Core Management Concepts (UOL Subject guide)

Core management conceptsP. WillmanMN2177

2014

Undergraduate study in Economics, Management, Finance and the Social Sciences

This subject guide is for a 200 course offered as part of the University of London International Programmes in Economics, Management, Finance and the Social Sciences. This is equivalent to Level 5 within the Framework for Higher Education Qualifications in England, Wales and Northern Ireland (FHEQ).

For more information about the University of London International Programmes undergraduate study in Economics, Management, Finance and the Social Sciences, see: www.londoninternational.ac.uk

This guide was prepared for the University of London International Programmes by:

Professor Paul Willman, Department of Management, London School of Economics and Political Science.

This is one of a series of subject guides published by the University. We regret that due to pressure of work the author is unable to enter into any correspondence relating to, or arising from, the guide. If you have any comments on this subject guide, favourable or unfavourable, please use the form at the back of this guide.

University of London International Programmes Publications Office Stewart House 32 Russell Square London WC1B 5DN United Kingdom

www.londoninternational.ac.uk

Published by: University of London

© University of London 2014

The University of London asserts copyright over all material in this subject guide except where otherwise indicated. All rights reserved. No part of this work may be reproduced in any form, or by any means, without permission in writing from the publisher. We make every effort to respect copyright. If you think we have inadvertently used your copyright material, please let us know.

Contents

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Contents

Chapter 1: Introduction .......................................................................................... 1

1.1 Introduction to the subject ....................................................................................... 11.2 Route map to the guide ........................................................................................... 11.3 Syllabus ................................................................................................................... 21.4 Aims of the course ................................................................................................... 21.5 Learning outcomes for the course ............................................................................ 21.6 Overview of learning resources ................................................................................ 21.7 Examination advice.................................................................................................. 5

Chapter 2: Management and the firm .................................................................... 7

2.1 Learning outcomes and reading ............................................................................... 72.2 Introduction ............................................................................................................ 82.3 The British experience .............................................................................................. 82.4 Railways and the second Industrial Revolution ......................................................... 92.5 Market failure and management ............................................................................ 102.6 Transaction cost economics .................................................................................... 122.7 Overview of chapter ............................................................................................. 142.8 Reminder of learning outcomes.............................................................................. 152.9 Test your knowledge and understanding ................................................................ 15

Chapter 3: Taylorism, motivation and performance ............................................. 17

3.1 Learning outcomes and reading ............................................................................. 173.2 Introduction .......................................................................................................... 183.3 Scientific management: the apogee ........................................................................ 213.4 Engineering and psychology ................................................................................... 233.5 Overview of chapter .............................................................................................. 253.6 Reminder of learning outcomes.............................................................................. 263.7 Test your knowledge and understanding ................................................................ 26

Chapter 4: The rise and decline of labour ............................................................ 27

4.1 Learning outcomes and reading ............................................................................. 274.2 Introduction .......................................................................................................... 284.3 Farmers and workers ............................................................................................. 294.4 Band of brothers ................................................................................................... 304.5 Overview of chapter .............................................................................................. 354.6 Reminder of learning outcomes.............................................................................. 364.7 Test your knowledge and understanding ................................................................ 36

Chapter 5: The rise of human resource management .......................................... 37

5.1 Learning outcomes and reading ............................................................................. 375.2 Introduction .......................................................................................................... 385.3 The emergence of HRM .......................................................................................... 395.4 Organisational behaviour ....................................................................................... 445.5 The psychological contract ..................................................................................... 465.6 Overview of chapter .............................................................................................. 485.7 Reminder of learning outcomes.............................................................................. 485.8 Test your knowledge and understanding ................................................................ 48

MN2177 Core management concepts

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Chapter 6: The origins of management science ................................................... 49

6.1 Learning outcomes and reading ............................................................................. 496.2 Introduction .......................................................................................................... 496.3 Inventory management .......................................................................................... 506.4 Telephone networks ............................................................................................... 526.5 Military planning ................................................................................................... 536.6 Overview of chapter .............................................................................................. 566.7 Reminder of learning outcomes.............................................................................. 566.8 Test your knowledge and understanding ................................................................ 56

Chapter 7: Accounting, finance and the firm ........................................................ 57

7.1 Learning outcomes and reading ............................................................................. 577.2 Background: definitions of accounting and finance ................................................. 587.3 Principal–agent theory ........................................................................................... 587.4 The institutional environments of accounting ......................................................... 617.5 Overview of chapter .............................................................................................. 627.6 Reminder of learning outcomes.............................................................................. 637.7 Test your knowledge and understanding ................................................................ 63

Chapter 8: Management accounting: costing....................................................... 65

8.1 Learning outcomes and reading ............................................................................. 658.2 Purposes of cost accounting .................................................................................. 658.3 Production and service departments ....................................................................... 668.4 Activity-based costing ........................................................................................... 698.5 Overview of chapter ............................................................................................. 718.6 Reminder of learning outcomes.............................................................................. 718.7 Test your knowledge and understanding ................................................................ 71

Chapter 9: Management accounting: decentralisation and performance measurement ....................................................................................................... 73

9.1 Learning outcomes and reading ............................................................................. 739.2 Introduction .......................................................................................................... 749.3 History .................................................................................................................. 749.4 Using return on investment (ROI) ........................................................................... 769.5 The balanced scorecard .......................................................................................... 789.6 Financial (ROI) versus balanced scorecard performance measure ............................ 809.7 Overview of chapter .............................................................................................. 819.8 Reminder of learning outcomes.............................................................................. 819.9 Test your knowledge and understanding ................................................................ 81

Chapter 10: Financial accounting ......................................................................... 83

10.1 Learning outcomes and reading ........................................................................... 8310.2 Management accounting and financial accounting ............................................... 8310.3 The elements of the financial report ..................................................................... 8410.4 Recognition and matching .................................................................................. 8910.5 Overview of chapter ............................................................................................ 9010.6 Reminder of learning outcomes............................................................................ 9010.7 Test your knowledge and understanding .............................................................. 90

Chapter 11: Modern portfolio theory ................................................................... 91

11.1 Learning outcomes and reading ........................................................................... 9111.2 Interest rates and the time value of money ........................................................... 9111.3 The return of a single security .............................................................................. 9211.4 The return of a portfolio ....................................................................................... 9211.5 Probabilistic considerations .................................................................................. 92

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11.6 Asset classes ....................................................................................................... 9311.7 What is a hedge fund? ......................................................................................... 9411.8 What is private equity? ........................................................................................ 9411.9 Market efficiency ................................................................................................. 9411.10 Optimal portfolio choice .................................................................................... 9511.11 The Sharpe ratio ................................................................................................ 9711.12 Overview of chapter .......................................................................................... 9711.13 Reminder of learning outcomes.......................................................................... 9711.14 Test your knowledge and understanding ............................................................ 97

Chapter 12: Security analysis and valuation ........................................................ 99

12.1 Learning outcomes and reading ........................................................................... 9912.2 Financial ratios .................................................................................................... 9912.3 Investment ratios ................................................................................................. 9912.4 Profitability ratios .............................................................................................. 10012.5 The profitability equation ................................................................................... 10112.6 Margin ratios ..................................................................................................... 10112.7 Efficiency ratios ................................................................................................. 10212.8 Leverage ratios .................................................................................................. 10212.9 Solvency and liquidity ratios ............................................................................... 10312.10 Overview of chapter ........................................................................................ 10312.11 Reminder of learning outcomes........................................................................ 10412.12 Test your knowledge and understanding .......................................................... 104

Chapter 13: The origins of modern strategy ...................................................... 105

13.1 Learning outcomes and reading ......................................................................... 10513.2 Two key definitions of ‘strategy’ ......................................................................... 10513.3 Porter and the five forces ................................................................................... 10713.4 Overview of chapter .......................................................................................... 11113.5 Reminder of learning outcomes.......................................................................... 11113.6 Test your knowledge and understanding ............................................................ 111

Chapter 14: Understanding organisational structures ....................................... 113

14.1 Learning outcomes and reading ......................................................................... 11314.2 Introduction ...................................................................................................... 11314.3 Organisational design ........................................................................................ 11414.4 Organisational boundaries: the issues ................................................................ 11514.5 Division of labour: the issues .............................................................................. 11614.6 Authority and communication: the issues ........................................................... 11614.7 Bureaucracy: the issues ...................................................................................... 11714.8 Know-how: the issues ........................................................................................ 11714.9 The components of organisation ........................................................................ 11814.10 The ‘M’ form .................................................................................................... 11914.11 Overview of chapter ........................................................................................ 12114.12 Reminder of learning outcomes........................................................................ 12114.13 Test your knowledge and understanding .......................................................... 121

Chapter 15: The analysis of organisations ......................................................... 123

15.1 Learning outcomes and reading ......................................................................... 12315.2 Strategy and organisational theory ..................................................................... 12315.3 Institutional theory ............................................................................................ 12515.4 Organisational ecology ...................................................................................... 12715.5 Critique ............................................................................................................. 12815.6 Organisational sociology and economics ............................................................ 129


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15.7 Overview of chapter .......................................................................................... 13015.8 Reminder of learning outcomes.......................................................................... 13015.9 Test your knowledge and understanding ............................................................ 130

Chapter 16: Contemporary strategic management ............................................ 131

16.1 Learning outcomes and reading ......................................................................... 13116.2 Introduction ...................................................................................................... 13216.3 Dynamic capabilities .......................................................................................... 13516.4 Core competences ............................................................................................. 13516.5 Critique ............................................................................................................. 13616.6 Strategy today ................................................................................................... 13716.7 Overview of the chapter ..................................................................................... 13716.8 Reminder of learning outcomes.......................................................................... 13816.9 Test your knowledge and understanding ............................................................ 138

Chapter 17: Strategy and decision-making ....................................................... 139

17.1 Learning outcomes and reading ......................................................................... 13917.2 Introduction ...................................................................................................... 13917.3 Efficient markets ................................................................................................ 14217.4 The decision process .......................................................................................... 14417.5 Overview of the chapter ..................................................................................... 14617.6 Reminder of learning outcomes.......................................................................... 14717.7 Test your knowledge and understanding ............................................................ 147

Chapter 18: The origins of marketing................................................................. 149

18.1 Learning outcomes and reading ......................................................................... 14918.2 Introduction ..................................................................................................... 14918.3 Definitions and a brief introduction to the history of marketing as a distinct ‘discipline’ of study ....................................................................................... 15018.4 Marketing and economic theory ......................................................................... 15018.5 Where does economic theory leave us? ............................................................. 15218.6 Marketing as ‘academic discipline’ .................................................................... 15218.7 The influence of other academic disciplines and marketing ................................. 15318.8 Types of marketing problems ............................................................................. 15318.9 The triumph of marketing? ................................................................................ 15418.10 Looking ahead: the marketing framework ....................................................... 15518.11 Overview of the chapter ................................................................................... 15618.12 Reminder of learning outcomes........................................................................ 15718.13 Test your knowledge and understanding .......................................................... 157

Chapter 19: The origins of marketing − the development of the practice ....... 159

19.1 Learning outcomes and reading ......................................................................... 15919.2 Introduction ...................................................................................................... 15919.3 Product1...............................................................................................................................................................................................160

19.4 Markets ............................................................................................................. 16119.5 Pricing ............................................................................................................... 16219.6 Channels and distribution .................................................................................. 16419.7 Brands and advertising ...................................................................................... 16519.8 Summary ........................................................................................................... 16719.9 Reminder of learning outcomes.......................................................................... 16719.10 Test your knowledge and understanding .......................................................... 167

Contents

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Chapter 20: Marketing in the digital age ........................................................... 169

20.1 Learning outcomes and reading ......................................................................... 16920.2 Introduction ...................................................................................................... 17020.3 Impact on conventional businesses .................................................................... 17220.4 Internet and branding ........................................................................................ 17420.5 Summary ........................................................................................................... 17420.6 Reminder of learning outcomes.......................................................................... 17520.7 Test your knowledge and understanding ............................................................ 175

Appendix 1: Syllabus .......................................................................................... 177

Notes


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Chapter 1: Introduction

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1.1 Introduction to the subjectThis subject guide is for the MN2177 Core management concepts course. It covers the main areas of general management and the intellectual foundations of management concepts as well as the functional areas of accounting, business strategy, finance, marketing, organisational behaviour and operations management. This is an alphabetical list, but each subject will be dealt with in an integrated fashion. The aim is to present the core concepts in each area, then to show the relationships between these concepts. This course forms the basis for the study of more specialised courses.

The course begins by showing how these functional areas emerged as subjects for academic study. It will pay particular attention to the social scientific origins of the management field in the core disciplines of economics, psychology and sociology. It then proceeds chronologically, illustrating the rise and development of the functional area disciplines in response to specific business problems.

1.2 Route map to the guideWe begin by looking at the pre-industrial roots of some management tools such as accounting and operations. It then deals specifically with the growth of the large industrial firm and the intellectual issues raised by this development. It describes the separation of ownership and control and the problems of agency. Several chapters deal with the issues of creating and managing an industrial labour force, looking at scientific management and the growth of theories rooted in psychology and sociology for the management of labour. The rise of collective labour organisation and the response of human resource management is then covered.

The second broad section of the course is more quantitative, showing how mathematical techniques were applied to the management of the firm. We then move on to consider, first, the rise of internal accounting measures in the firm and, second, financial accounting, particularly the firm’s reporting requirements. There is then a specific focus on the increasingly important area of finance; we look at risk, return and asset pricing, before turning to the financial analysis of the firm. These materials are presented in a non-technical way wherever possible.

The third broad theme is organisation and strategy; looking at the origins of business strategy and the various ‘schools’ within the strategy discipline. We pay particular attention to contemporary developments in business strategy and to strategic decision-making.

Finally, we look at the marketing field. The location of this at the end of the course has a two-part rationale. First, marketing was a later development than some other disciplines and it is possible to show how ideas were borrowed and used. Second, it synthesises economics, psychology and sociology and thus is a good ‘case study’ of the use of social science in management.


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1.3 SyllabusThe full syllabus for this course can be found in Appendix 1 on p.177 at the end of the guide.

1.4 Aims of the courseThe aims of the course are to:

• give you a thorough grounding in the key management sub-disciplines

• provide an overview of the development of these disciplines

• illustrate the disciplinary anchors of these disciplines in sociology, psychology and economics.

1.5 Learning outcomes for the courseAt the end of the course, and having completed the Essential reading and activities, you should be able to:

• demonstrate an understanding of core management concepts

• apply these concepts to specific business situations

• analyse and evaluate managerial tools such as balance sheets and marketing plans

• explain the relevance of social science to business practice.

1.6 Overview of learning resources

1.6.1 The subject guideThis subject guide presents a basic introduction to the concepts of management covered in the course. It seeks to describe and explain the central concepts, and to provide reading lists and advice on the examination. However:

1. It is not a textbook and often refers you to other texts or readings.

2. If you do not follow up the Essential readings, you will find it very difficult to do well in the examination.

For each chapter, we recommend that you begin by reading the text of the guide itself and thinking about the ‘Test your knowledge and understanding’ question at the end of each chapter, then work through the Essential readings outlined at the start of the chapter. Further reading is identified should you wish to study a topic in more detail, and a comprehensive list can be found on the virtual learning environment (VLE).

The advice normally given to International Programmes students is that, if they are studying one course over a year, they should allow at least six hours of study every week.

1.6.2 Essential readingTo study this course, you need to study Essential readings from a range of textbooks and academic journals.

Textbooks to borrow or purchase

Make sure you have a copy of the core textbook for the course:

Willman, P. Understanding management: social science foundations. (Oxford: Oxford University Press, 2014) [ISBN 9780198716921].


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This will be referred to as ‘Willman’ in the reading lists at the beginning of each chapter, followed by the relevant chapter or theme numbers.

You will also need to refer to several chapters of the following book so either make sure that you have access to a library copy or purchase it:

Kaplan, R. and A. Atkinson Advanced management accounting. (Harlow: Pearson Education, 1998) third edition [ISBN 9780130802200].

Detailed reading references in this subject guide refer to the editions of the set textbooks listed above. New editions of one or more of these textbooks may have been published by the time you study this course. You can use a more recent edition of any of the books; use the detailed chapter and section headings and the index to identify relevant readings. Also check the VLE regularly for updated guidance on readings.

Other Essential readings

The guide also refers to various other Essential readings. We aim to ensure that all these are freely available to you. As a general rule, if an Essential reading is a journal article, you will be able to find it in the Online Library; if it is an extract from a book, registered students on the course will be able to download it from the VLE. We have also made a few of the further readings available to download from the VLE.

If you have any problems accessing any of the Essential readings, let us know by raising a query via the Student Portal.

1.6.3 Further readingPlease note that as long as you read the Essential reading you are then free to read around the subject area in any text, paper or online resource. You will need to support your learning by reading as widely as possible and by thinking about how these principles apply in the real world. To help you read extensively, you have free access to the VLE and University of London Online Library (see below).

A list of Further readings relevant to the subject matter covered in each chapter is given at the beginning of the chapters. You can find a complete list of all the Further reading and references cited on the VLE.

You may also find the following additional textbooks useful in relation to the different parts of the course:

Additional introductory reading

Witzel, M. Builders and dreamers: the making and meaning of management. (Harlow: Pearson, 2002) [ISBN 9780273654377].

Accounting

Atkinson, A.A., R.S. Kaplan, E. Matsumura and S.M. Young Management accounting. (Harlow: Pearson, 2011) [ISBN 9780273760160].

Business strategy

Grant, R.M. Contemporary strategy analysis. (Chichester: John Wiley & Sons, 2012) [ISBN 9781119941880].

Finance

Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance – global edition. (Maidenhead: McGraw Hill, 2013) [ISBN 9780077151560].

Marketing

Weitz, B.A. and R. Wensley Handbook of marketing. (London: Sage, 2006) [ISBN 9781412921206].


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Operations management

Hopp, W.J. and M.L. Spearman Factory physics. (Long Grove, Illinois: Waveland Press, 2011 reissue of 2008 edition) [ISBN 9781577667391].

Organisational behaviour

Buchanan, D. and A. Huczynski Organisational behaviour. (Harlow: Pearson, 2013) [ISBN 9780273774815].

1.6.4 Online study resourcesIn addition to the subject guide, it is crucial that you take advantage of the study resources that are available online for this course, including the VLE and the Online Library.

You can access the VLE, the Online Library and your University of London email account via the Student Portal at: http://my.londoninternational.ac.uk

You should have received your login details for the Student Portal with your official offer, which was emailed to the address that you gave on your application form. You have probably already logged in to the Student Portal in order to register. As soon as you registered, you will automatically have been granted access to the VLE, Online Library and your fully functional University of London email account.

If you have forgotten these login details, please click on the ‘Forgotten your password’ link on the login page.

The VLEThe VLE, which complements this subject guide, has been designed to enhance your learning experience, providing additional support and a sense of community. It forms an important part of your study experience with the University of London and you should access it regularly.

The VLE provides a range of resources for EMFSS courses:

• Self-testing activities: Doing these allows you to test your own understanding of subject material.

• Electronic study materials: The printed materials that you receive from the University of London are available to download, including updated reading lists and references.

• Past examination papers and Examiners’ commentaries: These provide advice on how each examination question might best be answered.

• A student discussion forum: This is an open space for you to discuss interests and experiences, seek support from your peers, work collaboratively to solve problems and discuss subject material.

• Videos: There are recorded academic introductions to the subject, interviews and debates and, for some courses, audio-visual tutorials and conclusions.

• Recorded lectures: For some courses, where appropriate, the sessions from previous years’ Study Weekends have been recorded and made available.

• Study skills: Expert advice on preparing for examinations and developing your digital literacy skills.

• Feedback forms.

Some of these resources are available for certain courses only, but we are expanding our provision all the time and you should check the VLE regularly for updates.

http://my.londoninternational.ac.uk


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Making use of the Online LibraryThe Online Library contains a huge array of journal articles and other resources to help you read widely and extensively.

To access the majority of resources via the Online Library you will either need to use your University of London Student Portal login details, or you will be required to register and use an Athens login: http://tinyurl.com/ollathens

The easiest way to locate relevant content and journal articles in the Online Library is to use the Summon search engine.

If you are having trouble finding an article listed in a reading list, try removing any punctuation from the title, such as single quotation marks, question marks and colons.

For further advice, please see the online help pages: www.external.shl.lon.ac.uk/summon/about.php

1.7 Examination adviceImportant: the information and advice given here are based on the examination structure used at the time this guide was written. Please note that subject guides may be used for several years. Because of this we strongly advise you to always check both the current Regulations for relevant information about the examination, and the VLE where you should be advised of any forthcoming changes. You should also carefully check the rubric/instructions on the paper you actually sit and follow those instructions.

The examination will be a three-hour unseen written examination covering all aspects of the syllabus. In the examination, you will be asked to:

• Reproduce some knowledge. This will get you close to a pass, but you will also need to be able to apply this knowledge to the question.

• Apply knowledge to new situations. This will lift you to high lower-second or low upper-second marks, provided you get the questions right.

• Make new connections between topics and concepts. This will enable you to gain a first-class mark.

In the examination you must read the questions carefully to make sure you have understood them, choose the questions you wish to answer from the list available and manage your time carefully. You should always check the instructions on the examination paper before you begin and follow them carefully.

Remember, it is important to check the VLE for:

• up-to-date information on examination and assessment arrangements for this course

• where available, past examination papers and Examiners’ commentaries for the course, which give advice on how each question might best be answered.

http://tinyurl.com/ollathens

http://www.external.shl.lon.ac.uk/summon/about.php

Notes


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Chapter 2: Management and the firm

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2.1 Learning outcomes and reading

2.1.1 Learning outcomesBy the end of this chapter, and having completed the Essential reading and activities, you should be able to:

• explain key elements in the history of the firm

• discuss the main theories of firm formation

• outline several key managerial problems in the firm.

2.1.2 Essential readingWillman, Chapters 1 and 2.

2.1.3 Further readingChandler, A. The visible hand: the managerial revolution in American business.

(Harvard: Harvard University Press, 1977) [ISBN 9780674940529].Di Maggio, P. ‘Introduction: making sense of the contemporary firm and

prefiguring its future’ in Di Maggio, P. (ed.) The twenty-first century firm: changing organisation in international perspective. (Princeton: Princeton University Press, 2001) [ISBN 9781400828302].

Jensen, M.C. and W.H. Meckling ‘The theory of the firm: managerial behaviour, agency costs and ownership structure’, Journal of Financial Economies 3 1976, pp.305–60.

Williamson, O.E. ‘The modern corporation; origin, evolution, attributes’, Journal of Economic Literature 19 1981, pp.1537–68.

2.1.4 Works cited Arrow, K. J. The limits of organization. (New York: Norton, 1974)

[ISBN 9780393093230].Bromiley, P. The behavioral foundations of strategic management. (Oxford,

Blackwell, 2005) [ISBN 9781405124706].Cassis, Y. ‘Big business’ in Jones, G. and Zeitlin, J. (eds) The Oxford

handbook of business history. (Oxford: Oxford University Press, 2007) [ISBN 9780199263684; 9780199573950], p171–94.

Coase, R.H. ‘The nature of the firm’, Economica, 4(16), 1937, pp.386–405.Coase, R.H. The firm, the market and the law. (Chicago, Ill: University of

Chicago Press, 1988) [ISBN 9780226111001].Davis, G. Managed by the markets. (Oxford: Oxford University Press, 2009)

[ISBN 9780199216611].Doeringer, P. and M. Piore Internal labour markets and manpower analysis.

(Armonk, NY: M.E. Sharpe, [1971] 1985) [ISBN 9780873323321].Ghoshal, S. and P. Moran ‘Bad for practice: a critique of the transaction cost

theory’, Academy of Management Review 21(1) 1996, pp.13–47.Gospel, H. ‘The management of labor and human resources’ in Jones, G. and

Zeitlin, J. (eds) The Oxford handbook of business history. (Oxford: Oxford University Press, 2007) [ISBN 9780199573950], pp.420–46.

Landes, D.S. The Unbound Prometheus: Technological Change and Industrial Development in Western Europe from 1750 to the Present. (Cambridge: Cambridge University Press, 2003) [ISBN 9780521534024].

Michie, R.C. The global securities market. (Oxford: Oxford University Press, 2006) [ISBN 9780199280612].

Penrose, E. The theory of the growth of the firm. (Oxford: Oxford University Press, [1959] 2009) [ISBN 9780191570360].


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Pfeffer, J. New directions for organisational theory. (Oxford: Oxford University Press, 1997) [ISBN 9780195114348].

Prais, S.J. The evolution of giant firms in Britain. (Cambridge: Cambridge University Press, 1981) [ISBN 9780521282734].

Salaman, G. Class and the corporation. (London: Fontana, 1981) [ISBN 9780006355182].

Thompson, E.P. The making of the English working class. (London: Penguin, 1966) [ISBN 9780394703220].

Williamson, O.E. The economic institutions of capitalism. (New York: Free Press, 1985) [ISBN 9780684863740].

2.2 IntroductionThe corporate firm is a rather late arrival on the scene. Before the 19th century, only a handful of corporate-type entities existed and these were largely extensions of state power. Companies such as the Hudson Bay Company or the Dutch East India Company were important agents of empire. Governments granted them exclusive rights to trade and to conduct business in certain markets or products. So, for example, in 1670 the Hudson Bay Company was granted exclusive rights to fur trapping in large areas of Canada by the British government. It was a truly international venture, being the idea of two Frenchmen who gained a Royal Charter in Britain with the encouragement of Boston merchants. The company built forts, extended the speaking of English, founded cities and established distribution channels. The Hudson Bay Company still exists in Canada as a chain of department stores. At its inception, the company had 32 investors who shared risks and returns.

The Dutch East India Company, founded earlier, in 1602, funded risky long-distance trading in any items between Europe and the Far East. Investors, primarily in Amsterdam, would pool funds to support risky trips which, if successful, provided huge returns. This in turn prompted the development of the Amsterdam securities market in which spot and future contracts, call and put options, hedging and short selling were all possible (Michie, 2006, p.27). The number of investors was very large indeed. These entities have some important characteristics for the future analysis of the firm. Investors control supply side risk (with monopoly) before sharing investor risk, they get government to provide the support, and they diversify away some operational risk by embracing a range of uncorrelated activities.

2.3 The British experienceThe Industrial Revolution took off in Britain in the early 19th century and, as Michie notes, in the period before 1850, ‘The British economy remained mostly untouched by joint stock enterprise’ (2006, p.69). Enterprises were either entrepreneurially owned, as in manufacturing, or owned by local inhabitants, as in utilities and canals, and were funded by retained profit or bank loans. Railways changed everything, requiring large-scale finance but set against the prospect of steady low-risk returns from natural monopoly. This provided investors with an attractive alternative to government debt.

A crucial early development in Britain occurred in the textile industry: the growth of the factory. As well as the massive impact on output, it is significant for the development of management as an activity. Historically, cloth had been produced domestically (for example, in the home), usually by workers who had other concerns such as farming, using simple


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equipment and raw materials provided by an entrepreneur – who was also the purchaser of the finished product. This was a flexible and relatively low-capital-cost operation, but it left the entrepreneur with little control over production volumes. As the key historian of the Industrial Revolution has noted:

…the domestic weaver or craftsman was a master of his time, starting and stopping when he desired. And while the employer could raise the piece rates with a view to encouraging output, he usually found that this actually reduced output. (Landes, 1969, p.59)

This backward-sloping labour supply curve arose because the workers tended to have a subsistence income target, not a utility maximising one. Cutting the rates did no good either − it led either to the worker quitting or stealing some of the raw material in compensation (Salaman, 1981, p.27). In short, incentives alone did not work. What the entrepreneur needed was control of labour time and, to achieve that, work discipline and the absence of alternative income sources. The answer: the factory, in which workers were monitored (or managed). This was problematic because it was not, generally, a process they welcomed (Thompson, 1968).

Now this process is highly significant. The modern economic theory of the firm relies heavily on the ideas of monitoring, incentives and hierarchy. Historians have debated the relative importance of these contractual arguments for the growth of the firm versus technological ones; once the factory existed, it became possible to apply steam power and technological innovations in equipment to the raising of output, but the factory came first.

Economic structure aside, there is no doubt that the scale of firms increased. Prais (1976) quotes figures for both USA and the UK indicating that in both by the late 1920s the 100 largest firms accounted for approximately a quarter of all output. It was to rise to over a third by 1960. A vast amount of economic activity was moving from markets into firms. With this, a vast amount of employment came to be located in large, bureaucratic enterprises under formalised employment contracts. Let us look at the story in slightly more detail, and chronologically.

2.4 Railways and the second Industrial RevolutionAs Cassis (2007, p.175) puts it, ‘big business in the third quarter of the nineteenth century primarily meant the railroad companies’. They became exemplars in two ways. The first we have noted: they are almost the prototypical joint stock enterprise in that they needed lots of investors. The second concerns models of employment and management. They were the first modern organisations to develop ‘extensive hierarchies of managerial and white collar staff’ (Gospel, 2007, p.427). They engaged in systematic recruitment, set up promotional hierarchies and pay scales. Assuming lifetime or at least long-term employment, they introduced welfare arrangements such as housing, sick care and pensions. In the UK at least, they liked to recruit employees with a military or police background or relatives of those already employed; this led to a readier acceptance of the employment relationship as an authority relationship, necessary for a dispersed workforce. There were no unions until after the First World War.

By the turn of the century, as Cassis notes, in a variety of sectors:

The large enterprise of the turn of the twentieth century… appears as a centralised and vertically integrated firm, with its


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own distribution and purchasing facilities, whose various functions, including marketing, were entrusted to a hierarchy of salaried managers, and which tended to cluster around sectors where economies of scale and scope could be achieved through mass production. (2007, p.178)

This was more true of the USA than many parts of Europe.

The impact of the First World War was crucial. First, these mass-production industries – food, chemicals, oil, engineering – became central to the war effort, and expanded considerably. There was little product market competition. After the war, there were further merger waves in these sectors, particularly in Germany (Cassis, 2007, p.181). Big business became bigger. Second, there was a massive change to the labour market: labour markets were tight (because labour was scarce) and labour was crucial to the fighting of industrialised war. In Europe, a significant proportion of the male labour force was in the army, then dead. Unions became strong and employers had to bargain. Global securities markets collapsed. There was a mass of government debt to compete with equity investment. Governments wanted to control the securities markets in which this debt was traded and capital markets contracted. UK investors sold massive amounts of overseas securities and the London stock market became more localised. US investors had a very good war, and US markets – particularly New York – grew massively. As Michie puts it:

…the global securities market was reduced to a series of compartmentalized marketplaces only loosely linked to each other rather than the fully integrated system that was in full flow before 1914. (2006, p.204)

After the War, in the 1920s and 1930s, government involvement in business, particularly in European labour and capital markets, continued.

2.5 Market failure and managementCoase argues that firms exist because of market – or, more specifically, price mechanism – failure in the presence of transaction costs.

[T]he fact that it costs something to enter into…transactions means that firms will emerge to organize what would otherwise be market transactions whenever their costs were less than the costs of carrying out the transactions through the market. (1988, p.7)

Certain types of transactions in markets entail considerable costs of price discovery, negotiation and enforcement. For such transactions, Coase argues, it may be more efficient for what he terms an ‘entrepreneur’ to use ‘authority’ to direct resources to their most efficient ends. The boundary of the firm is set where the costs of organising a transaction within the firm equal the costs of carrying it out through the market. Within this boundary, the firm makes products or services; beyond it, it buys or sells them.

The revolutionary idea that Coase introduced in 1937 was the notion of transaction costs. Much later, he argued that without transaction costs firms would not exist, but nor would markets (1988, pp.6–8). Although economists were primarily interested in markets, they focused primarily on prices, and when they discussed market structure, they referred to the number of firms and products, rather than the ‘social institutions that facilitate exchange’ (1988, p.8) and thus defined transaction costs.


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Coase has pointed the way to an explanation of why so much economic activity took place outside markets, but it was many years before this insight was pursued − we see how below. But what the market failure approach did not do, was to offer a route to the study of the firm’s internal operations. The stylised ‘entrepreneur’ allocated resources using ‘authority’ to maximise ‘efficiency’ and set the boundary of the firm where market and hierarchy transaction costs equate. None of these concepts is defined, and they really do not tell you much about what went on within the firm. Coase is not really concerned with why some ‘entrepreneurs’ might be better than others. As a result, Coase made little impact – at the time – on the study of management either. However, in the longer term, the impact was substantial.

Several features of the Coase argument are replicated in much economic theorising about organisations down to the present day. First, in the pursuit of a theory of the firm, organisations are considered simple alternatives to markets such as the pursuit of efficiency by other means. There are two problems with this: first, firms may pursue multiple objectives (of which efficiency is one), and since these objectives may be in conflict, efficiency might not be the prime objective in the short term. Moreover, there is no obvious reason why markets could not emerge from organisational failure, rather than vice versa. In fact, much later, with the growth of outsourcing, they did, and one needed to explain why a ‘make’ decision turned into a ‘buy’ decision, with the corollary that firm size tended to shrink (Pfeffer, 1997).

Transaction cost arguments can provide a perfectly reasonable explanation of this shrinkage, but Coase did not pursue it. Second, as Penrose (1959) was to note many years later, markets do not make anything; they exchange but do not produce – firms do both and are thus much more than mere alternatives to markets. She makes the perceptive observation that there is a difference between a theory of the firm and the economics of the firm. Much later, Bromiley (2005, p.13) makes a parallel point about the difference between explaining why firms exist versus explaining what they do. For business strategy: ‘The existence of firms stands more as a constraint on theorizing than an interesting problem; a theory that predicts firms should not exist is clearly deficient.’

To use a metaphor: on the one hand, economists tended to see the world as a sea of markets with the occasional island (the firm). Those who study management tend to see the world as a desert of firms with the occasional oasis.

The second feature which has endured in economics is the representation of the firm in terms of one or more stylised actors; for Coase it is the ‘entrepreneur’, for later economists it is the ‘principal’ or ‘agent’. This simplification enables formal modelling but it is not receptive to ideas about organisational diversity or complexity; firms are timeless and geographically unembedded. The third feature is that intra-organisation relationships are treated in a very unproblematic way. Coase’s ‘entrepreneur’ exercised authority unproblematically, obeyed by those she hired. For Jensen and Meckling, monitoring ensures compliance and incentives provide motivation. Fourth, and related, rationality is an assumption, not a variable. Actors within firms are built in the same way as actors within markets, so that if one replicates the competitive conditions of markets within firms, the same behaviours will emerge. By extension, if an organisational feature is empirically common, logically it must be efficient, since inefficient organisations will disappear over time. Organisational diversity should disappear too.


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This has had consequences for the relationship between economic theories of the firm and empirical studies of what managers do, such as those discussed below. Specifically, as Pfeffer (1997, p.46) notes, the economic approach sees hierarchy design in terms of the prime need to control managers with self-interested goals and employees who are effort-averse. These assumptions about individuals within firms lead to the argument that hierarchies have control and coordination costs, rather than focusing on the positive impact managers might have on a firm’s performance. In fact, as we shall see, were one to design an organisation according to economic principles, it would probably be inoperable, primarily because of the reaction of employees to such organisational controls. However, before we turn to this, we need to look at the development of economic ideas about hierarchy. Coase looked at market failure, but what about the dynamics of hierarchy?

2.6 Transaction cost economicsWilliamson’s early work concerned managerial decision-making; he found that managerial discretion often undermined efficiency. Much later, he would articulate the problems of the ‘propensity to manage’ in two forms. It exists:

• instrumentally – managers pretend they can manage complexity, when they cannot

• strategically – managers pursue their own sub-goals (Williamson, 1985).

However, rather than turning to markets as the answer, he focused on the internal operations of the firm. The two aspects of ‘propensity’ rest on two assumptions about individual behaviour which are core to the entire project. Individuals are boundedly rational; they have limited capabilities to deal with information complexity and information uncertainty. Specifically, and crucially, they cannot write complete contracts. Second, individuals are opportunistic, in that they pursue ‘self-interest seeking with guile’ (1985, p.47); this is an extension of the conventional economic assumption about the pursuit of self-interest which may roughly be summarised as the idea that, since one cannot discover in advance who is trustworthy, organisations need to be designed to cope with a pandemic of dishonesty.

The third leg of this structure is the idea of asset specificity. The central issue is the existence of human or physical assets which are locked into a particular exchange relationship, for example, they have lower values elsewhere. This might be ex ante; for example, you have to build a pipeline to an oilfield and you are creating (in effect) bilateral monopoly. Or it might be ex post; for example, you have worked in the same firm for many years developing firm-specific skills. The three legs come together, as Bromiley notes:

… efficient operation may require investments that have little value outside that operation, but the parties cannot trust one another, nor can they write the perfect contract… bringing both parties to the transaction into the same company (internalisation) may be more efficient than doing the transaction in the market. (2005, p.97)

As with Coase, transaction costs in markets and hierarchies are important and Williamson borrows Arrow’s (1969) definition as follows:


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• Ex ante costs: the costs of drafting, negotiating and safeguarding an agreement

• Ex post costs: misalignment, haggling costs, the costs of running and referring to governance structures, ‘bonding’ costs.

But contractual governance costs can be optimised in either markets or hierarchies – ‘… transactions, which differ in their attributes, are aligned with governance structures, which differ in their costs and competences’ (1985, p.27) so that transaction costs are minimised.

The influence of transaction costs economics has been substantial, perhaps because of its scope, but also because of the nature of its assumptions. Asset specificity alone does not give you the firm; opportunism is key. Since opportunism is a very strong form of the self-interest assumption, it has attracted substantial criticism. It is a very negative view of human propensities (Ghoshal and Moran, 1996), it may well be ethnocentric and it is not empirically grounded. However, it not only gives you a theory of firm formation but also an approach to the optimisation of firm structure; for example, Williamson explains the growth of the multi-divisional firm in terms of efficiency – it economises on the transaction costs of capital markets and minimises managerial activity detracting from shareholder value (1985, p.288).

Activity 2.1

What assumptions about human behaviour does Williamson (1985) make? Try to make a list.

Williamson also develops an approach to the employment contract which is of generic interest to the relationships between owners, managers and labour, which we discussed at the outset of this chapter. Employment contracts are often characterised in economics as incomplete. They also have asymmetric authority (the employer issues instruction), asymmetric information (sometimes in favour of the employee), asset specificity (the skills and equipment used are often not transferable) and they are often of long duration. They are, empirically, the building blocks of hierarchy since monitoring and incentives are central to them. Williamson’s approach can be illustrated by reference to Figure 2.1.

Williamson (1985) discusses three contractual possibilities. Under spot contracting the parties contract at T1 that, when event 1 occurs, the exchange of money for effort (X1) will occur. If this occurs once, the spot contract form is efficient. However, if the game is repeated, two problems emerge. First, the transaction costs are high, both ex ante and ex post. Second, opportunism – by both parties – is likely. Under contingent claims contracting, the parties at T1 try to write a comprehensive contract covering all events and their related effort bargains. This fails the bounded rationality test in many circumstances, particularly where the number of discrete events is high. The third option is adapted from Simon (who was Williamson’s PhD supervisor). According to this approach the parties agree to an authority relationship. The employee, in exchange for a single comprehensive effort bargain, agrees to allow the employer the authority to make state-of-the-world definitions across a range of events. The problem here is how to define the acceptable range of events. However, an authority relationship economises on transaction costs and does allow some form of monitoring.


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Spot contractsT1..........E1..........X1T2..........E2..........X2T3..........E3..........X3Contingent claims

E1..........X1E2..........X2E3..........X3

Authority relation

T1..........T2.......... ..........X2T3..........

Figure 2.1: Alternative contractual forms

What Williamson comes up with as the optimal form relies very heavily on Doeringer and Piore’s (1971) idea of an ‘enterprise market’. He emphasises several elements: internal promotion ladders to encourage on-the-job training and cooperation, pay rates attached to jobs within these ladders (rather than individual performance), ascending with position on the hierarchy, moderate rather than intensive metering, and job security bolstered by a grievance or arbitration procedure to resolve disputes. He is, in effect, describing the institutional structure of managerial capitalism – what Davis (2009, pp.195–200) has referred to as ‘corporate feudalism’ – in which long-term attachments between firms and employees, bolstered by firm-specific benefits and privileges such as pensions, profit sharing and long-term employment, characterised not only the fabric of managerial work but, increasingly with the advent of labour unions and particularly in the USA, that of all permanent employees. And a key part of the efficiency gains that come from this considerable investment in hierarchy comes from its impact on the behaviours of those in the hierarchy. His distinction between ‘consummate’ and ‘perfunctory’ cooperation outlines but does not perform a theory of value creation by managers.

Consummate cooperation is an affirmative job attitude – to include the use of judgement, filling gaps, and taking initiative… Perfunctory cooperation, by contrast, involves job performance of a minimally acceptable sort … where… incumbents… need merely to maintain a slight margin over the best available inexperienced candidate.

Based on findings from different disciplines, understanding this difference provided the motivation for the development of theories about both management and labour performance.

Activity 2.2

What are the advantages to employers of long-term relationships with employees?

2.7 Overview of chapter In this chapter, we have tried, first, to describe in brief the emergence of the large firm and, second, to outline the first main attempt to develop a theory of it. This theory has a number of features that are significant for the chapters to follow.

1. It emerges essentially as a negative explanation about market failure: firms are implicitly second-best structures that arise when markets fail. Logically, one optimises the performance of a firm hierarchy by making sure it runs as close to being a market as possible. Within


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firms, managers potentially engage in problematic behaviours because the structures bring out the worst in them – opportunism. Coase is the precursor of a range of anti-managerial theories of organisation.

2. The theory is not empirically based. Not only is it surprising that economics developed a theory of the firm long after firms came to dominate industries (and then ignored it), it is surprising that the theory was not informed by any extensive observation of industry structure or firm behaviour. Empirical examination of the internal operation of the firm has remained unfashionable within economics and, as we shall see, it does not infect the modern field of organisational economics very much either.

3. Because the transaction cost approach remained marginal to economics for 30 years, and economics remained relatively uninterested in the firm, a space was created into which business disciplines such as marketing, organisational behaviour and strategy moved. Academic economics becomes much more involved with the study of managerial behaviour than with the growth of the economics of strategy and organisation and, less directly, of financial economics from the 1960s.

2.8 Reminder of learning outcomesHaving completed this chapter as well as the Essential reading and activities, you should be able to:

• explain key elements in the history of the firm

• discuss the main theories of firm formation

• outline several key managerial problems in the firm.

2.9 Test your knowledge and understandingWhat is transaction cost economics and why is it important for the theory of the firm?

Notes


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Chapter 3: Taylorism, motivation and performance

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• describe the main elements of Taylor’s approach

• discuss the strengths and limitations of scientific management

• explain the main elements of the human relations approach.

3.1.2 Essential readingWillman, Theme 1.

3.1.3 Further readingBraverman, H. Labor and monopoly capital. (New York: Monthly Review Press,

1974) [ISBN 0853453403]; 1988 edition [ISBN 9780853459408].Guillen, M.F. Models of management: work, authority and organisation in

a comparative perspective. (Chicago: Chicago University Press, 1994) [ISBN 9780226310367].

McGregor, D. The human side of enterprise. (New York: McGraw-Hill, [1960] 2006) [ISBN 9780140091243] Chapter 1: Management and scientific knowledge.

Taylor, F.W. The principles of scientific management. (New York, Harper, 1923) [ISBN 9781599866796] Chapter 1.

3.1.4 Works citedAbernathy, W.J. The productivity dilemma. (Baltimore: Johns Hopkins, 1978)

[ISBN 9780801820816].Batt, R. and Moynihan, L. ‘The viability of alternative call centre production

models’, Human Resource Management Journal, 12(4), 2002, pp.14–34.Burawoy, M. Manufacturing consent: changes in the labor process under

monopoly capitalism. (Chicago: University of Chicago Press, 1979) [ISBN 9780226080383].

Granovetter, M. ‘Economic action and social structure: a theory of embeddedness’, American Journal of Sociology 91 1985, pp.481–510.

Lewchuk, W. ‘Fordism and British motor car employees, 1896–1932’ in H.F. Gospel and C.R. Littler Managerial strategies and industrial relations: an historical and comparative study. (Farnham: Ashgate, 1983) [ISBN 9780435323653].

Marglin, S. ‘What do bosses do?’, Review of Radical Political Economics 6 1974, pp.60–112.

Mayo, E. The human problems of an industrial civilization. (New York: Macmillan, 1933).

Nelson, D. Frederick W. Taylor and the rise of scientific management. (Madison: University of Wisconsin Press, 1980) [ISBN 9780299081607].

Nelson, D. A mental revolution: scientific management since Taylor. (Columbus, OH: Ohio State University Press, 1992) [ISBN 9780814205679].

Norwich, J.J. A History of Venice. (London: Allen Lane, 1982) [ISBN 0713915625].

Quattrone, P. ‘Accounting for God: accounting practices in the Society of Jesus’, Accounting, Organisations and Society 29 2004, pp.647–83.


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Rose, M. Industrial behaviour. (London: Penguin, 1988) [ISBN 0140091335].Sabel, C.F. Work and politics: the division of labor in industry. (Cambridge:

Cambridge University Press, 1982) [ISBN 9780521230025].Thompson, E.P. The making of the English working class. (London: Penguin,

1966) [ISBN 9780394703220].Willman, P. Technological change, collective bargaining and industrial efficiency.

(Oxford: Oxford University Press, 1986) [ISBN 9780198272625].Witzel, M. Builders and dreamers: the making and meaning of modern

management. (Harlow: Prentice Hall (2002) [ISBN 9780272654377].Wren, D.A. The History of Management Thought. (New York, Wiley, 2005).

[ISBN 9780471669227].

3.2 IntroductionThe 19th and early 20th centuries in Europe and USA were, arguably, characterised by two features relevant to the design and conduct of business. The first was a belief in technological progress (and its benefits). The second was an inclination towards optimisation; put differently, if one thought systematically and rationally about a business problem, one could improve the chosen dependent variable – efficiency, productivity, profits, etc. In the absence of a theory of the firm, many analysts and practitioners felt the appliance of science to the factory could yield substantial benefits. Many had an engineering background (Witzel, 2002) and, again arguably, saw the optimisation problem as an engineering problem.

The problem to be optimised was how to run the most efficient business. Intellectual furniture existed; there were not many examples of large-scale manufacturing businesses but there was a history of large-scale organisation in two fields: government (particularly military) and religion (particularly international religious orders). In these organisations, many ‘managerial’ techniques had been developed. I offer two examples.

Jesuits knew about accounting. They had resources, international reach and an objective: saving souls. But,

A strictly economic analysis of the nature and role of accounting as an instrument for allocating, monitoring, and administering resources within the hierarchical structure of the Society of Jesus would leave undiscovered important aspects of the practices deployed by the Order to manage, organise, and account for its multifaceted activities. (Quattrone, 2004, p.675)

How to optimise the allocation of resources to maximise the saving of souls? The first thing one needs is a management accounting system to tell you where the resources come from and go to. The second thing, more controversial perhaps, is you have to put an economic value on a soul. At the margin, one might have to choose which soul to save or whether the expenditure was worth the return.

Venice knew about fighting wars at sea to generate and protect trade (they are not the only historical example). In the Arsenale, they built assembly lines.

[Venice] could standardise designs and build up stores of spare parts, making it possible to complete even major refits in a fraction of the time… the designs themselves, as well as the techniques, could be revolutionized….One of the secrets of Venice’s rise to power lay in the fact that she never saw the twin necessities of defence and commerce as altogether separate…the nobles were merchants and the merchants noble… (Norwich, 1982, p.109)


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How to maximise throughput and reduce production times; standardisation of inputs, process and product is an important component. Alignment of defence and commercial interests is another. You could use the ships to fight and then carry the spoils home.

How are these examples relevant to the operation of the industrial firm centuries later? First, they indicate that techniques for resource allocation and mass production had a long history in ostensibly non-commercial operations which could be adapted; there was something to work on for engineers to optimise. Second, they hint at the source of the agency problem in business. Military operations (which are a matter of life and death) and religious organisations (which are a matter of afterlife and eternal death) can generally exert more forces for cooperation or compliance on organisational participants than organisations that rely primarily on shared financial interests. Borrowing the techniques from such organisations did not borrow the underlying cooperation.

In much of the West, for the majority of the early period of industrialisation, it was not entirely clear why a pre-industrial workforce would wish to become an industrial one (Marglin, 1974; Thompson, 1968). If one invested in a factory in, for example, the cotton industry in England (which was important for the first Industrial Revolution), the capital investment required in steam production and productive equipment required high rates of utilisation which in turn required long hours of work. Control of absenteeism, turnover and simple inactivity was required to generate a rate of return. What incentives could be used to exact this? Money is one obvious answer, but we saw also the problems with simple incentives in the last chapter. Moreover, what would one buy with it? Penalties are another; throughout the 19th century in England, employment in factories was governed by the ‘master and servant’ Acts; the presumption of obedience was central. A third was the removal of opportunities. Prior to factories, farmers and their families used to spin cotton as an activity supplemental to their central activities. With the advent of expensive machinery, such an approach became hazardous to profit, and the need for a workforce with no other means of support became paramount.

Many management ‘theorists’ emerged in the late 19th and early 20th centuries, convinced that applying scientific principles to the management of firms would result in improvements in efficiency and productivity and, for the more messianic, a better world. The term ‘scientific management’ has often been applied to the ideas they promoted. We will look at just the most influential, F.W. Taylor, however, several characteristics of the set are relevant. First, they were obsessed with efficiency as an outcome variable; many of their works display a strong tendency to sample on this dependent variable, often with erroneous results. Second, they believed in general rather than specific solutions; their recipes were in principle universally applicable and promoted one best way of doing things. Third, they inclined, like Emerson and Fayol, to sets of points or principles which summarised their approach; 12 principles of efficiency for Emerson, 14 points of administration for Fayol. Fourth, since they were often engineers, they saw agency problems in engineering terms. Employees were important appendages to machines ‘and in the interests of plant efficiency should be treated at least as well as we treat machines’ (Emerson, cited in Witzel, 2002, p.227). Some were even military engineers who saw the exercise of authority as unproblematic.

An enormous amount has been written about Taylor (Braverman, 1974). He tends to be better thought of by those in operations management and


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research who are interested in the optimisation of processes than by those in organisational behaviour who are interested in the human response to this. Frederick Taylor argued that ‘scientific management’ consisted in devising the one best way to complete a task and then ensuring the workmen closely followed the rules, using supervision and monetary incentives. Five principles were central.

• The separation of conception from execution: managers analysed and designed work tasks, employees performed them.

• Simplification of tasks: each task was broken down into simple components which were then aggregated to exclude unnecessary efforts.

• Close supervision: employees were closely monitored to ensure adherence to best practice.

• Strict obedience to ‘one best way’: employee innovations in work design were excluded.

• Monetary performance incentives were applied to output generated in this way.

After initial successes, Taylorism was adopted by large firms such as DuPont and Ford. It was seen at the time as industrial science not capitalist ideology – Lenin was a fan. As we shall see, elements of it were adapted much later. It provided one basis for the modernisation of Japanese industry in the post-Second World War period. Its utilisation in service businesses grew as scale economies were pursued. ‘The factory of the past becomes the office of the future’ (Batt and Moynihan, 2002). However, it generated some of the characteristic problems of later versions of agency theory. The model ‘first-class’ workman in Taylor is a passive and obedient agent, indeed selected on those characteristics.

Let’s put the above list together, again in a negative way.

• Separation of conception from execution – the operator has no incentive to learn or share learning. If the operator does learn a better way, he is likely to appropriate the benefits.

• Simplification of tasks – skills are not worth developing, either for the firm or the employee. Indeed ‘de-skilling’ and thus loss of market power by employees is seen as one major consequence of the application of Taylorism (Braverman, 1974).

• Close supervision – many supervisors are needed and overhead rises. Taylorist firms develop high supervisory ratios, and efficiency losses.

• Strict obedience to ‘one best way’ – attracts the intrinsically obedient who are unlikely to innovate.

• Monetary performance incentives – given that people respond to symbolic rewards – this is expensive and likely to generate a simply calculative approach by the employee.

In fact, Taylorism depends on what in a different context Granovetter (1985) has referred to as both an oversocialised and undersocialised idea about the employee: oversocialised into obedience and undersocialised in being entirely motivated by money, not intrinsic rewards. Moreover, Taylor’s optimal employee is individually selected not collectively organised; in early 19th-century USA, this emerged as a problem.

Activity 3.1

Consider an organisation you know − school, shop, office. What would be the advantages and disadvantages of applying scientific management to that organisation?


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Let’s look at the model of organisation and of management. Organisations are seen as machines. Some of the machines are people but they can be managed the same way: managers think, workers do. Standardisation of (labour) input, work process and product output are the sources of efficiency; this is a mass-production model. The market does not send in shocks that disturb the organisation of work on a regular basis. Employee recalcitrance is endemic and monitoring is permanent. Task- or peer-based intrinsic rewards do not operate and the employee is homo oeconomicus. How well has Taylor understood the employee as economic man?

We would argue that in at least two respects the Taylor approach anticipates later developments by academic economists, albeit not formally.

• In the emphasis on the importance of selection and fit, there is understanding of both moral hazard and adverse selection.

• In the rigid adherence to the separation of conception from execution, there is a grasp of the problems of information asymmetry.

3.3 Scientific management: the apogeeScientific management in general and Taylor’s version in particular left a substantial legacy. The engineering efficiency approach to the design of operations generated huge returns to scale, and many large businesses in chemicals, engineering and car manufacture adopted it (Nelson, 1992). Much of the thinking was to become incorporated in the academic disciplines of operations research and management, which in turn found a central place in the MBA curriculum. For many, the ultimate expression of the engineering approach to production management came in the car industry, and in particular the operations of Ford, the most successful of the early car manufacturers.1

Ford dominated the early history of the car industry, both in success and failure. The Model T introduced in the 1920s was based on a strategy of low price and simple design; this generated huge growth in car ownership and thus market size. The production approach underpinning this was standardised design, assembly line technology and mass production. This had a number of implications. For Ford, the most serious was inflexibility; his early factories could only produce Model T cars, and retooling for product innovation required long-term plant closure that led to permanent loss of market leadership to General Motors (Lewchuk, 1983).

In assembly line car production, capacity utilisation is vital. Mass production degenerates into batch production whenever the line is stopped or product rectification is required; fixed capital costs are high, and the gap between capacity and output needs to be small. This is exacerbated by vertical integration; car assembly – the final operation before distribution and sale – has lower minimum efficient scale than upstream operations such as engine manufacture and body production, so interruptions to assembly within an integrated car manufacturing operation generate costs throughout the firm. Assembly is also the most labour-intensive phase of production.

1 This section relies on Abernathy (1978) and Willman (1986).


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PRESS SHOP BODY SHOP PAINT SHOPStamping of body panels

Steel: sheet strip and coil

PanelsSub-assemblies

Bodyassemby

Body inwhite

Clean, prime,paint body Painted body

ASSEMBLY PLANT

Trim lines Finalassemby

Test and rectification

Finished car shipped to distributors/dealers

Thousands of parts and trim items

Component plants Engine dress

and rear end assembly

RAW-MATERIAL SUPPLIERS

Steel: rod and bar stock

Forging of high-strength parts

FORGE

Casting of engine blocks, crankshafts etc.

FOUNDRY

Machining

Machining

ENGINE PLANT

Engine assembly and test

TRANSMISSION PLANT

Transmission assembly and test

Engine

Transmission

Figure 3.1: Cost components of car assembly

Figure 3.1 identifies the cost components of car assembly. There are three sets. First, capital equipment in the form of plant layout; this defines capacity and is fixed. The next two concern labour. The first is the hourly cost of labour. If the system is optimised at 100 per cent operation, these are the only costs. The third component represents lost capacity; the source of most lost capacity is labour behaviour, and control of this is at the centre of the derivative of Taylorism that some commentators call ‘Fordism’. The key dependent variable is ‘man hours per car’, for example, the labour input to each unit produced. Absenteeism, errors in work, stoppages due to disputes and the need for direct supervision inflate this denominator.

The key elements of the labour strategy that supports optimisation were as follows.

• The simplification of tasks and high assembly line speeds; automation of simple tasks where possible.

• Use of high levels of hourly pay and the avoidance of bonuses. Ford introduced the ‘$5 day’2 to attract and retain the labour required, and to reduce absenteeism.

• Close supervision of employees and strict discipline.

• Avoidance of labour unions.

In order to do this, Ford favoured company towns and company housing. Most significantly the firm invested in a ‘personnel department’ that not only provided welfare but also acted as a labour police force, monitoring absence, sickness, agitation and dissent. Optimising workforce performance was the key to optimising capacity utilisation. The main Taylorist absentees from this labour-management formula were incentives and heavy supervision; assembly line speeds substituted for both (Guillen,1994, p.56).

Many of these considerations still apply to the modern car industry. By extension, they apply to many capital-intensive mass-production operations. Labour costs may be a small proportion of total costs, but labour control becomes vital. As Braverman has put it:

2 This was a lot of money at the time.


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Taylorism dominates the world of production; the practitioners of ‘human relations’ and ‘industrial psychology’ are the maintenance crew for the human machinery. (1974, p.86)

How did psychology intervene, and what is ‘human relations’ in this context?

3.4 Engineering and psychologyThere were parallel but discrete origins in the USA and UK. In the USA, Munsterberg at Harvard – an admirer of Taylor – became concerned with fatigue, monotony and learning in work; he advocated selection testing and motivational tools. In the UK, the influence of wartime research on soldiers was deployed in the 1920s by Myers, among others, to study stress and fatigue and to develop recommendations on the optimal working day and rest periods and the avoidance of accidents and absenteeism (Rose,1988). The unit of analysis tended to be the individual worker (and by extension individual differences), but the concern was less directly with individual well-being and more with those variables also of concern to scientific management. As Wren puts it:

While the engineer studied mechanical efficiency, the industrial psychologist studied human efficiency with the same goal in mind of improved overall greater productivity. Acceptance by industry of the heretofore ivory tower psychologist was facilitated by the psychologist’s interest in efficiency. (2005, p.193)

A paradox of early theorising about employee behaviour was that both scientific management and the early psychologists focused on the individual as the unit of analysis but the employee response to both frequently involved collective action, which in turn generated the high levels of labour conflict that were of so much concern. An alternate approach relied on late 19th-century sociology and focused on the group.

Durkheim focused on the bonds that held societies together to generate solidarity. Traditional societies were bound together by kinship, religion and similarity; this generated ‘mechanical solidarity’. The division of labour, the growth in differentiation of status and the scale of modern societies broke down these bonds and generated anomie; this was an individual state of confusion, normlessness and anxiety, but it was generated by the absence of any groups or institutions that could provide a set of norms and values appropriate to a highly differentiated society – ‘organic solidarity’. Durkheim’s work contains far more analysis of societies with mechanical solidarity than those with organic and he is a little short on detail about how it might be achieved. The enduring legacy for the management field was his concept of the individual as plastic, shaped and shapeable by membership of norm-generating groups.

To get from this to a set of management techniques one needed something approaching an optimisation model – and it came from economics. Pareto, a 19th-century polymath who was an engineer, economist and sociologist, referred to the idea of a ‘social system’ – characterised by interdependent and varied components with self-equilibrating tendencies. This went into Harvard University as a broad idea and came out as a major influence on academic sociologists such as Parsons and Homans on the one hand and, on the other, as a central plank of what became the ‘human relations’ school – the idea of the factory as a social system that could achieve


24

equilibrium. In order to explore this approach and its effect on modern management theory, let us look at its most famous piece of research – the Hawthorne studies.

The Hawthorne studies took place in the USA in the eponymous plant of Western Electric from 1924–1933.3 It was a massive factory; by 1929, 40,000 men and women worked there. Western Electric was one of the forerunners in applying scientific management to its production units and it was regarded as a well-run plant. Numerous researchers using a variety of methods performed a series of behavioural experiments and deployed interviewing and observation techniques in ways that would get modern researchers fired and, given that the experiments involved some behavioural manipulations and physical deprivations, maybe sued (Wren, pp.370–73). In fact, the most widely quoted finding is simply a method flaw. Over time, researchers realised that every time they paid attention to a group of workers (subjected them to a ‘treatment’) output rose temporarily, then fell back – the ‘Hawthorne effect’.

The studies began with a concern for physical environment. The illumination tests, 1924–1927, subjected groups to lighting variations and, broadly, found no correlations between lighting and productivity. Subsequently, the ‘relay’ tests, 1927–29, involved experimental alteration of bonus arrangements, rest periods and hours of work, with mixed results. A third set of studies, in the ‘Bank Wiring Room’, probably had the greatest impact. Researchers discovered output restriction under incentive schemes that was enforced by informal groups. Workers felt that if they produced too much output, management would cut the rates, and if too little, they would be disciplined. Informal work groups emerged enforcing output norms lower than those management wanted, using emotional and physical sanctions. Further studies analysed informal group structure in depth, finding that supervisory behaviour with respect to informal groups was important. Managers who listened and communicated well were likely to be more integrated into work groups.

The results had potentially radical implications. Workers would act against self-interest by obeying group output norms. Managers who integrated with informal groups, using what would later be called a management ‘style’, gained much better understanding of group structure and how to manipulate it. Such groups could be used to improve output. In these studies we see the seeds of the organisational behaviour discipline – in its concern with intrinsic (non-economic) motivators, teams and team building and leadership. We can also see a logic which leads to the development of the modern human resource function; individual and collective affect (emotional states) may have an impact on firm performance, and it is thus worth investing to control these variables. More immediately, it allowed one of the key researchers, Elton Mayo, to identify worker discontent as anomie remediable by intervention designed to restore Pareto equilibrium to the social system of the factory. The intervention points were selection of workers, allocation and organisation of tasks, leadership style and the construction of teams (Guillen,1994). To quote Mayo:

The hallmark of human-relation theories is the primacy given to organizations as human cooperative systems rather than mechanical contraptions…

Any company controlling many thousands of workers…tends…to lack any satisfactory criterion of the actual value of its methods of dealing with people. (Mayo, 1933)

3 This section relies on Rose (1988).


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Since cooperation was the objective, unions were peripheral to the analysis.

Hawthorne in particular and the human relations school in general have been subject to a number of criticisms. However, the impact of human relations thought on subsequent academic research agendas is considerable, and the notion that the ‘mechanical’ and the ‘social’ systems of industrial enterprises must be jointly maximised was exported from the USA, most particularly in the work of the Tavistock Institute.

In an influential study, Guillen has analysed the theoretical development of both scientific management and human relations thought, and their impact on business practice in four Western countries. He argues that:

The development of engineering as a profession was the direct cause of scientific management, much as the development of social-psychological science accounted for the appearance of the human relations paradigm. (Guillen, 1994, p.26)

Scientific management adoption always precedes human relations adoption, and indeed in Germany he finds, for various reasons, human relations thinking has little effect on practice. The more consistent impact of scientific management on production is associated with the simultaneous development of cost accounting, production and inventory controls and incentive schemes (also developed by engineers) (1994, p.41).

If, as in the USA, human relations thinking emerges as a solution to problems of labour unrest generated by the application of scientific management, its ideological component becomes important. Several eminent sociologists in the 1950s, such as Daniel Bell, C. Wright-Mills and W.H. Whyte, saw human relations as a manipulative technique promoting solely managerial ends; later Marxist sociologists such as Braverman (quoted above) saw it as ‘manufacturing consent’ (see also Burowoy, 1979, and Sabel,1982). In Britain, however, it gave rise to a set of concerns about humanising the workplace through the reorganisation of work.

Activity 3.2

One key question emerging here is the relative primacy of engineering and social considerations. Does one, as Braverman implies above, (a) optimise on process efficiency and productivity and mould social concerns around that (as the human relations approach implies), or (b) is it worthwhile to choose a sub-optimal production technique because it has compensatory effects on the workplace as social system which, in turn, positively affects some performance measure?

3.5 Overview of chapter1. Early theorists were concerned to optimise production in large firms

using both existing organisational tools and a systematic ‘engineering’ approach.

2. This became systematised in the influential work of Taylor whose techniques were widely adopted and developed.

3. However, widespread concern about the approach to employees led to the application of social psychology to understanding worker behaviour, also in the interests of increasing performance.

4. This in turn led to the emergence of the ‘human relations’ approach.


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• describe the main elements of Taylor’s approach

• discuss the strengths and limitations of scientific management

• explain the main elements of the human relations approach.

3.7 Test your knowledge and understandingWhat was scientific management? Is it still influential in business today?

Chapter 4: The rise and decline of labour

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• outline the key features of the history of labour unions

• describe the potential benefits of unions to firms and employees

• discuss the reasons for union decline in modern industrial societies.

4.1.2 Essential readingFreeman, R. and Medoff, J. What do unions do? (New York: Basic Books, 1984)

[ISBN 9780465091324] Chapter 11.Willman, Chapter 3, Theme 2.

4.1.3 Further readingGospel, H. ‘The management of labor and human resources’ in Jones, G. and

J. Zeitlin, J. (eds) The Oxford handbook of business history. (Oxford: Oxford University Press, 2007) [ISBN 9780199573950], pp.420–47.

Pencavel, J. ‘The demand for union services: an exercise’, Industrial and Labor Relations Review 24(2) 1971, pp.180–90.

4.1.4 Works cited Berg, M. The machinery question and the making of political economy.

(Cambridge: Cambridge University Press, 1980) [ISBN 9780521227827].Blanchflower, D. and A. Bryson ‘Changes over time in union relative wage

effects in the UK and the US revisited’, Chapter 7 in J.T. Addison and C. Schnabel (eds) International handbook of trade unions. (Cheltenham England and Northampton Mass., USA: Edward Elgar, 2003) [ISBN 9781840649796].

Blanchflower, D. and A. Bryson ‘What effect do unions have on wages now?’, Journal of Labor Research 25(3) 2004, pp.383–414.

Braverman, H. Labor and monopoly capital (New York: Monthly Review Press, 1974) [ISBN 9780853453406].

Crouch, C. Trade unions: the logic of collective action. (London: Fontana, 1982) [ISBN 978006358732].

Davis, G. Managed by the markets. (Oxford: Oxford University Press, 2009) [ISBN 9780199216611].

Freeman, R. and J. Rogers What workers want. (Ithaca: ILR Press, 1999) [ISBN 9780801485633].

Gomez, R., A. Bryson and P. Willman ‘Voice transformation: the shift from union to non-union voice in Britain’ in A. Wilkinson et al. (eds) The Oxford handbook of participation in organisations. (Oxford: Oxford University Press, 2010) [ISBN 9780199207268].

Hobsbawm, E. The age of extremes: the short twentieth century, 1914–1991. (London: Michael Joseph, 1994) [ISBN 0718133072]. Vintage (1996) [9780679730057].

Marglin, S. ‘What do bosses do?’, Review of Radical Political Economics 6 1974, pp.60–112.

Tuchman, B. The proud tower. (London: Macmillan, 1966) [ISBN 9781299237247].


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Willman, P. Technological change, collective bargaining and industrial efficiency. (Oxford: Oxford University Press, 1986) [ISBN 9780198272625].

Willman, P., T.J. Morris and B. Aston Union business: trade union organisation and financial reform in the Thatcher years. (Cambridge: Cambridge University Press, 1993) [ISBN 9780521417259].

4.2 IntroductionAlthough circumstances in the 19th century differed between Western countries, particularly between nation-states in Europe and the immigrant society of the USA, it is fair to say that industrialisation in both required the creation of an industrial labour force. The rhythms, seasonality and control structures of a pre-industrial and agrarian society were very different from those needed by factory systems in the 19th century. This was the transition that obsessed both Marx and Durkheim. Although their analyses were very different, they were both concerned with the disappearance of one labour pattern and its replacement by another. In practice, it was a process that was both political and economic, full of conflict, and lasting in its impact on both industrial practice and academic theory.

This chapter is not a full history of this process. It is structured around several propositions. First, industrialisation in general and the factory system in particular required a labour force substantially different both in its social structure and its labour practices from what preceded it. Second, this was neither a comfortable nor welcome process for many members of that labour force, and their resistance to it took the form both of unionisation and political action. Third, the performance attributes of that labour force were sufficiently central to the success of specific firms that strategies for the management of workforces needed to move beyond compulsion to cooperation: capital-intensive operations required both skills and continuity, and both gave employees bargaining power. Fourth, the generation of compliance necessitated a specific set of managerial activities which began as labour welfare and continues as human resource management.

Eric Hobsbawm (1994), a Marxist historian, coined the term ‘the short twentieth century’ to refer to the period between 1914 and 1991. It covers the period from the start of the First World War to the collapse of the former USSR. It was in his interpretation one long set of wars, conducted by different means but which, particularly for Europe, resulted in major changes for labour and labour markets. Millions of employees put on uniforms and were killed. Immigration to the USA aside, international labour mobility shrank massively. But production and labour compliance became central to the fighting of wars that were won, increasingly, by the industrial production of food, energy and fighting machinery. In the latter part of the period, the central conflict was between a capitalist system and an ostensibly socialist, worker-owned, one. The paradox for both was that labour had to be controlled, but it also had to be bought. In this climate, we see the elaboration of the institutional machineries of labour performance and cooperation. In order to set the stage for this, let us turn to 19th century background.


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4.3 Farmers and workersTextiles in England were crucial to the first Industrial Revolution (Gospel, 2007). Factory owners installed machinery, attracted labour and exerted control over it (Marglin, 1974). Advocates and critics alike were under no illusions about the dominant forms of managerial control. Contemporary commentators, such as Ure, spoke of the ‘bloodless strife’ of trade and used military analogies to describe hierarchy and authority (Berg, 1980, p.201). Critics such as Marx spoke of male employees as ‘sergeants’ and women and children as ‘soldiers of the line’ (Braverman, 1974, p.64). Machinery fragmented work, controlled workers and shifted power to owners; machinery was broken in riots, rioters were imprisoned and transported. Unionisation emerged, primarily among the ‘sergeants’ who possessed scarce skills and bargaining power, not among the women and child soldiers. Textile unions consisting of male workers became among the largest in Britain. Similar patterns of labour force development, but not necessarily unionisation, developed in the USA and Japan (Gospel, 2007, p.425).

Railway companies came to dominate both the industrial landscape and the capital markets but, although military analogies were explicitly used in employment relations, the direct control approach to labour management was not. Railway operation does not generate huge concentrations of employment: employment is dispersed across the network and direct supervision is very expensive, but the potential for the disruption of service by a discontented workforce is enormous. The solution was largely the same in both the UK and USA: railways developed elaborate internal labour market structures with equally elaborate employment-dependent benefit systems to retain and pacify labour, without unions, until after the First World War.

Subsequently, as we have seen, large firms came to dominate Western economies. There are a number of ways to measure firm size; we could use volume or value of output, financial resources, market value or market share. For the present purposes, employment is the appropriate measure and Gospel has summarised the broad historical sweep of labour concentration. Referring to the UK, the USA, Italy and Germany, but also to Japan, he observes:

With slight differences between countries, the typical large employer in the early to mid-19th century was a textile company; by the mid- to late 19th century, the biggest single group of major firms in most economies were railway companies; by the mid-20th century, the main groupings were manufacturers (steel, chemicals, automobiles, electrical) and by the end of the 20th century, the biggest single group of large firms was to be found in retailing and financial services. (Gospel, 2007, p.424)

Throughout the ‘short’ 20th century in Western economies, which also roughly coincides with Davis’s period of ‘corporate feudalism’ characterised by managerial autonomy, these large firms had to come to terms with the ‘labour problem’. As we will see below, organisational size is a potent variable that explains many features of organisational structure and performance, and labour conflict is no exception. Unionisation spread in Western countries throughout the large manufacturing and service companies listed above. It also spread throughout government employment. The trends for the USA and the UK are shown in Figure 4.1.


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Figure 4.1: Long-term trends in unionisation in the USA and UK

Source: Willman (2014).

4.4 Band of brothersIn both countries, the ‘short twentieth century’ was a better period for union membership than that which went before or since. The initial turning point was the First World War, but the Great Depression was a bad hiccup. Recovery from the Depression dip roughly coincided with the Second World War. As we have noted above, tight labour market and product market conditions were very important, but government action to incorporate an organised labour movement into the war effort was also key. This was particularly important in Europe; for example, in 1914 it was by no means clear to contemporary politicians that trade unions loosely coordinated by the international socialist movement would support a call to arms that would have union members from different countries fighting each other (Tuchman, 1966). High levels of unionisation were sustained in many Western economies throughout the post-war period of corporate feudalism, but as Figure 4.1 (above) shows, decline started to set in from the late 1950s in the USA and the 1970s in the UK. There are very few Western countries (the exceptions are mostly countries in Scandinavia) that have not seen sustained decline in union membership, particularly in the private sector, since the mid-1970s.

Three questions concern us here. First, why did unionisation become widespread in the short 20th century? We deconstruct this into two subsidiary questions: why do workers join, and why do managers in firms choose to deal with them? Second, what changed to cause union decline in the late short 20th century? Third, what is the impact of this phenomenon on theorising about management? These questions will be examined in the remainder of this chapter.

First, union membership: unions provide their members with three kinds of service (Pencavel, 1971). They represent them collectively in wage and benefit bargaining; individually in collectively agreed grievance and disciplinary procedures; and they offer personal insurance against misadventure such as unemployment or ill health. There is widespread evidence from Western countries in the modern era that unions can generate benefits for workers who are members. These benefits may be monetary: there is a union wage differential (for example, a premium

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union members are paid as compared with similar non-union workers) in many Western countries, particularly in the USA for much of the 20th century, although this declined as union density declined in the latter half of this century (Blanchflower and Bryson, 2004). Table 4.1 indicates that the amounts in some countries may be substantial; there are also sectoral and skill-based differences within countries.

There is, equally, substantial evidence that employees want to be represented in their dealings with employers (Freeman and Rogers, 1999). We saw in Chapter 2 that employment contracts are incomplete; they contain many ‘silences’ that must be filled by discussion or negotiation and individuals often want to be represented in this process. There is some evidence from the UK that this is increasing in importance compared to collective action (see Figures 4.2 and 4.3)

Country Years Union % increase

Australia 1994, 8 & 9 12

Austria 1994, 5,8 and 9 15

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Canada 1997-9 8

Chile 1998, 9 16

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France 1996-8 3(ns)

Germany 1994-9 4(ns)

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Portugal 1998-9 18

Spain 1995, 7-9 7

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UK 1993-2002 10

USA 1973-2002 17

Table 4.1: Union wage differentials in selected countries

Source: Compiled from data in Blanchflower and Bryson, 2003 and 2004.

We read this modern evidence back into the argument for the early 20th century growth of unions at our peril and with some conditions. Strike activity in the early 20th century was – to generalise – much higher than in the last quarter of the century in most countries, but it is probably the case that most employees who joined unions did so for instrumental (i.e. such as benefit-related) reasons, so it was in the unions’ interest to confine those benefits to members and prevent spillover to non-union members. This is relevant to the third category of services – individual insurance. Early unions operated in the absence of a welfare state and thus were often as much benefit societies as bargaining agents as they had the funds to provide sickness benefit, unemployment benefit and funeral benefits (Willman et al., 1993). Over time, and with the growth of corporate feudalism and government-provided welfare, these benefits dwindled. In late 20th century Western Europe, employees were likely to rely on the state for many benefits, and in the USA it was the firm that employees relied on. As Davis (2009, p.59) notes, American multinational firms


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took on some of the welfare functions performed elsewhere by European welfare states. Embedded here is the hint that the firm can substitute for the union in providing certain types of employee benefit (see the next chapter).

Either way, since the wage differentials of union membership were often generalised to all employees, unions in the late 20th century had a harder and harder time justifying the instrumental rewards of union membership. There is very good social-psychological evidence to show that some people join unions for ideological, or at least non-monetary, reasons, but none to show that this can be the basis of mass membership. As Crouch (1982, p.55) noted, unions had to develop a range of services that were unrelated to their central public purpose but met some needs of potential members and which were available only to members.

Figure 4.2: Stoppages 1960–2006

Source: UK Data ‘Stoppage days’.

Activity 4.1

Think about the reasons why employees join unions. Do they explain why union membership in the UK and USA is in long-term decline? (See Figure 4.1.)

Figure 4.3: Employment tribunal claims registered 1972–2006

Source: Advisory Conciliation and Arbitration Service.

So, employees could see some benefits in union membership, but why would firms agree to deal with unions? There are at least three ingredients

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to the answer. First, because the economic benefits often outweighed the costs − this is essentially a bargaining power argument. In a railroad or steel mill, for example, labour costs tend to be a small proportion of total costs, but withdrawal of labour can lead to enormous costs, therefore the union wage differential might seem cheap at the price. Second (and implied by the first) there are economic rents that managers, autonomous of owners, can share to make their job easier (the agency argument from Chapter 2 may be relevant here). But, third, what if unions could be managed to provide benefits to the firm?

The argument for firms dealing with unions is put forward by Freeman and Medoff (1984). Their dependent variable is labour productivity; the outcome is indeterminate, dependent on the three effects; the reasoning is purely economic; and the identification of ‘voice’ solely with labour unions is an assumption. But the argument is that, since higher-priced labour (monopoly wage gains) should either get you better labour or make it easier to automate, and ‘voice’ should both lower exit and improve the quality of management, these two effects could generate net benefits if management controls are sufficiently strong to prevent the establishment of unproductive work rules (known as featherbedding).

The data they use to justify this is from the USA. There are some data from elsewhere that point the same way. To repeat, this is an argument about why firms need voice, not why they need unions. But it also indicates why unionisation might have become so prevalent in the Western private sectors where oligopolistic competition existed, since it defines the set in which the costs of unions to employers might be less than the benefits (Gomez et al., 2010). It may also point the way to the answer to the third question about the decline of unions.

However, first we need to identify some properties of the set of circumstances in which union effects on productivity are negative. Under what circumstances is the positive outcome described by Freeman and Medoff (1984) unlikely, and the costs of union activity likely to outweigh the benefits to employers? A note of caution: such circumstances used to and do exist. Here we identify four; they are not mutually exclusive.

• Perishable products and spot contracting. Perishable products are those that need to be produced, sold or moved before their market value disappears. When their production, sale or movement depends on labour, substantial bargaining power devolves on collectively organised labour. In many such markets, there is volume volatility or uncertainty. Let us offer two historical examples (Willman, 1986). Newspapers used to be produced by typesetting methods that required substantial, skilled labour. But nobody knows how much news there will be tomorrow and nobody needs yesterday’s paper. In this situation, labour power is substantial and labour demand is variable. Dock (longshore) work is similar. Ships arrive at uncertain times and, because they are charged to be in dock and because many products need to be unloaded fast, similar uncertainties existed. The central question is: who bears the volatility risk? In both industries, in many countries, the employer solution was to generate a hiring hall: each day, employers would hire from a larger pool the labour they needed, so the potential employee bore the risk. This is, in Williamson’s terms (see Chapter 2), a spot contract in the labour market. The union response is uniform, which is to shift the volatility risk, shrink the available labour pool by limiting it to union membership and exact compensatory payments equivalent to wages for those not hired, so the employer has limited hiring options and no incentive not to do so.


34

In the two industries mentioned, it meant that union members became among the highest-paid manual workers in their respective economies. In the short term, the management control problem was intractable. In the longer term, the automation of both industries swept the problem away.

• Natural monopoly. Whether in the public or private sector, unions maintain substantial powers in situations where monopoly enables them to inflict considerable damage on the consumer. Examples would be power supply and transport in the private sector or education and health, which is most often to be found in the public sector. Bargaining power for unions is enhanced where skills levels are high, and thus the substitution of current employees is difficult in the event of conflict. This natural monopoly may be local; by this we mean that it may be internal to the firm in the form of a production bottleneck. For example, in a large-scale retailing operation, unions find it difficult to organise a high turnover and dispersed group of employees in stores, but much easier to organise drivers who distribute saleable and perhaps perishable products, who are concentrated and smaller in number.

• Occupational communities. Historically some industries internationally have been more conflict-prone than others. They are often characterised by a strong overlap between community networks and employment networks. Examples would be mining, dock work (as above), rail employment, prison officers and lumberjacks. Where a community depends on a single industry or employer, disputes with the employer often become disputes between the employer and community. Unions become representatives of the community and union membership becomes socially compulsory. This is known as the Kerr–Siegel hypothesis. Again, it can operate at a micro level: even in large metropolitan areas, organisations (such as the police or fire services) that recruit serially from the same families can experience the same effects.

• State ownership. Public sector union membership is much higher than private sector membership in many economies. Several factors are at work. First, the potential for disruption is considerable. Second, the government often wishes to maintain employment standards as an exemplar to the private sector. Third, organisational size is often very large. Fourth, political decisions, rather than product market conditions, often define employment terms and levels. Fifth, organisational aims are essentially contestable: performance measures in public sector organisations are often set with organisational objectives in mind that are not fully shared by the employees subject to them. Put another way, the employer benefit might not equate to a definition of the welfare benefit of such organisations.

So we turn to the question of union decline. Employees want a voice. But the key property they want is that the employer will listen and respond, improving their relationship with the firm. Employers want a voice. But they do not necessarily want the wage premium or the joint decision-making involved in negotiating with unions. So it could become rational for employers to reject the union voice and invest in their own. Consider Figure 4.4. This contains data from the UK.


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Figure 4.4: Union and non-union voice

Source: Gomez et al., 2010.

Figure 4.4 is based on very comprehensive survey data and it covers private sector employers. It is interesting data not only for the UK, but as a test case on employer choice, since during the period covered there was no legislation requiring employers to deal or not deal with unions. There was also very little legislation requiring them to have any mechanisms within the firm supporting voice. Three categories decrease. Two are related to unions. Union-only voice, where the firm relies entirely on unions for voice (as in the Freeman and Medoff (1984) argument), goes down most. Dual voice, where managers use both union and non-union voice, declines, but less rapidly. But, if we focus on the other two curves, we see that voice mechanisms that the employer sponsors (non-union voice) expands, and the sector where there is no voice contracts.

Firms want voice. They want mechanisms for feedback from employees to managers. This leaves open what kinds of feedback occur and whether the firm uses it to respond to employee concerns, but it is wholly inconsistent with the separation of conception from execution at the heart of Taylorism, and quite difficult to reconcile with the idea that firms are receptive to perfunctory cooperation. There is substantial evidence from other Western economies that employers find the need to engage with, learn from and explain to those who work for them. The next chapter examines this more closely.

Activity 4.2

Imagine you are the CEO of the organisation running the public transport system in the city in which you live. What problems might unions cause you and what measures could you take to deal with these problems?

4.5 Overview of chapterSo the final question to address is: what is the impact of this on theories about management?

• Engagement of employees with the firms for which they work is intrinsically problematic. An employment contract is initiated by a firm in order to generate an outcome, which may be measured in a variety of ways, as we shall see below, but will involve measures of productivity, customer satisfaction, contribution to profit or a variety of preferred measures. It may be accepted by an employee for many reasons, but these reasons are likely to be both economic and non-

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economic. By this we mean only that there is overwhelming evidence that employees want more from work than pay.

• This employment contract is incomplete, and in most Western economies in the 20th century the employer would fill the ‘silences’ unless constrained by the state or by the collective organisation of employees in a union. However, filling the silences involves a ‘command and control’ approach in only a minority of cases and managerial practices to generate employee voice predominate even in the absence of any compulsion for their use.


• outline the key features of the history of labour unions

• describe the potential benefits of unions to firms and employees

• discuss the reasons for union decline in modern industrial societies.

4.7 Test your knowledge and understandingWhy do workers join unions and why do employers negotiate with unions?

Chapter 5: The rise of human resource management

37




• describe the history of personnel and human resource management

• discuss the content of human resource management approaches

• explain the relationship between human resource management and organisational behaviour.

5.1.2 Essential readingWillman, Chapter 4.

To complete Activity 5.2 you will also need to read:

Coyle-Shapiro, J.A-M. and M. Parzefall (2008) ‘Psychological contracts’ in C.L. Cooper and J. Barling (eds) The SAGE handbook of organizational behaviour: volume 1. (London: SAGE Publications, 2008) [ISBN 9781412923859], pp.17–34; available at: http://eprints.lse.ac.uk/26866/1/Psychological_contracts_(LSERO).pdf

5.1.3 Further readingBaron, J. and D. Kreps Strategic human resources: frameworks for general

managers. (New York: John Wiley, 1999) [ISBN 9780471072539] Chapter 2.

Becker, B. and B. Gerhard ‘The impact of human resource management on organisational performance: progress and prospects’, Academy of Management Journal 39(4) 1996, pp.779–801.

Tichy, N.M., C.J. Fombrun and M.A. Devanna ‘Strategic human resource management’, Sloan Management Review 23(2,Winter) 1982, pp.47–61.

5.1.4 Works cited Argyris, C. Understanding organizational behavior. (Homewood, Ill.: Dorsey

Press, 1960).Bass, B.M. Leadership and performance beyond expectations. (New York: Free

Press, 1985) [ISBN 9780029018101].Beer, M., B. Spector and P.R. Lawrence Managing human assets. (New York:

Free Press, 1984) [ISBN 9780029023907].Colquitt, J.A., J.A. LePine and M.T. Wesson Organisational behaviour: improving

performance and commitment in the workplace. (New York: McGraw Hill, 2009) [ISBN 9780071318112].

De Menezes, L.M., S.J. Wood and G. Gelade ‘The integration of human resource and operation management practices and its link with performance: A longitudinal latent class study’, Journal of Operations Management 28(6), 2010, pp.455–71.

Dobbin, F., J.R. Sutton, J.W. Meyer and W.R. Scott ‘Equal opportunity law and the construction of internal labor markets’, American Journal of Sociology 99(2) 1993, pp.396–427.

Ghoshal, S. and P. Moran ‘Bad for practice: a critique of the transaction cost theory’, Academy of Management Review 21(1) 1996, pp.13–47.

http://eprints.lse.ac.uk/26866/1/Psychological_contracts_(LSERO).pdf

http://eprints.lse.ac.uk/26866/1/Psychological_contracts_(LSERO).pdf


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Guillen, M.F. Models of management: work, authority and organisation in a comparative perspective. (Chicago: Chicago University Press, 1994) [ISBN 9780226310367].

Hamel, G. and C.K. Prahalad Competing for the future. (Harvard: Harvard Business School Press, 1996) [ISBN 9780875847160].

Huselid, M.A. ‘The impact of human resource management practices on turnover, productivity, and corporate financial performance’, Academy of Management Journal 38 1995, pp.635–72.

Jurgens, U., T. Malsch and K. Dohse Breaking from Taylorism. (Cambridge: Cambridge University Press, 1993) [ISBN 9780521405447].

Kotter, J. ‘What leaders really do’, Harvard Business Review, 68, 1990, pp.103–11.

MacDuffie, J.P. ‘Human resource bundles and manufacturing performance: Organizational logic and flexible production systems in the world auto industry’, Industrial & Labor Relations Review 48 1995, pp.197–221.

Pfeffer, J. Competitive advantage through people (Boston: HBS Press, 1994) [ISBN 9780875847177].

Rose, M. Industrial behaviour. (London: Penguin, 1988) [ISBN 9780140091335].

Rousseau, D.M. Psychological contract in organisations: understanding written and unwritten agreements. (Newbury Park: Sage, 1995) [ISBN to come].

Schein, E.H. Organizational psychology. (Upper Saddle River, NJ: Prentice-Hall, 1970) [ISBN 9780136411345].

Ulrich, D. The human resource proposition. (Harvard: HBR Press, 2005) [ISBN 9781591397076].

Wall, T. and S. Wood ‘The romance of human resource management and business performance and the case for big science’, Human Relations 58(4) 2005, pp.1–34.

Willman, P. and G. Winch Innovation and management control: labour relations at BL Cars. (Cambridge: Cambridge University Press, 1985) [ISBN 9780521268028].

Witzel, M. Builders and dreamers: the making and meaning of management. (Harlow: Pearson, 2002) [ISBN 9780273654377].

Wren, D.A. The history of management thought. (New York: Wiley, 2005). [ISBN 9780471669227].

Wright, P. M. and G.C. McMahan ‘Theoretical perspectives for strategic human resource management’, Journal of Management, 18(2), 1992, pp.295–320.

Yukl, G.A. Leadership in organizations. (Upper Saddle River, NJ: Pearson/Prentice Hall, 2006) [ISBN 9780138142681].

5.2 IntroductionHuman relations thinking and the adoption of its techniques were often associated with the creation of personnel departments. Guillen (1994, pp.73–74) notes the rapid spread of personnel departments in manufacturing in the USA in the second quarter of the 20th century. These evolved into the modern human resources departments whose toolkit is the human relations legacy. Second, there is an academic legacy. As Rose notes:

…technology supplanted the human relations climate as the favourite variable for explaining human behaviour…increasingly, investigators took the title of ‘organisation theorists’. Combined with applied psychology, the sociology of organisations formed the core of a newly popular and heavily promoted academic area, organisational behaviour. (Rose, 1988, p.81)

We shall look at both the practice of human resource management and theories in organisational behaviour below.


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In this section, we trace the lineage of the human relations approach down to the 21st century. In fact, there are several legacies to consider. In practical terms, we need to look at the evolution of the human resource function within the firm. There are, of course, enormous variations in human resource practice, but one may generalise to say that the concerns of the human relations movement with the management of people have been generalised into a set of practices employed by firms concerning recruitment, retention, rewards, motivation and the commitment of employees. In many firms there is a key departure from the spirit of the human relations approach, in that human resource management (HRM) is a staff function separate from line management; arguably this is a central issue in how HRM works and we will discuss it both specifically, in terms of the effectiveness of HRM, and generally, in terms of line-staff arrangements within the firm. There is also an academic discipline called HRM, which tends to focus on the design and effectiveness of individual HRM practices and the performance implications for firms of combinations or bundles of practices which involve intractable measurement problems.

The second legacy is the very sizeable academic field of organisational behaviour (OB). Its theoretical agenda is similar to that of human relations, but it is methodologically far more sophisticated, in part because it has developed as a branch of applied psychology. It is not primarily concerned with rationality – compared with economics rationality it is treated as a variable not an assumption – and is not always concerned to measure business outcomes such as efficiency or productivity. This chapter seeks to illustrate rather than summarise this field and its contribution, and it will do so by looking at how OB deals with two concepts which have been central so far: hierarchy and contract. These emerge prominently in the OB literature as studies of leadership and the psychological contract respectively. We turn first to HRM.

5.3 The emergence of HRMOne of the most influential modern models of the practice of the HRM function has been developed by Ulrich (2005). He argues for the organisation of the function to be framed around three types of activity, all of which support the actions of line managers in the management of people in different ways.

1. Shared services is the set of basic administrative tasks in the management of a workforce through which economies of scale may be achieved by the concentration of activity on an enterprise-wide basis. These activities include management of payroll, absence control and employee databases more generally. The measures of performance of such units are essentially the quality and timeliness of data provision and cost. There are clear outsourcing possibilities, since inter-firm scale economies can be exploited subject to confidentiality concerns about employee data.

2. Centres of expertise focus on areas of knowledge where there may also be economies of scale but where the complexity of information required is such that line managers require support and advice where relevant issues arise. Examples would be the selection of employees, designing and applying reward systems (including pensions), employee relations (including dealing with unions), training and termination of employees. Compliance with relevant law is often an issue in all such areas. Performance measures here are more complicated, but would include, in addition to those for shared services, some line management evaluation of quality of advice.


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3. Business partnership involves small HRM teams working with high-level line management to improve firm performance. Examples would be issues such as strategy implementation, organisational design and change management. The central ideas of HRM are central to the business of the firm, assisting it to maximise its use of human assets. Measurement problems here are intractable.

This is a simplifying, prescriptive and aspirational model, which summarises both the activities a firm may require from its HRM function and also the variance in relationships between line and staff. The shared service and expertise activities essentially deal with, on the one hand, the rise in bureaucratic employment issues within large firms and, second, the regulatory burden on employment. The assumptions underlying business partnership are qualitatively very different and are tied to a resource-based view of the firm; they include the idea that the management of human assets may be a source of competitive advantage. As Pfeffer puts it:

There is a substantial and rapidly expanding body of evidence….that speaks to the strong connection between how firms manage their people and the economic results achieved. (Pfeffer, 1994)

The relevance of this model here is twofold. First, using this threefold division is a useful heuristic for describing the development of HRM practice historically. Second, as we shall see, it outlines the core tensions within HRM practice. Let us look at each in turn.

Two early and uncorrelated developments are noteworthy. First, in some large 19th-century firms, ‘welfare’ departments were established that were concerned with the provision of canteens, medical services, housing and, in some cases, social work. This was particularly strong in Germany. In the UK it was associated with philanthropy by owners whose concerns were religious or social, rather than economic, for example Cadbury, the confectioner, and Wedgewood, in ceramics. The earliest recorded such department in the USA was the National Cash Register Company in 1897 (Wren, 2005, p.186). Retrospective cynicism might see in these ventures the pursuit of business objectives – for example, seeing the company doctor might be seen as a form of absence control – but there is probably also a genuinely altruistic interpretation, and no systematic evidence of cost-benefit analysis in the well-documented examples such as Cadbury.

Slightly later, more focused activities were driven by the workforce quality needs of scientific management: selective hiring, incentive pay and absence control were all central to the pursuit of efficiency. If this pursuit generated recourse to trade unions by employees, a set of bargaining and consultation arrangements needed to be designed and monitored. In addition, as Gospel notes:

Over time, in most countries, there has been a gradual build up in (government) intervention in terms of rights off the job (state welfare and pension systems), rights on the job (workmen’s compensation, health and safety, racial and sexual equality legislation) and regulation of collective employment matters (the law on trade unions, collective bargaining and information and consultation at work). (Gospel, 2007, p.423)

These tendencies came together in the post-First World War period in many firms and countries in the formation of a ‘personnel department’, which was essentially a lubricant to the bureaucratic employment relationship providing shared service and expertise-type functions to line


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management. As such, it tended towards reactive response and problem solving according to a line-management agenda, or in order to ensure compliance with external rules. This should not lead to a view of the personnel department as marginal. For example, Dobbin et al. (1993) argue that a combination of equal opportunity law and the power of the personnel function is a better explanation for the spread of internal labour market structures in the USA than is the efficiency argument. But the role did not include the strategic elements Ulrich (2005) identifies.

The major change to what we now characterise as HRM came in the 1970s and 1980s, first in the USA. It required several intellectual developments elsewhere and, as is frequently the case, a sharp shock and an opportunity. First, if HRM were to influence strategy, somebody had to be ‘doing’ strategy explicitly. As we show below, the academic study of business strategy was a relatively late arrival, and even early versions such as strategic planning post-date the emergence of personnel departments. But, second, the role of the management of people as an element in strategy needed to be articulated in a particular form – the resource-based theory of the firm. Once this intellectual toolkit was in place, and employees could be seen as a source of competitive advantage, the stage was clear for HRM to make a bid to be strategic.

The sharp shock was provided by the emergence of Japanese competition in the 1980s and in particular the use of what became described as high-performance work practices within systems. Consummate cooperation required HRM technique. The opportunity was provided by the removal of a constraint − the decline of trade unionism. The language of personnel management changed. An influential text was Beer et al.’s Managing human assets, embedding the idea that ‘people are an asset not a cost’ and thus the HRM function needs to be ‘fully aware of and involved in all strategic and business decisions’ (Beer et al., 1984, p.292). HRM became strategic – defined as the ‘pattern of planned human resource deployments and activities intended to enable an organisation to achieve its goals’ (Wright and McMahan, 1992, p.298). And the idea resonated among popular strategy authors:

The way we organise our business and leverage our intangible assets, primarily vested in people, is one of the most fundamental and sustainable sources of competitive advantage. (Hamel and Prahalad, 1996)

Three central issues emerged to beset this literature. First, what were these HRM practices that one deployed in order to generate competitive advantage and how did one deploy them? Second, were these practices the same everywhere? If firm strategies were different, were different bundles of HRM practices required to deliver them? Third, how could one measure the impact of HRM practices on competitive advantage? We look at each in turn.

Pfeffer (1994) offers seven generic (universally applicable) practices for building profits by ‘putting people first’. They are:

1. employment security

2. selective hiring

3. self-managed teams or team working

4. high pay contingent on company performance

5. extensive training

6. reduction of status differences

7. sharing information.


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This is an influential list but it is not the only list in play. Meta-analysis of the field (Wall and Wood, 2005) shows a variety of different items listed as HRM practices across a variety of studies. There is no widespread agreement on what should be included or excluded. So there is not a ‘theory’ of HRM and performance here. It is not clear whether the effects of these practices on performance would simply be additive or whether, in particular combinations, the whole would be greater than the sum of the parts. Some empirical studies around the relationship between these kinds of practices and performance variables generate very specific numbers; Huselid (1995), for example, argued that a dollar value of firm benefit could be identified for unit value increases in HRM use. However, the path by which these practices generate outputs remains obscure. The proposition that any firm adopting any HRM practice or set thereof will generate a performance improvement is weak. As Macduffie has remarked:

Innovative human resource practices are likely to contribute to improved economic performance only when three conditions are met: when employees possess knowledge and skills that managers lack, when employees are motivated to apply this skill and knowledge through discretionary effort; and when the firm’s business or production strategy can only be achieved when employees contribute such discretionary effort. (Macduffie, 1995, p.199)

However unattractive the Taylorist model of the excellent worker might be, it contains a model of the relationship between labour input, production process, output and reward that studies of the HRM performance link have so far failed to generate. This is, of course, partly because the unit of analysis for Taylor is the individual, while that for HRM studies is variable.

The second issue concerns inter-firm variation; if strategies are different, maybe HRM practices need to be. Wall and Wood (2005, p.431) identify three types of ‘fit’ between HRM practices and the firm.

1. Internal fit ‘posits synergy among the practices, meaning that their collective effect will be greater than the sum of their individual parts’.

2. Organisational fit ‘concerns the role of HRM in enhancing the effectiveness of other organizational practices or technologies, and vice versa’.

3. Strategic fit ‘assumes that HRM practices need to be aligned with the organization’s strategy to have their full effect on performance’.

The first concept of fit suggests that some combinations of HRM practice may be better than others. The second implies that some combinations may optimise the performance of certain technologies. But the third reaches to the heart of Ulrich’s idea about the organisation of the HRM department and its relationship to line management. For Ulrich, the essence of competitive advantage from HRM is the HRM–line management relationship, rather than a bundle of practices. The bundle of practices is a dependent variable. Let us look at the line management−staff relationship.

Witzel (2002, pp.51–54) offers an interesting set of observations. First, he notes that the line management−staff division, which became common practice and parlance in the business world, originated in military organisation. He uses the Prussian army in the 19th century as an example.


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Second, he noted that the line management units had to be Taylorist and the staff units had to coordinate, integrate and be goal-focused. Third, he offers a specific example: the Franco-Prussian war of 1870 when less well armed and less experienced Prussian troops defeated an apparently superior French army by virtue of the line management−staff relationship that generated flexibility and rapid response. Fourth, he observes that a prominent early management theorist, the American Harrington Emerson, observed this conflict directly and incorporated his views of it in his writings. The core issue that links 19th-century military operations and 21st-century management of people in organisations is the observation that an organisational attribute, rather than a capital or resource asset, can be the source of competitive advantage and, moreover, that organisations that are asset-poor can outcompete those that are asset-rich.

The third problem is of a rather different nature. Whatever the claimed impact of HRM practices on a dependent variable such as performance, it is still unclear whether any competitive advantage is being generated. If, as many authors have implied, effective management of human assets leads to competitive success, it is necessary to show that these ‘bundles’ of practices can be better implemented by some firms than others. There has been little analysis of this. In the car industry example used above, the key performance variable ‘man hours per car’ has fallen across the industry, in part as a consequence of the adoption of high-performance work practices, but this can simply generate a price war rather than a competitive advantage (Jurgens et al., 2003; Willman and Winch, 1985).

De Menezes et al. have used data on both operations management practice and the use of HRM in a longitudinal study that indicates the way forward in this field. They show that firms that innovate early and integrate HRM with production practices generate sustained performance improvement, arguing:

An integrated managerial philosophy is potentially a source of competitive advantage, highlighting the importance of continuous improvement and learning that is often allied to the lean production concept. (De Menezes et al., 2010, p.1065)

So, in the HRM field, it does not seem that simply adopting a practice or set of practices employed by a successful competitor offers a high chance of replicating their success. Many firms in many sectors do so for both practices and for targets, in a process known as ‘benchmarking’. As we have seen, we may improve an aspect of our own firm’s performance by adopting ‘best practice’ but it may not improve relative performance. Methodologically, it involves sampling on the dependent variable which can give rise to unexpected, often disappointing, results. In the HRM field, many studies even use cross-sectional data to study allegedly causal HRM performance relationships; these methods cannot discriminate effectively between firms that might be improving performance using HRM and firms that have improved performance so can afford the investment of HRM.

Activity 5.1

Find the organisations chart for a large firm of your own choice on the web. Try to identify line and staff functions.


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5.4 Organisational behaviourThis has recently been influentially defined as:

A field of study devoted to understanding, explaining, and ultimately improving the attitudes and behaviours of individuals and groups in organizations. (Colquitt, LePine and Wesson, 2009, p.7)

Let us deal with the omissions from this definition first. Organisational behaviour (OB) academics are not primarily concerned with firms, or firm performance, and they seldom study markets. The disciplines on which OB draws – psychology and social psychology – are deployed in markets by others (looking at consumer behaviour, see below) but these literatures have emerged separately. The field looks at affective states as worthy of study in themselves, and generates sophisticated models to relate affective states and behaviours. It is highly fragmented, with no core body of theory delineating a model of human behaviour comparable to economic man, and it is arguably held together by rather looser assumptions and a commonality of method.

Two sub-fields illustrate how this field differs from one that makes assumptions about rationality and self-interest. Economic approaches use principal–agent theory to describe hierarchy, while OB talks about leadership. Economists describe employment contracts as incomplete, whereas OB academics study how these silences are filled. We look at each in turn, as illustrations of the difference between rational choice and psychological approaches to organisation.

Figure 5.1: The history of leadership studies

Consideration of leadership precedes the business literature on the subject by centuries, with much of the literature concerned with military leadership. The academic literature emerges in the 1920s and the unit of analysis is the individual; leadership is about traits possessed by individuals, which may be innate (dispositional) or acquired (through experience). Trait theory is fundamentally depressing for the business literature because it implies that efforts to improve the quality of leadership in an organisation must be limited to appropriate selection of staff. The historical development of the literature away from this (see

1920s 1930s 1950s 1970s CURRENT

Followership

LeaderMemberExchange

ContingencyTheory

StyleTheories

Trait Theory

Personality,skills

Generic skillsets

Tasks, power,uncertainty

Relationshipstrust

Needs, valuesperformance


45

Figure 5.1) may be viewed as an attempt to embrace an increasing array of organisational variables in order to understand how leadership may be developed or enhanced within particular contexts.

Sensitivity both to the idea of leadership as an attribute of a finite set of persons and, more generally, to any notion of innate advantage was high in the West between the demise of the Third Reich and the discovery of DNA (which was to provide a language for discussion of genetics). Leadership became about behaviours that individuals could practise, although it was acknowledged that different individuals might practise them to different degrees. The approach was developed in the Midwest of the USA. Studies by Ohio State University identified two categories of leadership behaviour:

1. consideration: develop relationships of mutual trust, respect for followers’ ideas, regard for their feelings

2. initiating structure: define and structure own role and those of followers.

These behaviours could score either high or low and were independent of each other, but it was claimed that the most effective leaders came up high on both. The research was based on questionnaires to leaders and subordinates. The Michigan Leadership Studies began in the 1950s and indicated that leaders could be classified as either ‘employee centred’ or ‘job centred’. Twin categories of ‘task’ and relationship behaviours – similar to the Ohio studies – were identified which were theoretically orthogonal but empirically associated with being ‘high’ in the most effective behavioural pattern.

These two categories have, in modified form, very wide currency in the management literature being used in the analysis of teams and teamwork at the micro level, and organisational culture at the macro level. They replicate in this literature the broad engineering concern for efficiency and the human relations concern for work relations. It is thus worth mentioning that direct measures of efficiency were not taken in these large-scale sets of studies.

Although these studies used questionnaires from subordinates, they were still generic in arguing for leadership behaviours independent of either context or audience. The next two developments in leadership research addressed each in turn. Contingency theories suggested sources of variation in leadership effectiveness based in the power of the leader, the nature of the task to be completed and level of uncertainty in the work situation. Subsequent theories placed more emphasis on the leader–follower relationship as the unit of analysis; leader–follower relationships were variable, but patterned, and follower reactions to leadership became increasingly the most significant dependent variable. In a modern definition:

Leadership is the process of influencing others to understand and agree about what needs to be done and how to do it, and the process of facilitating individual and collective efforts to accomplish shared objectives. (Yukl, 2006, p.10)

Increasingly, the desired outcomes of leadership were seen to be followers’ emotional states and the behaviours associated with them. Increasingly, too, the leadership behaviours seen to be associated with such states and behaviours were distanced from monitoring and incentives. A simple interpretation of what an effective economic ‘principal’ should do, would be ‘bad leadership’ in the OB literature. A corollary of this is that many


46

writers on organisations treat the combination of monitoring, incentives and discipline as likely to generate precisely the outcome it was intended to avoid (Ghoshal and Moran, 1996). Leadership is a set of behaviours performed independent of hierarchical position.

A pervasive theme in the literature contrasts ostensibly rational activities around monitoring and exchange relationships with those focused more on affect. For example, Bass (1985) distinguishes transactional leaders who motivate employees through an exchange process involving rewarding and correcting, from transformational leaders who motivate employees by activating their higher order needs, offering inspiration, intellectual stimulation and individualised consideration. Using different language but basically the same dichotomy, Kotter (1990) distinguishes managerial activities such as planning, budgeting and controlling – the business of ‘coping with large organisations’ – from leadership activities such as setting direction, providing vision and inspiration and building teams. In more modern versions, ideas such as ‘authenticity’ and ‘charisma’ are used to describe effective leadership.

5.5 The psychological contractSociologists have long been interested in exchange. But these social exchange theorists tended to take a broader view than simple economic exchange. Resources, both tangible and intangible, are included and there needs to be some notion of balance. Social exchange is voluntary and continuing, but it entails unspecified obligations about the exact nature of reciprocity. Where social exchange continues, norms of reciprocity are established, such that people both help and avoid injuring those who have helped them. Continuing reciprocity generates trust between exchangers, which may provide the basis for enduring and profitable network linkages. Trust relations have dynamics, such that trustworthiness is rewarded and its loss can lead to a cycle of mistrust.

One important strand of OB develops this line of thought to analyse employment relationships: psychological contract research. Again, the human relations movement is in the lineage. Argyris (1960) used the term ‘psychological work contract’ to describe a Hawthorne-type relationship between informal work groups and managers involving a trade between stable wages and employment security for the former, and higher productivity and fewer grievances for the latter. The cognitive elements in this approach were refined by Schein (1970) in a focus on the matching of expectations and exchange performance where each party might have a different set of both preferences and perspectives.

But the defining approach that has generated the bulk of research on the matter is from Rousseau. She defines a psychological contract as:

Individual beliefs (sic), shaped by the organisation, regarding terms of an exchange agreement between individuals and their organisation. (Rousseau, 1995, p.9)

The content of the contract involves both tangible and intangible elements; a considerable segment may be ‘promise-based obligations’ made by one party concerning long-term commitments to the other, and these promises themselves may be both implicit and explicit. While there is much debate and critique about the definition of constructs, it is clear what the objective is here: to capture the sum of the relationship between employee and employer where that relationship involves, for the employee


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at least, a massively significant social exchange where both economic interests and psychological concerns are embraced. The former is captured by the notion of a transactional contract, typically short-term economic exchanges with limited emotional investment. The latter is captured by a second dimension − the relational contract − where both parties make considerable idiosyncratic investments.

Psychological contract breach – termed rather emotively ‘violation’ – is both significant and common; employees, at least, quite frequently perceive violation in terms of broken promises and studies have indicated consequences, depending on the seriousness of the breach (or its perception), in terms of lowered satisfaction or commitment, or even absence and exit. Breach appears to have a bigger downside impact than contract fulfilment has as an upside, and Rousseau herself (2005) appears to see them as independent constructs rather than as a dichotomy or continuum; employees report both fulfilment and breach coexisting within the same contract. Repeated breach generates a shift from a relational to a more transactional contract.

The approach has been criticised. Rousseau appears to focus primarily on the employee, a tendency reinforced by over-reliance on her graduating MBA students as research subjects. However, even if it is only a theory of employee behaviour, it has substantial scope. It is not particularly helpful to management practice, since the circumstances under which an individual generates a psychological contract involve individual difference variables and are quite idiographic. But it does quite clearly allow one to fill in the silences in the employment contract noted by Williamson. Moreover, it stresses the social and psychological factors that allow for the effective operation of highly incomplete contracts in ways that help to understand the impact of affect on contract performance.

There are clear links to institutional economics, not least the distinction between relational and transactional contract dimensions. Rousseau herself explicitly uses Hirschman’s exit-voice model in explaining responses to violation (1995, p.134). And many violations develop out of what are fundamentally agency problems: promises are made by recruiters or line managers who then leave the organisation, which in turn neither recognises nor honours the perceived promise. However, at the most fundamental level, similarity is assured by the fact that the psychological contract approach is a bounded rationality model.

We can elaborate on this by looking at how individuals construct contracts. Rousseau suggests that individuals have contract schema: prototypical mental models about how contracts work. These are rooted in ‘predispositions’, then based on work history and develop by accumulating information about contract obligations in work settings. Typically new entrants have incomplete information about the organisation, and Williamsonian problems about the construction of complicated contingent claims contracts that cover future contribution and reward. Information cues originate with co-workers or managers, and information search and processing is discontinuous – higher where there may be contract violation. Once formed, they have heuristic characteristics; they frame information search and are resistant to change (Rousseau, 1995, pp.27–36; 2001).

Activity 5.2

Read the first and last chapters of the Rousseau book or the article by Coyle-Shapiro and Parzefall. List why the ‘breach’ of a psychological contract might be important for an employer.


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5.6 Overview of chapterThis chapter has tried to trace the human relations legacy down to more modern theories (OB) and practices (HRM). At the most fundamental level, both are concerned to explore or manage the non-rational side of organisations, or at least the interactions between rational and non-rational. OB is based on the premise that it is intrinsically worthwhile to study attitudes and behaviours in organisations independent of any concerns with measures of performance. HRM is based on the premise that one can apply this knowledge to how people are managed in organisations in order to improve performance.


• describe the history of personnel and human resource management

• discuss the content of human resource management approaches

• explain the relationship between human resource management and organisational behaviour.

5.8 Test your knowledge and understandingHow would you account for the rise of the human resource function within large firms?

Chapter 6: The origins of management science

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• describe quantitative modelling approaches to operations management

• explain the basic concepts of queuing systems, inventory control and linear programming

• discuss some of the challenges facing the implementation of these management science concepts.

6.1.2 Essential readingHopp, W.J. and M.L. Spearman Factory physics. (New York: McGraw-Hill, 2007)

[ISBN 9781577667391] Chapter 2, pp.48–56.

6.1.3 Further readingAckoff, R.L. ‘The future of operational research is past’, Journal of the

Operational Research Society 30 1979, pp.93–104.Hillier, F.S. and G.J. Lieberman Introduction to operations research. (New York:

McGraw-Hill, 2004) [ISBN 9780071238281].Kirby, M.W. ‘Operations research trajectories: the Anglo-American experience

from the 1940s to the 1990s’, Operations Research 48 2000, pp.661−70.Mitchell, G. The practice of operational research. (Chichester: Wiley, 1993)

[ISBN 9780471939825].Pidd, M. Tools for thinking: modelling in management science. (Chichester: Wiley,

2003) [ISBN 9780470847954].

6.1.4 Works cited Ackoff, R.L. and M.W. Sasieni Fundamentals of operations research. (Hoboken,

NJ: John Wiley & Sons, 1968) [ISBN 9780471003335].Bixby, R.E. ‘Solving real-world linear programs: a decade and more of progress’,

Operations Research 50 2002, p.1.Dantzig, G.B. ‘Linear programming’, Operations Research, 50(1), 2002, pp.42–47.Gross, D. and C.M. Harris Fundamentals of queueing theory. (Chichester: Wiley,

1998) [ISBN 0471170836]. (Wiley Interscience, 2008) fourth edition [ISBN 9780471791270].

Morse, P.M. and G.E. Kimball Methods of operations research. (Cambridge, Mass.: Technology Press of MIT, 1950).

6.2 IntroductionTaylor’s aspiration (discussed in Chapter 3) was to develop a scientific management based on the universal application of certain principles. However, Taylor’s ideas were technological rather than truly scientific. One outgrowth of scientific management was management science (MS). Here are three definitions:

1. a scientific method of providing executive departments with a quantitative basis for decisions regarding the operations under their control. (Morse and Kimball, 1950)


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2. (1) the application of scientific method (2) by interdisciplinary teams (3) to problems involving the control of organized (man-machine) systems so as to provide solutions which best serve the purposes of the organisation as a whole. (Ackoff and Sasieni, 1968)

3. The attack of modern science on complex problems arising in the direction and management of large systems of men, machines, materials and money in industry, business, government and defence. Its distinctive approach is to develop a scientific model of the system, incorporating measurements of factors such as change and risk, with which to predict and compare the outcomes of alternative decisions, strategies or controls. The purpose is to help management determine its policy and actions scientifically. (S. Beer, Operational Research Quarterly, 1963, p.282)

MS often works by the construction of models that are external and explicit representations of part of reality as seen by the people who wish to use that model to understand, to change, to manage and to control that reality (Pidd, 2003, p.12). Figure 6.1 below elaborates. The inputs to the model are our beliefs and assumptions about reality and the scenarios we wish to play out. The outputs are insights on the way firms work and estimates about quantities.

BeliefsAssumptions Scenarios

Insights, Estimates of quantites of interest

Model

Figure 6.1: The role of a model

We will illustrate this approach by looking at three classic examples of operations research (OR)/MS:

1. inventory management

2. telephone networks

3. military planning.

Then we will turn to the post-war development of management science.

6.3 Inventory managementThe issue we wish to deal with here is as follows. A company (manufacturer, retailer) has to place orders for some goods. How often should they order and how big should their orders be?

We formalise this as follows:

D demand rate (in units per year)

c unit production cost (in £)

s fixed setup cost (in £)

h holding cost (in £ per unit per year)

Q lot size (in units)


51

2

( ) 202

DC Q h sD sDQDQ Q h

= − = → = (1)

Let us suppose that:

• We only order product when we run out.

• We will order enough to meet demand.

The total cost is as in equation 1 above:

We need to be clear about what assumptions we are making here.

• cD does not vary with Q

• Let’s set c=0 and plug in some numbers as follows:

D 1000

s £500

h £35

0

5000

15000

25000

10000

20000

30000

10 30 50 70

90 110

130

150

170

190

210

230

250

290

330

370

270

310

350

c(Q)

sD/Q

hQ/2

Figure 6.2: Curves for holding costs, fixed setup costs and unit production costs

We set holding cost and order cost equal. The curves are as in Figure 6.2.

2 3!

1 ...1! 2! 3! !

n

nnBB

n

λ

λ λ λ λ=

+ + + + +(3)

2 2 22

hQ sD sD sDQ QQ h h

= → = → = (4)

( )1

µ λ−(2)


52

Alternatively, differentiate c(Q):

This formula is the economic order quantity formula.

What does this tell us? First, it gives us a basis for computing lot sizes (if the assumptions are satisfied). Second, it gives us insight into a key trade-off between holding and ordering costs.

6.4 Telephone networks

6.4.1 The advent of queueing theoryA.K. Erlang, a mathematician working for the Copenhagen Telephone Company, was interested in applying probability to understanding lost calls in telephone networks.

Let us suppose:

• a telephone exchange has n lines

• a telephone call lasts for one time unit

• λ calls arrive per unit time, according to a Poisson process.

A Poisson process is a continuous time, discrete state stochastic process with a continuous rate of increase which is independent of the process’s history. It is commonly used to model arrivals of large numbers of customers who act independently.

Erlang was able to show that the probability of a call arriving and finding all lines in use (and consequently, the call being ‘lost’) is:

Erlang’s work stimulated a general theory of queueing, as follows.

Suppose:

• a number of randomly arriving customers seek a service with rate λ

• a number of servers process these customers with rate μ .

We are interested in the three following questions:

4. How many will be turned away?

5. How long will customers wait?

6. How long will waiting times be?

With one server, and assuming demand arrives according to a Poisson process and that service times are exponentially distributed, then, in steady-state, assuming μ >λ, the mean time for the customer’s journey will be:

(Gross and Harris, 1998)

The formula ρ = λ /μ is called the ‘traffic intensity’.

Let us see what happens if we increase the speed of the system, holding traffic intensity constant.

2

( ) 202

DC Q h sD sDQDQ Q h

= − = → = (5)

B =

11 2! 3!

λ λ2 λ2 λn

λn

n!

n!

+ + + + +…(1)

( )1

µ λ−(2)


53

Figure 6.3: Queueing theory: an illustration

For ρ=5/6

As Figure 6.3 shows, as the system scales up, it becomes more ‘fluid’ and waiting time diminishes.

Queueing theory is a massively general theory with applications to:

• telecommunications

• manufacturing facilities

• passenger transportation

• supply chains

• retail outlets

• healthcare systems

• law courts

• back office functions.

Activity 6.1

Visit a supermarket near you, ideally at a busy time. How do they manage the queues at the checkout?

6.5 Military planningInventory management and queueing theory are early examples of the success of management science, but the field was given immense impetus by the involvement of civilian scientists seconded to the analysis of military operations. ‘Operations analysis’ was used in determining operational policy against submarines in the Battle of Britain, the D-Day landings and Allied bombing campaigns. After 1945, many of the insights from this experience were to become important civilian applications. A good example is the development of linear programming.

George Dantzig, a mathematician, had spent the Second World War in the Pentagon. He had become interested in mechanising the planning process and his work was to leave OR/MS with one of its most important tools – linear programming. A linear programming problem runs as follows.

6

5

4

3

2

1

01 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

pedestrianscarsJourneytime

(holding traffic

intensityconstant)

λ (arrival rate, customers per unit time)

trucks Service timeWaiting time


54

Consider the problem of assigning 70 people to 70 jobs. Suppose a value or benefit vij would result if the ith person is assigned to the jth job. An activity consists in assigning the ith person to the jth job. The restrictions are:

i. each person must be assigned to a job (there are 70 such)

ii. each job must also be filled (also 70).

The level of an activity is either 1, meaning it will be used, or 0, meaning it will not.

Thus there are or 140 restrictions, or 4,900 activities with 4,900 corresponding 0–1 decision variables xij. Unfortunately there are ‘70 different possible solutions or ways to make the assignments’ (Dantzig, 2002, p.42).

This sort of mathematical object:

Or, in matrix notation:

Maximise vw

by varying x

subject to Ax ≤ b

and x ≥ b

consisting of a quantity to be maximised or minimised (an ‘objective function’) by varying certain other quantities (‘decision variables’) subject to certain restrictions on the combined values of the decision variables (a ‘constraint set’) is called a ‘mathematical program’. Dantzig was to discover a method for practically and efficiently computing the solution to such problems.

Maximise 150x1 + 250x2

subject to

x1 ≤ 4 (1)

x2 ≤ 6 (2)

3x1 + 3x1 ≤ 18 (3)

5x1 + 4x1 ≤ 40 (4)

x1, x2 ≥ 0 (5)

Another example of linear programming runs as follows.

You run a tailoring business. There is demand for up to 400 formal dresses at £150 each and 600 suits at £250 each. You have 1,800 hours’ labour. It requires:

• three hours for a dress

• two hours for a suit.

Maximise

by varying the xijs

subject to the constraints

∑ ∑m m

i=1 j=1vijxij

∑m

j=1xij = 1

∑m

i=1xij = 1

xij = 0 or 1


55

You have 4,000 yards of material:

• a dress takes five yards

• and a suit takes four yards.

You have already paid for labour and material and have no alternative uses for them. How might you find the revenue-maximising number of dresses and suits to produce?

0

2

4

6

8

10

2 4 6 8 100

x2

x1

(2)

(4)

(3)

(5)(1)

Figure 6.4: An example of linear programming

The decision variables x1 and x2 represent, respectively, hundreds of dresses and suits. Constraints (1) and (2) represent the constraints imposed by demand (at the price you have set). Constraints (3) and (4) represent constraints imposed by labour and material respectively. The remaining constraints (5) are required to ensure that you do not produce negative quantities of dresses and suits.

In 1947, Dantzig’s simplex algorithm was applied to a ‘diet problem’. The problem was huge for the time – nine constraints and 77 variables. Arriving at the optimal solution by manual calculators took 10 people 120 days. As long as calculations had to be done by hand, mathematical tractability imposed serious constraints. Data availability and quality severely limited opportunities for modelling.

The most intuitive way to model a system is to simulate. In the decades after the war, hand simulation gave way to computer simulation. And computer simulation packages have become steadily more user-friendly, visual and interactive.

Moore’s law describes how computing power doubles every two years, but the speed of LP codes has increased much faster than that. Bixby (2002) reports an LP with 5 million rows and 7 million columns (variables) solvable in half an hour. Very complex problems (e.g. airline crew scheduling) are now practically solvable.

Activity 6.2

You own an aeroplane with 200 seats. You wish to fill all those seats, at the highest revenue possible, on the next flight. What actions can you take to ensure this?


56

6.6 Overview of chapterThis chapter looked at the development, post-Taylorism, of quantitative modelling approaches to operations management. Basic concepts of three broad areas of management science – inventory control, queuing systems and linear programming –were introduced and their core insights and propositions examined.


• describe quantitative modelling approaches to operations management

• explain the basic concepts of queuing systems, inventory control and linear programming

• discuss some of the challenges facing the implementation of these management science concepts.

6.8 Test your knowledge and understandingWhat factors influence a firm’s decision about how much inventory to hold?

Chapter 7: Accounting, finance and the firm

57




• describe four different perspectives on the firm with the purpose of comparing their approach to accounting and finance

• discuss the principal–agent model

• explain the differences between economic and sociological models of the firm.

7.1.2 Essential readingWillman, Chapter 2, Theme 1.Watts, R. and J. Zimmerman Positive accounting theory. (Englewood Cliffs, NJ;

London: Prentice-Hall 1986) [ISBN 9780136861713] Chapter 1.

7.1.3 Further readingJensen, M. ‘Organization theory and methodology’, The Accounting Review

58(2) 1983, pp.319–39.Jensen, M.C. and W.H. Meckling ‘The theory of the firm: managerial behaviour,

agency costs and ownership structure’, Journal of Financial Economics 3 1976, pp.305–60.

Miller, P. ‘Accounting as social and institutional practice: an introduction’ in Hopwood, A. and P. Miller (eds) Accounting as social and institutional practice. (Cambridge: Cambridge University Press 1994) [ISBN 9780521469654].

Rajan, R.C. and L. Zingales ‘The firm as a dedicated hierarchy: a theory of the origins and growth of firms’, Quarterly Journal of Economics 116(3) 2001, pp.805–51.

Simon, H. ‘A behavioural model of rational choice’, The Quarterly Journal of Economics 69(1) 1955, pp.99–118.

7.1.4 Works citedA.V. Bhidé The origin and evolution of new businesses. (Oxford: Oxford

University Press, 2000) [ISBN 9780195131444].Burchell, S., C. Clubb, A. Hopwood, J. Hughes and J. Nahapiet ‘On the roles

of accounting in organizations and society’, Accounting, Organizations and Society 5(1) 1980, pp.5–27.

Chapman, C.S., D.J. Cooper and P.B. Miller (eds) Accounting, organizations and institutions: essays in honour of Anthony Hopwood. (Oxford; New York: Oxford University Press, 2009) [ISBN 9780199546350].

Jackson, T. Inside Intel: Andrew Grove and the rise of the world’s most powerful chip company. (New York, NY: Dutton Books, 1997) [ISBN 9780525941415].

Mackenzie, D. An engine, not a camera: how financial models shape markets. (Cambridge: MIT Press, 2006) [ISBN 9780262633673].

Rajan, R.C. and L. Zingales ‘Financial dependence and growth’, American Economic Review 88(3) 1998, pp.559–86.

Weetman, P. Financial accounting: an introduction. (Harlow: Pearson, 2013) sixth edition [ISBN 9780273789253].

http://www.sciencedirect.com.gate2.library.lse.ac.uk/science/journal/03613682

http://www.sciencedirect.com.gate2.library.lse.ac.uk/science/journal/03613682

http://www.sciencedirect.com.gate2.library.lse.ac.uk/science/journal/03613682/5/1


58

Zingales L.G. ‘In search of new foundations’, The Journal of Finance 55(4) 2000), pp.1623–53.

7.2 Background: definitions of accounting and financeThe following definitions are relevant for this and future chapters.

• We take finance to mean the different ways in which firms raise capital for the operation of the firm.

• We take accounting to mean the conceptual frameworks through which principals monitor the activities of their agents.

See also Weetman (2013) for further definitions.

7.3 Principal–agent theoryThe principal–agent model operates with assumptions about behaviour and stylised actors as follows.

1. There are two sets of actors in the firm. Principals are the shareholders in the firm and agents are the managers.

2. Actors aim to maximise their individual utility.

3. The agent acquires information that is not available to the principal and consequently may act against the interests of the principal.

4. This generates information asymmetries which are the basis of moral hazard.

5. The principal monitors the agent to prevent this.

6. The purpose of monitoring is to exercise control over the agent by acquiring information about the agent’s actions.

7. Principals compare the benefits and costs associated with each outcome and are unconstrained in their ability to compute infinite amounts of information.

8. Principals seek to achieve an optimal solution in which production is maximised.

The firm is seen as a nexus of contracts between principals and agents (Jensen and Meckling, 1976). The focus is on the contractual relations between self-interested individuals with divergent interests. Agency generates costs. These costs are the sum of the costs of structuring, bonding and monitoring contracts between agents. The purpose of monitoring is to exercise control over the agent by acquiring information about the quality of the agent’s actions. Maximising agents minimise the costs in any contracting relationship. Consequently, whichever organisational form emerges reflects a set of contractual arrangements that minimise agency costs.

Here is an example from the field of pension fund management, where there is an ‘accountability deficit’. The principals in a pension fund are those, normally employers and employees, who make contributions to the fund which are then invested on their behalf. There are at least three layers of actors whose interests may conflict with those of principals. First, investment consultants monitor the investment performance of fund management firms and advise on the selection of fund managers. Second, those fund management firms invest the pension fund’s assets on a daily basis. Third, the lawyers to the pension fund advise on the selection of an investment consultant. For the principals, the monitoring costs are potentially high and, since these agents have different types of expertise, monitoring is difficult.


59

Here is another example. Intel was established when Robert Noyce, general manager of Fairchild Semiconductor, and Gordon Moore, head of research at Fairchild Semiconductor, left Fairchild to form Integrated Electronics. Shortly before their departure, a scientist in Moore’s department discovered the ‘silicon gate’ technique to produce semiconductor memory devices. Intel subsequently became the market leader in producing such devices. As Jackson remarks, ‘Intel was founded to steal the silicon gate process from Fairchild’ (1997, pp.26–27). This type of development was not uncommon in the dot.com boom. Seventy-one of the firms included in the Inc. 500 list of young, fast-growing firms were founded by people who replicated or modified an idea encountered in their previous employment (Bhide, 2000, p.94).

Let us look at the dynamics more formally.

1. Horizontal hierarchy

2. Vertical hierarchy

Watchmaker

RamPietro

Watchmaker

Pietro

Ram

Figure 7.1: Horizontal and vertical hierarchies

Figure 7.1 shows an example of a horizontal hierarchy. Let us assume that managers specialise and that, in specialising, each manager gets half of what he produces and half of what the managers below him produce. (The most senior manager gets everything that is sent up.) In competing, the degree of expropriability of the technology is 0.75. Whoever produces more − the entrepreneur or the competing manager − wins the competition. In the horizontal hierarchy, with the specialisation alternative, each manager produces one unit and keeps half. In the competitive alternative, each manager produces 0.75, but the entrepreneur produces one and wins. Consequently, the managers decide to specialise. Since the managers do not work with each other, they cannot collude to beat the entrepreneur. The entrepreneur uses the logic of ‘divide and rule’ to maintain control.

In the example of the vertical hierarchy in Figure 7.1, the outcomes are different. Under the specialisation alternative, Pietro will give half of his one unit of production to the entrepreneur. He will also get half of the half unit of production sent up by Ram. His total benefit is therefore ½ + ¼ = ¾. In the compete alternative, Pietro leaves the firm together with Ram. Together they make ¾ each for a total production of 1½. They therefore compete with the entrepreneur and win. Pietro will make ¾ himself and keep half of the ¾ produced by Ram, for a total of 11

8. Ram will keep ½ + ¾ = 3 8 .

The incentive for managers to compete is greater in the vertical hierarchy because superior managers – and not the watchmaker – command the loyalty of subordinates.

Successful vertical integration is conditional on growing the firm in stages. Let us take this a little further.


60

Assume that:

• expropriability is 0.49

• there is a cost of specialising of 1.01

• managers work only for two periods.

The watchmaker avoids competition by taking on Pietro in the first period and Ram in the second period. Pietro specialises since his payoff is ½ + ¾ = 1¼ − 1.01 = .24. Ram specialises because he will gain Pietro’s place in the second period. Conversely, horizontal organization may be achieved by giving the managers the potential to participate in the rents of the critical resource if they specialise. The lesson is that too much power to managers will destabilise the entrepreneur’s position, while too little will give them little interest in the well-being of the firm.

In this framework control is defined in terms of access, which provides individuals with the opportunity to expropriate the entrepreneur’s resource. It is not identified with legal rights of ownership. Access is equivalent to the degree to which an actor has information, which is what is delivered by accounting. Thus, in this perspective the role of financial accounting and management accounting are intertwined. There are differentials of information within the firm and outside of it. Further, in contrast to the theory of the firm, which focuses on legal ownership as determining the boundaries of the firm, the focus on expropriation entails that the knowledge that one has into the core processes constituting the success of the firm determines the firm boundaries. Accounting plays a similar role.

Here is another illustration. In 1994 Maurice Saatchi, Chairman of Saatchi & Saatchi, an advertising agency, proposed a generous options package for himself, despite underperformance of the stock. But his principals, US fund managers who owned 30 per cent of the stock, voted down the proposal at the shareholder’s meeting. Maurice Saatchi and several key senior executives then left, forming rival M&C Saatchi. They also damaged the original firm, Saatchi & Saatchi, by taking some key accounts with them. Zingales remarked, ‘In hindsight, the mistake the US fund managers made was to treat Saatchi & Saatchi as a traditional company with clear boundaries defined by its assets’ (2000, p.1641). That is, they mistook legal ownership and managerial control.

Agency theory Power

Authority No. Firm is just a ‘nexus of contracts’

Yes. Managers occupy a position that facilitates expropriation

Rationality The actor processes information. Information asymmetries are core

Information asymmetry remains core

Accounting Accounting is the means through which owners of the firm monitor their investment

Accounting is distributed throughout the firm

Figure 7.2: Agency theory and managerial power theory compared

This shows us the limits of a simple agency theory perspective compared to one that recognises managerial power. We show the differences in Figure 7.2.

We can examine another aspect of agency theory with a simple three-actor model incorporating the idea that the parties have limited (‘bounded’) rather than complete rationality.


61

There are three actors in the firm: the entrepreneur, the customer and the employee. Each actor has inducements to participate in the firm and makes contributions to the firm, as in Figure 7.3 below.

Inducement Contribution

Entrepreneur Revenue Costs

Employee Wages Labour

Customer Good Purchase price

Worker

CustomerEntrepreneur

Figure 7.3: Agency theory in a simple three-actor model

Each actor will remain in the firm for as long as the satisfaction they derive from the net balance of inducements over contributions is greater than the satisfaction they could obtain if they withdrew.

All of the actors involved in the negotiation are active and, in particular, the employee is motivated. This opens up the question of the goodwill and social satisfaction provided by the employee, as it does the motivations of the entrepreneur and customer.

Actors not only bargain in terms of increments of contribution and inducement, but also in terms of all-or-none participation or non-participation. The decisions made by these parties are boundedly rational in that decision-makers have limited ability to recall and process information and limited insight into their own decision processes and future preferences. Actors satisfy their claims because they rely on habitual rules to make heuristic judgements about the world. The need to rely on ongoing patterns of interaction to make decisions, which entail that they form organisations. Again, we can contrast this behaviouralist approach with that of agency theory as in Figure 7.4 below.

Agency theory Behaviouralism

The firm objectives

Maximisation of the value of the firm

The viability of the firm

Rationality Full Bounded

Accounting Role

Accounting contributes to monitoring

Biases in behaviour entail that there are systematic influences on the way in which accounting is conducted

Figure 7.4: Agency theory and behaviouralism compared

7.4 The institutional environments of accounting This approach is taken further in literature that pays attention to the organisational and social contexts in which accounting (and finance) operate (Burchell et al., 1980). The focus is on the legitimacy of formalised structures. A technical activity becomes ‘institutionalised’ when it acquires a taken-for-granted quality that entails it is perceived as being correct. Accounting does not merely describe pre-existing economic reality, but rather plays a constitutive or inventive role in the construction of economic reality. ‘Accounting is a craft without an essence’ (Chapman et al., 2009, p.2). Accounting and finance are seen as a set of practices that evolve over time within a social context.


62

An example may be taken from Mackenzie’s (2006) study introduction of option trading on the Chicago Board Options Exchange. The trading of options had been hampered by the absence of an accepted mechanism for options pricing. The Black & Scholes formula was developed, which eventually provided a rigorous mathematical proof of the value of option contracts. However, initially the prices of options did not closely match the prices predicted by application of the formula. By contrast, it was only after the majority adopted the formula that the prices converged on its predictions. Mackenzie terms this ‘performativity’: adoption of economic theory entails that actors act in accordance with the precepts of economic models. Following the 1987 market crash, prices diverged again as ‘put’ options – akin to the purchase of insurance against a fall in an asset’s price – became more expensive than the formulas predicted.

In the literature on ‘critical’ accounting we may distinguish three strands.1. Political economic accounts: accounting is not a technically neutral

practice, but rather reflects sets of interests in conflict or competition.

2. Ethnographies of accounting: examining the role of accounting practices in the lived experience of users of accounts.

3. Accounting and governing economic life: contributing to social theory by examining the role played by accounting in the functioning of society.

Activity 7.1

Find a business magazine (such as Business Week or The Economist). Identify at least one story that describes an ‘agency’ problem.

Principal/ agent

Positional power

Behaviouralism Institutionalism

Model of agency

2 actors 3 actors 3 actors No model

Accounting Passive Passive Constructivist Constructivist

Information key?

Yes Yes Yes No – focus on standards

Evidentiary base

Statistics Experiments/ statistics

Experiments Qualitative

Scope of analysis

Organisation Organisation Organisation Environment

Figure 7.5: Various analytical perspectives on accounting compared

7.5 Overview of chapterWe summarise this chapter’s argument in Figure 7.5 above. Accounting, probably the oldest of the management disciplines, can be seen from a variety of perspectives. It is a technical ‘tool’ for monitoring and performance measurement, but also a set of calculative devices which constitute the fabric of the firm. Markets are, for economists, coordinated by prices, but the hierarchies which constitute firms are coordinated by accounting rules.


63


• describe four different perspectives on the firm with the purpose of comparing their approach to accounting and finance

• discuss the principal–agent model

• explain the differences between economic and sociological models of the firm.

7.7 Test your knowledge and understandingWhy have so many firms adopted a multi-divisional structure?

Notes


64

Chapter 8: Management accounting: costing

65




• describe the distinction between direct and indirect costs

• discuss different costing mechanisms

• compare the different approaches to costing, with examples.

8.1.2 Essential readingWillman, Theme 0.Kaplan, R. and A. Atkinson Advanced management accounting. (Harlow: Pearson

Education, 1998) third edition [ISBN 9780130802200] Chapters 3 and 4.

8.1.3 Further readingCooper, R. and B. Chew ‘Control tomorrow’s costs through today’s designs’,

Harvard Business Review January–February 1996).Hiromoto, T. ‘Another hidden edge – Japanese management accounting’,

Harvard Business Review July–August 1988.Johnson, H. and R. Kaplan Relevance lost: the rise and fall of management

accounting. (Boston, MA: Harvard Business School Press, 2001) [ISBN 9780875842547], Chapters 1 and 3.

Merchant, K. and M. Shields ‘When and why to measure costs less accurately to improve decision making’, Accounting Horizons 7(2) 1993, pp.76–81.

8.1.4 Works cited Labro, E. ‘Is a focus on collaborative product development warranted from a

cost commitment perspective?’, Supply Chain Management, 11(6), 2006, pp.503–09.

Weetman, P. Financial and management accounting. (Harlow: Financial Times/Prentice Hall, 2006) fourth edition [ISBN 9780273703693].

8.2 Purposes of cost accountingCosting procedures assist in making decisions regarding:

• mix of products, services and customers offered

• enhancement of the productivity of operations

• development of competitive strategy, for example, inventories.

Additionally, cost accounting provides information for financial accounting disclosures. A debate in costing revolves around the question of whether each objective implies a different approach to assessing cost.

Let us begin with a set of definitions:

Variable costs: Costs that vary proportionately with the level of an activity such as a production or sales activity.

Fixed costs: Costs that remain constant despite changes in the level of an activity such as a production or sales activity.


66

Direct costs: Costs that are unambiguously linked to the production of a particular output.

Indirect costs: The cost of capacity that provides services to more than one product.

Examples are given in Figure 8.1 below.

Direct costs:

‘Costs that are unambiguously linked to the production of a particular output.’

Indirect costs:

‘The cost of capacity that provides services to more than one product.’

Variable costs:

‘Costs that vary proportionately with the level of an activity such as a production or sales activity.’

Examples: Materials Example: Power costs for running machines where the power consumed by each machine is unknown, handling materials, cost of setting up machines.

Fixed costs:

‘Costs that tend to remain constant despite changes in the level of an activity such as a production or sales activity.’

Examples: Machine or labour that is dedicated to the production of one product.

Examples: Personnel costs, communication systems, depreciation on buildings and equipment and amortisation on intangibles.

Figure 8.1: Absorption costing

(See Kaplan and Atkinson, 1998.)

8.3 Production and service departmentsProduction departments directly produce or distribute the firm’s output. Examples include machining centres and assembly departments.

Service departments provide services to production departments. Examples are utilities, maintenance, purchasing, scheduling, production control, stockroom, materials handling, housekeeping, customer order handling and information systems.

The allocation of indirect costs seeks to assign the costs that are associated with service departments (‘overheads’) to particular resource utilisation processes. Figure 8.2 presents this graphically. (See Kaplan and Atkinson, 1998, p.61.)

Figure 8.2: Two-stage absorption costing system

Servicedepartments

Servicedepartmentexpenses

Productioncentreexpenses

Productioncost centres

Direct machine hours Direct labour hours

Products


67

The cost control objectives in assigning service department costs are manifold (see Kaplan & Atkinson, 1998). They:

• provide incentives for (1) the managers of service departments to operate efficiently, and (2) managers of production departments to efficiently utilise service department outputs

• ration demand from user departments: managers of production departments incur costs for using a service department

• provide signals on service department efficiency by adding a charge to the final product that reflects the cost of the service department

• facilitate comparison with externally sourced services, by assigning a price to the service provided by the service department

• provide opportunities for price/quality trade-offs as managers have information with which to negotiate with the service department.

We need to measure the costs of using service departments and this can be done in one of two ways.

‘Attribution’ is the process of assigning a cost that is unambiguously associated with a particular cost object to that particular cost object. For example, the power department knows how much is used by the manufacturing department by metering the power used by that department.

‘Allocation’ is the process of assigning a resource cost to a department or product when a direct measure does not exist for the quantity of the resource consumed by the department or product.

In absorption costing the allocation of indirect costs to a department takes place with reference to the proportion of a certain direct cost incurred by that department. For example, ‘direct labour hours’ refers to the proportion of total hours worked that are attributable to a particular department to which the indirect cost is allocated.

Example 1:

The monthly cost for Service Department S is $1,000,000.

The total number of hours worked within the plant is 100,000.

Within Department D 50,000 total hours were incurred.

Therefore allocation of indirect costs to Department D

= $1,000,000 * 50,000 hours / 100,000 hours = $500,000

The selection of a particular driver to assign indirect cost to a product depends on the nature of the activity.

Direct labour dollars ………………... Manual assembly

Direct labour hours

Machine hours ………………….…… Automatic machines

Units produced

Materials processed…………...... Continuous use of resource


68

Example 2: Tradition costing in a three-product firm.

Product A Product B Product C Total

Units sold 20,000 15,000 5,000

Direct material cost 2,500 2,300 2,000

Direct labour cost 1,400 2,100 700

Labour hours / unit 2 3 1 90,000

Machine hours / unit 1 2 5 75,000

Production batches 2 4 6 12

Sales orders 10 18 20 48

Purchase orders 20 15 25 60

Indirect costs 33,000,000

Depreciation 80,000,000

Materials & tools 17,000,000

Total: 135,000,000

Our task is to allocate the total indirect costs to the three products.

Product A Product B Product C



Indirect cost 3,000 4,500 1,500

Total 6,900 8,900 4,200

Product A: $135,000,000 indirect costs / 90,000 direct labour hours = overhead rate of $1,500 / direct labour hour

$1,500 * 2 labour hours / unit = $3,000

Product B: = 135,000,000 / 90,000 * 3 = $4,500

Product C: = 135,000,000 / 90,000 * 1 = $1,500

There are a number of problems associated with the allocation of indirect costs. For example, a meter measures the power consumed by a factory from the power plant, but does not measure the usage of power by the departments within the factory. One possibility is to allocate the usage of power to the departments with reference to the horsepower of the machines in the plant or the hours the machines have been operated (machine hours). However, ‘machine hours’ is an imprecise method for allocating indirect costs here, since machine hours in the production department bear no causal relationship to the actual consumption of resources in the service department.

To take another example: You take a trip to Bath for the dual purpose of sightseeing and shopping. The train ride costs £20. How do you allocate this cost between the two activities? You could use time spent on sightseeing versus shopping. Suppose you spend 50 per cent of your time sightseeing. You allocate £10 of overhead to the sightseeing activity.

However, there is no direct cause-and-effect relationship between the method used to distinguish between the different elements of these joint costs and the monetary allocation to sightseeing. Similarly, when allocating head-office salaries between different products, the bases used for this allocation bear no causal relationship to the actual consumption


69

of resources in the service department. There is, strictly speaking, no relationship between the cost driver and the overhead costs that are actually consumed by the production department.

Activity 8.1

Think about the production of this subject guide. What are the main direct and indirect costs?

8.4 Activity-based costing A second costing approach is activity-based costing (ABC: see Kaplan and Atkinson, 1998). This is illustrated graphically in Figure 8.3. The first step involves collecting data on specific activities. As Kaplan and Atkinson note, ‘One does not need extensive time and motion studies to link resource spending to activities performed’ (1998, p.99). Data on activities is gathered through:

• interviews

• surveys

• activity dictionaries.

The degree of acceptable approximation depends on cost and the objective of the costing exercise. Greater precision is required for productivity enhancements than for costing products, services and customers.

Figure 8.3: Activity-based costing

(See Kaplan and Atkinson, 1998, p.98.)

Activity-based costing links the resource expenses to activities performed in the firm, establishing a direct causal link between expenses that, in absorption costing systems, are treated as common and are allocated to products. The hierarchy of unit, batch, product and customer-sustaining activities captures the fact that different types of products consume resources differently and in accordance with the complexity of the product.

Unit-level activities represent work performed for every unit of product or service produced. The quantity of resources used by unit-level activities is proportional to the products’ production and sales volumes. Cost drivers for unit-level activities include labour hours, machine hours and material quantity processed. However, one of the advantages of activity-based costing is that it recognises that support activities that are conducted with respect to production are not only driven by unit-level activities.

Inspectincomingmaterials

Maintainmachines

Movematerials

Set upmachines

Preparetooling

Maintenancehours

Setuphours

No. ofsetups

No. ofmoves

No. ofreceipts

$ /Maintenancehour

$ / Setuphour

$ /setup

$ /move

$ /receipt

1) Resource

2) Activity

3) Product /service /customers

Resource driver

ActivityCostDriver

Indirect labour


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Batch-level activities include setting up a machine for a new production run, purchasing materials and processing a customer order. Resources required to perform a batch-level activity are independent of the number of units in the batch (number of components produced after a set-up, number of items in a purchase order or the number of products in a customer shipment).

Product-sustaining activities represent work performed to enable the production of individual products (or services) to occur.

Customer-sustaining activities represent work that enables the company to sell to an individual customer, but which is independent of the volume and mix of the products (and services) sold and delivered to the customer.

We may also use activity-based costing on Example 2, of our three-product firm. It emerges that the absorption and activity-based methods produce markedly different cost outcomes per product.

Product firm example – ABC

Activity Activity driver Indirect wages Depreciation Materials

Assembly Machine hours 12,000,000 58,000,000 5,000,000

Reception Purchase orders 9,000,000 2,000,000 1,000,000

Set up No. of batches 6,000,000 15,000,000 3,000,000

Wrapping Sales orders 6,000,000 10,000,000 8,000,000

Total 33,000,000 85,000,000 17,000,000

Total indirect costs = 135,000,000

Example: calculating the reception cost of product A.

Total cost of reception activity = 12,000,000 (= 9,000,000 + 2,000,000 + 1,000,000)

The number of purchase orders, the activity cost driver = 60

The activity cost driver rate = 12,000,000 / 60 = 200,000

The indirect cost allocation to product A, which consumed 20 purchase orders = 20 *200,000 = 4,000,000

Reception cost / units of product A = 4,000,000 / 20,000 units = 200.




Assembly 1,000 2,000 5,000

Reception costs 200 200 1,000

Set-up costs 200 533 2,400

Wrapping 250 600 2,000

Total 5,550 7,733 13,100

Comparison of absorption and ABC product costs:


Absorption 6,900 8,900 4,200

ABC 5,550 7,733 13,100

% Difference -20% -13% + 212%


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Figure 8.4 summarises the main difference between the two methods (see Labro, 2006). The choice of a management accounting technique has a major impact on the cost allocation outcome.

Figure 8.4: Absorption costing and activity-based costing compared

Activity 8.2

Examine the results of your last activity on the direct and indirect costs of this guide. Apply activity-based costing to the production of this guide. What differences emerge?

8.5 Overview of chapter This chapter introduced management accounting as a set of practices relating to the internal control of the corporation and their evolving role in facilitating decision making by managers. We focused on costing. We distinguished between direct and indirect costs, and between standard costing methods and activity-based costing.


• describe the distinction between direct and indirect costs

• discuss different costing mechanisms

• compare the different approaches to costing, with examples.

8.7 Test your knowledge and understandingWhat would be the best costing method to adopt in a retailing business?

Absorption costing Activity-based costing

RESOURCES

COST POOLS

PRODUCTS

RESOURCE COSTPOOLS

ACTIVITY COSTS

PRODUCTS / CUSTOMERS /

SERVICES

Allocations

Machine hoursDirect labour hours

Resource costdrivers

Activity cost drivers

Notes


72

Chapter 9: Management accounting: decentralisation and performance measurement

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• introduce themes in management accounting relating to the collecting, processing and analysis of information regarding the internal functioning of the firm

• describe the relationship between performance measurement and decentralised forms of organisation

• apply the balanced scorecard.

9.1.2 Essential readingWillman, Themes 4 and 5.Kaplan, R. and A. Atkinson Advanced management accounting. (Harlow: Pearson

Education, 1998) third edition [ISBN 9780130802200] Chapter 8.

9.1.3 Further readingChristensen, J. and J. Demski Accounting theory: an information content

perspective. (Boston: McGraw-Hill/Irwin, 2002) [ISBN 9780072296914] Chapter 10.

Ittner, C.D. Larcker, M. Meyer ‘Subjectivity and the weighting of performance measures: evidence from a balanced scorecard’, The Accounting Review 78(3) 2003, pp.725–58.

Merchant, K. and W.A. van der Stede Management control systems. (Harlow: Financial Times/Prentice Hall, 2007) [ISBN 9780273737612] Chapter 11, pp.470−79.

Meyer, M. and V. Gupta ‘The performance paradox’, Research in Organizational Behaviour 16 1993, pp.309–69, especially pp.325–53.

Meyer, M. Rethinking performance measurement: beyond the balanced scorecard. (Cambridge; New York: Cambridge University Press, 2002) [ISBN 9780521812436 (hbk)].

9.1.4 Works citedBraverman, H. Labor and monopoly capital. (New York: Monthly Review Press,

1974) [ISBN 9780853453406].Chandler, A. The visible hand: the managerial revolution in American business.

(Harvard: Harvard University Press, 1977).Kaplan, R. ‘The evolution of management accounting’, The Accounting Review

LIX(3) 1984, pp.390–418.Kogut, B. and D. Parkinson ‘Adoption of the multidivisional structure’, Industrial

and Corporate Change 7(2) 1998, pp.249–73.Kaplan, R. and D. Norton The balanced scorecard. (Harvard: Harvard Business

School Press, 1996) [ISBN 9780875846514].


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9.2 IntroductionAccording to Meyer (2002), the goals of performance measurement are as follows.

1. Look back: an assessment of how the unit performed in the past.

2. Look ahead: past performance should provide information on future return.

3. Compensate: performance measures should inform compensation.

4. Motivate: performance measures should motivate and direct action.

5. Roll up from the bottom to the top: performance measures of those in the smallest organisational units within the firm should be linked to the performance of the firm as a whole.

6. Cascade down from the top to the bottom: firm-level performance measures should inform the work of those at the smallest organisational units within the firm.

7. Compare: performance measurement should facilitate comparison between units.

We need to bear these goals in mind when we consider the development of performance measures within the large multidivisional firm.

9.3 HistoryApplying scientific management brought with it a concern to measure costs. Already in the 19th century, textile firms and then railroads had developed internal administrative controls to manage complex processes. Railroads in particular had to record and summarise massive volumes of (often small) transactions; in addition to financial statements, they also developed the reporting of operating statistics such as cost of transport per ton mile and operating ratios (normally income divided by sales) (Kaplan, 1984, p.392). As we showed in Chapter 2, the railroad legacy was significant for the emerging mass production and distribution business in the USA, and this was true also of accounting practices. A central problem was the separation of operating or direct costs from fixed or overhead costs. There was little concern for returns on capital invested (Chandler 1977, pp.269–79).

Scientific management advocates may be credited with two changes of emphasis. The first was to start the practice of allocating overhead costs, but not capital costs, to products or periods (Kaplan, 1984, p.394). The second was concerned with labour and, as we have seen, had two aspects of this: to develop standard labour and material costs per unit of output, and to use these standards for devising piece rates and bonus payments (Braverman, 1974). A key point here is the integration, at least for production workers, of organisation-wide measures with individual performance pay. There were many issues to deal with (see below) but this − the link between individual and organisational performance − has arguably been a ‘holy grail’ for performance measurement ever since.

As organisations became larger and more complicated, developing a set of performance measures that could operate across the entire firm became more problematic. Thanks to the work of Chandler (1977), developments of considerable significance at DuPont and then subsequently General Motors have been well documented. Faced with the problem of measuring the outputs of functionally diverse departments such as purchasing, manufacturing and sales, DuPont developed the measure of return on


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investment (ROI), which could also be used as a measure of corporate financial performance. Capital could thus be allocated to activities generating the highest return. In this functionally organised business, then, we have local profit measures evaluating departmental performance in a way directly analogous to the ideas of cost-or profit centres used much later (Kaplan, 1984, p.398).

In 1984, Kaplan felt that the development of management accounting had rather stagnated, since the achievements of General Motors (by 1925) in adapting these ideas to the emerging divisionalised form. As we shall see below, he was to do something about this, but it is worthwhile summarising his account of the four key elements of the system.

1. The overall objective was to achieve an average satisfactory ROI across a business cycle, not to achieve year on year increases.

2. There developed a pricing system to determine target prices that would yield the desired ROI when production and sales were ‘normal’ (operationally defined as 80% of capacity).

3. An explicit senior manager incentive scheme, based on an explicit profit formula, linked divisional and firm performance to individual rewards.

4. A sophisticated market-based transfer pricing system priced interdivisional transfer of product.

(Kaplan, 1984, pp.399–401.)

In order to understand these issues, let us compare measures in a unitary versus divisionalised firm. The unitary structure is presented in Figure 9.1.

Figure 9.1: The unitary firm (late 19th to early 20th centuries)

Different functions within the firm have measures appropriate to their activities, which are essentially difficult to compare. By contrast, within the multidivisional firm of Figure 9.2, we are attempting unified performance measures across diverse activities.

Gross sales less returns Capacity utilisation, down time, defects

Costs, raw materials,

availability

Accountingmetric

Organisationaldesign

Purchasing Manufacturing Sales

Central office


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Revenues of CEarnings of C

Revenues of AEarnings of A

Accountingmetric

Organisationaldesign

Unit ACars

Unit BTVs

Unit CFridges

Central office

Revenues of BEarnings of B

Purchasing Manufacturing Sales

Figure 9.2: The multidivisional firm

We have looked at revenues and earnings in Figure 9.2 as the key measures. Let us look at how these might be applied.

9.4 Using return on investment (ROI)Return on investment is a generic term capturing the idea that the returns of the business can be measured with reference to the income generated by the capital invested in the firm.

Return on investment (ROI) = income / invested capital.

As mentioned further in the chapter on financial ratios, the great advantage of the ROI measure is that it can be decomposed into components that reflect margins and efficiency.

Income / invested capital = (income / revenue) * (revenue / invested capital) = return on sales (margins) * capital turnover (efficiency)

In fact a whole hierarchy of such measures can be created and, in each case, a component of performance is identified and its contribution assessed. Another advantage of return on investment is that it can be compared to rates of interest, inflation or the performance of other businesses. However, there are at least two drawbacks of using ROI.

1. It was initially associated with a management style that was engaged with the operational details of the businesses concerned. In the post-war period, diversification meant that central-office managers were less familiar with the underlying business. ROI places a greater strategic emphasis on financial measures than on operational ones.

2. Actions that increase ROI may decrease the long-run value of the division and the firm and vice versa. For example, lowering investment may yield short-term increases in returns, but long-term declines.

Here is an example.

Division A of a firm has assets of $100,000 and net income of 25,000. ROI = 25,000 / 100,000 = 25%

Suppose Division A’s cost of capital is 15% and that a new investment opportunity yielding 4,000 on an investment of 20,000 becomes available.


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Despite the fact that the ROI of the new investment is 20% and is higher than the cost of capital of 15%, the divisional manager will reject the new opportunity because it reduces the division’s overall ROI.

= (100,000 + 20,000) / (25,000 + 4,000) = 24.2%

The idea of residual income becomes important here. It is defined as follows.

Residual income = (income – cost of capital) * invested capital. In our example:

Division A (before) Division A (after)

Invested capital 100,000 120,000

Net income before tax 20,000 24,000

Capital charge (@ 15%) 15,000 18,000

Residual income 5,000 6,000

The residual income calculation determines whether a project contributes or destroys value. In this case, it is positive. This therefore reflects the requirement of shareholders for both profits and growth and aligns the interests of the divisional manager and the enterprise.

Residual income was introduced at companies such as General Electric and Matsushita in the 1950s and 1930s, respectively, but was not otherwise widely adopted. Why?

1. The shortcomings of ROI metrics only came to be the focus of investors when there was greater discipline exercised by financial markets upon firms, for example through the takeover boom of the 1980s. ROI in our example makes divisional managers risk-averse and driven by the performance measure rather than the increase in shareholder value.

2. The widespread adoption of financial techniques for estimating the cost of capital only occurred following the development and dissemination of financial economics in the mid-1960s. Particularly if the capital for the new investment came from cash flows elsewhere within the company, the cost of capital could be wildly inaccurate.

3. There was a mismatch between internal accounting practices and practices for external financial reporting.

An extension of this line of reasoning finds expression in the concept of economic value added (EVA). EVA is calculated as follows:

EVA = (adjusted after tax operating income – cost of capital) * invested capital

EVA extends the residual income method by:

1. deriving the capital charge from methods developed in financial economics (capital asset pricing model, CAPM, which we discuss in the next session)

2. adjusting the reported accounting information in accordance with the framework of financial economics; it adopts a fair value conception of accounting − where necessary making adjustments to Financial Accounting Standard standards.

For example: Expensing versus capitalising

Leasing

Price level adjustments

Depreciation


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Both EVA and ABC (dealt with earlier) are complementary in that both may be calculated at the level of product, activity or customer. EVA focuses attention on areas where profitability is low. ABC may then be applied to correct these at a level of granularity. Both are rooted in the attempt to derive underlying economic processes in a manner that corrects for imperfect financial accounting standards. Kaplan and Atkinson note:

The integration of ABC and EVA is natural. Both were developed to solve a distortion in the financial reporting of company economics. ABC corrected the arbitrary allocations of factory overhead to products and the failure to assign other indirect expenses to products and customers. EVA corrected the failure of financial accounting statements to recognize the cost of capital as an economic expense before arriving at a profitability figure. (Kaplan and Atkinson, 1998, p.523)

Activity 9.1

Go to the website of any large firm and find the latest financial statement, then calculate the ROI.

9.5 The balanced scorecardThe balanced scorecard (see Kaplan and Atkinson, 1998, pp.367–80) is one of the most widely used performance measurement tools. In it, financial measures (addressing the shareholder requirements) are combined with non-financial performance measures reflecting the requirements of customers, suppliers and employees, processes, technology and innovation.

It balances ‘short-term’ financial measures with ‘long-term’ perspectives on innovation, business process design and customer and employee relationships. Kaplan and Atkinson (1998) argue that assessments of performance that focus exclusively on historical financial performance are no longer adequate, and that we need to introduce a focus on innovation and a forward-looking dimension.

The balanced scorecard thus combines four perspectives on performance:

1. financial perspective (shareholders)

2. customer perspective (customers)

3. internal business perspective (processes, technology and innovation)

4. learning and growth perspective (employees).

9.5.1 Customer value propositionsProduct and service attributes relating to functionality, price and quality, and the management of customer relationship, include delivery of the product/service to the customer, delivery and response times.

9.5.2 Internal business perspectiveThere are steps in a ‘generic value chain’:

1. Innovation: The balanced scorecard focuses on the development of long-term metrics associated with innovation. It incorporates metrics relating to how well the firm identifies new markets and customers, and develops new products and services, into the performance measurement system. For example, there may be measures relating to basic and applied research, such as percentage of sales from new product/proprietary products, new product introduction versus


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competitors/versus plan, and time to develop next generation of products. There may also be measures relating to product development, such as time to market of new product, percentage of products meeting customer expectation at launch and the time that it takes the product to break even.

2. Operations: focus placed on efficient, consistent and timely delivery of products and services to customers. Focus on quality and cycle time. Relevant measures here include, for example, yield (ratio of good items produced to good items entering the process), the time from a particular point in the production process to some point near completion, waste/returns, customer waiting times and the accuracy of the information provided to customers.

3. Post-sales service: warranty and repair activities, treatments of defects and returns, and processing and administration of payments; the time it takes to resolve a client’s complaint; the percentage of calls dealt with to customers’ satisfaction. There can be a shift from examining business processes within individual departments to an integrated analysis of performance of processes within the enterprise.

9.5.3 Organisational learning and growth perspectiveThese relate to people, systems and organisational procedures. These issues form the platform through which changes in internal business processes can achieve the requisite business performance to accommodate the requirements of shareholders and customers. There is a focus on employee satisfaction as contributing to employee retention and productivity. Information system capabilities can measure real-time availability of information to relevant employees. Organisational procedures can measure the alignment of employee incentives with overall success factors.

9.5.4 Combining the perspectivesBalanced scorecards try to describe cause-and-effect relationships between different aspects relating to the firm’s performance: ‘The measurement system should make the relationships (hypotheses) among objectives (and measures) in the various perspectives explicit so that they can be managed and validated’ (Kaplan and Atkinson, 1998, p.376). A chain of cause-and-effect relationships is established between performance drivers and outcomes to provide an overview of how the overall strategic performance of the firm is generated. It seeks to meet the previously identified shareholder requirement for financial return and requirements of targeted customers for price, timeliness and quality while maintaining satisfied employees. This focus is achieved by adopting a perspective that incorporates the requirements of all the major participants in the firm.

The balanced scorecard and EVA are complementary. Economic value added metrics may be adopted as the financial metrics within the balanced scorecard. These entail that investment decisions are consistent with maximising the net present value of shareholders’ wealth. Both EVA and balanced scorecard seek to address short-termism in performance measurement. Employed as a remuneration tool, EVA is a means for incentivising employees to act in ways that support shareholder value. EVA and the balanced scorecard integrate strategy at all levels of the firm. Both involve centralised decision-making. When performance measures include both financial and non-financial factors, managers must perform in certain dimensions as specified by top managers through the performance measures selected.


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9.6 Financial (ROI) versus balanced scorecard performance measure

Financial (ROI) versus balanced scorecard performance measure

Financial (ROI) Balanced scorecard

Constituents Shareholders primarily Shareholders, customers and employees

Discretion Easy to manipulate Less subject to discretion

Perspective Historical Forward-looking

Scope Decentralised Integrative

Business era Industrial age Information age

Table 9.1: Critique of the balanced scorecard: institutionalist perspective

(See Meyer and Gupta, 1993.)

The institutional (sociological) approach begins by examining puzzles regarding performance measurement. A key question is: why is it common to observe an organisation employing many different types of performance measure at the same time? Another is: why does the number of performance measures used by firms increase over time?

The question to be examined is… whether rational people in rational organizations would prefer seemingly non-rational performance measures.

Might the type of disorderliness observed in virtually all organizations and in their performance measures… contribute to rather than detract from coordination and control, motivation and incentive alignment and hence to positive outcomes? (Meyer and Gupta, 1993, p.317.)

A key function of performance measurement is to reflect variability in performance and to discriminate between good and bad performers. As a performance measure is used, it is less able to discriminate the best from the worst because their performances converge.

There are four reasons for this ‘running down’ of performance measures:

1. positive learning results in performance improvement

2. perverse learning is reflected in appearance but not the fact of improvement

3. high performers are selected and low performers excluded

4. measures exposing persistent differences in performance outcomes are suppressed.

This is the ‘use it and lose it’ principle in performance measurement.

If the performance measure that has run down is replaced with a measure that defines performance in the same way, the new measure would, like the old one, be unable to pick up variability. Necessarily, new performance measures are uncorrelated with existing measures and pick up new types of performance, and the evolution of performance measures entails that different aspects of a firm’s performance are assessed over time.

Consequently, coordination and control is best achieved through multiple, uncorrelated and changing performance measures that render it difficult to know exactly what performance is (Meyer and Gupta, 1993, p.311).

The balanced scorecard argues that by combining performance measures underneath a common bottom line, one achieves control. In contrast, the


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performance paradox argues that control is achieved only by abandoning the attempt to combine uncorrelated measures in such a way.

9.7 Overview of chapterThe chapter introduced themes in management accounting relating to the collecting, processing and analysis of information regarding the internal functioning of the firm. We investigated the relationship between performance measurement and decentralised forms of organisation. Following a review of different aspects of management accounting, we covered issues concerning agency and institutionalist perspectives on performance measurement. We outlined and discussed the balanced scorecard.


• introduce themes in management accounting relating to the collecting, processing and analysis of information regarding the internal functioning of the firm

• describe the relationship between performance measurement and decentralised forms of organisation

• apply the balanced scorecard.

9.9 Test your knowledge and understanding1. What is a ‘balanced scorecard’? Why has the idea of a balanced

scorecard become so influential?

2. What are the strengths and weaknesses of return on investment measures of divisional performance? How successful are other measures of financial performance in addressing these weaknesses?

3. How does the balanced scorecard seek to further enhance performance measurement through non-financial measures of performance?

Notes


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Chapter 10: Financial accounting

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• discuss the three elements of the financial report, namely, the balance sheet, the profit and loss statement and the cash flow statement

• interrogate the qualitative requirements of financial accounting for relevance, reliability, comparability and understandability.

10.1.2 Essential readingWillman, Chapter 8.Weetman, P. Financial accounting: an introduction. (Harlow: Pearson, 2013)

sixth edition [ISBN 9780273789253] Chapter 7.

10.1.3 Further readingAtrill, P. and E. McLaney Financial accounting for decision makers. (Harlow:

Financial Times Prentice Hall, 2013) [ISBN 9780273785637], Chapters 2 and 3.

Higson, C. ‘Financial statements: Economic analysis and interpretation’ (2006).Weetman, P. Financial accounting: an introduction. (Harlow: Pearson, 2013)

sixth edition [ISBN 9780273789253] especially Chapters 8–12.

10.2 Management accounting and financial accountingThe distinction between management accounts and financial accounts is long standing. Management accounting tools tend to be used for specific managerial purposes and can be varied (though not in an unlimited way) by managers pursuing particular objectives: for example, they may choose a particular costing method or resource allocation tool; they may collect information weekly, monthly or less often. In addition, management accounts may collect information which is non-financial (e.g. on specific activities), though often this information is collected because it is seen to predict future cash flows.

Financial accounts, by contrast, are there in part to control managerial agency and have predominantly (but not exclusively) an external audience. They must contain certain elements and be set out in a particular way to attain standards. Table 10.1 attempts to summarise the differences between management and financial accounting.

Management accounting Financial accounting

Nature of reports Specific purpose General purpose

Level of detail Disaggregated Aggregated

Regulations Unregulated Regulated

Reporting interval As required Mostly annual

Time orientation Past and future Mostly past period

Information Financials and non-financials Mostly quantifiable in monetary terms

Table 10.1: Management accounting and financial accounting compared


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Financial accounts have a number of discrete users, not all of whom have the same information interests. They include:

• owners and investors

• employees

• lenders

• suppliers and other trade creditors

• customers

• governments and their agencies

• public interest.

Some of these users do not share the same concerns; for example, investors and tax authorities have very different interests in the financial performance of a given company.

Financial accounts must comply with certain broad requirements for relevance, reliability, comparability and understandability. These may be elaborated as follows.

• Relevance relates to information that has the ability to influence decisions. Information quality in financial reports may have confirmatory value (relating to past events) or predictive value (future ones).

• Reliability relates to the requirement that the information in reports be a faithful and complete representation. It should in addition be presented in a neutral way, be free from error and be based on prudential assumptions.

• Comparability relates to the principles that similarities and differences between companies or over time should be discernible and capable of evaluation. It relates to the consistency of the data and the level of disclosure.

• Understandability has two distinct components, but the underlying principle is that the significance of information can be perceived. The first component relates to users: information must be presented in a way users can understand. The second relates to the level of aggregation of the data and the categories of classification.

10.3 The elements of the financial reportWe focus here on the three key components:

1. The balance sheet is concerned with the financial position at a particular moment in time. What is the accumulated wealth of the business at the end of each period, and what form does the wealth take?

2. The income statement (US, IFRS)/profit and loss account (UK). How much wealth was generated (or lost) by the business over that period?

3. The cash flow statement. What cash movements took place over a particular period?

Activity 10.1

Go to the website of a large firm of your choice and find the financial report. Answer questions 1–3 above.


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10.3.1 The balance sheetThe balance sheet is an assessment of a stock of wealth. The income statement and cash flow statement are both concerned with measuring flows (of wealth and cash respectively) during a particular time period.

Let us look at each in turn.

Cash

Trade receivables

Inventory

Property, plant and equipment

Intangibles (e.g. brands)

Financial assets and investments

Other assets

TOTAL ASSETS

Debt

Trade payables

Provisions

Other liabilities

Equity shareholder’s funds

Non-equity shareholder’s funds

TOTAL LIABILITIES and SHAREHOLDERS’ FUNDS

}}

List of the firm’s assets

List of the claims on the firm’s

assets by third parties and the

shareholders

Total Assets = Total Liabilities + Shareholders’ Funds

OR

Assets – Liabilities = Shareholders’ Equity

Figure 10.1: The elements of the balance sheet

As we will see, some assets are easy to value (cash) and others (value of the brand) may be more contentious. The same is true of liabilities. Debt is often clear, but provisions against, for example, a lawsuit, may be contentious. It is important to define assets and liabilities.

Assets are defined by the professional body, the Financial Reporting Council, as: ‘Rights or other access to future economic benefits controlled by an entity as a result of past transactions or events.’

‘Rights or other access’ may mean outright ownership, or a lease or rental agreement.

‘Future economic benefits’ may be cash flows or other benefits.

‘Controlled by an entity’ implies not only access but restrictions on the assets of others.

‘Past transactions or events’ means that there must be evidence that the entity has gained control of the resource.

Liabilities are defined as ‘obligations to transfer economic benefits as a result of past transactions or events’.

‘Obligations’ refer to another legal entity that has legal claim to payment. For example, trade creditors who have supplied goods in expectation of future payment, or lenders who expect to be repaid.

‘Transfer economic benefits’ could be in the form of cash, property or (unusually) labour.


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‘Past transactions or events’: a transaction generates a liability, a warranty implies an uncertain date at which the liability is incurred.

An aside: price to book ratio

The price to book ratio highlights the relationship between a firm’s current stock market capitalisation and book equity, the capital provided by equity shareholders to the firm.

Price to book ratio = Market capitalisation/Equity shareholders’ funds

Market capitalisation = Share price * No. of shares in issue

An entity level measure of the price to book ratio is Enterprise price to book.

Enterprise price to book = Enterprise value/Capital employed

The difference between the accounting measure and the market value is indicative of the value created by the firm. In Table 10.2 we show the book and market value of Tiffany, the luxury good firm. Tiffany has in this period a substantially greater market capitalisation than book value and so, even though the market value of its debt has risen slightly, it has substantially lower gearing on the market than the book measure.

2003 2004 2005

Shareholders’ funds 1,208.0 1,468.2 1,701.2

Debt (current & long term) 349.7 486.9 440.6

Minus cash 156.2 276.1 326.9

Net debt 193.5 210.7 113.7

Capital employed 1,401.5 1,678.9 1,814.8

Book gearing 13.8% 12.6% 6.3%

Table 10.2.1: Tiffany market gearing

2003 2004 2005

Market capitalisation 3,368.1 5,816.6 4,543.1

Market value of debt 371.0 520.8 472.0

Minus cash 156.2 276.1 326.9

Net debt 214.8 244.7 145.1

Enterprise value 3,582.9 6,061.3 4,688.3

Market gearing 6.0% 4.0% 3.1%

Table 10.2: Tiffany book gearing


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10.3.2 The income statement

Sales

− Cost of sales

= Gross profit

− Sales, general & administrative expenses

= Operating profit

+ Other income

− Exceptional items

= Earnings before interest & tax

− Interest

= Earnings before tax

− Tax

= Earnings after tax

− Minorities

}}

How the firm earned

its income.

How the income is shared

amongst those with a claim

on the firm.

− Preference dividends

= Earnings

Figure 10.2: The elements of the income statement

The income statement is a measure of wealth flow over the accounting period. It answers the question of how much wealth was generated (or lost) over that period. It shows both how the firm generated income and how the income is shared with those with a claim on the firm.

The profitability of the company is the degree of success in creating wealth for owners. Return on equity measures the performance of the firm from the perspective of its shareholders. Return on equity is calculated as follows:

Return on equity = Earnings/Average shareholders’ funds

Return on capital employed measures the return on the capital of the whole business. It is an ‘entity’ return on capital that measures the profitability of the firm’s assets, independent of financing.

Return on capital employed = EBIT/Average capital employed

So we need also a measure of capital employed, which is calculated as follows:

Shareholders’ Funds + Current and long-term debt – Cash = Net debt = Capital employed

Capital employed is equivalent to the net operating assets of a business.

Profit margins are calculated as follows:

Gross profit margin = Gross profit/Total sales revenue

Mark up = Gross profit/Cost of goods sold

Gross profit = Sales revenue – Cost of sales

Net profit margin = Operating profit/Total sales revenue

Sales margin = Net profit/Total sales revenue


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10.3.3 The cash flow statementProfit differs from the cash received by the firm. The cash flow statement is concerned with measuring the flow of cash during the recording period. The calculation is:

Cash flow = Cash inflow – Cash outflow

Cash will flow following:

• operating activities such as making and selling products

• investing activity such as trading assets

• financing activities such as raising (or repaying) equity or debt.

The main elements of the cash flow statement are shown in figure 10.3:

Earnings before interest and tax

Non-cash charges

Earnings before interest, taxation, depreciation and amortisation

Tax on EBIT

Investment in working capital

Cash from operations

Investment in long-term assets (capex)

Operating free cash flow

Interest and dividends

Tax shelter on interest

Cash flow before financing

Equity financing

Debt financing

Change in cash and financial assets

Cash flow = income – change in the balance sheet

Figure 10.3: The elements of the cash flow statement

Activity 10.2

For the same firm as the last activity, calculate the cash flow.

There are processes for distinguishing cash from profit. Examples follow.

• Repayment of a loan:

effect on profit: none; effect on cash: decrease.

• Making a sale on credit:

effect on profit: increase; effect on cash: none.

• Buying a current asset on credit:

effect on profit: none; effect on cash: none.

• Receiving cash from a credit customer (trade receivable):

effect on profit: none; effect on cash: increase.

• Depreciating a non-current asset:

effect on profit: decrease; effect on cash: none.

• Buying some inventories for cash:

effect on profit: none; effect on cash: decrease.

• Making a share issue for cash:

effect on profit: none; effect on cash: increase.


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We will pursue some of these issues further with a worked example.

Example: A match sellerA match seller has $4 in his pocket on Monday morning. He goes to the wholesaler and buys 100 boxes of matches for 4 cents each. During the day he sells the 100 boxes for 10 cents each. How do we calculate the profit?

(10 cents revenue per box – 4 cents cost per box) * 100 boxes = $6 profit

Alternatively:

Assets at the beginning of the period = $4 cash

Assets at the end of the period = $10 cash

Profit = Change in the value of net assets over the financial period: $10 – $4 = $6

The income statement, providing an indication of the financial performance of the firm, reflects the change in the values disclosed in the balance sheet over the relevant periods. In the second week the match seller buys all the matches he will need during the week (500 boxes) on Monday morning. He sells 100 boxes on Monday.

How do we now calculate his profit?

Monday morning’s assets = 500 (boxes) * 4 cents = $20

Monday night’s assets = 400 (boxes) * 4 cents = $16

plus cash = 100 boxes * 10 cents = $10

Total assets = $16 + $10 = $26

Profit = $26 − $20 = $6.

In this example we value the match seller’s remaining 400 boxes (his assets) at cost price.

An alternative is to value these assets at the expected market price. In this case the profit is calculated as follows:

Assets on Monday morning = $20 (500 boxes * 4 cents)

Assets on Monday night = $50 (400 * 10 cents + $10 cash)

Profit = $30

These are different account models, but the conventional and accepted accounting model does not value the assets at market price because of the principles of recognition and matching.

10.4 Recognition and matching Revenue (and profit and loss from a transaction) is not recognised until it is earned. Revenue is ‘realised’ when a legally enforceable sale has taken place – that is, when an asset has been created in the form of cash or a claim on the customer.

Matching of expenses and revenues: an expenditure is the payment of cash for the purchase, for example, of a machine. An expense is the recognition of that part of the expenditure which has been used in generating the revenue.

Depreciation of an asset is the expense deriving from consumption of a tangible asset that derives from the use of that asset for the purpose of generating the revenue for that period.


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Financial assets are treated slightly differently. Financial assets are 1) cash, 2) assets that will be settled in cash or in the form of another financial asset, and 3) shares in another firm. They are typically valued in the same way as non-financial assets, with two exceptions, where they are valued at market price.

4. ‘Held for trading’ financial assets are regarded as intending to profit from short-term market fluctuations. These are valued at current market price ‘fair value’ and revaluation of these assets impacts on the determination of income.

5. ‘Available for sale’ financial assets are regarded as held on an intermediate time frame and are valued at market price. Revaluation is not recognised in the income statement, but rather in a broader statement of the performance of the reporting entity.

10.5 Overview of chapter• The income of a business during a period is the increase in its assets

adjusted for any withdrawals by the owners.

• A firm’s balance sheet is a list of its assets and the claims against those assets.

• There are two types of claim. Liabilities are amounts owed to third parties. Shareholders’ funds are the residual claim on the firm, the difference between its assets and liabilities and measure the shareholders’ wealth in balance sheet terms.

• The change in the shareholder’s wealth over a period, adjusted for capital flows, measures the firm’s profit.


• discuss the three elements of the financial report, namely, the balance sheet, the profit and loss statement and the cash flow statement

• interrogate the qualitative requirements of financial accounting for relevance, reliability, comparability and understandability.

10.7 Test your knowledge and understandingWhat are the key elements of a cash flow statement and how should they be interpreted?

Chapter 11: Modern portfolio theory

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• introduce the financial framework relating to risk and reward

• describe asset allocation and long-term rates of return of different asset classes

• discuss the relative returns of asset class selection and security selection.

11.1.2 Essential readingWillman, Chapter 8.D. Hillier, M. Grinblatt and S. Titman Financial markets and corporate

strategy. (Maidenhead: McGraw-Hill Higher Education, 2011) [ISBN 9780077129422], Chapter 4.

11.1.3 Further reading Dimson, E. and P. Marsh Triumph of the optimists: 101 years of global investment

returns. (Princeton, NJ; Oxford: Princeton University Press, 2002) [ISBN 9780691091945].

Swensen, D. Pioneering portfolio management: an unconventional approach to institutional investment. (New York: Free Press, 2009) [ISBN 9781416554035].

Williams, A. Managing your investment manager: a complete guide to selection, measurement and control. (Homewood: Dow Jones Irwin, 1986) [ISBN 9780870947230].

11.1.4 Works citedFama, E.F. ‘Efficient capital markets: a review of theory and empirical work’,

Journal of Finance, 25(2), 1970, pp.383–428.Fama, E.F. ‘Efficient capital markets II’, Journal of Finance, 46(5), 1991,

pp.1575–1617.

11.2 Interest rates and the time value of moneyFor most financial decisions, costs and benefits occur at different points in time. Consider an investment opportunity that costs $100,000 today and pays $105,000 in one year. Is the net value of the project $105,000–$100,000?

No. In comparing these two payments we need to take account of the time value of money: the difference between money today and in the future. Suppose the one-year interest rate with the bank is seven per cent. This investment alternative enables us to have $107,000 in one year, which is superior to the project. In one year $107,000–$105,000 = $2,000.

What is the value of difference between these two projects today?

If the interest rate is seven per cent, then what amount would we need to invest today to have $105,000 in one year?

= X * 1.07 = $105,000


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X = $105,000/(1.07) = $98,130.84

The difference between the two investment opportunities is therefore worth $100,000–$98,130.84 = $1,869.16 today.

The present value of $105,000 received in two years’ time is: $105,000/(1.07*1.07) = 1.14

More generally, the present value of a future cash flow = C/(1+r)?, where

C= cash flow

r = interest rate

n = number of years.

11.3 The return of a single securityThe return of a security is composed of two elements:

1. the income that the security pays as dividends or interest

2. capital gains, comprising the change in the security’s price over a period.

Total return = (End price – Start price + Income)/Start price

For example: a stock pays a dividend of $1 and the share price increases from $10 to $11. The total return = $1 + $11 − $10 = $2. This is a percentage return of $2/$10 = 20%. We are assuming that the income was paid at the end of the period.

11.4 The return of a portfolioThe expected return is the average return we would expect to earn if we repeated the investment many times with the return drawn from the same distribution each time.

The outcomes differ each year with given probabilities of occurrence.

Current stock price Stock price in 1 year Return (R) Probability (Pr)

100 140 40% 25%

100 110 10% 50%

100 80 –20% 25%

Expected return = E(R) = Sum (Probabilities * Returns)

= 25% * 0.4 + 50% * 0.1 + 25% * −0.2 = 10%

11.5 Probabilistic considerationsWhen an investment is risky it may have different outcomes in terms of return. For example:

Current stock price Stock price in 1 year Return (R) Probability (Pr)

100 140 40% 25%

100 110 10% 50%

100 80 –20% 25%

Expected (mean) return = E(R) = Sum (Pr * R)

= 25% * 0.4 + 50% * 0.1 + 25% * − 0.2 = 10%

A definition of the risk of a particular security is the degree to which the price of the security fluctuates.


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Which is riskier: the securities of company A or of company B?

Price

Time

B

A

Figure 11.1: The risk of a single security

We use variance and standard deviation as measures of risk. The variability of different investments can be used as a measure of the risk of that particular investment.

The variance examines the distribution of returns around a mean return that is achieved over a period. The standard deviation is the square root of the variance, as follows:

Var (R) = 1/(T–1) * Sum (Rt – E(R))

S.D. (R) = √Var (R)

11.6 Asset classesAn asset class is a set of investments that have a broadly comparable relationship to economic returns and liquidity. Broadly speaking, traditional asset classes reflect the different payments that are made to the owners of the firm and the lenders of money to the firm. More recently, new types of investment opportunity have come to be accepted as alternatives to these traditional investment opportunities. These include hedge funds and private equity. This is despite the fact that private equity may be said to be an ancient form of investment, predating public equities.

Investment Return Return volatility (standard deviation)

Treasury bills 3.7% 0.9%

Fixed income 5.8% 7.0%

S&P 500 9.6% 21.4%

Small stocks 18.2% 42.8%*

Real assets 6.3% 13.4%*

Hedge aunds 8.7% 8.6%

Private equity 17.6% 16.1%

* Real assets: 55% Real estate investment trusts, 35% Commodities and 10% Inflation-linked treasuries.

Table: 11.1 Asset class risk and return: traditional assets (1926–2008)

Activity 11.1

Go to the BBC or Bloomberg website. Discover the returns and volatility of the six asset classes above. Since 2008, which would be the best portfolio?

The table above indicates the return to different asset classes over a long period in the last 100 years. Over this long time period, there is a clear, positive relationship between risk (volatility) and return. This relationship is more generally reproduced.


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11.7 What is a hedge fund?The boundary between hedge funds and other investment vehicles is not absolute, but is defined partly by legal structure: collective vehicles, limited partnerships, private limited companies, etc.

Hedge funds are often based offshore and are largely unregulated. They usually have an absolute return target and charge fees typically as a percentage of the assets invested plus a proportion of any outperformance of a hurdle rate. Hedge fund managers often invest significantly in the fund. Typically, and crucially, they can leverage and short-sell stocks.

11.8 What is private equity?The term ‘private equity’ refers to investment in private companies that are not listed on any stock exchange. Often these are start-up, small enterprises but they are not necessarily small companies, nor necessarily new. For example, private equity firms may buy low-performing businesses with the intention of installing a new management team, improving performance and selling them at a profit.

The private equity market is not a single market. It includes:

• venture capital: early stage/start-up and later-stage financing

• development capital/expansion financing

• buyouts: small, medium and large management buyouts

• mezzanine finance

• restructuring existing capital.

11.9 Market efficiencyThis account of the systematic risk of a particular security is dependent on the notion that arbitrage entails that investors are not compensated for idiosyncratic risk. If there was an opportunity to be so compensated, then new traders would enter the market and, borrowing at the risk-free rate, invest in a diversified portfolio of shares, increasing their price to such a point that this was no longer a realisable investment opportunity. This assumption is that the market is efficient in processing information relating to investment opportunities. Further, the Beta is determined with respect to a portfolio of securities that resembles the entire market, which is efficient. The hypothesis that financial markets are efficient takes three forms: strong form, semi-strong and weak (Fama, 1970, 1991).

11.9.1 Weak market efficiencyIt is not possible to use historical stock price information to produce alpha. This means that technical analysis (trading based solely on historical price patterns) would not earn abnormal returns. The weak form assumes that all information contained in past prices of a stock are reflected in today’s price.

11.9.2 Semi-strong market efficiencyIt is not possible to use any publicly available information to produce alpha. This means that fundamental trading (trading based on underlying firm information) would not earn abnormal returns. The semi-strong form assumes that all public information is reflected in today’s stock price.


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11.9.3 Strong market efficiencyMarket prices incorporate even the most private information held by the deepest insiders in corporations. This means that no trading would produce alpha. The strong form assumes that all information, both public and private, is reflected in today’s stock price, so that nothing – not even insider information – can be used to beat the market.

11.10 Optimal portfolio choiceThe diversification benefits of having different assets in a portfolio derives from the fact that asset prices move differently.

Covariance is the expected product of the deviation of two returns from their means.

Cov (Ri, Rj) = E[(Ri – E(Ri)) * (Rj − E(Rj)]

Correlation controls for the differing volatilities of the stocks.

Corr (Ri, Rj) = Cov (Ri, Rj)/(SD (Ri) * SD (Rj))

The correlation is between −1 and + 1, providing an indication of the strength of the relationship between the two assets.

Asset class

Equities Fixed income

Cash Hedge funds

Private equity

Real assets

Equities 1

Fixed income

0.25 1

Cash 0.02 0.03 1

Hedge funds

0.38 0.14 0.22 1

Private equity

0.41 –0.24 0.07 0.22 1

Real assets

0.47 0.27 –0.06 0.45 0.36 1

Table 11.2: Asset class correlations (January 1970–December 2008)

The table shows correlations between different asset classes in the 40 years before the financial crash. It illustrates the data we might use to construct an efficient portfolio.

11.10.1 The variance of a two-stock portfolioVar (Rp) = X1 * Var (R1) + X2 * Var (R2) + 2 * X1 * X2 * Cov (R1,R2)

SD (Rp) = √Var (Rp)

The greater the covariation or the correlation of the two stocks, the higher the volatility and the risk of the portfolio.

11.10.2 The variance of a portfolioThe variance of a portfolio is equal to the sum of the covariances of the returns of all pairs of stocks in the portfolio, multiplied by each of their


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portfolio weights. The overall variability of the portfolio depends on the total co-movement of the stocks within it.

Here is an example of an efficient portfolio with two asset classes.

Take a portfolio that is invested only in bonds and private equity. The risk and return characteristics of each asset class are as follows:

Asset class Return Volatility

Fixed income 5.8% 7.0%

Private equity 17.6% 16.1%

The correlation between the two asset classes is −0.24%.

Bond allocation Private equity allocation

Portfolio return Portfolio volatility

100% 0% 5.8% 7.0%

80% 20% 8.2% 5.8%

60% 40% 10.5% 6.8%

40% 60% 12.9% 9.4%

20% 80% 15.2% 12.6%

0% 100% 17.6% 16.1%

Activity 11.2

Now reconsider the data from your last activity. Does your view of what would be the optimal asset portfolio change?

A portfolio is inefficient as long as it is possible to find another portfolio that is better both in terms of return and expected volatility.

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0%0.0%

2.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

20.0%

Volatility

Inefficient portfolios

Efficient portfolios

Retu

rn

Efficient portfolios

4.0%

Figure 11.2: Efficient frontier (private equity versus bonds)

To the degree that the constituent investments are less correlated the scope for gains arising from diversification is increased.


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11.11 The Sharpe ratioThe Sharpe ratio measures the relationship between return and volatility.

Sharpe ratio = Portfolio excess return/Portfolio volatility.

Portfolio 2 has a higher Sharpe ratio than Portfolio 1. The tangent portfolio provides a higher return per unit of volatility than any other portfolio.

Volatility

Return

Risk-free return(T -Bills)

Inefficient portfolio

Tangent or efficient portfolio.

Conservative investorscombine the efficient portfolio with the risk-free asset.

Aggressive investorsborrow to investmore in the efficient portfolio.

Figure 11.3: Efficient and inefficient portfolios

11.12 Overview of chapterIn this chapter we have discussed:

• definitions of return and risk

• the risk and return characteristics of different asset classes

• the difference between systematic and idiosyncratic risk and the concept of Beta

• the role of correlation in portfolio diversification

• the construction of an optimal portfolio.


• introduce the financial framework relating to risk and reward

• describe asset allocation and long-term rates of return of different asset classes

• discuss the relative returns of asset class selection and security selection.

11.14 Test your knowledge and understandingWhat is an efficient portfolio?

Notes


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Chapter 12: Security analysis and valuation

99




• describe the meaning of different financial ratios

• explain their application in conducting financial analysis of firms.

12.1.2 Essential readingAtrill, P. and E. McLaney Financial accounting for decision makers. (Harlow:

Financial Times Prentice Hall, 2013) [ISBN 9780273785637], Chapter 8.Willman, Theme 7.

12.1.3 Further readingGraham, B. and D. Dodd Security analysis. (New York: McGraw-Hill, 1934).Weetman, P. Financial accounting: an introduction. (Harlow: Pearson, 2013)

sixth edition [ISBN 9780273789253].

12.2 Financial ratiosFinancial ratios are so-called because they develop a profile of a business’ financial health by relating two figures in the financial statements.

There are six different types of ratio:

• investment

• profitability

• margins

• efficiency

• financial leverage

• solvency and liquidity.

In this chapter we calculate some of the financial ratios of British Airways in 2007/08.

12.3 Investment ratiosInvestors in a company wish to know how well their investment has performed.

Earnings per share = Profit after tax for ordinary shareholders/No. of ordinary shares in issue

This ratio is frequently reported in the media as the headline figure comparing the quarterly and annual performance of firms. The comparison is made from one period to the next to assess the trend.

British Airways’ earnings per share (‘EPS’):


100

2008 2007

Profit £680,000,000 £290,000,000

Shares outstanding 1,158,630,000 1,151,943,000

Earnings per share £0.586 £0.252

Price/Earnings ratio = Stock price/Earnings per share

This is often called the ‘P/E’ ratio. It may be interpreted as the number of years it would take for the current level of earnings to cover the current price of the share. It is important to compare the P/E ratio of the share to that of other companies in the sector or that of a suitable index to get an indication of relative value.

Activity 12.1

What is the current P/E of BA?

Dividend yield = Dividend per share/Market price per share

In contrast with EPS and P/E ratio, which do not measure the actual cash received by investors, dividend yield does deal with the cash that investors receive. It is a measure of the income that the share pays to the investor. Another potential source of earnings from investing in equities is appreciation of the shares.

Price to book ratio = Market capitalisation/Equity shareholders’ funds

Financial ratios are most useful when compared to a benchmark of some kind:

• past periods for the same business

• similar businesses for the same or past periods (in the same sector)

• target performance for the business before the start of the current period.

There can be various definitions of the ratios found in literature and practice. It is important to use a consistent definition across the benchmarks.

Market capitalisation = Share price * No. of shares in issue

The price to book ratio measures the degree to which the current market price for the shares understates their true value.

An entity level measure of the price to book ratio is Enterprise price to book.

Enterprise price to book = Enterprise value/Capital Employed

The difference between the accounting measure and the market value is indication of the value created by the firm.

12.4 Profitability ratiosThe profitability of the company tells us the degree of its success in creating wealth for owners. It is important to understand the different ratios that refer to it.

Return on capital employed measures the return on the capital of the whole business. It is an ‘entity’ return on capital that measures the profitability of the firm’s assets, independent of how these assets have been financed.


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Return on capital employed = Earnings before interest and tax/Capital employed

The calculation of capital employed is as follows:

Shareholders’ funds + Net debt = Capital employed

Where:

Net Debt = Current debt + long term debt – Cash

Capital employed comprises the funds provided by shareholders and debt holders. Consequently, when calculating return on capital employed, the earnings figure used is earnings before interest and tax. That is, as a measure of earnings before debt-holders and shareholders have received any interest or dividend distributions.

The current debt measures include only debt raised as financing and not in the course of conducting business. Two tests can be employed to see whether liabilities are for the purpose of financing or operations.

1. Is the debt interest-bearing? This test excludes most trade creditors. However, zero coupon are not excluded by this test.

2. Motive: does the liability arise in conjunction with another transaction conducted in the course of business?

Return on equity = Earnings/Shareholders’ funds

Return on equity measures the performance of the firm from the perspective of its shareholders.

This ratio measures the return on the capital provided by the firm’s shareholders only. The net income figure reflects the profits attributable to equity holders, after payment of interest and taxes. Note the difference with return on capital employed (ROCE).

Activity 12.2

Using your BA data, calculate ratios 1–6.

12.5 The profitability equationA major advantage of the return on capital employed and of return on equity is that these ratios decompose into other ratios enabling a deeper and integrated analysis of performance.

ROCE = EBIT/Capital employed

ROCE = EBIT/Sales * Sales/Capital employed

ROCE = Margin * Asset turn

The decomposition of these return on investment ratios facilitates analysis of the factors driving investors’ returns.

Margin measures the difference between the prices at which the firm sells its product and the cost of production.

Asset turn is a measure of efficiency: how well the firm utilises its capital in generating sales.

12.6 Margin ratiosDifferent profit margins assess the relationship between revenue and different types of expense incurred by the firm in conducting its business.

Gross profit margin focuses on the cost of making goods ready for sale before any sales, general and administrative or depreciation expenses.


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Gross profit margin = Gross profit/Revenue

Net profit margin focuses on profit from trading but before interest and taxes.

Net profit margin = Operating profit/Revenue

British Airways’ net profit margin

£ million 2008 2007

Operating Profit 875 556

Revenue 8,753 8,492

Net profit margin 10.0% 6.5%

Sales margin examines the profit after financing costs and taxes.

Sales margin = Earnings/Revenue

Sales margin = Net profit after interest and tax/Revenue

British Airways’ sales margin

£ million 2008 2007

Profit after tax 694 304

Revenue 8,753 8,492

Sales margin 7.9% 3.6%

12.7 Efficiency ratiosEfficiency ratios calculate the efficiency of a company in organising its activities. Efficiency ratios examine how good the firm is in ensuring that capital is not needlessly tied up in unproductive assets.

Inventory represents goods that have been finished and could be sold for cash. The inventory turnover ratio measures how good the firm is in converting inventory into cash.

Inventory turnover ratio = Cost of goods sold/Inventories

The fixed assets turnover ratio measures how well a company uses its fixed assets to generate sales.

Asset turnover ratio = Total sales revenue/Assets

This ratio highlights how well a company has used its assets to generate sales. This type of ratio is best considered as a trend over a number of years.

12.8 Leverage ratiosFinancial leverage refers to the capital structure of the firm. It reflects a fundamental financing decision relating to how much of the assets should be funded by equity or debt. It is sometimes also called ‘financial gearing’, or ‘gearing’.

Creditors are interested in the sufficiency of the assets to meet their claims, which are prior to those of shareholders.

Equity to total assets ratio = Equity/Total assets = 1 – Total liabilities/Total assets

Debt ratio (gearing ratio) = Net debt/Capital employed

Since the debt ratio deducts cash from loans, this may make cash-rich firms look relatively unindebted, when in fact creditors may not be able to offset the loan against cash.


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The Debt to equity ratio = Debt/Equity, which does not deduct the cash from the debt figure, is a good comparator.

12.9 Solvency and liquidity ratiosSolvency and liquidity ratios measure the ability of a firm to meet its most immediate liabilities. The firm holds cash in the bank. Further, cash will flow to the firm most immediately from sale of stocks and cash collected from customers.

Current ratio = Current assets/Current liabilities

The acid test excludes inventories from the determination of current assets, as it is the least liquid current asset.

Acid test = (Current assets – Inventory)/Current liabilities

Interest cover = EBIT/Net interest payable

The gearing ratios focus on gearing as reflecting the composition of the balance sheet. The interest cover ratio assesses the degree to which the interest payments that the firm has to make are covered by its earnings.

BA’s interest cover

(£ million) 2008 2007

Finance costs 175 168

– Bank interest receivable 111 129

= Net interest payable 64 39

Earnings before interest & tax 875 556

Interest cover 875 / 64 556 / 39

13.7 times 14.3 times

Activity 12.3

Update the data on BA’s interest cover to the current year.

Loan covenants will often specify a minimum interest cover that the firm must maintain, and if that limit is breached, this triggers a legal default.

There are a number of reservations to be made about the use of all of the above ratios. First, they are based on historical data, mostly about costs, and such historical relationships may not continue; the value of ratio analysis for predicting future performance should be borne in mind. Second, they rely mostly on year-end data, so intra-year variations are not tracked. Third, companies may not be comparable in terms of ratios; the airline industry or hotels have high operating leverage, while trading businesses have low operating leverage. Usually we need to add to the ratios other information in order to do more detailed investigation.

12.10 Overview of chapterIn this chapter we have defined and examined the key ratios you will need to examine key dimensions of the performance of the firm.

The key ratios relate to:

• investment

• profitability

• margins


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• efficiency

• financial leverage

• solvency and liquidity.

We have defined these ratios and shown, where relevant, how they interrelate. We have introduced data from specific case examples to illustrate how the ratios work.


• describe the meaning of different financial ratios

• explain their application in conducting financial analysis of firms.

12.12 Test your knowledge and understandingSuppose that Company 1 and Company 2 have the same financial statements and that they are both attempting to acquire a third company (by issuing shares of their company). Company 1 accounts for business combinations using an acquisition method of accounting and amortises goodwill over a ten year period. Company 2 utilises a pooling method of accounting. How would the financial ratios of these two firms differ should they be successful in conducting the acquisition, assuming that the price paid for the third company significantly exceeds both its book value and current market price? Which ratios would be unaffected?

Chapter 13: The origins of modern strategy

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• discuss the core concepts of business strategy

• describe the main elements of the Porter framework

• outline the strengths and limitations of the approach.

13.1.2 Essential readingPorter, M.E. ‘The five competitive forces that shape strategy’, Harvard Business

Review, January 2008, pp.78–93.Willman, Chapter 6.

13.1.3 Further readingGrant, R.M. Contemporary strategy analysis. (Chichester: John Wiley & Sons,

2012) [ISBN 9781119941880].Porter, M.E. Competitive strategy: techniques for analysing industries and firms.

(New York: Macmillan, 1980) [ISBN 9780684841489]. Whittington, R. What is strategy – and does it matter? (Ontario: Thomson

International, 2000) second edition [ISBN 9781861523778].

13.1.4 Works cited Ansoff, I. Corporate strategy. (New York, NY: McGraw-Hill, 1965)

[ISBN 9780070021112].Boston Consulting Group Strategy alternatives for the British motorcycle

industry. (London: Her Majesty’s Stationery Office, 1975) [ISBN 9780100090651].

Chandler, A. Strategy and structure: chapters in the history of American enterprise. (London: MIT Press, 1962) [ISBN 9781587981982].

Mintzberg, H. The rise and fall of strategic planning: reconceiving roles for planning, plans, planners. (New York: Free Press, 1994) [ISBN 9780029216057].

Mintzberg, H, B. Ahlstrand and J. Lampel Strategy safari: a guided tour through the wilds of strategic management. (New York: Simon and Schuster, 2005) [ISBN 9780743270571].

Pettigrew, A. The awakening giant: continuity and change in Imperial Chemical Industries. (Oxford: Blackwell, 1985) [ISBN 9780631133568].

13.2 Two key definitions of ‘strategy’The business strategy field is relatively new (from the 1960s), but as we will see in the next five chapters, it has some controversial aspects, not least about what the term ‘strategy’ means. The first definition below from the business historian widely regarded as the ‘founder’ of strategy focuses on management; the second, from a major critic, focuses on markets:

The determination of the basic long-term goals and objectives of an enterprise and the adoption of courses of action and the allocation of resources necessary for carrying out these goals. (Chandler, 1962, p.13)

http://scholar.google.co.uk/citations?user=W27m-38AAAAJ&hl=en&oi=sra


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Strategic decisions are primarily concerned with external rather than internal problems of the firm and specifically with the selection of the product-mix that the firm will produce and the markets to which it will sell. (Ansoff, 1965, p.18)

The first definition focuses on factors internal to the firm, particularly the management process. The second focuses externally on markets. The quotes illustrate two main themes in the business strategy field. Chandler and his followers look at resources and capabilities. Others, often with a background in economics, look at how to position the firm in the market.

However, all of the early approaches to strategy were characterised by the following.

1. Commitment to profit maximisation: the objective of strategy is to maximise long-term returns and profits for the firm.

2. Separation of strategy conception from execution: senior managers are primarily concerned to formulate strategies that others implement.

3. Attachment to rational analysis: managers and firms act like conventional economic agents.

4. A prescriptive approach: for example, there are things that firms should and should not do.

5. Oligopolistic competition: strategy is broadly about how firms create and appropriate economic rents.

(Mintzberg et al., 2005; Whittington, 2000)

Firms may have different strategic ‘goals’. For example:

• NASDAQ: ‘To build the world’s first truly global securities market. A worldwide market of markets built on a worldwide network of networks, linking pools of liquidity and connecting investors from all over the world, assuring the best possible price for securities at the lowest possible costs.’

• Unilever: ‘Our purpose in Unilever is to meet the everyday needs of people everywhere – to anticipate the aspirations of our consumers and customers and to respond creatively and competitively with branded products and services which raise the quality of life.’

It should be noted that these two examples imply that firms may be committed to something more than or different from simple profit maximisation.

Later approaches (e.g. Minztberg, Pettigrew) raised two big questions. First, in a stream of publications (e.g. 1994, 2005), Mintzberg has questioned whether firms do have rational approaches to both the selection of strategic objectives and the process by which these decisions are made. He has referred to ‘emergent’ strategies in which conception and execution are not separated. A well-documented case of Honda motorcycle success in the USA has been used to illustrate the two processes (see Grant, 2012).

• One set of analysts, the Boston Consulting Group, argued that the Japanese had developed huge production volumes in their domestic market and volume-related cost reductions had followed. This resulted in a highly competitive cost position which the Japanese used for the penetration of world markets with small motorcycles in the early 1960s, particularly the USA (Boston Consulting Group, 1975).


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• Later interviews with those involved suggested that the small motorcycles that were the basis of success unexpectedly became popular, particularly in California, with people such as surfers who had not owned bikes before, and were sold through sports stores not motorcycle dealerships. Success came from capitalising quickly on an unexpected development.

Pettigrew, in a large-scale study of the British chemical firm ICI, focused more on the strategy process, seeing this as a partly rational, partly political process embedded in the culture of the firm. Not only were processes more complicated than traditional prescriptive strategy schools assumed, strategy was often focused on multiple, sometimes competing, objectives. We must bear these issues in mind in the discussions of the main strategy schools that follow.

13.3 Porter and the five forcesMichael Porter was for many years the dominant strategy academic. He argued:

The essence of formulating competitive strategy is relating a company to its environment. Although the relevant environment is very broad, encompassing social as well as economic forces, the key aspect of the firm’s environment is the industry or industries in which it competes. (Porter, 1980)

Some industries were more profitable than others, and within industries some firms were better positioned. Both industry profitability and the profitability of the firms’ position could be understood in terms of competitive forces. These are shown in Figure 13.1.

Figure 13.1: Porter’s five forces

Suppliers- Number of suppliers- Size of suppliers- Switching costs- Unique service/product- Ability to substituteBarriers to entry

- Time and cost of entry- Knowledge- Economies of scale- Cost advantages- Technology- Barriers

- Substitute performance- Cost of switching- Buyer willingness

Substitutes

Competitive rivalryBuyers- Number of competitors- Exit barriers- Niche, quality- Differentiation- Switching costs- Industry concentration- Diversity of competitors

- Number of customers- Buying volumes- Differentiation- Price elasticity- Incentives- Brand identity- Switching costs

STRATEGICPOSITION


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The basis for this approach is industrial economics, specifically the ‘structure–conduct–performance’ approach in which an industry can be examined by the number of firms, homogeneity of product, entry and exit conditions (structure), the strategies firms pursue (conduct) and performance – the firm and welfare performance indicators. Porter turns this model around to focus on how firms can create rents by understanding and manipulating the five forces. Where they do so successfully, they can create ‘competitive advantage’.

We can think of the approach as operating in two stages. Consider Table 13.1 below, which shows industry profitability at the turn of the century for the USA, then the largest economy.

US Industry in 2001 Return on equity

Banks 11.2%

Cinemas 5.7%

Computers 26.4%

Grocery stores 18.4%

Hospitals 1.4%

Hotels 9.8%

Natural gas production 0.7%

Newspapers 25.2%

Soaps and cosmetics 33.7%

Tobacco 0.0%

Table 13.1: Profitability of major US industries in 1999–2000

Some industries are unprofitable in the long term. It has been claimed that in the first hundred years of US air travel (1903–2003) the industry made exactly zero cumulative profit (Financial Times, 22 November 2003). An industry analysis of profitability may thus lead to a strategy of industry exit. However, firms within an industry may also vary in performance. For example, in the same year, return on equity in the computer industry varied from 80 per cent (Dell) to 1 per cent (Apple). This was prior to the launch of iPods, iPhones and iPads, which arguably changed the boundaries of the computer industry.

Within an industry – the second stage – firms can improve their competitive position by analysing and manipulating the five forces.

In detail, the five forces are as follows.

13.3.1 Barriers to entryThese will be high where there are:

• high capital costs to enter

• no opportunity for small firm entry because of incumbent economies of scale and scope or incumbent economies of vertical integration

• restricted access to distribution channels

• customer loyalty to incumbents

• restricted access to essential inputs

• threat of retaliation by incumbents

• excess capacity.


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13.3.2 Competitive rivalryThis will be high where there are:

• low industry growth

• commodity products and services

• low brand loyalty

• low switching costs

• excess capacity

• high exit barriers.

13.3.3 Power re buyersThe firm is powerful with respect to its buyers (customers) where:

• the product or service is differentiated or unique

• the product/service is essential to buyers

• buyers have few alternative sources of supply

• buyers have high switching costs

• buyers have no substitutes available

• the firm can integrate forward to purchase the buyer

• the firm is larger than its customers.

13.3.4 Power re suppliersThe firm is powerful with respect to its suppliers where:

• the supplier’s input is a commodity

• the supplier’s input is inessential to firm output

• the firm comprises a large proportion of supplier’s sales

• the supplier has many competitors

• the supplier has few other customers

• the firm has low switching costs

• the firm has substitute products available

• the firm can integrate backward to purchase the supplier

• the firm is larger than the suppliers.

13.3.5 Threat of substitutesThe threat of substitutes is high where:

• alternative products or services deliver either:

comparable benefits at lower cost, or

fewer benefits at significantly lower cost

• new technology can make product or service obsolete

• customers have low switching costs.

Analysing the five forces does at least two things for the firm. It allows an estimate of current profit possibilities and it opens up the prospect that the firm can alter its industry position to its own advantage. The conventional way this is done is in Figure 13.2. The axes are measured and positions plotted; when the axes are joined, the larger the area, the more attractive the industry. The position can then be managed in order to generate competitive advantage. At the extreme, this might suggest exit behaviour,


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but it can be used as an indicator of what to protect and where the major competitive risks lie. It is not simply about defence, it also points to what aspects of the industry structure the firm might try to influence. For the diversified firm, it points towards effective portfolio management, guiding market entry as well as exit considerations. So the optimal competitive position, indicated in the figure, is where entry barriers are high, rivalry is low, the firm dominates both suppliers and buyers and there is no substitute product or service available.

Activity 13.1

Perform a five forces analysis for Apple, Nike or Coca-Cola.

This approach has been extremely influential, but it is worth mentioning several limitations, noted by a variety of critics (see Willman, 2014, Chapter 6).

1. Although strategy is by definition forward-looking, the analysis of the five forces is retrospective.

2. There is no model, for example, of how to implement, following industry analysis, policies or practices that might lead to competitive advantage.

3. It assumes that a bounded ‘industry’, distinct from others, exists. This is perhaps much more likely in mature rather than fast-growing sectors.

4. The firm is not seen as a complex organisation but rather as a chess piece to be moved around an industry board.

5. In consequence, there is no model of the decision-making process in particular or the strategy process more generally.

6. The firm may be able to identify the optimum competitive position, but the model does not cover its capability to occupy it.

7. There is no dynamic of competition. Specifically, it does not model events where several firms are trying to occupy a similar position.

Figure 13.2: Star plot of industry structure

Activity 13.2

Perform a star plot analysis for Apple, Nike or Coca-Cola.

Entry barriers

Rivalry

LowLow

HighHigh

Power resuppliers

Power re buyers

Threat ofsubstitutes

High


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13.4 Overview of chapterIn this chapter we have looked at:

• different meanings of the term ‘strategy’ in the business literature

• the logic of the Porter framework.

We have also itemised the five forces identified by Porter and indicated how the five forces framework may generate competitive advantage for the firm. Finally, we have examined the strengths and weaknesses of the approach.


• discuss the core concepts of business strategy

• describe the main elements of the Porter framework

• outline the strengths and limitations of the approach.

13.6 Test your knowledge and understandingWhat does competitive advantage mean and how can a firm achieve it?

Notes


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Chapter 14: Understanding organisational structures

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• outline the main types of organisational structure within firms

• discuss the basic principles of organisational design

• describe the relationship between organisational structure and strategy.

14.1.2 Essential readingWillman, Chapter 5.

14.1.3 Further readingMintzberg, H. Structure in fives: designing effective organisations. (Harlow:

Prentice Hall, 1983) [ISBN 9780138554798] pp.1–25.Pfeffer, J. New directions for organisational theory. (Oxford: Oxford University

Press, 1997) [ISBN 9780195114348].Scott, W.R. Organisations: rational, natural and open systems. (Harlow: Prentice

Hall, 1997) fourth edition [ISBN 9780132663540].

14.1.4 Works citedAlbrow, M. Bureaucracy. (London: Macmillan, 1970) [ISBN 978033311265].Fayol, H. General and industrial management. (London: Pitman,

1916) (Financial Times/Prentice Hall, revised edition, 1988) [ISBN 9780273029816].

Gouldner, A. Patterns of industrial bureaucracy. (Glencoe, IL: The Free Press, 1954).

Hamel, G. The future of management. (Boston: Harvard Business Review Press, 2007) [ISBN 9781422102503].

Nonaka, H. and I. Takeuchi The knowledge-creating company. (Oxford: Oxford University Press, 1995) [ISBN 9780195092691].

14.2 IntroductionAs we saw in Chapter 1, early writing on the structure of business organisations was influenced by prior thinking about how large organisations, such as the church and, particularly, the state, operated. The central concept of bureaucracy, articulated by Max Weber in the early 20th century, was designed to explore and characterise the attributes of efficient public administration. This is some distance from the modern colloquial use of the term ‘bureaucracy’, which implies inflexibility and inefficiency (Albrow). The core idea behind bureaucracy was rationality – specifically, that an organisation could be structured around universal principles which ensured effectiveness.


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Principle Application Goal

Standardisation Minimise variance from standards around inputs, outputs and work methods.

Pursue scale economies, manufacturing efficiency, reliability and quality.

Specialisation of tasks and functions

Group like activities together in modular organisational units.

Reduce complexity and accelerate learning.

Goal alignment Establish clear objectives through a cascade of subsidiary goals and supporting metrics.

Ensure individual efforts are congruent with top-down goals.

Hierarchy Create a pyramid of authority based on a limited span of control.

Maintain control over a broad scope of operations.

Planning and control Forecast demand, budget resources, and schedule tasks, then track and correct deviations from plan.

Establish regularity and predictability in operations and conformity to plans.

Extrinsic rewards Provide financial rewards to individuals and teams for achieving specified outcomes.

Motivate effort and ensure compliance with policies and procedures.

Table 14.1: Guiding priciples for a standard orgamisational structure

14.3 Organisational designIn application to business organisations, ideas similar to Weber’s were articulated by Fayol (1916) who suggested that the guiding principles for designing an organisation should be:

• tightly prescribed roles: there should be a division of labour that makes individual responsibilities clear

• high degree of specialisation, to enable the development of expertise

• clear and explicit formal procedures to ensure rationality and accountability in decision-making

• clear and explicit hierarchy, so that reporting relationships are clear

• promotion based on defined criteria, to eradicate favouritism and corruption.

These are very general principles, and Fayol’s assumption was that it was possible to find one best, universally applicable, approach.

Despite the fact that modern organisational design does not favour ‘one best way’ approaches, some of the general components of this early approach have retained currency. Hamel (2007) characterises the core components of this approach (as in Table 14.1) and, while acknowledging the longevity of this approach, he expresses concerns about its relevance to 21st-century organisations.

The modern approach stresses organisational structure as the consequence of design choices (Scott, 1997). The choices that any organisation has to make can be understood as part of ‘organisation design’, including, but not restricted to:

• workflow relationships – how production is organised

• communication relationships – how information is transferred

• reporting relationships – how authority is distributed


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• the boundary of the firm – its relationship to labour, product and capital markets

• modularity of the firm – what are the core building blocks?

At any point in time, the organisation may be seen as experiencing a tension between two competing processes.

14.3.1 DifferentiationOrganisational structure divides the task of the organisation as a whole into manageable subtasks, and allocates them to units that are held responsible for their completion.

14.3.2 CoordinationOrganisational structure ensures that the different subtasks are integrated and controlled in a way that results in the organisation achieving its tasks.

Organisational design is the process of creating a structure which attempts to reconcile these twin tensions.

As we saw in the previous chapter, for Chandler, organisational structure follows from firm strategy, thus strategic choices imply and constrain design choices. Five key questions need to be answered.

1. Where should the organisation’s boundaries be?

2. How should work be divided and combined?

3. What are the lines of authority and communication?

4. How much bureaucracy do we need?

5. How do we leverage what we know?

We will look at each in turn, briefly outlining the key issues.

14.4 Organisational boundaries: the issuesThe firm market boundary is a central issue for the theory of the firm. In design terms, there are four major issues:

• Relations with customers and suppliers. These are key issues for the Porter framework we analysed in the previous chapter. The choice is essentially between making (vertical integration) or buying (relationship management).

• Relations with competitors and collaborators. At base, this is the horizontal integration counterpart to the vertical integration problem. However, there are two complicating factors. First, there are many intermediate stages between competition and acquisition – joint ventures, alliances and networks exist in many industries. The second complexity is that in many sectors firms both compete and collaborate with each other at the same time.

• Diversification. Broadly, this is movement into other sectors which may be related or unrelated. This is usually underpinned by divisionalisation and the adoption of an M-form organisation (see Chapter 9).

• Governmental and regulatory relationships. There are very few businesses that do not experience some form of government oversight, even if only in the production of financial accounts. For many firms, considerable resources have to be devoted to managing legal and regulatory matters.


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So the boundary decision is a (constrained) decision about two related matters. First, it is about the location of the firm’s boundaries, and, second, about what kind of internal roles are created in order to manage boundary relationships.

14.5 Division of labour: the issues

Grouping by

Functions(means)

Markets(ends)

Knowledge/Skill set

Work processes

Product

Customer segment

Place

Figure 14.1: Supply-side versus demand-side organisation

The division of labour is the process that sets the balance between integration and differentiation. In Figure 14.1 the firm must decide on the balance between organising around the supply side (means and functions) and the demand side (ends and markets). In practice, both considerations are important, but on either side, there are choices to be made. On the supply side one can organise around functions (e.g. finance) or processes (e.g. smelting, assembly). On the demand side, one can organise around product groups, market segments (see Chapter 19) or geography.

They key issues are complexity and priority. Using all five of the criteria on the right-hand side of Figure 14.1 will result in an extremely complex and probably unworkable organisational structure. So a choice must be made and the priority is driven by the organisation’s strategy.

14.6 Authority and communication: the issuesThere are both ‘formal’ and ‘informal’ issues to consider in designing authority structures within a hierarchy. The formal issues would be familiar to Fayol, and will be evident from the analysis of an organisational chart. Three key issues are:

1. Spans of control: each authority position in a hierarchy has a number of direct reports, and the number of direct reports is limited by the supervisory requirements of each post. This has implications for the number of levels in a hierarchy. De-layering in order to reduce costs will have implications for spans of control.

2. Reporting relationships: in most organisations, reporting relationships need to be both lateral and vertical – this leads to the emergence of matrices, which are discussed below.

3. Ease of communication: communication and authority relationships overlap but are not identical and consideration must be given to the information requirements of roles within the organisation.


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There are also three key informal issues:

1. Power and authority: authority in hierarchies is primarily dependent on position, but power may reside in any role which has control of a key resource or bottleneck. Where such a monopoly emerges, then the possibility exists that ‘single point failure’ will cause major organisational problems − control over distribution within many organisations is an example. In this case, duplication of roles may be considered.

2. Careers and career progression: hierarchies are also career ladders and the number of ‘rungs’ on such ladders may become important for motivation and retention. Extremely ‘flat’ organisations may be advisable for efficiency purposes but may cause other problems.

3. Centralisation and decentralisation: the organisation must be designed with the distribution of decision-making responsibility in mind. Decentralised organisations are often more adept at responding to market changes, but decentralised organisations tend to have higher costs (through duplication), lower information sharing (through fragmentation) and a higher demand for managerial skills.

14.7 Bureaucracy: the issuesBureaucracy (proliferation of formal rules) has a tendency to increase in firms through a ‘dynamic’ in which rule avoidance is followed by the establishment of more and more stringent rules (Gouldner, 1954). The most important set of rules concern the coordination of tasks and these have been categorised by Mintzberg (1983) as follows:

• Mutual adjustment refers to the process of mutual accommodation between task performers as members of a team. It works best in small teams (up to 6–7 people) but breaks down in larger groups through the transaction costs of coordination.

• Direct supervision refers to the direct observation of role performance. As we showed in the analysis of Taylorism in Chapter 3, it is effective but costly.

• Standardisation of work processes refers to the specification of precise role performance by rule. For example, in the operation of McDonald’s franchises, the preparation of a hamburger is standardised by detailed rules about content, cooking and presentation in order to ensure that variance is eradicated. Where variance is desirable, such standardisation may have negative consequences.

• Standardisation of outputs refers to the specification of the output characteristics of one part of the organisation where those are inputs to another part. This allows flexibility of process.

• Standardisation of knowledge/skills occurs where processes are highly variable and outputs are difficult to specify ex ante. Organisations may rely on standardisation of knowledge inputs. A good example would be professional service firms in law, accountancy and medicine, where professional training and standards are prime coordinating devices.

14.8 Know-how: the issuesFrom one perspective, organisations may be considered as bundles of knowledge or know-how. From this perspective, two firms with identical knowledge may perform differently depending on differences in their


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ability to leverage that know-how. Nonaka and Takeuchi (1995) make the distinction between explicit or codified knowledge on the one hand, and tacit or ‘sticky’ knowledge on the other. Figure 14.2 illustrates the processes that a firm may use to augment both.

Tacit Explicit

Tacit Explicit

Documentation

Combination

Learning

Socialisation

Figure 14.2: Leveraging explicit and tacit knowledge

The four key processes are:

• turning tacit know-how into explicit knowledge by documenting best practice and disseminating it

• combining explicit knowledge from different parts of the organisation. In this approach, new combinations of existing explicit know-how are seen as a major source of innovation

• building on existing explicit know-how by creating new tacit know-how through learning by doing

• preserving and transmitting difficult to codify tacit knowledge by socialising new entrants to the firm.

14.9 The components of organisationMintzberg (1983) has classified the components of the organisation in a five-fold schema and extended this into a five-fold classification of organisations characterised both by a dominant coordinating device and dominant component.

• A typical simple structure would be a small entrepreneurial firm with the entrepreneur providing both overall direction and supervision.

• A typical machine bureaucracy would be a large industrial firm in which scale economies are gained through standardisation.

• A typical divisionalised structure would be an international business (see below).

• A typical professional bureaucracy would be a large law or accounting firm.

• A typical adhocracy would be a project-driven structure in which the continuity is provided by support staff around a changing operational core. Mintzberg himself uses the example of a film studio operating with changing actors, directors and scripts.

We noted above that many firms move to a structure termed ‘matrix’ involving two (or multiple) lines of reporting. An example is given in Figure 14.3, which graphically shows the structure of ABB, a well-developed matrix. The two main organising principles are product group,


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on the one hand, and geography on the other. ABB generates economies of scale in product design and manufacture. On the other hand, it deals with large infrastructure projects where clients are governments with different needs and practices, so country managers become important.

Generically, four sets of pressures characterise the move to a matrix organisation, as follows.

1. The need to respond to at least two sectors simultaneously (e.g. markets/technology).

2. When firms face external uncertainties needing high information-processing requirements.

3. When firms face strong financial/human resource constraints – for example, consulting.

4. When flexibility and balanced decision-making is more important than the costs of complexity.

Figure 14.3: ABB: a matrix in practice

Activity 14.1

Go to the ABB website and find the organisational chart: how has it changed?

14.10 The ‘M’ formWe briefly described the ‘M’ (multi-divisional) form in the context of performance measurement in Chapter 9. Here we deal with the design issues of the structural form. The figure below shows the contrast between the functional (‘J’ form) and the M form organisation.

Percy Barnevik CEO(1988–1996)

12 (later 7) – strong executivecommittee

Group functions and financial services

Production divisions

Regional/Nationaloperations

Europe

Americas

Asia Pacific

Power transm

ission and distribution

Power plants

Industrial and building system

s

Transportation


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Figure 14.4: The ‘M’ form organisation

The latter is characterised by the following:

• distinct market-based groupings

• operating functions quasi-autonomous, reporting to a head office

• vertical decentralisation to divisional managers

• autonomous decision-making subject to the performance controls we discussed in Chapter 9.

There are several key organisational design issues within the M form. Two of these we will discuss here. First, when fixing the basis for creating divisions, the firm must decide what the nature of the quasi-autonomous businesses must be. The two most common criteria are product group or geography. Then it must make the choice of how to measure divisional performance; this involves the choice of measure but also the decision about whether to use one measure or several.

There is variance between M form organisations in the role taken by headquarters. The following six functions may be performed.

1. Manager of strategic portfolio: HQ simply decides which autonomous divisions to own. This is a minimalist role and if it is the only one performed, the M form is really just a holding company.

2. Allocator of financial resources: this is the internal capital market function of HQ. It may simply allocate according to performance, in which case high-performing divisions retain most of their earnings, or allocate according to some strategic plan.

3. Owner of performance control system: we have dealt with many of the issues here in Chapter 9, but the key point is that the performance system must be controlled independently of the divisions being controlled.

4. Appoints/replaces managers of divisions: this is the ultimate performance sanction available.

5. Personal monitoring of divisional performance by Board members; this practice reduces the information asymmetries between divisions and HQ.

6. Support services: HQ may centralise certain functions (e.g. HR, investor relations) in order both to retain control and prevent duplication.

The Multidivsional (’M Form) Corporation:Trading Efficiancy for Span of Operations

Functions

Functions Functions Functions

Divisions(product/geographic)

Functional structure(report by functions e.g. marketing, production)

Divisional structure(report by businesses)


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14.11 Overview of chapterThe chapter has examined structural and design options for firms. Beginning with the Weberian concept of bureaucracy, it has discussed the development of formal rational hierarchies in business. It covers the work of Mintzberg and Scott on organisational structure, and outlined the design implications. It has described the matrix form and indicated the conditions for its emergence. It has examined the M form and indicated the main design options.


• outline the main types of organisational structure within firms

• discuss the basic principles of organisational design

• describe the relationship between organisational structure and strategy.

14.13 Test your knowledge and understandingWhy did the ‘M’ form organisation become so common in industrial enterprises in the 20th century?

Notes


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Chapter 15: The analysis of organisations

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• describe some main currents in organisational theory

• relate these to current debates in business strategy.

15.1.2 Essential readingPfeffer, J. New directions for organization theory: problems and prospects.

(Oxford: Oxford University Press, 1997) [ISBN 9780195114348], Conclusion.

15.1.3 Further readingHan, S.K. ‘Mimetic isomorphism and its effects on the audit services market’,

Social Forces 73 1994, pp.637–63.Hannan, M. and J. Freeman ‘The population ecology of organisations’,

American Journal of Sociology 82 1977, pp.929–64.Podolny, J. Status signals. (Princeton: Princeton University Press, 2008)

[ISBN 9780691136431] Introduction and Chapter 1.Williamson, O.E. ‘Comparative economic organisation: the analysis of discrete

structural alternatives’, Administrative Science Quarterly 36(2) 1991, pp.269–98.

15.1.4 Works citedDi Maggio, P. and W. Powell ‘The iron cage revisited: institutional isomorphism

and collective rationality in organisational fields’, American Sociological Review 48 1983, pp.147–60.

Donaldson, L. American Anti-management theories of organisation: a critique of paradigm proliferation. (Cambridge: Cambridge University Press, 1995) [ISBN 9780521479172].

McKenna, C.D. The world’s newest profession: management consulting in the twentieth century. (Cambridge: Cambridge University Press, 2006) [ISBN 9780521810395].

Meyer, J. and B. Rowan ‘Institutionalised organisations: formal structure as myth and ceremony’, American Journal of Sociology 83 1977, pp.343–60.

Weber, K., G. Davis and M. Lounsbury ‘Policy as myth and ceremony? The global spread of stock exchanges 1980–2005’, Academy of Management Journal 52(6) 2009, pp.1319–47.

Whittington, R., M. Mayer and F. Curto ‘Chandlerism in post-war Europe: strategic and structural change in France, Germany and the UK, 1950–1993’, Industrial and Corporate Change 8(3) 1999, pp.519–51.

Zey, M. Rational choice and organizational theory: a critique. (Thousand Oaks, CA: Sage Publications, 1998) [ISBN 9780803951365].

15.2 Strategy and organisational theoryIndustry structure approaches to strategy such as Porter’s do not particularly need a theory of organisations since they treat the firm as a single decision point – a piece on a chessboard, so to speak. However, both the Chandlerian and resource-based theories discussed in the next chapter have to address organisational issues, as does any concern with strategy


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implementation. The Oxford English Dictionary defines strategy as follows ‘… as in the theory of games, decision theory, business administration, etc., a plan for successful action based on the rationality and interdependence of the moves of the opposing participants’. This includes participants within the organisation, so therefore many strategy theorists begin with a consideration of how organisations operate.

Up until the 1960s the dominant paradigm in organisational research was structural contingency theory. Its central premise was that organisations adapted structures to deal with ‘contingencies’ such as technology, size and (following Chandler) strategy.

Managers within organisations were depicted as the structuring and adaptive agents manipulating organisational characteristics to improve performance (Pfeffer, 1997, pp.158–63). Managerial agents were seen as benign and rational. Organisations in turn were seen as rational and purposeful systems. A positive correlation was assumed between fit and organisational performance; managers were the adapters of fit. Fit could be optimised in equilibrium.

Specific propositions emerged about organisational components. For example, bureaucracy and centralisation were seen as functions of technology, size and rate of change. Matrices were defined by rate of change and product diversity. Functional or divisional structure was defined by strategy and size. The method chosen was frequently multiple regression analysis with the organisational feature requiring explanation treated as the dependent variable (Donaldson, 1995).

In the 1960s, primarily in the USA, this picture of organisational rationality and managerial benevolence was attacked from a number of directions. Organisations were characterised as political systems – the key notions were power, inertia, bounded rationality and legitimacy. In addition, approaches within economics such as transaction cost economics and agency theory (discussed above) served either to demonise managerial agency or to downplay its significance (Donaldson, 1995).

All critical approaches debated whether managerially initiated strategy was feasible or desirable.

Many critiques stressed conceptual difficulties with the rational choice approach to organisational analysis. In this approach the individual is the unit of analysis; the individual is prior to and causes the collective. Individual choices are independent; collective action is aggregate individual action. The critique of rational choice (Zey, 1998) asserts that rational choice approaches to organisation have too restrictive and unrealistic assumptions. Zey (1998) lists the following.

• Individuals have rational preferences; they are complete and transitive.

• Economic man is also selfish; all forms of altruism are subtle self-interest.

• Preferences are revealed in choices; for example, actions are preferences – ‘the causal relation is from the action to the subjective’.

• Choice is rational if the outcome is rational. Process is not important.

• Value and utility are subjective.

• Organisations function rationally; for example, means–ends relationships are pursued, efficiency is maximised, decision-making is logical.

• Efficiency is not a contested concept; the market economy operates independent of context.


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• Power is a structural condition within economic transactions affecting payoffs; authority emerges unproblematically from principal–agent relationships.

Many approaches assumed rationality was bounded, or that social forces exerted themselves on organisations that were at least as powerful as economic ones.

15.3 Institutional theoryInstitutional theory (Meyer and Rowan, 1977) starts from the two premises that actors are boundedly rational and that social forces are important. Specifically:

• Organisation form is driven by ‘institutional myths’. Organisations adopt forms because of myths within an environment, as opposed to because those myths are necessarily connected to more effective organisational outcomes.

• They argue against the idea of the rational organisation. The authors argue, instead, in favour of an idea of rationalised institutional elements.

• Organisations are driven to adopt practices or routines in order to achieve increased legitimacy and to increase their survival prospects, and so that their adoption of these practices is not immediately connected to any direct increase in efficiency.

• As rationalised institutional rules arise in given domains of work activity, formal organisations form and expand by incorporating these rules as structural elements.

• Organisations that incorporate legitimated, rationalised elements in their formal structures maximise their legitimacy and increase their resources and survival capabilities.

• The more an organisation’s structure is derived from institutionalised myths, the more it maintains elaborate displays of confidence, satisfaction and good faith, internally and externally.

• Institutionalised organisations seek to minimise inspection and evaluation by both internal managers and external constituents.

DiMaggio and Powell (1983) do not describe firms as existing in markets, but in ‘fields’. Fields do not operate primarily under market rules but under social rules which emphasise legitimacy and conformity. There is a tendency for firms in fields to homogenise, not through competition in search of efficiency, but rather for firms subject to bounded rationality to seek legitimacy through accommodation of pressures towards isomorphism. Three types of isomorphism are identified.

1. Coercive isomorphism refers to pressure from the state or wider society, possibly embedded in law, regulation or external codes of conduct.

2. Mimetic isomorphism refers to imitation of one organisation by another in order to be accepted as a legitimate field member, or because, under bounded rationality, search for the appropriate organisational form was minimised.

3. Normative isomorphism refers to items such as professional socialisation, in which again legitimacy and conformity are prime objectives.


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Inter-firm competition emerges as a socially constrained activity, with managers having limited ability to define strategies or structures that would jeopardise legitimacy. There is a range of research arguing for the applicability of this approach. For example, in his discussion of the growth of management consultancy, McKenna (2006) asserts two examples of institutionalism. First, he argues that the major management consultancy firms adopted partnership governance structures primarily in imitation of law firms and investment banks in order to enhance legitimacy by association with a high-status organisational form. He goes on to offer another isomorphic example in the operation of consultancy firms. He suggests McKinsey exported the US divisionalised/diversified M form model to Europe in the 1970s just as it was beginning to decline in the USA. The agency for diffusion was not the enhanced efficiency properties that Chandler and Williamson identified, but the social pressure to conform with a structure advocated by high-status consultants. He points out that McKinsey did not have an office in Spain because of concerns about the political regime there, and Spanish firms divisionalised at much lower rates until the regime changed in 1976.

As Figure 15.1 shows, diversification trends do show a lag effect between the USA and Europe. The figure is part of an essentially institutionalist argument about the influence of Chandlerism in post-War Europe, and there is a major point to make here about the strategy literature in general. The practical influence of academic business strategy, particularly as it is put into practice by the major management consulting firms, is such that the tenets of strategy may become self-fulfilling properties, creating the trends they seek to theorise about.

Figure 15.1: The diversification of large industrial firms, USA and Europe (domestically owned top 100 industrial firms)

Source: From Whittington, Mayer and Curto, 1999.

A second example of empirical work in institutional theory is the diffusion globally of stock markets (Weber et al., 2009). They studied the creation of stock markets in emerging economies and identified coercive, normative and mimetic effects operating to different degrees in different countries. In some, governments had set up stock markets and pressured firms to list as part of a drive for economic development. In others, the initiative came from businesses themselves, as they tried to emulate the benefits – primarily the raising of capital – enjoyed by developed economies with stock markets. They found that coercive effect dominance – for example,

**

*

* *

% of firms diversified (related and unrelated) UK

90

80

70

60

50

40

30

20

10

0

1950 1960 1970 1983 1993

US

UKGermany

France


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the major role of governments – was associated with ceremonial, poorly-performing exchanges, judged by activity indices such as listing and trading volumes. By contrast, peer influence and normative emulation enabled more vibrant activity levels.

That major features of business life such as divisionalisation, partnership and stock markets can be attributed to the action of social forces is a major departure from simple economic theories of business behaviour. There are two major implications. First, the unit of analysis shifts from the firm to the field. Second, the scope for independent managerial action is downplayed in such approaches, raising questions about the integrity of the idea of ‘strategy’ itself. We shall return to this below.

15.4 Organisational ecologyThese two implications are shared by the approach of organisational ecology – which borrows ideas from biology and ecology to study organisations. In addition, it also takes collections of organisations, rather than the single firm, as the unit of analysis. In organisational ecology, these collections are termed ‘populations’. The approach examines interactions within and between populations of organisations. It concerns itself with patterns of birth and death of organisations and looks at selection mechanisms and life histories. A key question is: why are there so many kinds of organisation?

Key concepts include:

• density dependence, for example, the influence of population density on birth and death rates

• legitimacy and competition, and their interaction as in institutional theory

• niches, borrowed directly from ecology to mean a space on which an organisational population may survive

• structural equivalence, for example, identical patterns of inter-organisational ties.

Let us illustrate the approach with the canonical example – the analysis of US labour unions between 1836 and 1985 (Hannan and Freeman, 1977). The pattern of growth and decline is illustrated in Figure 15.2 below. As unions are founded and their numbers grow, they gain legitimacy as an organisational form and benefit from positive externalities which reduce costs; density has positive effects in the growth phase. When population size is larger, competition and resource constraints turn density-dependent effects negative. Concentration occurs as ‘niche width’ stabilises and death rates exceed birth rates. These selection effects are external to the individual organisation, but generate patterns of change for the population as a whole.


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US labour unions

1840 1860 1880 1900 1920 1940Year

1960 1980 20000

40

80

120

160

200

240

Num

ber o

f lab

our u

nion

s

Figure 15.2: US labour unions

The approach has been replicated, notably with Silicon Valley firms and US newspapers, which indicate similar patterns.

Activity 15.1

This is an optional extra acitivity for those of you who have access to Chapter 7 of Pfeffer (1997). How does he describe the strengths of organisational ecology in that chapter?

15.5 CritiqueThere are some common features of institutional theory and organisational ecology.

• In both, there is an assumption of internal organisational inertia – the organisation does not respond to changes but reacts to external social forces. The underlying assumption is based on elite dominance – that elites within organisations have no incentive to change. This in turn contains implicit ideas about power in a hierarchy, and Donaldson has noted that these organisational theories are ‘anti managerial’ (1995).

• The unit of analysis is the population or field, not the firm, and it is central to both approaches that any sources of variation in firm structures within a field or population are not of primary interest.

• Social forces, not efficiency, explain the occurrence of common organisational forms.

There are various critiques of both approaches, summarised in a review by Donaldson (1995), as follows.

15.5.1 Institutional theory• There are observable differences in organisational form within fields.

For example, within investment banking there was a lengthy period when both partnerships and joint stock companies coexisted.

• Where do agency and change come from? To continue the investment banking example, partnerships have disappeared, but it is difficult from an institutional theory perspective to find a simple explanation.

• Empirical support is strong only for the effectiveness of coercive forces – as in the stock market example.

• The relationship between isomorphism and performance variables is unclear. We know that performance differences between firms in


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a given industry persist, but whether better conformers are better performers is not clear.

15.5.2 Organisational ecology Some of these criticisms would also apply to organisational ecology, but in addition:

• there is no theory of change, even isomorphic change, within organisations

• there is no direct study of intra-organisational processes

• the randomness of selection processes is asserted, not proven – what is the role of selection in death rates?

15.6 Organisational sociology and economicsThere is a fundamental difference between these sociological approaches to organisation and those based on economics. They may be summarised as follows.

15.6.1 Sociology• Organisations as types of institution.

• Organisations in fields and societies.

• Formal and informal structures, multiple empirical actors.

• Historical and path-dependent emergence.

• Rationality as a variable.

15.6.2 Economics• Firm as production function then hierarchy.

• Firms in exchange relationships.

• Hierarchies with stylised actors.

• Profitable solutions to problems.

• Rationality as assumption.

Pfeffer has argued that economics has become a more powerful discipline in the study of business organisations. He remarks:

It seems almost impossible to consider the evolution of organisational theory, particularly in the future, without considering the influence of economics on the field’s methods and substance. (Pfeffer, 1997, p.14)

He attributes this to the focus on business organisations and in particular:

the location of much organisational studies in business schools…has led to a substantial overemphasis of economic models and logic. (Pfeffer, 1997, p.6)

He argues that there are a number of factors leading to the intrusion of economics into organisational theory.

• Economics has a powerful, elegant theory allowing the building of formal models of organisation, such as those based on agency theory.

• The growth of large firms and the share of economic activity that takes place within firms lead to an increase in the importance of organisational versus market behaviour.


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• There is an increasing emphasis on performance and efficiency as the main attributes of organisation, as opposed to non-economic features.

• The increasing impact of the practitioner business community that is looking for performance-improvement tools.

• Fragmentation of organisational theory with many different approaches based in sociology and psychology, rather than a unified theory. Donaldson (1995) has termed this paradigm ‘proliferation and incommensurability’.

Activity 15.2

What are to Pfeffer’s (1997) major criticisms of economic approaches to the study of organisations?

15.7 Overview of chapterThis chapter has analysed the development of some modern theories of organisation, dealing with both sociological and economic approaches and examining ecological and institutional theories of organisational fields, with empirical examples of each type of research. It has looked at the connection between the study of organisational forms and fields, and examined theories of organisation that imply restrictions on managerial action.


• describe some main currents in organisational theory

• relate these to current debates in business strategy.

15.9 Test your knowledge and understandingWhat is the contribution of institutional theory to an understanding of the strategy and structure of large businesses?

Chapter 16: Contemporary strategic management

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• describe the resource-based view (RBV) of the firm and its implications for strategy

• discuss the dynamic capabilities approach to strategy formation

• explain the concept of core competence and its use

• describe the idea of an integrated strategy process.

16.1.2 Essential readingWhittington, R. What is strategy – and does it matter? (Ontario: Thomson

International, 2000) second edition [ISBN 9781861523778], Chapter 2.

16.1.3 Further readingBarney, J.B. ‘Firm resources and sustained competitive advantage’, Journal of

Management 17(1) 1991, pp.99–120. Eisenhardt, K.M. and J.A. Martin ‘Dynamic capabilities: what are they?’,

Strategic Management Journal 21 2000, pp.1105–121.Hoskisson, R.E., M.A. Hitt, W.P. Wan and D. Yiu ‘Theory and research in

strategic management: swings of a pendulum’, Journal of Management 25(3) 1999, pp.417–56.

McGahan, A.M. and M.E. Porter ‘The emergence and sustainability of abnormal profits’, Strategic Organization 1(1) 2003, pp.79–108.

Prahalad, C.K. and G. Hamel, ‘The core competence of the corporation’, Harvard Business Review 68(3) 1990, pp.79–91.

Priem, R.L. and J.E. Butler ‘Is the resource based “view” a useful perspective for strategic management research?’, Academy of Management Review 26(1) 2001, pp.22–40.

16.1.4 Works cited Amit, R. and P.J.H. Shoemaker ‘Strategic assets and organisational rent’,

Strategic Management Journal 14 1993, pp.33–46.Hamel, G. and C.K. Prahalad Competing for the future. (Harvard: Harvard

Business School Press (1996) [ISBN 9780875847160].Kogut, B. and U. Zander ‘Knowledge of the firm, combinative capabilities, and

the replication of technology’, Organization Science, 3(3), 1992, pp.383–97.Nelson, R. and S. Winter An evolutionary theory of economic change.

(Cambridge, MA: Belknap Press, 1982) (Boston, MA: Harvard University Press, 1990) [ISBN 9780674272286].

Penrose, E. The theory of the growth of the firm. (Oxford: Oxford University Press, 2009; first published 1959) [ISBN 9780199573844].

Rumelt, R.P ‘Towards a strategic theory of the enterprise’ in R. Lamb (ed.) Competitive strategic management. (Englewood Cliffs: Prentice Hall, 1984) [ISBN 9780131549722].

Schumpeter, J.A. The theory of economic development: an inquiry into profits, capital, credit, interest, and the business cycle. (Cambridge, Mass.: Harvard University Press, 1934).


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Teece, D.J., G. Pisano and A. Shuen ‘Dynamic capabilities and strategic management’, Strategic Management Journal 18 1997, pp.509–33.

16.2 IntroductionIn recent years and in part as a reaction to the success of the Porter framework discussed in Chapter 14, the discipline of business strategy has developed a concern with matters internal to the firm. In the literature, there have developed two views of competitive advantage.

1. The competitive positioning view. The basis of this approach is that sustained superior firm performance requires effective product-market positioning. The intellectual origins are with Porter, and the variables one is concerned with in order to assess competitive advantage include: market share, product features, cost position, brand positioning, geographic scope and vertical integration.

2. The resource-based view. The basis of this approach is that sustained superior performance requires unique resources and capabilities internal to the firm. We discuss the intellectual origins below. The variables one is concerned with to assess competitive advantage differ and include: technological skills, teamwork capability, business processes, leadership, innovation and organisation culture.

In parts of the literature, these are assessed as alternative ways of doing strategy. However, as Figure 16.1 illustrates, they are potentially complementary in that the process of strategy formulation could examine both sets of variables.

Figure 16.1: Sources of competitive advantage

These ideas have deep roots back as far as Schumpeter’s notion of cycles of creative destruction (1934); he put considerable emphasis on activities such as technological change in developing economic growth. However, the main early contributions come from Penrose (1959). She maintained that firms can create economic value not due to mere possession of resources, but due to effective and innovative management of resources.

Unused productive services are, for the enterprising firm, at the same time a challenge to innovate, an incentive to expand, and a source of competitive advantage. They facilitate the introduction of new combinations of resources – innovation – within the firm. (Penrose, 1959, p.85; emphasis added)

She developed the idea that all firms have slack, or unused resources, that offer value-creating opportunities if recognised and exploited by managers.

Resource-based view

Input markets• People• Technology• Capital equipment• Buildings• Land

Factors of production Firm

Competitive positioning view

Products and services

Output markets• Technology products• Industrial products• Consumer products• Agricultural products• Services


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The idea was not initially taken up by strategy writers but Porter’s focus on the appropriation of existing rents was increasingly seen as failing to explain how rents were created unevenly across companies. In economics, Nelson and Winter (1982) argued that organisations have repertoires of creative routines that generate innovation and profit opportunities. Rumelt (1984, p.561) noted that the strategic firm ‘is characterised by a bundle of linked and idiosyncratic resources and resource conversion activities’. By idiosyncratic he means that firms have different bundles of these attributes and this might be a way of explaining differential performance.

16.2.1 The resource-based viewThese ideas were developed within the strategy discipline by Barney (1991) into the resource-based view of the firm.

For Barney, resources are the tangible and intangible assets that a firm controls, which it can use both to conceive of and to implement its strategies. They are of different types – they can be financial, physical, human and organisational. He distinguishes capabilities – a subset of the firm’s resources which are the assets that enable a firm to take full advantage of the other resources it controls.

The essence of this approach is heterogeneity, the idea that apparently similar firms may possess different bundles of resources. For heterogeneity to persist, there must be immobility, meaning that resource differences between firms may be long lasting. He also introduces the idea of path dependence – the history of the firm matters to the accumulation of resources. In the resource-based view, the firm is a portfolio of attributes, not a chess piece to be moved around the industry board. One does not look at marketing or financial attributes, but one looks inside the firm for sources of competitive advantage. This is depicted in Figure 16.2.

Figure 16.2: The firm as a portfolio of attributes

There are a number of implications. The first is that compared to Porter, the idea of an industry is relatively unimportant. The deployment of resources may not follow industry boundaries. The second is that competitive advantage is not seen as the outcome of a one-shot game to achieve the optimal position. Rather, competitive advantages must be built and success depends on the continuous renewal of advantages through management activity.

Resources that are to sustain competitive advantage must be valuable, scarce and difficult to imitate. Advantages persist due to barriers to imitation and these barriers may be created by managerial action. His definition is as follows.

1. Valuable − significant performance consequences (increases revenues, reduces costs).

2. Scarce − not widely disseminated among competitors.

Organisational

MarketingCompetitive

Costs marketVertical integration

Strategicgroup

Assets Revenues

Returns to investors

Financialstructure

Products

Promotion

Pricing

Distribution

Systems

Efficiency

Technology

Quality

Structure

Leadership

Culture

Motivation

Operational Institutional

Financial

History

Governance

Reputation

Relationships


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3. Difficult to imitate − not readily imitable by competitors; not substitutable; causal ambiguity.

In analysis of the sources of competitive advantage he adds another condition, namely that the firm must be organised to exploit its resources. This, as we shall see, opens up the possibility that firms with identical resources may be differentially competitive depending on whether they are organised to exploit, and suggests an underlying dimension to resource leverage that requires examination.

Valuable? Rare? Costly to imitate?

Organised to exploit?

COMPETITIVE IMPLICATIONS?

No Competitive disadvantage

Yes No Competitive parity

Yes Yes No Competitive advantage (temporary)

Yes Yes Yes Yes Competitive advantage (sustained)

Table 16.1: Relationship between resources and competitive advantage

Table 16.1 displays his approach. It requires an approach to resources that explains why they might not be easy for competitors to copy or to imitate. Barney deals with three barriers to resource imitation.

1. Causal ambiguity: By this he means that there may be barriers for rivals in understanding the resource implications. Either rivals cannot observe the resource, or they cannot replicate or reverse-engineer it. This may be because of the social complexity of organisational resources.

Examples: Organisational culture, systems, motivation, commitment.

2. Unique historical trajectory: By this he means that rivals cannot replicate the historical sequence of events. It is essentially an argument about the path-dependency of firm performance.

Examples: First-mover advantages such as location, raw materials.

3. Time compression diseconomies: This means that the resource is inherently time-consuming to accumulate.

Examples: Reputation, knowledge, skills, relationships, experience.

The last point requires some analysis of the difference between resources in terms of their imitability over time. He uses the idea of resource cycles as follows.

• Fast-cycle resource: Diffuses quickly through a population of firms; not a sustainable competitive advantage.

Examples: Web design; breakfast cereals; retail store layout; fashion items.

• Medium-cycle resource: Diffuses more slowly through a population of firms; sustainable in the short-run.

Examples: Total quality management (TQM) in manufacturing; business process re-engineering.

• Slow-cycle resource: Diffuses very slowly through a population of firms; sustainable as competitive advantage.

Examples: Microsoft’s operating system; Disney’s experience; legally protectable intellectual property (IP).


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16.3 Dynamic capabilitiesBarney’s idea that firms with similar resources might be differentially organised to exploit them led other researchers to question whether some underlying resource mobilisation set of attributes might be examined. Put another way, where do valuable, rare and inimitable (VRI) resources come from?

Teece et al. (1997) and Eisenhardt and Martin have developed the dynamic capabilities approach to analyse how VRI resources are created. They define the idea of dynamic capabilities as:

… the firm’s ability to integrate, build and reconfigure internal and external competence to address rapidly changing environments. (Teece et al, 1997)

Eisenhardt and Martin argue that capabilities themselves do not need to be idiosyncratic:

… competitive advantage lies in the resource configurations they create, not in the capabilities themselves. (Eisenhardt and Martin, 2000)

Examples of capabilities include:

1. strategic decision-making

2. acquisitions and alliances

3. innovation

4. divestment

5. absorptive capacity (by this they mean the ability to absorb competitor information).

16.4 Core competencesHamel and Prahalad (1996) have developed a parallel idea in the notion of core competences. These are organisational attributes that are:

• integral to the organisation’s success

• generating fundamental customer or cost benefit

• providing competitive differentiation

• learning-based accumulations of skill and experience

• vested in people

• supported by technology, processes and value.

They are clear that core competences are not:

• values or sets of wishes

• physical or financial assets

• individual skills

• patents or intellectual property rights

• products.

In fact, these items may be generated by the leverage of competences. Competences provide access to markets and consumer benefits.

The application of the two key competences, singly or in combination, are seen to generate the value proposition. The specific products are


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almost incidental; they are vehicles for the application of the competences to the value proposition. But the competence approach also sets a limit on product development − specifically, if a product is proposed which does not apply the competences, the implication is that it should not be launched. In this view, one function of the strategy process is to test the limits of the application of competences to product.

Activity 16.1

Go to the website of the Walt Disney Corporation. What do you think are the core competences of this organisation?

16.5 CritiqueThis set of approaches has some differences but rests on the general proposition that the sources of competitive advantage are internal to the firm. Some have questioned whether anything original is being offered. For an economist, this may merely be ‘a theory of rents based on resource market imperfections’ (Amit and Schoemaker, 1993). Others see this as a simple recapitulation of the central Chandler proposition that:

… what firms do better than markets is the sharing and transfer of the knowledge of individuals and groups within an organisation. (Kogut and Zander, 1992, p.383)

Other, more practical criticisms concern:

• vagueness, how to falsify

• ex post analysis, not prediction

• what are the mechanisms precisely through which resources create competitive advantage?

• how practically useful is the approach, particularly for new firms in dynamic environments?

• what are the organisational correlates of effective resource management?

All versions of the resource-based view (RBV) may be seen as an extension of the Penrose tradition which in turn develops Chandler’s idea of the firm as a bundle of capabilities. The managerial role is to identify and leverage these capabilities to generate performance; this is similar to the implied role in structural contingency theory. The RBV developed partly in reaction to the Porter emphasis on external industry factors and firm homogeneity. However, the value, rarity, inimitability and organisation (VRIO) approach also adopts the Porter notion of sustained competitive advantage. The dynamic capabilities model moves away from static analysis and implies an extension to the managerial role into the development of firm capabilities; it also identifies generic capabilities that may be transferable.

The competence approach tends towards the conclusion that industry does not matter at all, since products flow from competence application.

However, in all of these approaches, ex ante identification of resources, capabilities and competences is poorly theorised.


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16.6 Strategy todayIn the practice of strategy today the separation of conception as analysis from execution as process is very rare. This means that industry analysis, competence analysis and change management often need to be synergistic. But, for consulting firms, it does not follow that clients will buy all three from a single provider (many consulting firms now organise around industries). In many business schools there are strategy faculties that are focused on process or decision-making (sociology, psychology) and those that do analysis (economics, game theory).

Formulation

Internal

• Mission• Goals• Objectives

Action

• Industry analysis• Key success factors• Competitive position• Opportunities and threats

External

• Risk analysis• Negotiation• Strategic choice

Decision

• Resources and capabilities• Functional area analysis• Financial analysis• Strengths and weaknesses

AnalysisGoals• Values• Purposes

Vision

Implementation

• Competitive advantage• Strategic alternatives

Synthesis

• Structure• Culture• Processes• Systems• Deployments

DATA

Figure 16.3: Strategy as (rational?) process

Figure 16.3 attempts a summary of the strategy process. It implies a mix of abstract analysis of opportunity with more qualitative assessment of what can be implemented in the firm concerned. Synthesis of the external analysis may involve compromise between the optimal and the possible.

Activity 16.2

Within the firm, who do you think should be involved in the strategy process depicted in Figure 16.4?

16.7 Overview of the chapterThis chapter has examined the most prominent theoretical perspective to emerge in the strategic management discipline in recent decades: the resource-based view of the firm. The emergence of this re-focus on the ‘internal’ elements of company strategy has been placed in disciplinary context. Major works of both scholarly (e.g. Barney, Eisenhardt) and practitioner-oriented RBV authors (e.g. Hamel and Prahalad) have been reviewed to provide a representative picture of the concerns, methods, findings and debates of the RBV (and associated knowledge-based view) theoretical perspectives. The chapter concluded with a brief discussion of trends in strategic management practice.


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• describe the resource-based view (RBV) of the firm and its implications for strategy

• discuss the dynamic capabilities approach to strategy formation

• explain the concept of core competence and its use

• describe the idea of an integrated strategy process.

16.9 Test your knowledge and understandingCritically evaluate the contribution of the resource-based view of the firm to the discipline of strategic management. Illustrate your answer with examples.

Chapter 17: Strategy and decision-making

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• explain prescriptive and descriptive approaches to decision-making within organisations

• discuss the three meanings of bounded rationality

• describe biases and heuristics

• outline Prospect theory and framing.

17.1.2 Essential readingBazerman, M. Judgment in managerial decision making. (New York: Wiley,

2002) fifth edition [ISBN 9780471398875], Chapter 2.Bromiley, P. The behavioral foundations of strategic management. (Oxford,

Blackwell, 2005) [ISBN 9781405124706], Chapter 1.

17.1.3 Further readingFenton-O’Creevy, M., N. Nicholson, E. Soane and P. Willman Traders: Risks,

decisions and management in financial markets. (Oxford: Oxford University Press, 2005) [ISBN 9780199226450 pbk)].

Simon, H.A. Administrative behaviour. (New York: Macmillan, 1997; first published 1947) [ISBN 9780684835822 (pbk)].

17.1.4 Works citedCyert, R.M., H.A. Simon and D.B. Trow ‘Observation of a business decision’,

Journal of Organisational Behaviour 29 1956, pp.237–43.Fama, E.F. ‘Market efficiency, long-term returns, and behavioral finance’,

Journal of Financial Economics 49 1998, pp.283–306.Feldman, M.S. and J.G. March ‘Information in organisations as signal and

symbol’, Administrative Science Quarterly 26(2) 1981, pp.171–86.Gigerenzer, G. ‘Striking a blow for sanity in theories of rationality’ in Augier, M.

and J. March (eds) Models of a Man: Essays in Memory of Herbert A. Simon. (Cambridge, MA: MIT Press, 2004) [ISBN 9780262012089].

Kahneman, D. Thinking, fast and slow. (London: Penguin, 2011) [ISBN 9780141033570].

Kahneman, D. and A. Tversky ‘Prospect theory: An analysis of decision under risk’, Econometrica 47 1979, pp.263–91.

17.2 IntroductionThere are two literatures looking at decision-making within organisations:

1. rational and prescriptive – logical analysis of the decision task and the use of deductive methods to derive the behaviour of rational actors (e.g. expected utility theory in economics)

2. descriptive – empirical, often psychological, seeking general principles to explain observed preferences and actions (e.g. identification of heuristics and decision biases).


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Empirical work in management has investigated processes of decision-making in large organisations. The early work is particularly associated with the Carnegie-Mellon school in general and Herbert Simon in particular. Later work associated with Kahneman has been experimental. Both have developed concepts to describe systematic variance from rationality in decision-making. We will look at each but, first, let us clarify the rational model from which they dissent.

Utility maximisation in economics suggests a decision process in which the individual decision maker:

• thinks of all conceivable actions

• assesses all the consequences of each action

• derives a utility for each action, retrieved from the decision-maker’s own preferences

• computes the probabilities of all outcomes

• chooses the action.

The central question for descriptive approaches is as follows: is this a realistic description of how decisions are made or, if not, what percentage or types of decision can be so characterised? The example used by Simon himself is that of looking for a needle in a haystack. Does the actor search until she finds a needle, or then keep searching until she finds the brightest and sharpest needle? Simon’s answer involves two key concepts.

1. Satisficing behaviour. The actor searches until she finds a satisfactory outcome, rather than searching for the optimum outcome.

2. Bounded rationality. The actor cannot know how much longer the search for the optimum will take, and hence whether it is worth it or not.

These ideas came from some key early studies in management theory. Cyert, Simon and Trow (1956) and Simon (1947) found that:

1. Economic models appear to describe an approach to repetitive and well-defined problems with pre-established options.

2. Long-term or strategic decisions of a non-repetitive sort appear to generate highly unstructured search and decision processes.

3. Expected utility theory was a valid descriptive model for a category of decisions but: ‘We should be sceptical in postulating for humans… elaborate mechanisms for choosing among diverse needs.’ (Simon, 1955, p.137)

Feldman and March (1981) studied a range of organisational decisions and found that:

1. Much information that is gathered and communicated has little decision relevance.

2. Much information used to justify a decision is collected after the event.

3. Much information requested is collected then not used.

4. Regardless of information availability, more information is requested.

5. Complaints about lack of information coincide with relevant information being ignored.

This is inconsistent with rational organisational decision-making but not inconsistent with individual rationality as described in game theory or signalling theory – rational self-interest aggregates to an inefficient outcome.


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Simon’s ideas about bounded rationality have been very influential, but in the modern literature the term is used in at least three ways.

1. Rationality is limited by processing and informational requirements. There are sets of decisions that involve such complexity in both that rationality is affected. This is Simon’s original idea. The parameters of the decision, particularly complexity, are key.

2. Modern economists often use the term to refer to information asymmetry. That is, rational actors may make suboptimal decisions because they lack relevant information and the search costs for that information are very high. The parameters of information distribution are key.

3. A third use of the term follows, over a number of years, from the work of Kahneman and Tversky. It is well summarised in Bazerman (2002). Rationality is systematically impaired by cognitive factors which cause patterned deviations from optimum. The parameters of the decision-maker are key.

Thinking is very hard and the mind tries to avoid it when possible (Kahneman, 2011).

Their approach is as follows.

• It is not so much that one’s mind is lazy as it is extremely busy… think of all the tasks the mind must constantly perform/monitor − adjusting the heart rate, breathing and keeping muscles flexed, etc.

• Our mind copes with this amazing amount of demand by ‘automating’ as much as possible, for example, information processing through automation/routines.

• The automation allows us to concentrate on one thing while performing another – we can multi-task.

• To accomplish this, the mind has evolved shortcuts or rules-of-thumb to help it deal with complexity.

Heuristics are thus shortcuts used to help make judgements and decisions in complex situations with minimal effort. Most of the time heuristics work well and are necessary for the mind to work; for Gigerenzer (2004) heuristics are smart and are often the optimal response to situations. He uses the term ‘ecological rationality’; for example, most people estimate they are ‘better than average’ on a variety of indicators. This irrational (if underlying) distribution is normal but not if negatively skewed. If the distribution of driving ability is normal, the majority cannot be above the average; if, however, there are a small number of very bad drivers, many can be.

However, these rules-of-thumb can lead to systematic bias/errors – often suboptimal (Tversky and Kahneman, 1979). Heuristics are not biases but can lead to biases; and biases are not errors – error is random, biases are systematic deviations from rationality. We give many examples below but here is an indicative one: there is a widespread tendency from empirical work for people to overestimate the frequency of high-impact events – for example, aeroplane crashes – since they estimate frequencies based on consequences.

Activity 17.1

In this subject guide, which three-letter word ending is most common: -ing or -n- (- meaning any letter)?


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17.3 Efficient marketsWe illustrate the content of theories based on this approach by examining competing explanations for market behaviour in finance. The main theory is the efficient markets hypothesis. There are three different forms of the efficient market hypothesis (Fama, 1998).

• The weak form states that present prices reflect all information contained in the record of past prices. In other words, past prices are no guide to the future.

• The semi-strong form states that current prices incorporate not only all information from past prices but also all other published information.

• The strong form states that current prices incorporate all information that could be acquired by a painstaking fundamental analysis of the asset and economic circumstances.

Each has different assumptions about rationality. The strong form makes very strong assumptions about the behaviour of market actors and implies that there should be very few profit opportunities in markets since they are rapidly traded away.

The discipline of behavioural finance is based on observations of market anomalies which appear to contradict the efficient markets hypothesis. (For a review, see Fenton-O’Creevy et al., 2005, pp.28–51). For example, anomalies observed at the level of the market – noise (too much trading), stock picking and selling a falling stock – are seen as evidence of a cognitive bias to explain the pattern of behaviour underlying anomaly. The three biases relevant to the three mentioned anomalies are action bias (preferring action to inaction), retrievability bias and loss aversion. There is no ‘theory of irrationality’ explaining the incidence or frequency of anomalies and therefore nothing to match or disprove the efficient markets hypothesis.

We take one bias − loss aversion − to illustrate Kahneman’s work since it is central to his winning the Nobel Prize for his work. Loss aversion is central to ‘Prospect theory’ which is illustrated in Figure 17.1. Loss aversion is defined as engaging in high-risk behaviour to avoid the experience of loss relative to a reference point. Figure 17.1 illustrates that when we deal with gains, we tend to be risk averse (as predicted by expected utility theory) but when we deal with losses, we tend to be risk seeking; that is, we will take bigger risks to eradicate a loss. This is captured by the steeper curve in losses below R; we experience more subjective disutility than the objective size of the loss.


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Figure 17.1: Prospect theory: a hypothetical value function

Source: Kahneman and Tversky, 1979. © The Econometric Society. Reproduced by kind permission.

Prospect theory also distinguishes between probabilities and the weight those probabilities have in the decision-making process. This is illustrated in Figure 17.2.

Recall the aeroplane crash example above. The decision weight line illustrates that we would overestimate the chance of the airplane crashing but underestimate the chances of a car crash on the way to the airport.

Note: ‘weight’ − impact of (high/low probability) events

Decision weight

Normative line

Probability

Wei

ght

Figure 17.2: Decision weights versus probability

This is experimental work often with student subjects but there is empirical work in financial markets which illustrates decision biases. Fenton-O’Creevy et al. (2005) tested traders for the bias of illusion of control, for example, an unrealistic belief that we can influence events. They presented traders with a random walk line and suggested three inoperative keys on the keyboard could influence it (see Figure 17.3). Traders with a high illusion of control showed less-effective performance in terms of:

• risk management

• analysis

risk-seeking

risk-averse

£

Perceived value(Utility)

R


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• contribution to desk profits

• own remuneration.

At a conservative estimate the difference in annual remuneration between a trader with a high illusion of control (in the top 18 per cent) and a trader with an average illusion of control was about £100,000.

Figure 17.3: Correlation between traders’ illusion of control over experiment and their contribution to profits

Source: Fenton-O’Creevy et al., 2005.

17.4 The decision processThe following four tables show how biases can affect the decision process. A simple linear process of information gathering, processing, decision taking and outcome assessment is used as a framework to show how biases identified in Bazerman (2002) can affect each stage. Key points to note are:

• Some biases can affect several stages of the process.

• Some biases are individual and cognitive and some consist of pressures on decisions that are social or normative.

Illusion of control

Cont

ribu

tion

to

desk

’s p

rofi

ts

0.00 25.00 50.00 75.00 100.00

0.00

25.00

50.00

75.00

100.00


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Cognitive bias Consequence of bias

Retrievability and availability bias

Selective attention given to what stands out, or springs easily to mind

Base-rate insensitivity Focus is on objective not relative frequency

Failure to apply sampling theory to small numbers

True likelihoods are miscalculated

Conjunction fallacy Unconnected information is falsely assumed to be linked

Framing and order effects

Different weights are assigned to first versus last in a sequence

Subjective frequency estimates

Infrequent events are overestimated, frequent events underestimated

Confirmation bias Search is biased towards confirming rather than disconfirming evidence

Table 17.1: Influence of cognitive biases on information gathering


Loss aversion not risk aversion Lottery behaviour occurs - gambling on long odds

Miscalculated probabilities Only hits not misses are scrutinised, or vice versa

Gamblers’ fallacy Connections are mistakenly perceived between unconnected events

Over-confidence and self esteem Optimism is greater than objective chances merit

Ego-involvement Too little or too much emotional attachment is given to events or outcomes

Stress Load, uncertainty, conflict affect ability to think and act clearly

Framing of targets Behaviour changes according to whether a target is conceived of as ‘avoid worst case’ or ‘achieve goal’

Insufficient anchoring adjustment Readjustment to target after feedback is insufficient

Representativeness bias Isolated events or information are assumed to be representative

Table 17.2: Influence of cognitive biases on information processing


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Asymmetries of loss and gain

Losses are chased more than gains

Endowment effects What you have to sell is undervalued relative to what you buy

Social norms The risk or decision profiles of the local culture are followed

Groupthink Intragroup momentum governs a decision, and censors dissent

Herding Instead of making rational choices, we watch what others do

Incentives Risk-reward outcomes are distorted by personal payoff system

Impression management

More important to look good than do good

Competitive pressures It becomes more important to win than to achieve

Table 17.3: Influence of cognitive biases on decision taking


Hindsight bias History is rewritten; “I knew this would happen”

Regression to the mean

Random variations are perceived as systemically caused

Rationalisation of outcomes

Failures are re-evaluated as benefits

Illusions of control It is believed uncontrollable outcomes can be controlled

Escalating commitment Good money is thrown after bad; motivated by sunk costs

Failure reactions Learning is for future avoidance rather than analytical or constructive insight

Attribution errors Errors are over-attributed to will and personality, and too little to situation and chance

Table 17.4: Influence of cognitive biases on reactions to decision outcomes

17.5 Overview of the chapterThis chapter traced the evolution of behavioural decision theories from their origins in the 1950s to the present day. Behavioural theories are normally based on:

i. a concept of a ‘good’ or ‘rational’ approach to decision-making

ii. empirical evidence which shows that people do not follow such an approach

iii. a theoretical account of why such departures from rationality occur, and, sometimes

iv. some suggestions as to how to help people make more rational decisions.

In this chapter we centred mostly on the celebrated ‘heuristics and biases’ tradition of Kahnemann and Tversky, showing how the approach that these authors developed can shed light on both economic behaviour in financial markets and managerial decision-making.


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• explain prescriptive and descriptive approaches to decision-making within organisations

• discuss the three meanings of bounded rationality

• describe biases and heuristics

• outline Prospect theory and framing.

17.7 Test your knowledge and understandingWhat is a rational decision? Describe some of the barriers to rational choice in organisations and how they can be overcome.

Notes


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Chapter 18: The origins of marketing

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• explain what is meant by the ‘marketing framework’

• discuss the history of marketing theory and the marketing business orientation

• describe how marketing fits into the traditional economic model of perfect competition

• outline how marketing makes use of different theories used in other academic disciplines.

18.1.2 Essential readingWillman, Theme 6.Kotler, P. and G. Armstrong Principles of marketing. (Harlow: Pearson Education

Ltd, 2013) sixth European edition [ISBN 9780273742975] Chapter 1.

18.1.3 Further readingBrassington, F. and S. Pettitt Essentials of marketing. (Harlow: Prentice Hall,

2012) third edition [ISBN 9780273727644]. Nevett, T. and R. Fullerton Historical perspectives in marketing. (Toronto:

Lexington Books, 1988) [ISBN 0669169684]. Pindyck, R. and D. Rubinfeld Microeconomics. (Upper Saddle River, NJ:

Pearson/Prentice Hall, 2012) eighth edition [ISBN 9780133041705].

18.2 Introduction Before we can start discussing marketing theories and concepts, it is useful to understand that marketing was (and to a large extent still is) a composite of a number of other academic disciplines. It is also important to understand where marketing originated from and what its intellectual foundations are.

In this chapter we will examine the emergence of marketing as a management discipline. In particular, we will examine how marketing fits into the traditional economic model of perfect competition. We shall see that marketing divorced itself from economics in the mid-to-late 1960s with the emergence of modern founders such as Joseph Kotler and Theodore Levitt (who were themselves former economists). This will be followed by a discussion of the four main historical business orientations (for example, production, product, selling and marketing) and how marketing fits into this identification as well. The chapter will conclude with an examination of marketing problems and how marketing students can draw upon different academic disciplines such as psychology as well as economics to solve them.


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18.3 Definitions and a brief introduction to the history of marketing as a distinct ‘discipline’ of study

Let us begin with three definitions of marketing and then discuss the implications that those definitions have in relation to traditional economic theory. After comparing marketing to economics we will go on to trace the history of marketing as an independent academic discipline within the field of management.

There are many definitions of marketing. Here we present three of the most widely used versions from the inception of marketing to the present.

1. Marketing consists of those activities involved in the flow of goods and services from the point of production to the point of consumption (American Marketing Association (AMA), 1938).

2. Marketing is the process of planning and executing the conception, pricing, promotion and distribution of ideas, goods and services to create exchange and satisfy individual and organisational objectives (American Marketing Association, 1985).

3. Marketing is the management process that identifies, anticipates and supplies customer requirements efficiently and profitably (UK Chartered Institute of Marketing, 2003).

Activity 18.1

Here is a question to ponder: what substantial differences exist between the first formal definition of marketing, the AMA’s 1938 definition, and the one the AMA provided nearly 50 years later in 1985? What explains the changes, if any, in the definition?

Looking at the two most recent definitions of marketing one sees that they agree on the following points.

• Marketing is a management activity and not strictly a ‘market’ process (though it depends on market signals).

• Marketing is about giving customers/buyers/users what they need and want.

• In the AMA version, marketing is about exchanges (for example, of ideas, goods and services).

• The AMA definition also describes the ways in which marketing can stimulate exchanges (for example, through conception, pricing, promotion and distribution).

Further information about these definitions can be found in Brassington and Pettitt (2012).

18.4 Marketing and economic theoryWhy should we compare marketing to economics, you may ask? The reason is that marketing was originally embedded in economics courses and programmes. If one thinks of the conventional starting point in neo-classical economic theory, however, there would be no pressing need to study something called marketing. Why?

Well, let us begin with some key assumptions of the competitive framework, starting with the firm and the products they sell.

First, we have many small firms x (xi, i=1…n), each taking a price as given. The demand curve facing every firm is perfectly elastic. This


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means that individual decisions concerning production have no effect on the market price for the good in question. In other words, they are homogeneous firms that accept what the market gives them. They have no power to shape their market environment, at least over pricing, which is a very big component of what marketing is.

Second, we have a homogenous product (either real or perceived that way by consumers). There is no scope for branding your product differently from others. The decision for the firm amounts only to produce and price (P) at the point where marginal cost (MC) equals marginal revenue (MR) (e.g. MC = MR = P).

The total supply in the market is merely the summation of the individual supply curves of each firm. Graphically it would look something like the following diagram:

P

AC

Q

CSupply = M

p=MR=Demand

Figure 18.1: Price and demand conditions facing an individual firm (x)

So far we have just sketched out (in a very fast-and-loose fashion) the basic behaviour of a perfectly competitive firm in a perfectly competitive market. At this stage, however, it may be useful to clarify exactly what we mean by a perfectly competitive market and how this relates to the marketing framework.

More rigorously, the theory of perfect competition rests on the following four assumptions.

1. Price taking: Both consumers and firms do not affect the price – or stated another way, both consumers and producers believe (correctly) that their decisions will not affect the price. The ‘law of one price’ prevails.

2. Product homogeneity: Products are undifferentiated, therefore consumers consider only price when choosing where to buy from. This means that any firm that tries to raise its price will lose all sales.

3. Perfect information: Consumers have perfect information about their preferences, their income levels, the prices they face and the quality of the goods they purchase. Likewise, firms have perfect information about costs, prices and technology. This means that there is little scope for promotion policies as all information is known.

4. Perfect mobility of resources: Firms can freely enter an industry if they are making a profit, or exit it if losing money. This means that firms have few extra resources to devote to marketing efforts. Thus, in a perfectly competitive environment, the following three key points, or ‘theorems’, emerge for marketing as a discipline in its own right.

Theorem 1: Because of the law of ‘one price’, in a competitive market, price is not a strategic marketing tool for the individual firm.


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Theorem 2: Equally, price and product development are not important marketing tools when a firm operates in an industry with undifferentiated products.

Theorem 3: With perfect information, no gains can be had from informative promotion or formal advertising.

There is an obvious symmetry here, in that these three theorems fall out of the first three assumptions of competitive markets.

The answer, therefore, to the question that started off this sub-section is: ‘marketing does not fit into traditional economic theory in the sense that the perfectly competitive view of markets seems to rule out most marketing activities’.

Where it does fit, it only fits in rather tangentially, in that the most important strategic tools − pricing and promotion − become irrelevant marketing channels when markets approach perfect competition.

18.5 Where does economic theory leave us? Given that marketing exists and given that firms devote huge amounts of money to the marketing of their goods and services, we need to ask ourselves the following: ‘What theory or economic model is consistent with what firms do in practice?’

This question will be explored when we break the competitive assumptions of neo-classical economic theory and examine a world of economics which contains heterogeneous firms and consumers, differentiated products, imperfect competition and information, uncertainty, risk or social networks, and other non-economic social considerations. In other words, a world that more closely resembles the one we live in.

Indeed, by breaking these competitive assumptions, one would be able to answer questions such as: why, in 1995, did management gurus Treacy and Wiersema secretly purchase 50,000 copies of their own business strategy book The discipline of market leaders from bookshops across the USA? (Hint: ask yourself what is an important driver of book sales?)

18.6 Marketing as ‘academic discipline’ You may wonder why a history of marketing is of interest in the context of more recent developments. Well, to paraphrase Joseph Schumpeter (1883–1950), in order to understand the world around you and be a well-grounded social scientist, one needs a command of four disciplines – that is, economics, statistics, maths and history. However, if forced to choose one, Schumpeter always claimed he would have chosen history.

A proper historical account of marketing would begin with early capitalism and sociological theories of the growth of consumerist culture. However, that is a bit beyond the scope of this guide. Instead, we will briefly trace the growth and emergence of the so-called ‘marketing framework’, which began in the 1900s when marketing began to divorce itself from its founding discipline of economics. We will then go on to show why some marketers argue that the marketing framework is the most ‘advanced’ of all business orientations.

The development of marketing thought can be divided into four historical eras.

First era: Classical school (1900–50): These theories focused on aggregate market behaviour and were concentrated on the use


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of traditional economics and sociology to understand market-driven phenomena.

Second era: Managerial marketing school (1950–75): This era began in marketing departments within the newly formed managerial or business schools, which focused their attention on individual behaviour, but continued their reliance on borrowing techniques from other social sciences.

Third era: Behavioural marketing school (1965–1980): These schools have borrowed from different branches, mostly psychology, in an effort to gain even greater insight into individual consumer and organisational behaviour.

Fourth era: Adaptive/strategic marketing school (1980–1995): This school returned to a more economic focus. It was strongly influenced by Michael Porter and his five-forces model and the paradigm of competitive advantage. Advances in economic strategy and game theory also influenced the growth of the strategic marketing school.

It is interesting to note that most marketing courses only appeared in university course curriculums in the late 1960s and early 1970s. A good, and more detailed, description of these eras can be found in Nevett and Fullerton (1988).

18.7 The influence of other academic disciplines and marketing

As can been seen above, marketing itself is not (and has never been) a unitary theoretical discipline. Rather, it is a framework that draws from many different academic disciplines. Although its roots are in industrial economics, it is actually a composite of three major academic disciplines: economics, psychology and management. Each theoretical approach has its specific contribution to areas of marketing, which are summarised in the table below:

Academic discipline Area of marketing relevance

Economics Price theory and strategy

Game theory

Psychology Consumer preferences and behaviour

Advertising

Management General strategy

Demand analysis

18.8 Types of marketing problems Real-world marketing problems involve all three disciplines to varying degrees and proportions. A marketing practitioner has to decide which academic discipline is most relevant to the problem at hand. Marketing problems can be essentially divided into four groups.

1. Operational marketing problems involve working with existing opportunities, for example, by targeting the product to a specific segment of consumers.

2. Analytical marketing problems are related to the market structure in which a firm operates, and its effects on the firm’s marketing approach.


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3. Normative marketing problems are those which concern themselves with how things ‘should be’. An example of this is the emergence of corporate social responsibility and ethical marketing (‘no logo’ movement).

4. Strategic marketing problems involve evaluating the needs of customers and evaluating how the company can provide a solution to these needs.

Each problem requires a different set of academic approaches. It takes time to develop the requisite skills as a marketing analyst or practitioner to know when to use which approach to solve a given problem. In some cases, even defining what the problem is requires experience and subtle knowledge of the problem at hand.

18.9 The triumph of marketing? Having described the evolution of marketing theory and its evolution as a discipline of management study, we will now look at a brief account of the emergence of the current ‘marketing framework’, which has come to dominate the way in which certain industries and markets operate.

There are four main business orientations, each of which has emerged as a response to evolutions in the marketplace. If we were to ask the question: ‘What kind of a firm do you (have you) work[ed] for?’ the answer is likely to be found in one of these four orientations:

• Production: Here the focus is on producing more, selling high volumes, controlling costs and production efficiency. The firm which pioneered this orientation was Ford in the early 1900s, with its adoption of assembly line manufacturing and a standardised product − the Model T − which was famously available in any colour ‘as long as it’s black’! (See the mini-case activity below.)

• Product: This orientation moves away from standardised products and focuses on improving quality. The assumption is that customers want a better-quality version of the same thing and are prepared to pay a premium for a differentiated product. This approach was first adopted by General Motors in the 1930s, which gained market share from Ford by offering customers a diversified product line. (See the mini-case activity below.)

• Selling: The selling orientation, as the name suggests, focuses on aggressive sales and promotion to sell whatever the organisation wants to make. Here the seller’s needs come first, and products are ‘pushed’ under the assumption that if the price is low enough, customers will buy the product whether they like it or not.

Examples of this orientation include firms that use door-to-door salesmen to sell encyclopedias or vacuum cleaners. (This orientation is also nicely portrayed in the 1988 Hollywood movie Tin Men and a decade later in Boiler Room (1999), which depicts financial industry salesmen trying to convince prospective investors to buy stock over the phone.)

• Marketing: The marketing orientation is the most advanced orientation according to marketing founders such as Phillip Kotler. They feel this way because marketing, unlike other orientations, focuses on the end user by first defining customer needs and then developing offerings/products/services that deliver what the customer wants. In this approach, customers and their needs come first. Can you think of a company that uses this orientation?


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Activity 18.2

Why might customers have preferred to pay more for GM cars?

18.10 Looking ahead: the marketing framework Let us end this chapter on a rather philosophical note. What is the ultimate aim of marketing or of any form of production? The ultimate aim of production is not the production of goods and services, nor the satisfaction of a narrow set of consumer preferences, but rather ‘the production of free human beings associated with one another in terms of equality’. This was Jeremy Bentham’s (1743–1832) definition. We mention this in passing because a group of marketing scholars and practitioners who believe in something similar, which they call ‘social or ethical marketing’, and this is

Mini-case activity

Henry Ford versus Alfred Sloan: A contrast of business orientations

Before Henry Ford (1863–1947) first started to produce automobiles in 1905, they were very much a luxury item. Ford’s dream was to democratise car ownership, by making cars affordable. To achieve this ambition, his big innovation was to create a simple car, produced in a streamlined production process. Ford´s pioneering vision was to regiment the production process. He placed an emphasis on achieving productivity improvements and leveraging economies of scale. The gains made were substantial: in 1913 it took 12 hours to manufacture a Model T car, but by the following year this had been reduced to a mere 96 minutes thanks to the introduction of the moving assembly line.

This increase in productivity allowed Ford to reduce the price of a car from over $800 in 1908 to under $450 in 1914. This allowed a much wider segment of the population to purchase a car, radically changing American society and business. Production volumes also increased dramatically in that period, from just over 10,000 cars in 1908 to over 730,000 in 1916 (when their price fell to $360). He also had a radical social agenda. In 1914, when the average weekly wage was around $11 a week, he introduced a $5 wage for an eight-hour day for his workers. This not only motivated his workers, but also put automobiles within their economic reach.

His approach is characteristic of the production orientation, with a strong focus on efficient production of a simple, optimised product. By the 1920s Ford was by far the leading car manufacturer in America, but it was soon to be outdone by its rival General Motors (GM). How did this come about?

When Alfred Sloan (1875–1966) became head of GM in 1925, he felt that there was a need for a new development in the car market, which was suffering from saturation and technological obsolescence. His solution to this problem was to introduce the concept of planned obsolescence and an emphasis on a diverse product range and product styling, exemplified by annual model facelifts. His assumption was that customers would become dissatisfied with their ‘old’ car and would want to trade up to a newer and more expensive model before their current cars had reached the end of their useful life. This tapped into the ebullient mood of the 1920s boom years, and customers jumped on the possibility of differentiating themselves through their car.

By 1928 Ford had lost its position as market leader, and by 1936 GM had a market share of 43 per cent of the US market, while Ford could only claim only 22 per cent. GM retained its leadership until 1986. By allowing its customers to choose from a wide variety of models, and emphasising design rather than engineering, GM was one of the pioneers of product orientation.


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one of their ultimate aims. They believe the marketing orientation, with its focus on the end user and on solving problems for people, can achieve a better society.

Modern definitions of marketing identify it as a management process that involves the identification and anticipation of customer requirements. The development of marketing can be divided into four eras. When marketing became a widespread practice, at the start of the twentieth century, the main focus was on aggregate market behaviour. In the 1950s, the focus shifted towards individual customer behaviour. In the 1960s psychology was added to the traditional social scientific ‘tool box’ in an attempt to gain greater insight into individual consumer behaviour and into the behavioural decisions of organisations. The focus of later theories returned to the aggregate level and the paradigm of competitive advantage as well as the strategic decision-making of firms.

Most businesses can be classified into four main business orientations which evolved in response to changes in technology and society. These were: 1) production, which focuses on production efficiency and high volumes; 2) product, which provides a wider choice to the customer; 3) selling, where aggressive sales techniques are used to ‘push’ the product to the client; and 4) marketing, where customer needs are defined before a product which can satisfy the needs is produced.

As we saw, according to the traditional model of perfect competition, marketing should not exist (or at least, most marketing functions such as pricing and promotion would have no real effects). Indeed, it follows from the assumptions of the model that due to the absence of differentiated products, the firm cannot employ price or promotion as a strategic tool. It thus becomes clear that it is more interesting to examine marketing under a different economic assumption, for example, models of imperfect competition, which are not as restrictive as the neo-classical theory of perfect competition.

Marketing is not in itself a theoretical dicipline; rather, it draws on tools developed in a variety of other disciplines, such as economics, psychology and management, to solve various marketing problems. These problems can be divided into those which deal with the company’s existing opportunities; those which relate to the market environment in which the firm operates; those which influence the firm’s overall image; and, finally, those which are concerned with identifying a strategy for the future.

18.11 Overview of the chapterMarketing theory approaches, like marketing itself, have to span both the level of individual behaviour, which tends to be most informed by economics and psychology, and aggregate behaviour and organisational relationships where sociological and again economic approaches provide much of the initial theoretical background. On top of this, much of the aggregate work also relies to a considerable extent on advanced statistical techniques.


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• explain what is meant by the ‘marketing framework’

• discuss the history of marketing theory and the marketing business orientation

• describe how marketing fits into the traditional economic model of perfect competition

• outline how marketing makes use of different theories used in other academic disciplines.

18.13 Test your knowledge and understandingDescribe, with an example from a specific company, the main elements of the marketing plan.

Notes


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Chapter 19: The origins of marketing − the development of the practice

159




• describe the main elements of marketing

• discuss their integration into a ‘marketing strategy’

• outline the key elements of branding and advertising.

19.1.2 Essential readingWillman, Theme 6.Kotler, P. and G. Armstrong Principles of marketing. (Harlow: Pearson Education

Ltd, 2013) sixth European edition [ISBN 9780273742975] Chapter 1.

19.1.3 Further readingWeitz, B. and R. Wensley Handbook of marketing. (London, Sage, 2002)

[ISBN 9780761956822].

19.1.4 Works citedAbernathy, W.J. The productivity dilemma. (Baltimore: Johns Hopkins, 1978)

[ISBN 9780801820816].Dorfman, R., P.O. Steiner ‘Optimal advertising and optimal quality’, The

American Economic Review 44(5) 1954, pp.826–36.Drucker, P.F. The practice of management. (New York: Harper and Rowe, 1954).Holt, D. and D. Cameron Cultural strategy. (Oxford: Oxford University Press,

2010) [ISBN 9780199587407 (hbk)].Ofir, C. and R.S. Winer ‘Pricing: economic and behavioural models’ in Weitz,

B. and R. Wensley Handbook of marketing. (London: Sage, 2002) [ISBN 9780761956822], pp.267–81.

Pate, R. Adman: Morris Hite’s methods for winning the ad game. (Dallas, TX: E-Heart Press, 1988) [ISBN 9780935014129].

Stewart, D.W. and M.A. Kamins ‘Marketing communications’ in Weitz, B. and R. Wensley Handbook of marketing. (London: Sage, 2002) [ISBN 9780761956822], pp.282–309.

Webster, F.E. ‘The role of marketing and the firm’ in Weitz, B. and R. Wensley Handbook of marketing. (London: Sage, 2002) [ISBN 9780761956822], pp.66–84.

19.2 IntroductionAs Webster puts it:

Marketing exists both within the firm and outside it. It is both a set of organisational management activities and a set of institutional actors and functions within the marketplace, external to the firm, in which the firm participates. (Webster, 2002, p.67)

In this chapter, we will focus on the activities of marketing within the firm. This is rather more than looking at the marketing department or function.


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From its humble origins in concerns about distributional efficiency, the academic discipline of marketing generated somewhat imperial ambitions, most notably in the idea of the ‘marketing concept’ – seeing the whole firm from the customer perspective. This was most notably articulated by Drucker, who argued:

1. the sole purpose of the business is to create a customer

2. the customer’s view of what she is buying is more important than the firm’s view of what they are making

3. all firms are only about marketing and innovation

4. marketing is much more than sales

5. marketing is the whole business, seen by the customer.

(Drucker, 1954, p.39; see also Webster, 2002; p.71)

This approach sees marketing as strategy, and we will use the elements of a marketing strategy to organise the chapter. In the following sections, we will focus on what managers do when they seek to manage markets, under the conventional headings of product (including market segmentation), price, promotion (including branding and advertising) and place (channels and distribution).

19.3 Product1

The most important decision an organisation makes is what products to offer and in which markets to offer them. The decision commits the organisation to particular customers, to the use of particular technologies and to engagement with specific competitors. In marketing, a product is defined not as a physical item but as the total package of attributes the customer gets when she or he buys the product (Kotler and Armstrong, 2004). It may embrace things such as packaging, after-sales service and perhaps ongoing availability. Here are some illustrations.

• A Rolex and a Swatch are both instruments for telling the time, but they are very different products. A Rolex is both a status symbol and a piece of jewellery.

• Many car companies advertise their products with warranties of up to seven years and free servicing. The presumption for both is that the company selling the car will provide after-sales service.

• Apple sells a variety of devices fitted with iTunes software. The buyer assumes forward compatibility – that the software will allow stored music to be transferred to other devices, and that Apple will maintain other activities such as iStore.

There is an important time dimension to products. They are seen to have ‘life cycles’ of growth, maturity and declines, as depicted in Figure 19.1. These have implications for how the product is distributed, advertised and priced. The length of a life cycle is an empirical question, but the cycle in any given instance is a guide to the process of innovation and new product development. If the firm wishes to have non-volatile sales revenue it will innovate products to have some growing, some mature and some declining products. Conversely, it will not wish to launch new products too frequently since this will affect the sales revenues of more mature ones.

1 The term ‘product’ here is used to apply both to physical products and to services.


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Figure 19.1: The product life cycle

Activity 19.1

Apply the product life cycle curve to the Apple iPod. What will happen to Apple’s other products during ‘decline’?

19.4 MarketsMarketing does not define a market in the same way as economics. For economists, markets are a space where buyers and sellers meet. For marketing, the emphasis is almost wholly on the market as a pool of demand. Some of this demand is satisfied by the firm (market share) and some is market opportunity (latent demand).

Markets are divided into segments in order to be targeted. A segment is a set of actual or potential customers who are homogeneous with respect to the product. Defining market segments creates the framework for a marketing strategy. The main segmentation variables are as follows.

• Demography. This relies on variables such as income, age, gender, ethnicity and educational background as explanatory variables for tastes, buying behaviour or consumption patterns. However, marketers do not only apply the term to segmentation of consumer markets, they also refer to the demographics of firms, where the buyer is another business. Here the variables are primarily size and industry; for example, in management consulting, industry segments (termed ‘vertical’ segments) are very important since industry-specific knowledge is seen as an important part of the consulting process.

• Geography. This is also used to segment both consumer and business markets. The key variables here are geographic differences in product preference, market potential, trade regulations and competition. However, geographic segmentation may emerge from limits to the economical shipping distance of a product, or from the fact that customers want the product or service to be locally available. An example of the last point is the location decisions for shops and

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restaurants which are often calculated in terms of customer travel times.

• Psychographic variables. These typologies segment the market in terms of an individual’s lifestyle and attitudes towards self, family, home and peer-group identity. Some typologies may echo demography – such as categories such as ‘baby boomers’ or the ‘grey’ market. Others relate to lifestyle choices – such as ‘couch potatoes’ or ‘exercise freaks’. A very important distinction in the food market concerns those who work (whose time is presumed to be limited) who will prefer prepared foods versus those who prefer to buy ingredients and spend time cooking. Therefore prepared meals tend to be priced at a substantial premium over the cost of their ingredients.

• Product use. The purpose for which a product is purchased is important for marketing, hence knowledge about the buyer’s purpose is important. For example, the same item of crockery may be purchased by an individual for home use, by a restaurant for commercial purposes, or as a wedding gift.

Defining the combination of product and segment is important and the firm needs to ask the following questions.

• Where does the product have the most value? Market entry and development efforts should focus on the segments that value the product most highly and will pay the most.

• What is the growth potential? This relates to the size of the segment and the length of the product life cycle as discussed above.

• What resources do we need to commit? This relates to material we covered in Chapter 12. The decision to enter a market segment with a specific product should have a positive net present value.

• What is the competition? New market entrants should be differentiated in some way in the customers’ minds. We may think of the frameworks discussed in Chapter 13 as ways of analysing this issue.

• Does the opportunity fit the company? There may be opportunities in products and segments which are in themselves profitable but have damaging wider implications. Here are two examples. In the US car industry in the 1970s, companies were aware that consumers wanted smaller, more fuel-efficient cars but did not develop them because they thought it would cause a drop in the sales of full-size, more profitable models (cannibalisation). They only did so when Japanese imports captured market share (Abernathy, 1978). In luxury goods industries, such as cars, watches and diamonds, products are rationed and consumer ‘queues’ exist because the value of the product depends on its scarcity and exclusivity; expanding output to new markets would damage the ‘brand’.

19.5 PricingIn economics, price is set by the balance between supply and demand. However, marketing emphasises the ‘setting’ of prices and price structures by firms and the need to get prices correct for given market segments. As Ofir and Winer put it:

Understanding price thresholds and willingness to pay is critical to marketing managers’ being able to price appropriately and not succumb to extreme pressure to drop prices. (Ofir and Winner, 2002, p.278)


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If prices are too high, products will not sell, but low pricing represents foregone revenue. In addition to supply and demand, four other factors need to be considered.

• Cost. Generally marketing does not advocate pricing on cost; costs merely set the floor. Pricing on cost (for example, as low as possible) may be desirable as part of an entry strategy to gain market share, but in the anticipation of future price rises away from this threshold. However, the distinction between fixed and variable costs introduced in Chapter 8 is important. Where fixed costs are high and variable costs are low, firms will discount steeply at periods of low demand to spread the fixed costs over as much revenue as possible; hotels and airlines are good examples. Where variable costs are high, maximising unit margins is much more important; in packaged foods, for example, the materials and packaging in each item are a very high element in total cost.

• Competition. If costs set the price floor, competition sets the price ceiling. As we have seen, where competition is severe, differentiation of the product by adding or subtracting features or attributes is often the response. In many sectors, the dominant player exercises ‘price leadership’ – for example, they set the price that others then follow.

• Consumer power. Again, we can refer back to the Porter framework of Chapter 13. Where buyers account for a significant portion of sales, and where they can also switch to other producers, consumer power will translate quickly into price pressure. As an example, consider the retail food market in the UK. The market is dominated by a small number of large supermarket chains. To the producers of branded foods, they control access to the consumer; they set prices and they control the ways in which brands are presented in store. In addition, for many standard items the ‘own brand’ offers consumers a low price alternative. Their buyer power is considerable. For end consumers, it may seem that individually they have little power, but they have almost no switching costs between supermarkets, which thus offer ‘price match’ promises in the face of collective buyer power.

Importantly, pricing is strategic. By this we mean that the firm will not treat price as a dependent variable on costs or a revenue maximising device in all cases. Here are examples of pricing ‘strategies’.

• Penetration pricing refers to a market entry pricing strategy in which low prices are offered to build market share rapidly; for example, new newspapers or magazines are offered at an ‘introductory’ price.

• Skimming pricing attacks those parts of a market where the highest prices may be charged; for example, new electronic devices come to market with a high price, which subsequently falls.

• Discriminatory pricing which targets different market segments at different price levels; for example, restaurant chains differentiating prices by residential district.

• Predatory pricing or low pricing to drive a competitor out of the market; for example, the attack on early low-price transatlantic airlines such as Laker and People by larger airlines dropping prices only on that route.


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Table 19.1 summarises the factors that may affect firm price levels.

Negative Positive

High supply over demand Controlled supply

Intense competition High product value

Intrabrand competition Product differentiation

High buyer power High buyer dependency

Flexible costing High switching costs

Black markets for goods Price leadership

Table 19.1: Factors affecting price levels

19.6 Channels and distributionThe primary components of a distribution system are:

• sales representatives who are direct employees of the firm: they are effective where the firm has clients who buy large quantities and need technical support or customisation

• sales agents who are independent and carry the products of several suppliers: unlike direct employees, they are a variable not fixed cost since they generally work on commission

• distributors who deal with many suppliers and serve customers who require small amounts but general availability: such distributors carry large inventory costs but make margins on the ability to supply

• retail outlets and supermarkets: these are often independent of the goods they sell (e.g. Wal-Mart) but they may be franchised (McDonald’s) or wholly owned (Goodyear tyre stores in the USA).

Marketing began as the study of distribution and the choice of ‘channels to market’ remains significant. Once chosen, such channels represent a sunk cost for the firm and are difficult to change. Many traditional channels have been hit hard (as we will see in the next chapter) by the rise of internet shopping. Where vertical integration to the point of sale is too costly or not feasible, firms deal with intermediaries (e.g. the distributors mentioned above) with whom they must share the profitability of the value chain. When working with intermediaries, the supplier must make sure the channel works to its advantage; this is termed ‘channel support’. Channel support has three objectives:

1. to make sure stocks are available to the end consumer at the resale price

2. to make sure resellers actively display, advertise and promote the product to end users

3. to maintain resale prices and make sure margins do not deteriorate.

If suppliers lose control over channels, they may experience ‘intrabrand competition’; this occurs where a product is on sale at varying prices, because of differential pricing by resellers (see Table 19.1). This may lead both to foregone revenue and damage to the brand. Here is an example.

French wine producers sell into the UK market through supermarkets. The price and quantity is defined by the buyer power of the final vendors. If the final seller discounts the wine in store, the producer suffers two kinds of disadvantage; first, loss of revenue, since the contracts specify payment on the sale price and, second, damage to the brand if the consumer sees the wine as cheap and therefore low quality. The final seller may discount


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the wine in order to encourage consumers into the store, but the wine producer cannot diversify in the same way.

19.7 Brands and advertisingMany businesses advertise, and mostly what they advertise are brands. The American Marketing Association yields the following broad definition of a brand:

Some firms have many brands. For example, Unilever has Ben and Jerry’s, Dove, Flora, Lipton, Signal and Surf. This is common in the packaged goods sector; Unilever’s main competitor, Procter and Gamble, also has many. Some brands have many firms. For example, the Virgin brand does not involve just the Virgin organisation, but also Singapore Airlines, Stagecoach, EMI and the Royal Bank of Scotland, among others. This approach is known as ‘brand extension’, with the positive market value (brand equity) of the brand extended across different sectors as a low-cost way of effecting market entry. Brands are market differentiators, but are not differentiated in production. Currently, a visitor to a major UK supermarket such as Tesco may buy a branded tin of soup (e.g. Heinz) or a lower-price, own-branded one (for example, Tesco) which may have been made in the same production process. Coca-Cola branding signifies nothing about the production process. Some very big brands, including Coca-Cola but also Nike, Apple and Microsoft, can be identified simply by their logo.

Brands are said to have properties. Some, such as awareness, are subject to quantitative measures, for example, how many consumers have heard of the brand. They have more qualitative attributes such as image, association and personality which are essentially measures of the recognition or affective response the brand evokes with consumers. Some even argue that brands give consumers ‘identity’ (Holt and Cameron, 2010). However, in business terms, brands are revenue streams and profit opportunities. Companies develop brands mainly so that they can charge more, increase new and repeat purchases and differentiate an increasing set of products. Brands are bought and sold independently of the capacity to produce the product or service they represent.

Brands are promoted mainly, but not exclusively, by advertising. A prominent practitioner defines advertising more pithily than the AMA as ‘salesmanship mass produced’ (Hite in Pate, 1988, p.203). It is a species of marketing promotion and as such has the following functions (Stewart and Kamins, 2002):

1. to inform customers about products or offers

2. to persuade customers to buy

3. to remind customers of a product or brand

4. to act as a barrier to entry for potential new entrants by raising entry costs.

A brand is a customer experience represented by a collection of images and ideas; often, it refers to a symbol such as a name, logo, slogan, and design scheme. Brand recognition and other reactions are created by the accumulation of experiences with the specific product or service, both directly relating to its use, and through the influence of advertising, design, and media commentary. A brand often includes an explicit logo, fonts, color schemes, symbols, sound which may be developed to represent implicit values, ideas, and even personality.


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This combination of possibilities helps to explain why many already high-profile brands are supported by high levels of expenditure on advertising. However, not all advertising supports brands. There are cases where firms in an industry collude to increase demand for the industry’s product; for example, they increase primary demand, as opposed to increasing secondary demand for a specific brand within the industry. A good example here would be advertising for milk products, which in the UK and USA is funded by an industry body. In the USA, at least, there is evidence that this form of advertising works: over the decade 1984–1993, advertising increased demand for milk by just over 1 per cent and, more significantly, the price of milk by more than 14 per cent. This is theoretically interesting since it is an example of advertising paying off where all products are perfect substitutes.

Mostly, though, advertising is about differentiation to increase demand and as such competes with the conventional way to increase demand, which is to cut prices. So the decision on how much to spend on advertising is potentially a difficult one since it is an attempt to increase demand at constant or increasing prices. It thus turns into a calculation about the price elasticity of demand. Dorfman and Steiner (1954) developed the basic prescriptive formula as follows:Advertising expenditure

Sales revenue

Advertising elasticity

Price elasticity of demand=

So, if advertising elasticity = 2, then, for a given price–advertising combination, sales will increase by 2 per cent if advertising expenditure increases by 1 per cent. The same applies in reverse for prices; a price elasticity of 2 means that sales increase by 2 per cent if price decreases by 1 per cent. The theorem shows that the sensitivity of prices depends on advertising, and the sensitivity of advertising on price. The best position for the firm is where price sensitivity is low and advertising sensitivity high; substantial price rises can be sustained by moderate advertising expenditures.

There are three implications to point out.

1. The more productive advertising is in raising sales, the higher will be its proportion of sales revenue.

2. The greater the price elasticity, the less effective advertising will be and the smaller the percentage of sales revenue. High-price elasticity implies many substitute products.

3. Advertising should be highly effective for new products where there are few comparable offerings, so the advertising-to-sales ratio will be high at product launch. As the market becomes saturated, advertising elasticity will fall, and one would thus expect the advertising-to-sales ratio to fall across the life cycle of a product or brand.

This is essentially an equilibrium model, and one would expect advertising expenditures to be triggered by external events. For example, we have noted that advertising expenditures are used by incumbent firms as a barrier to entry for new firms, and there is evidence that where there are new entrants into markets, incumbent advertising expenditures spike.

Activity 19.2

Go to the Unilever website and estimate the number of brands it owns. Why are there so many?


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19.8 SummaryWe have focused on what managers do when they seek to manage markets, under the conventional headings of product (including market segmentation), price, promotion (including branding and advertising) and place (channels and distribution). These are the ‘four p’s’ of marketing and they constitute the elements of a marketing plan or strategy.

We have outlined the main elements of each and shown how they interrelate.


• describe the main elements of marketing

• discuss their integration into a ‘marketing strategy’

• outline the key elements of branding and advertising.

19.10 Test your knowledge and understandingDiscuss your assessment of the case for marketing to be viewed as a profession. How does this relate to both the nature of the responsibilities that are given to the marketing function and also to the nature of the actual job of a marketing manager?

Notes


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Chapter 20: Marketing in the digital age

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• discuss some business implications of internet technology

• describe the implications of the internet for marketing practice

• explain the role of branding on the internet.

20.1.2 Essential readingCastells, M. The internet galaxy: reflections on the internet, business, and

society. (Oxford: Oxford University Press, 2001) [ISBN 9780199241538], Chapter 3.

20.1.3 Further readingP. Barwise et al. ‘Marketing and the internet’, in Weitz, B. and R. Wensley (eds)

Handbook of marketing. (London: Sage. 2002) [ISBN 9780761956822] pp.527–57.

20.1.4 Works cited Achrol, S.R. and D. Kotler ‘Marketing in the network economy’, Journal of

Marketing 63 1999, pp146–63.Carr, G.N. ‘Hypermediation: commerce as click-stream’, Harvard Business

Review January–February 2000, pp.46–47.Chen, S.J and T-Z. Chang ‘A descriptive model of online shopping process: some

empirical results’, International Journal of Service Industry Management, 14(5), 2003, pp.556–69.

Degeratu, A.M., A. Rangaswamy and J. Wu ‘Consumer choice behavior in online and traditional supermarkets: the effects of brand name, price, and other search attributes’, International Journal of Research in Marketing, 17(1), 2000, pp.55–78.

Earl, M. ‘Evolving the e-business’, Business Strategy Review 11(2) 2000, pp.33–38.

Hanson, W. Principles of internet marketing. (Cincinnati: S.W. College Publishing, 2000) [ISBN 9780538875738].

Higson, C. and J. Briginshaw ‘Valuing internet businesses’, Business Strategy Review 11(1) 2000, pp.10–20.

Hoffman, D.L., W.D Kalsbeek and T.P. Novak ‘Internet and web use in the United States: baselines for commercial development’, Special section on ‘Internet in the Home’, Communications of the ACM, December 1996.

McWilliam, G. ‘Building stronger brands through online communities’, Sloan Management Review 41(3) 2000, pp.43–54.

Nelson, P. ‘Information and consumer behavior’, Journal of Political Economy, 78, 1970, pp.311–29.

Ward, M.R. and M.J. Lee ‘Internet shopping, consumer search and product branding’, Journal of Product & Brand Management, 9(1), 2000, pp.6–20.

http://www.tandfonline.com/doi/pdf/10.1080/0810902032000050000

http://www.tandfonline.com/doi/pdf/10.1080/0810902032000050000


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20.2 IntroductionThe purpose of this chapter is to understand the implications of the internet for the practices of marketing discussed in the last chapter, and in particular to look at the implications for branding. The growth of electronic marketing has been spectacular since the early 1990s, but it has not been linear. In particular, the so-called ‘dot.com’ boom up to 2000 and the subsequent crash in 2001 exposed as wildly optimistic many business models based on the internet’s technical capabilities alone. Some of the largest companies in the world, such as Google and Amazon, are based on internet technology, but many start-up internet businesses failed to establish revenue models that would ensure their survival and company failures were extremely common in the early years of the century (Castells, 2013).

The internet remains at the forefront of marketing developments based on the following properties.

• It allows faster and cheaper interactions than any previous medium. It can also personalise transactions based on recorded customer knowledge; this raises privacy concerns.

• It can dramatically reduce customer search times and indeed can use software to help the customer decision process. The prerequisite is that the customer must have some information on what is being searched for.

• It is globalising in two senses. First, it renders geographic distance irrelevant to the transaction (but not to its fulfilment). Second, it supports instant translation into a large number of languages.

• It is ubiquitous, allowing ‘24/7’ communications. Subject to internet connection, the location of the consumer is irrelevant.

• It can be accessed through and supports a range of different technological devices, including phone, PC, tablet and TV.

This gives it the potential to affect many of the dimensions of marketing discussed above: segmentation, pricing, customer service and relationship management, advertising, channels, value chains and brands. In addition it may have added a dimension to marketing. Traditionally, marketing distinguished business to business (B2B) marketing from consumer marketing (B2C). The internet is relevant to both, and has developed the idea of consumer-to-consumer (C2C) interactions. Two examples are, first, the importance of consumer ratings to other consumers and, second, the support of C2C transactions. Sites such as Travelocity are distinct from more traditional marketing modes in the specific sense that they are the agent of the buyer rather than the seller, acting as customer consultant by coordinating opinions (Achrol and Kotler, 1999). C2C transactions are supported on auction websites such as eBay, a large proportion of whose revenues come from consumers rather than businesses.

The internet has had a substantial impact on existing businesses, not least in the emergence of email as the primary vehicle for intrafirm communication, but here we focus on the marketing aspects of it − and there are great differences to be observed. For example, almost all large businesses invest substantial amounts into their websites, but Tesco sells high volumes and generates revenues through its website whereas Mercedes mostly advertises through its own website, while still selling predominantly through dealerships. This implies substantial variance in impact. But as we have seen, the internet also generates large new businesses. In order better to understand both sets of dynamics, let us take a case study of the largest electronic retailer in the world.


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Mini-case activity

Amazon

Amazon was founded in 1994 by Jeff Bezos, whose previous experience was on Wall Street. It began in his garage; today (in 2013) it is the largest electronic retailer in the world with a market capitalisation of over $8billion and 97,000 employees worldwide. The business model is distinctive. Bezos was not a technological entrepreneur like so many dot.com CEOs. He was looking for a way to make a successful business out of the internet and initially examined the prospects of selling several products, including CDs, videos, games, books and software on the internet. The model was a simple sales revenue one, where sellers ceded to Amazon a proportion of the customer revenue and also paid to be ‘featured items’. The business plan specifically allowed for no profit to be made in the first five years.

Amazon initially allowed global access to its US website but subsequently set up sites in other countries to which consumers were channelled. There are also a large number of distribution centres. Customers’ search and purchase history is monitored and provides the basis for recommendations which customise the website when they log in. For many customers, this is augmented by frequent emails highlighting products. Credit card and delivery details are held and password-protected. Software such as ‘1-click’ facilitates speedy purchase. Most goods, excluding ebooks, are delivered by courier; customers have a price list of different delivery options.

Amazon began with books. It had a major impact on traditional booksellers such as Barnes and Noble in the USA. The business models were very different. Barnes and Noble had to invest substantially in property for outlets and in stocks of books so that customers could browse. Amazon held little stock – it acted as a broker – and few properties. Interestingly, the markets positively evaluated Amazon’s performance even though it made losses in this period. Whereas investors looked at Barnes and Noble as a retailer and examined measures such as ROCE, Amazon was evaluated by looking at traffic measures – a common measure for an internet business.

Subsequently, Amazon diversified into thousands of different products, including its own-branded ebook readers – the Kindle – and was reliant on its own electronic delivery system. It also offers music downloads. But many products are branded household and personal items such as would be available in a conventional department store or supermarket. It thus competes with many conventional retailers, and with Apple. In the third quarter of 2013, its sales exceeded £17 billion. Its mission statement is primarily about marketing, for example: ‘We seek to be Earth’s most customer-centric company for four primary customer sets: consumers, sellers, enterprises, and content creators.’

Question: Faced with competition from Amazon, what can Barnes and Noble do?

Here are some generic marketing points to draw from this brief case.

• Products. Some products are more suited to web sales than others. The characteristics of those chosen originally by Bezos were that they were standardised, branded and have a high value to weight ratio. Information on product attributes was more important than sensory attributes; for example, the products did not have to be seen or handled prior to purchase (Degeratu et al., 2000).

• Customisation. Amazon reduces customer search times by customising the site on arrival. As the scale and complexity of the site increases, customers get more specific guidance based on their purchase history. The site is both a destination site for purchases and a search engine for products (Hoffman et al., 1996).

• Web interface. The site is both a distribution channel for goods and an advertising site for market communication. Both functions support revenue streams. The site allows speedy purchase, but also encourages customers who wish to search and browse.


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20.3 Impact on conventional businessesAmazon is a good example of a successful internet firm. But several conventional retailers have ended up with a so-called ‘bricks and clicks’ combination by making something of a reverse journey – from conventional to electronic selling. This journey is characteristic of many retailers in the UK who maintain physical retail outlets. This journey has been described by several authors, including Earl (2000). He identifies six stages of evolution as follows.

1. External communications. The company uses web technology to communicate with customers and the principal requirement is constant and efficient content management.

2. Internal communications. The company relies on the web internally for communication and information management and the principal requirement is architectural integrity of the system.

3. E-commerce. The business uses the internet for sales and the principal requirement is for an electronic channel strategy alongside conventional ones.

4. E-business. The company seeks to develop an internet-based business model and the key requirement is for high-performance web-based processes.

5. E-enterprise. The company understands that it is primarily in the information business and the key requirement is information literacy.

6. Transformation. In this stage the company ceases to discriminate between internet and conventional methods and the key requirement is for continuous learning and change.

Not all companies are capable or willing to go through all these steps but three issues that most will face concern channels, products and advertising. We look at each in turn.

• C2C. Products come with customer recommendations based on a star system, allowing customer networks to form.

• Fulfilment. Amazon requires a substantial investment in delivery (fulfilment) supported by a scalable international distribution system. Chen and Chang (2003) found that the three elements of successful online shopping were the customer’s encounter with the interface (web design), the quality of the purchase experience (mainly speed – a high proportion of web transactions are not completed) and fulfilment (reliability and speed of delivery, plus returns policy).

• Brands. Amazon began by relying on standardised products with recognisable brands to reduce customer uncertainty. However, the Amazon brand itself has developed over time to attract suppliers interested in sales and consumers interested in purchase. Even competitors such as Apple sell through the site.

There are many more general points to draw from the case. From a marketing perspective, we will limit ourselves to two. First, the capital requirements for an electronic retailer relying on physical distribution are substantial, and Amazon has benefited from substantial first-mover advantage since the barriers to entry are high. Second, Amazon has itself built a very reliable brand, and one which shows up in other search engines; Bezos deliberately chose a name beginning with ‘A’. Amazon’s growth has probably had a major negative impact on conventional retailers such as Barnes and Noble, but it has generated major spin-off benefits for the packaging and postal industries.


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20.3.1 ChannelsOne of the earliest claims about the role of the internet was that it would reduce search costs for consumers and reduce profits. Others argued that value chains would be disrupted and in particular all intermediaries between the manufacturer of a product or the originator of a service would be disintermediated – that is, their role would disappear. In this view, wholesalers, resellers and retailers would simply be substituted by a direct relationship between producer and consumer on the web. The information value added by intermediaries would disappear.

There is little doubt that some disintermediation has taken place (Barwise et al., 2002). However, they argue that intermediation has changed rather than disappeared. Citing Carr (2000), they argue for ‘hypermediation’ in that web transactions:

… routinely involve many intermediaries – not only wholesalers and retailers but also content providers, affiliate sites, search engines, portals, internet service providers, software makers… (Barwise et al., 2002, p.544)

They argue that many of the benefits of internet retailing accrue to such intermediaries.

20.3.2 ProductsOne broad question concerns which types of product can be sold through the web and which cannot. Our Amazon case study indicated that early success was associated with standardised products. The conventional wisdom was based on the argument by Nelson (1970) about the distinction between a ‘search’ and an ‘experience’ good; search goods are those whose quality could be judged by inspection alone; experience goods are those whose quality can only be judged through usage. Initially, it was felt that only the former could be sold through the web. However, sales of products which are not standardised (flowers) or which are experience goods (wine) have grown on the internet in recent years and it may be that consumers are prepared to trust the brand of the internet retailer in these matters. One category resilient to internet retailing appears to be certain luxury goods. One possibility is that where the shopping experience itself constitutes part of the customer value, the internet is not favoured.

20.3.4 AdvertisingThe web is widely used for advertising and some major internet operators, notably search engines, rely heavily on it for revenue. Key issues are, first, how to drive traffic to the website concerned and, second, the breadth and depth of customer usage.

A good example of the first point comes from the growth of Hotmail. Users of Hotmail have an incentive to encourage others to act similarly; this is free. This reliance on electronic word of mouth is termed ‘viral marketing’. Prior to the dot.com crash, traffic was used as a predictor of future revenues, not least because it was seen to attract advertising revenue. However, in the crash it appeared that overspend on marketing relative to revenue was one of the main causes of failure, particularly for B2C businesses (Higson and Briginshaw, 2000).

Breadth and depth are two measures of website usage. Breadth refers to how many web pages a user looks at, and depth to how long they spend on the site. Both are seen to be important for advertising effectiveness, but there is a clear issue of conflict between efficiency of search and purchase, on the one hand, and spending time looking at advertising, on


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the other. Researchers have looked at the style, frequency, content and copy quality of web advertising to try to assess its effectiveness, although (as with conventional advertising) the question is whether the appropriate success measure should be direct (sales) or more diffuse (long-term brand building) (Barwise et al., 2002).

Advertising is often categorised as pull or push. Pull media are initiated by the customer, for example, classified advertising in newspapers, where the reader must turn to the page concerned. Push media are those where the consumer has little choice – which reflects the more conventional advertising that takes place on television or in the cinema. Internet advertising mixes both, but the pull model has been dominant.

20.4 Internet and brandingThere has been a debate about whether use of the internet strengthens or weakens brands. Information economics would suggest weakening. The argument is that, initially, consumers would be less proficient at search and would rely on brands to reduce uncertainty of internet purchasers but, as proficiency improved, they would become less reliant on brands, and thus brand advertising would become less useful (Ward and Lee, 2000). In this approach brand advertising is a substitute for efficient search in encouraging purchase. The broader argument is that the internet has no special properties – it is merely a more efficient shopping channel.

The counter-argument relies on these special qualities, specifically that C2C capabilities can build online brand communities that generate increased customer loyalty. It has been argued, for example, that eBay’s auction system encourages C2C communication (Barwise et al., 2002). However, this differs from the idea that there is benefit in building an online community for an existing brand. There is evidence that membership of an online brand community can affect the components of brand equity (perceived quality, brand loyalty, awareness and association), but, on the other hand, there are also issues about how firms, accustomed to controlling these facets, can control an online community with a small number of active participants relative to the customer base (McWilliam, 2000).

20.5 SummaryThere is evidence that online technology has potential to:

• reduce customer search costs

• allow low-cost customisation of marketing

• support online brand communities

• enhance customer access to firms

• abolish some types of intermediary and create others

• enhance C2C communication.


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• discuss some business implications of internet technology

• describe the implications of the internet for marketing practice

• explain the role of branding on the internet.

20.7 Test your knowledge and understandingHow would a marketing strategy for an internet-based business differ from that of a conventional one?

Notes


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Appendix 1: Syllabus

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This is a description of the material to be examined, as published in the Regulations.

IntroductionThis chapter introduces the course and its approach. It discusses the pre-industrial roots of thinking about management and leadership, and shows the longevity of certain management practices. The industrial revolution prompted major developments in social theory and political economy – in particular in Europe and USA – which in turn have influenced the analysis of management in business. The chapter traces the roots of modern management technique in the developing disciplines of the social sciences and offers a framework for a critical understanding of the corpus of business knowledge.

Management and the FirmThe chapter looks at the growth of large firms in historical context and examines the major explanations for the growth of firms, specifically technological indivisibility and market failure. It specifically examines the work of Chandler. It describes the separation of ownership and control and introduces the problem of agency. It introduces the ‘varieties of capitalism’ debate and covers the varieties of institutional arrangements for firm governance that have emerged in advanced economies. The relationship between the factory system and the creation of an industrial workforce is discussed.

Taylorism, Motivation, and PerformanceThis chapter looks at the emergence of two important schools in the history of management science that attempt to systematically analyze human behaviour at work: 1. Taylorism and scientific management; and 2. the development in psychology and the human relations movement. If offers an overview of the background, principles, as well as limitations and problems of the two schools. Performance appraisal systems and reward systems in organisations are examined as well.

The Rise and Decline of LabourThis chapter looks at the historical root of industrial and labour relations and explores the linkage between workplace control and the broader economic and political context of work organisations. The evolution of internal labour market, the logic of collective action, and wage determination and rent-sharing in collective bargaining are examined. The chapter also introduces the markets for trade unionism and the mechanisms that unions grow. It overviews the rise and fall of trade unions with reference to historical and contemporary influences. Alternative voices schemes are explored at the end.

The Rise of Human Resources ManagementThis chapter looks at the origin and evolution of the field of human resources management (HRM) and introduces key theories and analytical concepts of HRM. The chapter will provide a framework for thinking systematically and strategically about aspects of managing the


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organisation’s human assets. Major approaches to HR strategy—Michigan School, Harvard School, and Resource-based models will be discussed.

Origins of Management Science This chapter will look at the development, post-Taylorism, of quantitative modelling approaches to operations management. Basic concepts of queueing systems and inventory control, and linear programming will be introduced and placed in context. We will discuss how these concepts have been developed as organisations have become more complex, and more mature in their ability to process data and harness computing power. We will also talk about how these ideas have spread beyond the engineering and manufacturing settings in which they were first introduced, and some of the challenges facing the implementation of these management science concepts in these new environments.

• Ideas of inventory theory like EOQ/newsvendor

• Basic queueing models, M/M/1, M/M/k—focusing on graphical presentation and insights (no proofs)—basic equations and say the real world more complex but the basic insights hold.

Accounting, finance and the firmThe chapter will comprise a review of models of agency provided by principal agent theory, behaviouralism and the theory of the firm provided by Rajan & Zingales (1998). It would also introduce accounting theories that do not utilize such models, such as the critical accounting school. These theoretical perspectives will constitute reference points for case discussion in later weeks. We will be drawing on discussions of principal/agent theory and behaviouralism provided in earlier chapters within the course.

Management Accounting: CostingThis chapter will introduce management accounting as a set of practices relating to the internal control of the corporation and their evolving role in facilitating decision making by managers. Then focus will be placed on costing. We will distinguish between direct and indirect costs, and between standard costing methods and Activity Based Costing. We will place issues relating to costing in historical perspective and drawing on Johnson & Kaplan’s Relevance Lost, make comparisons with costing in earlier periods.

Management accounting: Decentralization and performance measurement:

This chapter would introduce themes in management account relating to the collecting, processing and analysis of information regarding the internal functioning of the firm. We will investigate the relationship between performance measurement and decentralized forms of organization. Following a review of different aspects of management accounting, we will cover issues agency and institutionalist perspectives on performance measurement. We will then cover the Balanced Scorecard.

Financial accountingThis chapter will introduce the three elements of the financial report, namely, the balance sheet, the profit and loss statement and the cash flow statement. We will discuss the qualitative requirements of financial accounting for relevance, reliability, comparability and understandability. We will also look at processes for setting financial accounting standards.


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Modern Portfolio TheoryThis chapter will first introduce the financial framework relating to risk and reward and place this in the context of the characteristics of different asset classes. We discuss issues relating to asset allocation, long term rates of return of different asset classes, the research on the relative returns of asset class selection and security selection.

Security analysis and valuationWe draw on the previous chapter in examining different financial ratios and their application in conducting financial analysis of firms. In the latter part of the chapter we will extend this discussion to revisit issues relating to mergers and acquisitions.

The Origins of Modern StrategyThis chapter will focus on the origins of the strategic management discipline. The chapter will emphasise what differentiates thediscipline of strategic management from its sibling and parent disciplines. Particular attention will be paid here to understanding its level and units of analysis, principal questions, primary assumptions, typical research methods and key debates. The early ‘pre-theoretic’ schools that characterised the youthful strategic management discipline in the 1960s and 1970s will be surveyed. In addition, the influential ‘positioning school’ work of Michael Porter from the 1980s with its focus on industry analysis will be introduced.

Understanding Organisational StructuresThe chapter examines structural options. Beginning with the Weberian concept of bureaucracy, it discusses the development of formal rational hierarchies in business. It covers the work of Mintzberg and Scott. It examines explanations for the rise of m form organisations (Coase, Williamson) and introduces the concept of matrix organisation. Finally, it discusses institutional theories and the pressures of isomorphism.

Analysis of OrganisationsThis chapter analyses the development of theories of organisation, dealing with both sociological and economic approaches and examining ecological and institutional theories of organisational fields. It looks at the connection between the study of organisational forms and fields, and examines network theories of organisation

Contemporary Strategic ManagementThis chapter will examine the most prominent theoretical perspective to emerge in the strategic management discipline in recent decades: the Resource-Based view (RBV) of the firm. The emergence of this re-focus on the ‘internal’ elements of company strategy will be placed in disciplinary context. Major works of both scholarly (e.g. Jay Barney, Kathleen Eisenhardt, and Bruce Kogut) and practitioner-oriented RBV authors (e.g. Gary Hamel and C.K. Prahalad) will be reviewed to provide a representative picture of the concerns, methods, findings, and debates of the RBV (and associated Knowledge-Based View) theoretical perspectives. The chapter will conclude with a discussion of cutting edge trends in strategic management theory and practice.


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Strategy and Decision MakingThis chapter will trace the evolution of behavioural decision theories from their origins in the 1950s to the present day. Behavioural theories are normally based on (i) a concept of a “good” or “rational” approach to decision making; (ii) empirical evidence which shows that people do not follow such an approach; (iii) a theoretic account of why such departures from rationality occur, and, sometimes (iv) some suggestions as to how to help people make more rational decisions. In this chapter we centre mostly on the celebrated “heuristics and biases” tradition of Kahnemann and Tversky, showing how the theory which these authors developed can shed light on both economic behaviour and managerial decision making. We also discuss some of the controversies surrounding this theory and some alternative views.

The Origins of Marketing: The Development of the TheoryMarketing theory approaches, like marketing itself have to span both the level of individual behaviour, which tends to be most informed by economics and psychology and aggregate behaviour and organisational relationships where sociological and again economics approaches provide much of the initial theoretical background. On top of this much of the aggregate work also relies to a considerable extent on advanced statistical techniques.

The Origins of Marketing: The Development of the PracticeThe practice of Marketing has emerged from a number of different “traditions”, including business journalism, advertising, selling and, rather later, market research. We will look in more detail at the historical development of one of these traditions: advertising, to illustrate in more specific terms, the recurrent themes particularly in terms of the issue of practice and professionalisation but also allied issues such as the knowledge base, the questions of standards and the nature of regulation. We will then consider the more recent manifestation of these issues in both a US and a UK context.

Future Challenges for Marketing in the Digital Age and the role of Branding

It is perhaps an inevitable characteristic of the area of marketing that it has to confront questions of change both within the organisational function and also in the wider market environment. We will look at two key areas: the claims and evidence for the changing nature of the communications and promotion activity in responding to the shift from “broadcasting” to “narrow-casting” and the extent to which a more interactive relationship with customers is changing the underlying rationale of many marketing activities. We will finally consider one area of apparent continuity: the inexorable rise of the notion of “The Brand”.

Core Management Concepts (UOL Subject guide)

Education

Transcript of Core Management Concepts (UOL Subject guide)