Economic Problem
We have unlimited Needs and wants and there are limited resources. This is the basic Economic Problem.
Limited Resources
Resources available on earth to make goods and services to satisfy our needs and want are limited. These resources are also known as factor of production. These can be categorised as
Land
All natural resources provided by nature such as fields, forests, oil, gas, metals and other mineral resources
Labour
The people who are used produce goods and services. Capital
Finance, machinery and equipments needed to produce goods and services. Enterprise
The skill and risk taking ability of the person who brings together all the other factors of production together to produce goods and services. Usually the owner or founder of a business.
Business activity combines the factors of production to produce goods and services to satisfy our needs and wants.So a business activity takes inputs (factors of productions), processes it and gives an output
Opportunity Cost
Because of Unlimited needs and wants and limited resources we have make a choice. When we make a choice we have to give up something. This next best alternative foregone while making a choice is known as Opportunity Cost.
Specialisation and Division of Labour
Because of the fact that choice involves opportunity cost, the factors of production have to be used in the most efficient way. This is achieved through Specialisation and Division of Labour. This means every individual performs a specific task only so that he can give in the best output. Division of labour can be defined as
the separation of a work process into a number of tasks, with each task performed by a separate person or group of persons.
As the workers become specialised in a particular task, it results in 'specialisation'. Division of labour is most visible in assembly lines which are used for mass production of goods. example. a car assembly line.
There are advantages and disadvantages related with division of labour.
Advantages
Specialisation results in greater efficiency and productivity
Disadvantages
Repeatedly doing the same job can result in boredom for the workers
If a worker cannot complete his or her job on time this may result in a bottleneck for the whole production process.
Levels of business activity
There are millions of businesses around us. Business can be categorised in three broad categories or stages.
Primary Sector
All those businesses which are related with extraction of raw material from Mother Nature such as mining, fishing, farming, and logging are known as Primary Sector businesses.
Secondary Sector
All businesses which manufacture and process the raw materials which can be used by the end consumers are known as Secondary Sector businesses. These include building, construction, compute assembly, shoes factories, textile factories etc.
Tertiary Sector
Whereas all the businesses which provide services and assist both the primary and secondary sector businesses can be classified as Tertiary sector businesses. These include transportation, insurance, hospitals, educational institutes, showrooms etc.
A business may exist in all the three sectors also. For example. British Petroleum has its own Oil wells and it extracts raw oil, this is primary sector activity, this oil is converted into petroleum and other by products. This is secondary business activity. After
processing the oil into useable product BP sells it to end consumers through its network of Petrol pumps. This comes under the tertiary sector.
Stakeholders and their objectives
Many people are involved in running a business. Some have direct interest while others have indirect interest in the running of the business. These individuals or groups are known as stakeholders.
Stakeholders Who are they Objectives
Owners They invest capital in the business and
get profits from the business Profits, growth of the business
Workers
Employees of the business who give in their time and effort to make a
business successful
Job security, job satisfaction and a satisfactory level of payment for their efforts
Managers
Employees of the business who manage a business. They lead and control the workers to achieve organisational goals
High salaries, Job security,
Status and growth of the business
Consumers These are the people who buy the goods and services of the business.
Safe and reliable products, value for money, proper after sales service
Government
Government manages the economy. The government charges a tax from the business and also monitors the working of businesses in the country
Successful businesses, employments to be created, more taxes, follow laws.
The
community
Community is all the people who are directly or indirectly affected by the actions of the business.
.
They expect more jobs, environmental protection, socially responsible products and actions of the business
What is a small business?
A small business is a business that is independently owned and operated, with a small number of employees and relatively low volume of sales.
Different countries have slightly different description for a small business.
For example, in United States a business have less than 100 employees is considered as a „small business‟, whereas it is under 50 employees to qualify as a „small business‟ in European Union.
In Australia, a small business is defined as 1-19 employees.
Small businesses are normally privately owned corporations, partnerships, or sole proprietorships.
Apart from number of employees other criteria for classifying a business as „small‟ are: Amount of capital employed
Annual Sales turnover Value of assets Profits
Importance of small business in the economy
As we all know that small firms are important for the economy.
Small businesses employees majority of the workforce in any country. Every business starts small.
Small businesses are flexible and respond easily to changes in demand. Small firms often cater to local demands.
In difficult economic times, such as a recession, small business can be an important source of providing employment.
Small firms provide competition to larger firms through providing customised goods and services.
Small firms provide niche products and services which a larger firm might oversee.
Small businesses face the following problems Under capitalisation
Poor debt management
Lack of managerial skills of the owner Cannot retain experienced staff
Usually find it difficult to attract skilled staff Poor stock management
How can small business survive?
Small firms survive by being different (product differentiation). They can survive by Segmenting the market by income. They can target niche market segments of high
income customers, position their product as a „premium brand‟ at a high „premium price‟ eg Morgan sports cars
Small firms have the advantage of being able to respond quickly to change - they do not have the bureaucratic procedures often a feature of large firms where decisions are made only after endless meetings. This means they can be quick to exploit new market trends.
The Internet also allows small firms direct access to consumers, by passing
intermediaries. The web gives small firms the opportunity of international marketing. Small independent firms can join together to form a buying group to negotiate discounts
on joint orders.
Small firms can survive by selecting a premium niche and offering an exclusive brand‟ that exactly meets the customer requirements of their target segment. They will need to be totally customer orientated.
Business Objectives
Different businesses have different objectives. Objectives are aims or targets to work towards. These objectives can be summarised as
Maximise profit: Common for business owned by private individuals. It involves improving profit margins, improving the rate of return on investment
Grow or expand: It involves increasing the operations of the business, expanding to other regions or countries, gaining the
Survival: especially relevant for new businesses
Provide a service: especially for public sector businesses whose main objective is to provide services, create employment and welfare of the general public
To increase added value: Many businesses want to add more value to their products.
Business Growth
Many businesses have an objective and that is to grow in size. Keeping Growth as an objective has its own advantages for the business.
Why businesses set growth as an objective: Possibility of higher profits
More and salaries for managers Economies of scale
How can businesses expand?
Business can expand is two main ways:
Internal Growth or also known as organic growth where the business expands by opening more outlets/factories/offices gradually by using its profits.
External growth involves buying out other business and making them a part of your business. Examples are takeovers and mergers.
Integration can be of three types
Horizontal Integration: when one firm merges with another firm or takes over another one in the same industry and at the same stage of production. Example Vodafone and Hutch
Vertical Integration: one firm merges or take over another firm in the same industry but at a different stage of production. Vetical Integration can be either forward or backward.
Backward Integration is when a business merges or takes over a business which takes it near to the source of raw materials. For example an oil refinery combined with another firm which is into oil driling.
Forward Integration is when a business merges or takes over a business which takes it near to the customers. For example, an oil refinery is combined with company which owns Petrol stations.
Conglomerate Integration: It is also known as lateral integration. Take over or merge with another firm in a completely different industry. example a shoe manufacturer buys a biscuit producing business.
Business Measurement
In the world around us there are some businesses which are small and some are big. But how do we categorize these businesses as big or small. We can consider the following factors:
The number of employees: but business which use more machinery and technology i.e. capital intensive may have few employees but they still might be big. Example Microsoft has less employees but still it the biggest business on earth.
The amount of capital invested: A business which might not use a lot of investment in machinery but and involves less investment may still be big. Take the example of software companies and consultancy firms like McKenzie & Co.
The sales turnover: A business may be going through a bad phase and may not have huge sales does it make the business small?
Market capitalisation: markets are very volatile and share prices change every day does it alter the size of the business every day?
Market share: a business may not be a market leader but still may be huge whereas if the market is itself very small, a major market share won‟t make a business big.
So while deciding the size of business as big or small a combination of factors needs to be considered.
Aims of Public Sector and Private Sector
Usually the aim of public sector business is to provide services to the community. For example if the transport system is owned by the government and it is running a bus service to an interior village and it is not getting enough customers, the government might still continue it as its main objective is to provide service and not to maximise profits. Whereas private sectors business give priority to profits and may end the service if it does not find it profitable to run the service.
Secondly Public sector strives to create employment whereas Private sectors main aim is to become efficient and cut cost and in this process they might cut jobs.
Public sector business usually locates in regions where there is underdevelopment so as to create jobs and income for local population. Private sectors might not keep these things in consideration and will look for external economies of scale.
Market Economy/Free Market Economy Features Features
All the resources in a market economy are privately owned by people and firms.
Every business will aim to make as much profit as possible i.e. profit is the main motive. There is consumer sovereignty.
Firms will only produce those goods which consumers want and are willing to pay for. Price is determined through the price mechanism
Market economies responds quickly to people‟s wants
Factors of production which are profitable will only be employed. There is wide variety of goods and services in the market.
New and better methods of production are encouraged thus leading to lower cost of goods and services.
Disadvantages
Public goods may not be provided for in Market economy, thus the government will have to interfere to provide these types of goods.
Market economies encourage consumption of harmful goods Prices are determined by the demand and supply of goods.
Social cost may not be considered while producing goods and services.It may lead to unemployment because machines will be more productive than men.
Planned Economy/ Command Economy Features
Government decides how all scarce resources were to be used.
Government will decide what is to be produced, how much to be produced and how much should be charged for goods and services.
The economy only has Public Sector. Advantages
There is no competition between firms thus resulting in less wastage. Government ensures that everybody is employed.
Less gap between poor and rich Disadvantages
No incentives for businesses to produce.
Production of goods is decided by government thus there is no consumer sovereignty. Businesses usually are less efficient because of lack of profit motive.
Mixed economy Features
Mixed economy is a combination of market economy as well as government planning. It has both private sector and public sector. Some businesses are owned by private individuals while some businesses are owned by the government. India, Indonesia is examples of mixed economies.
Mixed economy attempts to overcome the disadvantages of a market economic system by using government intervention to control or regulate different markets.
Chapter 2: Types of business activity Levels of economic activity
In order for products to be made and sold to the people, it must undergo 3 different production processes. Each process is done by a different business sector and they are:
Primary sector: The natural resources extraction sector. E.g. farming, forestry, mining... (earns the least money)
Secondary sector: The manufacturing sector. E.g. construction, car manufacturing, baking... (earns a medium amount of money)
Tertiary sector: The service sector. E.g banks, transport, insurance... (earns the most money)
Importance of a sector in a country: no. of workers employed. value of output and sales.
Industrialisation: a country is moving from the primary sector to the secondary sector.
De-industrialisation: a country is moving from the secondary sector to the tertiary sector.
In both cases, these processes both earn the country more revenue.
Types of economies Free market economy:
All businesses are owned by the private sector. No government intervention. Pros:
Consumers have a lot of choice High motivation for workers Competition keeps prices low
Incentive for other businesses to set up and make profits Cons:
Not all products will be available for everybody, especially thepoor No government intervention means uncontrollable economic booms or recessions
Monopolies could be set up limiting consumer choice and exploiting them Command/Planned economy:
All businesses are owned by the public sector. Total government intervention. Fixed wages for everyone. Private property is not allowed.
Pros:
Eliminates any waste from competition between businesses (e.g. advertising the same product)
All needs are met (although no luxury goods) Cons:
Little motivation for workers
The government might produce things people don't want to buy Low incentive for firms (no profit) leads to low efficiency Mixed economy:
Businesses belong to both the private and public sector. Government controlspart of the economy.
Industries under government ownership: health
education defence
public transport water & electricity Privatisation
Privatisation involves the government selling national businesses to the private sector to increase output and efficiency.
Pros:
New incentive (profit) encourages the business to be more efficient Competition lowers prices
Individuals have more capital than the government
Business decisions are for efficiency, not government popularity Privatisation raises money for the government
Cons:
Essential businesses making losses will be closed Workers could be made redundant for the sake of profit Businesses could become monopolies, leading to higher price Comparing the size of businesses
Businesses vary in size, and there are some ways to measure them. For some people, this information could be very useful:
Investors - how safe it is to invest in businesses Government - tax
Competitors - compare their firm with other firms
Workers - job security, how many people they will be working with Banks - can they get a loan back from a business.
Number of employees. Does not work on capital intensive firms that use machinery.
Value of output. Does not take into account people employed. Does not take into account sales revenue.
Value of sales. Does not take into account people employed.
Capital employed. Does not work on labour intensive firms. High capital but low output means low effiency.
You cannot measure a businesses size by its profit, because profit depends on too many factors not just the size of the firm.
Business Growth
All owners want their businesses to expand. They reap these benefits: Higher profits
More status, power and salary for managers Low average costs (economies of scale) Higher market share
Types of expansion:
Internal Growth: Organic growth. Growth paid for by owners capital or retained profits.
External Growth: Growth by taking over or merging with another business. Types of Mergers (and main benefits):
- Horizontal Merger: merging with a business in the same business sector. Reduces no. of competitors in industry
Economies of scale Increase market share - Vertical merger:
Forward vertical merger:
Assured outlet for products
Profit made by retailer is absorbed by manufacturer Prevent retailer from selling products of other businesses
Market research on customers transfered directly to the manufacturer Backward vertical merger:
Constant supply of raw materials
Profit from primary sector business is absorbed by manufacturer Prevent supplier from supplying other businesses
Controlled cost of raw materials Conglomerate merger:
Transfer of new ideas from one section of the business to another Why some businesses stay small:
There are some reasons why some businesses stay small. They are:
Type of industry the business is in: Industries offering personal service or specialized products. They cannot grow bigger because they will lose the personal service demanded by customers. E.g. hairdressers, cleaning, convenience store, etc.
Market size: If the size of the market a business is selling to is too small, the business cannot expand. E.g. luxury cars (Lamborghini), expensive fashion clothing, etc. Owners objectives: Owners might want to keep a personal touch with staff and customers. They do not want the increased stress and worry of running a bigger
business.
Chapter 3: Forms of business organisation
Almost every country consists of two business sectors, the private sector and the public sector. Private sector businesses are operated and run by individuals, while public sector businesses are operated by the government. The types of businesses present in a sector can vary, so lets take a look at them.
Private Sector
Sole Traders
Sole traders are the most common form of business in the world, and take up as much as 90% of all businesses in a country. The business is owned and run by one person only. Even though he can employ people, he is still the sole proprietor of the business. These businesses are so common since there are so little legal requirements to set up:
The owner must register with and send annual accounts to the government Tax Office.
They must register their business names with the Registrar of Business Names.
They must obey all basic laws for trading and commerce.
There are advantages and disadvantages to everything, and here are ones for sold traders:
Pros:
There are so few legal formalities are required to operate the business. The owner is his own boss, and has total control over the business.
The owner gets 100% of profits.
Motivation because he gets all the profits.
The owner has freedom to change working hours or whom to employ, etc. He has personal contact with customers.
He does not have to share information with anyone but the tax office, thus he enjoys complete secrecy.
Cons:
Nobody to discuss problems with. Unlimited liability.
Limited finance/capital, business will remain small. The owner normally spends long hours working.
Some parts of the business can be inefficient because of lack ofspecialists. Does not benefit from economies of scale.
No continuity, no legal identity. Sole traders are recommended for people who: Are setting up a new business.
Do not require a lot of capital for their business. Require direct contact for customer service. Partnership
A partnership is a group consisting of 2 to 20 people who run and own a business
together. They require a Deed of Partnership or Partnership Agreement, which is a document that states that all partners agree to work with each other, and issues such as who put the most capital into the business or who is entitled to the most profit. Other legal regulations are similar to that of a sole trader.
Pros:
More capital than a sole trader. Responsibilities are split.
Any losses are shared between partners. Cons:
Unlimited liability.
No continuity, no legal identity.
Partners can disagree on decisions, slowing down decision making. If one partner is inefficient or dishonest, everybody loses.
Recommended to people who:
Want to make a bigger business but does not want legal complications.
Professionals, such as doctors or lawyers, cannot form a company, and can only form a partnership.
Family, when they want a simple means of getting everybody into a business (Warning: Nepotism is usually not recommended).
Note: In some countries including the UK there can be Limited Partnerships. This business has limited liability but shares cannot be bought or sold. It is abbreviated as LLP.
Private limited Companies
These are closely held businesses usually by family, friends and relatives.
Private companies may issue stock and have shareholders. However, their shares do not trade on public exchanges and are not issued through an initial public offering. Shareholders may not be able to sell their shares without the agreement of the other shareholders.
Advantages
Limited Liability: It means that if the company experience financial distress because of normal business activity, the personal assets of shareholders will not be at risk of being seized by creditors.
Continuity of existence: business not affected by the status of the owner. Minimum number of shareholders need to start the business are only2.
More capital can be raised as the maximum number of shareholders allowed is 50. Scope of expansion is higher because easy to raise capital from financial institutions and
the advantage of limited liability.
Disadvantages
Growth may be limited because maximum shareholders allowed are only 50.
The shares in a private limited company cannot be sold or transferred to anyone else without the agreement of other shareholders
Capital is still limited as the company cannot sell shares to the public. Public Limited Companies
Public limited companies are similar to private limited companies, but they are able to sell shares to the public. A private limited company can be converted into a public limited company by:
1. A statement in the Memorandum of Association must be made so that it says this company is a public limited company.
2. All accounts must be made public.
3. The company has to apply for a listing in the Stock Exchange.
A prospectus must be issued to advertise to customers to buy shares, and it has to state how the capital raised from shares will be spent.
Public Limited company
Limited companies which can sell share on the stock exchange are Public Limited companies. These companies usually write PLC after their names.
Advantages
There is limited liability for the shareholders.
The business has separate legal entity. There is continuity even if any of the shareholders die.
These businesses can raise large capital sum as there is no limit to the number of shareholders.
The shares of the business are freely transferable providing more liquidity to its shareholders .
Disadvantages
There are lot of legal formalities required for forming a public limited company. It is costly and time consuming.
In order to protect the interest of the ordinary investor there are strict controls and regulations to comply. These companies have to publish their accounts.
The original owners may lose control.
Public Limited companies are huge in size and may face management problems such as slow decision making and industrial relations problems.
Pros:
Limited liability. Continuity.
Potential to raise limitless capital. No restrictions on transfer of shares.
High status will attract investors and customers. Cons:
Many legal formalities required to form the business.
Many rules and regulations to protect shareholders, including the publishing of annual accounts.
Selling shares is expensive, because of the commission paid to banks to aid in selling shares and costs of printing the prospectus.
Difficult to control since it is so large.
Owners lose control, when the original owners hold less than 51% of shares. Control and ownership in a public limited company:
The Annual General Meeting (AGM) is held every year and all shareholders are invited to attend so that they can elect their Board of Directors. Normally, Director are majority shareholders who has the power to do whatever they want. However, this is not the case for public limited companies since there can be millions of
shareholders. Anyway, when directors are elected, they have to power to make important decisions. However, they must hire managers to attend to day to day decisions.
Therefore:
Shareholders own the company
Directors and managers control the company
This is called the divorce between ownership and control.
Because shareholders invested in the company, they expect dividends. The directors could do things other than give shareholders dividends, such as trying to expand the company. However, they might loose their status in the next AGM if shareholders are not happy with what they are doing. All in all, both directors and shareholders have their own objectives.
Co-operatives
Cooperatives are a group of people who agree to work together and pool their money together to buy "bulk". Their features are:
All members have equal rights, no matter how much capital they invested. All workload and decision making is equally shared, a manager maybe appointed for bigger cooperatives
Profits are shared equally. The most common cooperatives are:
producer co-operatives: just like any other business, but run by workers. retail co-operatives: provides members with high quality goods or services for a reasonable price.
Other notable business organizations: Close Corporations:
This type of business is present in countries such as South Africa. It is like a private limited company but it is much quicker to set up:
You only need a simple founding statement which is sent to the Registrar of Companies to start the business.
All members are managers (no divorce of ownership and control). A separate legal unit, has both limited liability and continuity.
Cons:
The size limit is not suitable for a large business. Members may disagree just like in a partnership. Joint ventures
Two businesses agree to start a new project together, sharing capital, risks and profits.
Pros:
Shared costs are good for tackling expensive projects. (e.g aircraft) Pooled knowledge. (e.g foreign and local business)
Risks are shared. Cons:
Profits have to be shared. Disagreements might occur.
The two partners might run the joint venture differently. Franchising
The franchisor is a business with a successful brand name that recruits
franchisees (individual businesses) to sell for them. (e.g. McDonald, Burger King)
Pros for the franchisor:
The franchisee has to pay to use the brand name.
Expansion is much faster because the franchisor does not have to finance all new outlets.
The franchisee manages outlets
All products sold must be bought from the franchisor. Cons for the franchisor:
The failure of one franchise could lead to a bad reputation of the whole business.
The franchisee keeps the profits. Pros for the franchisee:
The chance of failure is much reduced due to the well know brand image. The franchisor pays for advertising.
Many business decisions will be made by the franchisor (prices, store layout, products).
Training for staff and management is provide by the franchisor. Banks are more willing to lend to franchisees because of lower risks. Cons for the franchisee:
Less independence
May be unable to make decisions that would suit the local area.
Licence fee must be paid annually and a percentage of the turnover must be paid.
Public Sector
Public corporations:
A business owned by the government and run by Directors appointed by the
government. These businesses usually include the water supply, electricity supply, etc. The government give the directors a set of objectives that they will have to follow: to keep prices low so everybody can afford the service.
to keep people employed.
to offer a service to the public everywhere.
These objectives are expensive to follow, and are paid for by governmentsubsidies. However, at one point the government would realise they cannot keep doing this, so they will set different objectives:
to reduce costs, even if it means making a few people redundant. to increase efficiency like a private company.
to close loss-making services, even if this mean some consumers are no longer provided with the service.
Pros:
Some businesses are considered too important to be owned by an individual. (electricity, water, airline)
Other businesses, considered natural monopolies, are controlled by the government. (electricity, water)
Reduces waste in an industry. (e.g. two railway lines in one city) Rescue important businesses when they are failing.
Provide essential services to the people (e.g. the BBC) Cons:
Motivation might not be as high because profit is not an objective. Subsidies lead to inefficiency. It is also considered unfair for private businesses.
There is normally no competition to public corporations, so there is no incentive to improve.
Businesses could be run for government popularity. Municipal enterprises
These businesses are run by local government authorities which might befree to the user and financed by local taxes. (e.g, street lighting, schools, local library, rubbish collection). If these businesses make a loss, usually a government subsidy is provided. However, to reduce the burden on taxpayers, many municipal enterprises are
being privatised.
Economic Objectives of the Government
Most of the governments round the world have four main objectives. These are Keep inflation under control
Maintain a low level of unemployment Achieve a high level of growth rate Maintain a healthy balance of payments.
Economic factors affecting business
These are some of the economic environment factors which affect business
At what stage of the business cycle is the economy
If the economy is going through a recession it is obvious that businesses generally will not be doing well due to low aggregate demand in the economy. On the other hand, a boom period will lead to higher business profits and revenue for most of the businesses in the economy.
Inflation rate
High rate of inflation leads to lower purchasing power for consumers resulting in lower demand for goods and services. Moreover, a higher inflation rate will make business uncompetitive in the international market leading to lower sales for the business.
Prevailing interest rates
Higher Interest rates will lead to a fall in the aggregate demand in the economy thus leading to difficulty for business to find customers willing to buy its product. Lower interest rates will lead to a increase in demand in the economy.
Unemployment level
High level of unemployment in the country can also adversely affect a business. People will not have enough money to purchase a firm‟s product.
Labor costs
High labor cost will result higher production costs. This will make a firm‟s product more expensive as compared to other firms affecting its sales and profit margin.
Levels of disposable income and income distribution
High level of disposable income is good for business producing luxury goods. A large disparity in income distribution will promote businesses dealing in luxury goods as well as inferior goods.
Taxes
High level of taxes will lead to low disposable income and contraction of demand in the economy. Business will find it difficult to attract consumers.
Tariffs
Tariffs are taxes and imposed on imported goods. If the tariffs are low the domestic market may be flooded with cheap imported goods and the local businesses will have tough time selling their products.
Why government controls business activities?
Businesses are usually profit motivated. Many times in order to gain more profit the business might neglect issues like environmental protection and production of harmful and dangerous products.
Large business might take the advantage of their size and exploit consumers,
employees and even use unfair tactics to overcome competition from small businesses. Business might use media to portray a wrong image of their product or may even
mislead customers to buy products.
How government controls business activity?
Governments control the business activities is many ways both direct and indirect. We have already covered government‟s economic policies. However, government can control business activities in a more direct way. These are as follows:
Controlling what to produce
In order to safeguard the interest of the community government may ban or limit the production of certain goods and services. For example, selling of guns, explosive and dangerous drugs are illegal in many countries. Moreover, Goods which harm the
environment are also totally banned or strictly controlled in many countries, e.g. aerosol cans that use CFCs which has been banned because of their damaging effect on the ozone layer.
Employees Protection legislations
Laws against unfair discrimination at work and when applying for jobs. There is no unfair discrimination on the basis of Race, religion, sex, age, or colour.
Legislations for health and Safety at work: To protect workers from dangerous machinery.
Workers should be provided with proper safety equipments and clothing. A reasonable workforce temperature is maintained for workers.
Proper hygienic conditions and washing facilities are provided. Workers get adequate breaks between shifts.
Protect employees against unfair dismissal
Business can not dismiss the workers because they have joined a trade union or for being pregnant. There should be proper warning before dismissing a worker otherwise it will be treated as unfair dismissal.
Ensure fair wages for the employees
In many countries, government makes it mandatory to have a written contract of employment. It contains the details of the wage rate; working hours, deductions (if any) and other necessary details regarding working conditions. Minimum wages paid to different types of workers are also determined by the government.
Consumer Protection legislations
Most of the countries have consumer protection laws aimed at making sure that businesses act fairly towards their consumers: A few examples are
Weight and Measures Act: goods sold should not be underweight. Standard weighting equipments should be used to measure goods.
Trade Description Act: deliberately giving misleading impression about the product is illegal.
Consumer Credit Act: According to this act consumers should be given a copy of the credit agreement and should be aware of the interest rates, length of loan while taking a loan.
Sale of Goods Act: It is illegal to sell products with serious flaws or problems and goods sold should conform to the description provided.
Environment protection
In the recent years government across the globe have passes legislations to control business activities from harming the environment. This includes setting limits to the pollution, making it mandatory for businesses to treat their wastes etc.
Location decisions
Government often influences location of business through
Planning controls involve restricting the business activities that can be undertaken in certain areas.
Provide regional assistance to businesses which involves encouraging them to locate in underdeveloped regions of the country.
How does government help businesses? Providing cheap loans and giving grants.
Providing advice and information centres for businesses.
Providing college courses and training programmes for entrepreneurs. Offering subsidies or tax reduction to businesses.
Maintain a stable exchange rate of the currency. Just a moment…
Why does government help businesses?
To help small businesses to survive and encourage competition in the economy. To encourage firms to export and earn foreign exchange for the country.
To encourage businesses to set up in underdeveloped regions of the country and create wealth and employment opportunities in these areas.
Government Economic Policies
Government influences the economy through its economic policies. These are Fiscal Policy
It is related with taxes and government spending. This policy is there to control inflation and demand in the economy. Usually government collects money in the form of taxes and spends money through its development expenditure such as building roads, bridge, defence, transports etc. Government constantly monitors the aggregate demand in the economy. Inflation rate gives the correct measure of the aggregate demand in the economy.
When the aggregate demand in the economy is high, prices rise, this shows that the economy is spending too much. In this case, the government will lower is expenditure budget and cut back on investment spending, such as on road construction and hospital equipment. On the other hand the government might also increase the taxes, which would take spending power out of the economy by leaving consumers and businesses with less income to spend.
In the opposite scenario, when the economy is heading for a recession and
unemployment is rising, the government might increase its expenditure plans. There might be a reduction in taxes so as to leave consumers and businesses with higher disposable incomes.
Monetary Policy
Monetary Policy is related with a change in interest rates by the government or the Central bank. When the forecast for inflation is that it will rise above the targets set by government, then the Central Bank will raise its base rate and all other banks and lending institutions will follow. It is usually done when the economy is at the boom stage of the business cycle.
A higher interest rate will result in
Business will not be able to expand as they have to pay more interest to the bank for their loans and they have less profit left.
Businesses that are planning to take loan for expanding may postpone their decisions and wait for a cut in interest rates.
Consumers demand will also fall as they will not be getting cheap loans to pay for the buying new houses and luxury items.
If inflation is low and is forecasted to remain below governments targets, then the Central Bank may decide to reduce interest rates.
Supply side policies
It includes all those policies which aim at improving the efficient supply of goods and services. These might include:
Privatisation
Imparting training and improving the education level of the workforce resulting in higher skills.
Increase competition in all industries by removing entry barriers, thus leading to more efficiency.
Business Cycle
The business cycle or economic cycle refers to the fluctuations of economic activity about its long term growth trend. The cycle involves shifts over time between periods of relatively rapid growth of output (recovery and prosperity), and periods of relative stagnation or decline (contraction or recession). These fluctuations are often measured using the real gross domestic product.
There are four main stages in a trade cycle or business cycle.
Growth
GDP is rising
Unemployment is falling
Business are experiencing rising profits „Feel good‟ factor among the people as their incomes are rising.
Boom Results from too much spending. Economy experiences rapid inflation
Factors of production become expensive Recession Results from too little spending.
GDP is falling
Demand in the economy will fall leading to closure of firms and unemployment
Slump High level of unemployment.
Business will rapidly close down creating serious consequences for the economy.
What is a Recession?
Recession is defined as a period of reduced economic activity, a business cycle contraction.
The U.S.-based National Bureau of Economic Research (NBER) defines economic recession as:
"a significant decline in [the] economic activity spread across the economy,
lasting more than a few months, normally visible in real GDP growth, real personal income, employment (non-farm payrolls), industrial production, and wholesale-retail sales.”
In macroeconomics, a recession is a decline in a country's gross domestic product (GDP), or negative real economic growth, for two or more successive quarters of a year. A recession has many attributes that can occur simultaneously and can include declines in coincident measures of activity such as employment, investment, and corporate profits.
A severe or prolonged recession is referred to as an economic depression. During a recession
There will be reduced customer confidence and a reduce consumer spending. Businesses will reduce production levels as they find it difficult to sell their goods and
services.
In order to sustain growth, businesses will cut cost and will lay off employees.
Economy will see an increased rate of retrenchment and more money is spent by the government on unemployment benefit.
Government will get less revenue from income tax and VAT. Stock exchanges will see reduced activity.
How can government tackle the situation
In order to boost economic growth, governments may resort to several strategies. These strategies for moving an economy out of a recession vary depending on which economic school the policymakers follow.
Fiscal policy moves involve increase government spending to boost aggregate demand in the economy. Government may also reduce taxes. Tax cuts will promote business capital investment. Lower-bracket tax reductions are more effective and serve a double purpose including relieving the suffering caused by a recession.
Monetary policy involves increased money supply and reducing the price of money i.e. interest rates. Reduced interest rates will promote capital investment and spark
economic growth.
Supply side policies involve giving subsidies and increasing the level of education of the work force.
Global recessions
According to International Monetary Fund (IMF) global recessions are periods when global growth is less than 3%. The IMF estimates that global recessions seem to occur over a cycle lasting between 8 and 10 years. During what the IMF terms the past three global recessions of the last three decades, global per capita output growth was zero or negative. By this measure, three periods since 1985 qualify: 1990-1993, 1998 and 2001-2002.
Exchange Rate
Exchange rate is the rate at which one country’s currency can be exchanged for another country’s currency.
How is exchange rate determined?
A fixed exchange rate system refers to the case where the exchange rate is set and maintained at same level by the government irrespective of the market forces. Floating exchange rate system means that the exchange rate is allowed to fluctuate according to the market forces without the intervention of the Central bank or the government.
Appreciation and Depreciation
The exchange rate for any currency usually fluctuates. When the value of the currency goes up as compared to other currency it is known as appreciation. When the value of currency falls as compared to other currency it is known as depreciation.
Usually the exchange rates are determined by the demand and supply of that currency in the international market.
Demand for any country‟s currency on the foreign exchange market is determined by demand for that country‟s exports of goods and services and by changes in foreign investment in that country. This is because when foreigners buy another country‟s exports of goods or services they must pay for these in the currency of the exporting country.
In the same way Supply of any country‟s currency on the foreign exchange market is determined by that country‟s imports of goods and services and by its investment in other countries.
Thus when the demand for a currency rises its price goes up and it becomes costlier. What causes the fluctuation in currency value?
Changes in the imports and exports of the country: An increase in exports of a country will lead to an increase in demand for the currency and thus the value rises.
Changes in Interest rate: Higher interest rate will attract more foreign investors to invest in the country and thus the demand for currency will rise, resulting in appreciation in value of the currency.
Changes in Inflation rate: Higher inflation rate will make the country uncompetitive in the international market. The exports will fall resulting in decreased demand for the currency and hence lower value.
Revaluation and Devaluation
It refers to official changes in the price of a currency in a fixed exchange rate system. Devaluation is when the price of the currency is officially decreased in a fixed exchange rate system.
Revaluation is the official increase in the price of the currency within a fixed exchange rate system.
Breakeven Charts
These are graphs which show how costs and revenues of a business change with a change in sales. They show the level of sales the business must make in order to break even.
Criticism of break even analysis
Fixed cost is represented as a straight line but in actual fixed costs is likely to change at different levels of output. A stepped line may represent fixed cost more accurately. Important terms
Fixed cost: all costs which do not change with the change in output. Example rent, interest charges.
Variable cost: all costs which change with the change in output. Example materials, fuel and labour cost.
Total cost= fixed cost + variable cost
Revenue: income from sales of goods and services (Quantity sold X Price)
Breakeven point is that level of output where the sales revenue is equal to the total cost. That level of output where there is no profit or loss. If a business is unable to reach this level of output it will suffer a loss from this product. Any output in excess of break even generates profit for the company.
Margin of Safety: The horizontal distance between the breakeven level of output and the current level of output is known as margin of safety.
Method of plotting Break even chart
Calculate fixed cost, total cost and Sales at different levels of output in a table Plot the Sales on X axis, Output on Y axis
Plot fixed cost from the table Plot total cost from the table Plot sales from the table
The point at which the sales (total revenue TR) line crosses the total cost (TC) line is the breakeven point.
Breakeven point can be expressed in Output as well as in Value. Breakeven point: Calculating method
This method involves calculating break even output without the use of graphs. Calculate the Contribution per unit.
Contribution is the excess of price over variable costs. Any money received over the variable costs makes a contribution towards the fixed costs.
Contribution per unit = Selling price per unit – Variable cost per unit Divide Fixed Cost by Contribution per unit
(Fixed cost/contribution per unit). This will give you the break even output.
To calculate break even in revenue, multiply break even output with price per unit (Break even (in units) X price per unit)
Example
Variable Cost = $1 per unit Selling Price= $5 per unit
Maximum capacity output= 200,000 units per year Calculate
Break even output Margin of safety
Profits at maximum output Answer:
Calculate the Contribution per unit = $5-$1=$4
Break even output = FC/contribution per unit= $100000/$4=25,000 units
Therefore this business has to produce 25,000 units to breakeven. In other words, at 25,000 units of output the business will have neither profit nor loss.
Break even in terms of revenue will be= 25,000 X selling price=
25,000 X $5= $125,000 Margin of Safety= Maximum capacity- Break even output
200,000 units – 25,000 units = 175,000 units
Profit at maximum output = Contribution per unit X margin of safety $4 X 175,000 units= $700,000
To achieve a target rate of profit
We can also calculate the level of output needed to achieve the profit target by using the following formula:
(Fixed cost + target profit)/ Contribution per unit
EXTRA HELP FOR BREAKEVEN: Finance - Breakeven - Introduction Breakeven
A business can work out how what volume of sales it needs to achieve to cover its costs. This is known as the break even point.
The key to break even is to work out the contribution made from the sale of each unit.
The amount of money each unit sold contributes to pay for the fixed and indirect costs of the business.
Contribution = selling price less variable cost per unit
E.g. a product sells for £15 and has variable costs per unit of £11. Each unit sale therefore makes a contribution of £4 towards the fixed costs of the business. If the business had fixed costs of £20,000, then it would need to sell 5,000 units (£4 x 5,000 = £20,000 contribution) in order to break even.
The margin of safety is the difference between the number of units of planned or actual sales and the number of units of sales at break even point.
If, using the example above, planned sales were thought to be 6,000 units, then the margin of safety would be 6,000 units – break even 5,000 units = 1,000 units. The business would be able to sell 1,000 less than planned before they were in danger of making a loss.
A break-even chart plots the sales revenue, different costs and helps identify the break even point and margin of safety.
Drawing break-even charts
To draw a chart the following steps need to be followed:
1. Label the vertical axis “sales and costs in pounds”. 2. Label the horizontal axis “sales/production (units)”.
3. On another piece of paper sketch the scales that you want to use given the data, then use this plan on the chart.
4. Plot any two points from the sales revenue data for the sales revenue line and then draw a straight line for sales revenue (assumes that the price per unit does not change) – if the information is not given for sales revenue, then work out two points, e.g. for 1000 units sold and 1500 units sold. The start of the line should be through the origin (where the axes meet).
5. Draw a horizontal line for total fixed costs starting at the point on the vertical axis at the level of costs.
6. At the same starting point it is possible to draw the total costs line. Total costs are fixed costs plus variable costs. Work out what the total costs are for say 1000 units and 1500 units. Then draw the straight line starting at the same point as the fixed costs started and then through the two plotted points.
7. Where the sales revenue crosses the total costs line is the break even point. Read off the units of sales to give the break even level of sales.
8. The gap between the total costs line and sales revenue line after the break even point represents the level of profit.
It is important for a business to understand its break-even point because the contribution from every unit sold above the break-even point adds to profit. The break-even point provides a focus for the business, but also helps it work out whether the forecast sales will be enough to produce a profit and whether further investment in the product is worthwhile.
The main limitations of break-even charts are:
Do not take into account possible changes in costs over the time period. Do not allow for changes in the selling price.
Analysis only as good as the quality of information.
Do not allow for changes in market conditions in the time period – e.g. entry of new competitor.
Uses of break-even charts
There are other benefits from the break-even chart other than identifying the breakeven point and the maximum profit. However, they are not all reliable so there are some disadvantages as well:
Pros:
The expected profit or loss can be calculated at any level of output. The impacts of business decisions can be seen by redrawing the graph. The breakeven chart show the safety margin which is the amount by which sales exceed the breakeven point.
Cons:
The graph assumes that all goods produced are sold.
Only focuses on the breakeven point. Completely ignores other aspects of production.
Does not take into account discounts or increased wages, etc. and other things that vary with time.
Break-even point: the calcultion method.
It is possible to calculate the breakeven point withought having to draw the graph. We need two formulas to achieve this:
Selling Price - Variable Costs = Contribution Break-even point = Total fixed costs/Contribution Business costs: other definitions
There are other types of costs to be analysed that is split from fixed and variable costs: Direct costs: costs that are directly related to the production of a particular product.
Marginal costs: how much costs will increase when a business decides to produce one more unit.
Indirect costs: costs not directly related to the product. They are often termed overheads.
Average cost per unit: total cost of production/total output Economies and Diseconomies of scale:
Economies of scale are factors that lead to a reduction in average costs that are obtained by growth of a business. There are five economies of scale:
Purchasing economies: Larger capital means you get discounts when buying bulk.
Marketing: More money for advertising and own transportation, cutting costs. Financial: Easier to borrow money from banks with lower interest rates. Managerial: Larger businesses can now afford specialist managers in all departments, increasing efficiency.
Technical: They can now buy specialised and latest equipment to cut overall production costs.
However, there are diseconomies of scale which increases average costs when a business grows:
Poor communication: It is more difficult to communicate in larger firms since there are so many people a message has to pass through. The managers might loose contact to customers and make wrong decisions.
Low morale: People work in large businesses with thousands of workers do not get much attention. They feel they are not needed this decreases morale and in turn efficiency.
Slower decision making: More people have to agree with a decision and communication difficulties also make decision making slower as well.
Budgets and forecasts: looking ahead
Business also needs to think ahead about the problems and opportunities that may arise in the future. There are things to try to forecast such as:
sales or consumer demands.
exchange rates appreciation or depreciation. wage increases.
There are some forecasting methods:
Past sales could be used to calculate the trend, which could then be extended into the future.
Create a line of best fit for past sales and extend it for the future.
Panel consensus: asking a panel of experts for their opinion on what is going to happen in the future.
Market research. Budgets
"Budgets are plans for the future containing numerical and financial targets". Better managers will create many budgets for costs, planned revenue and profit and combine them into one single plan called the master budget.
Here are the advantages of budgets:
They set objectives for managers and workers to work towards, increasing their motivation.
They can be used to see how well a business is doing by comparing the budget with the result in the process of variance analysis. The variance is the difference between the budget and the result.
If workers get a say in choosing the objectives for a budget, the objectives would be more realistic since they are the ones that are going to do it and it also gives them better motivation.
Helps control the business and its allocation of resources/money. All in all, budgeting in useful for:
reviewing past activities.
controlling current business activity - following objectives. planning for the future
Chapter 7: Business Accounting
What are accounts an why are they necessary?
Accounts are financial records of a firm's transactions that is kept up to date by the accountants, who are qualified professionals responsible for keeping accurate accounts and producing the final accounts.
Profits and losses made. Current value of the business. Other financial results.
Limited companies are bound by law to publish these accounts, but not other businesses. Financial documents involved in buying and selling.
Accountants use various documents that are used for buying and selling over the year for their final accounts. They can help the accountant to:
keep records of what the firm bought and from which supplier. keep records of what the firm sold and to which customer. These documents are:
Purchase orders: requests for buying products. It contains the quantity, type and total cost of goods. Here is an example.
Delivery notes: These are sent by the firm when it has received its goods. It must be signed when the goods are delivered.
Invoices: These are sent by the supplier to request for paymentfrom the firm. Credit notes: Only issued if a mistake has been made. It states what kind of mistake has been made.
Statements of account: Issued by the supplier to his customers which contains the value of deliveries made each month, value of any credit notes issued and any payments made by the customer. Here is an example.
Remittance advice slips: usually sent with the statement of accounts. It indicates which invoices the firm is paying for so that the supplier will not make a mistake about payments.
Receipts: Issued after an invoice has been paid. It is proof that the firm has paid for their goods.
Methods of making payment
There are several ways goods can be paid for:
Cash: The traditional payment method. However, many businesses do not prefer to use cash for a number of security reasons. When cash is paid, a petty cash
voucher is issued by the person in charge of the firm's money who also signs it to authorise the payment. The person making the purchase signs it too to show that the money has been recieved.
Cheque: It is an instruction to the bank to transfer money from a bank account to a named person. In order to do this the bank needs a cheque guarantee card, saying that they have enough money in their account to support this payment.
Credit card: Lets the consumer obtain their goods now and pay later. If the payment is delayed over a set period then the consumer will have to pay interest.
Debit card: Transfers money directly from user's account to that of the seller.
Recording accounting transactions
Businesses usually use computers to store their transactions so that they can be easily accessed, calculated and printed quickly.
Who uses the financial accounts of a business?
Shareholders: They will want to know about the profit or losses made during the year and whether the business is worth more at the end of the year or not.
Creditors: They want to see whether the company can afford to pay their loans back or not.
Government: Again, they want to check to see if correct taxes are paid. They also want to see how well the business is doing so that it can keep employing people. Other companies: Other companies want to compare their performance with a business or see if it is a good idea to take it over.
What do final accounts contain? The trading account
This account shows how the gross profit of a business is calculated. Obviously, it will contain this formula:
Gross profit = Sales revenue - Cost of goods sold
Note that:
Gross profit does not take to account overheads.
Only calculate the cost of goods sold, and forget the inventory. In a manufacturing business, direct labour and manufacturing costs are also deducted to obtain gross profit.
The profit and loss account
The profit and loss account shows how net profit is calculated. It starts off with gross profit acquired from the trading account and by deducting all other costs it comes up with net profit.
Depreciation is the fall in value of a fixed asset over time. It is also counted as an indirect cost to businesses.
As for limited companies, there are a few differences with the normal profits and loss account:
Profits tax will be shown.
It needs to have an appropriation account at the end of the profits and loss account. This shows what the company has done with its net profits, in other words, how much retained profit has been put back into the company.
Results form the previous year are also included. Balance sheet
The balance sheet shows you a business's assets and liabilities at a particular time. The balance sheet records the value of a business at the end of the financial year. This is what it contains:
Fixed assets: land, vehicles, buildings that are likely to be with the business for more than one year. They depreciate over time.
Current assets: stocks, inventory, ash and debtors that are only there for a short time.
Long-term liabilities: long-term borrowings that does not have to be paid in one year.
Short-term liabilities: short-term borrowings that has to be paid in less than one year.
If your total assets are higher than your total liabilities, then you are said to own wealth. In a normal business, wealth belongs to the owners, while in a limited company, it belongs to the shareholders. Hence the equation:
Total assets - total liabilities = Owners'/Shareholders' wealth
Here are some terms found in balance sheets:
Working capital: is used to pay short-term debts and known as net current assets. If a business do not have enough working capital then it might be forced to go out of business. The formula:
Working capital = Current assets - Current liabilities
Net assets: Shows the net value of all assets owned by the company. These assets must be paid for or finance by shareholders' funds or long term liabilities. The formula:
Net assets = Fixed assets + Working capital
Shareholders' funds: The total sum invested into the business by its owners. This money is invested in two ways:
- Share capital: Money from newly issued shares.
- Profit and loss reserves: Profit that is owned by shareholders but not distributed to them but kept as part of shareholders' funds.
Capital employed: Long-term and permanent capital of a business that has been used to pay for all the assets. Therefore:
Capital employed = net profits
Capital employed = Shareholders' funds + long-term liabilities
Analysis of published accounts
Without analysis, financial accounts tell us next to nothing about the performance and financial strength of a company. In order to do this we need to compare two
figures with each other. This is called ratio analysis.
Ratio analysis of accounts
The most common ratios used are for comparing the performance and liquidity of a business. Here are five of the most commonly used ratios.
Ratios used for analysing performance:
Return on capital employed: This result could show the efficiency of a business. If the result rises, the managers are becoming more successful.
Return on capital employed (%) = Operating profit/Capital employed * 100 Gross profit margin: If this rises, it could mean that either they are increasing added value or costs have fallen.
Gross profit margin = Gross profit/Sales revenue * 100
Net profit margin: The higher the result, the more successful the managers are. This could be compared with other businesses too.
Net profit margin = Net profit before tax/Sales revenue * 100 Note: Net profit does not include tax.
