does this commitment to preservative-free food have on the company’s organizational structure?
  3. Does “clean food” put additional pressure on Panera and its vendors? Explain your reasoning.

Sources: “Our Food Policy,” https://www.panerabread.com, accessed July 24, 2017; Emily Payne, “Panera Bread’s Sara Burnett on Shifting Demand for a Better Food System,” Food Tank, http://foodtank.com, accessed July 18, 2017; Julie Jargon, “What Panera Had to Change to Make Its Menu ‘Clean,’” The Wall Street Journal, https://www.wsj.com, February 20, 2017; John Kell, “Panera Says Its Food Menu Is Now 100% ‘Clean Eating,’” Fortune, http://fortune.com, January 13, 2017; Lani Furbank, “Seven Questions with Sara Burnett, Director of Wellness and Food Policy at Panera Bread,” Food Tank, https://foodtank.com, April 12, 2016.

  1. Geographic departmentalization, which is based on the geographic segmentation of organizational units (such as U.S. and Canadian marketing, European marketing, and Latin American marketing).

People are assigned to a particular organizational unit because they perform similar or related tasks, or because they are jointly responsible for a product, client, or market. Decisions about how to departmentalize affect the way management assigns authority, distributes resources, rewards performance, and sets up lines of communication. Many large organizations use several types of departmentalization. For example, Procter & Gamble (P&G), the multibillion-dollar consumer-products company, integrates four different types of departmentalization, which the company refers to as “four pillars.” First, the Global Business Units (GBU) divide the company according to products (baby, feminine, and family care; beauty; fabric and home care; and health and grooming). Then, P&G uses a geographical approach, creating business units to market its products around the world. There are Selling and Market Operations (SMO) groups for North America; Latin America; Europe; Asia Pacific; Greater China; and India, the Middle East, and Africa. P&G’s third pillar is Global Business Services division (GBS), which also uses geographic departmentalization. GBS provides technology processes and standard data tools to enable the GBUs and SMOs to better understand the business and to serve consumers and customers better. It supports P&G business units in areas such as accounting and financial reporting, information technology, purchases, payroll and benefits administration, and facilities management. Finally, the divisions of the Corporate Functions pillar provide a safety net to all the other pillars. These divisions are comprised of functional specialties such as customer business development; external relations; human resources; legal, marketing, consumer, and market knowledge; research and development; and workplace services.

“Corporate Structure,” http://us.pg.com, accessed July 18, 2017.

Line-and-Staff Organization

The line organization is designed with direct, clear lines of authority and communication flowing from the top managers downward. Managers have direct control over all activities, including administrative duties. An organization chart for this type of structure would show that all positions in the firm are directly connected via an imaginary line extending from the highest position in the organization to the lowest (where production of goods and services takes place). This structure, with its simple design and broad managerial control, is often well-suited to small, entrepreneurial firms.

As an organization grows and becomes more complex, the line organization can be enhanced by adding staff positions to the design. Staff positions provide specialized advisory and support services to line managers in the line-and-staff organization, shown in (Figure). In daily operations, individuals in line positions are directly involved in the processes used to create goods and services. Individuals in staff positions provide the administrative and support services that line employees need to achieve the firm’s goals. Line positions in organizations are typically in areas such as production, marketing, and finance. Staff positions are found in areas such as legal counseling, managerial consulting, public relations, and human resource management.

Line-and-Staff Organization
(Attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license.)


At the top of the diagram is the president, which is shown as a line function. A line extends down, and connects to three separate line functions, which are vice president of marketing, and vice president of manufacturing, and vice president of finance. On each side of this connective line are staff functions, which are corporate attorney, and assistant to president. A line extends down from vice president of marketing to 3 line functions, which are each labeled sales manager. On each side of this connective line are staff functions, shown as marketing research specialist, and advertising specialist. A line extends down from vice president, and connects to 3 line functions, each is labeled, supervisor. A staff function extends from the connective line, and is quality control engineer. A line extends down from vice president of finance, and connects to 2 line functions, cost accountant, and credit analysis. Between these 2 positions is an internal auditor, which is a line function.

  1. How does specialization lead to greater efficiency and consistency in production?
  2. What are the five types of departmentalization?

Summary of Learning Outcomes

  1. What are the traditional forms of organizational structure?

Firms typically use traditional, contemporary, or team-based approaches when designing their organizational structure. In the traditional approach, companies first divide the work into separate jobs and tasks. Managers then group related jobs and tasks together into departments. Five basic types of departmentalization are commonly used in organizations:

  • Functional: Based on the primary functions performed within an organizational unit
  • Product: Based on the goods or services produced or sold by the organizational unit
  • Process: Based on the production process used by the organizational unit
  • Customer: Based on the primary type of customer served by the organizational unit
  • Geographic: Based on the geographic segmentation of organizational units

Glossary

customer departmentalization
Departmentalization that is based on the primary type of customer served by the organizational unit.
departmentalization
The process of grouping jobs together so that similar or associated tasks and activities can be coordinated.
division of labor
The process of dividing work into separate jobs and assigning tasks to workers.
functional departmentalization
Departmentalization that is based on the primary functions performed within an organizational unit.
geographic departmentalization
Departmentalization that is based on the geographic segmentation of the organizational units.
line-and-staff organization
An organizational structure that includes both line and staff positions.
line organization
An organizational structure with direct, clear lines of authority and communication flowing from the top managers downward.
line positions
All positions in the organization directly concerned with producing goods and services and that are directly connected from top to bottom.
organization
The order and design of relationships within a firm; consists of two or more people working together with a common objective and clarity of purpose.
organization chart
A visual representation of the structured relationships among tasks and the people given the authority to do those tasks.
process departmentalization
Departmentalization that is based on the production process used by the organizational unit.
product departmentalization
Departmentalization that is based on the goods or services produced or sold by the organizational unit.
specialization
The degree to which tasks are subdivided into smaller jobs.
staff positions
Positions in an organization held by individuals who provide the administrative and support services that line employees need to achieve the firm’s goals.

54

Contemporary Structures

  1. What contemporary organizational structures are companies using?

Although traditional forms of departmentalization still represent how many companies organize their work, newer, more flexible organizational structures are in use at many firms. Let’s look at matrix and committee structures and how those two types of organizations are helping companies better leverage the diverse skills of their employees.

Matrix Structure

The matrix structure (also called the project management approach) is sometimes used in conjunction with the traditional line-and-staff structure in an organization. Essentially, this structure combines two different forms of departmentalization, functional and product, that have complementary strengths and weaknesses. The matrix structure brings together people from different functional areas of the organization (such as manufacturing, finance, and marketing) to work on a special project. Each employee has two direct supervisors: the line manager from her or his specific functional area and the project manager. (Figure) shows a matrix organization with four special project groups (A, B, C, D), each with its own project manager. Because of the dual chain of command, the matrix structure presents some unique challenges for both managers and subordinates.

Matrix Organization
(Attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license.)


The matrix is made up of 5 columns and 4 rows. At the top of the matrix is the president; the president has lines extending to each column and row. The rows, from top to bottom, are labeled, Project manager A and Project manager B, and Project manager C, and Project manager D. From left to right, the columns are labeled Vice president of research and Vice president of sales, and Vice president of engineering, and Vice president of production, and Vice president of finance and administration. From left to right, the cells in the first row read, Scientist A, and Sales Representative A, and Engineer A, and Production Scheduler A, and Cost accountant A. Each row has this same construction, with scientist under v p of research; and sales rep under v p of sales, and engineer under v p of engineering, and production scheduler under v p of production, and cost accountant under v p of finance and admin.

Advantages of the matrix structure include:

  • Teamwork. By pooling the skills and abilities of various specialists, the company can increase creativity and innovation and tackle more complex tasks.
  • Efficient use of resources. Project managers use only the specialized staff they need to get the job done, instead of building large groups of underused personnel.
  • Flexibility. The project structure is flexible and can adapt quickly to changes in the environment; the group can be disbanded quickly when it is no longer needed.
  • Ability to balance conflicting objectives. The customer wants a quality product and predictable costs. The organization wants high profits and the development of technical capability for the future. These competing goals serve as a focal point for directing activities and overcoming conflict. The marketing representative can represent the customer, the finance representative can advocate high profits, and the engineers can push for technical capabilities.
  • Higher performance. Employees working on special project teams may experience increased feelings of ownership, commitment, and motivation.
  • Opportunities for personal and professional development. The project structure gives individuals the opportunity to develop and strengthen technical and interpersonal skills.

Disadvantages of the matrix structure include:

  • Power struggles. Functional and product managers may have different goals and management styles.
  • Confusion among team members. Reporting relationships and job responsibilities may be unclear.
  • Lack of cohesiveness. Team members from different functional areas may have difficulty communicating effectively and working together as a team.

Although project-based matrix organizations can improve a company’s flexibility and teamwork, some companies are trying to unravel complex matrix structures that create limited accountability and complicate day-to-day operations. Some CEOs and other top managers suggest that matrix structures make it easier to blame others when things don’t go as planned.

Herman Vantrappen and Frederic Wirtz, “Making Matrix Organizations Actually Work,” Harvard Business Review, https://hbr.org, March 1, 2016.

Committee Structure

In committee structure, authority and responsibility are held by a group rather than an individual. Committees are typically part of a larger line-and-staff organization. Often the committee’s role is only advisory, but in some situations the committee has the power to make and implement decisions. Committees can make the coordination of tasks in the organization much easier. For example, Novartis, the huge Swiss pharmaceutical company, has a committee structure, which reports to its board of directors. The company’s executive committee is responsible for overseeing the business operations of group companies within the global organization and consists of the CEO, CFO, head of HR, general counsel, president of operations, head of biomedical research, global head of drug development, CEOs of the pharmaceutical and oncology units, and CEOs of Sandoz and Alcon, other Novartis companies. Members of the executive committee are selected by the company’s board of directors.

“Executive Committee and Organizational Structure,” https://www.novartis.com, accessed July 19, 2017.

Committees bring diverse viewpoints to a problem and expand the range of possible solutions, but there are some drawbacks. Committees can be slow to reach a decision and are sometimes dominated by a single individual. It is also more difficult to hold any one individual accountable for a decision made by a group. Committee meetings can sometimes go on for long periods of time with seemingly little being accomplished.

  1. Why does the matrix structure have a dual chain of command?
  2. How does a matrix structure increase power struggles or reduce accountability?
  3. What are advantages of a committee structure? Disadvantages?

Summary of Learning Outcomes

  1. What contemporary organizational structures are companies using?

In recent decades, companies have begun to expand beyond traditional departmentalization methods and use matrix, committee, and team-based structures. Matrix structures combine two types of traditional organizational structures (for example, geographic and functional). Matrix structures bring together people from different functional areas of the organization to work on a special project. As such, matrix organizations are more flexible, but because employees report to two direct supervisors, managing matrix structures can be extremely challenging. Committee structures give authority and responsibility to a group rather than to an individual. Committees are part of a line-and-staff organization and often fulfill only an advisory role. Team-based structures also involve assigning authority and responsibility to groups rather than individuals, but, different from committees, team-based structures give these groups autonomy to carry out their work.

Glossary

committee structure
An organizational structure in which authority and responsibility are held by a group rather than an individual.
matrix structure (project management)
An organizational structure that combines functional and product departmentalization by bringing together people from different functional areas of the organization to work on a special project.

55

Using Teams to Enhance Motivation and Performance

  1. Why are companies using team-based organizational structures?

One of the most apparent trends in business today is the use of teams to accomplish organizational goals. Using a team-based structure can increase individual and group motivation and performance. This section gives a brief overview of group behavior, defines work teams as specific types of groups, and provides suggestions for creating high-performing teams.

Understanding Group Behavior

Teams are a specific type of organizational group. Every organization contains groups, social units of two or more people who share the same goals and cooperate to achieve those goals. Understanding some fundamental concepts related to group behavior and group processes provides a good foundation for understanding concepts about work teams. Groups can be formal or informal in nature. Formal groups are designated and sanctioned by the organization; their behavior is directed toward accomplishing organizational goals. Informal groups are based on social relationships and are not determined or sanctioned by the organization.

Formal organizational groups, like the sales department at Apple, must operate within the larger Apple organizational system. To some degree, elements of the larger Apple system, such as organizational strategy, company policies and procedures, available resources, and the highly motivated employee corporate culture, determine the behavior of smaller groups, such as the sales department, within the company. Other factors that affect the behavior of organizational groups are individual member characteristics (e.g., ability, training, personality), the roles and norms of group members, and the size and cohesiveness of the group. Norms are the implicit behavioral guidelines of the group, or the standards for acceptable and nonacceptable behavior. For example, an Apple sales manager may be expected to work at least two Saturdays per month without extra pay. Although this isn’t written anywhere, it is the expected norm.

Group cohesiveness refers to the degree to which group members want to stay in the group and tend to resist outside influences (such as a change in company policies). When group performance norms are high, group cohesiveness will have a positive impact on productivity. Cohesiveness tends to increase when the size of the group is small, individual and group goals are similar, the group has high status in the organization, rewards are group-based rather than individual-based, and the group competes with other groups within the organization. Work group cohesiveness can benefit the organization in several ways, including increased productivity, enhanced worker self-image because of group success, increased company loyalty, reduced employee turnover, and reduced absenteeism. Southwest Airlines is known for its work group cohesiveness. On the other hand, cohesiveness can also lead to restricted output, resistance to change, and conflict with other work groups in the organization.

The opportunity to turn the decision-making process over to a group with diverse skills and abilities is one of the arguments for using work groups (and teams) in organizational settings. For group decision-making to be most effective, however, both managers and group members must understand its strengths and weaknesses (see (Figure)).

Work Groups versus Work Teams

We have already noted that teams are a special type of organizational group, but we also need to differentiate between work groups and work teams. Work groups share resources and coordinate efforts to help members better perform their individual duties and responsibilities. The performance of the group can be evaluated by adding up the contributions of the individual group members. Work teams require not only coordination but also collaboration, the pooling of knowledge, skills, abilities, and resources in a collective effort to attain a common goal. A work team creates synergy, causing the performance of the team as a whole to be greater than the sum of team members’ individual contributions. Simply assigning employees to groups and labeling them a team does not guarantee a positive outcome. Managers and team members must be committed to creating, developing, and maintaining high-performance work teams. Factors that contribute to their success are discussed later in this section.

Strengths and Weaknesses of Group Decision Making
Strengths Weaknesses
  • Groups bring more information and knowledge to the decision-making process.
  • Groups offer a diversity of perspectives and, therefore, generate a greater number of disagreements.
  • Group decision-making results in a higher-quality decision than does individual decision-making.
  • Participation of group members increases the likelihood that a decision will be accepted.
  • Groups typically take a longer time to reach a solution than an individual takes.
  • Group members may pressure others to conform, reducing the likelihood of alternatives.
  • The process may be dominated by one or a small number of participants.
  • Groups lack accountability, because it is difficult to assign responsibility for outcomes to any one individual.

Types of Teams

The evolution of the team concept in organizations can be seen in three basic types of work teams: problem-solving, self-managed, and cross-functional. Problem-solving teams are typically made up of employees from the same department or area of expertise and from the same level of the organizational hierarchy. They meet on a regular basis to share information and discuss ways to improve processes and procedures in specific functional areas. Problem-solving teams generate ideas and alternatives and may recommend a specific course of action, but they typically do not make final decisions, allocate resources, or implement change.

Many organizations that experienced success using problem-solving teams were willing to expand the team concept to allow team members greater responsibility in making decisions, implementing solutions, and monitoring outcomes. These highly autonomous groups are called self-managed work teams. They manage themselves without any formal supervision, taking responsibility for setting goals, planning and scheduling work activities, selecting team members, and evaluating team performance.

Today, approximately 80 percent of Fortune 1000 companies use some sort of self-managed teams.

Ethan Chazin, “Self-Managed Teams: The Future of Employee Engagement,” LinkedIn, https://www.linkedin.com, July 19, 2017.

One example is Zappos’s shift to self-managed work teams in 2013, where the traditional organizational structure and bosses were eliminated, according to a system called holacracy.

Jennifer Reingold, “How a Radical Shift Left Zappos Reeling,” Fortune, http://fortune.com, March 4, 2016.

Another version of self-managing teams can be found at W. L. Gore, the company that invented Gore-Tex fabric and Glide dental floss. The three employees who invented Elixir guitar strings contributed their spare time to the effort and persuaded a handful of colleagues to help them improve the design. After working three years entirely on their own—without asking for any supervisory or top management permission or being subjected to any kind of oversight—the team finally sought the support of the larger company, which they needed to take the strings to market. Today, W. L. Gore’s Elixir is the number one selling string brand for acoustic guitar players.

Christian Wissmuller, “String Theory: Prominent Suppliers Discuss the Electric Guitar and Bass String Market,” Musical Merchandise Review, http://mmrmagazine.com, June 14, 2017; Alan Deutschman, “The Fabric of Creativity,” Fast Company, https://www.fastcompany.com, December 1, 2004.

An adaptation of the team concept is called a cross-functional team. These teams are made up of employees from about the same hierarchical level but different functional areas of the organization. Many task forces, organizational committees, and project teams are cross-functional. Often the team members work together only until they solve a given problem or complete a specific project. Cross-functional teams allow people with various levels and areas of expertise to pool their resources, develop new ideas, solve problems, and coordinate complex projects. Both problem-solving teams and self-managed teams may also be cross-functional teams.

Team Approach Flies High at GE Aviation

“Teaming” is the term used at GE Aviation manufacturing plants to describe how self-managed groups of employees are working together to make decisions to help them do their work efficiently, maintain quality, and meet critical deadlines in the global aviation supply chain.

This management concept is not new to GE Aviation; its manufacturing plants in Durham, North Carolina, and Bromont, Quebec, Canada, have been using self-managed teams for more than 30 years. This approach to business operations continues to be successful and is now used at most of its 77 manufacturing facilities worldwide.

The goal of teaming is to move decision-making and authority as close to the end-product as possible, which means front-line employees are accountable for meeting performance goals on a daily basis. For example, if there is some sort of delay in the manufacturing process, it is up to the team to figure out how to keep things moving—even if that means skipping breaks or changing their work schedules to overcome obstacles.

At the Bromont plant, workers do not have supervisors who give them direction. Rather, they have coaches who give them specific goals. The typical functions performed by supervisors, such as planning, developing manufacturing processes, and monitoring vacation and overtime, are managed by the teams themselves. In addition, members from each team sit on a joint council with management and HR representatives to make decisions that will affect overall plant operations, such as when to eliminate overtime and who gets promoted or fired.

This hands-on approach helps workers gain confidence and motivation to fix problems directly rather than sending a question up the chain of command and waiting for a directive. In addition, teaming allows the people who do the work on a daily basis to come up with the best ideas to resolve issues and perform various jobs tasks in the most efficient way possible.

For GE Aviation, implementing the teaming approach has been a successful venture, and the company finds the strategy easiest to implement when starting up a new manufacturing facility. The company recently opened several new plants, and the teaming concept has had an interesting effect on the hiring process. A new plant in Welland, Ontario, Canada, opens soon, and the hiring process, which may seem more rigorous than most job hiring experiences, is well under way. With the team concept in mind, job candidates need to demonstrate not only required technical skills but also soft skills—for example, the ability to communicate clearly, accept feedback, and participate in discussions in a respectful manner.

Critical Thinking Questions
  1. What challenges do you think HR recruiters face when hiring job candidates who need to have both technical and soft skills?
  2. How can experienced team members help new employees be successful in the teaming structure? Provide some examples.

Sources: GE Reports Canada, “The Meaning of Teaming: Empowering New Hires at GE’s Welland Brilliant Factory,” https://gereports.ca, July 17, 2017; Sarah Kessler, “GE Has a Version of Self-Management That Is Much Like Zappos’ Holacracy—and It Works,” Quartz, https://qz.com, June 6, 2017; Gareth Phillips, “Look No Managers! Self-Managed Teams,” LinkedIn, https://www.linkedin.com, June 9, 2016; Amy Alexander, “Step by Step: Train Employees to Take Charge,” Investor’s Business Daily, http://www.investors.com, June 18, 2014; Rasheedah Jones, “Teaming at GE Aviation,” Management Innovation eXchange, http://www.managementexchange.com, July 14, 2013.

Building High-Performance Teams

A great team must possess certain characteristics, so selecting the appropriate employees for the team is vital. Employees who are more willing to work together to accomplish a common goal should be selected, rather than employees who are more interested in their own personal achievement. Team members should also possess a variety of skills. Diverse skills strengthen the overall effectiveness of the team, so teams should consciously recruit members to fill gaps in the collective skill set. To be effective, teams must also have clearly defined goals. Vague or unclear goals will not provide the necessary direction or allow employees to measure their performance against expectations.

Next, high-performing teams need to practice good communication. Team members need to communicate messages and give appropriate feedback that seeks to correct any misunderstandings. Feedback should also be detached; that is, team members should be careful to critique ideas rather than criticize the person who suggests them. Nothing can degrade the effectiveness of a team like personal attacks. Lastly, great teams have great leaders. Skilled team leaders divide work so that tasks are not repeated, help members set and track goals, monitor their team’s performance, communicate openly, and remain flexible to adapt to changing goals or management demands.

  1. What is the difference between a work team and a work group?
  2. Identify and describe three types of work teams.
  3. What are some ways to build a high-performance team?

Summary of Learning Outcomes

  1. Why are companies using team-based organizational structures?

Work groups share resources and coordinate efforts to help members better perform their individual duties and responsibilities. The performance of the group can be evaluated by adding up the contributions of the individual group members. Work teams require not only coordination but also collaboration, the pooling of knowledge, skills, abilities, and resources in a collective effort to attain a common goal. Four types of work teams are used: problem solving, self-managed, cross-functional, and virtual teams. Companies are using teams to improve individual and group motivation and performance.

Glossary

cross-functional team
Members from the same organizational level but from different functional areas.
group cohesiveness
The degree to which group members want to stay in the group and tend to resist outside influences.
problem-solving teams
Usually members of the same department who meet regularly to suggest ways to improve operations and solve specific problems.
self-managed work teams
Teams without formal supervision that plan, select alternatives, and evaluate their own performance.
work groups
The groups that share resources and coordinate efforts to help members better perform their individual jobs.
work teams
Like a work group but also requires the pooling of knowledge, skills, abilities, and resources to achieve a common goal.

56

Authority—Establishing Organizational Relationships

  1. What tools do companies use to establish relationships within their organizations?

Once companies choose a method of departmentalization, they must then establish the relationships within that structure. In other words, the company must decide how many layers of management it needs and who will report to whom. The company must also decide how much control to invest in each of its managers and where in the organization decisions will be made and implemented.

Managerial Hierarchy

Managerial hierarchy (also called the management pyramid) is defined by the levels of management within an organization. Generally, the management structure has three levels: top, middle, and supervisory management. In a managerial hierarchy, each organizational unit is controlled and supervised by a manager in a higher unit. The person with the most formal authority is at the top of the hierarchy. The higher a manager, the more power he or she has. Thus, the amount of power decreases as you move down the management pyramid. At the same time, the number of employees increases as you move down the hierarchy.

Not all companies today are using this traditional configuration. One company that has eliminated hierarchy altogether is The Morning Star Company, the largest tomato processor in the world. Based in Woodland, California, the company employs 600 permanent “colleagues” and an additional 4,000 workers during harvest season. Founder and sole owner Chris Rufer started the company and based its vision on the philosophy of self-management, in which professionals initiate communication and coordination of their activities with colleagues, customers, suppliers, and others, and take personal responsibility for helping the company achieve its corporate goals.

“Morning Star’s Success Story: No Bosses, No Titles, No Structural Hierarchy,” Corporate Rebels, http://corporate-rebels.com, November 14, 2016.

An organization with a well-defined hierarchy has a clear chain of command, which is the line of authority that extends from one level of the organization to the next, from top to bottom, and makes clear who reports to whom. The chain of command is shown in the organization chart and can be traced from the CEO all the way down to the employees producing goods and services. Under the unity of command principle, everyone reports to and gets instructions from only one boss. Unity of command guarantees that everyone will have a direct supervisor and will not be taking orders from a number of different supervisors. Unity of command and chain of command give everyone in the organization clear directions and help coordinate people doing different jobs.

Matrix organizations automatically violate the unity of command principle because employees report to more than one boss, if only for the duration of a project. For example, Unilever, the consumer-products company that makes Dove soap, Ben & Jerry’s ice cream, and Hellmann’s mayonnaise, used to have a matrix structure with one CEO for North America and another for Europe. But employees in divisions that operated in both locations were unsure about which CEO’s decisions took precedence. Today, the company uses a product departmentalization structure.

Justin Young, “Unilever’s Organizational Structure for Product Innovation,” Panmore Institute, http://panmore.com, February 21, 2017; “Unilever UK Gets Its House in Order,” Grocer, February 12, 2005; “From Rivalry to Mergers: Anglo-Dutch Companies,” The Economist, February 12, 2005, p. 61.

Companies like Unilever tend to abandon matrix structures because of problems associated with unclear or duplicate reporting relationships, in other words, with a lack of unity of command.

Individuals who are part of the chain of command have authority over other persons in the organization. Authority is legitimate power, granted by the organization and acknowledged by employees, that allows an individual to request action and expect compliance. Exercising authority means making decisions and seeing that they are carried out. Most managers delegate, or assign, some degree of authority and responsibility to others below them in the chain of command. The delegation of authority makes the employees accountable to their supervisor. Accountability means responsibility for outcomes. Typically, authority and responsibility move downward through the organization as managers assign activities to, and share decision-making with, their subordinates. Accountability moves upward in the organization as managers in each successively higher level are held accountable for the actions of their subordinates.

Span of Control

Each firm must decide how many managers are needed at each level of the management hierarchy to effectively supervise the work performed within organizational units. A manager’s