Chapter 1: Motives and Functions of a Business PDF

Chapter 1 IMAGES /GETTY TT CER PLA © SPEN The Learning Goals of this chapter are to: Explain the goal of a business. 1 DVD rental shops like this one have 2 Identify the resources a business uses been established by entrepreneurs to produce a product or service. to satisfy customers and generate proﬁts. Identify the key stakeholders that are involved in a business. 3 Describe the business environment to which a ﬁrm is exposed. 4 Describe the key types of business decisions. 5 2 Motives and Functions of a Business A business (or ﬁrm) is an enterprise plumber, and your favorite restau- 왘 What types of stakeholders that provides products or services rant have in common? They are all must this business attempt to desired by customers. According businesses that provide products satisfy? to the U.S. Labor Department, or services desired by customers. 왘 What are the key functions more than 800,000 businesses are that managers must perform created in the United States every Consider a business called 4 Eyes to manage this business? year. Along with large, well-known DVD that is being created as an 왘 What characteristics in the businesses such as The Coca-Cola outlet for DVD rentals desired by business environment must Company and IBM, there are many customers. Some of the more im- the managers monitor? smaller businesses that provide portant decisions are: employment opportunities and All businesses must make these produce products or services that 왘 Is it is worthwhile to create this types of decisions, whether they satisfy customers. What do Alicia business? provide DVD rentals, produce Keys, a casino, a DVD rental ﬁrm, 왘 What resources does this computers, offer dentistry services, your local dentist, the New York business need to provide its or build houses. Yankees organization, your services? What resources are needed? How to satisfy stakeholders? Decision Performance of Value of the to Create the Business Business a Business Key functions of managers? How to deal with environmental concerns? 1 The Goal of a Business What is the goal of a business? Businesses are established to serve the Explain the goal needs of consumers by owners who seek to make proﬁts. The people who of a business. create a business may see an opportunity to produce a product or service that is not already being offered by other ﬁrms. Alternatively, they may be- lieve that they can produce a product or service that they can sell for a lower price than existing ﬁrms. By providing a product that is desired by customers, they may be able to make proﬁts for their business. 3 4 PA R T I BUSINESS ENVIRONMENT Where the Proﬁts Come From Businesses such as Dell, Gap, Ford Motor Company, and Motorola were created to provide products to customers. Businesses such as Southwest Airlines and Hilton Hotels were created to provide services to customers. Other service ﬁrms include dentists, hairstylists, travel agencies, insurance companies, tax services, and law ﬁrms. Some ﬁrms, such as AT&T, Micro- soft, and IBM, provide both products and services to customers. Managing a service business can be just as challenging and rewarding as managing a business that produces products. A business receives revenue when it sells its products or services. It in- curs expenses from paying its employees and when it purchases machin- ery or facilities. The difference between the revenue and the expenses is the proﬁt (or earnings) generated by the business. The proﬁts go to the owners of the business. Thus, owners who create a business have a strong incentive to ensure that it is successful, as they are directly rewarded for their efforts. For example, assume that you have decided to offer to tutor other stu- dents in the basics of developing a website because you know that many students would be willing to pay for this service. During this year, you re- ceive $5,000 from students for tutoring, and you pay a total of $1,000 in expenses to advertise your service in the college newspaper. Your proﬁt is shown below: Revenue $5,000 ⫺ Expenses ⫺ $1,000 ⫽ Proﬁt ⫽ $4,000 Since you are the only owner of this business, all the proﬁts go to you, al- though you may be taxed on the proﬁts that you earn. You can increase your proﬁts next year by either increasing your revenue or reducing your expenses. The proﬁts that you earn from your new business are dependent on three conditions. First, there needs to be a demand for the service that you offer. If there is no demand, you will not generate any revenue and, there- fore, will not earn a proﬁt. Second, you need to attract customers, meaning that they choose you instead of your competitors (other tutors). If you offer a better service or a lower price than your competitors, the customers who need your service may choose you instead of your competitors. In addition, your customers may want to rehire you for additional tutoring or may refer you to their friends who need tutoring. Third, to earn high proﬁts, you need to keep your expenses low. If you can run your business efﬁciently, your expenses should be relatively low, and you will be rewarded with higher proﬁts. Although most businesses are more complicated than the business just described, their performance is also dependent on these three conditions. Proﬁt as a Motive to Understand Business If you develop a good understanding of business, you may be more capable of creating and running a successful business, and you will be directly re- warded with higher proﬁts. Yet, even if you never plan to run your own business, you may proﬁt from understanding how a business operates. CHAPTER I MOTIVES AND FUNC TIONS OF A BUSINESS 5 First, if you develop strong business skills, you may be able to obtain a bet- ter job. Second, you are likely to ﬁnd your job more enjoyable if you un- derstand how job tasks are related to the ﬁrm and its industry. Third, you should be able to perform better, which could result in a more satisfying career path. Fourth, if you ever invest in businesses, you may be better able to identify the types of businesses that are likely to perform well. As a re- sult, you may invest your money wisely and enjoy higher returns on your investments. Thus, you can still proﬁt from understanding business even if you do not own a business. How the Proﬁt Motive Is Inﬂuenced by the Government In the United States and most other countries, people are free to start busi- nesses and proﬁt from them. Countries such as the United States, in which people can create their own businesses to serve the preferences and needs of consumers, have a free-market economy. Governments of free-market economies recognize the advantages of allowing business ownership. Not only do businesses serve consumers, but by creating work for the business owners and employees, they also reduce the country’s unemployment. In socialistic countries such as the former Soviet Union, businesses were typically owned by the government and were not proﬁt oriented. Without the prospect of earning a proﬁt, most people could not afford to create a business and had to ﬁnd some alternative form of work to earn an income. Furthermore, without a proﬁt motive, businesses had no incen- tive to produce products that satisfy consumers’ needs. Consequently, con- sumers were not able to obtain some products that they desired. In the last several years, many governments in these countries have sold the former government businesses to private owners and also are allowing people to start new businesses. In most countries, individuals are now allowed to own businesses, although some governments provide more incentives than others to encourage individuals to create new businesses. Many hospitals are nonproﬁt Nonproﬁt Businesses but must still manage their Not all business are created resources properly to provide to make a proﬁt. A nonproﬁt good customer service and organization is an organization to use their funds properly. that serves a speciﬁc cause and is not intended to make proﬁts. When its revenue exceeds its expenses in a particular period, the proﬁts are reinvested in nonproﬁt organization the organization. In the United an organization that serves a States, a nonproﬁt organiza- speciﬁc cause and is not intended to make proﬁts tion is not taxed as long as it qualiﬁes by meeting speciﬁc re- quirements established by the © ROGER TULLY/GETTY IMAGES Internal Revenue Service. Com- mon examples of nonproﬁt organizations include some hos- pitals, schools, charitable organ- izations, and churches. Although a nonproﬁt orga- nization is not totally focused on 6 PA R T I BUSINESS ENVIRONMENT Decision Making Decisions to Create a Business onsider the situation of 4 Eyes DVD, which was introduced at the beginning of the C chapter. Juan Gomez initially created this business because he knew that customers in his town wanted to rent DVDs. Second, he believed that he could offer a much wider selec- tion of DVDs and at a lower price than the only other DVD rental outlet in town. Third, he believed that he could keep his expenses low by renting space in a busy strip mall that is centrally located and easily accessible. The competitor’s DVD rental outlet is in a very exclu- sive shopping mall at the north end of town. Consequently, its rent is very high, and its loca- tion is convenient only for the wealthy people who live in that area. 1. Explain how 4 Eyes DVD could generate more proﬁts as a result of having an easily accessible central location rather than being in the exclusive shopping mall at one end of town. 2. Last month, 4 Eyes DVD generated revenue of $15,000 and had total expenses of $9,000. Determine its proﬁt level for last month. ANSWERS: 1. It should be able to generate a large volume of rentals in a busy, easily accessible section of town, which results in high revenue. It also has a lower rent expense than if it were in the mall. 2. Its proﬁts are based on revenue minus ex- penses, or $15,000 ⫺ $9,000 ⫽ $6,000. making proﬁts, it is still run like a business. For example, consider the busi- ness of a nonproﬁt hospital. It charges prices for its services just like a for- proﬁt hospital. The hospital will still bill the patient’s insurance for services rendered and bill the patient for any amounts not paid by the insurance company. If the hospital provided all of its services for free, it would quickly use up all the funds that were donated to ﬁnance it as well as any accu- mulated proﬁts it had generated. Its employees earn salaries just like the employees of for-proﬁt hospitals. If the hospital does not pay competitive salaries, its doctors, nurses, and other staff will seek employment else- where. Thus, it must provide its health-care services in an efﬁcient man- ner, or it will not have adequate funding to stay in business and continue to serve the community. Like for-proﬁt hospitals, if it wants to expand and needs more money than it has received from donations or accumulated over time, the hospital may even obtain ﬁnancing from creditors. 2 Resources Used to Produce Products or Services Identify the resources a To produce a product or service, ﬁrms rely on the following factors of business uses to produce production: a product or service. 왘 Natural resources 왘 Human resources 왘 Capital 왘 Entrepreneurship Natural Resources natural resources Natural resources include any resources that can be used in their natural any resources that can be used in form. The most obvious natural resource that is commonly used by busi- their natural form nesses to produce products or services is land. Agricultural businesses rely CHAPTER I MOTIVES AND FUNC TIONS OF A BUSINESS 7 on land to grow crops. Other businesses rely on land to establish a site for their production. Human Resources human resources Human resources are the people who are able to perform work for a busi- people who are able to perform ness. They may contribute to production by using their physical abilities, work for a business such as working in a factory to construct a product. Alternatively, they may contribute by using their mental abilities, such as proposing a change in the existing production process or motivating other workers. Capital capital Capital includes machinery, equipment, tools, and physical facilities. All of machinery, equipment, tools, these types of capital are commonly used by human resources to produce and physical facilities used by a products. Physical facilities are typically necessary to produce many ser- business vices as well as products. Especially in recent years, technology has enabled businesses to use their capital more effectively. technology How Technology Has Helped Businesses Improve Their Capital Technology can be knowledge or tools used to pro- deﬁned as knowledge or tools used to produce products or services. The In- duce products and services ternet is an obvious example of technology. By using technology to im- prove their capital, many businesses are able to produce products and services more quickly and at a higher quality. Thus, they are better able to meet the needs of consumers. information technology An important subset of technology, information technology, involves technology that enables informa- the use of information to produce products and services. It includes the use tion to be used to produce prod- of computers to transfer information among departments within a ﬁrm ucts and services and the use of the Internet to provide customers with information. Infor- mation technology accounts for only about 8 percent of the total output produced in the United States, but it represents more than one-third of the growth in the U.S. output produced. A recent study by the U.S. Commerce Department estimates that about half of all U.S. workers will soon be em- ployed in industries that produce information technology. It also found that information technology has reduced the cost of producing products and resulted in lower prices of products. Furthermore, workers in the tech- electronic business nology industries earn about $53,000 per year on average versus $30,000 (e-business) or electronic commerce (e-commerce) for workers in other industries. use of electronic communications, A related type of technology is electronic business (e-business), also such as the Internet, to produce or referred to as electronic commerce (e-commerce), which is the use sell products and services of electronic communications to produce or sell products and services. Amazon receives its orders online and commonly uses its distribution center to ac- commodate the orders. © MACDUFF EVERTON/CORBIS 8 PA R T I BUSINESS ENVIRONMENT E-business includes both business transactions, such as sales of products over the Internet, and interactions between a ﬁrm and its suppliers over the Internet. In fact, many people use the terms information technology and e-commerce interchangeably. An example of a successful e-business idea is Amazon.com, which enables customers to purchase books and other products online. Amazon.com’s creativity is not the product (books) but an alternative method of reaching customers. Its customers use the Internet to have their book or- ders delivered to them rather than having to go to a retail bookstore. Sev- eral other ﬁrms have applied the same idea to their own businesses. Com- puter ﬁrms now sell computers over the Internet, toy manufacturers sell toys over the Internet, and automobile manufacturers sell automobiles over the Internet. Hotels, airlines, and cruiselines allow customers to make reservations over the Internet. Exhibit 1.1 describes some of the successful ﬁrms that have been created to capitalize on e-business. Notice that these businesses started Exhibit 1.1 Successful Internet Businesses Business Name Business Description How the Business Was Created 1. Amazon.com This online bookseller is frequently cited as an Jeff Bezos founded the company in 1994. Bezos Internet success story. Customers can purchase quit his job as vice president of a Wall Street books and music and participate in auctions at ﬁrm, moved to Seattle, and started the busi- its website. Amazon’s innovative bookselling ness in his garage. When Amazon.com opened idea allows the company to offer popular titles for business in July 1995, Bezos himself fre- at deeply discounted prices due to low over- quently dropped off the packages at the post head costs. ofﬁce. Bezos’s estimated net worth (value of his house and other assets after paying off any debts) is now $10 billion. 2. Yahoo! This Internet search engine is the most visited David Filo and Jerry Yang were Ph.D. students site on the Web. It has evolved to offer a wide at Stanford who had put together an electronic variety of other products to attract users. directory of their favorite websites. It was es- Free e-mail, Web page hosting, and custom- sentially a list of their bookmarks that they designed start-up pages are just a few of the titled Yahoo! (which stands for Yet Another Hi- options available. Revenues are generated erarchical Ofﬁcious Oracle). The site was gener- through advertising sales. ating so much trafﬁc that the students dropped out of school and launched their company in 1995. Each of the founders now has a net worth of nearly $4 billion. 3. eBay eBay is an online auction service that enables The company evolved out of a method that users to sell goods to each other. The person- Pierre Omidyar devised to help his girlfriend to-person services attract a wide variety of collect Pez candy dispensers. By 1996, the vol- goods, most of them used. Sellers develop a ume of goods traded forced Omidyar to quit reputation, which creates some level of trust his job at General Magic and devote all his and excuses eBay from any responsibility. The time to the company. The company has been company proﬁts by charging fees based on the proﬁtable since 1996. sale price. 4. Google Google became very popular as a search en- In 1996, Sergey Brin and Larry Page were grad- gine because of its ability to effectively accom- uate students in Stanford’s computer science modate requests by users who wanted to department. They were interested in tracking search the Internet. This substantial reliance on the success of various websites. They then at- Google meant that Google could sell advertis- tempted to create a search engine that would ing on its website or charge websites that want account for the popularity of websites when to have “sponsored links” displayed by Google identifying websites that ﬁt search terms. The in response to speciﬁc search terms. value in this search engine is that it screened out websites that were less likely to satisfy the search. This led to the creation of Google. On August 18, 2004, Google went public. At that time, Brin and Page still retained ownership of some shares, making their net worth more than $3 billion each. CHAPTER I MOTIVES AND FUNC TIONS OF A BUSINESS 9 out very small and were created to offer a product or service that was not being provided by other ﬁrms. Thus, these new businesses were created to accommodate the needs or preferences of customers. As these e-businesses were created, many existing ﬁrms recognized that they should develop their own e-business to satisfy their customers. Thus, the innovations of some e-businesses transformed the way that all ﬁrms con- duct business. Many ﬁrms applied e-business to facilitate their existing operations. The Internet allows for easier communication from the ﬁrm to the con- sumer, from the ﬁrm to another ﬁrm, and from the consumer to the ﬁrm. Information ﬂows freely between ﬁrms and consumers, avoiding the de- lays and disrupted business transactions that used to occur when the two parties were not available at the same time to communicate. Firms are also using e-business to complement rather than replace their traditional oper- ations. Consumers who want to use traditional channels to make orders can still do so, while other consumers can communicate their orders elec- tronically. Thus, even if a ﬁrm is not classiﬁed as an Internet company, it can still use e-business to enhance its value. Although the use of the Internet to serve consumers has attracted con- siderable attention, the Internet is also having an important impact on the way businesses serve other businesses (referred to as “business-to-business e-commerce” or “B2B e-commerce”). Business-to-business e-commerce might be used, for example, when a ﬁrm needs construction work to re- pair its facilities, wants an outside ﬁrm to conduct seminars to improve relationships among employees, or requires speciﬁc supplies for its pro- duction process. The ﬁrm can request bids online from several businesses that may meet its needs and then select the ﬁrm that submits the best bid. This process is much easier and faster than calling various ﬁrms and wait- ing for return phone calls. Furthermore, having to send a message online forces the bidders to specify their bids in writing. Business-to-business e-commerce has already reduced the expenses associated with transactions between ﬁrms and is expected to reduce them even further once all ﬁrms take full advantage of the technology. In par- ticular, ﬁrms that rely on other businesses for supplies, transportation ser- vices, or delivery services can reduce their expenses substantially by using business-to-business e-commerce. Entrepreneurship entrepreneurship Entrepreneurship involves the creation of business ideas and the willing- the creation of business ideas and ness to accept risk. Entrepreneurs attempt to identify business opportuni- the willingness to take risk; the act ties. When they ﬁnd one, they invest some of their own money to create of creating, organizing, and man- a business with the expectation that they will earn adequate proﬁts as a aging a business reward for their efforts. However, they face the risk that the proﬁts of entrepreneurs the business may not be as high as expected. In fact, if expenses exceed people who organize, manage, revenue, the proﬁts may be negative and the business could fail. In a free- and assume the risk of starting a market economy, many businesses may be created within the same indus- business try, which results in intense competition. In this situation, a ﬁrm that charges too high a price for its product may fail because customers will switch to its competitors. Similarly, a ﬁrm that is not well managed may fail because its expenses are too high. This risk of failure can reduce the mo- tive to create a business. Entrepreneurs realize that if they overestimate the potential proﬁtabil- ity of a business or manage the business poorly, they will lose the money 10 PA R T I BUSINESS ENVIRONMENT Out of Business Decision Making How to Use the Factors of Production ifferent businesses use the factors of production in different ways. First, 4 Eyes DVD (in- D troduced at the beginning of the chapter) uses natural resources (land) for its business. The decision about natural resources determined the location of the DVD rental outlet. The location decision has an impact on the proﬁts of the business because customers want convenience. Second, human resources (employees) are needed to decide which DVDs to purchase each week for the purpose of renting them out. The human resources also serve the cus- tomers who wish to rent DVDs. The speciﬁc human resources who are hired can affect the degree of customer service and therefore the performance of 4 Eyes DVD. If the employ- ees order the proper DVDs, they can enhance the revenue earned from DVD rentals. There- fore, the decision regarding human resources affects the proﬁts of the business. Third, 4 Eyes DVD needs capital (physical facilities) so that customers can review the selection of DVDs and choose the DVDs they wish to rent. 4 Eyes DVD’s decisions about its physical facilities will inﬂuence the desirability of its DVD outlet. Those decisions will also affect its cost and, therefore, its proﬁts. Fourth, the creation of the DVD rental business was due to entrepreneurship. The owner, Juan Gomez, recognized an opportunity to create a business that would serve cus- tomers and invested his own money in the business. He may earn a large income from 4 Eyes DVD if it is successful, but he could also lose his entire investment if the business fails. The manner in which this entrepreneur uses the factors of production will determine whether the business will be a success. 1. How will the proﬁts of 4 Eyes DVD be affectedifit hires either too many human resources? Whatifit hires too few human resources (such that customers receive poor service)? 2. How will the proﬁts of 4 Eyes DVD be affected if its physical facilities are too small (such that it does not have room for its selection of DVDs to rent)? What if its physical facilities are much larger than is necessary? ANSWERS: 1. If it hires too many human resources, its proﬁts will be reduced because its expenses will be excessive. If it does not hire enough human resources, its proﬁts will be reduced because its revenue will be lower. 2. If its facilities are too small, its proﬁts will be reduced because its revenue will be lower. If its facilities are too large, its proﬁts will be lower because its expenses from leasing space will be excessive. CHAPTER I MOTIVES AND FUNC TIONS OF A BUSINESS 11 that they invested. Thus, they will incur a direct penalty if they make a bad decision. To limit their risk, entrepreneurs should be cautious and realistic before deciding to invest their money to create a new business. However, those entrepreneurs who develop good business ideas that serve consumer needs and who manage their business efﬁciently may be rewarded with large proﬁts. 3 Key Stakeholders in a Business Every business involves transactions with people. Those people are af- Identify the key fected by the business and therefore have a stake in it. They are referred to stakeholders that are as stakeholders, or people who have an interest (or stake) in the business. Five types of stakeholders are involved in a business: involved in a business. 왘 Owners 왘 Creditors 왘 Employees stakeholders people who have an interest in a 왘 Suppliers business; the business’s owners, 왘 Customers creditors, employees, suppliers, and customers Each type of stakeholder plays a critical role for ﬁrms, as explained next. Owners Every business begins as a result of ideas about a product or service by one or more entrepreneurs. As explained earlier, entrepreneurship is the act of creating, organizing, and managing a business. Today, more than 8 million people in the United States are entrepreneurs. Entrepreneurs are critical to the development of new business because they create new products (or improve existing products) desired by consumers. People will be willing to create a business only if they expect to be re- warded for their efforts. The rewards of owning a business come in various forms. Some people are motivated by the chance to earn a large income. Others desire to be their own boss rather than work for someone else. Many people enjoy the challenge or the prestige associated with owning a business. Most business owners would agree that all of these characteris- tics motivated them to start their own business. A recent survey by the Center for Entrepreneurial Leadership found that 69 percent of high school students were interested in starting their own business. Yet, about 86 percent of the students rated their business knowledge as very poor to fair. People need to learn how a business oper- ates before they set out to create a business. How Ownership Spreads An entrepreneur who creates a business initially serves as the sole owner. Yet, in order to expand, the business may need more funding than the entrepreneur can provide. Consequently, the en- trepreneur may allow other people to invest in the ﬁrm and become co- owners. When the ownership of the ﬁrm is shared, the proportion of the ﬁrm owned by the existing owners is reduced. Consider a bakery that two people created with a $100,000 investment each. Each person owns one- half of the ﬁrm. They can obtain more funds by allowing a third person to invest in the ﬁrm. If the third person invests $100,000, each of the three 12 PA R T I BUSINESS ENVIRONMENT SMALL BUSINESS SURVEY Background of Owners In a recent National Small Business poll conducted for the NFIB Research Founda- tion, small business owners were asked how many years they worked for another ﬁrm before they began their own business. Their responses are shown here: 1–2 years 3–5 years 3% 9% Never 34% 6–10 years 18% More than 11–20 years 20 years 21% 15% Notice the large proportion of owners who never worked for any other business be- fore starting their own business. Those business owners who previously worked for another business were asked what type of ﬁrm they worked for before starting their own business. Their re- sponses are shown here: Large ﬁrm Medium-size ﬁrm (more than 1,000 (100–1,000 employees) employees) 17% 26% Small businesses 57% people will own one-third of the ﬁrm. Any proﬁts (or earnings) of the ﬁrm that are distributed to the owners will be shared among three owners. By accepting investment from more owners, however, the ﬁrm may be able stock to expand its business so that the original owners beneﬁt despite their de- certiﬁcates of ownership of a creased share of ownership. business Many ﬁrms have grown by issuing stock to other investors; that is, they stockholders (shareholders) essentially sell a portion of the ownership to these investors. The stock re- investors who become partial ceived by investors is a certiﬁcate representing ownership of the speciﬁc owners of ﬁrms by purchasing the business. The investors who purchase stock are called stockholders (or ﬁrm’s stock shareholders) of those ﬁrms. The funds received by a ﬁrm that issues stock CHAPTER I MOTIVES AND FUNC TIONS OF A BUSINESS 13 S M A L L B U S I N E S S S U R V E Y (Continued) Business owners were also asked how many years of experience they had (working for other ﬁrms) in producing, distributing, or selling the same products or services as those that they sell now. Their responses are shown here: 1–5 years 10% 6–10 years 15% None 48% 11–20 years 18% More than 21 years 9% Notice the large proportion of owners who had no experience with the products that their business sells before they became the owner. This suggests that they were able to adapt their business skills to the product. The owners were also asked to describe their educational background. Their re- sponses are shown here: Vocational school 4% Some College diploma college 35% 24% High school diploma or less Advanced degree 19% 18% These results conﬁrm that many entrepreneurs have not had a highly specialized education. can be used to expand the business. Large ﬁrms such as Cisco Systems, IBM, and General Motors now have millions of stockholders, but when they were created, they were small businesses. When a ﬁrm’s performance improves, its value may increase as well, as reﬂected in a higher stock price for those who own the stock. Stockhold- ers can sell their stock to other investors whenever they want. They beneﬁt when a ﬁrm performs well because they will be able to sell the stock at a higher price than they paid for it if the ﬁrm’s value rises. As an extreme ex- ample, stockholders of Dell, Inc., have doubled their investment in some years because Dell performed so well. At the other extreme, stockholders 14 PA R T I BUSINESS ENVIRONMENT The executives of public companies communicate to their shareholders not only through ﬁnancial reports but also during the annual share- holder meeting, such as this one by Daimler-Chrysler. © JOCHEN ECKEL /BLOOMBERG NEWS/LANDOV who owned the stock of ﬁrms such as Enron and Global Crossing at the time these ﬁrms went bankrupt lost their entire investment. A ﬁrm has a responsibility to the stockholders who have invested funds. It is expected to invest those funds in a manner that will increase its performance and value. Consequently, it should be able to provide the stockholders with a decent return on their investment. Some ﬁrms per- form much better than others, however, so investors must carefully assess a ﬁrm’s potential performance before investing in its stock. Creditors Firms typically require ﬁnancial support beyond that provided by their owners. When a ﬁrm is initially created, it incurs expenses before it sells a single product or service. For example, it may have to buy machinery, rent a facility, and hire employees before it has any revenue. In the ﬁrst several months, its expenses may exceed its revenue even if it is well managed. Therefore, the ﬁrm cannot rely on cash from sales to cover its expenses. The owners of a new business may initially have to rely on friends or fam- ily members for credit because their business does not have a history that proves it is likely to be successful and therefore able to pay off its credit in a timely manner. Even ﬁrms that have existed for a long time, such as Little Caesars Pizza, Disney, and Nike, need ﬁnancial support as they attempt to expand. A fast-growing business such as Little Caesars Pizza would not generate sufﬁcient earnings to cover new investment in equipment or buildings. Many ﬁrms that need funds borrow from ﬁnancial institutions or indi- creditors viduals called creditors, who provide loans. Bank of America, SunTrust ﬁnancial institutions or individuals Bank, and thousands of other commercial banks commonly serve as cred- who provide loans itors for ﬁrms. Firms that borrow from creditors pay interest on their loans. The amount borrowed represents the debt of the ﬁrm, which must be paid back to the creditors along with interest payments over time. Large ﬁrms such as General Motors and DuPont have billions of dollars in debt. Creditors will lend funds to a ﬁrm only if they believe the ﬁrm will perform well enough to pay the interest on the loans and the principal CHAPTER I MOTIVES AND FUNC TIONS OF A BUSINESS 15 One reason for the success (amount borrowed) in the of Southwest Airlines is its future. The ﬁrm must con- attention to satisfying its vince the creditors that it customers. will be sufﬁciently proﬁt- able to make the interest and principal payments. Employees Firms hire employees to conduct their business op- erations. Some ﬁrms have only a few employees; oth- ers, such as General Mo- © NOAH BERGER /BLOOMBERG NEWS/LANDOV tors and IBM, have more than 200,000 employees. Many ﬁrms attribute their success to their employ- ees. Consider the following statements that ﬁrms made about their employees in recent annual reports: “Sara Lee is determined to be an employer of choice for highly talented people, retaining and attracting world-class indi- viduals who have a passion to excel, strong ethical values and a driving en- trepreneurial character.” —Sara Lee “We continually invest in our people—the source of our innovation and com- petitiveness—who strive each day to ﬁnd new products and technologies that will signiﬁcantly improve everyday living.” —The Dow Chemical Company Those employees who are responsible for managing job assignments of managers other employees and making key business decisions are called managers. employees who are responsible The performance of a ﬁrm is highly dependent on the decisions of its man- for managing job assignments of agers. Although managers’ good decisions can help a ﬁrm succeed, their other employees and making key bad decisions may cause a ﬁrm to fail. business decisions Goals of Managers The goal of a ﬁrm’s managers is to maximize the ﬁrm’s value and, therefore, to maximize the value of the ﬁrm’s stock. Maximiz- ing ﬁrm value is an obvious goal for many small businesses since the owner and manager are often the same. In contrast, most stockholders of a pub- licly traded ﬁrm do not work for the ﬁrm. They rely on the ﬁrm’s managers to maximize the value of the stock held by stockholders. The following statements from recent annual reports illustrate the emphasis ﬁrms place on maximizing shareholder value: “We are not promising miracles, just hard work with a total focus on why we’re in business: to enhance stockholder value.” —Zenith Electronics 16 PA R T I BUSINESS ENVIRONMENT “We believe that a fundamental measure of our success will be the share- holder value we create over the long term.” —Amazon.com “Everything we do is designed to build shareholder value over the long haul.” —Wal-Mart “We create value for our share owners, and that remains our true bottom line.” —The Coca-Cola Company Maximizing the ﬁrm’s value encourages prospective investors to become shareholders of the ﬁrm. To illustrate how managers can enhance a ﬁrm’s value, consider the case of Dell, Inc., which created an efﬁcient system for producing com- puters. This resulted in low costs and allowed Dell to provide high-quality computers at low prices. Over time, Dell’s sales increased substantially, as did its proﬁts. The ability of Dell’s managers to control costs and sell com- puters at low prices satisﬁed not only its customers but also its owners (shareholders). Suppliers Firms commonly use materials to produce their products. For example, automobile manufacturers use steel to make automobiles, while home builders need cement, wood siding, and many other materials. Firms can- not complete the production process if they cannot obtain the materials. Therefore, their performance is partially dependent on the ability of their suppliers to deliver the materials on schedule. Customers Firms cannot survive without customers. To attract customers, a ﬁrm must provide a desired product or service at a reasonable price. It must also en- sure that the products or services produced are of adequate quality so that Gap has created a very successful business as a retail clothing store that targets young customers. © JUSTIN SULLIVAN/GETTY IMAGES CHAPTER I MOTIVES AND FUNC TIONS OF A BUSINESS 17 customers are satisﬁed. If a ﬁrm cannot provide a product or service at the quality and price that customers desire, customers will switch to the ﬁrm’s competitors. Motorola and Saturn (a division of General Motors) attribute some of their recent success to recognizing the types of products that con- sumers want. These ﬁrms also are committed to quality and to pricing their products in a manner that is acceptable to customers. Summary of Key Stakeholders Firms rely on entrepreneurs (owners) to create business ideas and possibly to provide some ﬁnancial support. They rely on other owners and creditors to provide additional ﬁnancial support. They rely on employees (including managers) to produce and sell their products or services. They rely on sup- pliers to provide the materials needed for production. They rely on cus- tomers to purchase the products or services they produce. The president of Goodyear Tire and Rubber Company summarized the relationship be- tween a ﬁrm and its stakeholders in a recent annual report: “Last year I reafﬁrmed our values—protecting our good name, focusing on cus- tomers, respecting and developing our people [employees], and rewarding investors.” To illustrate the roles of stakeholders, reconsider the example of the DVD rental business. The owner who created the business makes decisions about its location, the types of DVDs to offer for rent, whether to sell other products (such as video games), and the prices to charge for DVD rentals and other products. The business needs creditors to support it with fund- ing so that it has sufﬁcient funds to cover its expenses. It needs employees to receive deliveries of new DVDs, organize them, and serve customers. It needs suppliers to supply the DVDs. Finally, the business needs customers to generate revenue. Interaction among Stakeholders The interaction among a ﬁrm’s owners, em- ployees, customers, suppliers, and creditors is illustrated in Exhibit 1.2. Managers decide how the funds obtained from owners, creditors, or sales to customers should be utilized. They use funds to pay for the resources (including employees, supplies, and machinery) needed to produce and promote their products. They also use funds to repay creditors. The money dividends left over is proﬁt. Some of the proﬁt (or earnings) is retained and rein- income that the ﬁrm provides to vested by the ﬁrm. Any remaining proﬁt is distributed as dividends, or in- its owners come that the ﬁrm provides to its owners. Products or Exhibit 1.2 $ (Invested) Services Interaction among Owners, Owners Firm Run by Customers of Firm Its Employees Employees, Customers, $ (Dividends) $ (Purchases) Suppliers, and Creditors $ (P ay m en s) ts ) ns ts an en oa Su fo Lo ym rS pp (L of pa up $ lie e pl (R s ie $ s) Creditors Suppliers 18 PA R T I BUSINESS ENVIRONMENT Decision Making How Business Decisions Affect Stakeholders he decisions of a business affect its performance, which in turn affects all of its stake- T holders. Consider 4 Eyes DVD introduced earlier. If it makes good business decisions, its proﬁts will be higher, and the entrepreneur who owns the business will receive higher proﬁts. It will have sufﬁcient revenue to pay any interest expenses on loans from creditors. It can afford to pay reasonable compensation to its employees and may even want to hire more employees if it expands over time. It can afford to continue to pay its suppliers (the ﬁrms that sell it DVDs) and will be able to order more supplies in the future. 1. Explain how the decision to borrow too much money might prevent 4 Eyes DVD from satisfying its stakeholders. 2. If the owner of 4 Eyes DVD hires his sons as employees and pays them excessive salaries, how would this affect the other stakeholders? ANSWERS: 1. It may be unable to pay its interest expenses on the loan each month. The business would fail, and any pay- ments to employees, suppliers, or even the entrepreneur (as income) would be discontinued. 2. Because of overpaying those employees, 4 Eyes DVD may not have sufﬁcient funds for its other stakeholders. 4 The Business Environment The success of a business is generally dependent on the business environ- Describe the business ment. Even after a business is created, its entrepreneurs and managers environment to which must continually monitor the environment so that they can anticipate how the demand for its products or its cost of producing products may change. a ﬁrm is exposed. The business environment can be segmented into the following parts: 왘 Social environment 왘 Industry environment 왘 Economic environment 왘 Global environment Social Environment The social environment, which includes demographics and consumer pref- erences, represents the social tendencies to which a business is exposed. demographics The demographics, or characteristics of the population, change over time. characteristics of the human pop- As the proportions of children, teenagers, middle-aged consumers, and ulation or speciﬁc segments of the senior citizens in a population change, so does the demand for a ﬁrm’s population products. Thus, the demand for the products produced by a speciﬁc busi- ness may increase or decrease in response to a change in demographics. For example, an increase in the elderly population has led to an increased demand for many prescription drugs. Changes in consumer preferences over time can also affect the demand for the products produced. Tastes are highly inﬂuenced by technology. For example, the availability of pay-per-view television channels may cause some consumers to stop renting DVDs. The ability of consumers to download music may cause them to discontinue their purchases of CDs in retail stores. As technology develops, demand for some products increases, while demand for other products decreases. Many businesses closely monitor changes in consumer preferences so that they can accom- CHAPTER I MOTIVES AND FUNC TIONS OF A BUSINESS 19 modate the changing needs of consumers and increase their proﬁtability as a result. Industry Environment The industry environment represents the conditions within the ﬁrm’s in- dustry to which the ﬁrm is exposed. The conditions in each industry vary according to the demand and the competition. Firms beneﬁt from being in an industry that experiences a high consumer demand for its products. For example, the demand for cell phones is very high. However, industries that have a high demand for their products also tend to have substantial com- petition because many ﬁrms enter the industry. Intense competition is good for consumers because it forces ﬁrms to keep their prices relatively low in order to compete. For ﬁrms, however, competition may result in lower revenue and, therefore, lower proﬁts. Economic Environment Economic conditions have a strong impact on the performance of each business. When the economy is strong, employment is high, and compen- sation paid to employees is also high. Since people have relatively good in- come under these conditions, they purchase a large amount of products. The ﬁrms that produce these products beneﬁt from the large demand. They hire many employees to ensure that they can produce a sufﬁcient amount of products to satisfy the demand. They can also afford to pay high wages to their employees. When the economy is weak, ﬁrms tend to lay off some of their em- ployees and cannot afford to pay high wages. Since people have relatively low income under these conditions, they purchase a relatively small amount of products. The ﬁrms that produce these products are adversely affected because they can not sell all the products that they produce. Con- sequently, they may need to lay off some employees. Under these circum- stances, some ﬁrms fail, and all of their employees lose their jobs. The unemployment rate rises as a result. The economic environment is more fully described in Chapter 3. Global Environment The global environment may affect all ﬁrms directly or indirectly. Some ﬁrms rely on foreign countries for some of their supplies or sell their prod- ucts in various countries. They may even establish subsidiaries in foreign countries where they can produce products and sell them. Even if a ﬁrm is not planning to sell its products in foreign countries, it must be aware of the global environment because it may face foreign competition when it sells its products locally. Furthermore, global economic conditions can affect local economic conditions. If economic conditions weaken in foreign countries, the foreign demand for U.S. products will decrease. Consequently, sales by U.S. ﬁrms will decrease, and this may result in some layoffs. The general income level in the United States will decline, and U.S. consumers will have less money to spend. The demand for all products will decline, even those that are sold only in the United States. Thus, even ﬁrms that have no international busi- ness can be affected by the global environment. The global environment is described more fully in Chapter 4. 20 PA R T I BUSINESS ENVIRONMENT SMALL BUSINESS SURVEY How Business Owners Use Their Time In a recent National Small Business poll conducted for the NFIB Research Founda- tion, owners of small businesses were asked how they allocate their time toward a variety of business tasks. Their responses are shown here: Personnel (recruiting, training, Finance evaluation) 6% 3% Marketing 22% Operations Other (production) 17% 42% Planning and strategy 10% Decision Making Responding to the Business Environment ecall that 4 Eyes DVD was created because there was very limited competition for DVD R rentals in the town. The business environment can change over time, however, and ﬁrms will have to respond to those changes in order to survive. 1. Suppose that the social environment changes such that consumers prefer pay-per-view television to renting DVDs. How will the proﬁts of 4 Eyes DVD be affected? 2. Suppose that a new DVD rental outlet opens in the center of town. How will the proﬁts of 4 Eyes DVD be affected? 3. What can 4 Eyes DVD do to counter a new competitor? ANSWERS: 1. The change in the social environment will reduce consumer demand for DVD rentals, which will reduce the rev- enue and therefore the proﬁts of 4 Eyes DVD. 2. The opening of a new DVD rental outlet will reduce the revenue and proﬁts of 4 Eyes DVD. 3. 4 Eyes DVD can counter a new competitor by reducing its prices on its DVD rentals and by offering other products such as DVDs for sale. However, the effectiveness of these strategies may depend on the prices charged by the new competitor. 5 Key Types of Business Decisions The key types of decisions involved in running a business can be classiﬁed Describe the key types as management, marketing, and ﬁnance decisions. Management is the of business decisions. means by which employees and other resources (such as machinery) are used by the ﬁrm. Marketing is the means by which products (or services) are developed, priced, distributed, and promoted to customers. Finance is the means by which ﬁrms obtain and use funds for their business management operations. means by which employees and A ﬁrm’s decisions are commonly based on data and information, which other resources (such as machin- are provided by its accounting and information systems. Accounting is the ery) are used by the ﬁrm summary and analysis of the ﬁrm’s ﬁnancial condition and is used to make CHAPTER I MOTIVES AND FUNC TIONS OF A BUSINESS 21 marketing various business decisions. Information systems include information tech- means by which products (or nology, people, and procedures that provide appropriate information so services) are developed, priced, that the ﬁrm’s employees can make business decisions. Business majors distributed, and promoted to take courses in management, marketing, and ﬁnance so that they can un- customers derstand the key decisions made by a business and how to make these de- ﬁnance cisions. They take courses in accounting and information systems so that means by which ﬁrms obtain they can understand how to analyze data and use their analysis to make and use funds for their business decisions. operations accounting summary and analysis of the How Business Decisions Affect Performance ﬁrm’s ﬁnancial condition Examples of management, marketing, and ﬁnance decisions are provided information systems in Exhibit 1.3. Notice from this exhibit that management decisions focus include information technology, on the use of resources, marketing decisions focus on the products, and people, and procedures that work ﬁnance decisions focus on obtaining or using funds. together to provide appropriate As mentioned earlier, a ﬁrm’s performance is commonly measured by information to the ﬁrm’s employ- its earnings (or proﬁts). The effect that each type of business decision has ees so they can make business decisions on a ﬁrm’s earnings is illustrated in Exhibit 1.4. Since management deci- sions focus on the utilization of employees and other resources, they affect the amount of production expenses incurred. Since marketing decisions focus on strategies that will make the product appealing to customers, they affect the ﬁrm’s revenue. Marketing decisions also inﬂuence the amount of expenses incurred in distributing and promoting products. Since ﬁnance decisions focus on how funds are obtained (borrowing money versus issu- ing stock), they inﬂuence the amount of interest expense incurred. As the management, marketing, and ﬁnance decisions affect either a ﬁrm’s rev- enue or expenses, they affect the earnings and therefore the performance of the ﬁrm. Although some decisions focus on only one function, many decisions require interaction among management, marketing, and ﬁnance. For ex- ample, production managers of a cell phone manufacturer receive sales projections from the marketing managers to determine how much of the product to produce. The ﬁnance managers must receive the planned Exhibit 1.3 Common Business Decisions Management Decisions 1. What equipment is needed to produce the product? 2. How many employees should be hired to produce the product? 3. How can employees be motivated to perform well? Marketing Decisions 1. What price should be charged for the product? 2. Should the product be changed to be more appealing to customers? 3. Should the ﬁrm use advertising or some other strategy to promote its product? Finance Decisions 1. Should ﬁnancial support come from the sale of stock or from borrowing money? Or a combination of both? 2. Should the ﬁrm attempt to obtain borrowed funds for a short-term period (such as one year) or a long-term period? 3. Should the ﬁrm invest funds in a new business project that has recently been proposed (such as expansion of its exist- ing business or development of a new product), or should it use these funds to repay debt? 22 PA R T I BUSINESS ENVIRONMENT Exhibit 1.4 Demand for How Business Decisions Revenue Firm’s Products Affect a Firm’s Earnings Management Production Decisions Expenses Marketing Marketing Decisions Expenses – Expenses Finance Interest Decisions Expenses = Earnings production volume from the production managers to determine how much funding is needed. How Some Business Functions Enhance Decision Making Proper business decisions rely on accounting and information systems. Accounting Managers of ﬁrms use accounting to monitor their operations and to report their ﬁnancial condition to their owners or employees. They can also assess the performance of previous production, marketing, and ﬁnance decisions. They may even rely on accounting to detect inefﬁcient uses of business resources that can be eliminated. Consequently, a ﬁrm’s accounting function can be used to eliminate waste, thereby generating higher earnings. Information Systems Firms use information systems to continually update and analyze information about their operations. This information can be used by the ﬁrm’s managers to make business decisions. In addition, the information can be used by any employee within the ﬁrm who has access to a personal computer. For example, FedEx uses information on its com- puter system to track deliveries and determine when packages will arrive at their destination. Applying the Key Types of Decisions to a Single Business To illustrate the key types of business decisions, reconsider the example of the DVD rental business. The management decisions of this business de- termine how its employees and other resources should be used. The typi- cal management decisions of this ﬁrm are: 왘 How many employees should it hire? 왘 What salary should it pay each employee? 왘 What should be the job description of each employee? 왘 To whom should each employee report within the business? 왘 How should the business motivate its employees to perform well? 왘 How should it use the space in its store? 왘 Should it charge a late fee? CHAPTER I MOTIVES AND FUNC TIONS OF A BUSINESS 23 The marketing decisions of the DVD rental business determine how the DVD rentals should be priced, distributed, and promoted. The typical mar- keting decisions of this ﬁrm are: 왘 What is the proﬁle of the typical customer who will rent its DVDs? 왘 Should it charge a membership fee to rent DVDs? 왘 What price should it charge per rental? 왘 Should it allow a discount for frequent customers? 왘 Should it consider distributing DVD rentals by delivery or through the Internet? 왘 Should it advertise its business? If so, where should it advertise? The ﬁnance decisions of the DVD rental business determine how it obtains funds and uses the funds it obtains. The typical ﬁnance decisions of this ﬁrm are: 왘 How much money should it borrow? 왘 Where should it apply to obtain a loan? 왘 Should it use some of the borrowed funds to expand? 왘 How can it expand its business so that its value will increase? The DVD rental business relies on accounting and information systems to report its ﬁnancial condition on a periodic basis. This information would be used to help make some of the decisions described above. For example, by monitoring how its revenue changes in response to a change in the mem- bership fee, the business can decide what fee is most appropriate. Its deci- sion about how much money to borrow is based on how much money it has (as reported by the accounting function) versus what it needs to meet its business objectives. Results of Bad Business Decisions When ﬁrms make bad decisions, their performance suffers. Exhibit 1.5 provides examples of how bad management, marketing, or ﬁnance deci- sions can result in poor performance. In each example, the bad decision Decision Making Integrating Business Functions any business functions are integrated, meaning that one function is dependent on M other functions. Consider the case of 4 Eyes DVD. The management decision about how much space to rent will inﬂuence the ﬁnance decision about of how much money the business needs to borrow, because renting a larger store will be more costly and require more ﬁnancing. Its marketing decision regarding pricing and advertising may affect the demand for its DVD rentals. If the demand is high, the store will require more employees to provide customer service. Thus, the marketing decision inﬂuences the management deci- sion of how many employees to hire. 1. Explain whether the management decisions of 4 Eyes DVD affect its revenue or its expenses, or both. 2. Explain whether the ﬁrm’s marketing decisions affect its revenue or its expenses, or both. ANSWERS: 1. Most management decisions affect the ﬁrm’s level of expenses, but they can also have an impact on the service to customers and therefore may affect the revenue as well. 2. Most marketing decisions affect the ﬁrm’s level of expenses, but they can also affect revenue because they are typically intended to increase sales volume and therefore revenue. 24 PA R T I BUSINESS ENVIRONMENT Exhibit 1.5 Management Impact on Impact on How Bad Business Decisions Decision Firm’s Operations Proﬁts Affect the Proﬁts Earned by the Owners Hire too many Excessive expenses employees Inefﬁcient production Hire employees who and possibly lower lack proper skills revenue Pay excessive salaries to Excessive expenses employees Low employee morale Pay insufﬁcient and inefﬁcient salaries to employees production Utilize space poorly Excessive expenses Marketing Impact on Decision Firm’s Operati

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